Been There, Done That

Yes, I recognize the deja vu. About one year ago I began reallocating assets to reflect a more inflationary posture. That posture lasted only a few months. Last summer's debt ceiling debate coupled with the EU debacle squelched my incremental inflationary expectations, and I peeled off risk positions in favor of a more balanced posture.

Fast forward to now. Once again I find myself adding long exposure in lieu of a tape that seems to be taking the Fed's "0% till 2014" promise to heart.

Will this action once again prove temporary in a world that's drowning in a debt bubble that wants to deflate? Not sure, but currently my actions need to express a perceived uptick in the odds of Big Inflation on the horizon.

position in SPX

Bullish Patterns

Am noticing lots of cup-and-handle patterns in many large cap equity charts. Some of the patterns span a few days while others are multi-month in nature.

Moreover, the action 'feels' bullish. The tape is consistently bid. Weakness is being bought regardless of news.

Feels too risky to be net short here. As such, I've been adding some long side exposure to balance things out. I've been buying some of my fave blue chip names (CSCO, JNJ, PG). Today I added a little commodity exposure via DBC.

To be clear, I'm in 'rent' rather than 'own' mode here. But I want to reposition my near term stance in this bullish tape. I'm now a coupla percent net long.

position in CSCO, DBC, JNJ, PG, SH

University Endowment Trends

This paper is somewhat dated (2008), but it still points out interesting trends in university endowments over a decade or so. Note big difference in endowment size between private (especially Ivy) and public. This really sticks out when examining endowment/student.

Asset allocation shows movement out of fixed income in favor of alternative assets. Some stats (medians):

2005 Overall

n = 726
endowment size = $72 million
return = 9%
AA equity = 59.6%
AA fixed income = 20.4%
AA alternative assets = 7.6%

Interestingly, Ivy League AA in 2005 was 38.1% equity/13.0% fixed income/37.1% asset allocation.

Of course, we now know that those increased allocations toward alternative assets were a source of pain during the credit meltdown of 2008-2009. Many alt investments, particularly illiquid ones, were crushed when bid/ask spreads fell thru the floor.

Still, the attractive characteristic of many alternative assets is that they can be less correlated with other asset classes, which makes them useful for diversification purposes.

position in SPX

The 'Risk Out' Scenario

Interesting proposition by Peter Atwater that the ultimate indicator that a secular bottom has arrived may not be one where individuals have moved out of more risky financial assets and into less risky assets. Instead, perhaps it will be a 'risk out' situation, where market participants flee securitized financial assets altogether.

There is, of course, a decent argument to be made that the probability is non-zero of a systemic meltdown that chases participants away. With systemic leverage thru the roof and issues of re-hypothecation raised by last year's blow-up of MF Global, it isn't that difficult to envision a scenario where the financial system ceases to function. Cascading bank failures, sovereign debt defaults, and other contagious events could bring the system to its knees.

Indeed, a good case for owning physical gold or other 'hard assets' is that they are tangible and outside the 'paper' financial system.

I'm going to keep Peter's proposal in mind. Perhaps the time to 'buy the list' is not when people are selling the list, but when both buyers and sellers have gone home en masse.

position in SPX

Federal Reserve Balance Sheet Leverage

By my math, Federal Reserve balance sheet currently sports leverage of 54:1. That's higher than Fannie, Freddie, Bear, Lehman prior to the 2008 credit implosion.

Indicator of how risk has been socialized, meaning that risk has been transferred from private to public balance sheets.

position in SPX

Portugal Debt Hammered Again

Portugal credit spreads are widening significantly this am. Ten yr CDS now pricing in over 70% chance of default.

For better or worse, I kicked much of my long exposure (mostly precious metals) last Friday and entered today's session about 10% net short via equity index ETFs.

position in silver, SPX

Debt Ceiling Quietly Increases $1.2T

And just like that, the debt ceiling goes up by $1.2 trillion. The new upper bound is now $16.4 trillion. Rick Santelli is correct. Not much noise from the media this time around.

Low Fed Rates till 2014 Sparks Gold

In today's FOMC announcement, the Fed signaled that they will be keeping rates ultra low thru most of 2014. That even raised my eyebrow...

This news put some giddy-up into gold, which vaulted about $50 this afternoon on the FOMC news.

I used this leap to sell my GLD position. It's up about 10% from its lows, price is now filling the gap, and stochastics are getting twisty in the overbought zone.

Am also concerned about the re-hypothecation issues surrounding these metal ETFs on the back of the MF Global situation last fall.

Selling this position puts me just about 0% net long (long metal and ag commodities against short equity index). Feels about right given the current field position of various asset classes.

position in commodities, SPX

Bullish Sentiment Approaching Extremes

Wanted to record that Jason's sentiment indicators are getting pretty stretched toward bullish extremes--both near term and long term.

When sentiment gets lopsided, then a trend reversal often approaches.

Couple that with Demark indicators signifying trend exhaustion on multiple timeframes, and it seems time to get cautious.

Personally, I added a bit to my index short positions today.

position in SPX

Treasury Yields Not Following Stocks

Usually, when market participants are ready to take on risk, they sell bonds and buy stocks. When bonds get sold, their yields go higher. Thus, higher stock prices and bond yields are often positively correlated.

Not this time--at least so far.

As stocks have lifted over the past few weeks, bond yields have not done the same. Ten yr Treasury yields are approaching mid December lows at ~1.8%.

This suggests that there is still lots of deleveraging behind the scenes--investors are swapping risky assets (perhaps assets grounded in Europe) for the safety in US Treasuries.

Stock bulls will argue that this is a positive. "Imagine what will happen to stocks when this pocket of 'de-risking' is past. Demand for stocks will swamp supply!"

Stock bears will argue that this is a negative. "Imagine what will happen to equities when this pocket of stock buying is past. Supply of stocks will swamp demand!"

And so it goes...

position in SPX

Bullish Pattern Resolution

The bullish reverse head and shoulders pattern forming recently in the equity indexes has indeed resolved to the upside.

The action hasn't been voracious out of the set up, but the tape has a persistent 'buy the dip' tone. Now that SPX 1280 has been cleared, this move technically 'works' to 1360.

I remain slightly net long (long commodity ETFs against short equity index). Should commodities continue to lift with stocks, I'll look to piece out of long exposure and add to my index short.

position in commodities, SPX

Why Wealthy People Own Gold

Straightforward explanation of why wealthy people own gold. The key point here is that the primary reason to own gold (in its physical form) is not to speculate in near term price moves.

Instead, wealthy people own gold to preserve their wealth against problems like inflation, bank collapses, and aggression.

Viewed thru this lens, owning gold is less of a 'buy-and-hold' investment strategy and more of a buy-and-will-to-the-next-generation family wealth preservation strategy.

More on AAII Sentiment

More on the AAII sentiment data, this time showing some historical perspective. Note the general behavior in the SPX as this series hits extremes.

As noted yesterday, just one piece of the puzzle, but a piece worth noting...

position in SPX

Strong Out of the Gate

The first trading day of the year saw some upside resolution to the reverse head and shoulders pattern forming over the holidays--although a late day pullback drained a bit of glory from the gains.

Would think technicians are eyeing the late October highs of 1285ish as a more definitive indicator that a new leg higher is underway.

By early afternoon, pundits predictably started trotting out the old saws about how the first few trading days of the year often 'forecast' the tape's annual performance. One tidbit I've picked up over the years: Don't succumb to early year urban legends designed to whip the masses into a bullish frenzy.

position in SPX

Leveraged ETFs

Decent demo of the slippage or tracking error that occurs when holding leveraged ETFs over time. While these vehicles may be useful for trading, the tracking error erodes long term returns, making them undesirable for investors with long time horizons.

no positions

More Gold Weakness

Action in precious metals continues ugly. New lows for the move today. Peering thru a longer time horizon lens, however, finds the yellow metal just now touching its multi-year uptrend line--a defined risk set-up for bullish traders.

One apparent takeaway from a macro perspective is that gold is not buying the thesis that the financial system is reliquifying--particularly w.r.t. the EU. Instead it is behaving like a wave of deleveraging, deflation in in the cards.

position in GLD

Euro Rumblings

Am continuing to pick up chatter like this that the situation in Europe is worse than appears. The EU version of TARP, the Long Term Refinancing Operations (LTRO), has seen a commensurate jump in bank funds with the ECB Deposit Facility to a record high half trillion euros.

The implication is that interbank lending in Euro is largely frozen. Banks are instead choosing to keep funds w/ the central bank.

Deja vu pangs here, as this is very reminiscent of the risk averse behavior we saw stateside in 2008.

Which probably shouldn't be surprising. After all, the situations are largely the same. Risk seeking behavior and easy credit ran up massive debt and leverage. Now risk appetites are waning. And price declines threaten leverage systems with insolvency.

position in SPX

Inverse Head and Shoulders Pattern

Back in early November technicians were eyeing the pennant patterns forming in the major indexes, and largely opining that the resolution of that pattern was likely to be higher. As we now know, the bulls were fooled as prices moved lower.

Now, technicians are eyeing a forming inverse head and shoulders pattern with similar optimism.

Will Hoofy's heros bring home the bacon this time? That seems to be the growing consensus.

Personally, I'm not playing it that way. There is far too much macro overhang for my tastes, not to mention overvaluation at the micro level, to merit holding a bunch of long equity risk.

Am currently about 10% net long, but that long exposure is in commodities. It is offset not quite one for one with an index equity short. This hedged position has not proven to be as effective this time around because of recent weak commodity performance relative to stocks.

Currently, however, my MO remains the same. Use price to my advantage to a) add exposure at lower prices and b) unload exposure at higher prices. All the while, I want to maintain sizeable dry power (read: cash and short term fixed income).

position in commodities, SPX

Hyper Hypothecation

On top of hypothecation and re-hypothecation, there is also hyper-hypothecation. Hyper-hypothecation is basically the re-hypothecation process done multiple times between various trading partners.

HH creates systemic counter-party risk in a leveraged system. If one trading partner in a chain fails to make good on a contract, then the entire system freezes up because there is not enough capital to meet all the margin calls.

Conceivably, prices may be in error if participants fail to understand the counterparty risks that cascade thru a market system. Once those risks are understood, prices are likely to drop...significantly.

This pretty much describes our ponzi-esque condition...

Hypothecation and Re-Hypothecation

The MF Global meltdown has brought the words 'hypothecation' and 're-hypothecation' to the forefront. Hypothecation is the relatively common situation where a buyer pledges collateral to secure a debt. The borrower retains ownership of the collateral, but in the 'hypothetical' case that the borrower defaults, then the creditor can take possession of the collateral.

In the US, the right of a creditor to take ownership of collateral if the debtor defaults is called a lien.

The lion's share of home mortgages reflect hypothecation. The home 'buyer' pledges the property to be purchased as collateral to secure a mortgage from a lender. Until the house is paid off, the creditor retains the right to take possession of the property if the borrower fails to keep up with mortgage payments.

Re-hypothecation occurs when financial entities pledge collateral that has already been posted by clients to support their own borrowing and trading. If a broker dealer such as MF Global puts up assets held by clients in 'margin accounts' as collateral to, say, speculate in Euro sovereign bonds, then this broker dealer would be engaging in re-hypothecation.

The immediate consequence of re-hypothecation is that it increases systemic leverage. More assets can be borrowed and controlled with less amounts of underlying equity.

As we noted many times on these pages, leverage becomes problematic when price moves against you. The higher the leverage, the smaller the change in price necessary to wipe you out.

Thus, when Euro bonds tanked over the past few months, MF Global was wiped out.

In the case where leverage is built on re-hypothecation, then the question becomes one of property rights. Whose property is lost when MF Global was wiped out? If re-hypothecation is in fact a legal aspect of a contract (e.g., a client of MF Global agrees that a condition of maintaining a 'margin account' at the firm is that holdings can be re-hypothecated for MF's own trading endeavors), then it is the client, not the firm, that is on the hook.

Thus, clients of MF Global may be out billions of dollars...