Opportunities in 2015

It is always a very difficult task to predict what will move markets one year forward, and some would go as far as saying it is futile and impossible. I kind of agree with this point of view, but in financial markets, everything is about probabilities, and understanding macro can tremendously help investors ‘predict’ what would be tomorrow’s most likely scenario.

What macro analysis is telling me about the financial world for next year is all about deflation, and let me explain my reasoning.

First the facts: The data flow out of Japan, China and Europe is bad, strongly suggesting appearance of the twin specters of recession and deflation.

Central banks responses to that fact are again more monetary stimulus. Europe is already accepting some negative interest rates, while his central bank chief Mario Draghi, is giving very loud hints that Europe’s version of QE may be coming. On the other hand, the world’s second largest economy, China, cut interest rates last Friday even as out-of-control credit binges threaten exploding debt dynamics… And last, but not least, Japan took the most dramatic pass out of the 3 regions buy going the equivalent of “all-in” - for poker fans - at the end of October, starting what might be considered a currency war.

Here is the logic chain: Japan, Europe and China all rely heavily on exports. Those stimulus strategies ultimately rely on weakening their respective currencies which in turn makes the dollar stronger. A stronger dollar creates global tightening credit conditions as it is the funding currency of the world economy and thus cancels out global stimulus effects.

You have to remember that the dollar still account for 80% of global trade transactions, and accounts for the most part of global borrowing, for a simple reason: investors prefer the liquidity and strength associated with the world reserve currency tied to the strongest and most dominant economy on the planet.

As an example, Turkey has $386 billion worth of debt payable is US dollars. Chinese companies have raised more than $180 billion worth of dollar-denominated debt, according to Morgan Stanley. These are two examples. Countless other EM has huge dollar exposure. The “US dollar carry trade” has been estimated, in total, at 3 to 5 TRILLION dollars. This means that, when the value of the dollar rises, these USD borrowers (companies and government alike) get squeezed. And what happens when export-focused Japan, China, Europe all attempt to weaken their currencies, directly or indirectly, even as the Federal Reserve stays “neutral”? They fuel strong dollar conditions, which in turn increase the risk of economic contraction, capital withdrawal, and credit defaults. The game is self-defeating.

What seems to be clear for me is that we are entering a negative feedback loop that may impact greatly financial markets. If my theory is correct, some exceptional money-making opportunities are at hands.

Commodities are the most at risk in this scenario and the fact that they already started a break out is confirmation of my theory. A stronger dollar means weaker commodity prices: Intermarket Analysis 101. I was alerted earlier this year by the Crude Oil break down that surprised many in financial medias, who failed to apply the saying “what can’t go up on good news must go down”. The price of Oil refusing to move up during the escalation of 2015 geopolitical tensions (Ukraine, Middle East) was a wonderful hint of what would be coming later in the year… Deflationary forces generated by US Dollar strength was  much stronger forces and not surprisingly commodity prices broke down in tandem after the summer.

But I think this is just a start! I believe that the commodity bullish secular cycle has ended. Therefor I opened a short AUD/USD at the start of November from 0.8720 after the completion of the small October consolidation pattern hoping for much lower prices around the 0.8 figure. I choose this currency pair because AUD is a commodity currency, as its economy relies heavily on exporting its resources to other countries, mainly China… which I am not optimistic about as well. I can also profit from the dollar appreciation in the meantime, so with the price action looking good to me it feels like a good play.

I will try to do some follow up on that position here in the blog and gives as much update as possible.

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Time And Cycles

Time-based economic forecasting is unfashionable. Until the mid-twentieth century, economists were sympathetic to the idea that business activity and prices fluctuate in regular cycles. The majority view today is that booms / busts reflect policy errors, market failures or supply-side shocks: cycles still occur but they are unpredictable. The behaviour of the global economy in recent years, however, is explicable in terms of the old fixed-length cycles. The approach suggests that another significant economic downswing will occur in 2016.

According to the old approach, there is no single “business cycle”. Observed growth fluctuations, instead, are the product of separate cycles in different parts of the economy. The three main cycles are: the 3-5 year Kitchin cycle in stockbuilding; the 7-11 year Juglar cycle in business investment; and the 15-25 year Kuznets building cycle. Each cycle is named after the economist who “discovered” it.

Recessions almost always involve significant weakness in business investment. In the US, recessions occurred in 1981-82, 1990-91, 2001 and 2008-09, according to the National Bureau of Economic Research. The spacing, clearly, fits the 7-11 year periodicity of the Juglar cycle.

The severity of recessions, however, depends on the direction of the other cycles. In 2008-09, a Juglar downswing coincided with the weak phase of the Kitchin stocks cycle and the final stages of a downswing in the longer-term Kuznets building cycle. The previous occurrence of simultaneous weakness in the three cycles was in 1974-75. Global industrial output fell by 13% from peak to trough in 2008-09 and by 12% in 1974-75 – much larger declines than in other post-World War Two recessions.

In the early 2000s, by contrast, the recessionary impulse from the Juglar investment cycle was moderated by an upswing in the Kuznets building cycle. The 2001 US recession was unusually mild, while the UK avoided any fall in output. Central bankers attributed this benign result to their policy-making brilliance, a belief that contributed to complacency during the credit bubble and the initial stages of the subsequent bust.

The short-term Kitchin stocks cycle is usually associated with minor growth fluctuations, unless reinforced by the other cycles. Such fluctuations, however, can still have a significant impact on financial markets. The last Kitchin cycle downswing occurred in 2011-12: the global economy hit a soft patch and equities fell by 23%. The weak cyclical backdrop contributed to the Eurozone crisis.

What do the cycles suggest about current economic prospects? The last Juglar cycle downswing began in 2008 so the next one is scheduled to occur between 2015 and 2019. The Kitchin cycle is due to enter another weak phase in 2015-16. A recession will be likely if the two downswings coincide. The most probable year for a recession is 2016, since the Kitchin cycle will embark on another upswing in 2017-18, offsetting Juglar cycle weakness.

Thankfully, any such recession should be of average severity or even mild because the longer-term Kuznets building cycle will remain in an upswing until the early 2020s, at least. The “great recession” of 2008-09 was a once-in-a-generation event resulting from a rare confluence of the three cycles. The next boom / bust episode will be painful but not system-threatening.

Source:http://moneymovesmarkets.com/journal/2014/7/31/time-and-cycles.html

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How Is Barclays Positioning In FX, Equities & Other Markets Right Now?

 

 

Barclays Capital's Global Asset Allocator team is out with a note outlining their positioning strategy in FX, equities, bonds, and other markets. The following are the key points in Barclays' note. 

The threat of higher US inflation and yields in H2 calls for a more defensive portfolio. We go long US 30y breakeven inflation and are positioned for a back-up in US front-end yields. We are also long USD versus EUR, JPY and AUD via options.

We also go long value sectors in the US (energy and financials) versus growth ones (healthcare and food and beverages) as this strategy typically outperforms in an environment of rising US yields.

We are more defensive but not bearish as stronger global growth should partially offset the headwinds from higher yields. We stay long a basket of growth-linked assets (EM equities, resources stocks and base metals) and also long euro periphery equities (Spain and Italy with equal weights).

Also in equities, we favour the FTSE 100 over the FTSE 250. The former should benefit from firmer global growth in H2 while small/medium sized firms in the 250 are expensive and are likely to underperform with higher UK yields. European fixed income – core and periphery – looks less appealing after prolonged rallies. But we still see room for spread compression in European banks credit.

The Japan trade remains alive, but we think it is better expressed via long equities and short fixed income. Go long large caps as they appear cheap and pay 20yf10y JGB rates for slightly positive roll down, unlike most other bearish duration trades.

We go long front-end Brent futures (Sep 14) to take advantage of the backwardated curve/positive roll. Going long energy equities via options (our current implementation) also makes sense as vol is low and there is room for equities to catch up with crude prices.

 

Source: http://www.efxnews.com/story/25109/how-barclays-positioning-fx-equities-other-markets-right-now

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Dollar Index Breaking Through Long Term Support

We are experiencing a very important market event this month, as the US dollar is breaking through a significant long term support. Such a move, if sustained, is very important for market participants because the USD is one of the most important asset class in macroeconomics. I can give many reasons of the utmost importance dollar has in the global economy, like it being the world reserve currency, but it is not the subject of this article. In the next few lines, I would like to review some strategic implications implied by this important market event, and give a trade recommendation in conclusion.     

First, let’s take a look at a 5 years chart of the US Dollar Index:

During the past 2 years and a half the strong support I am talking about (in green) supported price no less than 6 times. In technical analysis, the longer a support hold and the more times price rebound from it, the more significant it is. A break of that important support should not be taken lightly by market participants in the face of its potential market forces.  

A weak dollar has many inter-market resonances of which the most important one is for me its impact on commodity prices. Due to many of them being priced in dollar terms, a strong inverse relationship exist between the two assets.

As can be seen on the chart above, the CRB commodity index broke out of its recent 3 years downtrend last February. A dollar breakout will therefore be further evidence confirming this nascent uptrend.  

In addition, it is also important to understand that a falling USD is bullish for the relative performance of foreign stocks (see relative performance of the iShares MSCI EAFA ETF vs USD in the chart below). The prevalent under-performance to US stocks before this year stopped, but have yet to decisively turn the other way. I expect this important USD breakout to be the catalyst for a foreign stocks out-performance.

Combining all the above, countries that produce commodities stand to benefit even more from a weaker US Dollar. Not surprisingly, we have seen developed countries commodity producers like Canada and Australia see their stock markets hitting new multi-year highs lately. But from a contrarian point of view, I am very interested in Brazil, another big commodity producer, that have been beaten down lately by the negative sentiment surrounding Emerging Markets in general.

Technically speaking, the iShares Brazil ETF (EWZ) is strong, breaking out of a triangle consolidation pattern to the upside. Since the start of last month, it is performing better than the S&P500 on a relative basis which is confirming the thesis presented above. 

I believe it is a smart idea to begin or to increase exposure on this market as long as the USD is confirming its downtrend.

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Time To Hedge Long-Term Core Equity Exposure

Major US equity indexes all entered in all-time high territory last year. That in itself was a very bullish indication, as it showed the past of least resistance still remains to the upside. Last month, everyone on twitter, financial newspapers, market news websites was celebrating the fifth year anniversary of the current bull market, and let’s face it, market sentiment seems very bullish today… maybe too complacent?

To answer this question, let’s review some of the technical, internal and sentimental perspectives of the current bull market...

I first want to tackle the "too complacent" argument that a lot of market commentators - mainly from the contrarian or perma-bear category (think ZeroHedge) - bring to the table since early 2013 to predict the theoretical impending stock market crash. Even if the argument can seem logical, orderflow traders understand that a very bullish sentiment is not enough to predict a market down turn, even less a market crash. “The Market can stay irrational longer than you can stay solvent” as John Maynard Keynes is known to comment. I agree that sentiment extremes are important warning signal for traders. What many contrarians fail to understand is without any catalyst or reason for the sentiment state to be shaken, the turn will never happen by and of itself.

That’s the reason why many missed the 2013 rally, afraid by the extreme bullish sentiment signals provided by indicators like NAAIM & AAII surveys*. Take a look at the three failed sell signals in the chart below (blue circles). Those contrarians were blind to the major sentiment driver that was QE3, which along precedent FED monetary stimulus launch (QE1, QE2, OT), was a strong bullish signal for risky assets. As the old Wall Street adage goes: “Never fight the FED”.

Then, let’s now review the other sell signals, the two most successful ones. It is important to note that they both coincided with “changes in the rules of the game” (George Soros quote) via the end of QE1 in 2010 and QE2 in 2011. Those signals predicted the two major corrections (-17% and -19% respectively) of the current bull market. You will notice the similarity with current conditions where we will see the end of QE3 in the next few months (around September 2014 per consensus projections). Will history repeat or this time is different?

If you remember from my previous article on market cycles, seasonality is very challenging for stocks in 2014, and some other technical indicators are pointing out to weaknesses. For example, see the below S&P500 monthly chart. The RSI is showing a bearish divergence in overbought territory, a strong TA warning similar to what occurred at both 2001 and 2007 tops.

Looking at the shorter time frame, we can see one more bearish divergence on the daily RSI indicator as well as on the On-Balance-Volume (OBV). The price is building a rectangle consolidation pattern in a kind of rounding top, two well-known distribution chart patterns. This information, combined with confirming volume behaviour (increasing on down days) and yesterday bearish close below the rectangle support and the 50 DMA are more technical damages that warn we are close to seeing a top.

Finally, an interesting phenomenon is happening in terms of sectors rotation. It is clear that market participants are turning to a less aggressive risk taking stance. Take a look at how money flows from risky cyclical stocks (XLY) into safer, more defensive sectors like utilities and consumer staples (XLP, XLU) in the chart below.

Seasonal, technical, internal and sentimental evidences are too many warnings for me not to turn more cautious. 

Let me be clear here, I am a trend follower. As such, I will paraphrase the old Mr Patridge from "Reminiscence of a stock operator":  Well, you know this is a bull market!

I am not saying we are seeing the final top of the current five years bull run. I have many reasons to think it is not (that goes from fundamental to market breadth analysis) and I will cover them in my next article, but the main one is I always assume a trend will continue until proven otherwise. Top and bottom picking is the game of uninformed, loosing traders, and I recommend to play the downside only after a Dow bear market signal. Furthermore, US equities is the best asset class performer and as such I strongly advise being exposed to it. 

That being said I can easily see the market offer future buying opportunities at better prices for the many reasons presented above. An easing to the first obvious support zone near 1730 and maybe deeper into the very big support 1550 (old all-time high and 38% Fibonacci retracement of the current 2,5 years up-leg) will offer such opportunities.

That is why I would also advice in the meantime buying protection through the acquisition of puts. We all buy fire insurance and hope it is never needed.  I’m suggesting the same today for your stock exposure.

*NAAIM member firms are asked to provide a number which represents their overall equity exposure at market close on a specific day each week. Responses are processed to provide the average short (or long) position of all NAAIM managers as a group. The responses can range from 200% fully leveraged short to 200% fully leveraged long position.

The AAII Sentiment Survey is a weekly survey of its members which asks if they are "Bullish," "Bearish," or "Neutral" on the stock market over the next six months. AAII first conducted this survey in 1987 via standard mail. In 2000, the survey was moved to AAII's website.

RPS: Sell signals are generated when the two surveys indicate complacency.

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Cycles Within Cycles

Seeing how investors psychology affect all security prices through the boom/burst cycle of optimism and fear, technical analysts are devoting an entire field using cycles theory to predict this repeated pattern. Similar to natural scientists, they identify reliable temporal patterns and cycles that have stood the test of time. I would like to review those cycles in this article, but first I need to warn that this analysis is not something to depend stricly upon, for the simple fact that they are not as strong order flow generators as macro factors can be for example. That being said they are consistent enough to be considered by technical analysts when they time long-term investments, so I still find interesting to look at them.

The longest cycle I want to review is the well-known Kondratieff or K-wave cycle. A large academic body of knowledge is attached to this theory, but even if it is an intellectually stimulating topic, it is not really actionable. It is too long in duration to be important for trading purposes, averaging around 60 years in time, but more importantly have not enough history to be statistically relevant. It is also vital to understand that not every researchers agree on the dates of peaks and troughs. An acceptable dating is the one proposed by George Modelski and William Thompson which validate the last troughs in 1792, 1850, 1914 and 1973. The next projected low is expected around 2020/25 which confirm the projections of the US birthrate theory that project it in 2020. In fact researchers have found a strong correlation between the stock market and US birthrate advanced 45 years:

Next come the famous secular trend which last for about 34 years, a 17 year period of dormancy followed by a 17 year period of intensity. I say famous because I believe it is the most popular cycle that analysts are refering to in the common media. It is statistically more reliable than the Kondratieff one, and it is interesting to note that commodities are also linked to this cycle as when stocks go through the dormancy period, commodities rallies and vice versa. The next major low projected by this cycle come around 2017-18. (I would likely review this cycle in latter articles because many interesting studies and theories revolve around it).

Next come an important part of cycle analysis that is referred to by technical analysts as seasonality. 

Taking a look at the decennial pattern, commonly use due to the price tendency in the stock market to have similar characteristics every ten years, it appears clearly how this decay is following its predecessors pattern. It is important to remember when studying seasonality that direction is more important than levels. True, this decay start is better than its historical averages and can even be consider a little overbought, but the direction seems to be repeated again. Interestingly enough, if the pattern continue to fit past history, this uptrend will continue until August 2017. I would like you to notice that it is also predicting some kind of range trading this year that fit with the presidential pattern, our next topic. 

The presidential cycle is likely the most well-known temporal pattern in the market today. It is reliable and backed by many studies on a long enough time span to be  classified as statistically relevant. This pattern is signaling a correction for the stock market in 2014 from mid-April to the start of October. I find very interesting the fact that it fits with the range trading we identified on the decennial pattern. After this unfavorable time passed, stocks are forecasted to rally until the next election in November 2016. When the next presidential cycle first two years under performance kicks-in this will be in agreement with the slightly up but still flatish end of decay usual average.  

Putting all the pieces together, we can summarize that following technical analysts cycle theories, stock market should keep the uptrend ongoing till the next presidential election after this year dangerous time window has passed. The end of this decay should then produce a major low for stocks that is in line with the secular and Kondratieff projections, ence the title of this post: "Cycles within cycles".

To conclude I just want to repeat that one problem with the theory is that a large enough sample is not possible yet, and that such projections could be the result of chance. It is something to keep in the back of an investor’s mind but not something to use alone to commit funds to the stock market.

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