I changed my mind

I changed my mind about the market. I changed it several times, in fact, but I have settled on the reverse of my position last week. I now think that the market is more likely to go lower. There are several reasons for the change. First, because US markets were closed last Monday and the Fed made it's dramatic 75 bps announcement Tuesday morning, the markets never had the big, fast drop that slides usually end with. Last Tuesday's and Wednesday's lows were ultimately unsatisfying in that they did not shake out enough longs, and emboldened many (including myself) to gamble on some upside. Indeed, too many people have been saying that last Tues/Wed marked intermediate lows, and the market is poised for a good rebound before falling lower again. This suggests that too many people have assumed the worst is over for the time being and put risk back on the table.

Last Friday's slide was also indicative of a weak market. The high was at the open, (and slightly short of my 1380 target for SPX), and the market did not see it again all day. Despite a bit of a rally today, we are still far below Friday's high. This is not the sharp rebound that I was expecting.

Finally, today's new home sales data was aweful, providing another reminder how bad the economic situation is likely to get. I am not sure what Bernanke and co. are going to deliver on Wed, and I don't really care, but I don't think the market is going to be happy whatever it gets.

I returned to my previous short level earlier today, purchasing 3 units of HXD and 2 units of SDS.

MARKET POSITION: EQUITIES - SHORT (11 units); GOLD - LONG (1 unit)

Chill-Out time

It's Chill-Out time for the equity markets. It got a little heated at the beginning of the week, but the scene is a bit calmer now. VIX is down to 28, the US 10 yr is up a whopping 22 bps as I write this, and the global equity markets have bounced off their lows. The tone of the media has also changed. Although it is impossible to measure this scientifically, it seemed that ALL of the stories on Tuesday / Wednesday were doom and gloom, whereas the mix is much more balanced today. Positive stories today included the bail-out of the monolines and progress on the fiscal stimulus package. This will be important to watch as it could have a strong impact on the markets when it finally goes through Congress, though I am sceptical about the final impact on the economy.

Light week data-wise. Initial unemployment claims were surprisingly low again today. This also needs to be carefully watched. If this remains at such a low level, it will be a major hole in the recession story, which has now become mainstream. Existing home sales were very poor today, however. Lower interest rates seem to be having an impact on refi applications, but the banks and consumer credit companies see rising losses on the horizon and they are scared. Anecdotal evidence suggests a BIG decline in new auto loans, for example.

I expect the market to bounce around a bit here but ultimately move slightly higher over the short term. Not surprisingly, the chatter is still somewhat negative, and I will wait for some optimism to return before re-establishing my full short position. This is a risk management exercise more than an attempt to goose returns. I am looking for SPX to reach about 1380, maybe higher.

MARKET POSITION: EQUITIES - SHORT (6 units); GOLD - LONG (1 unit)

The end of the beginning?

Was today the end of the beginning of the bear market? Only time will tell for certain, but there were a few prominent signs. After Asian stocks fell hard for two days running, the international media were screaming about a stock market crash when NY opened today. After the Fed cut rates 75 bps in a surprise inter-meeting move, the market only opened down about 4%, then rallied through the day to close down 1%. This is the first market move greater than 3% in some time. In response, VIX hit 35 this morning (see last Friday's post re: VIX).

These facts led me to close out 5 units of my short position near today's close. I waited through most of the day to see if the market might collapse (as it has done several times recently) but it held up OK. This was a sign the market might finally be finding some support, though it also meant that my price was not great. In particular, I gave up all of yesterday's gain in HXD. Well, one should try to be as dispassionate as possible.

I am thinking there may be a short rally from here as the market finally clears its oversold position. Could last anything from a few days to a few weeks. I plan to re-establish the shorts, hopefully at better prices. I am hoping that I am not attempting to time the market too closely here....

MARKET POSITION: EQUITIES - SHORT (6 units); GOLD - LONG (1 unit)

What is VIX telling us?

A quick (admittedly non-scientific) comparison of VIX and SPX since 1990 suggests that, in major market declines, SPX typically bottoms once VIX reaches about 32-35. However, in the most severe market declines (1998, 2001, 2002), the decline did not happen until VIX spiked over 40. As I type this, VIX is about 28. This is well above its level one month ago, but still well below the levels typically seen at a market bottom. From this perspective, it is not surprising that today's early rally was not sustained. VIX says there is still more downside to come. And if this is a severe market decline -- which, given the economic circumstances, it may be -- the additional downside may be considerable.

S&P/TSX closes below Nov. lows

The north american markets faltered towards the end of trading today after trying to rally mid-day. The S&P/TSX closed below its Nov. intra-day low. Based on this sign of inherent weakness, I decided to increase my short CDN equities position. The TSX has not declined as much as SPX over the past month and therefore it is also a convergence play. I increased my holdings of HXD by 2 units at today's close (22.50).

MARKET POSITION: EQUITIES - SHORT (11 units); GOLD - LONG (1 unit)

Goodbye liquidity crisis; hello economic crisis

Libor finally fell below Fed funds yesterday, signalling the end of the liquidity crisis. I guess bankers have finally realised that the Fed will do what it takes to save the financial system, and it is highly unlikely any of the major players are going to go bankrupt (I present Countrywide as an example). But the liquidity crisis, lasting as long as it did, was a major shock to the US (and most developed countries) economies, and it seems pretty likely that a recession is very close if not underway already. I know I said this a few months ago, and obviously I jumped the gun, but the data has got considerably worse since then, and many other respected players are saying the same thing. Worse (for the economy) is that general consumer and business sentiment seems to have fallen off a cliff, and it will be very hard to bring that back in the current environment. Companies continue to announce layoffs and house prices seem to be in free fall. I said in the past that I would not officially announce a recession until the PMI falls into the low 40s and the 4 week average of initial unemployment claims moves above 350k, and I will stick to that. But it does not look good.

The financial markets are telling the same story. Swap spreads have increased over the past few months and look set to move wider. EM spreads have also started to move out. Asset-back CP spreads have moved in from their nuclear holocaust levels but remain relatively wide and the yield curve is inverted once again. Treasuries yields have plummeted and the 10 year yield is now substantially less than 12 month CPI. SPX is down about 11% from its high even though we are 4 months into a Fed easing cycle -- not good. Oil and industrial metals are finally coming down in recognition of the slowing in the US. On the other hand, gold is pretty strong (though off recent highs), presumably as the market realises that the FED has no choice but to further debase the USD to save the US financial system and economy from depression.

Equities indeed fell over the past week, though the decline was relatively orderly -- no big drop as I suggested last week. As I have mentioned before, this feels very much like a bear market. There have been no really big down days (all less than 3% declines). Sentiment is interesting. Although the talk is very negative, and surveys are showing excessive bearishness, there is also a lot of people saying that the market is oversold and it is time for a relief/rebound rally. There are also a lot of people who recognise that the economy is in bad shape but refuse to see how bad, and think the Fed can still save the day. But every time the market tries to rally it falters after a relatively small move.

I remain as last week. I am waiting for a rally before adding to my short equities position. Gold stocks soared last week (as gold went over $900) for a whopping 60% gain over the past few weeks, making me slightly annoyed that I did not add to my small position. But I still believe that the rally is somewhat premature. Investors are looking around and trying to see where they can put their money that's recession proof, and gold is an easy answer. Gold has soared similarly in the past and then given the gains back in a short period. Gold will go higher over the next couple of years but the big moves will be gradual. I will wait for the current pandemonium to calm down before I increase my position. Bonds continue to perform well, but I think they can go still further as long as the yeild slide is gradual.

MARKET POSITION: EQUITIES - SHORT (9 units); GOLD - LONG (1 unit)

Volatility often presages market declines

The type of volatility the equity markets have been experiencing the past few days -- up 1% one minute, down 0.5% 30 mins later, is often a precursor to large market declines. The market is fighting an internal battle as it debates whether the economic outlook is really as bad as it looks. Of course there is no guarantee which direction will win out, but my bets are clear. I am not going to increase my position at current levels, but I probably would if SPX goes above 1460 again in the next week or two. Otherwise, I will wait for the next throwback rally.

Outlook for 2008

It's been a while since the last post as I got caught up in holiday activities. I was also waiting for some more clarity on the economic front, which was provided this week. A US recession has probably not yet started, but the economy appears to be on the edge, and the trend is not good. Manufacturing PMI was below 50 this week and December employment numbers were weak. Holiday sales were also pretty weak. Consumers have not yet rolled over but they seem to be worried. No wonder -- with house prices falling, foreclosures rising, and companies starting to announce mass layoffs -- it is only logical. FOMC minutes showed that the Fed is much more worried about the weak economy than inflation.

Equity markets were weak in the Christmas-New Year's period and this is ominous. Typically the market rallies pretty hard around this time of year, and for it not to happen means that the market is weak. The large decline in the Nikkei yesterday was also a warning. I am not yet ready to declare a bear market (I will wait until SPX decisively breaks through the August/November lows), but it sure feels like a bear market. Rallies are not sustained; if the market opens higher, it falls towards the end of the day. And there are few people talking about the fact that the market is well off its highs. The bond market has rallied smartly over the past week and yields are now back where they were several weeks ago. Ditto with currencies.

Gold has also jumped back up and is now above its all-time high. Part of me wants to take this a buy signal and increase my position, but I think that the current gold rally is premature. People have decided that they do not want to increase their equity position so they are casting around for alternatives and they choose gold. But gold will probably get hit in the impending equity meltdown, even if it is one of the last to fall. That will be the time to increase gold, along with oils and agriculture.

Although I generally dislike it when seers write their predictions for the upcoming year (as they are usually wrong), in my case it is a good idea, as it forces me to order my thoughts and justify my positions. Most importantly, it provides a record of my thoughts at this point in time, which is one of the major reasons for this journal.

My long-term outlook for monetary policy is based on the fact that consumers (and some corporates) have undertaken a massive increase in debt over the past 7 years. The Fed knows that a debt-deflation spiral is real possibility so they will do all they can to prevent it. The only way out is through easy monetary policy and higher inflation -- essentially inflating some of the debt away and allowing households to gradually repair their balance sheets. That will probably take several years. Once that is more or less complete, and inflation expectations start to really get out of control, the fed will be forced to jack up interest rates, causing another recession.

So I continue to expect a major decline in equities globally as the economic reality sets in. This could be imminent (SPX is down over 2% as I write this), or it could be next month or in March. But it is probably sooner rather than later. Bonds will do well but commodities (including gold and oil) will probably get hit, though they may fall slightly later. Once that happens, it will probably a good idea to exit long bond positions and increase exposure to gold, agriculture and oils. Probably emerging markets as well. I expect these to be the major growth areas over the next few years. But I will probably stay short of the major indices for a while longer. The upcoming recession could be severe, and equities probably have far to fall.

MARKET POSITION: EQUITIES - SHORT (9 units); GOLD - LONG (1 unit)