Massive Cyclicals Euphoria?

Paulo Santos wrote an article in Seeking Alpha on Friday that caught my attention, Massive Cyclicals Euphoria:
Three factors have unleashed a massive euphoria on cyclical stocks in the last two days. These were:
  • The ECB's proclamation that it will buy limitless quantities of troubled-nation debt, as long as these are under austerity programs;
  • China's new stimulus program, amounting to $158 billion in infrastructure projects;
  • And finally, today's weak NFP print, which led to renewed speculation the FED will decide on further quantitative easing printing during its September meeting.

This speculation seems misguided

The ECB said nothing new. It won't buy bonds if the countries in question are not under austerity programs, so it won't buy Spanish or Italian bonds right now.

China's new stimulus program amounts to 2.1% of GDP, will be implemented over several years, and most importantly, it mostly gives continuity to past investments. That is, if China decides to build 1000km of new roads in a given year, and then decides to build 1000km more in the next year, while this provides for a "stimulus announcement", it doesn't carry any growth for basic materials per se. As such, this stimulus doesn't change much.

Finally, it's hard to see how the FED will really print more with the markets putting on multi-year highs. The reason for the FED printing - the way it transmits its intentions to the general economy, is by taking markets higher. If the markets are already rallying, it makes no sense for the FED to print into them.

Sectors seeing wild speculation
Is Mr.. Santos right? Is the "massive cyclicals euphoria" unwarranted or are there reasons to believe that smart money is betting on a global economic recovery, looking well past doomsday scenarios in Europe, China, and the United States with its looming fiscal cliff.

Last Sunday, I wrote an article, Bring on the Risk, where I discussed why I`m still long risk assets and think investors need to pay attention to the tape and forget all the endless distractions out there. In particular, I wrote that I am long US financials, energy, tech and thought now is a good time to load up on out-of-favor coal, copper and steel shares.

Here are some of the cyclical stocks I was looking at on Friday (click on image to enlarge):

Shares of coal, copper and steel -- all leveraged plays on a global recovery -- rallied sharply but before you get too excited, warn you that these stocks were decimated over the last year and have seen many, many  powerful countertrend rallies during this time, only to head lower (this is typical in global deleveraging).

Some of the weakest names rallied the most, which is what I saw in other sectors I track. For example, Bank of America (BAC) and Kinross Gold (KCG) both rallied sharply on Friday and they were laggards in their respective sector.

This tells me risk appetite is alive and well. Is it just another powerful countertrend rally  or is something else going on here? That is the trillion dollar question, which is why investors need to pay attention to the tape in the next few weeks. 

A lot of active money managers are trailing their benchmarks in 2012. Hedge funds, mutual funds and pension funds are all looking for a big beta boost going into yearend to salvage an otherwise terrible year.This means the euphoria in cyclicals might not be short-lived and skeptics like Mr. Santos focusing on "fundamentals" are going to be chasing these stocks at much higher levels going forward.

I am of the school of thought that even though the market isn't always right (few predicted the storm of 2008 coming), most of the times stocks and bonds lead economic news. A great example is how the S&P Homebuilders Index (XHB) bottomed last October and kept grinding higher, making higher highs (click on image to enlarge):

Now, if I told you to invest in US homebuilders last October, you'd think I was nuts and yet that is exactly what top hedge funds like Citadel were doing. This is why I track top funds' activity closely and try to see where they're adding positions and why. Elite funds aren't perfect, but they often move opportunistically ahead of the pack.They might be doing it again, loading up on out-of-favor cyclicals.

Importantly, always try to relate their investments to macro news and ignore all the noise the media loves to harp on. I can easily scare you with news of Grexit, run on banks in Spain, slowdown in China, US fiscal cliff, etc., but I am more focused on what top funds are buying and then tracking the tape to see if it's worth buying.

For example, in my long comment on tracking top funds activity in Q2 2012, mentioned that both Soros and Caxton, two of the best global macro funds, bought shares in copper mining giant Freeport McMoran (FCX). They made the right call, making excellent returns since then (click on image):

Again, don't get too excited as Soros and Caxton might have booked profits on Friday and moved on to their next trade. We won't know until Q3 13-F filings become available in mid-November. The point is that they were buying shares of a copper giant despite all the hoopla of how the world is ending.

The very best managers focus on taking opportunistic risk. They relate macro factors to micro investments. They completely ignore distractions and focus on taking intelligent risk on a timely basis.

Are there things that concern me going forward? You bet. I am concerned about Europe and what will happen in Greece and Spain. The next six weeks are crucial starting with the decision of the German constitutional court on the ESM. This week is decision time for the Fed and Europe.

This means I'm bracing myself for another volatile week but remain confident that no matter what happens, risk assets will keep grinding higher. Despite Friday's tepid jobs report, I'd be surprised if the Fed moves ahead with QE3 (employment growth is weak but no reason to panic), and don't really care what the German court decides (pay attention: European financials giving harsh warning to bears).

Finally, I agree with Soros, who recently told Thomson Reuters Digital Editor Chrystia Freeland that Germany needs to embrace its leadership role in Europe or leave the euro (watch below).