Traditionally in the US, January is a time for chasing small caps. The NASDAQ has outpaced the S&P 500 almost 7% to 4.6% so far this month. In Asia, some of the larger markets will close or be affected by the closures around the Chinese New Year Holiday. Since the New Year will be a Dragon Year, expect at least a few strong sessions when markets reopen.

What does this mean for riskier assets? A bullish forecast off the back of a January rally is a dangerous one. Right now, the positives and potential negatives suggest another volatile year.

Housing Stocks Come Back to Life

There is no doubt that the US is starting to rouse from the GFC imposed slumber. A Financial Crisis induced recession is harder to bounce back from than the more common inventory cycle recession. One consequence (amongst many) is that one traditional avenue of entrepreneurial capital (residential real estate) has not be readily available to finance new business start-ups because of falling housing prices and general bank reluctance to extend credit to the private sector. That deep freeze appears to be thawing a bit. The bellwethers of the US domestic housing market (ITB and XHB for ETFs, LOW, HD, PHM, and LEN for individual stocks) have turned up strongly. Will this be a “head fake” like the last time XHB surged from July 8th 2009 to April 23rd 2010 (+89%)? Perhaps, but with other positive “green shoots”, this surge (from October 4th 2011, +58%) may not reverse as dramatically as the last one. Given the sharp run-up and some good earnings reports, don’t be surprised if there is a correction in the coming weeks, though.

The housing sector bears watching. If entrepreneurs can unlock capital in residential housing, the Great American Job Creation Machine can crank back into gear (recent job report numbers are rounding errors compared to what they should be for a full blooded recovery).

Summer in Europe?

Unfortunately in our interconnected world, the troubles brewing in Europe still look likely to cause more heartburn in the next few months. There is little doubt that Europe has failed to sort out the sovereign debt crisis of its periphery to the satisfaction of financial markets. Credit agency downgrades only confirm what most market players have been saying for months…the sums do not add up. The next “final deal” will just be one of a series of “deals” that will see a series of painful writedowns for the banks. Bank Capital is being bolstered largely by clever accounting tricks these days. And with hedge funds buying up troubled sovereign debt and relatively cheap Credit Default Swaps, the prospect for an orderly “voluntary” haircut looks somewhat diminished. The rot is spreading from the periphery to the core and until the Germans are forced to make some hard political decisions, the rot will continue to spread inward.

So what is left for Europe? Very likely…devaluation.

In a rambling article for Bloomberg, two professors from MIT make the case that Italy is crucial to the Euro’s survival and that unlike most other European countries, Italy has a significant amount of trade outside the EU (55% of exports according to the authors). Given those two factors, a Euro trading at parity with the US dollar should help Northern Italian exporters boost exports enough to make a difference. And, since Italy boasts a massive and vulnerable bond market, any improvement should help to relieve pressure on the Euro’s long term survival as a common currency (ETF: FXE).

How will this play in the US and other emerging markets?

In the short term, it means that a summer holiday in Europe might be a great bargain. In the medium to longer term, a more competitive Europe could hamper any manufacturing renaissance in the US as a large swing in exchange rates allow German exporters to price more keenly than US Midwestern component makers (and makers of commercial aircraft). For China, the authorities in Beijing probably have enough fiscal and monetary firepower to overcome the negative effects of a Euro devaluation (the Eurozone is both a large customer and competitor of China).

One can only guess whether China will continue to diversify its foreign exchange holdings into Euros. Given the likelihood of a significantly lower exchange rate in the not too distant future, it would not be surprising to see the People’s Bank directing its traders towards other currencies for the time being. Given the massive size of the foreign exchange reserves and China’s desire to hold down domestic inflation, the US dollar is probably the only reasonable home for recycling the trade surplus (ETF: UUP).

The market took great comfort in the 4Q GDP number (+8.9%) published an efficient 17 days after the end of the quarter (perhaps the BEA could pick up a few pointers). With a small improvement over the consensus of 8.7%, concerns of a weak Chinese economy have been banished from the 24 hour news cycle for the time being.

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

Ever since the markets started to destabilize in late 2007, regulators around the world have come up with new edicts to ban short selling, particularly of bank stocks. By squeezing out the shorts and making it tougher for new negative bets to be put on, the fervent hope of the regulators in the US and Europe was to buy the banks enough breathing space for the crisis to pass.

When it became obvious, in the darker hours of 2008, that the problem was not a short term one, Central Banks and Governments stepped around the equity markets and went directly to the source of the funding problem. The answer was to guarantee the liabilities of the banking system. In the US, this happens with depositors automatically through the FDIC but this was the first time such a massive, coordinated effort was undertaken to guarantee all bank creditors, even those with subordinate claims.

The gambit allowed most banking systems to start the rebuilding process although in countries like Ireland, it has landed the tax payer with a crushing new liability (estimated at nearly 40% of GDP). The financial authorities also recapitalized selected banks and in the case of the Federal Reserve, threw open the short term lending windows to push liquidity out on terms not seen in several generations.

This last week, we have now seen the advent of a new type of short squeeze, and most likely an unintended one at that. By changing the game for the CDS (Credit Default Swap) market (a voluntary writedown of Greek debt is not a default event), the EU has caused the issuers of CDS’s to change their view of the cover they need. Since CDS’s are unlikely to be triggered, the need for the CDS writer (typically an investment bank) to hedge is much diminished.

In the case of Euro sovereign debt, that means there is less need to hold short positions on the big banks that would get whacked by a sovereign default. The unwind of those shorts is part of the reason why the markets have greeted an otherwise unimpressive announcement from the EU with such enthusiasm.

How “Wall Street” really works

As we have argued in the past, the bulk of the professional financial world does not view the markets the way the mainstream financial press would have you believe. The trading floors are not populated with swaggering “Masters of the Universe” betting the balance sheet on single ideas.

Although there is the occasional story of tremendous profits (Soros breaking the British pound, Paulson betting against home mortgages), the bulk of financial firm profits derive from managing risk (and charging for the service). Firms take on liabilities (derivatives agreements, for example) and then try to match off the risks in correlated assets. If done correctly, the firm can profit by exploiting the different prices available in the market. At the bigger firms, a whole department is charged with adding up all these assets and liabilities on a real time basis so that managers can determine just how exposed the firm is at any one time.

The plan goes wrong from time to time in one of three ways: fraud, overconfidence and liquidity squeezes.

For fraud, we have an excellent recent example in the UBS case in September. A trader, Kweku Adoboli, managed to “fool” the system and blow a $2.3 billion hole in the bank’s finances (to say nothing of the reputational damage).

For overconfidence, the emerging story of how former Goldman Chairman, Jon Corzine has transformed MF Global from a profitable derivative broker into a flailing investment bank is a fresh take on an old problem.

But the most common pitfall is liquidity squeeze. Since the margins between the liabilities and assets which banks use are often very small (due to the competitive market forces), investment firms leverage their balance sheets to make their activities sufficiently profitable (on an equity basis). Leverage ratios of 20:1 are considered very prudent in most parts of the professional financial world (whereas individual experience is usually limited to an 80% Loan To Value mortgage which equates to a 5:1 ratio). Going into the Global Financial Crisis, many top tier names were sporting leverage ratios above 40:1. When markets are stable and funding is abundant, this is a formula for minting money. Indeed as late as 2006, financial firms accounted for over 40% of corporate profits in the US. However, when market values become volatile and funding dries up, leverage works against the system, losses pile up quickly and insolvency is a serious risk.

Why does this matter?

Since better than 80% of market transactions are initiated by financial intermediaries, it is important to understand what drives their behaviour. Listening to Financial “Captains of Industry” waffle on about capital raising and discovering tomorrow’s new opportunities will tell you as much about their firms’ trading plans as Coke’s latest ad campaign will tell you about the risk of getting fat. That doesn’t mean you should not invest any more than it means you cannot enjoy a sugary cola from time to time. It does mean that you need to make sure you tone out the marketing fluff and concentrate on the useful information available in the market.

That is why using objective tools to measure the market is so important. If we rely on emotions, which is what financial news writers get paid to stir up, we will end up most despondent at the bottom of the price range and most euphoric at the top.

Curbing your enthusiasm

If we look at the Fund King rankings, it is still evident that the “melt up” (yes, the mainstream financial media is working hard to peddle that as a legitimate term) is still looking very short term in nature. When you consider that the latest source of buying pressure is driven by trading desks rebalancing their risk exposure, one can see that this is not a typical building block for a multi-year bull market. We would expect a serious lack of follow through this week.

Two Fund King Portfolios to look at:

The Global ETF Portfolio would only have you positioned in Bonds, Gold and Japanese Yen.

The T Rowe Price portfolio, which boasts some top performing equity funds would have you all in cash.

Sure, it has been in the rumor mill for a while now. But, now that the French and Germans have imposed their vision of a “voluntary writedown” on private investors, it is still amazing to see the lengths that the authorities will go to declare the event a non-default.

The Wall Street Journal has a good blog on the subject: “So, about that insurance you bought on Greek Debt…” which covers the key details.

For the market, the dance will go on. Anyone who might suggest that this little manouver will disrupt the fragile fabric of the market is more than a little desperate for attention.

For investors, this little drama should serve as a “Caveat Emptor”. Not all investments are created equally and not all of them have the rights to the underlying assets that their promoters might hint at. When commentators brush off the risk of an ETN, which is backed by the sponsoring bank’s balance sheet, versus an ETF, which should be backed by assets that are subject to periodic audit, think back to the “smart money” hedge funds who will soon have to explain to investors why they were unable to capitalize on a sure thing like Greece’s default (oops, sorry, voluntary restructuring).

Despite well telegraphed intentions, the Standard and Poor’s downgrade of US Government long term debt still came as a big shock to most investors. The markets have and will continue to react accordingly. Expect high volatility and no small amount of panic.

With the US economy barely growing (latest reading at 1.6% for 2Q), the next question is the one which we find on the cover of the Economist this week. The magazine and other sources like ECRI are not willing to say for sure that there will be a second recession but are warning that the chances for a double dip are on the rise. The popular image is of the US economy being like a slow moving bicycle…the slower it moves, the more easily it can tip over. Like most easy images, this one obscures more than clarifies. As the impact of the tsunami in Japan on global supply chains demonstrated, the US economy is far more complicated than a bicycle.

Earnings are pretty good

While politicians are doing their utmost to stymie growth in the US, on the earnings side S&P500 companies have turned in positive numbers. In the latest round of reporting, the earnings have grown at just under 18% or about 5 percentage points better than expected. How can the largest listed corporations in the US be earning better than expected profits with the US economy so close to “stall speed”? The magic trick is achieved by non-US sourced earnings which may account for as much as 50% of the total (up from less than 40% before the onset of the Global Financial Crisis). The developing world continues to develop a middle class that is keen to acquire the trappings of their recently improved status.

Valuations are out of line

The dichotomy between the US economy and its leading corporations is part of the reason why there has been a disconnect in the “Fed Model” which compares the interest yield on the current 10 year Treasury to the inverse of the PE ratio (otherwise known as the “earnings yield”). If 50% of the earnings used in the earnings yield calculation are from non-US sources, comparing that result with a less than free market rate on 10 year US Treasuries (thanks to QE2) is an exercise in GIGO (garbage in, garbage out) financial modeling.

What should an investor do?

In the case of risky assets, one should be watching for short term opportunities at this point. SPY is very oversold (see chart) so even though the long-term outlook is unclear, there will no doubt be a rebound as soon as the panic subsides and cooler heads move in to pick up the pieces.

Otherwise, continue to monitor the situation from the sidelines. Gold will continue to move up as investors who are extremely risk adverse will look for havens beyond short term US Treasuries. If one thinks about gold as a low inflation currency, it is not hard to fathom its latest appeal. Of the 100 largest ETFs listed in the US, IAU and GLD remain at the top of the rankings. Health Care, Biotechs and Pharmaceuticals are also found amongst the top 20 but the ratings are far from conclusive at these single digit levels.