Data Diary

The definitive guide to building your own meme

Posted on 28 July 2011 | 11 responses

Apparently it only takes 10% of the population to be true believers for the rest of us lemmings to follow suit. (From the Rensellear Institute via History Squared – please note that the research was funded by the Armed Services).

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.

 

Taking over the farm

Posted on 26 July 2011 | 2 responses

Isn’t it a good thing that ‘Animal Farm’ is still taught at high schools (at least at my niece’s high school in Canberra anyway)? The importance of an educated democracy seems more relevant by the day.

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.

The combover and market breadth

Posted on 25 July 2011 | 1 response

Much like my hairline, the number of stocks covering the bald patch in US equities continues to thin…

Last time we looked at this chart (1st June here), equities were about to dip lower. Now with the European mess behind us, equities have all but recovered that lost ground. It’s just that this has been achieved with fewer and fewer stocks pushing higher relative to their more pessimistic siblings. Declining market breadth suggests a lack of conviction in the most recent recovery.

So will the inevitable resolution of the US debt ceiling debates clear the way for broader participation – and maybe even new highs in the S&P500 index? Perhaps – though maybe the markets have overestimated the ability for politicians to amicably resolve the issue. In any event, without a meaningful break higher in market breadth, we’ll be waiting for the return of the government stimulus machine before adding meaningfully to long positions.

 

 

The gold price and the power law

Posted on 25 July 2011 | 9 responses

The Financial Crisis Observatory (here) publishes research that gravitates around a model proposed by Didier Sornette that suggests that bubbles follow a predictable pattern – and that their collapse can be forecast with reasonable accuracy.

The key insight of Didier and his comrades is that financial market prices tend to follow a power law as they accelerate into bubbles. Specifically, they fit a log periodic function to observed price movements to forecast the evolution of prices to a ‘singularity’ whereupon prices collapse.

I’ve been reading the pieces coming out of the observatory for a while. They appeal to my fatalistic nature, in addition to mirroring the trader’s wisdom that parabolic price rises tend to end in tears. (Note, I’d caution that forecasts can be subject to revision based on ‘new information’.)

One of the latest papers, “The Second Wave of the Global Crisis” (published 3rd July), has a satisfyingly specific target for the end of the ‘gold price bubble’ – 27 July 2011 (here for the full piece). Following is a chart from the paper. The thick black line that sits over the gold price illustrates this price acceleration and the forecast terminal point:

 

…the thin line indicates daily gold price between November 3, 2003 and May 26, 2011, whereas the smooth thick black line has been generated by the following version of equation (1) with parameters chosen by the least squares:

p(t) = 1978.2 – 734.8 (2011.573 – t)0.36 {1 + 0.024 cos[16.5 ln(2011.573 – t) – 36.3]}, (1b)

where p(t) is gold price at the moment t. Note that the quasisingularity moment (tC) here equals 2011,573, which corresponds to July 27 and suggests that the gold bubble should start collapsing before this date anyway.

 

Australia’s expensive cities – the Purchasing Power Party

Posted on 13 July 2011 | 7 responses

Australia, the land of milk and honey, has generally been a pretty cheap place to live.  Plenty of sweeping plains and abundant natural resources have made life a little easier for wave after wave of new settlers to the country. But the current super-cycle resources boom is undermining this privileged state of affairs.

Where once China exported deflation to the globe as its workforce migrated to the cities and competed with the developed world in manufacturing, now this burgeoning urbanised population requires accommodation, roads and railways. China is competing with Australians for their own natural resources – and so prices must climb higher. This is the logic that underpins the huge investments currently being made to extract yet more resources out of the earth at an even faster pace. (Whether this logic has been perverted by capital markets is an argument for another time.)

One of the prices that has climbed higher has been the Australian dollar relative to just about everything. We’ve argued for a couple of months now that this year’s spike has taken the currency beyond the realms of reasonable – that the extrapolation of China’s implied thirst for resources was excessive given the risks to it’s growth model. So to the latest “Cost of Living” survey by Mercer (here) that identifies the world’s most expensive cities – Australia gets a special mention:

And the primary reason (it wasn’t because house prices went up or the cost of consumables climbed faster than our international peers):

All six cities jumped at least 10 places between their 2010 ranking and their 2011 ranking – and two, Canberra and Adelaide, jumped 40 or more positions. This movement is due primarily to the recent strength of the Australian dollar, which appreciated by almost 14% against the US dollar over the 12 months considered. Consequently, a New York City assignee would need more US dollars to purchase a similar basket of goods and services in Australia, and the Australian cities’ rankings all went up.

We may yet see a thrust of Chinese national hubris that will take commodity linked prices to as yet unseen peaks, but I’m confident that history will view the current period as an aberration rather than the status quo.

Advisors versus clients – what really interests people

Posted on 8 July 2011 | 2 responses

Interesting survey (here) by Russell Investments with the following table illustrating a disconcerting disconnect between clients and their advisors.

Now granted this is a survey of financial advisors only, so the responses may be paint a particularly advisor heavy view of reality – but still the picture makes some intuitive sense. Advisors struggle to get their clients to focus on their investment plans, as these same clients are being distracted by the torrent of bad news and what governments are (not?) doing to resolve the problems.

If we were to assume that the majority of the clients are of a baby boomer vintage, then maybe it’s reasonable for them to be more concerned about the immediate vagaries of the market and government policy. Investing for the long term is a different proposition when you are in asset liquidation mode.

 

China Flash PMI undermines copper

Posted on 23 June 2011 | 1 response

China’s latest flash PMI data was not good (via Markit here) – if the trend continues, next month will see China on the wrong side of the ledger:

You’d think that weakness in the China growth engine would be reflected in commodities prices – but the charts would suggest otherwise.  Consider that bellweather of commodity demand – copper:

Apologies for the somewhat crowded chart, but it’s interesting from a few perspectives – starting from the top:

1) The copper price has rolled off its highs but has materially lagged the selloff in Chinese equities. As we have discussed previously (most recently here and background here), the Shanghai Composite has been led down by the resources and financials sectors. Eyeballing the relative price movements suggests that equities tend to lead the copper price – particularly at turning points.

2) The copper price has been diverging from equities since the start of March. With domestic tightening leading to unwinding of copper inventories in China and difficulties in its property development sector, it’d be reasonable to expect copper to follow the equities markets lead rather than the reverse.

3) I’ve included the RSI for copper to illustrate that the price could fall someways before becoming oversold by this measure. Notably, the MACD looks to be crossing over again – suggesting that momentum is turning against coppers price.

Finally, and in some ways following on from yesterday’s post about the impact of the investor class on commodities prices, consider the following chart that maps US equities against the copper price.  For mine, the correlation says a lot about US monetary policy, its impact on investors, and the resultant movement in the copper price.

Australian dollar update – pressure is building

Posted on 23 June 2011 | No responses

Another month chalked up on the wall, and not much has changed for the little Aussie battler. It is trading around 1.05, just as it was when we last had a look (back on 26 May here) – but the pressure is building for a break one way or another…

 

All things considered, it has held up remarkably well. From all reports, its been central bank buying that has provided the support – everyone from the Chinese, to the Middle East, to South America, to Eastern Europe have been said to be on the bid.

The question then is who has been doing the selling?

One answer is hedge funds that have been taking advantage of the relative strength to exit long positions. We can see that open interest on the Aussie dollar futures contract has fallen back from its highs:

And that its been the leveraged accounts that have been closing out positions:

Historically, hedge funds have a reasonable track record in anticipating the changes in currents in foreign exchange markets. Hence the weakness in the money flow index as derived off the futures markets bears watching.

Still there’s no denying a central bank with a large cash balance if they have a mind to buy a currency whatever the price – barring a full blown currency crisis Bank of England 1992 style. Couple this with the anticipated inflows that are expected to support the capital spending commitments over the next 12 months and you can make a pretty convincing case for the Aussie dollar to revisit its highs. It could even break to news highs if a global government of substance decided to get the cheque book out again.

Without additional government stimulus however I remain positioned for more downside. Risk markets are showing a distinct unwillingness to embrace a world without monetary support. If the central bank bid were to step back, then I think we can expect a stop loss frenzy on a break of 1.0475.

 

Investors and commodity prices – the RBA talks its book

Posted on 22 June 2011 | 3 responses

In its latest Bulletin, the RBA added its two-pence into the Central Bank piggy bank of analysis for the reasons for high commodity prices (here). They conclude:

Commodity prices are currently both high and volatile relative to the past few decades, consistent with the physical supply and demand fundamentals that underpin these markets. However, the increase in prices and volatility is not unprecedented, having occurred during other large global supply and demand shocks throughout the past century. There is a lack of convincing evidence (at least to date) that financial markets have had a materially adverse effect on commodity markets over time periods of relevance to the economy. It is possible that speculators have had some effect on commodity price volatility, but their contribution would appear to be relatively small – particularly when compared with the contribution from fundamental factors – and short term in nature.

If we line up the central banks with the papers they have published, we get some interesting correlations (apologies for the simplistic paraphrasing):

Federal Reserve – commodity prices are driven by physical demand from emerging economies; not our monetary policy

Bank of Japan – commodity prices are higher than physical demand alone implies; we should know, we are a commodity importer

Australia – commodity prices are driven by ever increasing demand from emerging economies; we should know, they are our best customers

Hmm.

Speaking of correlations in the commodities markets, RBC published an interesting chart recently (via FT) that compares real copper prices to inventories:

All those grey circles in the upper left quadrant are telling us that the last decade has been very different to previous ones – prices have remained stubbornly high against relatively stable supply. The big question is why?

Clearly, demand from China for industrial resources has grown very strongly, just as it has risen for agricultural products and energy across the developing economies. This supports the argument that the growing demand in absolute volume terms requires a higher level of inventories on a weeks-of-consumption basis. There is no doubt then that higher demand from China et al has pushed up prices relative to the experience of the prior two decades.

But to downplay the impact of investors that have plowed relentlessly into the supercycle commodity story, as the RBA has done, is plain irresponsible. It is self-evident, to me at least, that the weight of investor money in the sector means that this capital flow is capable of being the marginal price setter. With commodity investors making up some 40% to 50% of futures markets turnover, can they really be anything else?

We’ve discussed this before (in May last year here and with some charts from James Montier here). The evidence is plentiful – from the volumes being traded in futures markets to the distortions being created in the forward curves.

If nothing else, the growing presence of investors increases the potential for extreme movements in commodities prices. It is well to remember in this context that commodities as an investment in their own right do not pay a dividend. Investors rely solely on higher prices to generate returns – or at the very least, stable prices to get their money back.

Still when you look at this chart from the RBA’s analysis, one gets the sense that the supercycle proponents are comfortable with the risks for some time yet. To be fair, it’s a pretty compelling picture…

 

 

Disappearing capital in China

Posted on 20 June 2011 | 4 responses

For all those that were thinking it might be safe to get back in the water, Chinese short-dated lending rates have exploded higher today – from Shibor.org:

With interbank rates pushing higher across the curve, the screws are being tightened on debt-fuelled construction.

Now wonder the Shanghai Composite has broken lower – down 0.9% again today – the odds of a test of last July’s lows are shortening…

 

 

« newer posts — older posts »