Click here to listen to Through A Trader’s Eyes Podcast 19 – May 21, 2010

I’m getting a few e-mails regarding the Economic Cycle Research Institute’s Weekly Leading Index Growth Rate continuing to fall.  The folks at this great research firm have said repeatedly that for the economy to be weak or strong, the trend must be sustainable and persistent in a particular direction.  The growth rate peaked in October 2009 at 28.5 and is currently 9.  So, the growth rate has definitely slowed but this is still showing that there is growth.  What’s disturbing about the picture below is the fact that it doesn’t look like it’s bottomed.  So, is this the definition of a persistent move?  Given all the headline risk regarding the global economy, I’d say so.  I discussed about a month ago that the GDP Growth rate in the U.S. has probably peaked.  That doesn’t mean we’re not growing but the rate of growth is slowing.  The car isn’t accelerating but rather on cruise control.

It’s not the fact that the economy is still growing.  Investors key off of the rate of change.  Remember, above is the rate of change, not the absolute number (see correlation between the two lines).  As the economic decline began to slow in mid to late 2008, that was a sign that a change in the S&P 500 and stocks in general was coming (many stocks bottomed in November of 2008).  The ECRI peaked in October 2009.  This is 6 months prior to the S&P 500 peaking (at least for now).

While this is something I’m watching very closely, I’m more concerned about the internals of the market and the attitude of investors.  In the short-term, there is a tremendous amount of fear and a bounce is very likely.  The quality of that bounce will be key.  Are sellers pausing or do institutions step in with a high amount of volume and intensity?  We’ll know next week probably.

I still don’t believe this is the end of the bull market.  While I’m not a raging bull, I have gone back and looked at history.  And history suggests that stock markets don’t go from bull market to bear market over night.  Long strong bull markets tend to have violent and quick sell offs that make you believe it’s over.  And while we should trade that, protect capital, and sell some, I would not become overly bearish at these levels.   Bear markets usually develop over time with deterioration in the internals.

If the economic backdrop continues to deteriorate (i.e. the above picture) and the internals (long-term) suggest deterioration, then a bear strategy will be implemented. Until then, I’m treating this as a correction and holding lots of cash looking for the buying opportunity.

In the last few weeks, we’ve seen investors shifting away from “risk” assets.  That money has gone into treasuries primarily. We’ve seen rates fall from 4% in early 2010 to it’s current level of 3.2%.  Remember in late 2008, the panic caused investors to drive treasury rates to around 2%.  Can we get there now?  Perhaps but the uptrend we’ve been for over a year now is still intact based on the MACD.  As many of you know, I’m not a person that relies on one indicator.  But, below, you can see 10-year treasuries on a monthly basis going back to 1992.  The most reliable indicator was using MACD  on a monthly basis.

We haven’t changed direction yet based on the MACD. The fear trade is currently driving rates lower.  Keep this indicator in your back pocket when you’re allocating your overall portfolio.

In the last month, we’ve seen the dollar race up over 10%, 10-year government bonds’ yield drop from 3.8% to 3.2%.  We know Europe is in big trouble, emerging markets such as China are putting on the brakes and raising interest rates.  Money is flowing INTO the United States at a feverish pace because investors want safety and they want to invest in companies that don’t sell products to foreigners (at least for now).

Let me be clear that I don’t want to build a long-term portfolio based on a rising dollar and betting against emerging market consumers.  But, for the time being, it’s working.   This led me to run a screen for the biggest U.S. companies that have 85% or more of their revenue coming from inside the borders.  See below.

The other day, I received a comment on the blog regarding the fact that gold is running up while oil is breaking down.  So, I decided to do a little research.

One way to make money in the markets over the long run is to find correlations and take advantage of them when they breakdown.  Pretend you’re looking at a braid.  One’s up, the other one seems to catch up.  The other one falls and soon the first one follows.  They may vibrate differently but they end up going in the same direction and at the same destination.  Typically, you buy the cheap one and sell the expensive one.  So, should we be selling gold and buying oil?  That may be what the blog reader was really asking.

From 2000 until mid 2008, gold and oil moved in tandem.  In fact, they were about 80% positively correlated.  Gold was always generally about 10 times the price of oil.  But, 2008 changed all that.  The correlation broke down and it’s been very sporadic ever since.  There have been times they’ve moved almost opposite of each other.  Why is this?  The simple answer is that the global economy slowed taking oil with it.  On the other hand, all the easy money and stimulus around the world has lead investors to buy gold as a reserve currency.  Also, gold has been a “safe” place to put your money.  AKA, part of the fear trade.   (I don’t always agree with that but it’s definitely in a long-term bull market that doesn’t look over yet.)  In fact, I remain long precious metals.

Above is the picture of the ratio from 2000 to the present.  I’ve drawn a red vertical line when everything changed (mid 2008).    Y0u can see oil plummeted while gold continued to push higher.  In fact, the ratio went from averaging 10 to a high of over 25 (gold is 25 times the price of oil).  This was after reaching a low of around 7 earlier in 2008.  The recovery in 2009 caused the ratio to revert closer to the mean but the recent European troubles have caused another spike.  That’s the ratio.  Now for the correlation.  In other words, how tight is that braid?

You can see the drop off that started in 2008 (red vertical line) and now the correlation is zero.  That means gold & oil aren’t correlated at all.  For now, that pairs trade of buying the cheap one and selling the expensive one won’t work.  The correlation has broken down.

But, we can’t just look at the last decade.  So, I decided to go back prior to 2000.  I looked at the data from 1986-2000 to see what the average ratio was between gold & oil.  Remember, in the 2000s (last decade), the ratio averaged about 10.  From 1986-2000, the ratio was 20!  Below is a picture of that ratio.

The current ratio is 17 in 2010.  So, perhaps we’re just going back to the normal ratio of 20.  How about the correlation back in the 1980s and 1990s?  You can see from the picture below (mislabeled – should read Gold vs. Oil Correlation).  There was no correlation.  It ebbed and flowed back and forth with no real reliability.

What’s the conclusion from all of this?  It tells me just like the dollar and gold, that these correlations aren’t consistent enough for us to trade around.  Treat gold & oil independently and trade them based on other variables besides watching what the other one is doing.

Click here to listen to Through A Trader’s Eyes Podcast 18 – May 13, 2010

A few years ago, a book was written called The Black Swan by Nassim Taleb.  The story goes that everyone always thought the only color swan in existence was a white one.  One day, out of nowhere, a black swan comes swimming in the pond.  Where did it come from?  We never knew there was such a thing.  Taleb goes on to tell various stories about chance and randomness and how we prepare for various things we think we know about.  But, what about those things we don’t know about?  There are so many things we can’t prepare for because they are unknown.  They are the “black swans”.

I live just outside San Antonio, Texas.  I bought a new home in the fall of 1998 and a month after I moved in, San Antonio had a 100 year flood.  In 2002, we had another 100 year flood.  So much for the 100 years.  Here was a perfect example of the “black swan”.

In 2000, the stock market crashed.  Granted it took awhile but it collapsed.  A once in a generation sell off… Not.  In just 8 years, it happened again.  Except this time, there was no place to hide.  Hedge funds closed down, advisors went out of business. Bonds went down, stocks went down, real estate went down.  Diversification didn’t work.  Only cash did.

Let’s go back to September 11th, 2001 for a minute.  That was a classic “black swan” event.  A plane hitting a building affected your retirement portfolio.  Who would have thought that would ever happen?  We plan on interest rates going up or down, the economy speeding up and slowing down, inflation, and deflation.  But, a plane hitting a building?  Prior to 9/11, I never met with an individual and listed out the various risks and said “don’t forget about planes hitting buildings”.  Back in the 80′s, terrorism was basically guys in the streets of some countries throwing rocks at each other.  Now, it’s a different game.

Greece…another “black swan”.  It’s spreading now and it’s affecting all the PIIGS (Portugal, Ireland, Italy, Greece, & Spain).

An oil spill,  financial reform…  Where does it end?

Because there is so much we don’t know compared to what we do know, diversification matters.  Real diversification is essential.  You’ve heard me a thousand times beat down portfolios that are just a basket of essentially the same thing.  Plenty of investors think they are diversified by owning baskets of mutual funds.  But, they found out in 2008 they weren’t really diversified.  I’ve always been a proponent of diversifying with income, some principal protection, and some investments that can give me some capital gains.

Yesterday was another one of those “black swan” events.  Out of nowhere, the market drops 1000 points in 15 minutes.  How do you prepare for that with a mutual fund portfolio?  The answer is you don’t.  For those of you who have individual bonds that were up yesterday, who owned some gold, who had a lot of cash, and some stocks, you slept well.

These “black swans” are happening a little too frequently for my blood.  Perhaps all these “black swans” are really white after all since they are now occurring with such frequency.  Investors may need to get used to the fact that it will always be something.  What will be the next crisis?  I have no idea and neither do you.  That’s why it’s so important to have an overall strategy that goes outside the stock market.

As the economy recovered in 2009, Australia was the first country to start tapping on the brakes to prevent further inflation by raising interest rates.  They haven’t stopped.  Now, we see China is tapping on the brakes as well.  For the last several years, all we heard was if you’re going to invest, it better be in “global growth”.  While this is certainly true in the long run, what about now?

The argument has been our country is driving dollars offshore.  There are billions of people industrializing.  The U.S. dollar is going to zero.  Interest rates are going to the moon and inflation is right around the corner.  But, let’s review the last few months.  Earlier this year, I discussed on a podcast that perhaps we should maybe prepare for lower interest rates in the near term, not higher.  I thought of this because literally every person I talked to then (and even now) believes inflation is here and we better prepare.  So, I first examined the contrarian view.  Since then, the numbers have proved me correct.  Inflation could be a problem down the road but even though the monetary base has exploded, the multiplier effect has been going down.  Money isn’t circulating as fast as people would have imagined.  So, we’re still in a flat to deflationary environment.  Thus, the Fed hasn’t raised rates and long-term rates have actually come down.

In the last few weeks, the Greece situation has been the hot topic and money has come out of the Euro and into U.S. dollars.  Yes, the dollar has risen.  Now, we all know the government doesn’t want this to happen.  They need a weaker dollar so we can inflate our way out of this.  But, the dollar is going up, interest rates are coming down, and the place to be is the United States of America.  Put on your global hat for a minute.  Let’s say for a minute you’re a billionaire with money and assets that have to be allocated anywhere in the world.  You look at the most exciting places to invest:  China, Latin America, India, etc.  Exciting but risky and they’re growing so fast that their government has started to put the brakes on to slow it down.  That’s typically not the best investing environment.  On top of that, some of the brightest investment minds we have are saying China is another bubble about to burst.  So, that’s out (for now).  Then, you look across the pond to invest your money.  Good ‘ole Europe.  The grandfather (or mother) of the world.  But, they’re falling apart, behind the curve, their currency is falling, and it’s just a mess.  What’s left, the United States of America.  Money is flowing into U.S. treasuries, the U.S. dollar, and stocks with limited international exposure.  Small caps, mid caps, etc. are the place to be.

If you put a gun to my head and said you can only invest in two areas for the rest of your life and you have to stick with it, what’s it going to be?  Emerging markets and materials would be my choice.  But, fortunately, we have a little more freedom than that.  So, we look for rotations and try to track where is the money flowing.  In the last month, Chinese stocks are down over 10%, the S&P is down about 2%, and the Russell 2000 (small cap American stocks) is up slightly.  The dollar is up 4.5% and 10-year treasury rates have fallen from 4% to 3.5% meaning money is coming into U.S. bonds.

I perceive this rotation as America being the hide out and the safe place to be for the short-term.  Again, this isn’t a long-term trend but it could last a while.  The global growth story is out there and has been for some time.  Now that the retail investor is catching on to this, I think we have to put our contrarian hat on for a minute.  The place everybody likes to bash is the place attracting the capital.  The U.S. of A.