Watching the market action over the last few months, I am reminded of the traditional circus of my youth. When the Ringling Brothers rolled into Madison Square Garden, the elephants would march in at the beginning of the show. Each elephant would hold the tail of the elephant in front with his or her trunk and they would parade around the main ring. When the ringmaster raised his hands, the elephants would lift their trunks, and consequently, the tails of the elephant in front. When the ringmaster lowered his hands, the trunks went down. Around and around it would go until the elephants found their places and started lifting clowns and circus girls into the air with their now unoccupied trunks.

Obviously the ponderous elephants today are the financial markets around the globe which have risen only after dramatic flourishes by the ringmasters (Central Bank worthies and European politicians). However, when these ringmasters let their arms down to prepare for the next flourish, the elephants have been dropping their trunks around the world. Without the ringmaster, market participants are not willing to step out of line and risk capital (note the repeated approaches to but few breaches of the 200 day moving average on the SPX). And this observation is not just a reminiscence of youth. Thanks to Bloomberg, it is not hard to plot the increasingly correlated nature of the main equity indices.

Data Source: Bloomberg

I constructed this chart by taking the weekly correlation measurements at monthly intervals. At the far left it measures the correlation for 12 months (Dec 15 2010 – Dec 15 2011). The next point is from Jan 15 2011 – Dec 15 2011 (11 months) and so on until the last data point on the right which measures just the past month. The function on Bloomberg is CORR for the Correlation Matrix.

What do I think this means?

Although this is a non-standard “study” of the market, I think it demonstrates pretty clearly how dramatically the nature of the markets have changed over the year. What surprised me the most was how much GLD’s relationship with the SPX has shifted (much to the chagrin of gold bugs with 2000 price targets). I also looked at TLT as a proxy for treasuries and its correlation moved from -0.79 to -0.87 through the same period. I suspect that the “dead hand” of policy risk (both political and monetary) has stamped down the risk appetite amongst investors for any significant investment time horizon.

I think there are two key take-aways from these “observations”.

First, we need to watch for opportunities to sell puts and calls when the VIX is high because there are not the usual amount of “asset allocation” opportunities to make money. With little divergence to play for and markets that appear range bound in the medium term, clipping options premiums may not be a bad way to pass the time.

Second, we need to watch for the divergence. Although I have not done an exhaustive study, it makes sense that market convergence and divergence would happen in waves. As we saw in the 2008/9 period, the high correlation into the meltdown was matched by a divergence once the markets started to rally off the bottom. If history is any guide, a shift towards more divergence should spell the end of the current slog. At that point, we should see winners and losers emerging and asset class breakouts (hopefully to the upside). It will be a concurrent indicator at best but with the current lack of confidence, that may be a useful confirmation of a change in trend.

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.

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.

When the weather is not cooperating in Southern California this time of the year, the natives will regale you with the atmospheric conditions that produce the dreaded June Gloom conditions. If you happen to have just spent the winter in Chicago or Boston, you might be wondering what all the fuss is about.

Gloom hangs over the markets today. The natives are swooning at every jobs figure that does not defy gravity and the European crowd are indulging in dramatic pratfalls that make their soccer (sorry, football) melodramatics look prim and restrained. For Europeans, the crisis that was “Made in America” does not fully explain how Greece ended up in so much trouble. The Europeans are trying desperately to avoid answering the hard questions that are being asked by the voting public and the bond market.

From a macroeconomic point of view, the global economy is still recovering from a severe financial crisis. That recovery has actually been delayed by all the public funds and government projects that have sought to cushion the blow to the economy and its citizens. Throwing more debt on the pile of debt that got us into trouble in the first place has not worked. The Austrian School of Economics was first and most vocal in pointing out that the bad debts had to wash through the system before the economy could return to a healthy basis and start growing again. However, the thought of letting the market clear out the bad debt was a political non-starter in countries as diverse as China, the US, Brazil, France, Germany and the UK.

But now, after three years of pump priming, disaster management and wishful asset valuations, the markets are finally getting a chance to sort out some of the wreckage. The FED has admitted that its monetary stimulus has not produced the desired results and the Germans are starting to talk about how private investors may end up wearing real losses when Greece’s debt is restructured (and/or defaulted upon). The US housing market is still trapped in suspended animation but, with the Case Shiller index double dipping, it should not be long before real solutions are proposed and acted upon.

What does this mean for investors?

In a word: Patience.

Although we mentioned that it looked like another “Sell in May and Go Away” year, we did not take nearly enough of our own advice and our portfolios have suffered accordingly. Investors who joined the rally late (in the early part of this year) will be keen to sell into any rallies now that the markets have “confirmed” their initial bias that risk assets are to be avoided. A quick break to the upside will be smothered very quickly.

On the downside, most of the bad news in the market is actually pretty old news. The problems in the developed markets have been worked over for several major news cycles: American mortgages underwater, sovereign debt issues in Europe and budget deficits almost everywhere. In the developing markets, the worries about inflation, hot money, loose monetary policies and rising currencies are not fresh. All of this means a simple relapse into 2008/9 conditions, while not impossible, are nonetheless extremely unlikely. There is plenty of money swirling around the system to capitalize on any sizable dips in the financial markets.

Resurgence in Biotech

Although it is too early to say for sure how strong the trend is, we have noticed a fairly broad improvement in the biotech (XBI), medical devices (IHI) and health care (XLV) sectors. The numbers are not conclusively high at this point but they are better than most of the alternatives in the market.

Some market observers have cherry picked past data and noted that times of economic distress are often also times of tremendous technological innovation as well. Perhaps the energy released by a Schumpeterian “Creative Destruction” wave is fueling innovation in the biotech and medical devices sectors. Or it could be simple rotation into what could be viewed as a more defensive sector in the US at this point.

There is no question that the medical/pharmaceutical/health care complex in the United States is ripe for innovation. Andy Kessler has explored this area since at least 2007 with the central thesis that the delivery of medicine and health care ought to enjoy some of the liberating innovation and efficiency gains that we have seen in the IT sector since the invention of the integrated circuit. Was he a bit early? Perhaps, although there is no question the cracking of the human genome is just now starting to pay dividends in terms of new medicines and delivery systems wending their way through the drug approval process.

Have some cash ready for Autumn Opportunities

So, we may have some excitement on the biotech front. We will definitely see some frothy IPOs in the social networking space (Linked In, GroupOn, Facebook…) which might help spark some small return of investor appetite for risk. And we can definitely look forward to a good scare on the European sovereign debt crisis and some worries about China’s rediscovery of the business cycle which will frighten investors back to the sidelines. Therefore, until the RSI numbers start to improve into the 20’s, there is no rush to get back into the market.

If the second half of “Sell in May…” hold true, there should be some good opportunities in the fall. Keep a bit of cash available and be ready to rotate into different asset classes after the summer torpor lifts.

When most people think of the carry trade they think of borrowing in Japanese Yen at near zero interest rates and investing in Aussie, New Zealand or Canadian fixed interest instruments to pick up the yield difference. (Click here for an excellent Financial Times illustration) If a hedge fund can wrangle 10:1 financing from its prime broker, that difference can be magnified tremendously. The risk in the trade is that exchange rates will move in an unfavorable direction (in the Yen carry trade example that would be a strengthening Yen).

However, the biggest game in the last two years has not been the Yen but the US dollar. There are actually two separate “carry trades” going on in the financial markets right now.

Carry Trade #1

The first is with the big “money center banks” which can borrow at less than ¼ of 1% in the short term from the Federal Reserve and lend it to the US Government by buying Treasuries that yield many times the borrowing cost. The trade is protected on the currency side because both are done in US dollars. The trade has been further protected by the Federal Reserve which has been using its QE2 mandate to buy up longer dated Treasuries in the secondary market. One of the unintended consequences in the US is that money center banks have actually curtailed their commercial lending operations as a result.

Source: St. Louis Federal Reserve

Carry Trade #2

The second trade is with currencies that are closely linked to the US dollar. In the case of the Hong Kong Dollar, the link is explicit (and the property market is booming) but throughout the exporting nations of Asia, the link to the currency of the biggest market for finished goods is well understood. The flows of money have been so strong as to kick off secondary waves of capital movement (eg. Chinese M&A and property purchases in Australia). In this second trade, the risk of currency movements is present but not significant (think Chinese reluctance to revalue the RMB) and more than made up by the trading opportunities in these markets. With short term borrowing costs well below the 1% mark, many projects look viable even at very inflated costs.

So, in one sense, the QE1 and QE2 programs have been a resounding success but thanks to the globalization of capital movements and bank reluctance to extend new loans, the beneficiaries have not all been in the US.

But, that looks likely to change. As we approach the end of the Quantitative Easing Program, Mark 2 (QE2), it is time to think about what might happen to interest rates and liquidity when the status quo changes.

The status quo to which I refer is the US dollar 3 month swap rate which is the rate at which major financial institutions around the world borrow US dollars from one another.

Source: Bloomberg

As you can see from this chart, the rate has been kept at less than 0.25% for more than two years now.

And the game has not been limited to financial institutions. Large credit-worthy multinationals have also been able to borrow at very preferential floating rate terms (usually a small margin over 3m LIBOR) which has largely mirrored the 3m Swap.

Source: Bloomberg

What should investors watch for?

The question for investors is how long can these rates stay down at these levels? The advice given to all young traders when they first start in the business is: “Don’t fight the FED”. And the last two years have shown that the FED can still pull off the neat trick of reflating the global banking system. The question now is where will these rates go and how will the big financial players react when the cost of funding makes their more speculative positions unattractive?

Stability leads to instability

Hyman Minsky (1916-1996) was a neo-Keynsian economist who was the first to note that financial stability leads investors to gear up and sow the seeds of the next bust. The Minsky Moment (the tipping point coined by PIMCO’s Paul McCulley to describe the ’98 Russian financial crisis) may be a rise in short term interest rates once the FED stops pumping up base money with the QE2 program.

Mark your spot on the sidelines

Although the financial press and the regulators have been at pains to talk up the financial stability in the system, it seems obvious that much of the apparent stability and record profits at Too Big To Fail Banks have been secured on the back of a two year fire sale on short term money. When that sale ends and these two interest rates start to return to more realistic levels, investors may wise to spend a few months on the sidelines with cash waiting for bargains.