Monday, December 6, 2010

Risk on!

Further to my last post about climbing a wall of worry, market technicals point to a continuation of the bullish momentum seen last week. I call this the QE2 risk trade and what we saw last week could be the start of a significant move higher in risky assets. My Inflation-Deflation Timer Model agrees and remains at an inflation reading as it calls for the high beta trade of  commodities and emerging markets.


Cyclicals look healthy
Market relative charts can be revealing. The chart below of the Morgan Stanley Cyclicals Index compared to the market shows that the cyclicals staged a relative breakout last week, indicating that investors are piling on the QE2 train. The US economy is showing surprising resilience and Barry Ritholz has speculated that we could even be in for an upside cyclical surprise in 2011.


Speculation is not excessive
The QE2 risk trade has much more upside potential. Since QE2 is a form of currency debasement, its effects should show up in gold and commodity prices. As a measure of investor sentiment in this trade, consider the action in gold stocks.

Despite gold prices moving to all-time highs, levels of speculation in the precious metal equities are not excessive. Take a look at this chart of GOX vs. HUI. GOX is an equal-weighted index and therefore gives higher weight to smaller capitalization gold stocks, while HUI is a capitalization-weighted index and gives a higher weight to the more senior names. The chart shows that small cap golds have actually been lagging large caps. These are not signs of speculative blowoffs that accompany major tops.


Here in Canada, I also watch the performance of the TSX Venture Index, which represent the small cap juniors, compare to the more senior TSX Composite. The chart below shows that the small caps have been fair steadily outperforming the large caps since late 2008. While the TSX Venture Index is at an important Fibonacci retracement level relative to the TSX Composite, they are nowhere near their previous highs indicating that speculation is not excessive.



Giving in to the Dark Side
The social and economic risks of the current backdrop are enormous and when it blows up it will be a doozy. As well, central bankers tend to be closed-mouthed and reserved in their comments by their very nature. (Paul Volcker once quipped that when he went to a restaurant during his tenure as Fed Chairman he was compelled to say "I'll have the steak but that doesn't mean I don't like the lobster.")

When a central banker speaks out and actually takes a position, you have to sit up and take notice. Thomas Hoenig of the Kansas City Fed wrote a New York Times Op-Ed about the social risks of the class divide between Wall Street and Main Street [my emphasis]:

Americans are angry in part because they sense that the government was as much a cause of the crisis as its cure. They realize that more must be done to address a threat that remains increasingly a part of our economy: financial institutions that are “too big to fail.”
In spite of the public assistance required to sustain the industry, little has changed on Wall Street. Two years later, the largest firms are again operating with bonus and compensation schemes that reflect success, not the reality of recent failures. Contrast this with the hundreds of smaller banks and businesses that failed and the millions of people who lost their jobs during the Wall Street-fueled recession.
He went on to warn about the social risks of the Wall Street/Main Street Divide [my emphasis]:
Crises will always be a part of our capitalist system. But an absence of accountability and blatant inequities in treatment are why Americans remain angry. Without accountability, we cannot hope to build a national consensus around the sacrifices needed to eliminate our fiscal deficits and rebuild our economy.

Party on dude!
The Divide is large and growing. This November the GOP regained control of the House and the wrangling over tax cut extensions have begun. The newly emboldened Republicans have vowed to hold up the extension of jobless benefits until their tax cut proposals pass and the tax cut proposals have bogged down in the Senate. Consider what this price relative chart of Tiffany's vs. WalMart says about the current environment:


I could rail all day about the inequities in the system. I could also say that this path is highly risky and it will all end in tears. I agree with John Hussman that equity valuations are stretched. My inner trader tells me that none of this matters, until it matters. Even Jeremy Grantham has allowed that the SPX could rally up to 1500 before falling to GMO's fair value estimate of 900 (my comment: but markets always overshoot fair value so expect another 2008-like episode with 50-ish% haircuts.)

For now, it's time to take a walk on the Dark Side and ride the Wildness. Just don't forget your risk controls and overstay the party.

1 comment:

stephen said...

Cam-

Point well taken on the TIF:WMT spread, but isn't it better to equalize the volatility of the two rather than allocating an equal dollar amount into each?