Market Recap: Whip it, Whip it Good

We became very defensive last week and that turned out to be a prudent decision as all asset classes saw substantial corrections. The bond market became front and center as the selling that began last Mar intensified to the downside, sending yields to the highest level since 5/06. Stocks followed the trip lower as the higher cost of capital drove risk aversion and de-leveraging. Trend lines and support levels were taken out one after another which now puts the recent rally in jeopardy. In currencies there was some weakness, as expected, in euro/yen on apparent carry trade unwinding, though the dollar/yen seemed to rebound on the higher bond yields. Oil prices were mixed on the week and gold failed to hold the bounce we were watching rolling over to make a lower low on the rise in bond yields and risk aversion.

International Interests: Back in the U.S.S.R.

Our favorite currency indicator, the euro/yen was right on cue this week as the global market sell off seemed to be triggered by selling in Germany, potentially on Russian President Putin’s assertion that he would point missiles at Europe due to their plan to build a missile defense shield (the hot rhetoric toned down as the week went on). This should be no surprise to our readers as we have been pointing to the leadership out of the Dax and euro/yen for a few weeks. It never felt like we saw a huge wave of de-leveraging as the selling was relatively orderly, but clearly the euro/yen sell off coincided with the selling the Dax.

The dollar/yen saw similar correction on the US stock market sell off but rebounded nicely on the rising bond yields. This week traders will have to be on their feet as the economic calendar is busy and we are at make or break levels on these important currency pairs. While the unwinding of carry trades seemed muted any further breaking of support could intensify the move and at a time when liquidity seems to be drying up. We are not taking a position in any of the currency pairs we have been watching but would remind readers that last week we pointed to British pound sterling as a decent place to hide as their central bank is currently one of the more hawkish. We still are eyeing the 1.40 level in the euro/dollar exchange and think some benign economic data this week could help the euro get back on its feet. There are a lot of moving parts in this market and with all the leverage, it may be wise to use them simply as confirmation of moves in other assets rather than be making directional bets.

Bottom Line: The euro/yen was at the front of the risk aversion trade earlier this week as the hawkish rhetoric out of Russia was enough to place European traders on defense. The ripple effect across the pond happened as expected and we will continue to watch the euro/yen for risk and carry trade implications.

Cost of Capital: Paranoia, They Destroy Ya’

The bond market experienced some of the highest level of volatility in a couple of years as a chain reaction of events set off a steepening sell off taking out key technical levels bringing in negative convexity mortgage sellers who only exacerbated the problem. The fact that the curve steepenend in a sell off (front end out performed) leads us to believe that either the market is discounting an acceleration of growth or duration holders such as mortgage back securities were puking their hedges. Of course it could be a combination, but we don’t think that the market is steepening the curve due to expectations the Fed is about to ease due to the activity in the Eurodollar pit which all but removed any easing discount. The chain of events is as follows: first we heard from Chairman Bernanke who still indicated the risk of inflation was their primary concern, just before a better than expected ISM services number which weighed on prices. Wednesday morning we woke up to an expected 25 bps rate hike out of the ECB (though some whispers were looking for 50bps) which coincided with some potentially inflationary weaker productivity numbers. That was only the pre-party as Thursday we woke up with a no-action out of the BOE but a surprise hike out of the Bank of New Zealand which really started the puking overnight, triggering sell-stops who were buying the 10% level on the 10YR and long term support at 108-00 on the bond contract. Mortgage holders then were forced to sell more as pre-payment assumptions would fall getting reducing the need for their convexity hedges. Adding insult to injury was the announcement form PIMCO’s Bill Gross that they would be lifting the high end of the range on their 10YR yield to 6.5% over the next 5 years. The market really started to fall apart as sellers were puking and support levels were sliced through like butter in what felt like a bit of capitulation, “get me out” trade which accelerated Thursday night before finally finding a bottom near 5.25% on the 10YR which is near the previous 5/06 high in yields. Friday we saw some stabilization as value buyers came in to take the market back near the unchanged level. Unless we are about to see an acceleration of growth or inflation, bonds got very cheap in a short time frame but we have to respect the market and the power of momentum.

We have been watching this triangle develop for the past few months and even found a chart drawn in 1/07 where we had a final leg low of 106-00 on the bond contract. The low Friday morning was 105-16, indicating a typical overlap capitulation move, that stopped just above last years low that was the line in the sand for the triangle. If we can hold these levels through this week’s barrage of economic data, the market could finally be looking to break out of the contracting triangle that we have been following. We don’t expect the bond market to make it easy as there was some major technical damage done last week, however we have to remind ourselves that the economic and inflation environment is much more benign today that at the last time we visited these levels and we can attribute much of the violent move to technical selling and hedging adjustments out of the mortgage back security market which is now, through the use of derivatives, larger than the treasury market.

That being said, the bond market looks to have taken over the driver’s seat and all other markets will be watching to see what direction is next. A super melt-down from these levels may indicate much higher yields to come, which would be destructive to leveraged assets at the benefit of cash, currently our favorite asset class.

Bottom Line: The bond market puke definitely took us by surprise even though we thought a potential catalyst to risk aversion in stocks and currencies could be higher interest rates. We continue to believe the bond market is driving the quarter to quarter economic cycle and the evidence of the abrupt slow down in leveraged activity may indicate the market has successfully put on the breaks yet again. We continue to be on the lookout for volatility while they technical damage was severe, however we think the risk towards an acceleration of growth and inflation is remote and thus will look to own treasuries on stabilization of pullbacks.

Beta Maximus: Hey, Hey, What Can I Do….

We had been getting more defensive on equities and last week recommended investors should look to be peeling out of longs and raising cash. We identified some potential technical formations that were contracting as they advanced and vulnerable to news and potential shocks coming from the currency and bond markets. The multiple catalysts from the euro/yen to the Dax to the bond market proved to be all they boyz needed to test bids and take out the week hands who had been buying late in the game, sending stocks down on a 3 day 3% drop before rebounding on Friday as the bond market stabilized. It is unclear whether this is a major top or the larger correction we have been anticipating before another advance to new highs. That being said, we believe many of the risks cited here before as potential catalysts for a correction were quickly identified by the stocks market as all assets seemed to be moving in sync. The risks have not gone away, but with stocks now watching bond yields and carry trade implications, we believe the external issues facing the stock market our now being discounted. We would still refrain from committing new cash to equities on this pullback but instead continue to use rallies to lighten up long positions. If we were to vault to new highs it is liable to be brief and parabolic which can be dangerous to buy. If we grind higher in a similar “pain trade” to the March low as traders waiting for a larger pullback are forced back in at higher prices this will likely be gradual but limited in its gains. If we continue to move lower, we would employ the same strategy of selling bounces and raising cash to invest in higher yielding money market instruments.

This will be an important week for the equity markets as all eyes will be focused on the 10YR yield and the economic data that can drive prices. I don’t believe equities can handle much further rise in bond yields and if the selling continues in the credit markets expect stocks to suffer. On the flip side, if bonds can hold a bid and take back some of last week’s move, it could be all stocks are needing for a sustainable rally.

Bottom Line: We became very defensive on equities at the beginning of June as we believed the stars were coming aligned to drive some risk aversion and subsequently a correction from the March rally. The chart pattern is unclear at this time as the S&P will have to fight some heavy resistance above these levels. If the bond market can stabilize we believe it could be a catalyst to rally stocks back towards their previous high. As we have said many times prior, stocks are not in charge of their own destiny and the activity this week made that more evident in the minds of stock investors.

Duke & Duke: Throw Out Your Gold Teeth and see how they roll….

Commodity markets took a back seat this week to the other three major assets, currencies, debt and equity though there was still some interesting developments in the gold and energy markets. Gold failed to hold the bounce of the bottom of its recent sell off as traders seemed to want to sell everything on the board this week. They took out the previous low on Friday and could be in store for much lower prices. A rallying dollar and higher interest rates are not typically a positive environment for gold prices and traders looked towards the exits despite the bounce in stocks and bonds on Friday.

Crude saw similar increased volatility as they traded it back towards the previous triple top resistance at the 68 area on geo-political fears with Turkey amassing tanks at the Iraqi border only to reverse later in the week as tensions seemed to cool a bit. These commodity markets should continue to be volatile as the dollar and interest rates sort out their trend and discount for economic growth and inflation.

Bottom Line: We were unsure whether the bounce in gold was sustainable and it didn’t take long for traders to knock it back down below the previous low. We are not looking to buy the dip here as the chart has broken down and the fundamental landscape of strengthening dollar and higher interest rates provide a stiff headwind for precious metals.

The Ex-Ante Factor: Right Place, Wrong Time

Last week we mentioned that we were getting defensive on equities and that the charts were nearing a turning point but we weren’t sure whether the currency, bond or stock market would be the catalyst for a turn. We seemed to get a perfect storm of events this week that probably started out of Europe with Putin’s threat to point missiles at Europe which drove some risk aversion in the euro/yen and subsequently the Dax. That risk aversion spread across the pond in no time and was intensified as bond prices which were already in a decline accelerated and proved to be too much for leveraged equity investors to handle. In fact at one point on Thursday I had a tough time finding any asset class that was showing a positive return except the yen. The classic beneficiary of a flight to quality, the US treasury market was also shunned in the sell off and was in fact one of the prime catalysts for further declines. I would say the bond market definitely grabbed the attention of equity investors this week who are now at the mercy of interest rates and the subsequent cost of capital. This is especially important in a leveraged environment where the private equity “put” has been one of the main supporters of equity valuations. With a highly leveraged investor, only a slight move in yields can tilt the return on capital/cost of capital relationship. With private equity moving into more cyclical sectors and paying ever higher multiples, the rise in interest rates can certainly damage their models for prospective returns.

Going forward we find ourselves in a tough situation as the contrarian in us has us looking for a bottom with all the negative sentiment while our prudent style of investing shows us otherwise. We also are seeing the current situation unfold similar to our forecast though our timing and trade execution has been challenged by the might markets. The triangle in bonds were have been following is still valid and despite a scary flush this week we will stick to the game plan until we are proven wrong. We would look to see bond prices hold this level of 5.25% and gradually push yields lower as the effect on a 75bps hike in the bond market starts to work its way through our credit economy. We have pointed out before that the bond market is responsible for driving the economic cycle since the 2002 re-flation campaign as bonds rally and ease during the slowdowns and take back the stimulus the following quarter as the stimulus has worked its way through the economy. We also believe this type of push/pull cyclical nature is indicative of the contracting triangle we are watching in the long bond. Some of our friends in the real economy who depend on the cost of capital to transact business have given us anecdotal evidence that the recent back up in yields has already put the breaks on the recent pick up in activity. We can only imagine what the 50bps rise in mortgage rates over the past couple of weeks has done to housing sales. Barring some unexpected pick up in growth by the consumer (May retail sales tepid) or increased inflation pressure (gold falling apart) we expect bond yields to hold these levels. If this occurs we believe it will be a net/net positive for stock prices over the near term as the market seems much more concerned with the yields than with growth. I guess this can be attributed to leveraged speculation from hedge funds and debt financed private equity.

This is consistent with our big picture thesis in the stock market would be tripped up by a back up in yields only to recover together moving higher through the summer. As equity investors relying ever so much on lower cost of capital exhaust all they can from the debt markets we can see a scenario where stocks upon rallying to a new high become vulnerable to falling earnings and revenue which would restrict private equity in their ability to service the higher levels of debt. In turn, bonds would continue to rally as corporate spreads widen on lower cash flow yields, breaking out of their contracting triangle in a flight to quality. Once the Fed signals they are finally ready to ease we would become very defensive on bonds as they start to discount a higher inflation premium in a steeper yield curve.

What is the Discount?
The back up in bond yields was much higher than the equity discount therefore both the implied risk premium and equity risk premium narrowed further suggesting stocks are still relatively expensive to bonds. The equity risk premium represented by the implied yield of the S&P v the yield of comparable corporate bonds narrowed to a paltry 18bps while the risk premium v US 10YR notes narrowed to 2.22%. Both these spreads represent their lowest of the year and well below the average for 2007, but not quite the extreme levels seen last May.

I want to point out that the pundits and strategists have been pounding the table on the relative value of stocks v bonds while citing the Fed model for evidence. The model used here is similar to the Fed model in that it compares bond yields and stock yields however we include the dividend yield for a total return estimation for stocks (actually making stocks cheaper than the Fed model would suggest). We distinguish our conclusions by comparing both the risk premium earned by investing in stocks v risk-free bonds and the equity risk premium earned by investing in stocks v comparable corporate bonds. Stocks should always yield more than bonds due to their lower claim on assets and higher cost of capital. Stocks should always yield more than government bonds but the implied risk premium is what investors can use to gauge whether they would rather take the risk or simply earn the risk-free return. Is the 2.22% extra return over the 10YR treasury enough spread to warrant the risk? That is up to each individual investor and their risk tolerance. More importantly in our evaluation is the equity risk premium which is the implied equity yield over their comparable corporate bonds. Currently the 18bps spread is rather paltry in our mind and considering the fact that both equity and bond yields are low by historical standards, we continue to prefer risk-free cash, especially in an environment which we view will be more deflationary in the coming years.

Bottom Line: The puke factor that hit the bond market last week caught us a bit by surprise even though we were looking for higher yields to tip the stock market apple cart. Our big picture thesis remains in tact and we continue to see the different asset classes in sync with each other. We remain defensive but wouldn’t mind a scenario where stocks catch a bid on a stabilization in the bond market as traders eye the previous all time high in the S&P 500 before a larger correction ensues which in turn drives the bond prices higher outside of the triangle.