This rally looks technically ok - for now

Three weeks ago, I called for the end of the little correction we had experienced in the beginning of the year, and the reason was mostly technical. Today, I cannot find a technical reason to call for the end of this three week old rally: market breadth and internals are quite good (see this post to understand why these indicators should be followed). Sentiment used to be ultra-bullish, which was bearish. It is not anymore. Most of the liquidity indicators I follow have turned up. Volume is lacking, but it has been lacking since the March 09 bottom.

The fundamentals however are deteriorating. Leading economic indicators around the world look toppy, Greece is only the beginning of a multi-year (multi-decade ?) long round of sovereign credit problems, and the financial sector is likely to face renewed troubles due to fading official support and high default rates in commercial and residential real estate (why does everyone thinks that because banks are paying huge bonuses then they must be fine? This is simply flawed logic). Add to this stretched valuations and soon-to-be fading policy stimulus, and voilà! you have a recipe for some choppy waters in risk assets.

But for now, Mr. Market just doesn't seem to care, and the path of least resistance seems to be up.

Stop it with the data-mining, Mr. Rosenberg

I have a lot of respect for David Rosenberg, the chief economist over at Gluskin Sheff (previously with Merrill Lynch). However, I have a lot of trouble reading his daily commentaries because: 1) they're a tad too long, 2) they often repeat, and 3) Rosenberg much too often cherry picks data to fit and prove his preconceived opinion (opinion to which I agree for the most part - the point being I much rather like people forming an opinion out of data and logic rather than the other way around).

As an exemple, Rosenberg recently highlighted the extremely high (0.95) correlation between the S&P 500 and the Copper/Gold ratio over the past three years. Unfortunately, the reason for this is more the fact that the correlation between stocks and both the metals has been very high over that period. In econometrics, this is known as multicollinearity (a violation of regression assumptions), and is typically detected by a high correlation which carries low significance, reflecting inflated standard errors.

Let's look at the data since 1997: the correlation between stocks and the copper/gold ratio drops to 0.55, while the correlation between stocks and copper is a lower 0.37 (the one between stocks and gold is about zero). 0.37 is still statistically significant so we haven't got rid of the multicollinearity problem, but at least now we can overlook it. Conclusion: Copper/gold has a somewhat significant and relatively high correlation with equities.

Mr. Rosenberg, you see, your point was valid. Why did you have to torture the data to "prove" it?

Reversal?

After opening and spending most of the day in the (deep) red, most risk assets, including equities, managed to turn out a small again gain last friday. This is what technical analyst call a "key reversal day", and is short-term bullish. However, the fall of the past few weeks has done a lot of technical damage: supports and trendlines broken, oscillators and indicators rolling over, etc. As such, the technical picture is not yet supportive of a sustained advance. Stay tuned.

Once again, the Baltic Dry and gold prove to be the best early indicators

They may call it "Doctor" Copper, but the metal is, just like other industrial metals, at best a leading indicator of industrial activity, and industrial activity is preceded by changes in financial conditions. The earliest signals of the correction we are experiencing in risk assets have been given by the Baltic Dry index and gold -- peaking in end November / early December, with copper and equity markets peaking more then a month afterwards:

 

Remember this the next time you watch CNBC and hear about "Doctor" Copper.

As an aside, following this logic, equities are not yet ready to stage a sustained rebound.

Quick market update

I am reminded that I haven't commented on the market in a little while, so there it is: market's overbought oversold short term (only about 30% of stocks on the NYSE are above their 50-day moving average), and new highs still overweight new lows, so we're likely to see some sort of rally or trading range, but who knows. Longer term risks are still to the downside due to high valuations, complacency among participants, and underestimated economic and financial risks. And the same more or less applies to most risk assets, which do include gold and the euro.

Links 7/1/10

There have just been too many interesting pieces in the last few days for me to quote them all on this blog, so for once my dear readers, you are going to have to read it all (trust me it's worth it):

• Bill Gross: Let's Get Fisical, also: Time's interview
  
• Tim Duy: Fed Watch: Out of the gate with a bang
  
• a sell signal from Mark Hulbert: Bullishness now at dangerous levels
• From The Pragmatic Capitalist: The ultimate guide to 2010 investment predictions and outlooks

Dull. Bye.

This whole Dubai thing is a non-story. So what if a few banks are going to lose a few billions. The amount of write-downs in the past couple years was what, 1500 billions? Wait a few months for the pain to come in the U.S. commercial real estate market, and the Alt-A and Option-ARM mortgage troubles. THAT is going to hurt.

There might be one interesting thing in this, and it's the way the markets have reacted. It seems the 9 months-old rally is finally getting frightened by bad news. This is not a sign of strength. Financials have been underperforming for weeks now. Not very good.

Even more on the dollar carry trade

From "BarCap analysts", via FT Alphaville:

The size of carry traders is notoriously difficult to measure, and there is considerable speculation on their size based on very incomplete evidence. Consider, however, a measure of the classic incentive to put on carry trades — volatility-adjusted spreads. We use two such measures, the volatility-adjusted spread between AUD and JPY and the volatility-adjusted spread between AUD and USD. In each case, we divide the 10y yield differential between by one year implied volatility.
These measures do not encourage the view that carry trades would be put on in size . Whatever the incentives from the rate differentials, implied volatilities remain high enough to discourage carry trades. In both cases, the incentives are not only well below the peak, they are well below the average.

If anything, this suggests that the market may be overestimating the extent of carry trades now in place and underestimating the potential for carry trades to be instituted if implied volatilities pull closer toward historical norms and realized volatility.

Well excuse me anonymous BarCap analysts, but you are pretending to be more stupid than you actually are. The carry trade everybody's talking about is more about capital gains than about pure yield carry, and your measures are not adapted to this. These measures were useful when the carry trade was about shorting yen and going long higher yielding currencies (notably as you mention, AUD) using enormous leverage, hence the need to monitor volatility. The topic du jour is about borrowing dollars and going long low- or zero-yielding things like commodities, stocks or other low-yielding bonds and currencies, presumably with a much lower leverage. Volatility has become less important, but more to the point, AUD volatility is pretty much irrelevent to the debate.

A more interesting argument comes from David Rosenberg (I actually think he borrowed it, I saw that somewhere else recently):

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April. There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring. Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

The Alternative Universe Newswire

The Alternative Universe Newswire

Thursday, January 29, 2009 at 9:21 AM Posted by Macro Man

There is a theory in particle physics, known as the many-worlds hypothesis, which posits that there are an inifinite number of universes, with a new one created whenever a particle's qunatum wave function "collapses." Readers of Philip Pullman's His Dark Materials trilogy will be familiar with one "practical" interpretation of the hypothesis, wherein similar but slightly different universes overlap each other.

Macro Man can confirm that this is in fact the case, as he possesses a rather unique newswire that feeds in from one of the alternative universes. He usually keeps it under wraps in the bottom of a drawer, but sometimes feels compelled to have a look at it when real-world news headlines leave him scratching his head. He finds that the alternative universe newswire sometimes offers a fresh, more truthful perspective on events than his everyday sources of news.

Recently, he's taken to looking at the alternative newswire with depressing frequency. Consider the following real-world headlines that have crossed his screen recently, and compare them with the alternative-universe newsfeed:

Our world newsfeed(OWN): Russia, China blame woes on capitalism

Alternative world newswire (AWN): Wen, Putin admit Martingale forex strategies "misguided".

In gambling, a Martingale strategy is one in which one's stake is doubled after every losing bet until he finally wins (or loses all his money.) If one possesses infinite wealth, this strategy will deliver a profit of the original stake when one finally wins; in the real world, however, its practitioners usually bust before finally winning.

In markets, the term refers to adding to a losing trade to "improve your average". Unsurprisingly, market punters usually achieve similar results to roulette players in using the strategy.

And in macroeconomics, it has come to mean an endless cycle of buying foreign exchange reserves to maintain an artificially weak exchange rate, regardless of the negative externalities of such a policy. To be sure, the US is culpable for a great deal of the current global economic stress, but this does not absolve either China or Russia for pursuing their own misguided policies which have generated a collosal misallocation of resources.

That the ongoing travails of the rouble has impaired the kleptocrats' financial standing in some small degree provides at least one small rainbow in an otherwise never-ending torrent of doom and gloom.


OWN: Brown says UK was right to sell gold in 1999, says UK bought euros by selling gold

AWN: Brown admits selling XAU/EUR below 300 was "collossally stupid"

The high print in XAU/EUR in 1999 was 270. It is now 632. Macro Man isn't sure what is worse: that Gordon Brown is too stupid to understand that that is a bad trade, or that he thinks that YOU are too stupid to understand that that is a bad trade.
OWN: "We foresaw economic downturn," Trichet says.

AWN: Trichet reveals ECB forecast model (pictured, below.)
OWN: Brown defends economic record, blames global crisis for downturn

AWN: Brown admits that UK is buggered

OK, maybe it's not fair to pick on Gordon twice. But the gold headline above was literally unbelievable, and the graphic below (which amde the rounds yesterday) is too good not to share.