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.

That was a brutal start to May!

This week, we look at two factors which drove market behavior last week: the vastly increased speed of trading and the emotional transmission mechanism.

The speed of trading

For several hundred years, the laws of physics pioneered by Sir Issac Newton were the foundation of the industrial revolution. By measuring, understanding and harnessing the natural forces all around us, inventors, entrepreneurs and others were able to build machines, power plants, factories and all the modern conveniences that we take for granted today. However, as we started to explore the very small (atomic scale) or the very fast (speed of light) or the very massive (the universe), Newtonian physics broke down. It failed to explain our observations. As a result, Albert Einstein was compelled to invent a new set of laws. Those laws did not invalidate Newtonian physics (an apple falling out of a tree can still hit you on the head) but it recognized the old physics as a set of rules that work when things aren’t moving extremely quickly or are extremely small or large.

Moving over to the financial markets, we are in the same place as Einstein and others found themselves in the early 20th century.

The Efficient Markets Hypothesis and Modern Portfolio Theory were crafted in the middle of the 20th century when the speed of financial markets were within normal human scale. Transactions were initiated and executed by humans using telephones, scraps of paper, pens, order books, haggling and time stamp machines. In physics, it was still about the apple rather than the subatomic particles which make up the apple.

But, now speed forces us to reevaluate our understanding of the financial markets. According to an article in the FT, transactions can now take place in as little as 16 microseconds. To understand how fast that is, note that the average human eye blink takes 350,000 microseconds (ref). So, we have entered the age of Algorithmic Trading in general and we are seeing how one cutting edge product, which has been christened “High Frequency Trading” (HFT), has changed the nature of the market.

HFT is estimated to account for 50%-70% of the daily volume in US equities. It is a heady period not dissimilar to the excitement that surrounded the dawn of the atomic age. Scientists in a number of countries raced to turn the new physics theories into real world applications in the 1930’s and 1940’s. Success in the atomic race translated into superpower status in the post-WWII period. Success in HFT has already translated into outsized profits at firms like Goldman Sachs.

And just as regulation did little to stop the proliferation of nuclear technology, one should not expect too much to come from efforts to control this latest advance in the science of trading financial assets. The SEC has tried to curtail “flash trading” but it will be difficult to convince market participants to not seek ways to profit from their high speed machines.

Unfortunately, just like early experiments in harnessing the power of the atom, occasionally the chain reaction process gets out of control. Last Thursday, the computers got stuck in a loop, cratering the market before anyone could hit the “reboot” switch.

The emotional factor

So, how does a computer loop translate into a global phenomenon? In our interconnected world, assets are constantly being measured against one another. The ability to move from emerging market equities to short term US Treasuries or Gold is almost frictionless for a medium sized institution. All the excess cash created by our Central Banks is sloshing around the financial markets chasing returns. So, when Institutional investors smelled smoke, they had to assume that there was a fire nearby. Given the speed issues explored above, a “shoot first, ask questions later” attitude has emerged. In short, traders pushed the panic button. In the US, they pulled their bids and let the computers find out just how low they could go. In the rest of the world, they dumped “beta” and dove for safety.

That’s it?!?! There must be more behind the story than that! Part of the emotional component of the markets is our need for an explanation that we can grasp; we need a scapegoat. We must have a cause and effect in order to feel that we have control over the universe or at least our corner of it. So, where was the fire? Was it Greece, which has been exposed as a financial basket case for months now? Was it the Euro, which is showing the strain of the substantial political compromises that accompanied its creation just over 10 years ago? Was it the UK elections where observers have been calling for a hung parliament since the beginning of March? Was it a “fat finger error” where a junior clerk sent an order for billions instead of millions? One thing is for sure: this story is too good for the media and congress to ignore. But as investors, we should not spend much time with these historic events that were well discounted. The markets look forward and so should we.

How to deal with high speed markets

Although the price of computing power has come down through the decades, the systems that drive HFT are still well beyond most investors’ budgets. And, even if we had access to those systems, success is not assured. As we saw on Thursday, even the traders whose job it is to watch the markets on a tick by tick basis were powerless in the face of a rogue wave of computer generated trades. Developing a system that works in increments of 10s of microseconds is not a viable option.

Since we have been comparing the new market to modern physics, perhaps we should take a page from the physicists’ handbook at the atom smashers in the US and Europe. Contrary to popular imagination, the scientists as CERN do not throw the switch and see what comes out the other end (maybe a black hole!). They spend years planning for their experiments so that when the near light-speed collisions occur, they already know what to look for. Once the protons start ramping up to 7 trillion electronvolts, there are no technicians scrambling around the tunnels with socket wrenches.

Investing should be the same. One should have an investment plan and universe of assets firmly in mind before investing in the financial markets. If your goal is to fund retirement in 10 or 20 years, days like last Thursday are non-events. Using a systematic approach that allows you to regularly review and rebalance your portfolio will allow you to keep well positioned for whatever the market decides to throw at us.

One of the tools which helps one to maintain a longer term perspective is the Weekly Leading Indicators from ECRI. The ECRI is founded on the study of the Business Cycle which has managed to survive many announcements of its demise. As you can see from the chart, we are still expanding. There is no doubt that we will hit corrections along the way but until the WLI turns negative, the chances of a double dip recession are limited.

But what about the impending collapse of Europe?

The problems in Europe are significant as the internal contradictions of the Euro come sharply to the surface. But two things are likely to happen. First, Germany and France are going to find ways to bail out their banks. If that means saving Greece and Portugal at the same time, then that is what will happen. Second, a weakened Euro will help export related companies in the core industrial center of Europe (Germany, France, Northern Italy…). Although European leaders will denounce “market speculators” a 10% shift in the value of the Euro vs. the Dollar will have a significant impact on exports in the coming months. A bigger shift will have a proportionally bigger impact. So, while one might shy away from Greek sovereign bonds in the coming few weeks, there should be significant opportunities for the former Eastern European countries that supply the German export machine. That is why you will find Emerging Europe on top of the System Rankings and near the top in many of the portfolios.

Other Picks

In our international mutual fund portfolios, Japan and India still rank highly although EPI, the Indian ETF does not make it into the top rankings of our ETF portfolios. US Small Caps, High Yield, Real Estate Related, Biotech, Technology and even Financial Services feature in the top rankings as well.

Wisdom of the ages or a silly superstition? Besides being a catchy rhyme, does it have any basis in reality? Along with the January Effect and the concept that equity markets tend to outperform from October to May, this old market saying returns every year as regularly as Mother’s Day.

While every year is slightly different and most of the studies on calendar variations of market performance conclude that the anomalies are too small to make consistent profits, there is good reason to pause this May and decide what we want to watch for in the coming months. As regular readers will notice, we have our doubts about how well the efficient market hypothesis explains market movements. Those doubts are based on observations of how investors’ emotions can have a significant impact on the direction of money flows and asset prices. That doesn’t mean we are ready to embrace every market superstition but let’s look at some of the reasons why Sell in May might hold some validity.

1. Earnings Cycle
   By the end of May, most corporates will have reported first quarter earnings. Generally 1Q earnings closely follow the release of the previous years’ fully audited earnings report. March, April and May are very busy periods for analysts. And this year is no exception as they scramble to upgrade their earnings estimates to current trend. The next significant set of earnings won’t come until August/September and the second quarter is a great quarter for booking bad news. So the start of our Sell in May period is a relative data vacuum followed by potentially disappointing 2Q earnings as the summer drags on.
2. Summer in the Northern Hemisphere
   The saying originally came from England as London stockbrokers and fund managers prepared for the English summer (horse racing, Wimbledon, summer holidays). Market volumes traditionally fall off in summer months and lower liquidity often brings lower stock prices.

So, mark your calendar to take some time this month to review your portfolio. Equity markets have run hard and while equity analysts are falling over themselves to revise their S&P500 earnings numbers upward you should try not to get caught up in the false enthusiasm. Who will be the first to reach $100? (current forward earnings estimates have already broken into the high 80’s/low 90’s). The correct answer is: “Who cares?” Earnings mania could give us just the short term top that makes people remember the “Sell in May” adage.

That said, we still see strength in certain segments of the equities markets. At the top of the ETF list (found here) is the REIT ETF (RWR), followed by Consumer Discretionary (VCR & XLY), Biotech (XBI) and Homebuilders (XHB). The rest of the top 20 is filled with various flavors of US Small Cap indices.