Conflicting Signals

Of course, there are almost always conflicting signals in trading -- that's why it is so difficult to do it successfully. But it seems that the signals are more conflicting than usual now. On the negative side are all the economic fundamantals that I have mentioned many times since starting this journal, so I will not repeat them here. On the positive side are several more ephemeral factors: 1) the yield curve has moved from flat/slightly inverted to upward sloping. This usually foreshadows stronger economic growth. 2) Sentiment seems to be midly bearish (though not overwhelmingly so). Its tough to know how many others out there are net shorts, but I certainly don't get the impression either that everyone is heavily long either. 3) Ed Hyman of ISI is calling for higher stock prices, based on moderate GDP growth (no recession) and falling interest rates. Ed is a highly respected economist and knows his stuff. But I wonder if the corporate connnections he usually relies on to guage the economy are poorly suited to predicting a consumer spending induced slowdown.

Despite yesterday's rally, the TSX still remains below my target up-bounce range of 13,550 to 13,900. So I would not be surprised to see some additional upside from here. But as I keep mentioning, it is important to stay on one's toes and not get wedded to one side or the other.

MARKET POSITION: SHORT (4 units)

Massing in the wings

I get the feeling that there are a large number of investors massing in the wings, waiting to buy the next dip. Everyone seems to know that the fundamentals warrant more pain, but they do not believe (or do not want to believe) that the bull market may be over. The US economy will soldier on.

I have trouble with this version of events. I do not see how the unraveling of what was probably the greatest bubble in American history --yes, far greater than the tech bubble of the 1990s -- can not have serious negative implications for consumption, and therefore the economy. Toll Brothers' recent conference call highlighted how bad things really are, and the economy probably has not hit bottom. If no one wants to buy a house now, what about when people really start to lose their jobs?

Many people in the investment community have pointed out that investors probably overestimate the impact of Wall St. events on Main St. This is probably true. But they are also underestimating the impact of Main St. on Wall St.

The market appears to be rolling over and it will probably re-test the recent lows. As of now, my positions are showing losses so I will not be adding to them. However, the TSX remains below my upper risk level of 13,900 so I will also not be reducing my position. It is a case of sitting tight and waiting to be proved right (or wrong, as the case may be).

MARKET POSITION: SHORT (4 units)

Profiting from the long-term increase in food prices

A few well-known, savvy, long-term strategic investors have mentioned farmland as a good investment. I assume this is a play on food prices. As far as I know (I admit I need to do some research on this), food prices have been falling in real terms since the advent of the green revolution in the 1960s. Improved chemicals, fertilisers, seeds and machinery have all kept food prices down. Most farmers are still notoriously poor.

However, there seems to be several forces now working against this trend, including: 1) population growth. Although the growth rate is declining, the earth is still expected to add about another 3 billions inhabitans over the next 40-odd years. That is a lot of mouths to feed. 2) There are diminishing returns to the above inputs. 3) Lack of land and water. Growing populations, desertification, falling water tables, disappearing rivers, etc. are all placing pressure on marginal farmland. 4) Climate change. This may open up new farmland in Canada and Russia but my guess is that more fertile land will be lost in the warmer climes than gained in the north.

There have been many stories on increasing food prices over the past 6 months or so. With all of the above factors working together, this could be the start of a long-term, structural increase in food prices around the world. The proportion of total household spending on food has been on a long-term decline, especially if you strip out the increasing spending at restaurants. The proportion should climb back up.

So, how to profit from this trend? Farmland is difficult to purchase for a small-time investor. Too much money, too much hassle, little diversification. My big idea: if food prices increases, farm incomes should also increase. This should translate into higher capital expenditures by farmers, ergo companies that manufacture farm equipment should also prosper.

A brief investigation shows that the largest farm equipment manufacturers are: John Deere (DE), CNH Global (CNH), Kubota (KUB) and Agco (AG). I would like to purchase a broad basket of shares to reduce company-specific risk, plus this is not supposed to be a stock-picking exercise. However, DE, CNH and KUB are also exposed to the construction equipment industry, making them less of a pure play. Whether this will be a help or hindrance over the long-term is tough to say. The slowdown in global economic growth may hurt, but the global infrastructure construction boom is probably still in its early stages.

I will return to this topic in the near future.

Let me take that back

In yesterday's post, I said that investors were starting to hope that the worst is over. I think traders / investors are starting to fear that the worst is over. The smart money seems to think that, although things are fine medium-term, we are due for some more short-term pain. In Macro Man's lingo, this is the "W" correction. There will be another leg down, and it should be bought. But investors are worried there may not be another leg down, and so they are trying to decide if they should jump back in or wait.

It is tough to know how to play this knowledge. I am a contrarian by nature, which gives two possible options: 1) there will not be another leg down, and this rally should be bought, or 2) the next leg down should be sold.

The fundamentals (as discussed in past posts) point towards option (2), and the fundamentals should rarely be ignored. But, as always, it is important to remain aware that I might be wrong, and I may need to change my mind. For now, the TSX is below the target range for the upward retracement, and I will watch and wait.

MARKET POSITION: SHORT (4 units)

Wait for it...

The upward bounce continues and investors are starting to hope that the worst is over. I am having trouble believing that everyone could have gotten off so lightly. Sure, the credit markets took it on the chin, and some hedge funds blew up. But given the scale of the sub-prime problem, the amount of leverage in the system, the level of take-no-prisoners risk-taking, it seems naieve to think that the whole problem would be solved by some minor Fed easing and limited asset transfers. The equity markets were down about 10% from their peaks -- hardly a crisis!

The TSX is still below its target "up-bounce" range (TSX currently at about 13,400, target range 13,550 - 13,900). So it would not be unreasonable to expect some more upside. But it is times like these a trader needs to stay vigilant and ready to change his mind if he is proved wrong. If the TSX moves above 13,900 I will be forced to reduce my short position.

MARKET POSITION: SHORT (4 units)

Bounce Begins

Asian and European markets higher after the Fed's 'surprise' (depending on whom one speaks to) cut in the discount rate Friday. Yen is lower and the usual carry-trade suspects (NZD, AUD, etc) are higher. It seems that some calm has returned and traders/investors are tentatively taking some risk.

However, the reduction in the discount rate does not change the fundamentals. Monetary policy in the US remains tight given the economic situation. I think the markets are starting to realise that all is not as rosy on Main St. as the bulls/economists would have us believe.

There is speculation whether the reduction in the discount rate is a signal that the Fed will cut at its next meeting, or whether it was merely a sop to the markets to try to calm the situation. I don't think the Fed knows for certain what it will do at the next meeting. If markets continue to fall and the situation morphs into a true crisis, the Fed will probably cut. But if markets recover, the Fed will probably not. The strange logic is that the market is more likely to rally if it thinks that the Fed is going to cut....you can run yourself in circles here.

When the Fed finally does cut, it will probably be greeted with great joy. But as the markets see that it is having limited effect on the real economy, they will dispair. The first cuts never seem to have any impact, just as the first increases never seem to have any impact.

MARKET POSITION: SHORT (4 units)

Guess who's back from holidays?

A few of the Dipbuyers returned from summer holidays yesterday, and immediately got to work trying to re-start the party. The music was started, some other guests came back, and they even danced for a few hours. The problem is that the booze (AKA credit) is all gone, and all of the stores (AKA banks) are closed for the night. Thus it seems that the party is unlikely to last.

Indeed, despite the dramatic recovery in NY yesterday, Asian markets tumbled pretty strongly overnight. The Nikkei fell over 5%, to a level that was last seen 12 months ago. European markets are currently giving up early gains. Currency markets remain volatile (the Yen is jumping around like a kangaroo). Given how long the liquidity lasted, there must be a lot of traders / funds out there hoping (please) that they are not forced to exit positions at severe losses. The pain is getting bad, but I don't think we are there just yet. Usually markets go vertical when they are near turning points, both on the upside and downside.

Looking out a few weeks / months, the big question is whether this is just a credit crunch, or something worse. The general opinion seems to be that this is like 1998 -- we just need liquidity conditions to return to normal (preferably with a little help from the Fed), and everything will be fine i.e. the bull run can resume. The major problem with this theory is that it ignores the fact that there is also a severe housing market downturn going on at the same time. This could continue for another 12 months, maybe longer. Manufacturing is also weak. This has already placed a lot of pressure on consumer spending, one of the major drivers of economic growth the past 5 years. Banks are also tightening lending and this will not help the situation. Thus we could have a situation where the market is "saved" by Fed easing, but then belatedly realises that the economy is in pretty bad shape.

Looking at yesterday's trade in retrospect, the timing was poor, and it cost me money. The trade was definitely impetuous, and perhaps I need to consider introducing some sort of "cooling off" policy whereby I must wait an hour or two following the decision to trade. This would allow the circumstances to be evaluated in a calmer manner.

MARKET POSITION: SHORT (4 units)

The great shakedown

Markets declining sharply again today. I bought 2 more units of HXD at 24.85. I was a bit impatient and rushed the trade -- it traded down to as low as 24.11 shortly afterwards. But now it is around 25.00.

Starting to see some signs of capitulation out there. US 10 year broke throught its resistence around 4.70 and is now trading around 4.63. Yen is down more than another point to 113. I think a lot of people are getting shaken out of dodgy, overleveraged trades.

MARKET POSITION: SHORT (4 units)

Watching the dominoes fall

Contagion is a good word to describe current events. Dominoes keep falling in the great contraction of global liquidity. Investors/traders are bailing out of positions because they are losing money in one market or another, and are trying to curb losses / reduce risk. Banks are severely reducing their lending to funds and forcing funds to mark-to-market collateral. The most recent victim is the global carry trade (mentioned yesterday). Today we see the Yen up significantly while the AUD and NZD are down 3-4 cents in ONE DAY. Emerging markets are starting to feel heat; yields on gov. bonds such as Hungary and Turkey are rising.

There seems to be no turning back now. This will get worse. Selling is begetting more selling. The fundamental problem is that there is such a large amount of leverage in the financial system at present. Everyone is playing with borrowed money. The most likely scenario is that this will continue for a while, then the central banks will be forced to step in. The central banks do not want to bail everyone out -- they are concerned about moral hazard, certainly. But they also do not want this to spread to the real economy. Most importantly, perhaps, they do not want this to cause a collapse of the banking system. Bernanke is, after all, the expert on the Great Depression.

I am seriously considering adding to the short position sometime today.

MARKET POSITION: SHORT (2 units)

More damage needed?

Looks like my call on a short-term bottom was a little pre-mature. We continue to witness a very large reduction in risk/leverage. Asian markets fell sharply again last night. Nikkei closed below its March low, which is bearish. Europe down - FTSE is approaching March lows, though DAX remains far above. The USD is strengthening against the Euro and C$. The Yen is up sharply the past few days while the NZD is down, indicating that the global carry-trade is unwinding.

It's tough to make a short-term call here. The declines over the past few days were large, and a technical bounce would be normal. At the same time, the negative news is starting to become overwhelming. The Bulls' rhetoric seems to be waning. The mainstream media is starting to discuss the possibility of a recession. Wal-Mart (the US and world's #1 retailer) went out of its way yesterday to highlight the difficult economic environment.

There has also been a lot of talk about the Aug. 15 deadline for redemption requests at hedge funds (given a 45 days to quarter-end notice period). Many investors at losing funds are likely to throw in the towel and ask for their money back. This would prompt more de-leveraging / selling. There has been a massive move into quantitative trading / investing over the past few years. For a while, it must have seemed like free money. But as with all great things in the markets, it cannot last. Goldman is unlikely to support ALL of its hedge funds.

Medium-term trend remains down based on poor economic outlook and negative sentiment / technicals.

MARKET POSITION: SHORT (2 units)

Short-term bottom forming?

Yesterday's rally did not turn out as well as expected. After opening up, N. American markets drifted downwards all day, culminating with a sharp slide that caused a negative return by end-of-day. Asian markets were mixed overnight. Europe opened down but has been rallying this morning. Perhaps we may be working through the sellers and forming a short-term bottom. Again, I do not expect it to last. Despite all the rhetoric coming out of the traditional bullish camps, I don't get the impression that everyone is waiting to jump back in with two feet and increase risk/leverage. The opposite, in fact -- people seem wary. And how long are investors going to tolerate large losses from these funds before they bail-out?

A recent report by Lehman Brothers on the quant-fund massacre last week http://www.dealbreaker.com/images/pdf/quant.pdf provides a few interesting lessons:

1) Language it important: your model did not blow up, it "misbehaved"
2) Turns out everyone is running the same model (more or less). Oops! How did that happen? (hint: everyone is using the same dataset and techniques to build their models)
3) The market has acted in unexpected ways. Funny that -- I always thought the market was predictable, as long as your computer programme was big enough
4) When things go really wrong, blame the asset class, not the manager!

MARKET POSITION: SHORT (2 UNITS)

Whew! Am I glad that's over....

Asian and European markets up this morning, some very strongly. I am assuming that this is a "relief" rally, as in "Whew! Am I glad that's over..." Uncertain how long this rally will last, but I guess anywhere from 2-6 days. As mentioned last week, the economic fundamentals do not look good (in the US - globally it looks OK for now). The liquidity tap, if not off, is down to a trickle, and this should prevent any meaningful rally in the markets. That is what makes this "correction" different from the past few. People were frightened. It seems unlikely that hedge funds will be wanting to increase leverage again quickly, and private equity firms will probably be wary of big new deals in this environment. Similarly, I don't see the banks lining up to throw money at these guys like they did only a few months ago.

The "crash" is probably over, however, I do expect this market to gradually grind lower for the next several months, at a minimum, maybe longer.

MARKET POSITION: SHORT (2 units)

Knowledge & Confidence

My suspicion was 'correct' -- NY and Toronto rallied throughout the day yesterday after opening sharply down. In the end, TSX closed down only a few points, while SPX closed flat. Short covering was probably a factor, but two other factors may also have played a role: 1) there seems to be a growing sense that the world is not coming to an end (despite all the crazy talk on Thursday). Maybe all the money the global central banks pushed into the system is having a soothing effect. 2) There has been a lot of speculation that all the quant traders are running the same models (more or less), and as the credit markets crashed they have been forced to reduce risk/leverage wherever possible. This probably has some truth to it -- how many different strategies (real differences, not superficial) can be employed with the same backward-looking dataset? Anyways, perhaps this selling has come to a halt, at least temporarily.

This sets us up for the rally to continue into the first half of this week. However, it seems unlikely to last. Economic fundamentals are still poor. Central banks may be willing to provide emergency liquidity, but I doubt they are willing to cut rates to save the credit markets. Things would have to get REALLY bad before that happened e.g. equity markets down 20-30% in a very short time period. At this point they could justify the cut to themselves by pointing to the likely effects on the real economy.

After reading more of "The Black Swan" over the past few days, I am reminded of the dangers surrounding knowledge and confidence. It is probably impossible to consistently forecast the markets, especially the short-term day-to-day movements. Anyone who claims they can do so is either lying, lucky, or, most likely, never checks their own record.

It is important to keep the limitations of one's knowledge in check and not become overconfident. In the markets, being over-confident is worse than being stupid.

MARKET POSITION: SHORT (2 units)

Initial Thoughts

Trading started several months ago but, for some reason (?), I did not start the journal until today.

Coming back from holidays on Monday 6 August (4 days ago), I had the strong feeling that the markets were ready for a technical bounce. In fact, I had tried to buy HXU at the last moment last Friday afternoon, but was too late in entering the order by a few seconds. Toronto was closed Monday but NY rallied. On Tuesday at the opening, I was surprised to find Toronto trading flat from Friday's close. Being quite certain that the markets would rally following the Fed statement later (no matter what they said -- any old excuse would do), I bought HXU at 28.37. Stop loss was set at 27.95. I thought there might be a dip before or after the statement, but thought the spread would be sufficient to take account of any market 'noise'.

I was away from the computer from before the Fed announcement until after the close. I was slightly annoyed by the outcome. Markets did indeed rally, and there was a dip first. But the dip was large, and my stop loss was hit. In fact, my stop loss was hit at 27.88, and the low was 27.83. Close was 28.60. There must be a lesson to be learnt there, but I am not really sure what it is. For now, I am taking it to be: "be sure in your trades and set stop losses wide". If you are not sure, then don't trade!

Wednesday: market rallied again but I decided to stand on the sidelines. I did not expect the rally to last very long -- this was a technical bounce, after all, so it was a matter of waiting for it to peter out.

Thursday: European markets tank after more bad news on sub-prime. Turns out the problem is spreading to Europe. Amazing where this junk is turning up. In retrospect, not too surprising though. Considering that China, Japan, India, Russia, Saudia Arabia, etc. have been buying all the US Treasuries over the past few years, what has everyone else been buying? Securitised and structured products. And why not? They have a AAA rating, and the yields are certainly better. But ratings do not say anything about liquidity risk. And right now, it seems that no one wants anything without a government name. The technical bounce is over.

Toronto gaps sharply lower at the open and I am a buyer of HXD at 21.78 (no stops set after Tuesday's experience...for now). Market subsequently rallies for the next few hours. I know this cannot last, but I am annoyed at my impatience. I could have entered the trade at a much better price. Try to tell myself that it is the big moves that matter, not the intraday. In the end, market gives up all its gains and more.

Friday (am: London): Asia down sharply overnight. Nikkei is down a lot but the March lows held (so far). Europe also down. US$ up. Everyone is worried. Apparently the central banks are injecting liquidity into the markets. But I have a strong feeling it won't be enough to prevent a bear market. It may prevent a seizure of the credit markets, but the damage to the American household has already been done. People are worried about their homes and jobs. Spending will slow, dragging the economy down with it. In the financial markets, the global buyout binge is finished. finito. This has been driving the market up for the past 6 months, and now it is gone.

This all said, I have a sneaking suspicion there will be some short covering today before the weekend. The selling will continue next week.

MARKET POSTIION: SHORT (2 units)