MARKET RECAP: Leverage with a Capital L

A very interesting option expiration week for the markets as the S&P closed at a new high and is in striking distance of the all time high reached in 2000 around 1550. In currencies, the dollar/yen hit a recent high though finding some resistance at the upper end of the channel while euro/yen seemingly broke down from its rising wedge but recovered on Friday. In commodities, crude rallied and gold remained under pressure though appeared to be looking for a bounce. The bond market perhaps saw the most important action of the week as interest rates hit a high not seen since the peak in February with the long bond yield back near 5% presumably on an announcement the PBOC would be shifting some reserves out of US treasuries and into Private Equity (Blackstone getting $3b). The small corrective contracting triangle we have been following in bonds appears to be invalidated on this news and we must now reassess our strategy possibly tweaking our outlook.

INTERNATIONAL INTEREST: Carry On My Wayward Son

This week the yen traded lower v the dollar and the euro as the BOJ interest rate policy remained on hold, though they did indicate they were prepared to hike in the near future. Despite the warning the markets took the inaction as a green light to remain in carry trades financed by the yen and global stock indices obliged by hitting new highs. For a couple of weeks we have been watching the euro/yen pair as we were convinced most of the speculative flows were trading in Europe with the German DAX index leading global stock markets and its tight correlation with the EURJPY. After finishing a deep correction last week that coincided with multiple foreign central bank meetings, the euro resumed its ascent this week trading back near the recent high v the yen. As the chart illustrates the ride was a bit bumpy with the initial rally taking the form of a rising wedge that was broken to the downside but recovered on Friday. I read this as a warning sign that the advance from the 3/07 lows is in the late stages perhaps needing a bit more upside to the 165 area before rolling over. This was also evident in the USDJPY that ran into resistance at the upper trend line of the channel that has also been in effect since the Mar low.

We believe both of these pairs that have been a by-product of the yen carry trade are in the latter stages of their respective advance and could have some important implications for risk assets upon reversal. If the yen were to rally and reverse these patterns, we would likely see de-leveraging of positions and risk aversion in all assets that have benefited from cheap financing the yen has provided. A simple 50% retracement of the rally would be a 2.25% move and if magnified by the leverage employed you could see much larger moves in the underlying assets that are financed.

Bottom Line: traders in all assets need to be on their toes in the coming weeks as we believe the euro and dollar are in the final stages of an advance v the yen which could have a dramatic impact on the leveraged assets financed by the yen carry trade.

COST OF CAPITAL: PBOC Shakin’ the Trees

The bond market threw us for a bit of a loop on Friday as the triangle we have been watching for a couple of months is in jeopardy and potentially invalidated. Selling continued across the curve sending interest rates to their highest level since the peak in February. The PBOC announced Friday that they were widening the band of Yuan coupled with a report from FT of an asset allocation shift out of US Treasuries into Private Equity only exacerbated the selling. It is unclear whether this allocation shift has taken place but what a profound example of the current leveraged environment chasing meager returns. That is the trade dominating markets since the March low via carry trades that favor equities and corporate debt at the expense of sovereign debt and the yen. The fact that this announcement comes when we believe the carry trade is in the latter stages amuses us as market turns are often preceded by such seemingly bullish news. The fact that the world’s largest communist nation is investing with one of the world’s largest most speculative capitalist vehicles makes it even more ironic.

We find little evidence in the recent data to drive the selling in treasuries with growth decelerating in almost every sector of the economy and must chalk it up to technical break downs and potentially too many longs looking at the same chart pattern. Imagine how many bond holders anticipating a flight to quality rally as stocks looked toppy and the triangle implied a massive rally to new highs. It was a rude awakening for traders to read that one of the largest holders of treasuries would be a seller and rotating into the very trade they were betting against. That being said, we must go back to the drawing board and reassess where we are in the pattern. Assuming we invalidate the triangle what is the next alternative pattern? We still believe the big flight to quality trade will emerge but may have simply been put off for the time being. The triangle idea was that we were in a corrective mode before the rally to new highs. That is still on the table only the correction is potentially taking a different form than we first believed. Our line in the sand now gets moved to the February low at 109-06 on the bond contract only 3/4 of a point below Friday’s close. If we can hold this area over the next couple of weeks the rally to new highs is still in the cards as we would be finishing off a corrective move before the blast off. The same corrective move we were anticipating only instead of a triangle it would simply be what Elliott wave analysts label an ABC zig-zag which contains impulsive-corrective-impulsive move. Looking at the chart from the Mar highs consider the first move lower to be and impulsive A, the subsequent chopping a corrective B and the current selling an impulsive C to finish the correction. If we can hold the Feb low that pattern would move to the front of our screen and we would still be looking to get long on a reversal. If the low gives there is something else in the works that we do not see at the moment. With rates near their highs, the Fed on hold and economic growth slowing we don’t think a short bond position has a favorable risk/reward at this level.

Bottom Line: The PBOC busted our triangle idea for the corrective move but we still believe in the big picture theme of a flight to quality rally to new highs in bonds. We will be looking for some more downside as stocks finish off their advance but a reversal could be swift and strong. A long position near the previous low would have a very favorable risk/reward profile as the 109-06 area is a line in the sand for the pattern.

BETA MAXIMUS: King of the Pain Trade

All aboard… The S&P traded to a new high this week and closed there as the pain trade continues to draw in the underinvested who have been waiting on a correction to buy. With Private Equity deals abound, talk of shrinking equity supply and a Johnny-come-lately retail investor finally coming to the party its understandable why we continue to move higher in this parabolic advance. Last week we mentioned that we were looking for a correction to the 1480 level before the final advance to the 2000 highs and would be looking to buy that area for the big blow off “break out the hats and hooters” top some 75 points higher. As has been the case since the Mar low, the corrections have been brief and shallow giving the patient investor little opportunity to add long positions. It’s still very possible we get that correction soon, but it’s also very possible that it already occurred on a much smaller scale. With this in mind at this point we prefer to play the market from the short side when the opportunity presents itself as opposed to hop on now with the advance appearing to be in the latter stages and potentially reversing at any point along the way.

Looking at the charts you can see we are hanging on to the rising trend line and popped above the upper trend line on Friday’s close which has acted as resistance all week. We would be looking to see a reversal from this grinding rally and if the market takes out the multiple trend lines and support levels which are a few points below the momentum could shift. If we are then working on the deeper correction or have put in a larger top is irrelevant as they both would be played the same way until we get to the 1480 area.

Bottom Line: Stocks continued their advance as the previous 2000 highs appear to be a foregone conclusion. We are highly skeptical of this rally and view any reversal as a potential change in trend. We will not be in front of a freight train on a mission but are on our toes looking for any signs of weakness that could roll this baby over the edge.

DUKE & DUKE: Gold selling under the radar….

Gold remained under pressure this week as the break of the rising trend still has some trapped longs. We point out that the selling has gone virtually unnoticed by the mainstream press as they continue to point to the abundant liquidity supporting global assets. We mentioned last week that gold is arguably the most sensitive asset to market liquidity and that it could be a warning sign of things to come in other assets buoyed by leverage. Any traders short gold should be aware that we are due for a bounce and it’s still possible they haven’t put in the final top. If you hear CNBC discussing the falling gold price and benefits of falling inflation be on the look out for a bounce and potentially a larger rally.

Crude finally saw a big rally this week after sitting in the doldrums for a while. They still seem to be confined to a range and while we conceivably got the low near $60 we were looking for we can’t rule out another lower low. A break out above the resistance at $66.85 could have crude screaming higher back to the $70 level.

THE EX ANTE FACTOR: Buy in May and Go Away?

Last week we mentioned that we expected to see some divergences among the highly correlated markets that are driving trading across all assets. We might have seen the first in as a potential top and reversal in gold indicates to us there is some tightening of liquidity. Next on our list would be the yen currency pairs v euro, dollar and sterling as they all seem to be finishing off impulsive patterns implying an eminent reversal and rally in yen. With much of the speculative flows trading in London and Frankfurt we will keep a close eye on EUR/JPY and GBP/JPY for signs of divergence but won’t rule out they underperforming USD/JPY for clues as well. As we have traveled to these new highs in stocks the currencies that have been leading the way are starting to lose steam and have faded a bit on the new highs in DAX and SPX. We believe that the writing is on the wall and investors should remain defensive as the leverage that has been pushing asset prices higher could be more expensive to obtain in an environment where the yen is rallying. This type of grind higher trading becomes ever more susceptible to a reversal as the margin of error shrinks the higher you go without correcting. Any wrong move across the pond or a sneeze out of an Asian central bank could be the catalyst. Equally as plausible is the so-called melt up scenario that sees a blow off top emerging as both shorts and underinvested longs capitulate wanting to cover or get in at any cost. The news out of the PBOC rotating into Private Equity is just the type of news that sends them to the moon.
As we come upon the Memorial Day weekend and the annual kick off the summer season market liquidity will be drying up as many head for the Hamptons. We think a perfect storm could be developing where the market needs to correct at a time when general liquidity is drying up and market liquidity is thin causing a de-leveraging trade where everyone is on the same side. Though we aren’t expecting a massive puke, there are ingredients for one to occur. It reminds us of the investment staple: Leverage Works Both Ways.

What is the discount?
This week’s decline in bond yields took its toll on the implied risk premium earned from stocks despite a rise of 7bps in the earnings yield (the P/E fell despite a rising S&P). The risk premium of 2.48% matches the lowest print of 2007 from the week of 1/26 and is 30bps below the average for the year. This is concerning as we hear stories of the retail investor piling into this rally in the latter stages and at potentially the most expensive levels on a total return basis. We think investors should be looking to raise cash instead of deploy it as our indicators are pointing to a de-leveraging environment where cash yields should out-perform assets appreciation.

Long term investors with relatively high exposure to equities are encouraged to favor large cap names that are counter-cyclical with diverse revenue streams (ie, international exposure). High dividend payers should also be considered as the yield can often provide a floor under the price in a falling interest rate environment.

Bottom Line: While we were not expecting the long bond to break the small corrective triangle we were following presumably on the news that the PBOC is diversifying out of US treasuries, our big picture them is still on the table. The highly correlated markets that are product of the leveraged speculative flows are still marching onward, though we are seeing some patterns finishing off moves from the March lows which has us on the lookout for divergences. Gold is already showing signs of weakness and we will be eyeing the FX market for further clues. We are not looking for an impending collapse but are playing defense as we view the upside limited and the risk/reward for being long assets as potentially inverted at this stage in the game.