1) BIX relative to SPX – looks suspiciously like the S&P500 financials are setting up to outperform the broader index. The trend break in the RSI is one prerequisite that has been checked recently:

Trying to reason how this might work requires a bit of imagination – US financials benefit from the flight of capital from Europe and China into the USD perhaps? The flipside is that materials and exporters take a hit by this same rise in the USD. Alternatively, the Fed is playing a game of cat’n'mouse and will in fact unleash QE3 in January (as consensus would have us believe).  In any event, it doesn’t mean that the market as a whole is about to head higher does it…

2) Market breadth – which leads us to a quick look at recent trends in market breadth. Following is a chart of market breadth capturing those hectic days of late 2008 and early 2009:

Note that during the selloff into the March 2009 lows, breadth began to signal value investors were entering the market as early as December.  First, the NYSI created a small divergence into a new low. Next, the NYSI broke its relative downtrend as the market rallied out of this low. Finally, as the market plunged into the capitulation selling, the NYSI flashed that a valuation floor had been found.

Now to a glimpse at how the NYSI is behaving today – the recent low gave us a small divergence – which has duly been followed by a relatively healthy rally. The question from here is how breadth will respond should we get the deeper selloff that seems so near to hand.

One of the more remarkable features of the first phase of the crisis was that banks were permitted to roll their problem assets. Through the magic of mark-to-market accounting, the system was able to buy time and often times induce enough investors to stump up for tranche 1 of the recapitalisation. But it was always a finger-in-the-dyke solution.

The European sovereign debt crisis has called time. While markets have long ignored the flagrant abuse of the Maastrict Treaty at al, something broke over the last two months and the herd is now running scared.

The key problem is that the leverage in our banking system is based on collaterallised lending. This global pool of collateral has been bid up by decades of credit expansion. At some point the suspension of disbelief that this virtuous cycle requires becomes impossible to sustain. Total leverage relative to cashflows – rather than collateral – is too high. At this point, the banks find themselves in a prisoners dilemma.

And so we arrive at today, where the European banks have broken ranks and have begun a firesale of assets. While quick exits often prove profitable for the buyers, history is pockmarked with examples where the resultant lower asset prices have a disturbing ripple effects on markets.

It is this uncertainty that investors of all shades and hues have to contend with. While the bear market rally from March 2009 failed on declining volumes, there is a strong liklihood that the current selloff will be joined by volume selling as the flight from all but the very safest collateral goes mainstream.

One of the conclusions of this field of research is that markets generally exhibit increasingly volatile price behaviour as a crescendo matures. And further (and the point of this paper) once the event that precipitates a crash has occurred, then this price volatility also recedes in a relatively predictable fashion. Or to quote the paper,

“Results demonstrate that the relaxation dynamics of a financial market immediately after the occurrence of a crash resemble an earthquake after-shock. The frequency of a large aftershock decays according to a power law.”

The authors then note that the news cycle was synchronised to the ‘Lehman’ crash and also followed the same decay profile – as measured by the frequency of mentions of ‘financial crisis’.

Which then got me thinking about how “European crisis” was tracking in GoogleTrends. (Note the scales between the two charts are very different – the European crisis is still a babe in the woods.)

The European crisis has been on the stove for some time – and is only now reaching boiling point. The financial system is the the crucible in which all this rising volatility is happening, so it’s interesting to compare the news chart above with that of European bank CDS spreads (that also reached new extremes overnight).

Whichever way you look at it – it’s increasingly likely that someone is going to get stopped out and soon.

Two recent articles that stand out on the European sovereign debt festival are:

1) John Hussman (here) – who coherently argues that the ECB is incapable of printing money (without a radical overhaul).

2) Grant Williams (here) – who walks through the contradictions in Basle III that highlight the terminal condition of Europe’s banks.

We are deep in Act III…History doesn’t favour the creditor, meaning that the odds still favour disintegration over political unification. Europe’s banks are being mercilessly squeezed – who will be first over the parapet?   (I’ve got my money on Deutsche Bank.)

The human race is in the grip of the necessity of having to evacuate the solar system in 4.5 billion years.

My own contribution to the t-shirt printing industry is:

Evolution is the race against entropy.

All this is a long-winded way of saying that I’m currently trapped in my own mini vortex of working around the clock. I’m hoping normal transmission will resume shortly.

From a valuation perspective, it is likely that this widespread weakness is throwing up opportunities to accumulate specific stocks. But until we start to see market breadth strengthen into weakness, the odds remain with the bears for the broader indices. Watch for government intervention in some form or another as the most likely catalyst for a rebound when the time comes.

Exhibit 1 – The downdraft has been accompanied by high volumes. It could be argued that this is capitulation by the weaker hands, but for mine we haven’t traded low enough to attract ‘value investors’ (witness Jeremy Grantham’s latest tome – S&P 950). Rather the volume selling suggests that this selloff is different relative to last year’s correction.

Note too, that momentum is still reeling from the severity of the fall. Given the damage done to confidence and level of uncertainty in the market, it is likely that we will at least revisit the recent lows. Watch to see how the MACD responds should this eventuate.

Exhibit 2 – An old favourite, the McClellan Oscillator that measures market breadth has completely broken down. Again, we’d expect to see a divergence in this indicator when investors are starting to accumulate on market weakness:

At the risk of repeating myself, the playbook we’re following is one where we take our lead from government stimulus. Negative real interest rates are not sufficient in a deleveraging market. That is why QE3 in whatever disguise is more likely than not and also why Japan, the UK and any other sovereign state with their hand still on the monetary tiller will follow suit. In the absence of fresh stimulus we’ll wait for signs that the market has exhausted it’s selling impetus before leaping into the void.

This really does explain a lot. For example, ever wondered how bell-bottoms took over the world?  (Though what else would you wear with lamb-chop sideburns.)

Part of the fun of investing is trying to discern the next fashion. The real challenge is being able to translate that view into an attractive risk/reward investment. Too often it seems I get caught looking the wrong way.

For example, back in May, we noted the dark mutterings of a learned few about the US debt ceiling debate and suggested that there was a fair degree of complacency about the process to its resolution (“Chicken Little says the ceiling is fine”). While the note touched on the risk to the US dollar, the conclusion focussed on US Treasuries. Looking back across the two months, the clear winning strategy was to short the US$ against ‘real’ currencies and gold. Treasuries remain caught in swirling cross-currents that are just too difficult to untangle.

So what are the likely trends from here?

As the ‘sell USD’ meme has gone mainstream, the risk/reward probably favours a counter-trend move. Certainly, ‘safe haven’ sentiment is at extremes (here), capital flows are becoming concentrated in fewer stocks (here and here), and the climbing interest in protecting the downside even as volatility remains subdued (here), all suggest that the weak side is one where the USD rallies hard.

On the assumption then that the market is vulnerable to a USD rally – whether it is the result of a ‘resolution’ or not – what are the trades to consider?

1) Short gold – When I look at the relative underperformance of the gold miners versus the metal, I get the feeling that the ‘alternative money’ is due for a nasty sell-off. Note that the gold miners (HUI – blue line) have failed to make a new high while gold (black line) has pushed on through. This view is number 1 for good reason.

2) Short ‘safe haven’ currencies – we’ve been positive on the CHF since the start of the year (“Trends you can trust“), but with the most recent move it has got just plain ridiculous. While the Swiss central bank may have given up fighting the trend, the current mood leaves USDCHF particularly vulnerable to a sharp correction.

3) Neutral Risk assets – If we take the defensive posturing of money managers as a guide, the argument could be made that there are willing buyers for risk assets (equities and/or lower grade bonds) on resolution of the debt ceiling. While I’m not a buyer down the risk curve from a longer run valuation perspective, it’s unclear to me as to which way these asset classes can run in the shorter term.

4) Neutral Commodities – On the face of it, a stronger USD should hang heavily on the commodity sector. Still, commodities are more inclined to follow the breezes coming out of China, so the sector may not be as susceptible to movements in the big dollar.

So what then to make of the politicians digging trenches in Washington? Luigi Zingales (here) had a good take on the matter – concluding that politicians are incentivised to wait until the building has fallen down before calling for help. There are few rewards for the politician who averts disaster by imposing pain – it’s human nature to prefer to pay up for insurance after the disaster has already struck.

In any event, the current posturing is broadly irrelevant to the bigger picture. We remain captive to the rolling up of the debt overhang in our financial institutions to the sovereign state. This is the process happening in Europe and in the US. China is following the same path just under a different guise. This aggregation will continue until the balance sheets of the financial institutions have been restored. Only then can inflation really take charge.

For the US, the ‘debt ceiling’ debate is not really about external creditors, they have been well and truly slapped by the not-so-invisible hand of the US govt and its central banking quango. Looking at the recent export figures and relative inflation rates, the Sauna Accord (from August 2009 here) has all but driven the USD to where it needs to be for the country to be competitive.  Foreign holders of US assets are unlikely to get much joy from swapping their currency exposure to Europe or Asia at these levels.

It’s the internal creditors of the US debt roll-up that should be concerned. That’s the US taxpayer.

If we follow the script that has been well written by the Japanese 90′s recession, then the US government will be enacting more stimulus measures in the not too distant future. While monetary policy has little effect in a balance sheet recession, the debt ceiling seraglio points to the difficulties faced by US government is getting more direct spending measures out the door. I’m confident that creative accounting will find a way and the deficit will be monetised. And it is here that US based taxpayers must recognise that this solution is all be about the redistribution of wealth. Redistribution across the existing tax base and, more likely, between current and future tax payers.  The path of least resistance for politicians has always been to let relative prices do the work that they cannot achieve through legislation.

If politicians are failing to represent to the interests of the majority it is because their incentive structure is wrong. The US has the democratic institutions to address this. I’m hopeful accountability will soon be back in vogue in the farmyard.

According to the notes – a signal is given when:

1) The RSI reaches an overbought level (bottom pane – been there and now heading south)

2) The MACD closes below the Green signal line (middle pane – almost there)

3) The monthly close of the stock price is below its 12 month moving average (almost there – it’ll have to rally just under 10% from here to make it back above the MA by the end of June)