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)

Let's recap, shall we?

A brief review of the facts:

1. Most forward-looking indicators (e.g. PMI, durable goods, etc) are showing that the economy has slowed dramatically over the past 2 months
2. The housing situation, while difficult to say whether it has become worse, has certainly not become any better.
3. The labour market is weak. Payroll numbers have help up OK (though their accuracy is debateable) but the 4 week MA of initial jobless claims continues to increase, and is approaching worrisome levels. A rise past 350k would be a strong signal that a recession is underway.
4. Consumer confidence is plummeting, particularly future expectations. Surveys show that a large percentage of Americans believe the economy is already in a recession.
5. Energy prices remain punatively high, despite the retreat from recent highs
6. Despite 100 bps of cuts from the Fed (plus BoC and BoE cuts), LIBOR remains high, the credit markets are glued up, and the stock market is 5% below it highs (as I write this SPX is 1490).

Is this a pretty picture? One that points towards a return to healthy growth and profits next year? I think not. So I must continue to stay short, wait and be patient. The market will come over eventually.

Speaking of patience, once again I rushed the trade last week to increase my short position. Although I wanted to increase around 1500, and saw that as a reasonable place to enter, I jumped the gun and made the trade before the market was able to get there. It was not an outright stupid move (I still believe that next year selling at 1465 will look pretty smart) but I could have got much better execution if I had been patient.

With less than 3 weeks left in the year, it's difficult to foresee how things will develop. It is possible we will get the usual Santa Claus rally and could even see SPX back close to its high. But if that were to happen, I would expect January to be pretty ugly.

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

Market offers more opportunities

The market continues to offer opportunities to increase my short position. After a hard and fast rally last week, the market seems to be weakening again. No surprise, given the events in the credit markets these days. A growing number of people are starting to say that a recession may be just around the corner. Housing, employment, consumer confidence, profits are all weakening. And the market is only 6% off its highs! A testament to human optimism and trend following.

I think by the middle of next year, now will be seen as an incredible opportunity to go short. Last week's oversold condition has been rectified, and the market is ready to start declining again. So I am taking this opportunity to increase my short position by two more units. I was hoping to be able to do it closer to 1500 on the SPX, but I am not sure we are going to get there with all the negativity these days.

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