Sunday, December 2, 2012

QE4 Rumours Start Circulating

Market Notes
Source: Short Side Of Long
  • Lets face it, sentiment surveys have not given investors an edge towards either the bullish or bearish side in recent months. When we look at the chart above, we can see that the AAII spread started to approach what one might call an extreme low reading or a contrarian buy signal. However, this was not confirmed by other surveys, especially the NAAIM, which was at the opposite spectrum of sentiment showing high optimism and therefore giving us contrarians a sell signal. Finally, Investor Intelligence remains around neutral readings, but here too advisors just move from bullish to neutral camps and back again. Not many are actually turning bearish. Furthermore, the market action has been one of sharp sell offs and just as sharp rallies, leaving behind weak bottoming phases without proper wash outs (also known as V reversals which are prone to failure). This can be seen in the June 2012 & November 2012 bottoms and is very much unlike the price action during the middle of 2010 & middle of 2011. Furthermore, at both the 2010 and 2011 sell offs, volatility spiked into what I call a "capitulation zone", whereas during recent sell offs the VIX has barley moved above 20 (historical average). The reason I was able to call a bottom in late September 2011 and early October of 2011, is because the majority entered total panic and expected a repeat of 2008. Back then, one prominent blogger wrote that "the cleansing process stocks should either test the March 09 lows, or if Bernanke tries to stop the bear market with another round of quantitative easing, we could see the March 09 lows breached." Today, the view of this same investor is to see all time new highs in the stock market and there are many like him. The market is up a lot since those days and the recent short term bottoms in June & November do not look like they were proper buying opportunities for longer term investors. The bull market that started in March 2009 is ageing and struggling to create any meaningful net gains. According to the historic data of the Presidential Cycle, the current rally is already one of the greatest ever. All of these are usually not good signs for the long run.
Source: Short Side Of Long
  • While sentiment surveys are not giving us the edge when it comes to stock market sentiment, we have to remember that these surveys are more about who "said" what, instead of who "did" what.  In the previous post, I discussed how within the foreign exchange world, the Australian Dollar Japanese Yen cross pair is commonly known as the perfect example of the carry trade concept and also a great sentiment indicator for all risk assets. A follow up on the recent COT positioning data shows that hedge funds have engaged into very large bullish bets on the Aussie Dollar and at the same time very bearish bets on the Japanese Yen. Looking at the chart above, readings have now moved into an extreme territory of 2.5 standard deviations away from the mean. This is a contrarian sell signal and a major warning flag for those long any risk asset, including global equities. The correlation coefficient between the Aussie Yen cross and MSCI World Equity Index stands at 80% positive over the last 260 days (one trading year) and 85% positive over the last 520 days (two trading years). In other words, these two assets move in essentially the same direction.
Source: BarChart / Short Side Of Long
  • I believe technical analysis is a useful tool when cross referencing fundamental conditions of an asset class. Price action on the chart can tell us what is currently happening, however in my opinion using technical analysis on its own to "predict" what will happen in the future is a recipe for disaster (many will disagree with me). The chart above shows Silver, the largest single holding investment in my fund. The goal of an investor like me is to buy low during panics, while the goal of a trader is to buy high with a break out in mind. Those who have been following the blog for a while would know of the major purchases in late December 2011, early July 2012 and again a technical breakout out of a small triangle in August 2012. There have been other minor positions through the last 12 months, but their NAV % is very small in comparison. The point is that I am not a buyer right now, while the majority of traders are ready to play the breakout on the upside with many positioning themselves to the long side as Silver's Open Interest explodes. Silver now approaches a major decision point, with fundamental conditions possibly improving further. The Federal Reserve could embark on another round of quantitative easing called QE4, where they buy Treasuries. If implemented as Operation Twist ends, this action could finally start pushing up the Fed's balance sheet and should be beneficial to precious metals. At the same time, Silver's price action has been stuck between a $26 support and $35 resistance without a clear break in either direction, indicating neither bulls nor bears dominate the trend. I am not into short term predictions, but one thing is certain - both the Gold and Silver price action has been rather weak in the last few days despite rumours of QE4 in circulation. Failure by these assets to break out on the upside and clear major resistance levels ($35 for Silver) despite favourable QE conditions, will signal that not all is well within the Precious Metals sector. Furthermore, Gold Miners have already broken down and have yet to confirm their recovery above 200 MA. With Gold up for the 12th annual year in the row, PMs bulls should carefully watch the price action in coming weeks as we await the Fed decision and the follow through price reaction (don't turn bearish in a secular bull market, just be cautious)!
 Source: Short Side Of Long
  • Investors continue to ignore Soft commodities like Sugar, Cotton, Coffee and Orange Juice - all which have been awful performers over the last 12 months. If an investors job is to buy fundamentally strong value at cheap prices, then it does not get any better than these assets right now. Sugar, in particular is my favourite agricultural commodity due to the demand and supply problems I see developing in the coming quarters and years. On the other hand, hedge funds do not seem to hold the same amount of optimism as I do, as they hold the lowest net long position in 5 years. Furthermore, small speculators which are also known as dumb money, continue to hold net short positions in Sugar. The price of this commodity is down 17% this year, down 47% since the February 2011 top and furthermore down over 66% from its all time highs. Finally, the Sugar price action shows that we have spent a very large amount of time trading below the 200 MA, usually a signal that a major bull market is just around the corner. I am looking forward to engaging further into the Sugar market in the coming weeks and months ahead, as I believe it offers great long term prospects.
    Featured Article
     Source: The Wall Street Journal

    Unless you have been living under a rock, you have probably noticed that the Fed is once again starting to "telegraph" its plans of action through various media outlets. The recent front page article in the Wall Street Journal, made the case that "bond buying is expected to continue in effort to spur slow-growing economy". In other words, it seems that only a few months after QE3 started, which essentially is QE infinity, the FOMC board is gearing up for QE4 or what some term as QE infinity expanding as Operation Twist ends in late December. 

    As Sober Look Blog and Ed Yardeni pointed out in recent days, Fed's balance sheet has not been growing all that much since the announcement of QE3. Let us remember that the Federal Reserve launched QE3 on September 13th of this year, when the overall Fed balance sheet stood at $2.825 trillion. Fast forward to today and the balance sheet sits at $2.853 trillion, which in a grand scheme of things is a very small increase at best.
     Source: Sober Look Blog

    It is my take that the Federal Reserve is noticing that $40 billion per month is just not enough to push stock prices higher and therefore achieve their desired "wealth effect". With that in mind, they are now gearing up to double down as they engage into purchases of Treasuries as well. At the rate of $40 billion in MBS and $45 billion in Treasuries, both being un-sterilised, the Fed will be mimicking QE2 at the rate of $680 billion over the 8 month period. Remember that QE2 was $600 over the 8 month period from November 2010 until June 2011.

    But... lets be honest here - the first part of this article has probably not told you anything new that you do not already know. It is just a summary of market expectations. The question investors need to ask themselves is whether or not more QE will work?

    This question is a very difficult one to answer, because there are no true facts as of today. These types of central banks programs are in experimental stages and investors do not have historical evidence from previous business cycles to draw upon. If you belong in the school of thought that sees money printing as an inflationary force, your view is that it will improve the value of assets that respond well to inflation (like stocks, commodities, corporate bonds & risk currencies etc). The other school of thought would obviously claim that money printing does not work and will not work into the future.
    Source: Short Side Of Long

    During the initiation phases of previous Fed programs like QE1, QE2 or Operation Twist, the stock market became extremely oversold, which helped the Fed and gave its programs some credibility. Consider that during the same time the Fed started to "telegraph" its plans of action, the percentage of stocks above the 50 MA entered single digit readings, while the volatility index (VIX fear gauge) spiked into the anxiety zone, and finally market expectations for inflation turned meaningfully down. At those inflection points, the market was ripe for a rebound regardless due to oversold conditions, so Fed's quantitate easing programs "gained the respect" of market participants. These so called Pavlov's dogs, or as I called them Bernanke's dogs, started to believe that the Federal Reserve could actually make the stock market rise.

    No one knows for sure how much of a rebound the stock market would have achieved without Fed's assistance, however one thing is certain - when the Fed engaged into a program promising QE to infinity aka QE3, it actually failed to push the stock market higher. Take a note that the Fed's announcement was on September 13th during a time when the stock market was overbought as the percentage of stocks above the 50 MA was close to 90%, while the volatility index was at extremely complacent levels last seen in 2007, and finally market expectations for inflation were truly overheating. As the inflation trade was already fully discounted by the market up to that point, Fed's QE3 announcement failed. Therefore in my opinion, this shows that the Fed does not have that much of a mystical ability to manipulate asset prices as easily as Bernanke's dogs would like to believe, unless of course the market conditions are ripe for a rebound regardless. So let us come back to the main question...
    Will more QE work?
    If we use equities as a measure of whether or not more QE will work, my personal opinion is that at the current market conditions, more QE will most likely NOT work properly like QE1 and 2 did. My view is that the stock market is just not oversold enough, there is no panic and anxiety when we gauge various indicators of sentiment including the VIX, and most importantly market participants expect inflation and growth as the main consensus outlook right now.
    Source: Albert Edwards / SocGen

    What waits for us around the corner are economic surprises to the downside (chart above), earnings disappointments, profit margin mean reversion and most likely another deflationary shock of some kind. If and when the Fed engages into QE5 after those events occur, as volatility rises dramatically and sentiment turns bearish once again, the Fed's mystical powers and abilities might all of a sudden re-awaken and once again appear to be working. Bernanke's dogs will praise the new programs of money printing and will hold hands singing "Kumbaya, my Lord, Kumbaya". But the more contrarian ones amongst us will know that the most likely outcome was one of oversold conditions, where a rally was overdue regardless and that Bernanke will just be throwing more fuel onto the fire which should give the eventual rally more of a boost.

    Trading Diary (Last update 16th of November 12)
    • Equities: Short positions are held in various US equity sectors, which include Dow Transports (IYT), Technology (XLK), Discretionary (XLY) and Industrials (XLI). Large put options have been bought on Apple (AAPL). Call options have been sold on Homebuilders (XHB), JP Morgan (JPM), Amazon (AMZN), IBM (IMB), Commonwealth Bank (CBA), Adidas (ADS) and others.
    • Bonds: There isn't a lot of exposure in the bond space, as we believe this sector is experiencing euphoric investor demand. Call options have been sold on Junk Bonds (HYG). We plan to short Long Bond Treasuries (TLT) in due time.
    • Currencies: Long positions are held in Japanese Yen (FXY). Put options have been bought on British Pound (FXB) & Canadian Dollar (FXC). Put options have been sold on Japanese Yen (FXY).
    • Commodities: Long positions are held in various commodity sectors, which include Silver (SLV, SIVR, PSLV, Comex futures), Agriculture (RJA, JJA) and Sugar (SGG). We plan to increase  longs in PMs and Softs in due time.
    What I Am Watching