Sage Weekly Letter – Father’s Day 2012

• Posted by Robert Sinn
• on June 17th, 2012

Suddenly markets appear to be convinced that the G20 (read European Central Bank and US Federal Reserve) has a master plan to save the global economy and financial markets from a spiral downward resulting from the worsening eurozone debt crisis. Two weeks ago on June 3rd I wrote one of the more difficult Weekly Letters I have ever written – the negativity among market observers was palpable and it was exceedingly difficult to find reasons for optimism. This weekend I found the following observations from June 3rd quite useful to look back at:

During my weekend reading & analysis two main themes kept coming into my mind:

• Every bullish/non-apocalyptic scenario I read included a heavy dose of ECB/Fed intervention at some point in the next month
• Markets are currently heavily positioned one way: Long US dollar, short euro, long treasuries, low equity allocations with nearly everyone recommending holding unusually large cash allocations

While I agree with some of this conventional wisdom (some central bank action will have to take place soon and cash isn’t a bad place to be) I’m fairly certain that some of the above conventional wisdom & market positioning will look rather silly two months from now.

One of the more important aspects of writing a weekly letter, and blogging in general, is to be able to capture the mood of the market (and my mood) at a particular moment in time. This allows for insightful post-mortem analysis later on, we can ask ourselves: Why was I thinking that at the time? Why was market positioning so one sided? Was it really so difficult to foresee the resolution? etc. etc.

When markets become as extremely biased as they were in early June (long dollar $DX_F $UUP, short euro $EURUSD $FXE, long treasuries $TLT, underweight equities $IWM $SPY) it usually isn’t long before the market pendulum swings back the other way. Such has been the case during the last two weeks, as Howard Marks wrote “it is the movement toward an extreme itself that supplies the energy for the swing back.” - we have witnessed the pendulum swing back toward the midpoint and in fact the S&P 500 ended the week at the 50% retracement level of the entire April-June market correction:

 

So where do we go from here?

This is of course the billion dollar question and one that is never easy to answer. Nearly every equity chart (sectors and major indices) displays a similar inverted head & shoulders bottom formation and many of these charts broke above the neckline at Friday’s close. This creates an interesting market dynamic in which many technicians and market observers who were advising cash and/or bearish positions just two weeks ago have now turned positive on taking on market risk, albeit at much higher levels than two weeks when caution was in vogue and cash was king.

This is what the market does as it fools the majority into being fearful when they should be greedy and greedy when they should be fearful, and it will ever be so. This is not to say that equities and other risk assets cannot advance higher in the coming days, I simply aim to highlight the very real possibility of a bull trap after the risk rally of the last two weeks. Let’s examine the most important charts:

Click to enlarge

The $CRB is mired in a well defined downtrending channel, should the global central bank easing/QE speculation prove to be true it would be natural to expect a rally to the upper end of the channel over the coming weeks. However, should the CRB fail to catch a bounce it would portend a bleak outlook for global economic activity as well as global central banks that may indeed be pushing on a string.

 

The Gold Miner’s ETF ($GDX) led risk assets lower throughout March, April, and into mid-May. GDX also turned higher before the broader equities markets and even displayed a bullish divergence with gold itself in late-May which presaged gold’s $100 rally during the last 2.5 weeks. GDX didn’t participate in last week’s equity market rally – this is a negative divergence, however, should GDX breakout from the bull pennant and rally above the inverted H&S neckline at 48.75 it would paint a very bullish picture for risk assets.

 

It is worth noting that since the May 18th momentum low the S&P 500 has outperformed the Russell 2000 by 35 basis points – this is noteworthy because it tells us that market participants continue to remain underweight higher beta small caps as they prefer to participate in rallies through the more liquid and generally safer large and mega cap stocks.

For any further rally in equities to gain credence the Russell 2000 ($IWM $RUT) will need to decisively break above resistance and its falling 50-day simple moving average:

Simply put the rally may have a little bit more fuel in its tank before it runs out of gas but I would advise being cognizant of the risk of a bull trap similar to the one we witnessed in early July 2011.

Perhaps the most important chart of them all, US Dollar Index ($DX_F $UUP) – bull flag at support or the end of the rally?

 

Macro Thoughts

From my vantage point the Greek election coverage is much ado about nothing. Greece is nearly certain to leave the eurozone one way or another during the next six months – money is leaving the country in droves and banks are only able to meet depositor demands for cash through the ECB’s Emergency Lending Assistance program (ELA) which essentially means that the Greek Central Bank owes the ECB for the euros which it has been “allowed” to print during the last several weeks. The situation is clearly untenable as Greece is exceedingly unlikely to be able to stick to the current bailout targets or anything close to them. This will require a third Greek bailout which seems unlikely to materialize given the overwhelming bailout fatigue throughout the eurozone and even among the eurocrats in Brussels.

Greece will have to be allowed to leave and a substantial multi-pronged backstop will have to be set into action – eurozone-wide bank deposit guarantee scheme (regardless of moral hazards involved, it has to be done), ECB rate cuts, quantitative easing and/or potentially the “nuclear option” of the ECB guaranteeing all EZ sovereign debt. Should the ECB fail to deliver the downside risks are significant to say the least, and even if the ECB does deliver there will still be little clarity as to the future of the common currency.

It seems that suddenly everyone is convinced that the Fed will embark on QE3 (really more like QE4 given that the “Twist” was QE3) this Wednesday. Of course these same Fed pundits seem to change their opinions on additional Fed easing on a daily basis, so perhaps they will change their mind one more time before Wednesday’s announcement. Regardless of what the Fed announces it is interesting to note that the silver market ($SI_F $SLV) has displayed little optimism with regard to a new round of Fed asset purchases:

Either the price of silver is being weighed down so heavily by falling global industrial demand or the Fed pundits have it wrong – I guess we will find out the answer soon enough……

Best Ideas

• I continue to like $AUDUSD from the short side although things could potentially get quite volatile this week with the Fed announcement etc. Fading last Sunday’s rally above parity worked very well, Friday’s rally back above parity right into the confluence of the 38.2% Fibonacci retracement level and the falling 50-day moving average offers another attractive short entry point

• We got our rally back above $SPX 1340 on Friday, I used Friday’s rally to close the put side of an iron condor I initiated ten days ago leaving me with realized gains on the put spread and unrealized losses on the bear call spread side – I will look to initiate new bear call spreads (most likely using July SPY 134 & 137 strikes) into any further rally early in the week
• $GOLD and $FISV are two of my favorite long setups should the risk rally persist a bit longer (if gold breaks decisively above 1640 this week, $GOLD the stock could easily breakout above 95 and into a vacuum higher to at least par and potentially to the gap fill at 102.89)

Happy Father’s Day to all the fathers out there, always remember the influence that you have upon your children’s lives – at times it may not be easy to make all the right choices and lead by example but in the end it is well worth it. I love you Dad.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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