As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).

Source: Bloomberg

Why is the yield curve so steep?

The short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.

An unpleasant task but it is important to step back and remember where we are in the greater cycle of investing.

Here are the three questions:

1. Are we in a Secular Bear Market?
2. What does a Secular Bear Market look like?
3. Why are we in a Secular Bear Market?

The third question will help us to see the signposts for the next Secular Bull Market. The signposts are both political and interest rate driven.

Are we in a Secular Bear Market?

The answer is Yes. Does that mean the market will go in a straight line down and there are no investment opportunities to be had? No…except, as we shall see, Japan. Just as certain asset classes surged and corrected during the Secular Bull Market of the 80’s and 90’s, certain asset classes will surge and correct during a Bear Market Phase as well.

What does a Secular Bear Market look like?

Here is the Dow and S&P500 which can be put together in a few minutes using Yahoo Finance and Excel. Charts and statistics can be manipulated to tell a particular story and these charts are no exception. We have used a logarithmic scale (so a 10% rise in the 1950’s looks like a 10% rise in the 1990’s) and have squeezed it to emphasize the long term time periods. On top of that, we have laid lines of our choosing to frame your thinking. Why bother describing this? Because it is important to think about the construction of any chart that might influence your investment process. Don’t be afraid to draw different lines and even conclusions.
Source: Yahoo Finance DJIA, SPX, Nikkei

The most interesting thing to note about the two US market charts is that a Secular Bear Market is not a smooth downward progression that the words imply. A Bear Market is generally defined as a 20% drop from the peak but that definition refers to a cyclical bear market. And, since many of those 20% drops happen quickly in otherwise Secular Bull Markets, one can see how the general perception of a Secular Bear Market is formed. However, the longer term beast that prowls the financial markets these days is a generally sideways affair. Generally, because one always has the example of Japan, which has gone to great efforts to make the last 20 years as dreary as possible.

Why are we in a Bear Market?

This is an important question because it will help us find the signposts for the next phase. Despite many sunny assurances that the Great Recession is behind us, the world does not feel like it is enjoying a strong recovery. A big part of the problem is the structure of the developed world’s economies. After a long period of globalization and attendant wealth creation, the demands for pensions, government programs, subsidies, worker protections and the like have finally taken a toll on the fiscal positions of many European and US states. The government’s share of GDP has grown dramatically, particularly in response to the Global Financial Crisis. Good growth is being crowded out by Government growth.

What should we look for? Dramatic action. The US and Europe did not break out of the malaise of the 70’s until dramatic actions were taken. Governments in the US and Europe will have to make some hard choices over the coming few years in order to set up for the next round of economic growth. What signs should one look for? Political reordering, sneaky pension cuts for public employees, a change in Social Security retirement age in the US and perhaps a government willing to stand up to public employee unions.

On the financial side of the equation, the big problem is that there is plenty of liquidity being created in the banking system but very little is being turned into money that businesses and individuals can use.

Courtesy of ShadowStats.com

Why isn’t money moving from the Federal Reserve to Main Street? Simply because it makes no sense for US banks to even look at making a loan.

This chart is presented in a fashion that one might not be familiar with because we are showing it from the bank’s perspective. To a bank with access to short term Fed Funds, the dramatically steep curve in US dollar rates means that the bank can make a bundle in the US by simply borrowing at next to nothing and lending it to the US Government for a few years. Compared to the complexities of a 30 fixed rate mortgage, this trade is the path of least resistance. Not only do you not need loan officers, you do not need an advanced degree to lay on the trade.
Data Source: Bloomberg

For now, it means that banks and other financial institutions around the world will continue to crawl over each other to get in on the trade. That means continued dollar strength (UUP) and weakness in the British Pound (FXB) and Euro (FXE) for the foreseeable future.

The signpost to look for is the flattening of the yield curve. When the long end comes down (because the FED appears determined to keep the short end anchored near zero) the loan officers will be out in force to recycle the profits that are being racked up today. Once that engine restarts, expect to see a huge surge in asset prices, economic activity and eventually, inflation.

What to do in the meantime?

As we pointed out in the beginning of the post, the next few years will be dominated by the Secular Bear Market. That means a general sideways drift with plenty of smaller bull and bear cycles along the way. To make money in rotational markets one must pay close attention to asset allocation and being ready to shift assets between classes. The old “Buy and Hold” formula which worked so well for almost two decades will only deliver very slim returns with lots of volatility. We continue to refine and test the Fund King System to meet the challenges of these markets.

Right now the System is telling us to stay in the following asset classes: Emerging Europe (TUR is back), High Yield, India, Tech, Reits, US Consumer, US Small Caps and Homebuilders. In our commodities only portfolio, only Gold (GLD) and Silver (SLV) look interesting.

For more information, go to our Portfolios Page. Gold members can see the most recent recommendations.

Disclosures: We eat our own cooking so you can safely assume that we own, have recently owned or are about to own the ETFs discussed here. In this particular post, we do not own GLD or SLV although we have owned both in the recent past.

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.