International Interests:
The dollar is making some headway against the yen. Might be
worth watching as we expect a reversal v the euro soon.
Do we need another high or is this a retrace of an initial
move lower? Hard to tell be considering the correlation this
euro chart has with other assets, it could have important implications.
The up and coming Fed meeting shall prove to be a major influence.
Due to recent flattening in the curve we are leaning towards
the Fed standing pat (see Ex Ante Factor).
The cheapest asset on the board is the US dollar. The excessive
bearishness is typical of a change in trend and we are prepared
to buy the greenback when it stabilizes. It may be in the process
now and if the Fed stays on hold it could see a nice rally
from oversold conditions.
Cost of Capital: Bearish Flattening Suggests the Fed on Hold
We had been cautious on the front end as the market was removing
the flight to quality discount. Our reluctance to chase bonds
has proven to be the correct call as they continue to retrace
the rally. We are targeting the 4.50% level at a minimum and
considering the Fib levels we might as well be prepared for
a 4.75% low before they bottom. While we are skeptical they
can push it that far it’s certainly in the cards and
we will wait at least for 4.50% before nibbling again.
The bond contract is heading right for our support level at
109-00. Holding that level provides a massive risk/reward as
we could be finishing off a 2nd wave correction that sees a
new all time high. A 3.50% 10YR note spells trouble for the
economy.
Beta Maximus: Getcha Some Beta
Yikes! While we were looking for a pullback in tech and materials
we didn’t expect the bottom to fall out in one hour of
trading. The NDX was clearly extended and ripe for a correction.
We think there could be more selling in store and a break of
that trend line could take us back to the 2100 level. Buyers
should be patient and looking for dips instead of chasing momentum.
Duke & Duke: To Print or Not To Print
That is the question and the main issue. As we mentioned above we
are not expecting the Fed to continue to ease and accommodate thus
we are cautious on the commodities and materials as they approach
new highs. If the Fed does ease on Halloween it could be Katy bar
the door for the dollar and thus mega bullish for these commodities.
The Ex Ante Factor: Psycho Killer, Qu'est que c'est?
Friday, 10/19/2007, is the 20th anniversary of Black Monday when stock
markets around the world crashed. We are all aware of the magnitude
and severity of this fat tail market event as it has been well documented
and debated. While a few of you were may have been trading during
that time, most of today’s Wall Street traders were in diapers and likely
have no concept of what it was like to be exposed to that type of meltdown.
I used to discuss with my old boss at the CME who was clerking in the
S&P pit at the time. He recalled, “no one knew where the market
was, traders took their wads of order tickets threw them up in the air
and walked out of the pit.” In today’s computer driven instant
fill market it’s hard to imagine what those traders or their customers
must have experienced. I don’t want to dwell on the causes, the
chart patterns or economic conditions as this week many will try to draw
parallels with today’s market. There is a more viable lesson at
work and one that confronts us on every executed trade.
Fear and Greed
As technicians, religiously analyzing charts, we sometimes neglect one
of the most important components to market behavior that is psychology,
sentiment or bias. Recognizing the prevailing crowd’s psychology
is paramount for contrarian traders seeking an edge. With so many investors
caught wrong in the last market debacle, speculating on internet companies
with a new paradigm to justify the mania there has been a proliferation
of money dedicated to take advantage of the next “bubble”.
Public pensions and other large institutional money rotated into long/short
strategies that were designed to shield from volatility and a market meltdown.
Institutional demand for “hedge” funds has led to an unprecedented
amount of money, much of it unsophisticated, speculating from the short
side of the market. This short bias fad has spawned a new generation of
perma-bears who will be damned (and fired) if they miss the next crash.
Lightening strikes and lottery tickets
The very nature of a 20 sigma event is that it is statistically impossible.
So why do so many traders have standing bets on an event that in theory
can’t happen? Fat tail events such as Black Monday or the 2000 collapse
of the tech bubble leave not only scars to P/L but also more enduring
scars on psychology. No one likes to be made a fool and the legacy of
these “crashes” is that of extreme bearish sentiment on those
who think “we won’t get fooled again” and “this
time I will profit from the demise of others.” Many of today’s
perma-bears who continue to short every rally as if it were a top were
the same who bought the whole way down in 2001 looking for ever higher
highs. These same traders finally puked at the lows and this time will
likely be getting long at the top. Keep in mind, this sentiment is not
just reserved for retail day traders. Recall that famed hedge fund manager
Julian Robertson closed his Tiger fund in March 2000, after underperforming
due to his resistance to buy into the tech boom. We shall see a similar,
throwing in the towel from one of today’s skeptics prior to a top.
Dominick often keeps us grounded by reminding us, “there is no
top tick trophy” and “there will be no bears left when this
market tops.” Substantial capital has been preserved by following
this advice over the past couple of years and as long as we keep this
in mind we can stay ahead of the psychology of the crowd’s behavior.
Last week was a perfect example as the market was making new highs, Cramerica
was piling into GOOG and Wall Street was raising price targets left and
right. We were ignoring the hype and instead looking for a turn as Dominick
identified a potential ending diagonal which would see an impulsive reversal
lower. We got a false alarm on Wednesday which we soon covered but after
hitting his maximum upside target at 1586.75 to the tick on Thursday afternoon
the bottom fell out. This sharp late day reversal left pundits and analysts
scratching their heads to determine the catalyst. We laughed at the ridiculous
excuses, kept our focus and traded the charts in front of us which pointed
to a potential reversal of trend. Friday’s bounce was a typical
retrace and if we start heading lower early next week we could
be looking at a large swing.
If the pattern unfolds as we are expecting we should see prices heading
lower next week. How it handles support could carry important implications
to the pattern for the remainder of 2007. Bears will see us ending a large
B wave off the August low with a violent C wave lower. Bulls will see
us pulling back in a corrective 4th wave move prior to higher highs. Having
removed our bias, we don’t care which pattern unfolds as we are
nimble and ready to pounce on either scenario. The initial downside target
is in the 1520 range which is the near previous corrective move low. Finding
support there could vault us to new highs while losing it could send us
back near the lows of the year. The timing of this could coincide with
the Fed’s spooky 10/31 meeting.
Trick or treat?
The pundits and analysts attribute the rally on expectations
of a Fed ease at the upcoming meeting. The bond market’s recent
flattening trend is not suggestive of another ease and we think the Fed
will likely stand pat on Halloween. If general consensus is for an ease
and we don’t get one the market would be expected to sell off as
the weak hands that piled in late want out of positions. However consider
this, if the yield curve remains flat with a tight Fed policy stocks ironically
could benefit from the lower long term interest rates. We think after
flushing weak longs, the market could be setting the bears up for another
squeeze to new highs where there is no apparent resistance which potentially
could drive the capitulation necessary for a major turn.
Next week earnings season gets into full swing with the technology sector,
among others, reporting results (GOOG reports Thursday). We also have
October option expiration that has been preceded by heavy call buying
and declining implied volatility premiums. With implied volatility near
the lows (despite Thursday’s spike) we think the market is susceptible
to a wild week. With the DJIA up against the 1.382 from the 2002 low it’s
time to strap it on.
Bottom Line: The stock market is yet again near an important turning
point. We have shifted from long exposure to net neutral or short and
will adjust depending on how the market trades in the coming weeks. Thinking
like a crook we must assume the market will not give bears an easy top
to get short (they don’t ring a bell) and in fact, we expect a capitulation
prior to a major top.
What is the discount?
Markets across the board were virtually unchanged this week but
one noticeable development has been the narrowing of the spread
between high and medium grade corporates. While not a huge
surprise given that equities are back near their highs of the year.
| Indicator |
Yield |
Chg 1 W |
AVG 2007 |
2007 High |
2007 Low |
SPX Earnings Yield |
5.44% |
-0.01% |
5.60% |
5.93% |
5.36% |
SPX Dividend Yield |
1.81% |
0.00% |
1.84% |
1.95% |
1.77% |
High Grade Yield |
6.10% |
0.08% |
6.01% |
6.30% |
5.68% |
Medium Grade Yield |
7.14% |
0.06% |
7.02% |
7.41% |
6.62% |
US 10YR Yield |
4.68% |
0.04% |
4.75% |
5.18% |
4.38% |
Implied Return |
7.25% |
-0.01% |
7.45% |
7.84% |
7.13% |
| |
Implied Credit RP |
2.46% |
0.02% |
2.27% |
2.91% |
1.92% |
High/Medium Spread |
1.04% |
-0.02% |
1.01% |
1.27% |
0.86% |
Implied Equity RP |
2.57% |
-0.05% |
2.69% |
3.41% |
2.03% |
Equity-Debt RP |
0.11% |
-0.07% |
0.42% |
1.17% |
-0.17% |
| Source: Barron's |
Your annualized return today had you owned the S&P
500 and reinvested dividends:
| 10 Years Gone |
10/31/1997 |
| SPX Return |
Annualized |
Simple Price |
5.30% |
Div Reinvest Index |
6.99% |
Div Reinvest Cash |
6.84% |
10YR Yield |
5.83% |
Earned Risk Premium |
1.16% |
| Source: Bloomberg |
Stocks look cheap by this metric but we have to ask ourselves if 10YR
yields are discounting slowing earnings growth.
Asset Allocation: Stay with quality
| |
Equity |
|
| Allocation |
S&P Sector |
Weight |
| 50.00% |
Cons Discretionary |
0.00% |
| |
Cons Staples |
20.00% |
| |
Energy |
0.00% |
| |
Health Care |
20.00% |
| |
Industrials |
20.00% |
| |
Materials |
0.00% |
| |
Technology |
20.00% |
| |
Utilities |
0.00% |
|
| Fixed Income |
| Allocation |
Credit Risk |
Weight |
| 50.00% |
Government |
50.00% |
| |
High Grade |
20.00% |
| |
Medium Grade |
0.00% |
| |
High Yield |
0.00% |
| |
Preferred |
10.00% |
| |
Cash |
20.00% |
|
| Allocation |
International |
Weight |
| |
W Europe |
5.00% |
| |
E Europe |
5.00% |
| |
Asia Pacific |
5.00% |
| |
BRIC |
5.00% |
| |
Emerging Mkts |
0.00% |
|
| Allocation |
International |
Weight |
| 0.00% |
W Europe |
|
| |
E Europe |
|
| |
Asia Pacific |
|
| |
BRIC |
|
| |
Emerging Mkts |
|
|
