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.

The Bear Market rally is running out of steam as we expected although a bit short of the mark we anticipated. The rally will likely stumble on for a few days this week (there have been some good earnings releases) but is unlikely to have enough momentum to carry the S&P500 index above the 200 day moving average. It has been an energetic rally but since there is no confirmation of the start of a new bull market in risk assets, now is time to dial back whatever risky bets one put on over the last two weeks.

Source: Bloomberg

Our view is not just based on divining patterns within the charts. The various portfolios we track are all showing very low ratings at the top of the rankings with some more aggressive portfolios suggesting a hefty weighting in cash. Given the precarious nature of the European Sovereign Debt crisis and the likelihood of a slide back into recession in the US, we are comfortable waiting for confirmation of market strength and missing some of the early upside if it turns out that we are being too conservative.

One short term factor which may put pressure on risky assets is the year end hedge fund redemption season (firms generally have 30-60 day notice periods).

Although on balance it is unlikely that the major institutions which make up the bulk of the hedge fund investment audience will abandon the “asset class” overall, there should be some significant withdrawals from some previous high flyers. As the notified hedge funds liquidate assets to meet the redemptions, do not expect other institutions to bid aggressively until the end of the year. When the money is reallocated to new funds, we could see a stronger than usual “January Effect”.

October has dealt risk investors a nice bear market (or counter trend, if you prefer) rally. As we pointed out last week, these are not uncommon and are just as sharp (large magnitude, short time frame) as the more familiar bull market correction. So, although there is no catchy “buy the dips” analogue, one should think about “selling the peaks”.

But what about the positive noises coming out of Europe and retail sales in the US?

While there is a slim possibility that the lows plumbed at the beginning of the month will mark the end of the bad news and the beginning of a new bull phase for risk assets, the Fund King System suggests that the momentum is just not there yet. Much digital ink has been spilled on the subject of “short covering” but the real story is that many funds were underinvested in terms of risk. The rally has been fast and furious because these investors have been scrambling in the past 5 or 10 trading sessions to participate in the rally in an attempt to patch up otherwise dismal performances for the year. Even legendary investor Bill Gross (a.k.a. “The Bond King”) has been compelled to play catch up. However, once European leaders fall short of hopes for a bank recapitalization on November 3rd and/or the next US data point on employment or retail sales disappoints, the momentum will fade quickly.

Where’s the ceiling?

This rally is all about emotion so there is no reason why it should not end at the otherwise arbitrary 200 day moving average for the S&P 500 (currently around 1276). With a 16% rally from the October 3rd close in their pockets, look for institutions to scamper for safety by lowering their exposures to risky assets once again.

As we advised last week, by all means participate in the rally but do not confuse a bear market rally with the start of a new bull market. Be prepared to return to a defensive posture on the sidelines as soon as momentum breaks down. If you only wanted to watch one indicator, the S&P500 (SPX) at 1276 would be the number to watch.

Other important factors

The most important development over the last few weeks is the announcement by ECRI that the next recession is imminent (if we are not already there). ECRI does a very good job at calling the big turns in the major economies (and, perhaps more importantly, avoids “false alarms”) because business cycles are their specialty.

One should also revisit some of the implications of the unavoidable Greek default on other EU countries. In his letter from a trip to Ireland, John Mauldin reminds us that the Irish expect to be able to renegotiate their situation in line with the terms offered to the Greeks. Expect a few more “nasty surprises” to surface in the wake of the default.

Fund King Portfolios

The various portfolios have taking a bit of a hit in the last few weeks, especially relative to the major equity indices. However, the ratings and rankings suggest that the counter trend rally will be short lived and we are due for a return to pre-October market conditions.