Time To Buy VIX On Complacency Reply

The recent rally in global equity markets and a sense of relief created by coordinated actions of central banks have created a sense of complacency amongst investors. Bullish sentiment is also above historical averages despite risks of debt crises in Europe, the US, and Japan along with significant slowdowns in China and India. As a result, the VIX has hit multi-year support at 14.54 on Friday and is currently not trading much higher at 15.04. Similar lows in volatility have not been broken since 2007 (and the 1990s before then) the VIX breaking below fifteen has been quickly been followed by sell offs and increased volatility. I recommend buying the VIX at these levels, because technicals indicate a limited downside of a few percent and fundamentally investors have ignored the structural problems in the global economy. One inkling of bad news or a below expectations manufacturing or jobs’ Friday number will likely send the market back into a downtrend panic.

One Year VIX

The way for investors to capitalize off of complacency is by buying calls on either the VIX or iPath ETNs correlated to VIX futures (VXX for short term futures, VXZ for medium term). As a warning, VXX does not perfectly reflect the movement of the VIX, but VXX and VXZ are the best ETNs available for investors to profit off on increasing volatility. I also recommend traders using the VXX to place a stop somewhere between 19.25-19.80 to protect yourself from an economic “Goldilocks scenario” that can drive the VIX down to the 12-13 range.

Source: Nicholas Pardini


A Brief Remark On Gold And Bond Market Sentiment Reply

As a brief update to Monday’s missive on the gold sector, we wanted to appraise readers of the fact that the HGNSI (Hulbert gold newsletter sentiment index) plunged Monday to a new low for the move of minus 15.7.

This means that gold timers now recommend a net 15.7% short position, which is actually quite rare. There have been forays into negative territory by this indicator before of course, but they were generally short-lived. A reading of 15.7% is among the most extreme seen in the course of the past several years. In fact, not since the depths of the 2008 crash have such extreme readings been recorded.

Since gold stock indexes have broken below an important support level, this deterioration in sentiment is understandable, but it is also a sign that the remaining downside potential is becoming more and more limited.

Click charts to enlarge

The break of lateral support in the HUI has turned gold timers mega-bearish. The last two times they were this negative on the sector were in October/November 2008 and March 2009. Those dates should ring a bell.

As the past examples of HGNSI plunges into double-digit negative territory show, one needs to be alert to a potential turning point when they occur. The HUI’s 200-week moving average in the 443 area is probably the level that will contain a putative ‘worst case’ decline, but a turn could easily happen sooner than that. If the market were to turn around very quickly and managed to close above the broken support level again, we would regard that as a very bullish development.

Bond Market Sentiment

We were struck Monday by a sudden proliferation of expressions of bearish sentiment on the US treasury bond market in the financial media. One market commentator proclaimed that the ‘mother of all shorts has begun‘. Investment banks were mailing out advice to their clients as to ‘what to do if bond yields rise‘ (as an aside, we have a suggestion in this context: whenever t-bond yields rise, the developed world’s best performing stock index is usually Japan’s Nikkei).

In the FT Alphaville article on the topic (linked above), the following chart by HSBC was helpfully provided – it shows which stock market sectors are likely to do best when t-bond yields rise:

Above is the ‘What to do if/when t-bond yields rise‘ manual by HSBC. We would simply buy the Nikkei.

Reuters meanwhile informs us that ‘bond bears growl again as US yields surge‘:

The rout prompted investment bank UBS to declare the start of a long bear market and even prominent investor, and one-time bond bull, Jeffrey Gundlach says yields will rise further.

What has investors questioning the bond market’s ability to sustain super-low bond yields is the steady improvement in U.S. economic data that has buoyed the stock market to four-year highs. It means the flight to safety that has underpinned capital flows to U.S. debt in recent months may be eroding.

“There appears to be an asset allocation shift out of Treasuries and into risk assets that includes equities,” Tom Sowanick, chief investment officer at OmniVest Group LLC in Princeton, New Jersey, said on Friday.

News that a majority of banks passed the Federal Reserve’s stress test is another reason for investors to gain confidence to take more risks. “Banks now have been given a green light from the Federal Reserve to return capital to shareholders. This is positive,” Sowanick said.

Treasuries are the worst performing U.S. bonds so far this year. Barclays Capital’s Treasury total return index was down 1.68 percent after a stellar 9.81 percent gain in 2011. As Treasuries prices drop, yields go up.

What? Even Jeffrey Gundlach is turning bearish on treasuries? Shiver me timbers! If we had a single cent for every time the bull markets in JGB’s and US treasuries have been prematurely declared to have expired by a sheer endless parade of experts, we’d have bought the entire US by now and used it as decoration for our front lawn.

Let us see: the ten-year note yield is at 2.35% at the time of writing, and a veritable herd of bond bears is suddenly crawling out of the woodwork? Color us unconvinced. Just because stock prices have risen for a few months, nothing has really changed fundamentally. Europe remains in as critical a condition as before. The probability of a US recession happening this year remains quite high. China has just created a fresh growth scare as well (more on this in a follow-up post).

As our readers know, we don’t like government bonds as an investment vehicle for a number of reasons – chiefly due to the fact that the income one derives from them is obtained by coercion instead of voluntary exchanges in the marketplace.

However, this does not mean that we have no opinion on the market’s trend. As to that, please wake us up when the big bad bear has really arrived. As the long-term chart of the 30-year bond depicted below shows, there could be quite a big correction in prices before the trend is actually in danger. Moreover, the cumulative net cash flows into the bearish Rydex Juno fund (which shorts treasury bonds) are currently higher by a factor of 11.5 than the cumulative cash flows into the Rydex long bond ‘1.2 times’ strategy fund. Bond bears lost no time whatsoever to jump aboard the shorting train, as the cash flows into the Juno fund have jumped by more than 30% since the beginning of the year.

There is certainly room for treasuries to fall (and yields to rise) further in the short term – there could be a brief bounce as equity markets correct, followed by a new leg down in bond prices. That should create sufficiently oversold conditions to allow for the bull market to resume. Speculators are currently net short t-note futures, but their position is not yet at an extreme. We think it will get closer to such an extreme before the market actually turns up again. While we agree with Bill Fleckenstein and others that there will eventually be a ‘funding crisis’, i.e., a fiscal crisis in the US, we think we are still years away from that point (obviously we may be forced to reevaluate this view depending on future developments).

Above is the 30 year T-bond price and yield since 1980. It will take a big price decline to endanger the long term uptrend.

Above is a weekly chart of the 10 year t-note yield. The recent fast move higher has brought bond bears out of the woodwork. Yields are now at a first level of resistance, but this could easily be broken in coming weeks. However, we would not expect to see much more than a test of the downward sloping long-term channel.

It is a bit surprising to us that an increase in the t-note yield from 1.90% to 2.35% has created so much anecdotal bearish sentiment. We don’t think that when the actual long-term turn in the bond market finally comes, it will be advertised that well. It seems far more likely that it will sneak up on people who by the time will have become quite complacent about bonds, similar to the secular upturn in US yields that began in 1942. The JGB market looks actually ‘riper’, as people have indeed become quite complacent about it. Japan is also quite likely to experience a fiscal crisis sooner than the US, as its public debt situation is already quite stretched, to put it mildly.

Charts by: Decisionpoint, StockCharts, HSBC 

Source: Seeking Alpha

The Australian Dollar: Another Look Reply

About a month ago I posted here on the Australian dollar and why I thought it was an attractive short. To sum up that post, the Aussie is expensive in terms of purchasing power parity; Australian exports are waning, along with China’s; and commodities, at the core of 19% of Australia’s economy, are weakening in price, displaying less global demand. At the same time, I acknowledged that Australia’s interest rates are higher than those of the US, which explains at least some of the enduring strength of the Australian currency.

Since then, the Aussie has moved down by about 2%. It is fair to say that the Australian dollar is still expensive in terms of purchasing power parity. Also, as we can see from the chart below, the Aussie (blue) is clearly diverging from an index of industrial metals (red). In addition, just yesterday German car makers announced markdowns of up to 25% for Chinese auto buyers, so it would seem the Chinese economy has not strengthened since last month. These factors suggest the Australian dollar may be headed still lower. (Source for all charts: Bloomberg)

AUD, industrial metals

click to enlarge

If we are to maintain or add to a short position, it is worth examining the investment aspect of the Aussie dollar. After all, with an interest rate differential of 2.66% in favor of Australia in 5-year government bonds, the higher rate provides a major incentive for investors to hold the Aussie. This is especially true since the rate of inflation of the two countries has been very similar over the past decade, as we see below:

Australia inflation minus US inflation

This graph represents the inflation differential between Australia and the United States. The difference is derived by taking the Australian “year on year” rate of inflation minus the corresponding US rate. As we see from the red horizontal line, on average over the past ten years Australia’s inflation has been 0.5% higher than that of the US–the two rates have been remarkably similar. Interestingly, the trailing 3-year average (pink line) shows that the differential has averaged 1.06% over the past three years, indicating that Australia’s average inflation has risen somewhat relative to the US.

This is important when we consider the interest rate differential:

AUD-US interest rate differential

We see that the Australian government 5-year bond yields about 2.66% more than the US 5-year treasury note. This difference explains the attraction and strength of the Aussie to a large degree, but we can see that this differential is trending down from its high of about 4%. We can also see a sharp drop over the course of this month, from 3% to its current level of 2.66%. Remember, though, that Australian inflation has been running about 1% higher than the US, and is trending higher. The net benefit to investing in Australian bonds over US bonds is only 1.6% net of inflation.

If we compare Australian equities to American ones, the relative attractiveness of the two markets is more open to debate. The trailing price to earnings ratio of the S&P 500 as of last night’s close is 14.54, while the price to earnings of the Australian counterpart is 14.31. In other words, relative to the price, US stocks earn slightly more.

On the other hand, the dividend yield of Australian stocks is clearly higher, at 4.82% vs the S&P 500’s 1.96%. Interestingly, this differential at 2.86% is remarkably close to the interest rate differential of 5-year government bonds, at 2.66%. (Taking into account inflation, as we did with interest rates, the gap is about 1.06% less.)

Of course, the merits of the two equity markets are a question of investor preferences and analysis. The Australian market is of course more exposed to commodity prices and to China’s economic growth. In addition, Australia arguably has more ability to stimulate its economy by lowering interest rates, since US rates are near zero. Whatever the relative merits, as we can see below, US stocks have been outperforming those of Australia for some time now, since the end of 2009:

AUD, stock ratio

This longer-term chart going back to 1996 shows the Australian dollar in blue, and the relative strength of the Australian and US equity markets in red. The red line falling indicates US stocks are outperforming, and vice-versa. In other words, money has effectively been flowing out of Australian stocks and into American ones, though this depiction is a bit oversimplified. It is safe to say that the relative strength of the two stock markets has coincided with the ebb and flow of the Australian dollar, and that apart from the financial distress of 2008-2009, the relationship has been rather strong.

With an inflation rate of only about 1% more than the US, there is no doubt that the higher “real” yields on offer in Australia give an incentive to investors to hold the currency. This difference is a plus, of course, but may not be sufficient to keep the currency at a very expensive premium of 39.5% to the US dollar in terms of OECD purchasing power parity. In terms of real interest rates, it is relatively inexpensive to short this overvalued currency. With waning interest in Australia’s commodities, the risk-reward has tilted in favor of the sellers.

Source: Seeking Alpha