MARKET RECAP:

Sorry to keep sounding like a broken record but market volatility continued to rule trading sessions in all asset classes with stocks retreating from a new high, bonds breaking out of their range, the dollar making a new low as gold and crude remained bid. We were expecting the volatility with Bernanke testifying (more dovish?), earnings season getting into full swing and option expiration. The financials generally reported better numbers but remained for sale with GOOG and CAT driving the defensive trade on Friday.

INTERNATIONAL INTEREST:

We have pointed to our friend Dominick’s (www.tradingthecharts.com) 1.40 level a couple of times before and the potential for a DXY reversal due to the tightening of credit. The EUR traded to a new high this week and only fractions from 1.40 despite a steep decline in EUR/JPY suggesting traders are preferring the euro and sterling possibly due to their relatively tighter central banks. This is why we had preferred sterling for short term security. We think the dollar will remain under pressure as the market begins to discount a Fed ease, possibly by the fall, and that traders will remain prone to favor GBP. That being said, we would be on the lookout for a reversal in EUR and a bottoming in the DXY as the credit cycle tightens. Expect this week’s earnings reports to highlight the weak dollar’s benefits on US multinational profits which we view as typical late cycle rhetoric. The Yen saw a nice pop on Friday as the market was retreating from risk. It appears to have broken out of the descending channel and any further upside would imply carry trades could be coming unwound.

Bottom Line: A flight to European currencies v the dollar continued this week as their tighter central banks are providing a safe haven as volatility picks up. We expect the weak dollar will start drawing the attention of the mainstream press with financial pundits extolling the benefits of a weak currency, thus marking the potential inflection point we are expecting.

COST OF CAPITAL:

US treasuries were the prime beneficiary of the continued stress in credit markets with the belly of the curve (5YR) outperforming. This indicates to us the market may be re-discounting a Fed ease. Chairman Bernanke’s testimony was leaning more dovish as he distinctly recognized slower than previously expected GDP growth, deeper housing correction than they expected and problems in the credit markets. We believe these comments from Bernanke coupled with out performance in the 5YR sector suggests the bond market is setting up for an ease. Next week no rest for the weary as we have a relatively busy economic calendar topped off with Friday’s 2nd Q GDP number. This carries more significance as the street has generally expected growth to come in above 3% from the tepid 0.7% Q1 growth. A miss could drive treasury prices higher as the Fed will now have even more ammo to justify an ease which we would then expect by the September meeting. While we are expecting the Fed to lower rates, we remain cautious on the long end as the risk still exists that mortgage redemptions could drive selling and that the curve could trade with a steeper bias to discount higher inflation premium when the Fed signal they are easing credit. Thus we still favor the 5YR note and pullbacks to 5% should be bought.

Bottom Line: We think Bernanke and the bond market sent an important message to investors this week and that a Fed ease is right around the corner. We encourage investors to lock in short term deposit assets and purchase 5YR treasuries.

BETA MAXIMUS:

In light of his week’s equity volatility, we had to quote Keith Jackson, “Whoa, Nellie”. Wednesday started with a brisk 15 point drop in SPX only to reverse almost all the sell off in the afternoon and on Thursday, with a ensuing larger 20 point sell off on Friday that recovered some of the losses into the close. A mixed bag of earnings coupled with credit fears and a breakdown in financials all weighed on sentiment. The botched IPO of Man Financial (-12% from Thursday’s offering), further selling in BX and momentum shifts from leaders GOOG and CAT were all catalysts. CAT has been the best performing DOW stock since the 2002 low and saw an ominous reversal from its all time high. We view this breakdown in market leaders, financials, growth tech and industrials as further evidence that we are in the late stages of the bull market advance. We remain in sell the rally mode and while we aren’t calling a top just yet, the risk/reward oh holding equities seems highly inverted at this point. With tech earnings and economic data next week, we see no reason for volatility to subside and it would not surprise us to see a rally back to new highs. Nevertheless, it is not time to get cute but rather stick the plan of selling and scaling out on rallies.

Bottom Line: The market is cracking at the seams with cycle leaders rolling over as the major indices remain near all time highs. We want to remind investors that due to the late stages of this bull run and the leverage involved, equities are not in control of their destiny and are vulnerable to a number of outside forces.

DUKE & DUKE:

Crude and gold continued to rally this week as the dollar weakness kept a bid in the commodity sector. With risk premiums rising and the dollar expected to remain under pressure we think the underlying bid in metals and energy to keep prices elevated. However, with crude within striking distance of the previous high of $79/brl we would be on the lookout for a reversal. As we pointed out last week, the CRB index looks to be finishing off a multi-year impulsive move and is ripe for a change in trend. With the economy slowing and a potential low in the dollar around the corner we feel the variables are in place.

Bottom Line: Crude and Gold have both benefited from recent dollar weakness and rising risk premiums. A reversal in the CRB appears imminent and we prefer cash to hard assets.

THE EX ANTE FACTOR:

Dominick’s target of 1556 SPX has been met, exceeded, vibrated around, turned away, recovered and turned away again all in the past 5 trading sessions. With a sloppy tape on what is becoming increasingly bearish news flow, the shorts must be feeling they are finally in the driver’s seat as the risk seems to be shifting from being short or underinvested to being long and overweight. With Dom’s targets being met coming out of a potentially 4th wave flat, we have certainly become defensive and on alert for a reversal of the bull market trend. That being said, as traders we must always be aware of both sides of the market, so on Friday I went through a list of potential catalysts that in this cycle have been bullish underpinnings for stocks. Next week as we look for a turn, we must keep in mind that the market may have some work to do on the upside and could draw energy from the following potential catalysts.

First and foremost, the 10YR note yield is back below 5%. This week the bond market price action yielded some important insight with broad implications. Bernanke’s testimony definitely leaned more dovish as he cited concerns over slower than previously expected GDP growth, a deeper housing correction that previously estimated and problems in the credit markets. With the 5YR or belly of the curve outperforming in this week’s rally, we think they are starting to re-discount an ease, potentially by the September meeting. The 10YR note trading below 5% lowers the discount rate for multiple valuation and cost of capital assumptions. Though spreads are widening, this should still lend support to stocks and LBO activity. As long as the curve stays flat and the 10YR remains below 5% the same mortgage duration hedges that exacerbated the selling in June will need to buy them back, potentially providing more fuel in a rally. These falling yields can also provide support for the ailing financial sector by providing support to their assets and book value discount (provided they have a conservative portfolio). In full disclosure, I think when the Fed does signal an ease the yield curve will trade with a steeper bias which would likely derail this stimulus.

Gold rallying as the dollar is falling implies liquidity injections as the Fed pseudo-eases before actually lowering the target rate. This excess liquidity that is pushing up gold has in the past found its way into the stock market.

Oil could be topping in a B wave which would potentially reverse in a hard sell off. Lower oil can reduce implied inflation premiums helping the yield curve and acting as a catalyst for a rally in the transportation and consumer discretionary sector.

The EUR/JPY and GBP/JPY, my preferred carry trade indicators, while showing some weakness Friday seem well contained inside their respective rising trend lines.

These comments aren’t designed as a buy recommendation but rather offering variables for your own risk management analysis. I don’t believe this market has been rallying on assumption of better earnings growth (as the economy is slowing) but on valuation metrics and the ability to access liquidity. Nest week as I look for a turn, one eye will be watching the FX, Oil, Gold and Bond markets to determine their potential impact on stock prices while the pundits concentrate on whether earnings meet Wall Street analysts’ estimates.

What is the discount?
The implied risk premium blew out 23bps this week as the 10YR note rallied through 5% and stock prices fell. This is supportive of a rally next week in stocks but we would not use this relative cheapness to buy equities but rather take advantage of next week’s rallies to sell out of risky positions in cyclical stocks. I expect the implied risk premium to widen further perhaps back above 3.00%. Assuming 50 bps lower in 10YR yields and 50bps higher in S&P earnings yield puts the 10YR note yield at 4.70% and the S&P at 1380.

Bottom Line: While the implied return widened significantly this week we would not be buying the dip but rather using the retracement as a selling opportunity as you roll into 5YR treasuries. Any pullbacks to 5% area should be bought. There could be another push to a new high but the increased volatility coupled with failing leadership has us looking for a turn.