Glenorchy Capital

The behaviour of smart money suggests that the Greek crisis is now a mere storm in a tea cup. OK so what is smart money and how do we track it? Well in essence there is no “smart” money, that is, there is no group of players (with consistent members that is) who consistently makes money and can thus be termed smart money. However, we can identify areas of the market which generally lead the mainstream investor. Those areas of the market are typically off the radar to the average investor, in fact the average investor would not know of them or their significance let alone how to invest in them.

Let’s look at a three areas of the market that would be indicative of what the smart money is up to; small cap equities, credit default swaps, and yields on bonds relative to US treasuries:

Beauty is in the eye of the beholder……we see that the small cap market in Greece has stabilised and showing signs of turning higher. In all probability it would seem that selling pressure has been exhausted in the equity market. Due to their relative illiquidity you don’t buy small caps unless you are sure that the general market has bottomed.

The cost of insurance against default on Greek Sovereign debt has declined materially

An so too has the spread between the Greek 10yr and US 10yr, interesting how it got to a maximum of 350bps the same as that level reached during the credit “crisis” in 2008. Yes very interesting indeed.

OK we don’t place any importance on the behaviour of any one indicator, but when all three confirm each other we have something!

The crisis in Greece is passing and as a consequence the Euro is about to make a comeback and given the amount of short positions it promises to be one of the biggest comebacks in the history of the Euro………believe it or not!

Just a few months ago weakness in the USD resulted in strength in commodities and equities and weakness in US Treasuries. But now all that has changed…….although so it seems! What will happen if the USD Index falls materially lower? Well we think it is quite likely that the correlations between asset classes will once again rise to where they were towards the end of last year.

We are rather confident that the US Dollar Index is setting itself up for a rather significant fall. Sentiment toward the Euro which constitutes some 55% of the Index remains at record low levels. Just where is that marginal seller of the Euro going to come from? It appears that the PIGs crisis is passing with Credit Default Swaps coming back to earth as are the yields on government debt of Greece, Italy, Spain and Portugal. Also bearish sentiment towards the GBP is more or less at record levels. Being short the GBP and Euro now would have to rank up there with the most crowded trades in the world. Experience tells us that crowded trades ultimately end up being losing trades for the majority of participants. There is also something else that one should consider with respect to the USD. If you look at the performance of the USD against emerging market currencies then it is not looking too healthy. In fact many emerging market currencies are already trading at multi-week highs against the USD. And where emerging market currencies go against the USD……..the USD Index will follow……….and commodities.

Judging by the mood of the market buying real estate stocks would have to be up there with the most dumbest of things to do! Yet seemingly against all odds the real estate sector, in its various shapes and forms, is one of the star performers of the stock market this year! What is driving this behaviour? Well I guess the media of popular opinion will inform us over the weeks to come as to the “real” reasons. Our suspicions are that the price performance is more to do with inflationary fears than anything else. In times of high inflation you don’t want to have money lying around in the bank rather you want it to be invested in hard assets (things that hurt when dropped on your foot) and yes that includes “bricks and mortar” as well!

Just how strong is the real estate sector? We believe that the behaviour of small cap stocks gives a true representation of the behaviour of a market or sector. We find that problems with markets often show up first in small caps before large caps. Anyway the graph below of the S&P 600 REIT sector suggests that the strong showing in the big real estate ETFs such as IYR is not just a reflection of the behaviour of a few large caps rather it is a broad based phenomenon.

Crunch time perhaps? We are coming to a critical juncture in US financial markets and as strange as it may seem it appears that equity markets are leading the way. Equities, as per the Vanguard Total Market Index at least, are in a perfect up trend. In fact small caps as per the Russell 2000 are now trading at multi-week highs. This typically is not what you would expect if this was a false rally in equity markets.

We are still of the feeling that there are few genuine bulls of the equity market, let us not forget the total “stop-out” of bullish commentary in early – mid February! If you put a gun to investors heads and asked them if they thought equity markets would close the year 20% higher or 20% lower from current levels, the vast majority would say 20% lower (remember if they sit on the fence the trigger gets pulled). OK that is rather drastic but I hope you get the point – this still remains one of the most hated rallies in modern history…..perhaps that is why equities have advanced the degree to which they have over the last 18 months and why they are likely to continue to rally over the course of this year. Not until there is a general complacency towards risk or a universal belief in a bull market in equities will the rally run into genuine problems.

We think where equities go, so too will commodities. Yes commodities remain about 10% away from their highs reached at the start of the year but to expect the CRB to be at or close to multi-week highs given the recent strength of the USD Index is somewhat unreasonable. Perhaps the king-pin to commodity prices is US Treasuries (TLT). A breakdown in the US Treasury markets is liable to propel commodities higher to multi-week highs. One reason which few realise is that a rise in treasury yields would increase the carry costs of holding commodities for physical delivery and thereby dramatically reduce the contango condition of many commodity markets which have been effectively held down the near dated contracts (on which many ETFs are based). Whether or not a breakdown in US Treasuries pulls down the USD Index remains to be seen, but with record short positions against the Euro (long the USD) we don’t think that it would take much to trip the USD Index.

While everyone is transfixed on the impending “default” by the Greeks and problems of the Portuguese, has anyone noticed that Credit Default Swaps on the PIGS government bonds (and Greece in particular) are lower than were they were trading at on the 1^st of February? Could we go so far as to say that the European CDS market for sovereign debt is suggesting that the EU Debt Storm (call it what you will) is passing?

And what if the Credit Default Swaps on the Greek and Portuguese debt continue to move down? Well we can only think that the worst position to have in the world would be shorts on the Euro!

It is all too easy these days to get caught up with the short term emotion of the market, perhaps this is still the hangover of the big crash of 2008. We always take time out at the start of each week to ask ourselves the all important question; has there been any fundamental change in long term trends within each asset class?

In essence we see little reason to doubt the health of the trends in equities, commodities, treasuries, and real estate that had their origins in October/November 2008. Any pull back in equities, commodities and real estate has, so far at least, been met with a deluge of bearish opinion/sentiment which has effectively limited any downside. The opposite applies to US Treasuries.

Now what about currencies? After all the USD Index has risen dramatically over the last 4 months! We would like punters to look beneath the scenes. Yes on the face of it the USD (as per the USD Index) does look strong but if you strip out the effect of the Euro things looks somewhat different. Take a look at the behaviour of the CAD, AUD, and emerging market currencies (using the ETF CEW as a proxy). Have these currencies broken down against the USD? Granted they are not exactly making new highs and have not done so for a few months now but all the same these currencies are not exactly trading at multi-week lows which would typically suggest a change in long term trend. We think the rise in the USD Index is a false move and we all know what is likely to happen to equities, commodities and US Treasuries when (as opposed to “if”) the USD Index falls!

We have updated our Earnslaw portfolio and members should login to view the details.

Since inception in February 2009, our Earsnlaw portfolio has returned 39%.

Also, in making some behind the scenes changes to the site I accidentally restricted access to some posts. whoops!. Sorry about that. All posts are now able to be read by everyone. Only the portfolio pages require membership.

All the best
Emilio Niederhoffer

When it comes to investing and market timing the immortal words of John Templeton ring loudly in our ears;

“The best time to invest is at the point of maximum pessimism”

Just where in the world would the ordinary average investor dare not tread with respect to equity markets? We think that place would be the Greek stock market. Yes it would be a brave man to even contemplate “walking on to the floor” of the Athens stock exchange and announcing “I am a buyer”. But if you want to find deep value then look no further. The price to book value of the average stock listed on the Athens exchange is a mere 0.890! One could argue all they like about the level of growth and earnings but when we see a nation’s stock market trading well below book value we see value!

Apart from futures on the FTSE/Athens 20 Future the best way to get access to the Athens stock exchange is via the Lyxor MSCI Greece ETF that trades on Euronext (code GRE)

If the US economy was contracting wouldn’t there be an increasing number of junk grade bonds entering a distressed condition? Yes that would be a reasonably logical assumption. Then why has there been no increase the level of distressed debt (junk grade issues trading in excess of 1000 basis pts over US treasuries) over the last month or so? In addition why has there been no material movement in junk grade CDS premiums, at least nothing out of the ordinary?

TRACE Distressed Debt Index

MARKIT High Yield CDS Index

We think that the two indices above are not so subject to speculative activity that the equity market is and accordingly the behaviour of the indices above give a more true representation of the mood of the market. In short equity markets are not genuinely bearish. The weakness we are currently experiencing appears to be entirely due to the crowds panic reaction to the excessive spending habits of a couple of Mediterranean nations, which have little or nothing to do with the earnings prospects of US Industrial heavy weights (aka DOW members).

Just how oversold is the equity market? One of the most reliable indicators we have found is the NYSE 50 day moving average ratio. In essence it is the ratio of stocks trading above their 50 day moving average to below. A ratio below 25% we consider oversold and above 75% overbought. Currently the ratio is 24%.

Of course just because the market is in an oversold condition does not mean that it is going to get even more oversold over the coming days/weeks. But we would just like to point out that if the S&P 500 were to fall to support at 1030 the 50 day moving average ratio would quite likely fall to 10, that is, the market would become as oversold as it was in early March last year.

OK now to take a stand! We consider the current weakness in US equity markets as a buying opportunity. Odds suggest that if you want to get bearish you are a few weeks too late!