Tuesday Update: Equities Consolidate while Dollar Falls

Posted on June 2, 2009 by BMWFan

Equity markets spent the day consolidating the gains of the past two days. All major equity indices reached new highs above yesterday’s highs, but could not hold that level. Treasury bonds got a slight bid after yesterday’s decimation. The dollar continued its downward slide with oil ramping up in sympathy. Risk appetite continued to be high with the small cap Russell2000 putting up the best performance.

Pending Home Sales Surprise: How Many Will Close?

The market got a shot as the pending home sales released by NAR beat expectations.

According to the WSJ:


The National Association of Realtors said pending sales of existing homes in April rose 6.7% — the biggest monthly jump in eight years. The data built on a flurry of other recent reports suggesting that the housing market and the broader economy are stabilizing.

The good news about the economy keeps on rolling in providing fuel to the rally. However this particular headline might turn out to be the most misleading.

Two must-read articles discuss the consequences of higher mortgage rates and their impact on the retail mortgage market the day after.

Over the past few weeks, mortgage rates have spiked up. Though many prospective buyers would have locked their rates, a lot of others may not have been able to.

The jump in mortgage refinance applications over the past two months has created a jam in the mortgage processing pipeline. As a result, many mortgage originators were unable to process the applications, especially refinance applications, in time for them to make the rate lock (which they do by hedging their interest rate risk). So if this spike in mortgage rates does not recede, at least some of the current contracts may not close, due to the lack of mortgage credit at the right rate.

Market Sentiment Driven by Fear: The Fear of Being Left Out

Right now the market sentiment is being driven by fear: the fear of being left out.

This is a strange phenomenon, since typically the fear is of buying too high, only to see the market fall. This is one of the pitfalls of bear market rallies since even though portfolio managers are not convinced about the underlying fundamentals of the economy they are forced to participate since they are paid to be in the market.

The rally is being driven by optimism about future recovery and is fueled by excess liquidity which has been pumped into the system by central banks throughout the world. Though there is no doubt that things will get better, the market is perhaps over-estimating the extent of the recovery in the face of severe macro-economic challenges. However, bull markets have to climb a wall of worry, so unless proven wrong, the markets will continue to rally. However once it is proven wrong, the correction can be vicious.

The Anti-Dollar Trade

The anti-dollar trade continues to be strong with even the beleaguered Euro continuing to charge ahead taking out the 1.43 level today. Oil continued to trade strong with the July contract trading as above $69 before pulling back.

Though there is a lot of talk about inflation due to the Fed’s monetary policy, there has been very little attention paid to the dynamics of how the Fed’s current policy will lead to inflation. There is a large supply of spare factory capacity and unemployed Americans to keep prices on the input side low. Though short term interest rates may remain low, longer term interest rates are likely to continue to be creep higher over time, as the bond market adjusts to the huge overhead of new treasury supply. Higher interest rates will put a cap on economic growth which could have driven inflation.

The Fed’ s printing pre

ss is pumping money into the economy but so far that money has not translated to higher velocity of money.

Most of the excess liquidity has gone to strengthen the balance sheets of banks allowing them to off-load assets to the Fed, cut their leverage, and raise their capital ratios. The new money being printed by the Fed is essentially filing in the gap created by the loss of wealth due to fall in asset prices.

This can change soon if the economy shows signs of a stronger recovery leading to loser lending standards. However, as of now, small businesses continue to be short of credit, and with tougher lending criterion becoming the norm, a return to the go-go days of the past is improbable.

Fed’s Silence does not Imply No Plan

Though the Fed has not yet outlined how it will reduce the amount of dollars in circulation that does not mean it does not have a plan. Till this crisis unfolded no one thought that Bear Sterns will be bailed out using the Fed’s balance sheet, or the Treasury debt will be monetized using the Fed’s printing press.

The Fed is unable to outline its strategies at this point since those actions are likely going

to drain liquidity from the market. From the economic sentiment point of view, any perception of tightening liquidity can become a big damper. They cannot afford to take that risk right now when the economic recovery is in a nascent state.

However, once they see the economy finding a firm footing, and asset prices recovering, they will be more willing to lay out the plan.

The Fed has already stated that when it comes to hard to value assets, they plan to hold them to maturity, essentially taking out the liquidity as the loans are paid back, or taking losses if the default. Other assets with short to intermediate term maturities too can be dealt

with in the same manner. This gradual removal of liquidity is unlikely to create a shock.

The challenge of course will be securities with a longer term but those are not a dominant portion of their balance sheet.

The often cited comparisons with the Weimar Republic are very much out

of context. The ability to measure economic activity has increased by orders of magnitude over the past century. Not only is the data more accurate, it is also available real-time, cutting the reaction time of the Fed. The Fed is acutely aware of the risks, and will be monitoring them aggressively; there is no reason to suspect that they are asleep at the wheel.

With savings rate creeping higher and asset prices down substantially, the talk of hyperinflation, in my opinion, is pre-mature. It is driven more by trading houses moving away from the equities into the rally in inflation sensitive instruments like commodities.

This anti-dollar rally is not based on measured economic data.

From a trading perspective I do not see any point in fighting the group-think in the markets, except with quick counter-trend plays. However, I see a much higher risk in jumping in on the inflation band-wagon since it happens to be the flavor of the month.

One look at oil prices last year should fix those thoughts.

Market Outlook

Today, the SPX tested the 948-949 multiple times but was repelled. Though some may consider this market action as bearish, the fact that this is happening after a strong push over

the past two days, means that the bullish sentiment is still very strong.

Others are referring to the relative underperformance of the Banking index (KBE) over the past few days. I presume that the market is reacting rationally to the pending new equity issuance from banks. However, banks have been leading this rally, so I will not be surprised if the weakness in that sector results in the market pulling-back to test the 200Day SMA from the upside. We are also approaching the release of market-moving economic data next week, and traders are likely to book profits.

If the test is successful, which I expect it to be it will likely pull in a large amount of cash parked on the sideline. I plan to do some buying when the market retests the 200 day SMA. However, I will be hedging the positions with either puts or bearish ETFs till a clean break of the current level (the yearly high) occurs.

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Smashing Start to June

Posted on June 1, 2009 by BMWFan

The financial markets built upon the macro themes of the past week, as better than expected economic news from China and the USA lifted the equity markets.

The GM bankruptcy filing was completely ignored by the market. The reflation trade was back in full force, and Treasuries were sold hard, with yields getting close to the highs of last week.

The Dollar also fell though it finished off

its lows. The SPX smashed through its 200 Day SMA and closed at the high for the year, along with the Nasdaq.

Technical Buy Signals: Possible Explanation for Futures Spike?
The strong monthly close on Friday,

coupled with the open above the 200 Day Moving Average (on the S&P) triggered a lot of technical buying in the market. Fund managers who were waiting for equities to reach the 200Day SMA jumped in with their cash.

A lot of bears, who were shorting the market near the 200 Day SMA, had to cover.

The buying pressure was also aided by calls by several Market Guru’s including Michael Belkin indicating that we are now in a global bull market for equities. The Coppock Guide, one of the oldest Market Timing signal also issued a buy. This flury of technical buy signals might be the reason for the spike in future purchases at market close on Friday.

Economic Data Impresses the Market
The overnight session started off on a very positive note with both the Chinese PMI surveys coming above some cautious estimate.There were expectations that the PMI would show a renewal of contraction in China, leaving a lot of disappointed bears. In the US personal income and spending data, the ISM Manufacturing survey, and Construction spending all came above expectations.

Equities were led by energy and materials names which were aided by the weak dollar.

Treasury bonds were sold hard as fear of inflation is finding a receptive audience; though oil finsihed up gold finished lower. Most major equity indices closed at the high of the year.

Banks Raise New Capital
During the past month or two, a capital raise by banks has been a remarkably accurate buy signal for the general market.

Today JPMorgan and AmericanExpress announced that they will sell equity to repay TARP.

Our trading experience would be much more profitable if the banks would pre-announce, their capital raising announcement.

Market Outlook
The equity indices finished strong, and it is likely that the momentum will spill-over to Tuesday. However rising treasury yields has led many to doubt the whether the economic recovery underpinning the equity markets rally will ever materialize.

For today at least the markets ignored the yields and went-up across the board. The path of least resistance is up and there is no point fighting it.

I plan to close out my short term bearish put positions on any sign of weakness.

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US Assets and Foreign Ownership: Not an Easy Addiction to Break

Posted on May 31, 2009 by BMWFan

A significant challenge in predicting the outcome of the current economic crisis is that it is global, with multiple stake-holders each with their own interests, but with a lot of inter-dependence. The intertwined nature of the global economy means that no single player can deviate from the norm, without paying a significant price itself.

This interdependence has a significant impact on asset ownership strategies. In this article

I will discuss how foreign, especially Chinese, ownership of US based assets will be affected.

The US as the Driver of Global Growth

They used to say that if the US sneezes, Europe catches a cold. Western Europe is playing its part well with the Cold; but they have also been joined by Eastern Europe which has caught a severe flu. Asian economies show symptoms of allergies, though it likely to be seasonal.

The drop in US economic activity is giving the Western European economies a hard time; they also have their own sub-prime mess with the loans made in Eastern Europe to finance economic expansion. Eastern Europe will not recover till consumption in Western Europe recovers, which in turn will not recover till the exports to the US recover. Japan is in a similar boat with exports tumbling.

The emerging Asians economies have been affected but still continue to grow as internal demand continues to be strong in India and China.

China Stimulates; Recklessly Perhaps?

From the US perspective

the biggest wild-card is China. The Chinese central planners have relied on the US consumer to help lift the Chinese people out of poverty.

They are now trying to encourage domestic consumption with massive stimulus; however consumer behavior does not change overnight.

The Chinese are culturally tuned to saving, and to expect them to become profligate spenders at a time when millions are being laid off from empty factors is over-reaching.

Ano ther factor to keep in mind is that

the pace at which the stimulus money has been spent in China has raised questions about the nature of due-diligence done in making those loans. Until now the Chinese were growing at a break-neck speed and any overinvestment was quickly absorbed by rising demand. However, the same reckless style may not work out this time, since demand growth is bound to slow down, given the global economic conditions.

China and USD Based Assets

There has been a lot of speculation about the Chinese controlling the US bond markets, the Chinese dumping US Treasures etc. in the financial media. Given the size of the China’s USD denominated holdings, it is natural for the Chinese to be worried about the financial turmoil in the US.

With the current uncertainty in the global financial system, it is also prudent for them diversify their holdings away from paper assets into hard assets, like commodities and gold.

Economic Destinies Joined at the Hip

However, until their local economic consumption reaches a level that can challenge the US consumers, China will continue to need a healthy US. The Chinese have been dependent on the US consumer appetite, and their entire capitalist model is based on export-driven growth.

Their economy and fiscal policies cannot make a sudden U-Turn from that model, especially since any significant disruption could result in civil unrest. The fear of civil unrest is strong within the CCP since the absence of vents to express dissent leads to an accumulation of pent-up frustration; which can blow up at the most untimely moment.

The Hesitant Financier

Given the dependence of their economy on the US consumer, the Chinese cannot afford to take any action which will significantly destabilize the US markets or hinders US recovery. This means the talk of the Chinese dumping US based assets or stopping the purchase of US Treasuries is perhaps overdone.

The Chinese may not like what is happening in the US, but they do not have any other viable alternative market as of today. They cannot afford to pull the plug on the US since the repercussions on their own economic and political system will be severe. Plus as a significant owner of USD denominated assets, it is against their interest to trigger a collapse in US based assets.

How Long Will this Affair Last?

This situation of the hesitant financier is unlikely to continue for too long.

Within a decade, the size of the economies outside the US will reach a point where the dependence on the US consumer as the driver of growth will severely diminish.

Further export oriented economies like China will redirect efforts to spur domestic consumption and bring their economies back into balance with global norms.

However, it is premature to call an end to central role of the US in

the global economy. The flight to the dollar and US treasuries in Q4 2008 is ample evidence that regardless of what the pundits may say, when fear was in the air, everyone rushed to the perceived security of Uncle Sam.

After more than half a century of global leadership, the US’ central role will not change overnight. But the US can also not afford to be complacent. In the next few years, there will be alternatives available which will be big enough to offer the US serious competition. We have perhaps a decade to fix our house, before we lose the safety net provided by the bigger the safer economic group-think.

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Weekly Roundup: Strong Finish to a Choppy Week

Posted on May 29, 2009 by BMWFan

Asset prices went up across all asset classes on Friday, as stocks, bonds and commodities rallied with the US Dollar Index clos ing

at the lowest level of the year.

The equity markets had a spectacular finish after chopping in a tight range till the last half an hour. The energy sector outperformed most of the day with crude oil closing above the $66 level. The closing rally also lifted the materials, industrials, transportation and the banking index, while the Nasdaq closed at a new high for the year.

Yields fall as Bond Buyers Remerge
After the massive sell-off in long dated treasury bonds earlier this week, bond yields have pulled back substantially.

It seems bond buyers were waiting for this round of treasury auction to be done before they stepped back. Since yesterday’s highs, the yield on the 10 year bond have fallen from 3.758% to 3.465%, while they fell from 4.628% to 4.338%. The drop in yields provided a much needed relief to the equity markets which were a bit disappointed by the less than expected rise in the first quarter GDP estimates.

Dollar Sells Off
The US Dollar continued the sell-off with the DX closing at its lowest level of the year. The Euro-USD futures (6E) too closed at the highest level of the year at 1.4164, which happens to be close to the 50% retracement (1.4156) of the Euro’s fall from last April’s high (1.5985) to November’s lows (1.2326). Some market commentators are calling for the Euro to continue to rise against the dollar till the 61.8% retracement at 1.4587.

I feel that central bankers outside the US are likely to make noises to stop the rise of the USD. Most of the developed economies are dependent on the US as their primary export market and continuing fall of the dollar will hinder their exports. As a result we are likely to see efforts at competitive devaluation by other nations to stall the fall of the dollar. Some of their actions may be pure jaw-boning to stop speculative traders; others may take specific market measures to help their cause.

The Spectacular Close: Futures Spike 2% in a Few Seconds
What a lot of traders are talking about is the spike in the equity markets at the close. The SPX was trading in the opening range (903-912) for most of the day before it broke through

the upper resistance about 15 minutes before close. This seems to have triggered a large number of buy stop orders as the SPX surged into the close.

The move was violent and the SPX futures market, the most liquid market in the world, too got overwhelmed.

Though the closing print on the SPX (cash) was 919.14, the ES futures traded all the way up to 927.75 at 4:00PM. The chatter is that there was an order to purchase 2500 contracts of the SPX futures at close entered by a single dealer (JP Morgan according to some). This corresponds to a notional value of $575 Million dollars. This resulted in all the offers to sell between 914 and 927 to be hit.

This also triggered a lot of stop orders to buy, adding to the stampede.

Unnatural Market Action: Window Dressing or Something More?
It is common for stocks, especially those which have performed well in the prior month to trade up on the last trading day of the month. This is because of what is called window dressing where fund managers want to own stocks which have performed well to look good to their customers. However the spike at the end was not window-dressing.

There is some speculation that there was an effort to prop up the market into the close to ensure a finish close to the high levels of the month. It is very odd for a major dealer to wait till the close to enter such a large order especially on a Friday which happened to be the last trading day of the month. Liquidity tends to be less near the close on Friday as many traders and desk square out their positions before the weekend.

We are living in an era of significant government intervention in the financial markets.

What some call market intervention for the greater good, others call market manipulation. It is not clear what happened today, but it was certainly not normal.

My Portfolio: Trading
I booked some profits on the TLT I has purchased earlier this week when it reached my 3% profit target. I continue to hold the bearish TBT Put spread. My USO put spread is not doing too well as crude oil continues to rise thanks to a falling dollar. Though USO is now at the upper end of

the channel it is trading in, I will have to re-evaluate this position soon.

Altered Trading Mindset: Contra-Trend versus Trend Following
As readers may have observed, over the past few months my style of trading has become contra-trend. This is primarily a result of the market behavior over the past year where no trend sustains itself long enough to allow position trading. With sector rotations occurring every day, very few equity sectors are able to sustain their gains.

Over the past month, the macro themed trades like commodities and currencies are finally showing a sustainable trend. However, I have missed out on these trends because I could not reset my trading thought-process to follow the trend.

This afraid to hold fear seems to be common theme across many traders.

This perhaps is the biggest indicator that though the equity markets have risen in value, the bullishness which should accompany it is missing.

Market Outlook: 200 Day SMA Beckons but Short Interest Missing
The SPX is creeping ever closer to its 200 Day SMA which now stands at 928.60, about 1% away from the close today. This average is coming down about 2 points every day, and it is very likely that we will touch the average next week, especially after the bullish close this Friday.

Many market participants are expecting a big round of short covering once the SPX reaches this level and fresh money pours into the market to chase the rally. One caveat though is the large drop in short interest in the market.

According to Bespoke Investment Group,

the short interest on S&P 500 stocks is at the lowest level since February 2007, with the average stock having 7% of its float short.The largest decline in short interest was in the Real Estate Group.

The past few months have decimated the bears, who seem to

have thrown in the towel. Though this can be bullish in the short term, it also means that any correction may be more severe since there are not that many shorts who will buy to cover during a decline. One can argue that there are so much money on the sidelines belonging to the people who missed the rally that they lack of short interest will not matter.

In any case, we are living in very interesting times with the financial make-up of the world changing dramatically. For an investor it poses significant challenges. At these times, I like to remember that cash too is a position.

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Thursday Roundup: Bond Market Leads Equities

Posted on May 28, 2009 by BMWFan

The financial markets had a relatively sedate day with the action in the bond markets driving equities. The 7yr Treasury auction was met with reasonable demand which had a calming effect on the bond market which finally got a bid. This helped the equity markets finish positive for the day. The energy sector out performed today

with a greater than expected draw-down in oil inventories sparking another rally in oil and oil related equities.

Treasury Market Recovers

The treasury markets were volatile today, selling off before the auction and then recovering after the auction to finish strong.

One metric I follow at the long end is the difference between the 30yr and the 10yr yields. This spread narrowed today, closing below its

50 Day SMA for the first time since early January.

I presume the 4.5%+ yield on the 30yr bond is attracting buying interest, now that the technical factors associated with the spike in yields have abated.

Often the most complex market behavior has very simple explanations.

The recovery in Treasuries after the bond auction, could simply be attributed to the fact that the Treasury is done selling for this month; and the next auction is going to be in the second week of June, almost a life-time in the current markets. With the overhang of new supply not present, bonds were bid today.

Economic News: Continues to Point to Improvement

The equity markets have some good economic news to cheer.

There are clear signs now that the economy is gradually bottoming out. The new Jobless Claim number came better than expected, while continuing claims continue to go higher.

The Jobless Claim number seems to have topped out in the mid-600K and seems to be declining gradually. This job-loss number is a co-incident indicator; it hits its top when the economy hits bottom.

On the other hand the news from the housing market continues to be dismal, with almost 12% of all home mortgages delinquent.

Durable Goods orders came in higher than expected

in April but were revised downwards for March.

The GDP number tomorrow is going to be important in setting a tone for the market. There are some expectations that last quarter numbers may be revised up.

My Portfolio

I continued to day-trade today, using the action in the bond market to guide my equity futures trades. The TLT acted as a leading indicator for the price-action in equities for most of

the day.

I added to my TLT position in the pre-auction sell-off.

The treasuries are getting a bid and I expect a 3% return over the next few days.

I was a bit pre-mature in establishing my bearish put spread on the USO; it has rallied about 2% from my entry point. However, I am not particularly concerned since this is a spread which expires July. It is quite reasonable to expect a pull-back to the $60 level in the front month crude contract over the next two months. There is a huge overhang of excess supply parked in tankers anchored off-shore which the market

is ignoring.

Like last summer, the price of oil is being driven up by the falling dollar trade, where investors seek haven in commodities. However, the economic environment we are in is dramatically different from last year, and I believe that the speculative excess in the oil markets is not sustainable.

Market Outlook: 200 Day SMA Looms

The S&P500 is now within 24 points of its 200 Day SMA. I expect the market to test that level soon.

After a rally of such a magnitude, it would be highly unlikely for the market to come so close to the 200Day SMA but not touch it. Perhaps a bullish GDP report tomorrow will provide the ammunition for the market to make that charge

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Thoughts on Technical Analysis on Leveraged ETF

Posted on May 28, 2009 by BMWFan

There has been some debate am ong traders

on how to use technical analysis on leveraged ETFs. Some traders argue that technical analysis works the same way on the leveraged ETFs as it does on the non-leveraged ETFs. Others argue that the unleveraged ETF or index corresponding to the leveraged ETF is the better tool.
In this article I will review some topics of relevance when using technical analysis on leveraged ETFs. Henceforth, I will refer to leveraged ETFs as LETF and the underlying ETF or index as the underlying instrument, UI.

Characteristics of Leveraged ETFs

When viewing a LETF I first look at the following characteristics:
1. Duration of compounding: Until now almost all LETFs compound daily; i.e. they aim to achieve the leveraged return based on the previous day’s closing price with the base being reset every day. There is some talk of LETFs which compound on longer durations in the pipe-line; however in this article I will assume daily compounding.


2. The amount of leverage: Most LETFs offer 2x or 3x leverage.
3. Trading Volume versus the Underlying Instrument (Follow vs. Lead): In some cases the trading volume on LETFs is not big enough to affect the behavior of the UI; the LETF follows

the UI. In some other cases there is speculation that LETFs have become the trading instrument of choice and their price action affects the UI; the LETF leads the UI.

Price Behavior of LETFs vs. the UI: Path Dependency of Results

The fundamental reason behind the debate on technical analysis of LETFs is because LETF returns are path-dependent.

In a window covering many days, the final value of the LETF will be affected not only by the absolute movement in the price of the UI, but also by the path taken by the UI to reach that value. So a roundtrip in price of the UI will not only, not translate to a round-trip on the LETF, but the value for the FETF will be different for different price-paths.

For example, suppose a 2x LETF is trading at $100, as it the UI. If the UI moves up by 2% to 102 by the close of the day, the LETF will close at $104. If on the next day the UI moves down to $100, the LETF will close at $99.9216. However, if the price of the UI first went down to $98 and then back to $100, the LETF will close first close at $96, and then at $99.9194.

Non-Trending Markets: Volatility Decay

The skew between LETFs and UI returns leads to what some call the volatility decay on LETFs when the markets are not trending but trading in a range. The roundtrip example above illustrated that.

When the process continues over a larger time-period, this decay accumulates. In the above example, if the UI completed three roundtrips (100->102->100), the LETF’s value will fall to 99.94. If the size of the oscillations is large, the effect becomes even worse. So three roundtrips to 102 (100->102->100) will reduce the LETFs value to 99.765, a 23bp loss in just six d

ays.

The effect is even more pronounced in LETFs with 3x leverage which will have a value of 99.296, a loss of 70bp after three round-trips. The chart below shows the decay over six round-trips.
2x3x1

Path Dependence: When is it Relevant?

The path dependence of LETFs becomes relevant when the technique you are using relies on absolute price levels. Support-Resistance Levels, Gap Analysis, price targets based on patterns, Fibonacci retracements and extension levels, all rely on absolute price values. The behavior here gets significantly altered.

On the other hand, the technique you are using relies on relative price movements over a given time-frame the path-dependence of the LETF becomes less important. This is typically true of most price-patterns, oscillators among others. Note that the type of pattern observed may change; or the settings of the oscillator and their interpretation will change from the LETF to the UI.

In the next sections, I will address some specific topics of interest.

Time Window of Analysis: Intra-Day versus Multi-Day

If the TA is being performed exclusively within the time-window between the reset of the compounding events (i.e. intra-day), then almost all indicators, including those based on absolute price levels will work. Intra-day support-resistance, trend-lines, chart-patterns on LETF will provide the same information as their counterparts on the UI.

Note that calculated indicators (e.g. oscillators) will have to start with a clean slate at the start of the reset window to get a pure and true result; in practice this level of absolute perfection may not be necessary for the trader to make a decision.

Volatility Decay and Trend Lines

Volatility decay means is that the chart patterns observed will wary between LETF and the UI. The LETF has an inherent negative bias and the price will shift downwards. As a result during periods of consolidation the horizontal support and resistance lines get converted into downward trend lines. In the example earlier, where the UI makes multiple round-trips to the same starting price, the UI will form a forming a horizontal ledge pattern, but the LETF will form descending channel.

Adjusting Technical Price Levels

In the above example, a trader looking for a breakout will have to consider different price-points. On the UI a break above the upside resistance (102) will constitute a buy point.

In the case of the descending channel, the breakout buy point is not that obvious.

Is it the highest point of the channel or a break above the previous swing high, prior to the break above the channel high?

Volatility Decay and Gaps
Many traders consider price gaps in charts as strong signals, and use the price levels of the gap as key trading points. Due to the decay associated with the LETF, a downside-gap fill on an UI will often not translate into a gap fill on the

LETF, since the LETF would still not have recovered to that level. LETF may show an upside-gap fill simply due to volatility decay, when the UI is still trading above the upper side of the gap.

This phenomenon is very well illustrated by comparing the TBT the Ultra-Short Long Bond fund, and the Yield of the 30 Year Bond (TYX). These are good a pair since the price of the long bond varies inversely with its yield. Further the bond market is huge and technical trading in bond ETFs is unlikely to have a meaningful impact on the bond yields.
TYX vs TBT
The TYX gapped down on multiple occasions in late November of 2008. These gaps also appeared in the TBT. The TYX filled the gaps in late April and early May. However, even after the massive rally in TBT this week, it still has not filled all the gaps. TYX though is now at a much higher level.

During the period between February and mid April of 2009, the TYX were range bound and oscillated in a flat channel.

During the same period the TBT traded in a downward sloping channel as the volatility decay reduced its value. Any trading decisi ons based

on gaps on the TBT would have been against the spirit of gap analysis.

The Cart before the Horse Hypothesis

There is some talk in the media about how in certain sectors, trading in LETFS is having a significant impact on price movements. If the trading in the LETF becomes the primary driver of price movements, then pure technical analysis on the LETF may become significant. However, most of these hypotheses are primarily based on intra-day price movements which make the issue moot.

So Does TA Work on LETFs?

Without doubt, there is merit to chart reading and technical analysis on LETFs. However, the interpretation of these charts has to be adapted to account for their specific peculiarities introduced by the volatility decay inherent in their structure.

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Wednesday Roundup: The Bond Market Strikes Back at the Fed

Posted on May 28, 2009 by BMWFan

The financial markets were rocked by an unreal break-down at the long end of the yield curve today. The breakdown was even more surpris ing

since it occurred after a fairly successful auction by the US Treasury.

Though the economic future is uncertain, the yield curve is now at one of the steepest level, ever.

The equity markets started with a bullish bias, with all the indices trading above yesterday’s highs. However, the sell-off in the long-bonds led to a nasty sell-off in the equity markets also. Though the sell-off was small given the environment we are in, the breadth and ferocity showed that the equity markets are no longer ignoring what is happening in the bond market. Incidentally, the US Dollar strengthened against the Euro showing that an element of risk aversion is returning, as is the negative correlation between the US Dollar and US equities.

Mortgage Market Drives Treasury Collapse

The US bond markets are not trading in their natural equilibrium due to the massive intervention by the Fed.

The Fed has been buying Mortgage backed securities to keep mortgage rates low.

This has reduced the spread between the treasury bonds and mortgages to near historic lows. However, with a steady rise in 10year treasury yields, the rates on mortgages can no longer escape the treasury market.

Today, holders of mortgage bonds started selling them, realizing that their yields could not go any lower.

Further, higher mortgage rates will reduce refinancing and pre-payments of mortgages. This increases the duration (a measure of how soon a bond pays back the cash owed) of mortgage portfolios, and forces portfolio mortgage managers to hedge their duration risk by selling long bonds.

The Fed Juggling too Many Balls

The Fed kept the mortgage rates low by buying MBS, which resulted in the tightening of the spread between mortgages and treasury bonds.

They also had an eye on the stress-test results and wanted to keep the equity markets buoyant to allow the banks to raise capital. As a result the Fed’s statement after their April meeting did not emphasize their plans to buy Treasury bonds.

This gave the bond vigilantes the green signal to attack the long end of the treasury yield curve. Their task was easy given the pending supply overhang of treasury sales to finance President Obama’s income redistribution agenda. This created an imbalance between mortgage rates and treasury yields, which caused the dam to burst today.

Not only are mortgage rates rising, but Treasury bond rates are also spiking.

The Fed is clearly unable to juggle so many balls at the same time. What they seemed to forget is that too much cheer-leading will lead to an increase in risk appetite which was not going to be good for the bond market.

Bond Yields and Green Shoots

As I have been alluding too, the rise in bond yields is going to have a significant drain on any economic recovery. Whether it is the first time home buyer, a home-owner wanting to refinance, a corporation trying to raise debt or the US Treasury financing its deficit, rising bond yields are bad for the economy at this point of time.

In an unbelievable irony, the steepness of the yield curve is near historic highs, just two months after the Fed’s internal documents revealed that the ideal short term interest rates should be -5%; i.e. negative. This is likely to put a significant downward pressure on the Fed’s efforts to reflate asset prices, a cornerstone of the plan to the nation’s balance sheet.

The powers that manage our financial markets, cannot allow treasury yields to stay at this level and expect the economy to recover.

I personally expect strong Fed actions to scare the bond vigilantes. The equity markets will be carefully watching the bond markets and if the carnage continues, the equity markets are going to be affected negatively.

My Portfolio

With 30 year bond yields reaching a healthy 4.6%, I purchased some TLT today, and added to my TBT put spread positions. As I review the trade after hours, I may have pulled the trigger a bit early since the bond market dislocation is likely going to take some time to settle down. Hence this is going to be a position with a tight stop, while I look to re-enter the trade.

I also opened a bearish put spread on the USO which tracks crude oil.

Crude oil is trading well ahead of its fundamentals with a massive supply overhang. High bond yields are going to cast a shadow on economic recovery and crude oil is ripe for a pull-back as speculative sentiment changes.

OPEC is unlikely to make any changes to its quotas which will not reduce the supply overhang.

Market Outlook: Return to Quality

The bulls have been ignoring the bad news in anticipation of the end of the recession in the second half of this year. Their optimism is not misplaced since very well respected economists, including the ECRI have come out in support of

the claim. However the pace of recovery is likely to be anemic.

Equities are priced based on earnings, and it is still not clear how a slow economic recovery will translate to earnings in an environment with high yields.

The bond market melt-down may mark a turning point in investor sentiment. Investors are likely to focus more on the fundamentals, instead of chasing the hottest sector. I expect a rotation out of speculative junk equities which have been bid up spectacularly since March, into more quality names. Companies with greater predictability in their financial performance are likely to be in vogue again, perhaps marking the end of the speculative excess of the last three months.

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Monday Roundup: Little Kim no Match for American Consumers

Posted on May 26, 2009 by BMWFan

The equity markets reversed course today

in another dramatic session.

North Korea shocked the world (at least according to the head-lines) by testi

ng a nuclear device which actually worked. This lead a flight to safety in the overnight market with the US Dollar getting a strong bid and with the EUR-USD trading as low as 1.386 down from its close above 1.4. The equity markets gapped-down open but continued to rally up from the

open.

Consumer Confidence Lights a Fire

The initial rally in the equity markets was not unexpected. The markets had sold off hard into the close Friday as traders did not feel comfortable holding long positions over the long weekend. The gap-down open gave traders an opportunity to re-initiate the long positions.

However what lit the spark was the biggest gain consumer confidence since 2003; it came in at 59.4, well above the consensus of 42.6. The market ignored the worse than expected Case-Shiller Home Price Index numbers, and of course Kim Jong-Il’s nuclear test.

Underneath the Consumer Confidence Numbers

The consumer confidence was led up by its future expectation’s component, with the expectation measure rising to 72.3, the highest since December 2007, while the gauge for current conditions was at 28.9, higher from last month’s reading of 25.5, but a far cry from future expectations.

The divergence between the two components of the consumer confidence number, mirror the equity markets very well. Though current conditions are nothing to write home about, the expectations for the future are driving the market higher. However, the risk to these green shoots remains high.

The yields on long term treasuries continued to rise today. The reduction in mortgage payments is a key pillar of the Fed’s strategy for recapitalizing the American consumer. The expectations are that lower mortgage servicing burden, will allow the consumer to spend even under times of reduced credit availability. However, that experiment is likely to fail if yields continue to rise, since mortgage spreads are near historic lows and any rise in treasury yields will affect the mortgage rates.

Risk Tolerance Returns

The equity markets were led by the small cap Russell2000 and the technology heavy Nasdaq100.

The longer dated treasuries were sold, while the US Dollar lost most of its earlier gains, closing almost unchanged.

This was in a sharp contrast from last week, when equities were being sold, even when the US Dollar

was collapsing against. The positive correlation between the Euro and US Equity market returned today, perhaps indicating a more subtle approach to selling US based assets, compared to the indiscriminate selling of the previous week.

My Portfolio

I continued to stay primarily in cash and day-trade. I was able to close out my short Euro positions at a profit, while I continue to hold the bearish put spread on the TBT, perhaps in the vain hope that the long bond yields will pull back to allow the green shoots to grow.

Tomorrow’s Outlook: 200 Day Moving Average

The holid ay shortened weeks typic

ally h

ave a bullish bias.

The market was oversold coming into the open today and was bought right from the get-go. Typically, the day after a strong trend-up day also has a bullish bias, especially at the open.

This is primarily due to trapped shorts that capitulate the day after the trend-up day has shredded their position.

I do not expect another ripping day either after such a strong rise. We are likely to remain range-bound tomorrow, unless of course the existing home sales data surprises to trigger another rally.

The other big factor affecting the market is the looming presence of the 200 Day Moving Average of the SPX at 934.36, well in the striking distance from today’s close of 910.33. A positive catalyst will send the SPX to this critical level.

What happens at that level is going to be an important factor in determining where this market goes.

If we break through this level on a convincing basis, it is likely that the SPX will hit 1000 or even higher. There is also the chance that the market will sell-off after it hits the 200 Day SMA, and start the long awaited, but still nowhere to be seen, correction.

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Weekly Roundup: Appetite for US Assets Crashes

Posted on May 22, 2009 by BMWFan

This week marks a possible turning point in the current financial crisis. It seems all of a sudden the world has awakened to

the risk associated with the rescue efforts of the Federal governments, primarily the oversupply of dollars.

The trigger for this sentiment change was S&P’s decision on Thursday to lower Britain’s outlook from stable to negative.

This resulted in a major sell-off across all asset classes.

Yields on 30 Year treasuries jumped up by 31 bps, the US Dollar lost almost 3.5% against the Euro, and equities gave up most the week’s early gains.

U-Turn in Risk Appetite

Since the fall of Lehman Brothers, the US was seen as the safe haven with treasuries being bid to astronomical levels, and the dollar strengthening. As news of stabilization of economies across the world trickles in, investors are now looking beyond the safe haven and focusing on the end-result of the government policies.

Th anks to the numerous b

ailouts, and the extensive spending plans of the Obama administration, the US Treasury will have to issue a lot of debt to finance Government spending.

Coupled with the Fed efforts to flood the system with liquidity, there is a fear of inflation and the subsequent loss of the Dollar’s purchasing power. As a result, US based assets, which were the safe-haven of choice a few months ago, are being dumped like hot potatoes.

Some of the movement is purely due to trading momentum.

As equities have become range-bound, and no longer trending, traders are looking for new trends. US treasuries and foreign exchange markets are seen by many as the next trending market, and with each move up, more trend-followers are jumping into the fray.

Selling Overdone?
My personal view is that the reaction of the market is overdone. This is especially true when it comes to the EUR-USD exchange rate.

This fact is being acknowledged by world leaders. Eurogroup Chairman, Jean-Claude Juncker came out with a statement that the rise in the Euro is not line with fundamentals, and economic recovery in Europe is still some way off.

The White House also reaffirmed that it sees no risk to the US’ AAA rating. One argument in favor of the White House’s statement is that Americans are taxed at a lower rate than Europeans, and the US Government (unfortunately) has the ability to service the rising level of debts, by raising taxes.

A part of the selling the bond market was driven by bond dealers taking up short positions, before they bid on the large amount of Treasury bonds which will be issued next week.

Euro-Zone: In a Much Worse Shape

As I have written in earlier articles, the Euro-zone is facing a financial crisis similar to the US, but with much more limited set of tools to work with. This article in Washington Times goes into details of the problems, including the specter of a complete collapse of major banks whose liabilities are often greater than their government’ s ability to bail them out.

I had an interesting exchange with well known commentator Ashraf Laidi on the forum on his web-site, ashraflaidi.com. Ashraf wrote:

“… making a claim such as the “US is the best of the worst” opens up a whole new discussion that tend to reach socioeconomic boundaries that are beyond the scope of Forex market supply and demand. The hard currency discipline of the ECB may have some macroeconomic hardships but not on its currency, while the Fed is now suffering the worst of corroding home values, contracting credit, soaring unemployment each underlined by severe consumer deleveraging. a country that depended on credit for so much longer than E(e)urope is now having that “drug” taken away from it. And the consumer h as now left

a void in aggregate demand. And that’s not good for the consumer/debt-dependent US dollar”

My take-away is that right now, there is a flight out of US Dollars in the Forex markets, which tend to trend and in the short term the flight will continue.

The ECB is constrained by its ability to act in an aggressive manner due to conflicting stake-holder interests, a limited charter and also a fear of doing too much.

A smaller central bank role may allow market forces to work their way through; however it also increases the risk of a much worse crisis.

The ECB’s hard currency discipline may come back to haunt it if it is forced to act in a much more aggressive manner further down the road. So far the ECB has been behind the curve in reacting to the crisis, erring on the side of less intervention. However, they have been forced to follow the US Fed’s lead after some time.

If the same trend continues, the very factors which are pressuring the US Dollar right now may also come to bear on the Euro-Zone. This does not bode well for the intermediate term outlook for the EUR-USD, once the current anti-dollar surge in the market subsides.

My Portfolio
I continue to day-trade without establishing any significant position. Today I primarily traded the EUR-USD futures (6E), along with some equity futures.

My IYR puts are doing fine. I also opened a small bearish put spread position in the TBT.

I expect some pull-back in long bond yields next week and a spread is a low-risk method of taking that view.

Trading Macro Events: A Lesson
I had also opened a short Euro position yesterday, based on some topping patterns I had observed. What I had not accounted for is that much of the Asian markets were closed when the ratings news about Britain came out. As a result, after pausing around the close of the US markets, the Euro continued to rise once the Asian markets came on-line, and caught up with the selling.

The Euro traded within 2 ticks of the stop on my position. I decided to add to the short position within a few ticks of my stop. This strategy lowers your average cost of the position and with the stop close to the entry price, the additional loss is limited. As of close of trading on Friday, the Euro had pulled back 50c from the intra-day high, close to my break-even point. I plan to exit the position on any weakness, with the focus on being break-even.

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Thursday Roundup: Sell the US

Posted on May 22, 2009 by BMWFan

The world market s

got a shock today with S&P lowered its outlook on Britain to negative from stable, a signal that the sovereign AAA ratings may be cut.

The primary reason cited was the debt/GDP ratio passed 100%. The market soon acknowledged that the US also has the same risk. This resulted in a sell-off across all US assets. The USD fell across all currencies by almost 1%. The long treasury bonds fell by 2% and the equity indices shedding 1.5-2% across the board.

Fed Intervention leads to Treasury Collapse

The Treasury bond prices collapsed after the Fed came to the market to buy US treasuries under its Quantitative Easing policy.

However, the market was disappointed by the amount of bonds purchased; bonds worth $45B were offered but the Fed purchased only $7B.

Government Interference and Unstable Markets

This is another indication of how government interference leads to unstable markets. The expectation of Fed intervention has led to many (including me) to buy bonds, under the assumption that the Fed will try its best to allow the green shoots to grow by keeping the cost of borrowing low.

However, once the natural balance of the market is interfered with, any unexpected event can result in a rush to the exits. Today the ratings challenge led many to sell to the Fed and when the Fed could not buy it all, prices just collapsed.

Equity Markets: Range Bound Trading Continues

As I had alluded to, the market seems to have found a trading range between 875 and 930 on the SPX. After being repelled by the upper end of the range yesterday, the market found support at the lower end today, nicely rebounding into the close.

The morning’s job loss numbers came better than expected but continuing claims did not pause. This disappointed some bulls who were hoping to see a further drop in jobless claims. Coupled with the weaker dollar theme, the market was under pressure throughout the day. Gold was up on weaker dollar and is enjoying a nice bull run.

My Portfolio
I continue to day-trade without opening any new positions long or short. Today the IYR traded in a wide range, and I sold some of my puts during the weakness, only to buy them back on market strength.

The debacle in the TLT today reaffirmed my decision to close out the bulk of my position last Friday; better to be lucky sometime.

Short the Euro

After the Euro breached 1.390 mark against the USD, I opened a small position going short

the Euro and long

the USD. This is a contra-trend trade, where I will keep tight stops (< 1.0%). I do believe that the four day collapse in the dollar is over-done to some extent, and there is likely to be some profit-taking and risk reduction before the long weekend.

On a more fundamental basis, I believe that the Euro zone is in a much tougher situation than the US, and the ECB does not have the sovereign power to respond appropriately. The Euro-Zone will have to follow policies similar to the US Fed.

They will just do it later than needed, when the situation is even worse.

So even though I am bearish on the US Dollar versus the commodity currencies (AUD, CAD, NOK), I am even more bearish when it comes to the Euro versus the rest.

Tomorrow’s Outlook

I continue to expect equity markets to trade range bound, with a slightly bullish bias.

We had two days of strong price losses, and we are due for a rebound, especially going into a holiday weekend.

I expect a pause in the dollar’s slide and the treasuries to get some bid.

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