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Trader’s Narrative

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Morning Notes For November 11th 2010

The following is a guest post by a buy-side analyst working in a US asset management firm. The author’s comments are in italics. I welcome your feedback in the comments:

  • A Gold Standard, which can prompt brutal economic adjustments and exacerbate inflationary/deflationary forces via accelerated capital flows, is incompatible with the demands of modern economies, most critically a fractional reserve banking system and open capital accounts. – Roubini Global Economics – most would agree that the gold standard exacerbated the great depression by handcuffing monetary policy.
  • Greenspan oped – says China is continuing to suppress its currency while at the same time the US is pursuing a policy of currency weakening. The twin weakening of both the yuan and the dollar is causing a firming of exchange rates in the rest of the world. Greenspan says “we should discourage reserve accumulation whose sole purpose is to suppress exchange rates”. Greenspan calls on the IMF to initiate a set of rules that limit the accumulation of reserve assets and sterilize capital inflows. FT
  • President Barack Obama asked G20 leaders to shift global demand away from US consumption and borrowing and called for market determination of exchange rates to reverse undervaluation, but analysts remain skeptical as to what can be achieved at the November 11-12 G20 Summit. – Roubini Global Economics – the old model of building an efficient manufacturing base, which exports goods to US consumers is probably unsustainable. Countries that relied on that model for growth will likely be disappointed and are better off shifting ‘global demand away from US consumption.’
  • Stephen Roach, Morgan Stanley’s non-executive Asia chairman, said Asian cur¬rencies will strengthen and U.S. jobless benefits should be expanded. – Bloomberg
  • Deutsche Bank CEO Josef Ackermann said quantitative easing is the right approach for the US, which has limited tools to stimulate its economy. – Bloomberg
  • Francesco Garzarelli, chief interest-rate strategist at Goldman Sachs in London, said a bailout of Ireland and Portugal through the European Financial Stability Facility would resolve current market tension and not lead to contagion. – Bloomberg – Irish sovereign debt continues to sell off, resulting in a spike in yields and, thus, borrowing costs.

Ten Year Ireland Sovereign Debt Yields
ireland sovereign debt 10 year Nov 2010

While there are some undeniable indications of an overbought market right now, the bull market that started in March 2009 seems to be intact. Those indicators are of course mostly of the sentimental variety. We looked at the Hulbert Newsletter sentiment for the general market and the Nasdaq in particular yesterday.

Today the results of the weekly Investors Intelligence survey show very little has changed from last week. The bulls are slightly higher at 48.4% and the bears inched down to 23.1%. Over all however, we aren’t seeing the type of wildly bullish ebullience evidenced by either the Hulbert indicator or the Investors Intelligence survey itself just a few months ago.

But as I mentioned, the market internals suggest that the overall health of the bull market is intact, notwithstanding any potential short term corrections. Back in January when the year was still very young, I made a similar suggestion based on the pattern of new highs and new lows, The High Low Index & The Stock Market: Up!.

In a nutshell, the market usually makes a major top when there is a dearth of stocks making new highs. That is, when the stock market is rallying with the coincident indicator of a large portion of new highs, it is highly improbable that it will turn out to be a major top. The most recent rally from September has induced a concomitant rise in the number of new highs.

So I once again looked at the indicator which tracks the number of highs on the Nasdaq (I don’t use the market internals for the NYSE unless they’ve been scrubbed of non-operating company issues). The indicator is rather simple, it tracks the number of new 52 week highs divided by the number of new highs and new lows. To smooth things out we then apply a 2 trading week (10 day) moving average.

Click to see larger version of chart in a new tab:
NASDAQ new high low index Nov 2010

The two major market tops in 2000 and 2007 occurred with a lower number of new highs. So as the indexes were powering higher, there were less and less issues actually making new highs. So in effect, fewer and fewer of the stock index constituents had to do most of the bull’s work and then eventually all the bull’s work until they just gave up.

But that is not what is happening right now. As the market revisits the April levels, the relative number of new highs is relatively high. It reached a short term peak in mid-October at 87.7% and today at 85.6%.

According to Ned Davis Research the stock market has never formed a significant top when a significant portion of securities are making new 52 week highs. None of the 13 bull markets since 1967 (as defined by the firm’s own stringent requirements) ended when 25% or more of issues were hitting new highs.

So while I won’t be surprised by a pause or a short term correction to digest the move up, especially as we approach an area of previous resistance (thanks to the April 2010 top), the health of the bull market remains stable.

The market took a breather yesterday with many previously strong indexes and commodities selling off. The decline in silver was especially pronounced and produced a reverse hammer candlestick which has obviously bearish connotations.

Of course, yesterday the CME raised the margin requirements for silver from $5000 to $6500. While this is being credited with causing the reversal, I don’t think that it completely explains what happened. It definitely contributed to it but often we grasp at news or reasons for the market’s moves when all you need to do is watch the price action itself.

Anyone paying even cursory attention would know that the precious metal was already extremely overstretched to the upside and had been sporting extreme bullish sentiment for some time. I outlined just how extreme in late September when silver reached a new 30 year (nominal) high accompanied by a 95% bullish DSI.

Silver managed to shrugged that off and went on a parabolic rise peeking above $29. Personally I was expecting it to reach the nice round number $30 before reversing. But it doesn’t look like it is going to now.

There is currently a rare technical occurrence in silver: the relative distance from its medium-term and long-term moving averages is at an upside extreme. In the past 30 years, that has only happened 6 other times and all of them were instances of a major top:

silver parabolic chart Nov 2010

Needless to say, the RSI indicator also reached an extreme overbought level yet again. Note that I’m ignoring instances where either one or the other is at an extreme and looking at just instances where they are both signaling an overbought condition. This confluence of overbought extremes identified the major tops in silver in the following years: 1982, 1987, 1998, 2004, 2006 and 2008. The current condition remains to be seen but historical precedent would suggest this is a major inflection point.

Interestingly enough, the large commercial hedgers have slowly reduced their large net short exposure since late September. They are still maintaining a large chunk of contracts short (54,811 net short) as of November 2nd, 2010 which is the latest data available. Meanwhile, small speculators are net long with 16,257 contracts.

Morning Notes For November 9th 2010

The following is a guest post by a buy-side analyst working in a US asset management firm. The author’s comments are in italics. I welcome your feedback in the comments:

  • USA gets downgraded by a Chinese rating agency – this news actually hit Tuesday 10 AM ET. China’s Dagong Global Credit Rating Co. downgraded the U.S. to A+ from AA, with a negative outlook, because of quantitative easing – Bloomberg
  • Gold continued its post-QE2 climb, surpassing the US $1,410 mark on November 9 as China announced a number of measures designed to curb inflows of hot money. – Roubini Global Economics

Ten Year Chart of Gold
gold price 10 year chart Nov 2010

  • An international backlash against the Federal Reserve’s move last week to pump billions of dollars into the U.S. economy is threatening to undercut the Obama administration’s economic goals for this week’s G-20 meeting of world leaders. – Washington Post
  • US homeowners can’t take advantage of lower rates – homeowners are unable to take advantage of low rates because of negative equity and/or stringent new lending requirements. Refinancing levels are well below where they normally should be given how low rates are. FT
  • “New risks for munis” – The greatest default risk is in smaller municipalities with shrinking tax revenue bases and large projects. WSJ
  • According to the WSJ, the Fed is expected to grant approval to some US banks to resume capital payouts to shareholders (either via buybacks and/or dividends) although its not clear whether a public announcement will be made (or if the banks will simply be given guidance privately).
  • US Housing market – new bleak Q3 report published from Zillow – “Nationally, home values continued to decline, and several local markets that had been showing strong signs of stabilization took a turn for the worse.” – Zillow
  • Inflation/food worries – one of the lead FT articles – “food price fears as US warns on crop yields” – the US government again on Tuesday cut its forecast for corn yields, raising concerns about surging prices. Worry growing over supply shocks. – FT
  • CNBC’s Steve Liesman reports that the G20 Leaders Summit communiqué, it is officially be published this weekend, will call for more flexible, market-based exchange rates and will also declare that no financial institution should be too big to fail. The leaders are expected to endorse the Basel III rule changes. Large systemically important banks will be encouraged to create “living wills.” – CNBC
  • Banks – the G20 has drawn up a “two-tier” bank regulatory plan, whereby global regulators would focus their attentions on large world-spanning institutions instead of more domestic-focused firms. This means that many banks in Japan and China, which have a more domestic focus, would wind up being exempted from the new regulatory framework. A list of 20 large global banks whose importance is “systemic” is being drawn up. Some of the banks that may wind up on that list: GS, MS, BAC, C, RBS, HSBC, Barclays, RBC, Standard Chartered, UBS, CS, SocGen, BNP, Santander, BBVA, Mizuho, Sumitomo, Nomura, Mitsubishi, Unicredit, Intesa, DB, and ING (and some think the Japanese banks may wind up being removed as they are primary domestic institutions). FT
  • Goldman Sachs Asset Management’s Jim O’Neill said China is accelerating the yuan’s appreciation as part of the “grand bargain” to win US support for Beijing to gain a bigger say at the International Monetary Fund. – Bloomberg
  • The National Federation of Independent Business Index of Small Business Optimism improved by 2.7 in October to 91.7, though it remains in “recession territory” and well below the long-term average of 98.7 – Roubini Global Economics

NFIB Small Business Optimism Index
nfib small business optimism index chart Nov 2010

The sentiment sands are shifting rather quickly these days as the market rally takes most by surprise, forcing them to reevaluate their positions. We’ve already covered the recent data in the weekly sentiment overview and the necessary sentiment addendum so I won’t blame you if you’re sick and tired of sentiment surveys.

The latest development arrives courtesy of Mark Hulbert who is the keeper of a 30+ year sentiment indicator which tracks the mood of newsletter editors for equities, bonds and gold. This is similar to the Investors Intelligence survey which has been running for about the same duration but instead of the whole newsletter universe, it focuses on a smaller subset that actively tries to time the market for various asset classes.

According to Mark’s latest column, there has been a large jump in bullishness on the part of the newsletter editors that try to time the equity market by shifting their exposure.

Currently, the Hulbert Stock Newsletter Sentiment index (HSNSI) is at 60.8% meaning that the average equity market timer is telling clients to be long equities with almost 61% of their portfolio. That is a jump of almost 40% points since late September 2010. And it is very close to the “line in the sand” level of 65% which has coincided with market tops historically.

For example, in late April 2010 the HSNSI peaked at 65.5% along with the market. And again in January 2010 at 65.2%. But then again, this isn’t a 100% reliable signal. As an example, consider that in October 2006 the HSNSI once again peaked at those levels (67.8%) but the S&P 500 index shrugged it off and continued rallying well into February 2007.

The extreme bullish sentiment from newsletter editors towards equities is also confirmed by the Hulbert Nasdaq Newsletter Sentiment index (HNNSI) which tracks the exposure to the Nasdaq Composite by market timers:

Click to see larger chart in a new tab:
HNNSI sentiment bullish extreme Nov 2010

The Nasdaq being the home of the more speculative companies, the bullish sentiment for the HNNSI is a bit more volatile with a higher range. Usually we see tops in the 70%-80% range of bullishness but there have been other times where the market has reacted to less bullish levels in the HNNSI.

In April 2010 however this sentiment indicator hit one of its highest levels (80%) just as the market topped out. Last week the HNNSI once again hit 80% implying that the average market timer is suggesting their clients put 80% of their portfolio long the Nasdaq. As of Monday it backed off slightly to 73%.

All this suggests that we are definitely seeing a build up of speculative froth as investors and traders react to the rally by succumbing to the allure of going long. It will be interesting to see what the AAII and Investors Intelligence surveys make of this in the next few days.


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