Rhody Trader

Back in August I wrote about how the Commitment of Traders figures suggested that the uptrend probably wasn’t over yet on the basis of the fact that the notorious incorrect small speculators were short. Believe it or not, those Small Specs are even more bearishly biased now than they were 2+ months ago. Check it out.

You can see from the graph how the level of net shorts (Longs – Shorts) is at a low level it has touched a few times the last six months or so. What”s even more interesting to my mind is the 35% bullish (see the highlighted area in the table) indicating that 65% of the positions are short. That’s a big negative bias.

This sort of positioning suggests we may yet see higher highs in stocks.

For a while during the height of the risk aversion action EUR/JPY and the stock market were very closely linked. This was reflective of the carry trade and how investors had a hair trigger getting out of it when they became worried. That relationship has been fairly choppy of late, however, as Zero Hedge observed today.

Here’s a chart of the 1mo rolling correlation between EUR/JPY and the S&P 500. Notice how at several points in the last year it’s been well short of strongly positive and has even gone well negative.

There’s been talk in the markets about the increasing use of the dollar in carry trade strategies (even the pound is being thrown into that discussion as well). It’s interesting that we’re not just talking about banks and money managers and that sort involved here. Germany and Austria have taken advantage of the lower US rates by issuing dollar-denominated debt. As this Bloomberg article indicates, the swap rates are such that issuing in dollars is about 25bps cheaper than doing so in euros.

If you’re wondering what the big carry trade is right now, look no further than AUD/USD.

Here’s something to ponder. Back in 2007 when all of this global economic mess started unfolding 10 yr Treasury yields peaked in June. Stocks did not peak until October. Yields put in an initial bottom in January 2008, while stocks made their first minor low in March 2008. The major low in yields was reached in December 2008, while stocks hit their low in March of this year. That’s a pretty good case for stocks lagging bonds by a 2-4 months.

Now, bond yields made their most recent peak in June (again). Could we be in for another stock peak this month or next? If bonds don’t make a quick u-turn there’s going to be a strong case for it.

I’m in demand as a contributor again.

This sort of thing seems to go in cycles. Around the time my book came out (2006) I was getting requests from all kind of places, like magazines and websites. As a result, my name was all over the place in trading media circles. The last couple of years have been a bit less intense in that regard, but now I’m getting queried on the subject again.

I was contacted by www.forexpros.com about contributing regular content there. I’ve also been corresponding with one of my former colleagues (old boss actually) about doing some writing for www.forexlive.com. I’m taking a look at things and sorted out what it means for my employer (www.ifrmarkets.com), but the odds do seem to favor my getting involved in the not too distant future.

Maybe I’ll write another article for Stocks & Commodities and/or SFO Magazine. Haven’t done that in a while.

I suppose I really should do some work to raise my profile again. I’ve got my trading faq book in the works, after all.

I love it when the relationships in the markets change. Partly it’s my twisted sense of humor leading me to laugh at those who got locked into the old ones. Mostly, it’s becaues they provide us with new information.

Today we’re seeing a change. Any time before now a better than expected jobs report would have crushed the dollar as stocks rallied and bonds were sold off – the classic risk acceptance trade (so to speak). Today, though, the greenback is shooting higher against the Euro and Yen especially (the Pound is holding up better, no doubt thanks in part to the beating it took yesterday)

The above Dollar Index chart shows how at first we got the expected downside reaction as per the old pattern, then we got the shift to the new pattern. I’m sure there were quite a few trader caught out by that turn around. This sort of thing, by the way, is why I don’t new trade.

So if the dollar is going to rise on positive news, what’s the implication. Well, it suggests the Fed won’t be eager to further pump up liquidity because of the improving conditions. Some folks are even looking for a rate hike by year-end. I’m not personally in that boat right now – but then my rate move calls have never been that great, so don’t put much stock it it. I certainly don’t.

On top of that, the markets have long viewed the US as likely being the first of the major global economies to come out of the recession. Improving data helps support that view. This is a positive for the dollar as long as the other economies are seen to be lagging, and Europe in particular seems to have a long way to go by their own comments.

I’ve been following the Commitment of Traders data for some time now, finding it to be a very useful indication of when markets may be getting ready to turn, and when they are not. I particularly like to keep an eye on the Small Specs in the mini S&P 500 futures, which is what the graph below from www.commitmentoftraders.com depicts.

The yellow bars are the Small Specs. They are basically the retail market, by and large. That tends to be the group that gets it wrong the most, so watching what they are doing provides some perspective of things in the stock market. In other words, when the yellow bars are above the zero line, especailly way above, stocks probably are not going higher, and vice versa.

The table of how the different groups are positioned provides a bit more detail. As you can see, the Small Specs are currently 58% short (42% long), having been as much as 67% short recently – all while stocks have been rising.

It’s rather cynical, I know, but I’ll start worrying about the market turning down when the Small Specs flip to long.

The subject of Bollinger Bands was discussed recently on the VIX and More blog. I’ve employed the Bands for many years now, but not in what a lot of folks would call the classic way. I did research on volatility back in college with Bollinger Bands as the focal point and later published my first ever magazine article in Technical Analysis of Stocks & Commodities. I’ve done my fair share of testing with different ways of employing the Bands, but in the end I settled into using it to help me identify markets readying to make a move into a new trend.

One of the things mentioned by the Vix and More post is the idea of the Bollinger Bands supposedly containing 95% of the price action based on using a 2 standard deviation setting. John Bollinger himself has apparently indicated it’s more like 89% from is own research. My thinking is that a lack of understanding of the statistics of price action keeps people caught up in these figures.

Academics will generally tell you that it’s returns rather than prices which approximate a normal distribution (but as noted by V&M and others do not match it because of the fat tails). Regardless, the look-back period of the Bands don’t really include enough data to really draw much in the way of conclusions in any case. That’s why I’ve never really put much weight on where prices are relative to the Bands. I just use their width as a visual look at historical volatility.

I just got fininshed reading a really good post at the Psy-Fi blog, Mandelbrot’s Mad Markets. It’s a well written discussion of some of what underlies financial risk management and why it all went to hell in 2007 and 2008 – and why it will do so again some time down the line unless decision makers start understanding the limitations of their tools.

Basically the bottom line is that despite what some folks might lead you to believe (or delude themselves into believing), the markets cannot be modelled nice and neat with bell curves and standard distributions, at least not with current tools. This has very serious implications because it means things can go much worse than folks expect and are more likely to do so than would be predicted. This is something discussed in Benoit Mandelbrot’s book The (Mis)Behavior of Markets.

Traders may not think all this modeling and forecasting stuff impacts them, but they would be wrong. First of all, it tells us that markets can go further and faster than we’d ever expect. Can you see how that might  be useful to know? Also, it puts the whole idea of “risk reversion” in question because there may not be a proper mean to which prices can revert. Oh, and it may take much longer for that reversion to happen and see the market go much further away from the mean than would be expected.

Now that I’ve got Ducati sorted out with the linking I can get back to addressing his response to my The US is not the next Zimbabwe post.

Duc does a good job bringing up the why’s and wherefor’s of debt issuance, who’s doing the lending to the government, fiscal and monetary policy, etc. At the end he asks the question “The question is where will the money flow and determine the initial winners?” This is something I actually was thinking a bit about when I was writing the original post.

You see, when the government does deficit spending it is creating private sector savings. If Uncle Sam writes you a check you are going to do one of two things with the money. You’re either going to spend it or you’re going to save it (keeping in mind that paying down debt is the same thing as putting the money in a savings account from the perspective of your net worth). If you spend the money, the next person in line makes the same decision, and so on until at some point the money is all in savings.

Now, if the government taxes that money back in then there’s no net increase in savings because the payment to the IRS will wipe it out. If, however, the Treasury issues debt to cover that spending, then the saving is kept in the economy – albeit in the form of Treasury debt somewhere along the way. This is the answer to the Where Is The Money We’re Borrowing Going To Come From? question from Henry Blodget at the Business Insider – it’s coming from the gov’t who’s spending the money and borrowing it back.

Of course in the current economic situation debt repayment is at the top of the list for many citizens. That’s been the big issue with some of the stimulus programs, like tax rebates. They aren’t getting spent, but used to reduce credit card balances. That means the government money is flowing into the banks as debt is being payed down. This, of course, is helping the bank balance sheets, but since lending standards are tighter and loan demand is reduced, that money isn’t flow through the economy as readily as it would were the money spent on construction projects or other “purchase” programs. The money would still end up in the banks for the same reasons as noted above, but it would pass through more hands along the way, having a greater impact.

Either way, what we’re seeing happen here is the government taking on the debt of the private sector. That’s not a good thing, of course, and it’s going to have repurcussions for some time to come, most likely in the form of reduced growth potential as the government withdraws money from the economy through taxation and/or reduced spending to repay its debts.