This post is featured from The Commodity Analyst newsletter. Originally sent to subscribers Tuesday November 15, we are sharing portions of the content a few days delayed here. For details and samples of the newsletter, see here: http://realfinancenewsletter.com
The past week saw sideways, albeit volatile, movement of risk assets. While last Wednesday was a large selloff, the indices made back almost all of what they lost on Thursday and Friday, with the euro and Australian dollar recovering as well. Despite the seemingly lackluster action in equities and risk assets, fixed-income market fundamentals continued to deteriorate, and we believe a collapse in asset prices could be imminent.
The following charts show the CRB Raw Industrial index and the GSCI Total Return index.
As can be seen, the breakout of the GSCI index has hardly been confirmed by the CRB RIND. While the CRB RIND has at least slowed its pace of decline, it still remains within a quarter of a percent from yearly lows, while the GSCI index has rallied magnificently since October 4th. As we have indicated before, this continues to signal a preponderance of speculation on a recovery rather than a real recovery. Given that the CRB RIND rebounded well before equities themselves bottomed in the 2010 summer correction as well as the 2008-2009 bear market, we believe the CRB RIND’s stubbornness in turning upwards indicates a continued fall in aggregate demand that is afflicting developed markets, not a simple lack of liquidity that the ECB and Europeans would have us believe. On that note, let us turn to our now weekly practice of dissecting the latest news (or lack thereof) out of Europe.
Europe
The ECB had to again buy sovereign bonds in the secondary market this week to calm investor fears about Italy’s insolvency. However, the more bonds the ECB buys, the less liquidity there is in the sovereign market and the less confidence investors have in the sovereigns. Shown below are charts of the Italian and Spanish 10 year bonds.
As can be seen, Italian yields went absolutely parabolic on Wednesday of last week, rising to an astonishing 7.5% before ECB buying on Thursday and Friday drove them down to 6.5%. However, yields rose back up to 6.7% today as the ECB stepped away. Interestingly, while the Italian bonds at least showed a respite from selling for 2 days, the Spanish bonds did not.
As many have surmised, speculators and hedgers alike will move from country to country, much too fast for the ECB to keep up. Even though the ECB was able to somewhat calm Italian yields (for a whopping 48 hours), investors simply moved to shorting Spanish bonds. In essence, shorting Greek, Irish and Portuguese bonds is no different than shorting Spanish, Italian or even French bonds. All of these countries suffer from the same problems: lack of growth, massively bloated financial system and overindebtedness on the sovereign, corporate and individual levels. To top all of it off, none of the Eurozone countries can print its own currency and monetize its debt. The only difference between a France, Italy or Spain at this point is what stage of the crisis they are in. Indeed, even German bonds will likely come into question at some point if the ECB maintains their “virgin” stance.
At this point, most every investor, economist and analyst expects the ECB to print money, and therefore save the world economy. However, the market is getting far too ahead of itself here. As long as the status quo in the equity markets persist, the ECB will not be nearly motivated enough to embark on such a departure from their sacred covenants. We know this from the daily, deliberate statements by ECB officials that they will absolutely not monetize Europe’s debts. It will take a renewed deflationary crisis to get the ECB to finally move off their hardline stance, and we are nowhere near this point.
Today’s news that Germany has approved legislation to allow countries to exit the euro, as well as Fisher’s statements that US growth remains strong enough to discourage further easing attempts show that regulators and politicians are clueless as to the environment we are entering. While QE out of the US and Europe will eventually happen, they absolutely will not while markets remain at these elevated levels. If and when the S&P 500 reaches around 1000 or the euro-dollar cross goes below 1.20 or so, the respective central banks may be inspired to act, but there is not even a chance of this at current levels.
US Stocks
While US stocks remain at fairly elevated levels as compared to early October, they are showing signs of cooling off. The S&P 500, the euro, and the Australian dollar have still not exceeded their October 27 highs. From a technical perspective, this break in upward momentum is bound to be a bearish signal for traders.
Posted below is a chart of the AAII Bullish sentiment readings divided by Bearish sentiment readings, as well as a chart of just the Bearish readings. These are surveys conducted with individual investors on a weekly basis.
As we reported 2 weeks ago, this index is very useful as a contrarian indicator. 2 weeks ago, this index was at 1.72, meaning 1.72 bulls for every bear. The index then promptly lost 6% over the next 3 trading sessions. Today, this index stands even higher at 1.82.
The last time the index was slanted this bullish was February 17th of this year. As shown by the chart above, the S&P lost 7% almost immediately after this reading. Also, the last 2 times there were this few bears in the survey (as denoted by the AAIIBear Index chart above) were on February 17th and July 7th. The S&P posted losses of 7% and 19% very soon thereafter both of these readings.
While these are purely technical sentiment readings, they are indicative of the complacency in markets nowadays. It seems as though individual investors as well as commodity investors have decided to largely ignore the macro risks for the time being and focus on the upside.
While the S&P 500 at large is trading at a fairly cheap 13.2x earnings, a deeper look into the market reveals a not so necessarily cheap market. The Dow Jones US Financials Index is trading at around book value and 12x earnings, which is not all that cheap considering assets on banks’ balance sheets from the bubble years are still held at book value, not to mention the systemic risk of contagion from the European banking system.
The Nasdaq 100 is trading at a 16x P/E, which is low historically, but certainly does not sound all that low in a vacuum. Especially considering that Apple makes up 14% of the index, and that Apple, the world’s largest company by market cap, trades at a premium multiple to the stock market at large, stocks do not look priced for a recession.
The energy services sector seems to be the most frothy. The OSX is now trading at a 19.50 P/E, significantly above the 5x it traded for in the depths of 2008. With WTI crude at 98 and Brent at 112, crude itself seems overpriced, and the services sector may be even more overpriced. Both could endure swift falls in the case of renewed recession.
Trade Recommendation
Traders can take advantage of the implied to historical volatility disparity in the energy services sector. We recommend purchasing the January 2012 119.1 put for $5.35 per contract. With the current 30 day historical volatility at 51.26% and the implied volatility of this option at 44.62%, this option can be purchased at somewhat of a discount, given the assumption that recent volatility continues.
Crude Oil
WTI crude has gone on an amazing run since October 4th, rising an incredible 31.22%. While this is somewhat in line with the rest of risk assets, crude has had an especially good run. The last few days can most likely be chalked up to speculators buying due to a perceived geopolitical risk from Iranian hostility. However, just as in the Arab Spring, these speculators will eventually need to liquidate, taking prices down significantly from current levels.
The following chart shows the price of crude in orange and the Managed Money net long position in white.
As can be seen, the managed money position has grown to a high level, in the 91st percentile of readings going back 5 years, with prices only in the 79th percentile. This indicates a preponderance of speculators driving prices up. If and when there is an easing of geopolitical tensions and/or signs of economic slowdown, speculators could exit the crude market very quickly, driving prices near recent lows around $75/barrel.
Trade Recommendation
We recommend shorting crude oil futures at a price of $98.50 or better. A stop could be placed at the $100 level or just above, as this is psychological support/resistance.
ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
