Monday, October 3, 2011

Holding On By a Thread?

In my last comment, beyond the global financial tsunami, I posted the four parts to a frightening CBC documentary Meltdown and ended it off by saying I'm more concerned about what's in store for our collective future than Q4 2011. But the truth is people ask me all the time what I think about markets, and that's what everyone is focused on. Will Q4 be a "beta rally" as portfolio managers nervously try to make up for lost ground or pretty much continuation of the terrible market we had in Q3 where everyone cut risk across the board, preparing for fallout of the Greek debt debacle?

Let me begin on a positive note. One of my favorite quantitative strategists, Martin Roberge who recently started working at Canaccord Genuity, sent me his October comment making the following main points:
  • Holding by a thread…but holding! August lows remain legitimate supports for the S&P 500, but a final flush should not be ruled out. However, we believe extreme investors’ pessimism and a positive divergence between prices and breadth argue for a temporary breakdown. Should the S&P 500 revisit July 2010 lows, we will revisit our views on equities (neutral). But for now, we stick to corporate bonds.
  • European policymakers hold the key! Equity markets are dirt cheap, but multiples will likely stay compressed until the European sovereign debt crisis comes to a positive resolution. Potential solutions revolve around creating a lender-of-last resort entity while assuring capital infusions into the banks.
  • Has a US recession become THE risky call? Stronger-than-expected economic statistics in September raise our conviction that not only will the US economy avert a recession, but it should re-accelerate in H2/11. Our optimism lies on a steady increase in the US lagging indicator (i.e., the back-end of the US economy).
  • China; a welcome trade-balance slowdown! A strong yuan is needed to stimulate imports and redistribute economic growth globally. While this dynamic implies a manufacturing slowdown, hence low PMI readings, a recovery in China’s LEI and a likely end to the tightening cycle suggest that fears of a hard-landing are premature.
  • Sectors: keep a barbell approach. Industrial cyclicals are not cheap enough and defensives not rich enough to warrant a rotation. However, we believe the energy sector still represents the cheapest offense should a beta-rally unfold in Q4/11.
  • Go long on energy E&S companies and go short on diversified metals. Supply conditions for both underlying commodities are tight, but demand for oil rigs should be more robust than that of China-sensitive commodities for the next year.
  • Go long on food retailers and go short on drug retailers. Food stocks are enjoying rising retail food inflation while drug stocks are fighting weakening drug prices.
  • Gold equities. Historically, October is a bad month for gold stocks, but investors should buy dips before what could be a strong November-February time window.
Martin wanted me to highlight Figure 4 above (click on image to enlarge), what he calls the "Mother of all divergences," showing the S&P 500 vs. an index of economic surprises for the US economy. Interestingly, he notes:
...while weak/negative economic statistics led the plunge in equity markets this summer, markets are still near August lows despite a much improved performance of the US economy last month. This divergence bears watching because the last time the index of US economic surprises climbed above zero in early October 2010, the S&P 500 exited its trading range and pushed strongly higher in Q4/10. Obviously, this time is different, but our point is that to the extent the stock markets fell because of rising fears of a recession developing into the US, these fears seem exaggerated.
Martin is right, the news outside of Europe isn't as bad and there are signs the US recovery will continue as manufacturing activity is expanding. But as I stated in my comment on pensions raising cash and trimming GPs in private equity, in this wolf market dominated by psychopathic traders, the only people making money are high-frequency traders, short sellers, and a handful of elite hedge funds. Moreover, Bogle is right: "game of prices is rigged. The game of values cannot be rigged." That's why you're seeing insane downward movement in prices as high-frequency and naked short-selling psychopaths rig prices. They're basically making a killing while they scare everyone else to death (blogs like Zero Hedge help them spread doom & gloom).

That's the problem in these myopic markets focused on everything coming out of Europe. Another one of my favorite strategists, Francois Trahan of Wolfe Trahan & Co., sent me their latest research comment, warning "All Eyes on Europe ... Is China The Forgotten Tail Risk?" Indeed, what's going on in China is a lot more important than what's going on in Europe and it's why investors have been bailing out of cyclicals like commodities, energy and alternative energy (Chinese solar shares and pretty much all solars have been decimated).

[Side note: Francois Trahan and Kathy Krantz wrote an excellent book, The Era of Uncertainty, which I will shortly review when I have some time over a weekend. It's a must read for sophisticated and novice investors who simply don't understand how to properly assess the macro environment. I will add some of my comments to their excellent research.]

And what about bonds? US Treasuries continue to rally as investors flee risky stock markets in search for a safe haven. As gold loses its luster, nervous investors plow into bonds. As I stated in a previous comment asking whether bonds have peaked, another
one of my favorite strategists, Jim Bianco of Bianco Research, warned investors that the corporate bond market leads the stock market and it was already selling off in early August.

What worries me is that while the Fed can impact short rates, it's having a much tougher time impacting long bond yields which reflect inflation expectations. And right now, the bond market is signalling a protracted period of deleveraging and debt deflation. Bond traders are worried about a Greek 'twist' of global deflation which will impact all economies, including the Chinese economy.

All this means that Q4 will be rocky as investors continue to worry about how policymakers will address the crisis in Europe and its fallout on the global economy. I remain 100% in cash but am looking closely at sectors that got slaughtered in Q3, including agribusiness, energy, alternative energy, commodities, technology and other cyclicals. There is no rush to buy and I warn you, things can shift dramatically in this environment, so be nimble, scale in if you want to pull the trigger and if you don't like risk, raise your cash levels and hold some bonds. These schizoid markets will be here for a long time and it's not worth losing your mind trying to figure them out.

I leave you with some interviews with Lakshman Achuthan of the Economic Cycle Research Institute who told Bloomberg Radio’s Tom Keene and Ken Prewitt on “Bloomberg Surveillance” that the “U.S. economy is tipping into a new recession.” Watch it here. And on Yahoo's Daily Ticker, he stated "The vicious cycle is starting where lower sales, lower production, lower employment and lower income [leads] back to lower sales" and the weakness in global leading economic indicators has become a "contagion" that is spreading like "wildfire." Watch that interview below.

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