In 20/20 hindsight, Sell in May was a pretty good idea. Sell in April might have been even better but that is not how the old saying goes. Gold has just moved past the $1200 mark and billionaire investors are back in the news telling you that Gold is the only sensible investment. Should you listen? Of course. Should you buy? Only in our Commodity ETF portfolio does GLD rate highly. In the other portfolios that include GLD, the ETF ranks in the middle of the pack with its trusty sidekick SLV. That means the System is telling us that there are better places to put our money right now. How can that be with such a beautiful chart? Because, if you look closely, you will see that the scale is very large both in terms of time and price. It masks some serious monthly volatility that regularly reaches into the 20% zone. Gold may be as good an investment as people like Mr. Kaplan say but be prepared for a wild ride and you should probably wait for the next downward lurch to buy in.

What has changed over the last few weeks?

The biggest change in the global financial landscape is the nearly US$1 trillion European Rescue. While property investors as far away as China hoped that some of the new liquidity would somehow eventually slosh into distant emerging markets, the package’s announcement appears to have pushed excess liquidity to the sidelines instead.

In the short term, the “Flash Crash” scared well over US$10 billion out of US equity markets as seen in the latest statistics from the Investment Company Institute report (click chart to see report).

Usually, it is not all that helpful to look backwards. Historians are not normally known as the best investors. But in this case, these two events will help us gauge the overall investment background so that we can rate the impact of both positive and negative surprises.

1. Government Intervention yields diminishing returns
   Whether one agrees or disagrees politically, the last two years have been all about Government Intervention. But that is starting to change. When the US Congress passed TARP the second time around, the conversation was apocalyptic in nature. Nearly all of the G20 countries jumped in with deficit and stimulus packages (BBC summary) and politicians and central bankers were applauded for staving off the Second Great Depression.
   This time, however, the conversation sounded more like the owner of an old car unhappily agreeing to a big repair job that cannot be put off any longer. The impact was muted as voters (who are also consumers and investors) recognized that the bailout was going to cost lots of real money while delivering very few tangible benefits.
2. Investors are skittish
   The reaction to the “Flash Crash” of May 6th shows that investors are skittish, pure and simple. That is important as we look at the Fear and Greed chart which we talked about several weeks ago. Sentiment wise, we are still facing the “Wall of Worry” near the “Caution” marker.

The volatility we have seen this month has knocked down some of the scores in our System although they still remain positive. In addition to funds being scared to the sidelines on the back of the muddled Euro Rescue and the Flash Crash, there have been reliable reports of large short positions building up in the markets. On the other side of the equation, on Thursday and Friday of last week, the number of SPY ETF shares expanded by 5%, leading to speculation that the Plunge Protection Team might be active.

So what is the next surprise?

Markets move on surprises. Right now, investors are broadly positioned in anticipation of more negative news, so a negative surprise will have less impact than a similar positive surprise.

So, does that mean the next surprise will be positive? Certainly that is not the consensus view. For consensus, turn to an editorial for the Wall Street Journal in which PIMCOs CEO argues (in the third from last paragraph) that investors are still over-extended and over-leveraged. As part of Mr. El-Erian’s “New Normal Economy” hypothesis, investors are still not prepared to accept the newer, more subdued rates of return that we are likely to see in the future. This view of the world was radical when PIMCO popularized it in early 2009 but, after a year on the shelf, it has now become consensus and has been priced in to the markets.

So, we would argue that a negative surprise will have a relatively small negative impact on the market because the market is ready. A positive surprise on the other hand would likely have a more positive impact on the market than one would normally expect. We therefore will continue to implement the System recommendations on our various portfolios despite the setbacks in the past three weeks.

Despite all the positive press that China’s “Economic Rising” has garnered lately, investing in China has been a slog since August of last year. As one can see from the chart of the Shanghai composite below, China’s equity markets have been pretty sloppy since last August. China shares are not particularly cheap with most consensus forecasts suggesting P/E’s in the mid 20’s for a slice of the action.

From the System’s point of view, the high volatility and lack of upward direction has relegated China assets to the bottom half of the rankings for all the portfolios that include China for several months. However, after losing 13 plus percent in a month, China this week has tipped into the Short column in our Asian Index Long Short portfolio.

Source: Bloomberg

Why is this happening when the press reports are in near universal awe of China’s ability to navigate through the Global Financial Crisis? China, after all was swift to turn on the liquidity pumps at the banks to inflate a property bubble of impressive proportions. Despite the continued weakness in China’s primary export markets of the US and Europe, companies were eventually compelled to restock shelves in the past few quarters leading to a nice snapback in export orders.

But the markets are forward looking and if one scratches beneath the veneer of good news, there are problems a plenty. The largest problems are tied to inflationary pressures (primarily from an overheated property market) and the sustainability of economic recovery in China’s two biggest export markets (the US and Europe). But the latest drop appears to be anticipating something more specific. China’s banks have all been ordered to raise more capital (slowing down loan growth is not really an option) and China’s Agricultural Bank is slated to become the largest IPO ever at US$20-30bn. The initial idea is a dual listing in Hong Kong and Shanghai in July but over the past few sessions, there has been enough talk about Plan “B”s to suggest a bit of indigestion ahead. A shaky launch could be the catalyst to send China shares into a swoon (with impact on the Hong Kong market in general).

So what is the bet?

Defining what you are trading on is very important because there can be several outcomes. If you are unclear about the original conditions, it is unlikely that you will be able to react properly to the outcomes. The bet is that China’s regulatory officials feel comfortable pushing ahead with the Agricultural Bank IPO and other fund raising activities at a time when international appetite for risk is waning. That doesn’t mean the IPO has to fail miserably or even get launched at all. It means that the presence of the deal (the overhang) will cause indigestion in the market and cause prices to fall. Why are the Chinese authorities feeling confident? For one thing, property prices are rising in double digits in almost all the cities. For another, China’s leaders are busy trying to batten down talk of the “Beijing Consensus” or “China Model” as they swan around the world with a bit of a G2 swagger. In short, the bet is about a bit of hubris in the market which will be corrected in the time honored fashion of falling prices.

How to play this opportunity?

For the average investor, it is quite difficult to short the market. Products do exist. Proshares offers YXI and FXP, the inverse and double inverse of the FTSE Xinhua 25 index, FXI. However, one should read the well written and un-camouflaged health warning on the Proshares site carefully. Because the inverse ETFs are designed to track one day movements in the underlying index, a volatile market like China can lead to large tracking errors between the ETF and the target index over relatively short stretches of time. Some investors will choose to short FXI in a margin account to try to obtain a better tracking over periods of one month or so.

Should you play this opportunity?

If you decide to short anything, you need to pay closer attention to it than a long trade. For many investors, the extra attention to detail is the dealbreaker. If you are not sure, err on the side of caution. If you are ready to play, you first need to consider how FXI will diverge from SSEC (the Shanghai composite index). While it is true that the FXI is made up of the bluer chip companies that are able to meet Hong Kong’s listing standards and that the P/E ratio is lower (16.7 at the end of April) than those in Shanghai, the FXI is heavily weighted in precisely the same financials that will be impacted by a less than stellar Agricultural Bank launch.

For those who are unwilling or unprepared to go short, there is still a good opportunity on the long side. If IPO indigestion tanks the market, there will be a good chance to pick up shares in the second largest economy (and largest exporter) on the cheap. When will that happen? Watch the System rankings in the coming months. When China starts to move off the bottom of the list, there may be a good opportunity to catch a rebound. Why do we think there will be a rebound on the other side? Because our central investment premise is that markets move in cycles. If this cycle is a down one for China, it makes sense that the next one will move in the opposite direction.

Not perfectly correlated

Price Source: Reuters

Other trades this week

Not a lot has changed from last week. Emerging Europe, Japan, India, US Small Caps, Biotech and High Yield are still hanging in there. One subsector which has scored well lately is the Homebuilders (XHB) in the US. Homebuilders are reported optimistic despite phased out government incentives to new home buyers. In our commodities only ETF portfolio, Gold (GLD) and Silver (SLV) shine in an otherwise dull clutch of investment opportunities. However, in mixed portfolios, neither precious metal ranks highly.

It’s time to take a reading of where we are on the Fear and Greed curve. If we want to be better investors, it is critically important to take stock of where we are in the cycle from time to time.

Source: Investment Postcards Blog

This week, I am borrowing the chart shamelessly from Prieur du Plessus who runs a very informative investment blog from his base in Cape Town. If you would like to receive his thoughts, he offers a free email subscription (follow this link).

The Fear and Greed Cycle is a classic and has been around for decades at least.

What is a classic?

According to Mark Twain, a classic is “Something that everybody wants to have read and nobody wants to read.”

OK, many of the “classics” we were forced to read in school were pretty dry but that’s not the reason we ignore the Fear and Greed cycle. We ignore it because it reminds us that our emotions play a strong role in our investment decisions. When the market is low, so are our emotions and we fail to buy (or worse, we dump at the bottom). When the market is at the top, our emotions are bubbling over and we fail to sell (or worse, we buy more). Since this is the core argument behind the IRP System, we won’t belabor the point here other than to say that we believe emotions are the key driving factor behind price movements.

So where are we today?

Globally speaking, we are in the middle of the left hand side of the curve, somewhere in the region of Caution. Some markets are more confident than others but there are many investors who still bear the emotional scars of the Global Financial Crisis. We are edging in on Enthusiasm but we are a long way from Conviction.

One of the interesting features of this recovery is the unevenness of it. Because the Global Financial Crisis was largely a G-7 event, the normal order of recovery has been scrambled. Usually, the global heavyweights in the developed markets lead the market recovery followed by smaller caps, emerging markets and exotic themes. This time, the financial markets were led out of the woods by the BRICs (Brazil, Russia, India, China) economies that were able to sidestep the worst of the recession. Countries like Poland did extremely well by not falling into recession at all. So, our normal “rules of thumb” may be a bit stretched but the emotional state driving investor decisions remains the same. Therefore, when we point out that US Consumer Discretionary Spending stocks look promising (VCR & XLY) while China (FXI) Brazil (EWZ) and India (EPI) have come off the boil, it should be noted that market sector leadership was very different this time around.

So what can we expect?

Given the ferocity of the bounce from last March, it is tempting to conclude that this trip up the left side of the curve will happen very quickly. In economic terms, that would be anticipating a double dip recession or W shaped recovery. That outcome is still quite possible but we are preparing for a longer, messier, uneven recovery similar to what we have experienced over the last 12 months. Economically, this more likely but messier scenario would see growth returning in fits and starts around the globe. On the Fear and Greed curve, it would leave us struggling between Caution and Optimism for the next 12 to 18 months.

What should we watch out for?

One should be on the lookout for signs of hubris and in the case of China’s recent property bubble and the potential bubble that has built up in Sovereign Debt, those signs of overconfidence are already here. Bubbles in one or two asset classes are not a sign of the end and with all the stimulus cash sloshing around the global economy, it is to be expected. However, when the majority of asset classes look bubbly, it will be time to look for the exit. We are not about to embark on a 20 year bull run in asset prices, not at these starting levels anyway.

What looks good this week?

This week, our international portfolios are still positive on Emerging Europe (GUR/GMM), India (EPI) and Japan (EWJ). Our mixed US/International portfolios are positive on Consumer Spending (VCR & XLY), Biotech (XBI), Pharmaceuticals (XPH), US Small Caps (VB, IJR & IWM) and Homebuilders (XHB).

New ETF Pages…

We are building up our ETF information pages (starting with AWCI) so please click through and check them out. Any suggestions (ETFs you would like to see, different presentation or any other comments) would be most appreciated.