Archive for August 27th, 2012
Monday, August 27th, 2012
by Jeffrey Saut, Chief Investment Strategist, Raymond James
August 27, 2012
Peter Drucker was a writer, consultant, and teacher who was deemed the father of modern management theory. His groundbreaking work turned management theory into a serious discipline, and he influenced or created nearly every facet of its application. He coined such terms as the “knowledge worker,” which plays to the intangible capital theme often discussed in these missives. One bòn mót he once related was:
“The most enduring lesson I’ve ever learned came from an old janitor at New York University, which had completed a new magnificent graduate-school building that had no windows on the first nine stories. We moved in; and, you know there’s always a short, brutal heat wave in New York at the end of April. The temperature went from 80 to 90 to 100; and everybody, the women included, stripped down to the barest essentials. It continued to get hotter and my patience wore out! I went down to hunt-up the janitor and scream at him. Way down in the third basement I found an old toothless man and yelled at him, ‘Can’t you read a thermometer?’ He looked back at me and said, ‘Mister, if I could read a thermometer what would I be doing as a janitor?!’”
Indeed, the janitor’s job was to watch the calendar because in New York you heated the building until May 15th and then you turned on the air conditioner. The janitor merely followed the orders he had been given – no questions asked! In the stock market many mavens also follow the calendar . . . you simply play the summer rally long; then around Labor Day, you sell because of the “look out for October” history-haunts. They read the calendar, not the temperature, of the markets. Unfortunately, many investors failed to participate in this summer’s rally, conditioned by the shared experience of the past two summers. Indeed, for the last two years the S&P 500 (SPX/1411.13) has topped out in the spring and then slid into the summer doldrums. Accordingly, many professional investors were too timid to believe the June 4th low was the daily, and intermediate, term cycle-low, which launched this year’s summer rally. Now they are faced with performance anxiety as the end of the third quarter looms. Yet investors are still skeptical, voicing concerns about Euroquake, a slowing China, our dysfunctional government, the fiscal cliff, etc. I have addressed most of these concerns in prior missives. Nevertheless, the single most reoccurring “knock” I have heard since the bull market began in March 2009 is that the volume has been extremely low by historical standards. In theory that “knock” makes sense, but followers of said theory have missed out on the ninth strongest Bull Run in the history of the S&P 500.
To this “low volume” point, the eagle-eyed folks at the Bespoke organization had this to say:
“In order to illustrate the fallacy of this argument, the chart below shows the performance of the S&P 500 since the bull market began on March 9th, 2009 along with its performance if we took out all days where volume (as measured in SPY) was below the 50-day moving average. So far this bull market [has left] the S&P 500 up 108.5% (blue line). If you back out all days (up and down) over the same period where volume was below average, you come out with a decline of 30.1%. Bears can argue whatever they want, but if you followed the low volume argument, you would be down 30.1% instead of up 108.5%!”
This week, however, volume will not be the question du jour as participants put on “rabbit ears” for what is said at the Jackson Hole meeting. Indeed, the Kansas City Federal Reserve will again host the annual Federal Reserve meeting near Yellowstone National Park with the highlight being Ben Bernanke’s Friday morning speech where Wall Street will be looking for hints of future policy moves. Recall, I was wrong-footed at the last Fed meeting thinking there would be a change in Mr. Bernanke’s policy statement. My reasoning was that the Fed would change its policy statement on fears it would be viewed as too political by changing its policy statement at the September meeting, which is so close to the presidential election. Accordingly, this week’s Jackson Hole’s affair may be the last chance for the Fed to act. That said, while the economic figures have strengthened over the past few weeks, last week this pattern did not hold. Whether that will cause Ben Bernanke to lean toward another quantitative easing should be the focus of the week. If QE3 is the “call,” the SPX should vault above the previous reaction highs of 1420 – 1422 with price objectives of 1477 and then 1509. If not, it likely implies the indices will have to spend more time digesting the ~12% rally from the June 4th low.
Whatever the outcome, I think any correction will be shallow with the path of least resistance remaining to the upside with the “carrot in front of the horse” being the under-performance by the pros staring at the end of the quarter performance derby. Manifestly, most investors I know are dramatically underperforming the major indices.
Last week, however, the under-invested crowd got a break as the SPX snapped its six-week winning streak. This should have come as no surprise after the SPX’s first attempt to travel above its April highs failed. As stated, it usually takes two, or even three, attempts before a successful upside breakout occurs. Also, as anticipated, the pullback was shallow, indicating the bulls are still in control; and while the momentum has been lethargic, there are no clear-cut bearish divergences that typically occur at topping formations. Indeed, at a “big top” the Relative Strength Index (RSI) will diverge and fail to confirm new reaction highs in the broad averages. Furthermore, the leading stocks continue to lead. Typically, if a top is forming, the leaders lag and the laggards lead and that is just not happening. All said, the picture looks pretty good with the stock market’s daily internal energy level back to a full change. That puts the SPX in great position to vault above the 1420 – 1422 level and keep pushing higher.
As for my comments on gold last week, gold looks to have broken out to the upside, and in the process has traveled above its 200- day moving average. To me, this looks like the start of a move higher and not the end of a move. Coincident with gold’s upside breakout, Credit Suisse penned a report on Freeport-McMoRan Copper & Gold (FCX/$36.13) with a favorable rating. The report’s byline reads, “The cheapest growth stock in our universe.”
The call for this week: Hurricane Isaac blew into the Gulf, but is having little effect here in Tampa. Still, like a snow day up north, the schools are closed and the Republican National Convention is taking the day off. The stock market, however, is not as it continues to track the typical election year chart pattern, as can be seen in the chart on page 3 from the good folks at Bespoke. If the correlation continues to hold, the equity markets should track higher into the beginning of September before giving us a more substantial pre-election correction.
Copyright © Raymond James
Monday, August 27th, 2012
(Editor’s Note: Mr. Vialoux is scheduled to appear on BNN today at 11:30 AM EDT)
Economic News This Week
The June Case/Shiller 20 City Home Price Index to be released on Tuesday at 9:00 AM EDT is expected to improve on a year-over-year basis from -0.7% to -0.3%.
The August Consumer Confidence Index to be released at 10:00 AM EDT on Tuesday is expected to slip to 65.5 from 65.9.
The Fed Beige Book is scheduled to be released at 2:00 PM EDT on Wednesday.
U.S. second quarter revised real annualized GDP to be released at 8:30 AM EDT on Wednesday is expected to be revised upward to 1.7% from 1.5%.
July Personal Income to be released at 8:30 AM EDT on Thursday is expected to increase 0.3% versus a 0.5% gain in June. July Personal Spending is expected to increase 0.5% versus no change in June.
Weekly Initial Jobless Claims to be released at 8:30 AM EDT on Thursday are expected to slip to 370,000 from 372,000 last week.
Canada’s June GDP to be released at 8:30 AM EDT on Friday is expected to slip to 1.6% on a year-over-year basis versus growth at 1.9% rate.
The August Chicago Purchasing Manager’s Index to be released at 9.45 AM EDT on Friday is expected to slip to 53.5 from 53.7 in July.
The August Michigan Consumer Sentiment Index to be released at 9:55 AM EDT on Friday is expected to remain unchanged at 73.6.
Earnings Reports This Week
The S&P 500 Index slipped 7.03 points (0.50%) last week. Intermediate trend changed from neutral to up when the Index briefly moved above resistance at 1,422.38. However, the Index also recorded a bearish key reversal last Tuesday implying the likelihood of at least a short term peak. The Index remains above its 50 and 200 day moving averages, but is testing its 20 day moving average. Short term momentum indicators have rolled over from overbought levels and are trending down.
Percent of S&P 500 stocks trading above their 50 day moving average fell last week to 73.40% from 81.40%. Percent is intermediate overbought and has rolled over from above the 80% level, a frequent indicator that the Index has passed a short term peak.
Percent of S&P 500 stocks trading above their 200 day moving average slipped last week to 70.40% from73.40%. Percent is intermediate overbought and showing early sign of peaking
The ratio of S&P 500 stocks in an uptrend to a downtrend (i.e. the Up/Down ratio) slipped last week to (279/127=) 2.20 from 2.26. Twenty three stocks broke resistance and 24 stocks broke support (mostly utility stocks).
Bullish Percent Index for S&P 500 stocks increased last week to 70.40% from 70.00% and remained above its 15 day moving average. The Index is intermediate overbought.
The Up/Down ratio for TSX Composite stocks increased last week to (151/73=) 2.07 from 1.72. Twenty stocks broke resistance and two stocks broke support.
Bullish Percent Index for TSX Composite stocks increased last week to 62.60% from 60.57% and remained above its 15 day moving average. The Index remains intermediate overbought.
The TSX Composite Index slipped 7.66 points (0.06%) last week. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing early signs of rolling over. Strength relative to the S&P500 Index has been negative, but is showing early signs of change.
Percent of TSX stocks trading above their 50 day moving average increased last week to 72.36% from 69.92%. Percent is intermediate overbought above the 70% level. Peaks from above the 70% level normally lead to at least a short term correction by the Index.
Percent of TSX stocks trading above their 200 day moving average increased last week to 51.63% from 48.37%. Percent is intermediate overbought.
The Dow Jones Industrial Average fell 117.23 points (0.88%) last week. Intermediate trend is up. Resistance is at 13,388.66. The Average briefly fell below its 20 day moving average, but managed to recover above that level on Friday. The Average remains above its 50 and 200 day moving averages. Short term momentum indicators are trending down from an overbought level. Strength relative to the S&P 500 Index remains negative.
Bullish Percent Index for Dow Jones Industrial Average stocks slipped last week to 83.33% from 86.67% and eased below its 15 day moving average. The Index is intermediate overbought and showing signs of rolling over.
Bullish Percent Index for NASDAQ Composite stocks increased last week to 53.91% from 53.59% and remained above its 15 day moving average. The Index remains intermediate overbought.
The NASDAQ Composite Index slipped 5.80 points (0.19%) last week. Intermediate trend is up. Resistance is at 3,134.17. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and showing early signs of rolling over. Strength relative to the S&P 500 Index has turned positive.
The Russell 2000 Index fell 10.70 points (1.31%) last week. Intermediate trend changed from down to up on a break above resistance at 820.44. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators have rolled over from overbought levels. Strength relative to the S&P 500 Index recently turned neutral/positive.
The Dow Jones Transportation Average fell 75.80 points (1.46%) last week. Intermediate trend is down. Support is at 4,795.28 and resistance is at 5,290.06. The Average is just above its 20, 50 and 200 day moving averages. Short term momentum indicators have rolled over from overbought levels. Strength relative to the S&P 500 Index remains negative.
The Australia All Ordinaries Composite Index slipped 17.32 points (0.40%) last week. Intermediate trend is down. Resistance is at 4,515.00. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought. Strength relative to the S&P 500 Index remains neutral.
The Nikkei Average fell 91.74 points (1.00%) last week. Intermediate trend is up. The Average remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought. Strength relative to the S&P 500 Index has turned positive.
The Shanghai Composite Index fell another 22.79 points (1.08%) to close at a three year low. Intermediate trend is down. The Index remains below its 20, 50 and 200 day moving averages. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index remains negative.
The London FT Index fell 75.82 points (1.30%), the Frankfurt DAX Index dropped 91.31 points (1.30%) and the Paris CAC Index gave up 55.82 points (1.60%) last week.
The Athens Index added 4.77 points (0.75%) last week. The Index remains above its 20 and 50 day moving average, but below its 200 day moving average. Short term momentum indicators are overbought. Strength relative to the S&P 500 Index remains neutral.
The U.S. Dollar Index lost 1.01 (1.22%) last week. Intermediate trend is up. Support is at 81.16 and resistance is at 84.10. The Index remains below its 20 and 50 day moving averages and above its 200 day moving average. Short term momentum indicators are oversold, but have yet to show signs of bottoming.
The Euro added 1.80 (1.46%) last week in anticipation of news by the European Central Bank to be announced at the end of the week at the Jackson Hole Conference. Intermediate trend is down. Support is at 120.42 and resistance is at 127.43. The Euro moved above its 50 day moving average last week, but remains below its 200 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking.
The Canadian Dollar slipped 0.30 cents U.S. (0.30%) last week. Intermediate trend is down. Short term trend is up. The Dollar remains above its 20, 50 and 200 day moving averages. Short term momentum indicators have rolled over from overbought levels.
The Japanese Yen added 1.44 (1.15%) last week. Intermediate trend is down. Short term trend is up. Support is at 124.12 and resistance is at 128.77. The Yen remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are neutral.
The CRB Index added 2.56 points (0.84%) last week reflecting weakness in the U.S. Dollar Index. Intermediate trend is up. The Index remains above its 20, 50 and 200 day moving averages. Strength relative to the S&P 500 Index remains neutral.
Gasoline added $0.02 (0.69%) last week. Gasoline remains at or above its 20, 50 and 200 day moving averages. Strength relative to the S&P 500 Index remains positive.
Refined product prices normally weaken in fall, but not this year. U.S. inventories of gasoline and heating oil are at or below their five year average.
In addition, the fifth largest refineries in the world (in Venezuela) literally blew up over the weekend. At least 26 people were killed. Largest export customer for its products is the U.S.
Crude oil added $0.35 (0.37%) last week. Intermediate trend is up. Crude remains above its 20 and 50 day moving averages and is testing its 200 day moving average. Short term momentum indicators are intermediate overbought. Strength relative to the S&P 500 Index remains positive.
Natural Gas slipped another $0.03 per MBtu (1.10%) last week. Intermediate trend is up. Resistance has formed at $3.28. Gas remains below its 20 day moving average and fell below its 50 day moving average last week. Short term momentum indicators are trending down. Stochastics already are oversold. Strength relative to the S&P 500 Index has turned negative.
The S&P Energy Index slipped 3.68 points (0.68%) last week. Intermediate trend is up. The Index briefly moved above resistance at 544.25 last week. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are rolling over from overbought levels. Strength relative to the S&P 500 Index remains positive.
The Philadelphia Oil Services Index added 3.19 points (1.39%) last week. The move above a reverse head and shoulders pattern continues. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought and have rolled over. Strength relative to the S&P 500 Index remains positive.
Gold gained $55.90 per ounce (3.46%) last week. Intermediate trend changed from down to up on a break above resistance at $1,642.40. Gold remains above its 20 and 50 day moving averages and moved above its 200 day moving average last week. Short term momentum indicators are short term overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index turned from neutral to positive.
The AMEX Gold Bug Index added 20.87 points (4.88%) last week. Intermediate trend is down. Short term trend is up. Intermediate resistance is at 464.76. The Index remains above its 20 and 50 day moving averages and just below its 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to gold remains positive.
Silver added $2.52 per ounce (8.98%) last week. Intermediate trend changed from down to up on a break above resistance at $28.44. Silver remains above its 20 and 50 day moving averages and moved above its 200 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to gold turned from neutral to positive
Platinum gained another $81.00 per ounce (5.51%) last week. It broke above resistance at $1,504.80. Strength relative to gold recently turned from negative to positive.
Ditto for Palladium! It gained $71.25 per ounce (12.23%) last week. Resistance at $641.90 was broken. Strength relative to gold also has turned positive.
Copper gained $0.08 per lb. (2.35%) last week. Intermediate trend is down. Support is at $3.24 and resistance is at $3.56. Copper remains above its 20 and 50 day moving averages and below its 200 day moving average. Short term momentum indicators are trending up. Strength relative to the S&P 500 Index remains negative, but showing early signs of change.
The TSX Global Metals & Mining Index fell 7.02 points (0.81%) last week despite strength in precious metal and copper prices. Intermediate trend is down. The Index remains above its 20 and 50 day moving averages, but below its 200 day moving average. Short term momentum indicators are showing early signs of rolling over. Strength relative to the S&P 500 remains neutral.
Lumber fell $12.58 (4.09%) last week. It remains above its 50 and 200 day moving averages, but fell below its 20 day moving average on Friday. Strength relative to $SPX is turning negative.
The Grain ETF added $1.35 (2.17%) last week. Units briefly reached a new high. Units are above their 20, 50 and 200 day moving averages. Strength relative to $SPX is negative/neutral.
The Agriculture ETF slipped $0.46 (0.91%) last week. Intermediate trend is up. However, units fell below their 20 day moving average, short term momentum indicators have rolled over from an overbought level and strength relative to the S&P 500 Index remains negative.
The yield on 10 year Treasuries fell 13.8 basis points (7.60%) last week. Yield remains below its 200 day moving average and briefly fell below its 20 day moving average. Short term momentum indicators have rolled over from overbought levels and are trending down.
Conversely, price of the long term Treasury ETF gained $3.21 (2.64%) last week.
The VIX Index jumped 1.73 (12.9%) last week. Short term momentum indicators are trending higher from oversold levels.
The earnings focus this week is on the Canadian banks. Look for modest gains on a year-over-year basis. At least two of the banks are expected to increase their dividend.
Economic reports this week are expected to have a mildly negative impact on equity markets (Consumer confidence, Chicago PMI, Michigan consumer sentiment).
Macro news heats up this week. The focus is on Bernanke’s speech next Friday at 10:00 AM EDT and Draghi’s speech on Saturday morning. Other events to watch include Eurozone consumer confidence on Thursday and China’s PMI next Saturday (estimated to fall from 50.1 to 49.8).
Short and intermediate technical indicators for most equity markets and sectors are overbought and are showing signs of rolling over. Mary Ann Bartels, Merrill Lynch’s technical analyst predicted downside risk by the S&P 500 between now and the end of September at 8-10%. Following is a link from CNBC to her video: http://www.cnbc.com/id/48756751
North American equity markets have a history of moving lower from the beginning of September to mid-October during a U.S. Presidential election year (particularly when polls show a close race. Thereafter, equity markets move higher regardless of who wins.
September is the weakest month of the year for North American equity markets. This is the month that analysts review their estimates for the current year, realize their estimates are too high and revise them accordingly. History is about to repeat.
Other issues that could impact equity markets include Hurricane Isaac, the Republican convention and increasing media comments about the possibility of Israel attacking Iran before the Presidential election.
Cash on the sidelines on both sides of the border is substantial and growing. Bank of Canada’s Mark Carney highlighted the situation in Canada last week. However, political uncertainties (including the Fiscal Cliff) preclude major commitments by investors and corporations before the Presidential election.
The Bottom Line
Equity markets on both sides of the border have had a good ride since their lows on June 4th. Now they are showing short and intermediate technical signs of an intermediate peak. It’s time to take profits in selected seasonal trades such as agriculture and leisure & entertainment. Other seasonal trades such as energy and gold have additional intermediate upside potential, but no longer are buy candidates. A cautious stance appears appropriate until the second half of October when upside opportunities are expected to re-appear.
Tom Rogers’ Weekly Elliott Wave Blog
Following is a link:
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Materials Sector Seasonal Chart
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About the Conference: Guest speaker topics will include grains, Oil, Natural Gas, Precious and Industrial Metals trading. Incorporating the information from commodity related stocks and ETF’s will be a specific study for traders to expand their understanding. The speaker list includes Internationally famous technicians who have presented world wide, authored numerous books and trading systems: Jordan Kotick -Barclays Head of Technical Strategy, David Keller -Fidelity Mana ging Director of Research, Tom McLellan -McLellan Financial Publications and the McLellan Oscillator, Alan Knuckman -Agora Financial Resources Traders, Martin Pring -Pring Turner Capital Group, Don Vialoux -Techtalk, Paul Ciana -Bloomberg, Adam Sorab -CQS Management Limited, Jeffrey Kennedy -Elliott Wave International (EWI).
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Disclaimer: Comments and opinions offered in this report at www.timingthemarket.ca are for information only. They should not be considered as advice to purchase or to sell mentioned securities. Data offered in this report is believed to be accurate, but is not guaranteed.
Don and Jon Vialoux are research analysts for Horizons Investment Management Inc. All of the views expressed herein are the personal views of the authors and are not necessarily the views of Horizons Investment Management Inc., although any of the recommendations found herein may be reflected in positions or transactions in the various client portfolios managed by Horizons Investment Management Inc
Horizons Seasonal Rotation ETF HAC August 24th 2012
Monday, August 27th, 2012
by Don Vialoux, Timingthemarket.ca
Upcoming US Events for Today:
- The Dallas Fed Manufacturing Survey will be released at 10:30am. The market expects –6.0 versus –13.2 previous.
Upcoming International Events for Today:
- German Business Climate Index for August will be released at 4:00am EST. The market expects Economic Sentiment to show 102.3 versus 103.3 previous.
Equity markets rebounded on Friday, almost erasing all of the previous days losses as investors once again grew optimistic that the Federal Reserve would initiate another round of easing. CNNMoney.com reports that “investors were reacting to a letter sent by Federal Reserve Chairman Ben Bernanke to the chairman of the House oversight committee, Rep. Darrell Issa, that said the central bank has more room to support the economy.” Investor speculation will be answered one way or another as Ben Bernanke delivers his annual speech in Jackson Hole on Friday and the ECB will deliver its latest monetary policy announcement next week. The risks, both to the upside and the downside, remain profound. If speculation is not answered with decisive action from central banks around the world, equities could easily lose all of the momentum gained in the month of August, falling back towards the lows of the summer. On the other hand, equities could also break overhead levels of resistance if further monetary stimulus forces the reflation trade. Upcoming announcements from central bank officials will likely take precedent over the trading activity in the week ahead as investors position themselves accordingly for either scenario.
The technicals of the market are just as mixed as analysts expectations pertaining to upcoming monetary policy announcements. Tuesday saw a key reversal day in which markets opened higher, breaking resistance, then selling off through the remainder of the day to finish lower, exceeding the previous day’s trading range. Then Thursday saw the biggest declining session for equities in about a month. Yet, through this seemingly significant activity on the week, benchmarks, such as the S&P 500 Index, continue to hold above significant moving averages (20, 50, and 200-day). Cyclical sectors continue to outpace defensives. And commodities, such as Gold and Silver, are breaking out above levels of resistance as investors place bets on simulative monetary policy. But, at the same time, other technical indications are questionable.
Everyone is well aware of the dismal market volumes, which suggest a severe lack of conviction to equities at present. This lack of volume is causing the NYSE Advance-Decline Volume line to show a fairly clear divergence compared with price. Typically the chart profiles of the two closely resemble one another, but over the past two months the AD Volume line has been flat while equity prices have moved firmly higher. The warning sign that the recent lack of conviction implies should be obvious.
And another indication of breadth that we closely follow is also suggesting caution. The NYSE Summation Index can often provide good leading buy and sell signals for broad market trends. As technical momentum indicators such as RSI, MACD, and Stochastics, produce respective sell indications, the market has been shown to sell off soon thereafter, such as in May of this year and November of 2011. However, it can also be early. In February of this year and even just a few weeks ago in July when similar sell signals were flashed, equities still pushed higher. The suggestion remains that a correction is more likely than not as breadth deteriorates. Another sell signal was flashed last week and the trend in this gauge of breadth has been flat since the last sell signal, once again generating a potential warning signal.
So the word of the day is resistance, a level that is restraining price action from breaking out above a previous trading range
. Resistance is being realized across multiple time horizons for equities, currencies, and bond yields, each of which imply a pullback/pause in equity markets is reasonable around present levels.
Equity market resistance is obvious. Resistance at previous year-to-date highs for the S&P 500 and Dow Jones Industrial Average were tested last week. The FTSE All-World Index is struggling at the upper limit of a triangle pattern. And the S&P 100 Index is holding near the upper limit of a multi-year declining trend channel. Equity investors are looking for a positive catalyst in order to break these levels, otherwise flat to negative trading may be the result, especially as we enter the most negative period of the year for equity markets in September and October.
And seemingly confirming the equity market impediment is resistance in the Euro. Correlation of the Euro to the “risk-on” trade has been strong ever since the European debt crisis began. Last week the Euro tested long-term resistance presented by a declining 12-month trendline. The US Dollar, conversely, tested long-term support. Once again, a positive catalyst looks to be required in order to force a breakout.
Even bond yields are bouncing off of resistance. Yields on the 30-year treasury firmly rebounded off of a declining 200-day moving average as well as a declining long-term trendline that has been intact for over a year. The pattern is consistent across 5 and 10-year bonds, suggesting investor reluctance to liquidating these safe-haven investments.
So although sell signals for equity markets have not become widely realized, this is hardly the place to buy either. Equities remain a hold with a strongly cautious bias. Seasonal tendencies do not support gains over the coming month. Fundamentals are sluggish. And technicals show that markets are at a pivotal point. It will remain up to investors as to how much risk they intend to hold, knowing that upcoming events pertaining to central banks in the US and Europe could move equity markets in either direction.
Sentiment on Friday, as gauged by the put-call ratio, ended bullish at 0.85. This sentiment gauge had been suggesting investor complacency prior to last week’s market declines, a situation that commonly precedes a correction. This indicator will warrant close attention into the end of this week in order to determine if complacency is high going into the central bank events at the end of this week and into next.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
Horizons Seasonal Rotation ETF (TSX:HAC)
- Closing Market Value: $12.43 (down 0.24%)
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* performance calculated on Closing NAV/Unit as provided by custodian
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Monday, August 27th, 2012
by Axel Merk, Merk Funds
Vice President Joe Biden was accused of racism when suggesting a Romney administration would “unchain banks” that in turn might put the black audience he was talking to back into “shackles.” The political uproar overshadows a reality that knows no racial boundaries: a person in debt is not a free person; a nation in debt is not a free nation. Does it mean those with large bank accounts are free? Not so fast…
We don’t want to downplay the horrific crime of slavery, but want to provide food for thought: debt is often taken on voluntarily; once taken on, however, one is forced to work to pay off one’s debt. To be unshackled from banks and creditors, investors may want to consider living debt free and owning gold. Let us explain.
Access to credit may fundamentally change one’s lifestyle. On the plus side, it opens the path to home ownership and access to capital goods, be that a car, or these days even a mattress or exercise machine. But it also makes the creditor, rather than oneself the boss. One symptom of the building credit bubble that caught my attention a decade ago was the rise of Spanish language billboards promoting mortgages. Proud immigrants in search of the American dream were lured into mortgages they could ill afford. Rather than focusing on feeding themselves and their family, the focus shifted to serving the bank. That shift only became apparent once the loan became too expensive to service, either because interest rates were resetting to higher levels or because someone lost their job and thus their income, but the debt remained.
Berkshire Hathaway CEO Warren Buffett famously discusses in his annual shareholder letters that the insurance business is a great business to be in, as policyholders pay him to hold money:
“Insurers receive premiums upfront and pay claims later. … This collect-now, pay-later model leaves us holding large sums — money we call ‘float’ — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. …”
Indeed, Buffett has said that he would never allow his firm to be in a situation where he is at the mercy of banks. It doesn’t mean he will never borrow money. But it means that when borrowing money, he always wants to be in a situation where he could pay it back if needed. Consumers have seen all too often that they only qualify for a loan when they don’t really need it. Jamie Dimon, CEO of JPMorgan Chase has said responsible banks act like mothers: they will decline your loan request if it is too risky for you.
One cannot be a truly free person with debt. While bankruptcy may have been downgraded to a mere business transaction in the U.S., some countries continue to put those that can’t pay into prison. The neighborhood surrounding Dubai’s airport has seen thousands of abandoned cars, often Ferraris or other expensive vehicles, as the formerly rich fled the country after their fortunes turned to avoid debtors prison.
Anyone is likely to argue that a nice pile of cash in a bank account will make one feel financially secure – some place that pile at $100,000. Some at a million; as a million bucks isn’t what it used to be, the wealthy often say they are not comfortable if they don’t have $10,000,00 or more. We have met people with very modest means that feel that they are wealthy; and others that have lots of money, but don’t feel wealthy. Aside from the fact that some of them might simply have a distorted sense of reality, the wealthy often also carry a great deal of debt. Those able to manage their debt thrive in this low interest rate environment. But let even a wealthy person with debt hit a road bump, say lose a job (or face an obstacle in refinancing a loan) and such a person may quickly join the lower ranks of the 99%. In our assessment, highly accommodative monetary policy is a greater driver of an increasing wealth gap than the policies of either Democrats of Republicans.
But even with $100 in a bank account, what does one really hold? One owns a promise by the bank to pay $100. The $100 bill is a Federal Reserve Note; it’s a piece of paper issued by the Federal Reserve. That $100 bill could be returned to the Fed; in return the Fed would issue a credit balance to your account (you would have to go through a bank, as the Fed won’t open accounts for individuals). The “resources” of the Fed are without limit: through its various quantitative easing programs, the Fed has increased the credit balances of the financial institutions where it has purchased securities. The Fed literally creates money out of thin air, with the stroke of a keyboard. Even prudent central banks like to see a little bit of inflation; it means that the dollar bills you hold erode in purchasing power, giving you an incentive to put the money to work to make up for the shortfall.
Importantly, the $100 bill in your bank account is really someone else’s loan – the bank’s loan, the Fed’s loan. In fact, if you take out a loan from a bank, you will pay a merchant, who will in turn deposit the proceeds in his or her bank. As such, we talk about credit in a society. For simplicity’s sake, let the banks hold 10% in reserves; $100 in bank reserves with an offsetting $100 in demand deposit liabilities can thus be multiplied into $100 in bank reserves plus $900 in loan assets with an offsetting $1,000 demand deposit liabilities through the leverage of the fractional reserve banking system as banks lend and new deposits are made in a circular fashion. Between the Fed and the banks and the banks and their depositors the system can have a multiplier effect of about 100; that is, $100 created by the Fed can lead to $10,000 in credit. That’s why we sometimes call the credit created by the Fed (the monetary base) super credit. In the current environment, banks have not been aggressive in lending, and as such, we have not seen the “velocity” of money pick up. A key reason why many are concerned about the Fed’s increase in monetary base is because it has the potential to fuel inflation. Indeed, a key reason I personally hold a lot of gold is not because of the environment we are in, but because I am concerned about how all the liquidity that has been created might be mopped up one day. Federal Reserve Chairman Bernanke claims he can raise rates in 15 minutes; we think there may be too much leverage in the economy to have the flexibility when the time is needed; the political will to induce a severe recession to root out inflation may not be there.
It’s all about debt. So if one doesn’t want to have debt, what is one to do? The answer is real assets that are free of claims. Real estate held free and clear might be one answer, although keep in mind that governments tax real estate, thus making home owners tenants of the government. As the housing bust since 2008 has shown, the fact that many others owe a lot of money on their property changes the dynamics of this real asset.
The purest form of a debt free asset is gold. Gold is true money, the only form of money that isn’t someone else’s liability. While central banks might be able to lower the gold price by dumping their own reserves, central banks cannot print more gold – it’s very difficult to ramp up gold production. If your bank goes broke, if Greece goes broke, gold will still be there. Some call gold a relic from the past. To us, it’s the purest indicator of monetary policy, precisely because it has little industrial use. We created the cartoon below last year after CNBC’s Steve Liesman suggested to me on the air that gold might not be accepted in a store.
Mind you, we are not suggesting that everyone should sell all they own and buy gold instead. Everyone should consult with his or her financial adviser for specific investment advice. Specifically, one must be keenly aware of the volatility the price of gold can have relative to the U.S. dollar; given that we have a lot of our expenses in U.S. dollars, one has to be aware of the fluctuating value of the investment relative to the U.S. dollar. But we want to get investors to be keenly aware that we live in a credit driven society. We also believe that the developed world has made too many promises, too much debt has been issued.
Governments with too much debt may a) engage in austerity to pay off their debt; b) default outright; c) default though inflation. All scenarios suggest to us to hold assets that are debt free. We see gold playing a very important part in portfolios that take the risk into account that our policy makers continue to spend and “print” more money than is prudent. We don’t need actual money to be printed – credit creation through quantitative easing – is far more powerful.
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President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds
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Monday, August 27th, 2012
by Sharon Fay, AllianceBernstein
The laborious pace of the US recovery has inevitably fostered comparisons with Japan. But we find several reasons why a protracted slump like Japan’s is unlikely, as my colleague Gerry Paul argues below.
Three Reasons Why the US Is Likely to Escape Japan’s Fate
After five years of tepid growth, investors can be forgiven for wondering if the US is headed for a decades-long slump like Japan’s. The US, like Japan before it, is suffering from the repercussions of a massive real-estate, stock-market and banking-system collapse. But there are three reasons why the US economy and stock market are likely to escape Japan’s fate.
The first is faster postcrisis deleveraging. Purging the enormous debt amassed during the global credit bubble is the biggest challenge facing the US (and most developed countries). Though daunting, the US debt problem is much smaller than Japan’s, in part because asset prices were never as inflated. At the height of their respective bubbles, the ratio of equity and real estate values to disposable income in Japan was roughly double the ratio in the US, as shown in the display below.
Further, in Japan, aggregate income was falling along with asset prices, while debt loads remained constant. In the US, aggregate income has grown as debt levels and service costs have declined, further easing the burden.
A key factor behind the US’s deleveraging success has been its ability to sustain economic output. The US Federal Reserve slashed interest rates, which lowered borrowing costs and weakened the dollar, which in turn lifted exports. The early boost in federal-government spending—even as tax revenues plunged with the recession—helped offset cutbacks by businesses and households, and remains an economic support.
The US also moved much more swiftly than Japan to deleverage its banking system. In Japan, the government propped up insolvent (so-called “zombie”) banks for over a decade. In the US, banks were forced to write off many of their toxic mortgage assets, particularly those held in securitized form; as a result, the banks had to recapitalize.
Corporate debt was a huge problem in Japan, but Japanese companies did not move aggressively to restructure; “zombie” companies persisted in Japan too. US companies, less leveraged to begin with, improved their balance sheets and cut costs. Household debt, which had skyrocketed during the credit bubble in the US but was not a major issue in Japan, has fallen sharply since 2008, both as a percentage of disposable income and in absolute terms, largely due to defaults. It has even returned to its long-term trend.
As a result, the US deleveraging has progressed much more rapidly, although it will take many more years to return to balance. While government debt has risen, we expect strengthening economic activity and rising tax revenues to ultimately help reduce government deficits. History shows that the faster a country deleverages after a financial crisis, the less overall damage to the economy and the better the prognosis for future growth.
The second key difference between the US and Japan is lower deflation risk. Deflation is a destructive force. Once it takes root, as it has in Japan, it becomes self-reinforcing and extremely difficult to dislodge. It also makes it much harder to dig out from under excess debt.
Applying lessons learned from Japan’s experience and the US Great Depression, the US Federal Reserve moved quickly and aggressively to combat deflationary pressures at the onset of the recession by injecting massive liquidity into the financial system via ultralow interest rates and quantitative easing. Though the Japanese ultimately followed the same path, they took more than a decade to get started, far too late to outrun expectations of deflation.
Today, US inflation is expected to remain positive, but low. With nominal interest rates extremely low, real interest rates are negative. This situation is terrible for savers, but stimulates consumption and investment and helps banks to recapitalize, because they earn a spread on their higher-yielding investments. Ultimately, negative real interest returns should encourage investors to shift to more risky assets in order to improve returns.
The third reason why the US is likely to escape Japan’s fate is better demographics. Japan’s shrinking workforce and longer life spans are causing significant structural imbalances: there are ever fewer workers to generate tax revenues to support growing retirement and healthcare programs. The ratio of workers to nonworkers is higher in the US than in Japan and should stay that way for decades to come, thanks to a higher birth rate and a more open immigration policy. While the rising cost of government healthcare programs remains an issue in the US, it is primarily the result of escalating medical costs. We believe that it remains solvable with a bit of political will.
In sum, more aggressive government and corporate actions to deal with problems in the US are bearing fruit. Indeed, corporate profits have eclipsed precrisis levels, and the financial health of American corporations has never been better.
For now, however, all investors can see are reasons for worry. They have responded by shortening their investment horizons and dumping equities in favor of safe-haven assets, such as US Treasuries and gold.
But this won’t always be the case. As current economic and financial imbalances resolve, we expect investors to regain their confidence to take more risk.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Sharon Fay is Head of Equities and Joseph G. Paul is Chief Investment Officer of North American Value Equities, both at AllianceBernstein.
Copyright © AllianceBernstein
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Monday, August 27th, 2012
The lull in market activity over the past weeks is poised to give way to a multitude of events that could potentially determine the market direction for the remainder of the year. Policy responses from both sides of the Atlantic are awaited, though nuances rather than headlines may be more important. In the short run however, Deutsche Bank notes some indicators suggest that risky assets may be vulnerable. Specifically, relative to fundamentals they also find that the US equity rally over the past quarter has now been excessive relative to the US economic leading indicators. Looking at cross asset valuations by comparing the level of asset prices today vs. their peaks and troughs since Sep-2008 we also find that the S&P500 appears to be the richest relative to fundamentals.
Deutsche Bank: The cross asset view: Equities could be vulnerable in the short term
In the table below, we calculate a ‘pointer’ for each asset, corresponding to the position of today’s price relative to its historical peak and trough. A pointer equal to 0% means that the current price is equal to the historical trough, a pointer equal to 100% means the current price is equal to the historical peak. We use the pointer of the global PMI Composite as a benchmark (pointer of 68.5%). In this simple framework, assets with a pointer above/below this level have under-reacted or over-reacted to the deterioration of global fundamentals.
For the market to move further into a risk-on mode from current levels, positive developments regarding one or more of the following issues would be required:
- Spain will need to make a formal application for the aid program, which, as Draghi mentioned, is a necessary though not sufficient condition for bond purchases by the ECB
- Political developments in Italy signaling an intention to follow Spain in seeking aid via the ECB/EFSF/ESM bond buying program
- Further clarity on the mechanism of ECB bond purchases: whether the ECB would target yields levels or pre-commit a potential size of asset purchases. Setting an explicit cap on yields could be politically contentious as it commits the ECB, at least theoretically, to unlimited bond purchases. In addition, a justification of the level of cap would be onerous
- Draghi mentioned that the ECB is working to address the seniority issue of ECB bond purchases, though exact details are yet to be specified. Ultimately, there will always be a risk that, in extreme situations, ECB does not fulfill its pledge of not being explicitly senior. The ECB could nevertheless make its commitment more credible by either (1) an explicit specification of the parri-passu nature of the purchases via a guarantee from the EFSF/ESM for any ECB on these purchases or (2) by retroactively being more supportive of the Greek PSI by allowing T-bill issuance refinanced at the Greek central bank to pay for redemption of bonds held by the ECB
- Resolution over the Greek negotiations: We maintain the view that a compromise agreement between Greece and the EU leaders is likely to be reached, with more time to Greece for fiscal adjustments. Recent political commentary does appear to suggest that a compromise may be feasible. Implementation, however, will continue to remain a concern, and Greece’s adherence to fiscal plans may be revisited again in the future.
Eventually, we do expect a resolution on the above issues and a support framework for Italy/Spain to be set in place; however headline risks may dominate over the coming weeks. Some of the key events which could impact market valuation in the near term include:
- 30th August: Italian BTP auction
- 31st August: Bernanke’s Jackson Hole speech
- 6th September: Spanish bond auction
- 6th September: ECB meeting
- 6th September: Meeting between Rajoy and Merkel
- 12th September: German constitutional court ruling on the ESM
- 12th September: Dutch elections
- 12th/13th September: Fed meeting
- 14/15th September: EcoFin meeting
Given the deluge of potential new information in the near term, the risk reward perspective would argue to exit trades with high sensitivity to headline risks.
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Monday, August 27th, 2012
by John Hussman, Ph. D., Hussman Funds
One of the questions we often receive is why we don’t simply lift our hedges when the market advances above some moving average or another, and replace them when the market breaks below those moving averages. Certainly, when one looks a chart, extended market advances always break above various moving averages, and extended market declines always break below various moving averages, so simple trend-following strategies seem utterly self-evident. Unfortunately, if you actually take that strategy to historical data, the results typically aren’t nearly as compelling. Moreover, once any amount of slippage or transaction costs are taken into account, the most widely-followed strategies generally underperform a passive buy-and-hold strategy over time, and often don’t even manage downside risk particularly well.
The charts below feature a variety of moving-average crossover strategies using the S&P 500. The darker blue line tracks the total return of the S&P 500, and the others track a variety of strategies that are long when the S&P 500 index is above the given moving average, and in T-bills otherwise (the moving averages are exponential – giving a weight of 2/(N+1) to the most recent observation, and the rest to the prior value of the MA, where N is the length of the MA). The moving average lengths are Fibonacci numbers, which is a common practice among technicians.
At first glance, these strategies seem very promising, particularly for the 21-week moving average crossover, which produces a cumulative return about 40 percentage points more than a buy-and-hold since 1950. Unfortunately, over 62 years, that difference is actually quite small, amounting to just 0.5% annually. And even that excludes all transactions costs, taxes, and slippage. If you look carefully, you’ll also notice that drawdowns are not particularly small. In fact, the 21-week crossover strategy has a maximum drawdown during this period of nearly 40%. The reason is that the strategy has had an awful tendency to buy into rallies just at the point where they fail abruptly, and to sell into declines just at the point where they rally sharply. You can see this reflected in the drawdown of the 21-week crossover strategy (purple) during the 2000-2002 decline. The trend is your fickle friend.
A somewhat more realistic picture emerges if we consider even modest transaction costs. The chart below reflects a cost of 0.25%, which in today’s terms is the equivalent of allowing for the S&P 500 to slip about 3.5 points between the time of the signal and execution. Given tax differences between long-term and short-term gains, as well as brokerage costs, this isn’t an unreasonable cost to assume, but it is enough to entirely destroy the advantage of these crossover systems, particularly shorter-term ones that trade a great deal.
There are numerous ways to reduce whipsaws and trading frequency, for example, adding some “padding” around the moving averages and requiring the index to trade through the average by 1% or so before the signal is taken, but these filters also have a trade-off in terms of timeliness. Another way to reduce whipsaws is to track when one “fast” moving average crosses another “slow” moving average, which is the basis of MACD-type systems. Among the foregoing moving averages, the 21-week / 34-week crossover performs best, and very slightly survives even a 0.25% slippage, though it still experiences drawdowns of more than 25% in post-1950 data, and much worse drawdown losses in Depression-era data.
To provide a better view of the full period, the chart below presents the same data on log scale. Note that the combination of whipsaw losses (buying into advances just before they fail, selling into declines just before they rally) and transaction costs are most severe for the 8-week crossover, which has a maximum drawdown of nearly 45% in the 1950-2012 data. This is exactly opposite of what many investors assume. There is a belief that if investors use a sufficiently short moving average, they will “catch” emerging advances and will quickly identify market declines, allowing them to have their cake and eat it too. This is simply not supported in the data.
Does all of this suggest that trend-following measures should be ignored? Not at all – but it does emphasize that simple trend-following schemes (like moving-average crossover rules) are unlikely to be very effective in isolation, and are not usefully applied as a top-level filter in the hope of catching market rallies without being vulnerable to downside risk. Typically, the best that can be achieved with popular moving-average crossover systems is a moderate reduction in drawdown risk, but zero or negative incremental long-term return versus a buy-and-hold.
It’s also notable that since the 2009 low, and even ignoring transaction costs, the foregoing moving average crossover strategies would have lagged the S&P 500 by anywhere between 64 percentage points (13-week) and 104 percentage points (34-week). Including transaction costs increases this gap for all crossover strategies, with the 34-week crossover strategy achieving a cumulative total return of just 12% since the 2009 low (3.3% annualized). Clearly, moving-average strategies can have substantial tracking risk versus a buy-and-hold approach.
I am comfortable with the tracking risk that our own hedging strategy experiences because I believe that we can reasonably target full-cycle returns substantially above a passive buy-and-hold approach, with significantly reduced drawdowns. We’ve achieved both objectives in prior market cycles, measured from bull-market peak to bull-market peak, or bear-market trough to bear-market trough. But this was not the case in the 2007-2012 cycle, due to missed returns in 2009-early 2010 as we worked to make our approach robust to Depression-era outcomes. From a fiduciary perspective, I continue to believe that ensuring the ability to withstand extreme strains was necessary. From a practical perspective, I continue to believe that the ability to withstand extreme strains will be more relevant in the coming years than investors would presently like to believe.
So what is the difference between mediocre trend-following measures and more historically useful approaches? The key issue here goes back to what I’ve always emphasized about “signal extraction.” Generally speaking, single indicators provide weak information because the true signal (whether about market conditions or economic prospects) is invariably confounded by random noise. The ability to infer signals from noisy observable data is typically enhanced by using a variety of indicators. Nearly all modern signal processing – in fields as diverse as radar tracking, MRI scanning, and genetic analysis – is based on the observation that multiple sensors are best suited to picking up true signals in the presence of random noise. Just as we find for economic data, market action should always be analyzed in the context of multiple indicators that capture a broad range of sectors, security types, yield-spreads, leadership, and so on. The information isn’t just in the obvious trends, it is also in the less obvious divergences.
Ever since the late-1800’s, careful market analysts have been very aware of this fact as well. Consider Robert Rhea’s exposition of William Hamilton’s work in his book, The Dow Theory:
“The most useful part of Dow Theory, and the part that must never be forgotten for even a day, is the fact that no price movement is worthy of consideration unless the movement is confirmed by both averages. Many who claim an understanding of the Theory consider only the movements of the Industrial stock average if they happen to be trading in industrials. Some even chart only the one average and profess to be able to interpret the movements correctly. It is true that there are times when such conclusions seem justified, but over any extended period such procedure inevitably results in disaster… When the Averages disagree, it’s usually a sign of distribution.”
I’ll add as a side note that veteran Dow Theorist Richard Russell expresses enormous concerns today about market action, partly (though certainly not entirely) because of the joint breakdown in the Industrials and the Transports a few months ago, and the subsequent failure of the Dow Transports to confirm the rally in the Dow Industrials since then. Price-volume behavior is also problematic here. As William Hamilton observed a century ago, a market that becomes “dull on rallies and active on declines” should not be trusted. From that standpoint, the wholesale collapse of trading volume in recent weeks is almost creepy.
Based on a century of historical data, the multiple-sensor approach is what turns out to be most effective in our own work. In that sort of analysis, concepts like “breakout” and “crossover” turn out to be far less useful than concepts like “uniformity” and “divergence.” While our broad measures of market action have been unfavorable for some time as stocks have played hot potato between periods of overbought froth and periods of ragged market internals, we now see an unusual combination of both. Even the best trend-following measures we track broke down in mid-April as a result of clear deterioration in market internals (see No, Stop, Don’t), and we have not yet observed a recovery on that front.
So for those who have asked whether we can reduce the extent of our hedging until the trend-following components of market action turn negative, the simple answer is that they’ve already done so. Moreover, I should note that even very popular trend-following approaches such as the 200-day moving average, the “Golden cross” (50-day vs. 200-day), the 34-week crossover, the 55-week crossover and others, have produced flat or negative total returns – even before transaction costs – since the April 2010 market peak. Saying that some trend-following measures are “positive” is much different than saying that they are promising.
Still, it’s worth repeating that we addressed a more general trend-following issue earlier this year, in order to reduce our use of actual put options in a world where monetary policies make investors believe that free ones can be taken for granted. Consistent with the analysis above, historical tests indicated that it would be unprofitable to simply remove hedges whenever the trend components are favorable. A strategy like that has no exit criteria other than a trend breakdown, and when stocks are severely overbought, the required decline can be very steep and incur a great deal of loss before establishing a hedge.
Still, that fact suggested its own solution, which was to allow sufficiently overbought conditions to act as an alternate exit criterion. That approach turned out to be very effective, particularly in reducing the frequency of “staggered strike” hedges without reducing their long-term benefit. Accordingly, we added criteria earlier this year to restrict the use of “staggered strike” positions, requiring not only a very negative return/risk estimate, but also either negative trend-following measures or the presence of hostile indicator syndromes (e.g. “overvalued, overbought, overbullish” conditions). The limited set of instances that survive those criteria are historically associated with average market losses on the order of between -25% to -50% at an annual rate, depending on the particular set of syndromes involved. There’s not a chance that I would ignore that data here.
While our estimates of prospective market return/risk are presently in the most negative 0.5% of historical data, based on horizons from 2-weeks to 18-months, it is easy to blend our present defensiveness into our stress-testing period in 2009-early 2010 and simply assume that market conditions here are really no different than those that have generally accompanied the market’s run since the 2009 low. This would be a mistake. The phrase “most negative 0.5% of historical observations” reflects both a large magnitude and a low frequency.
In my view, the period since March 2009 can be reasonably divided into three segments; one generally favorable, one moderately unfavorable, and one extremely hostile. The first of these runs from March 2009 to April 2010, that end-date being the last time that our investment strategy would have accepted significant market exposure, based on ensemble models we developed during our stress-testing period, and which are presently in use. This segment began in March 2009 with our estimates of prospective 10-year returns above 10% annually, but with other features sufficiently characteristic of Depression-era outcomes that stress-testing against that data was necessary.
The second segment runs from April 2010 to early March 2012, when our present methods have been – with a few small exceptions – persistently defensive. During this period, we did spend more than we would like in hedging costs due to put-option decay, and have added additional criteria (related to trend-following measures) that would have reduced those costs without eliminating the intermittent benefits we’ve had from those positions. But this was a minor change compared to the introduction of the ensemble methods, and addresses what was essentially just a periodic inconvenience due to central bank interventions. Our investment stance would have been largely defensive since April 2010 in any event.
The third segment is the period from early March 2012 to the present, where our estimates of prospective market return/risk have been extremely negative on intermediate horizons out to 18 months, where our estimates of 10-year prospective returns have hovered around 4.5% annually, and where there are sufficient divergences in market internals, overvalued-overbought-overbullish conditions, and evidence of exhaustion to motivate a strongly defensive stance. In March, these estimates dropped into the worst 0.5% of historical observations. In mid-April, even our best trend-following measures broke down, and have not recovered because of broad divergences in market internals during the recent bounce. This set of conditions survives the tight restrictions required of our most defensive investment stance. This isn’t a stance that we expect to maintain indefinitely, but I can’t emphasize strongly enough that investors would be wrong to simply blend present conditions into the longer period since early-2009 as if there is no distinction.
That said, the next few weeks will include significant “headline risk” for the market, as Fed Chairman Bernanke speaks at Jackson Hole on Friday, the ECB meets on September 6, and the German Constitutional Court rules on the legality of the European Stability Mechanism on September 12. Accordingly, it is important to inventory our risks:
In Strategic Growth Fund, we have two primary risks. The first is the risk that our generally defensive and value-conscious portfolio of individual stocks will lag the indices we use to hedge, either falling more in a market decline, or advancing less in a market rally. This is always a risk that we accept when we are hedged. While our stock selections have strongly outperformed the indices we use to hedge since the inception of the Fund, there are certainly periods where that doesn’t occur. We’ve focused a great deal of attention on maintaining portfolio characteristics that we expect to perform well over time, but it is reasonable to point out that we remain light on financials and cyclicals, as global credit risks and recession concerns loom. The other risk is the “staggered strike” position of the Fund, which represents just under 2% of assets in put option time-premium looking out to the end of the year. I expect this position to provide significant hedging benefits in the event of a significant market decline (particularly in the event of indiscriminate selling), but we’ll also experience some time decay in this position if the market remains stable or advances over the next four months, which is not our current expectation.
In Strategic Total Return, our main risks are reflected in the 10% exposure that the Fund carries in precious metals shares, and in the Fund’s duration of about 1.8 years in Treasury securities. Though the ratio of physical gold to gold stock prices (based on the XAU) remains well over twice the historical norm, which provides some margin of safety, a strong commodity selloff could put pressure on gold stocks, and a 20% decline in those stocks, for example, would translate to a Fund decline of roughly 2% driven by our precious metals shares. Meanwhile, a 1.8 year duration essentially translates into a portfolio change of about 1.8%, on the basis of bond price changes, for every 100 basis point move in interest rates. Barring a very strong advance in interest rates, I view this source of risk as fairly muted, but again, I believe that present economic and market risks make it important for investors to inventory every exposure.
In Strategic International, our primary risk is the potential for differences in performance between the stocks held by the Fund and the indices we use to hedge. Here again, we’ve focused our attention on maintaining a diversified portfolio with characteristics that we expect to perform well over time, and both our holdings and our hedges are geographically diversified and reasonably matched, but we remain light in financials and cyclicals, which is likely to be a source of some day-to-day divergences.
Finally, in Strategic Dividend Value, our primary risk is that the Fund’s most defensive stance is a 50% hedged position, so while dividend-paying stocks tend to have lower sensitivity to market fluctuations, we estimate that the Fund has a moderate net sensitivity to market fluctuations even given its partial hedge. I believe that Strategic Dividend Value is suitable for investors who are bringing their market risk down from a more fully invested stance, but the market environment remains hostile enough that my preference remains for shareholders to defer moving from risk-free investments to the Fund just yet, since I do expect that the Fund will have some amount of exposure to market losses.
In short, we understand our risks, and we believe that they are acceptable in view of the prospective returns that we associate with them at present. My concern is that in the face of very widespread complacency about global economic recession, and the nearly infinite faith in the redemptive capacity of monetary policy, investors have neither taken an inventory of their risks, nor have any sense of the low prospective long-term returns (and potentially awful intermediate-term returns) that are presently associated with those risks.
Copyright © Hussman Funds