“When the only tool you have is a hammer, every problem begins to resemble a nail.”
- Maslow’s Maxim

The market is gearing up for the announcement of another round of Quantitative Easing to be dubbed QE3, although one could argue that QE3 has already started with the opening of practically unlimited swap lines between the US and European Central Banks.

The signs that the Risk Markets need a kick to keep the party rolling are popping up around the globe:

US

GDP was a bit soggy in 4Q. There are plenty of reasons for disappointment:

1. a bit too much inventory build,
2. a worrying drop in the savings rate,
3. lower 4Q earnings surprises and growth than 3Q numbers, and
4. 1.5 – 2% GDP growth rate which means that US voters will go to the polls in November with around 8.5% unemployment.

To confirm the slow growth trend, the FED has made the unprecedented announcement that it will keep rates at current near-zero levels for the next three years. Team Obama may hope that the Republicans tear themselves apart in the primary season but that is no reason not to try a few more Keynesian and Monetarist kicks to the system to spruce up the economic backdrop for the autumn.

China/Asia

Asia typically greets the first day of trading after Chinese New Year with a rally, especially for a “Dragon Year”. However this year, only Taiwan managed to pull out a positive day on delayed reaction to strong Apple numbers. Hong Kong and Chinese investors parsed poor real estate sales results over the Chinese New Year Holiday and took the Hang Seng Index down towards the so recently breached 20k mark.

Europe

And not to be left out, Europe is preparing for another cycle of summits to solve the “Euro Crisis”.
Whatever solution bubbles up from the cauldron this time, it seems to be too late to save Greece from exiting the Eurozone. The real question now is whether the Eurozone can draw a line at Spain and Italy (Portugal appears to be the other acceptable casualty of the Euro Crisis). No matter what the politicians decide, recession (and worse) will haunt the Eurozone for most of 2012.

What is the System Saying?

The system can be described as somewhat lukewarm about risk assets with a definite preference for US listed equities. Top ratings for funds and ETFs are in the teens and for S&P 500, there are a few rating in the 30s and 40s. Given the extremely high likelihood of another round of government stimulus and Central Bank pump priming, one should wait for the next burst of bullish enthusiasm before taking profits.

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).

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.

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.

S&P 500 in 2008

Source: Bloomberg

This year, we are faced with a similar pattern. There is good news in the S&P 500 (75% of the companies have exceeded expectations in 3Q numbers) and the US economy is still growing (albeit at a sluggish 2-3% pace). When this pattern appeared in 2008, the US economy was already in recession (started from December 2007, declared on December 1st 2008).

This time around, while there is a significant risk that the US economy is already tipping into recession (ECRI declared one in September), the two big issues dominating the market continue to be the European Sovereign Debt Crisis and the Political Gridlock in the US.

The Euro Crisis impacts the largest economic area in the world on a combined basis. Unfortunately, the central design flaw of the Euro (monetary union without fiscal union) has been exposed. There is too much sovereign debt in Europe and too much of it is owned by European banks which in turn have too little capital to absorb any losses. Germany is the only player with the economic and political clout to resolve the problem and it has yet to decide on which expensive resolution to adopt.

The US continues to struggle with political gridlock which in normal economic circumstances might not be such a problem. However, with such tepid consumer demand growth and a corporate sector keener to horde cash than invest in new projects and employees, the issue of the federal budget is causing deep anxiety amongst investors. For the middle of the road voter, who will once again swing the election next year, the choices are stark and surprisingly well understood. The Republican plan emphasizes spending cuts and will translate into an immediate reduction in GDP. The Democratic preference for stimulus spending financed with higher taxes will lead to a more gradual reduction in GDP but runs the risk of blowing out the deficit and attracting the negative attention of the bond market.

Neither outcome is particularly good for corporate profits and stock market performance. This is why we are seeing the October rally start to fade.

S&P 500…last six months.

Source: Bloomberg

What should investors do?

The System continues to favor short ETFs, short term US government paper and Gold. In other words, there is no underlying momentum in risk assets that should give one confidence at this time. The fate of the macro-economic foundations of half the globe’s GDP is in the hands of politicians who are faced with no easy choices and one of the leading forecasters of business cycles has called for a recession in the US.

We have often observed that the Bull Market slogans of the 80′s and 90′s (Buy and Hold…Buy the Dips) have served investors poorly since the dawn of the new millennium. At this juncture, we would remind investors of that observation continue to maintain a cautious investment stance.

Investors in global equity markets must feel very much like poor French farmers in Eastern France in the beginning of 1940. The Bulls and Bears have both lined up impressive resources, politicians and central bankers are playing a high stakes game of chicken in Europe and twitchy investors (hedge funds, perhaps?) are jumping back and forth between “risk on” and “risk off” trades to attempt to eke out enough performance to hang onto some of their funds at the year end redemption sweepstakes.

For the week ahead, there doesn’t appear to be anything too dangerous on the economic front and with Italy and Greece poised for new, technocrat governments, the political side might not yield any surprises for a few days.

That said, the S&P 500 is having a difficult time cracking rhrough to the positive side of the 200 day moving average.

The Fund King System is still suggesting a cautious outlook with low positive ratings on US government bonds, gold and Japanese Yen. The rest of the field is still rating in negative numbers, suggesting that discretion is still the better part of valor as we approach the holiday season.

New Developments

We will soon be releasing our app for the Android system as soon as we have worked out all the kinks. An iPhone/iPad app is on the to do list as well.

The improvements in the code will also be retrofitted into the systems that we use on the website.

What does this imply? It implies that trouble in a company is broadcast by its stock price. One does not need to mud wrestle with the financial statements, interview senior management, listen to fund managers and Wall Street analysts. All of that hot air means nothing if investors do not act on it. And in the stock market the only action that matters is clicking on either the “BUY” or “SELL” button. So what the Fund King system can measure is the action at the margins, which has the most material influence on prices. If more investors act on these changes, they tend to become self-fulfilling, creating a recursive feedback loop, and the company share price declines.

Don’t take my word for it. Try it yourself!

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 Wall Street Journal has a good blog on the subject: “So, about that insurance you bought on Greek Debt…” which covers the key details.

For the market, the dance will go on. Anyone who might suggest that this little manouver will disrupt the fragile fabric of the market is more than a little desperate for attention.

For investors, this little drama should serve as a “Caveat Emptor”. Not all investments are created equally and not all of them have the rights to the underlying assets that their promoters might hint at. When commentators brush off the risk of an ETN, which is backed by the sponsoring bank’s balance sheet, versus an ETF, which should be backed by assets that are subject to periodic audit, think back to the “smart money” hedge funds who will soon have to explain to investors why they were unable to capitalize on a sure thing like Greece’s default (oops, sorry, voluntary restructuring).

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”.