Strange

More of the same in equities today: open higher, grind lower through the day, and another new low at the close. What I find strange is how little volatility there was (relatively speaking). With the Indymac and GSE announcements, I expected either a strong rally or a collapse. Difficult to see this trend going on for much longer -- it seems that everyone is bearish (especially on financials). Either there needs to be a bounce to clear the oversold condition, or there needs to be a collapse to bring valuations to a more reasonable level.

Although I am increasingly uncomfortable with my short index position, I am not going to cover unless there are either some signs of capitulation or valuations get to a more reasonable level (say, below 1100 on SPX). I also took advantage of the strength in energy equities today to add one unit to my short energy position. As mentioned before, it seems that the price of oil is now squeezing the global economy so badly that demand is suffering, so the price should decline soon. However, if it does go higher still, the position is well hedged against my short index positions, as an even higher oil price would put severe downward pressure on global equity markets.

MARKET POSITION: EQUITIES - short SPX (5 units); short S&P/TSX (5 units); short EAFE (3.5 units); short energy (2 unit); short real estate (2 units)

Classic Bear Market

Equities have been in a classic bear market the past 6-8 weeks. Sometimes jumping higher, investors constantly waiting for a bounce, but prices gradually moving down, down, down. It is amazing that SPX is down about 200 points from its recent peak and still there have not been any days with drops of 3% or more. On the contrary, whenever the market does drop a lot intra-day, it usually recovers some or all of the drop by the close, just to keep people in the game. There have also been lots of the classic bear market pattern of higher opens and lower closes.

Performance last week was good; portfolio gained 2.7% vs. losses of about 2% on both SPX and the S&P/TSX indices. However, the portfolio has still not re-gained its level before the March lows. Looking at some past trades, the decision to clear my long gold position my probably correct but clearly poorly timed -- gold shares have since rallied nicely. I am happy with the short energy position and may add to it on a pull-back. The short real estate position has finally recovered to close to the purchase price, and should do well from here.

Economic news was pretty light this week. Initial claims pulled back but the previous week was a holiday and the non-seasonally adjusted number was about 400k. The trade balance improved, which some people saw as a positive but is pretty negative from my perspective -- weak imports mean weak domestic demand and lower exports from the rest of the world. Consumer sentiment was more or less unchanged at very depressed levels. The decision by the regulators to close Indymac will certainly have repercussions for the US housing market, given that the company was the 3rd largest mortgage company in the country.

In other parts of the world, the BOE remained on hold despite an economy that appears to be on the verge of recession. Note that sterling and euro yield curves are very slightly inverted at the 1Y/10Y levels, indicating a high probability of recession. China export growth is decelerating, which should be no surprise given slowing demand in the major developed economies. The Japanese economy has also been producing some weak figures, but I think that the return of -inflation there should mean higher asset prices over the medium-term (a good trade to consider after global equity prices fall a bit more).

I have been short equities for a while now, and my faith that the market was always going down did not waver much -- until now. This is for a number of reasons: 1) Sentiment is starting to get pretty negative. It seems everyone and their dog is a bear now. The news on the economy is getting bad, and a recession is starting to become widely accepted (again). Those people who think the market may go up are only talking about a short-term bounce. 2) short interest is very high by historical standards (though this is not as objective a measure as it appears on the surface). 3) the market has been oversold for a while. In addition, there might be a post-Indymac bounce just as there was a post Bear bounce in March, plus there is the rumour of the Treasury injecting funds into Fannie and Freddie Monday morning that should alleviate concerns there for the short-term anyways.

On the flipside, there has still not been a real capitulation. No large down days in equities, JPY/EUR is strong at 169, and the 2-year US bill closed on Friday at 2.58, hardly indicating fear (although treasuries were supposedly weak due to concerns that the government would have to take on the GSE's liabilities -- these seems extreme). VIX has remained comfortably low, again closing well below 30 (although this signal's value may have declined significantly since everyone appears to be watching it to time a bottom -- e.g. Bloomberg story last week). Finally, valuations are still much too high. As I mentioned last week, SPX aggregate earnings are probably about $70 right now. Assume a typical market bottoming p/e of 12 or even 14 would put the index in the 840-980 range.



What is needed is a steep enough decline to bring valuations and expectations down and also knock oil off its pedastal. This would probably set-up a nice rally that could last for 3-6 months, if not longer. Although a bottom in August in September still seems the most likely scenario, there is the possibility of a major decline in the next few days given the recent events. I plan to watch the price action closely to try an anticipate if it is worth taking some money off the table, if only for a short period.


MARKET POSITION: EQUITIES - short SPX (5 units); short S&P/TSX (5 units); short EAFE (3.5 units); short energy (1 unit); short real estate (2 units); CASH (1 unit)

Performance to 4 July 2008

Quick post. On performance, June was my best month so far, but this was off a terrible April/May, so does not account for much.

On the markets: equities globally are down, a lot in most cases. Many people are calling for a bounce here, based on three factors: the markets are very oversold, markets have touched a few important technical lines (e.g. the Jan/March lows on SPX), and general sentiment seems to be getting pretty bearish again as investors realise that the US probably has NOT escaped a recession.

I agree with all of these points, yet I still do not see the conditions necessary for a sustainable move upwards. For me, the most important indicators are those that point to a high level of concern or panic, and I do not see that yet. Vix is still in the mid-20s, the Yen is softish, there has yet to be a 3%+ down day nor a large downside gap at the open.

I remember the old trader's maxim: do not sell a stock just because it has gone up. I also remember that over the past 6 months, there has been many times that the market looked like it was very overbought, and then it went higher still. I also remember that in bear markets, the last few days/weeks can account for over half of the fall in prices.

The combination of factors weighing on this market are very strong: housing crash, credit crunch (which spreads indicate is still with us), a weakening economy (unemployment up 1.1 pp over the past year), and ridiculous oil prices ($140+ last week). And valuations are not reflecting this. The P/E on SPX is currently a little over 17. Given the poor earnings outlook + bouyant (if not rising) inflation, the p/e should probably be more like 14, if not 12. I remain short.

There has been no change in my positions but I have re-tooled the weightings to reflect changes in market valuations.

MARKET POSITION: EQUITIES - short SPX (5 units); short S&P/TSX (5 units); short EAFE (3.5 units); short energy (1 unit); short real estate (2 units); CASH (1 unit)

Orderly slide

This recent slide in the equity markets has been perfect. Fairly steep, but orderly, gradual. No large gaps or sudden slides. I suspect this is because many participants are a bit shell-shocked. They thought that the economy avoided a recession, or they thought that it was going to be short and shallow, and therefore the bottom in the market was already in.

There is a large and growing bear contingent on the web, and this worries me a bit. But many of them were talking about a bounce last Friday, and it never came, so maybe they were as surprised as everyone else by the markets over the past 2 days.

I think that as long as the decline remains fairly orderly and VIX stays at reasonable levels (say, below 32/33), we could have an acceleration of the decline over the next few weeks. I am looking for about 1100 on SPX. And if concerns about global growth continue to rise, then commodities should fall, and the TSX could fall pretty hard and fast with them. I am going to watch VIX for a sign to cover, plus for a large downside gap on the open.

MARKET POSITION: SHORT EQUITIES (10 units); SHORT REAL ESTATE (3 units); SHORT ENERGY (1 unit)

Quick update

Equities have been trending downwards the past two weeks, and today we had the first really big down day in a while (almost 3% on SPX) and the Dow made a new low for the year. Credit spreads have jumped out, the TED spread has turned up again, USD is soft, gold spiked up and oil prices are hitting new highs. The big question, of course, is whether this represents a tradeable bottom, or at least are we near to one i.e. should I be covering my shorts?

Sentiment is getting pretty bearish. I hear a lot of talk about SPX re-testing the March lows. Short interest is high and rising. The economic news has continued to be bad, and I get the feeling that the consensus may swing towards a 2008 recession again. On the flip side are a number of other factors: VIX is still pretty low (23.9 today), treasuries are still well above their lows earlier this year -- and the curve is still pricing in a hike this year; stocks are not cheap, commodity prices are still very high (I expect these to break down before the market bottoms), EUR/JPY -- a great crisis indicator -- is high (167/168), and there are few people talking about a serious breakdown in the equity indices -- most are just talking about a re-test of March lows.

So unless we have a major breakdown over the next few days, I think I am going to stay put for now. In 2002, the market fell through June, and then SPX lost another 190 points in the first few weeks of July. Goes to show that when the market really collapses, it can move far. I think the real bottom will come in August or September. A large gap-down on the opening Monday might change my mind over the short-term, however.

Portfolio Performance

I am late posting May performance as I have been traveling the past few weeks. I will not say much here -- the charts speak for themselves. Disappointing. Returns have improved the past couple of weeks but have a long way to go to make up for the carnage in April and May.

The US markets have been pretty weak the past few weeks but Canada remains pretty strong. US economic data has been weaker than expected, for the most part, though it is still inconsistent. My base case is still that as concerns about global growth increase, commodity prices will weaken (gradually at first, then more quickly), and the TSX should also fall. Although there are a few holdouts, consensus seems to be that high commodity prices are here to stay. I never feel comfortable agreeing with the consensus (although this sometimes gets me into trouble).

Sentiment is interesting again. My greatest concern is short interest on the NYSE, which is at all-time highs. Hopefully this does not indicate a generally bearish disposition, as this would mean that the market is close to a bottom. However, other indicators suggest that the market is still not overly concerned. VIX is in the low 20s, many people still seem to think that the US has dodged a recession, and there is little panic talk. Price movements may have become short-term over-sold, but so far the action has been relatively calm, indicating that we are not at a panic bottom. However, if there are a large number of shorts out there, the market could rebound pretty quickly after a bottom is formed. We should get more confirmation this week with the FOMC meeting plus several key data releases.

I sold my remaining unit of gold last week on moderate strength. I took a loss on this position after haveing a sizeable gain at one point. I will not try and give a lesson right now, but needless to say, I see the downside as greater than the upside over the short-term.

MARKET POSITION: SHORT EQUITIES (10 units); SHORT REAL ESTATE (3 units); SHORT ENERGY (1 unit)

The end is nigh

I have a strong feeling that the end is nigh for equities. All equities. Let me be clear. I am not saying that equities will crash and never recover -- I am talking about a rather quick and messy slide that takes 15%-20%+ off of the major indices from current levels. It will probably also be a "V" shaped bottom, with a fairly quick bounce up from the lows. This is also not a prediction for the next week, but rather what I expect over the next 3 months.

My rationale is based mostly on current oil prices, which are having a severe impact on consumers and businesses in most countries at current levels. The liquidity cruch of 07/08 appears to have passed (the worse of it, anyways), but it has left economies weakened and vulnerable, and the big jump in oil prices is a kick in the head that will be impossible to dodge. The hawkish rhetoric coming out of some central banks does not help either. The UK and German yield curves are now inverted, pointing to recessions there within about 12 months. The US yield curve has also flattened as yields have risen -- definitively NOT what is needed to get the US economy and financial sector back in shape.

The slowing in global growth will inevitably impact commodities prices as everyone remembers about the laws of supply and demand. This will impact the TSE and many other indices that have been supported by commodity producers.

I would like to exit my remaining gold position at a decent price if possible -- unfortunately I missed the latest uptick but it is a relatively small position so I am not overly concerned. So far, the short energy position has worked well and I may add to that position in future. Other positions, such as short real estate and short EAFE equities, are also starting to do better. The one major loser in my portfolio is my short CDN equities position, though I feel comfortable with it given my comments above.

My fundamental analysis is supported by sentiment. As of last week the consensus was that the US had dodged a recession, but that is starting to change. This is now the best time to be short -- as the consensus slowly moves from one extreme to the other.

Bonds have been big losers over the past few months but I think the worst is past. Bonds yields also spiked up at about the same time last year, then dropped with equities in the summer/fall. I expect the same to happen again this year, as concerns about the economy return over the next month or so. However, I expect inflation to remain troublesome so it is very possible that the previous lows may hold.

MARKET POSITION: SHORT EQUITIES (10 units); SHORT REAL ESTATE (3 units); LONG GOLD (1 unit); SHORT ENERGY (1 unit)
Posted by CDN Trader