Energy and Macro Market Issues

Uprisings in the Middle East and Northern Africa have many market participants refocusing attention on crude oil and the energy space.

I found the above map instructive (taken from this article) as it offers a 'big picture' view of energy supply/demand worlwide.

The US position is net importer of oil (we use ~25 million barrels/day, but have production capacity of only 7 million bpd--nice data set here). The world currently consumes 80-85 million bpd of oil.

On the other hand, the US is self-sufficient w.r.t. coal (important source of electricity generation domestically).

When trying to make sense of the 'macro' picture, smart market participants factor in energy issues and the related geopolitics.

position in oil

Egypt and the S&P

Strife in the Middle East, particularly in Egypt, sent stock markets lower and crude oil higher at the end of last week.

While smaller cap indexes have already technically broken intermediate term uptrend lines, large cap stock indexes like the S&P 500 (SPX) remain in uptrends.

It is often said that trend lines on price charts should be drawn with a crayon rather than with a sharp pencil (to avoid getting too excited when prices look to be pushing thru the trend lines). As such, it appears that we would have to see price weakness thru SPX 1260 before concluding that a significant trend change may be underway.

position in oil, SPX

Baltic Dry Index

The Baltic Dry Index (BDI) is a price index of international oceanic shipping rates. When the BDI goes up, it implies generally higher prices to ship stuff via cargo vessels around the world.

Many market participants regard the BDI as an indicator of global trade. Higher BDIs imply stonger trade patterns.

During the 2008 credit market collapse, the BDI experienced a jaw-dropping decline--falling from over 11,000 to under 1000 in just a few months.

Over the past few months, the BDI has been weakening once again. Thus it represents a divergence in the thesis that economies are generally strengthening worldwide.

Another metric that may be worth watching...

Defining and Measuring Inflation

This article touches on why inflation, as measured by the Consumer Price Index, is chronically under-reported.

Did you know that the dominant definition of inflation has not always been linked to 'change in prices?' A century ago, inflation was commonly defined in terms of the quantity of money and credit.

You can ponder which definition makes more sense...

Support

Like many risky assets, silver has had a nice run since last summer. The commodity nearly doubled in price from August to early January. A tradeable proxy for silver is the ishares Silver Trust ETF (SLV).

Recently, SLV broke its uptrend line and began following thru to the downside.

Technicians may be eyeing the 24-25 level as 'support.' Support reflects a price level that may impede further price declines--at least temporarily. The conceptual argument in this case is that when silver gapped higher last November, it left lots of potential buyers behind. Many of those would-be buyers told themselves that if SLV ever returned to the 24-25 level, then they would not miss the opportunity to get long again.

Essentially, then, support levels identify price levels where potential demand may reside.

Should SLV drop another buck or so from there, then watch to see whether that potential demand doesn't materialize--at least for an opportunistic trade...

no positions

Divergences

Small cap stocks have been leading domestic markets higher. The Russell 2000 (RUT) is up well over 100% since the early 2009 lows.

Over the past week, the RUT has shown some weakness. In fact, the multi-month uptrend line in place since last summer was violated last week.

On the other hand, larger cap stock indexes such as the S&P 500 (SPX) continue to show strength. Uptrends are still technically in place.

This is an example of a 'divergence.' Divergences occur when market indicators that are 'supposed' to move together fail to do so. Often, divergences portend a change in market character. Perhaps investors are rotating out of small caps because they see relative value in large cap stocks. Maybe weak small caps reflect declining risk tolerance among investors.

Of course, perhaps this divergence is just a random phenomenon that merits no meaningful interpretation...

In any event, I've found it useful to look for divergences and keep them in mind when making sense of the tape.

position in SPX

Government Jobs

Nice article from John Mauldin (a sharp cookie) outlining some of the 'macro' or 'structural' issues that could impact financial markets in the next year or two. One focus of this particular piece is the increasingly visible role of government in the job picture. I found the data on govt vs private sector jobs are interesting. Check out the USA Today table showing avg salary difference govt vs private sector.

As John notes, the old assumption was that govt jobs paid less but were more secure. Private sector jobs paid more but were more volatile. The old risk:reward axiom.

That risk:reward axiom seems out of whack currently. The question market participants need to ask is whether that divergence is likely to continue.

Stated differently, how will this government intervention influence prices over time?

Correlation

The capital asset pricing model (CAPM) focuses attention on reducing non market (or security-specific) risk by managing the 'beta' content of a portfolio. However, this approach does not address market (or systemic) risk. This is the risk that is shared by all positions in a portfolio.

Degree of market risk can be estimated by examining the correlation between portfolio components. The higher the correlation between components, the more they move together. Higher correlation suggests higher market risk.

Data suggest that correlation between risky assets has been increasing for years.

First, check out the average correlation between components of the S&P 500 (blue bars). Correlation between S&P 500 stocks has about doubled in the past decade.

Next, the Russell 2000 (blue line). Once again, correlation has about doubled in the past 10 years. Note that the internal correlation of the Russell is higher than the internal correlation of the S&P.

What about foreign stocks? Below we see the correlation between the S&P 500 and the EAFE (Europe Australasia Far East) Index. Once again, we observe a steady march higher in correlation. The correlation between the S&P and the EAFE current stands at about 0.9!

One historic attraction of commodities and other hard assets has been their negatively relationship with stocks--which has made them good diversification vehicles. That attraction has been waning. The gold line below shows the average cross correlation between various asset classes including S&P 500 stocks, gold, oil, 10 yr Treasury rates, and various foreign exchange (forex) cross rates. Prior to 2005ish, these cross correlations were indeed negative. Over the past few years, however, correlations between broad asset classes has turned positive--and the relationship appears to be increasing.

An important question you should be asking is why--why are correlations increasing among risky assets?

In any event, results suggest that, when investors are long risky assets, they are taking on ever greater levels of market risk.

position in S&P 500

GOOG's Outside Day

Last night Google (GOOG) reported better than expected earnings and the stock 'gapped higher' out of the gate this morning. However, the opening print was near its session high, and GOOG spent the rest of the day heading lower.

The result was what technicians sometimes refer to as an 'outside day'--where the session high is higher than the previous day's high, and the session low is lower than the previous day's low. (btw, here's a nice tutorial if you're having trouble making sense of candlestick charts)

When outside days occur after a trend as been in place (GOOG has been in an uptrend), and when the close of the outside day is opposite the trend (GOOG closed lower), then that often portends a trend change--particularly when the outside day occurs on big volume (it did today).

Because many traders consider this stock a key 'tell', or indicator, of general market strength, GOOG's price action over the next few days may be worth watching.

no positions

Capture the Flag

Interesting multi-year 'flag' or 'pennant' pattern in Amgen (AMGN). Textbook technical analysis suggests that these patterns typically resolve in the direction of the primary trend. If using the 2005 high of about $85 as a reference, then the primary trend has been down.

In any event, these patterns tend to end with a bang rather than a wimper, as stocks often 'uncoil' at the end of the tapering pattern.

no positions

Euro Bank Debt

Interesting article noting that, while European banks are having trouble selling bonds in their homebase markets, these firms are having little trouble selling debt here in the US. The author (a smart cookie, I might add), wonders whether US investors are taking on risk without doing their homework first.

He notes that the current situation reminds him of a similar set-up occuring 3-4 years ago in reverse order. In 2005-2007, US financial firms were having some trouble placing all the mortgage backed securities and derivatives flowing from the housing market. Domestic firms found European banks to be eager buyers. Subsequently, the US housing market collapsed, shouldering many Euro banks with huge losses.

Deja vu?

Market Cap

Nice introductory article on market capitalization (market cap). Mkt cap = share price * number of shares outstanding.

For stocks, market cap provides a basic measure of the underlying company's overall value.

According to the article (which draws on data from Morningstar), 'large cap' stocks have market caps greater than $8 billion, 'mid cap' stocks have market caps between $1 billion and $8 billion, and 'small cap' stock have markets caps of less than $1 billion.

As the general value of stocks change, so do the standards for what comprises large, mid, and small cap stocks.

Hedgies Selling Gold

As a group, hedge funds appear to be reducing their positions in gold. Over the past decade, gold has been among the best performing assets, rising about 5 fold during the period.

Gold is often viewed as a 'hedge against inflation.' An alternative view is that gold is a bet on disorder--monetary, social, etc.

From the article, it seems that some hedge fund managers believe that interest rates will be rising worldwide, and that those rising rates will hurt gold prices.

position in gold

AAII Asset Allocations

The American Association of Individual Investors (AAII) surveys its membership periodically about their current asset allocations. The December data show (long term average in parenthesis):

stocks 62% (60%)
bonds 20% (16%)
cash 18% (24%)

As noted in this article, these allocations sometimes provide some contrarian information on sentiment, with AAII members often reporting high allocations toward equities near market tops and low equity allocations near lows.

I personally find it interesting that, in the 20+ years of historical data shown in the article, average AAII member allocations toward stocks has never fallen below 40%.

Note also that other asset classes, such as commodities and real estate, are not considered in the survey.

Rising Treasury Yields

The Federal Reserve announced its Quantitative Easing part II (QE2) program late last summer. The stated goal was to 'buy down' interest rates through the purchase of longer dated Treasury securities. By further surpressing interest rates, the thesis went, the economic recovery would gain more traction.

To purchase those bonds, the Fed essentially creates money out of thin air. Some folks refer to this as 'monetizing the debt.' A country sells sovereign bonds, and then prints money to buy those bonds back.

The Fed is currently on the record that it wants to purchase ~ $700 billion worth of Treasuries in this manner.

We can discuss the wisdom of this policy some other time. Here, I wanted to point out that since the QE2 announcement, long term interest rates have been going up instead of down. In the graph below, divide the TNX number by 10 to get the yield on the 10 yr T-note. The yield on the 10 yr note currently stands at about 3.3%--up nearly 100 basis points since October.

The bond market seems to be either sniffing out either a) a strengthening economy, or b) inflation.

Either way, given that our economic and financial systems are operating in a state of high leverage, and that the Fed is intervening in unprecedented ways in the Treasury market, staying close to interest rate levels and trends should improve your market awareness.

Keep an eye on 'em...

position in TLT

Muni Bond Weakness

Stocks have been levitating higher, but municipal bonds have been getting hammered.

Note that the downside action corresponds pretty well to the fall elections. As you may know, lots of states are on the verge of bankruptcy. But many newly elected Congresspeople have been talking tough about deficits and spending.

Perhaps muni bondholders are worrying that states won't get the bailouts that they'll surely be asking the Federal goverment for...

Hedging

Nice introductory article on hedging portfolios using both inverse (i.e., short) ETFs and put options. Hedging is one way to manage risk.

B-School Benchmarking

For those looking for worthy b-schools to guide infrastructure benchmarking efforts, Business Week has great info and publishes the best lists--you can find lists of top MBA and undergrad b-schools.

Most, if not all, of these schools are running student investment funds (also knowns as student managed funds or SMFs) of some type. Most of them have a web presence--linked to either finance department or to the b-school web page families.