Sizing up the next moves in the Market

by Marketanthropology

Like any major move, the crash in crude oil was propelled by more than just one condition. Speculative positioning, production, demand - they all played a supporting role. And although the circumstances that led to its precipitous decline can be reverse engineered and neatly written to lay at the feet of a more conspiratorial and geopolitical commiserator - such as the Saudis, the reality is the currency markets likely played the biggest role over the past year and were instigated by conditions that set sail long before the Saudi's could even look to turn the screws.

As we have speculated, we believe the significant moves in the currency and commodity markets since last summer represent the blowoff tails from these respective trends. Our general belief is the two largest and most traded currencies in the world have been wagged by the divergent policy paths between the U.S. and Europe, which caused a strong disinflationary tailwind to develop in the markets since 2011 when the ECB raised its refinancing rate twice to 1.5% - while the U.S. maintained a zero interest rate policy, subsequently buttressed by additional rounds of quantitative easing. With the ECB finally finding religion and cutting rates below the U.S for the first time in a decade - as well as pulling up to the alter of QE, the torque in the currency markets from the differentials in policy paths should begin to back off. 
The blowoff move in the U.S. dollar index is butting up against long-term resistance at its 50% retracement level from the July 2001 high. Interestingly, this set-up was also where a long-term high was established in 2001 from the 50% retracement level from the February 1985 long-term high.    

As we showed last November, the dollar appears to be following with approximately a three year lag, the moves in yields. Similar to our expectations that 10-year yields will trough in a range between ~1.5 and 3.0% over the next several years, we still expect the dollar to follow the leading moves lower in long-term yields.

The disinflationary blowoff in the SPX:Oil ratio appears to be exhausting. Should the dollar finally turn lower, similar to our expectations with precious metals - we suspect the commodity will strongly outperform U.S. equities.

To date, oil made a cycle low 32 weeks after turning down last June. Should the low hold, the duration of the decline would be the same as in 2008/2009 and one week less than the move in 1985/1986.

*The duration comparative was corrected to reflect an error we noticed on our last update that measured the move to the low in 2008/2009 to be 33 weeks.

Although we expect yields to be supported over the next several months, we do not foresee a sustained move higher out of the long-term yield trough that would invariably come with the Fed significantly raising rates. Despite yields remaining historically low over the past 6 years, we are reminded that it took over twice that time in the previous cycle to traverse the transitional divide between secular growth cycles. While the Fed has succeeded at gestating a rich valuation premium in the U.S. equity markets, it has largely been maintained at the expense of raising rates. As much as we expect another pulse of inflation to make its way through the system as the economy improves and Europe and China hit the gas, as Larry Summers rightfully mentioned in an interview just yesterday, "We're in an extraordinarily uncommon and unusual place ... so this is not the time for the traditional central bank playbook."

Considering what happened in 1937 (which Summers mentioned yesterday as well) or the cyclical top in equities in 1946 that took shape after the Fed ended their extraordinary support of significant Treasury purchases, we suspect the Fed will be tested and squeezed between their dual mandates. In either case - and despite the daily headline concerns with deflation, we believe those assets closely tied to rising inflation expectations should outperform in the next move across the trough.

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Reflections From 4 Months of the SPY

by Greg Harmon

It is just 1 trading day shy of 4 months since the SPDR S&P 500 ETF ($SPY) made its October low. Think about what has happened in that time. Japan expanded its Quantitative Easing. The ECB starting Quantitative Easing. Greece moved to the precipice of disaster….again. Putin has either invaded Ukraine, or freed them or something. Now we will help too (not sure which side). The US economy has been described as slowing, exploding and everywhere in between. We are going back into Iraq, gathering support to fight the Islamic State and shutting out embassy in Yemen.

Through all this the SPY moved up to new all-time highs quickly in the standard ‘V’ recovery and has basically done nothing since Thanksgiving. But there are signs that all that is about to change.

The chart above shows the price action for the SPY since October low with the Volatility Index ($VIX) as an area chart behind it. There is a lot to note on this chart. First the basics. The SPY peaks correspond to troughs in the VIX and when the VIX spikes the SPY has found a low. There is a negative correlation.

Now notice the blue shaded Bollinger Bands® surrounding the SPY price candlesticks. Each bottom in the SPY has happened at the bottom of the Bollinger Bands. The highs do not have such a clear cut signal. But each of the 4 highs in the channel since the October low have happened with the upper Bollinger Band flat or falling. This move higher is different. That upper Bollinger Band is moving higher, allowing the price candles to move higher, not containing them.

Some other things are different too. Since the start of the year, the RSI has been slowly trending higher. This momentum indicator is now breaking 60, a level that turns it bullish. The other momentum indicator, the MACD, has also reversed trend higher. These support more positive price action. Finally, look at the spiky VIX hills themselves. Notice that the valleys have all been lower than the current level. The VIX can go lower. Remember that stuff above about it being negatively correlated to the SPY? The SPY can go higher then.

So the SPY has momentum on its side. Bollinger Bands opening to the upside and a VIX that could let it rise more. How high can it go? One measure is that the move into the consolidation box will be equal to the move out of the box. The two rising purple arrows show that and the higher one points to a level of 224 in the SPY. This does not mean it will happen or if it does it will happen quickly. But if the SPY does break the box to the upside, it has all the makings for this time to be different.

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Greek Choice

Crude at a low, King Dollar at a high? Surprise a few investors?

by Chris Kimble

CLICK ON CHART TO ENLARGE

Crude Oil’s decline has been rare in a couple of ways, percentage decline and how quickly it took place.

The decline took it down to support that has been in play since the 2009 financial crisis lows. Momentum is now the lowest its been in over 20-years.

Could the low be in place in Crude?  It seems a little early to make that call.

CLICK ON CHART TO ENLARGE

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Timing (And Trading) Implied Volatility

by Trading the Odds

The majority of readers will already be familiar with the fact that the CBOE Volatility Index^® (VIX^®) is not a tradable asset (it is just a number), and trading the VIX^® in fact means trading its derivatives (futures) or even derivatives of derivatives (options on futures, ETFs/ETNs like XIV^® – VelocityShares Daily Inverse VIX Short-Term ETN – and VXX – iPath® S&P 500 VIX Short-Term Futures™ ETN – ).

Due the mean reverting nature of the VIX^® (e.g. when bottoming out in the 10-12 range, a sudden spike is much more likely than a further drop, and conversly after a sudden spike to extended levels, a (quick) drop and/or slow decrease to regular levels is just a question of time and much more likely than a further rise), timing and trading the VIX^® would of course be much easier than timing and trading its derivatives (and derivatives of derivatives) where one has to take into account (and overcome) time to maturity (futures, options), time decay, risk premium (futures, options, ETFs/ETNs), roll yield (ETFs/ETNs), term structure (contango/backwardation of futures), seasonalities (e.g. FED announcement days, the last days before maturity, …), among others.

Some time ago MarketSci published an intersting article about timing (and trading) the VIX^® ( Random Thoughts RE: Trading Volatility ETFs (Part 1) ), utilizing a 10-day EMA (Exponential Moving Average) and a 10-day SMA (Simple Moving Average), going long (selling short) the VIX^® index at the close when the 10-day EMA of the VIX^® closed under (over) the 10-day SMA. Expectably (selling short an asset which is always bottoming out in the 10 – 12 range) – in contrast to going long the XIV^® (selling short volatility) – the short side of the trade was more or less treading water over the course of the time frame under review (since 1990) while the long side went straight up (low risk / high reward).

But as previously shown, with respect to a highly volatile asset like the VIX^® , a 10-day moving average – even an EMA – is disadvantageous compared to a shorter-term moving average. And additionally – at least with respect to trading the Volatility Risk Premium Strategy – utilizing the CBOE Mid-Term Volatility Index ( VXMT^® ) as a the repective trigger index instead of the VIX^® may have some benefits again as well.

To make a long story short:

Image I shows the respective equity curves:

(1)  VIX^® with 10d EMA vs. 10d SMA: blue line (complies to MarketSci’s posting)
(2)  VIX^® with   3d EMA vs. 10d SMA: grey line
(3)  VIX^® before 1/1/2008 , VXMT^® after 1/1/2008 with   3d EMA vs. 10d SMA: red line
(4)  120% of VIX^® | -20% of VXMT^® with   3d EMA vs. 10d SMA: black line
       ^* just VIX^® before 1/1/2008 , VXMT^® after 1/1/2008
(5)  120% of VIX^® | -20% of (VIX^® + 10%) with   3d EMA vs. 10d SMA: green line
       ^* before 1/1/2008, VIX^® had been increased by 10% in order to replicate the VXMT^®

Image I – Total Equity Curve(s)
(01/01/1990 – present)

Some remarks are mandatory:

(1) Any additions/changes in the respective underlying are only related to the exponential moving average ( e.g. 120% of VIX^® | -20% of VXMT^® ). The 10-day SMA remains unchanged and is always based on the VIX^® index.

(2) The blue line represents MarketSci’s 10-day EMA | 10-day SMA mean reversion strategy. The respective performance (hypothetically trading the VIX^®) could’ve been easily boosted by utilizing a 3-day EMA instead of a 10-day EMA ( grey line ). Simply replacing the VIX^® by the VXMT^® index ( red line ) would be very disadvantageous (a least with respect to a mean reverting strategy) due to the fact that the VXMT^® is regularly trading (significantly) above the VIX^® index  ( contango ). Even better works a mixture of 120% VIX^® minus 20% of VXMT^® , regularly (artificially) reducing the index value ( black line ).

(3) This very simple mean reversion strategy works best when applying this kind of ‘mixture’ right from the start, means first of all simulating VXMT^® index values in the simplest way by adding a constant 10% premium to VIX^® index values before VXMT^® index values are available (1/1/2008), and secondly applying the previously mentioned formula again ( 120% of VIX^® | -20% of  (VIX^® + 10%).

Image II shows the respective equity curves (long / short seperately) for MarketSci’s 10-day EMA | 10-day SMA (black / grey) and the 120% of VIX^® | -20% of (VIX^® + 10%) with 3d EMA vs. 10d SMA (green line) mean reversion strategy.

Image II – Total Equity Curve(s)
(01/01/1990 – present)

And last but not least – probably surprising the most – the respective Summation Index, simply representing the running total of net advances = raw quality of forecast (getting an index move right: +1 ; getting it wrong: -1). This image clearly shows that trading is NOT about being right or wrong (means just getting the direction of the move right), but all about making money (effectiviness and efficiency). MarketSci’s 10-day EMA | 10-day SMA (blue line) and the 120% of VIX^® | -20% of (VIX^® + 10%) with 3d EMA vs. 10d SMA (green line) mean reversion strategy are at equal level (at the end of the field !), but the latter strategy is doing things in an optimal way, being right when the VIX^® index  moves big and losing small when being wrong (it ouperforms the 10-day EMA | 10-day SMA strategy by a factor of 1E+8) while the “VIX^® before 1/1/2008 , VXMT^® after 1/1/2008 with 3d EMA vs. 10d SMA” ( red line ) is at the top of the pack even after 1/1/2008, unfortunately winning small and losing big, depleting its net asset value since 1/1/2008 by 99.9%.

Image III – Summation Index
(01/01/1990 – 10/15/2014)

But how to take advantage of these findings will be subject to another posting. And may be some food for thought for your own analysis as well.

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Debt Doesn’t Matter …

by Bill Bonner

The Bad Analogy Debtberg

Last week, McKinsey Global Institute reported that the world’s total debt levels were twice what we thought – $200 trillion, or about three times the planet’s total output.

So, what a relief it was to discover… only a few hours later… that there was nothing whatsoever to worry about. Our concern was totally misplaced. It was nothing but a colossal misunderstanding or, as Nobel laureate economist Paul Krugman put it in the New York Times, a “bad analogy.”

So now, we can go back to our Portuguese lessons here in São Paolo without a care.

Growth in global debt, per the latest McKinsey report on the non-deleveraging echo bubble era: Since Q4 2007, global debt levels have increased by a cool $57 trillion. Thankfully, Paul Krugman informs us that it “doesn’t matter”. Phew! Dodged a bullet there! – click to enlarge.

Mastering the Essentials

Are you curious about how much progress we are making in Portuguese? We didn’t think so. But we’ll tell you anyway. We pride ourselves on our ability to learn foreign languages quickly. Put us down in any city in the world… and after three days of intensive language lessons we’ll be able to walk into any bar in the city and order a beer. With confidence.

So it is in São Paulo. We can’t conjugate the verb conhecer yet. We can’t pronounce it either. But we have mastered the essentials – “please,” “thank you” and “debt bomb.”

Only now there’s no further need to think about debt. Especially here in Brazil. Even after 13 years of socialist government, public debt is only 60% of GDP. According to World Bank data, private credit was 70% of GDP as of the end of 2013 – or barely a third of America’s 192% level.

Of course, Brazil used to be a basket case of epic proportions. At the start of 1980, for example, a hamburger cost about 4 cruzeiros (the Brazilian currency from 1942 to 1986). The same hamburger cost about 5 trillion cruzeiros by Christmas 1997.

Brazil had to bring in a new currency – the real – and a new government to set things right. That’s not the kind of thing you forget overnight. Especially when there is a whiff of inflation in the air. Prices are already rising in Brazil at an annual rate of 7.1% – beyond the government target of 4.5% plus or minus two percentage points… and the highest rate since 2003.

But why bother to think about it? “Deficits don’t matter,” said Dick Cheney. “Debt doesn’t matter either,” says Paul Krugman.

In developed economies, the private sector has slightly lowered its debt load (by 2 percent of GDP), while public debt has exploded into the blue yonder as the banking system’s losses were socialized – click to enlarge.

“Money We Owe to Ourselves”

What a pity. All these years, we’ve been laboring under the illusion that these things mattered. Thank goodness Krugman has finally clarified things. From his piece in yesterday’s New York Times, modestly titled “Nobody Understands Debt”:

“You can see that misunderstanding at work every time someone rails against deficits with slogans like “Stop stealing from our kids.” It sounds right, if you don’t think about it: Families who run up debts make themselves poorer, so isn’t that true when we look at overall national debt? No, it isn’t. An indebted family owes money to other people; the world economy as a whole owes money to itself. […]
Because debt is money we owe to ourselves, it does not directly make the economy poorer (and paying it off doesn’t make us richer).”

Let’s see. Debt doesn’t make us poorer. So we don’t need to worry about it. But does it make us richer? Ah, there’s the question… For if it makes us neither poorer nor richer, why bother with it at all?

What’s that you say, Paul, it CAN make us richer, if it is used intelligently? Isn’t that the whole point of lowering interest rates? Aren’t the lower rates supposed to encourage borrowing, spending… and greater wealth?

So, there is something about debt that can have a real effect on the bottom line, isn’t there? Debt, invested properly in wealth-producing assets, can make both borrower and lender richer. And if that is so, isn’t it also likely that debt CAN make us poorer? Don’t we all know that is also true?

You borrow money … you squander it … and you’re worse off. And so is the person to whom you owe the money. You can’t pay. He can’t collect. You both lose. It doesn’t matter whether you are a family or a nation. You’re all worse off. Debt does matter, after all.

We are not surprised that Mr. Krugman of all people has dug up the old “we owe it to ourselves” canard. This is patently untrue.

As Ludwig von Mises presciently wrote:

“It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract. A host of sophisticated writers are already busy elaborating the moral palliation for the day of final settlement. The most popular of these doctrines is crystallized in the phrase: A public debt is no burden because we owe it to ourselves. If this were true, then the wholesale obliteration of the public debt would be an innocuous operation, a mere act of bookkeeping and accountancy. The fact is that the public debt embodies claims of people who have in the past entrusted funds to the government against all those who are daily producing new wealth. It burdens the producing strata for the benefit of another part of the people. It is possible to free the producers of new wealth from this burden by collecting the taxes required for the payments exclusively from the bondholders. But this means undisguised repudiation.”

An Age of Wonders

According to the McKinsey report, world debt has grown by $57 trillion since the beginning of the crisis in 2007… raising the level of debt to GDP by 17 percentage points.

That – not real economic growth – explains why US stocks are so expensive. It is also why there is a house for sale in Florida for $139 million.And it’s why a single painting – which was worth almost nothing when put on the market in the late 19th century – recently changed hands at auction for $300 million.

This reveals the true absurdity of Krugman’s “debt doesn’t matter” argument… and the futility of central bank policies since 2007. The financial crisis that began in 2007 came as a result of too much bad debt in the US housing and financial sectors.

Americans couldn’t pay down that bad debt. They had to put on the brakes. Suddenly, all those mortgage-backed securities proved to be worthless… and every bank on Wall Street was threatened with bankruptcy.

How did the feds respond? They stepped on the gas! Government debt grew by $25 trillion over the last seven years. And 8 out of 10 households (mostly out of the US) have more debt than they did in 2007.

Meanwhile, China has quadrupled its total outstanding debt – from $7 trillion in 2007 to $28 trillion last year. China’s debt – approaching 300% of GDP – is now greater than that of the US or Germany. And half of it is collateralized by real estate. Yes, dear reader, we live in an Age of Wonders…

We wonder what will happen to $200 trillion worth of world debt when the collateral gives way. We wonder why anyone would pay $300 million for a single painting by a dead Frenchman.

We wonder when the Nobel Foundation will reconsider …

Private and public debt trends in the US, the UK and the euro area compared. And no, “we” do not “owe the public debt to ourselves”. “We” owe it to the people who bought government bonds – who are a distinct group. Of course “we” were not asked if we really agreed with this debt expansion. No citizen includes his share of the public debt on his personal balance sheet, and yet, it has been contracted in his name. However, there is a deep-seated belied that the paternalistic State is in possession of some secret stash of wealth from whence these debts can be paid. Unfortunately this is not the case – click to enlarge.

As Ludwig von Mises pointed out:

“The long-term public and semi-public credit is a foreign and disturbing element in the structure of a market society. Its establishment was a futile attempt to go beyond the limits of human action and to create an orbit of security and eternity removed from the transitoriness and instability of earthly affairs. What an arrogant presumption to borrow and to lend money for ever and ever, to make contracts for eternity, to stipulate for all times to come!”

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