One of the important lessons the 2007-2009 credit crisis taught me was to not be narrow minded as a predominantly equity-focused investor and money manager. There are other asset classes and moves in other asset classes that can shed light on global financial trends. Equity investors should pay close attention to not only the stock market but also the credit markets (debt securities) and the currency markets as both the credit and currency markets trump the size of the equity markets. When the credit and currency markets are not confirming the message of the equity market you better listen up. I believe we are at another inflection point and investors need to do just that, “listen” to the markets and act accordingly.
One of the topics I have been covering recently in my articles is the concept of answering a simple question, “Do you want to be right or do you want to make money?” If you want to make money in investing then check your ego at the door, lose your “perma bear” or “perma bull” viewpoint on life and “LISTEN” to the collective message of the markets and look for subtle changes in trends that can provide clues to the markets actions. The key concept of listening to the message of the markets is flexibility. If bearish developments are beginning to ramp up then take up your risk management hat. However, if bullish developments are occurring then put aside your fear and act accordingly.
This key concept of flexibility and moving with the message of the markets helped one navigate 2010. When the leading economic indicators were rolling over and a growth scare turned into a double-dip scare risk, management was the order of the day. Even before the April to July correction in the markets that nearly reached bear market territory (20% + correction), there were plenty of signs for one to be cautious. The rolling over of the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) in 2009 was what turned me cautious heading into 2010 (“2010: A good year for the economy and a mediocre year for stocks?”) and why I advocated overweighting defensive sectors (“Contrary Investing: Loving the Unloved”). Conversely, when the WLI bottomed and staged a recovery my risk management hat took a back seat and I advocated overweighting beta based on the WLI trend reversal (“Investment implications of a bottom in leading economic indicators”).
As things now stand a rising WLI, growing M2 money supply growth rate, QE2 in full force, and fiscal spending from past packages kicking in, all suggest staying with the trend and buying any market dips. To be a bear right here you would have to be fighting both the Fed and Uncle Sam (fiscal and monetary stimulus) and completely ignoring the message of the markets, NO THANK YOU! Those forces alone provide plenty of support for the bulls but I think the bull case for the next few months could strengthen even further with another development, subsiding of the euro debt crisis.
Listening to the Markets – Watch the Euro and European Debt/Equity Markets
A major catalyst for higher equity prices in 2010 was when fears of a US double-dip recession began to subside. As fears decreased with incoming bullish economic reports the markets vaulted higher coupled with expectations of further Fed easing. I think the big bullish catalyst for 2011 will be subsiding fears over a euro debt crisis. As I mentioned earlier, equity investors need to not only watch the stock markets but the currency and credit markets. Watching these other two markets would have served investors well in 2008 to signs of heightened risk and deleveraging. One of the big key themes of 2008 was the yen-carry trade (“The carry trade: a tsunami in the making,” 02/19/2007) unwind that, once it began, snowballed into a global crash in the fall of 2008. Note in the figure below that the break down of the bullish 7 year trend in the euro/yen exchange rate in 2008 occurred right before the major sell-off in the S&P 500. What is also notable is that the euro/yen exchange rate showed signs of stabilizing in late 2008 to early 2009 which hinted of a trend reversal and a pause in the deleveraging stampede. The euro/yen rallied and so did the markets too. However, right when the ECRI WLI was stalling in late 2009 so was the euro/yen exchange rate. Again, the significant break in the 2008-2010 trend line in the euro/yen correlated with the April 2010 peak in the S&P 500. As the euro/yen stabilized last summer so did the S&P 500.
(Click all images for larger view)
Source: Stockcharts.com
What I want to bring to your attention now is what looks like a bullish wedge forming in the euro/yen. If the upper trend-line, which has acted as resistance from 2008-2011, is broken, this will be sending a clear message that fears of a euro debt crisis are subsiding. Thus, if this exchange rate breaks out the bears will have to take a back seat, AGAIN!
Source: Stockcharts.com
Similarly, I believe a breakout may occur in the immediate future as the euro is showing considerable strength not only against the yen and USD but also against other major world currencies as shown in the figure below.
Major Currency Returns vs. Euro Year-To-Date
Source: Bloomberg
And speaking of the USD, the greenback has declined against nearly all major global currencies in the last two weeks, not just against the euro.
Major Currency Returns vs. USD (01/10/11-01/26/11)
Source: Bloomberg
What is already starting to hint at a euro breakout is improvement in European equity markets and in the European sovereign credit markets. This can be seen in my equally-weighted PIIGS equity and credit default swap (CDS) indexes.
What’s changed in Europe?
In reality, there are still clear sovereign debt issues to worry about in Europe, however, a global coalition is moving to support European debt that is lifting their credit markets. Things first began to turn when China and Japan decided to step in the ring and buy European debt, but momentum is building as other Asian countries are looking to do the same. This mutually beneficial decision helps Asian markets particularly by cheapening their currencies and bidding up the Euro to help their export-driven economies.
Europe Rescue Debt ‘Hot’ as Asia Central Banks Lead
The pledge by Japan and China to buy European debt is encouraging Asian funds to follow suit as agencies start selling bonds to finance Ireland’s bailout.
A 5 billion euro (.84 billion) auction yesterday drew 44.5 billion euros in orders as the Japanese government snapped up more than 20 percent of the issue. Asian investors bought about 38 percent and government agencies 43 percent, according to two people familiar with the transaction. State institutions took 38.5 percent of the securities at a similar sale on Jan. 5, according to the European Commission in Brussels.
“I heard these issues will be hot,” said Masataka Horii, one of four managers in Tokyo of the .9 billion Kokusai Global Sovereign Open Fund, Asia’s largest bond fund. “Investors may see the new bonds as safe because central banks are buying.” He declined to say whether he would bid.
Kokusai, Daiwa SB Investments Ltd. and Fukoku Mutual Life Insurance Co. say they are interested in the AAA rated bonds sold to fund bailouts, even after investors sent the debt of Greece, Ireland, Portugal and Spain tumbling. ICBC Credit Suisse Asset Management Co. said it is interested in buying European government debt. German Chancellor Angela Merkel said her nation will do whatever is needed to save the 17-nation currency, while Europe’s economy is showing signs of improvement.
‘Overwhelming’ Response
The European Financial Stability Facility’s five-year 2.75 percent bonds were sold at 2.89 percent, or 6 basis points more than the benchmark swap rate, according to data compiled by Bloomberg. That’s down from the range of 8 basis points to 10 basis points where the bonds were initially marketed. German five-year debt with the same AAA rating has a yield spread of 44 basis points below the swap rate, according to Bloomberg prices.
“The response from international investors was overwhelming,” EFSF Chief Executive Officer Klaus Regling said at a press conference yesterday in Frankfurt.
For those interested in a further explanation for improvement in Europe, here is great article by Dian Chu at the EconForecast blog (“Euro’s Reversal of Fortune & Outlook”)
What’s really changed?
I believe that a rally in the euro and European equity and credit markets is in the offing and will serve as a bullish catalyst for global economic growth and equity returns for the first half of the year. However, have things really changed in Europe and the US for that matter? Not really. We still have horrible state and local government finances, US debt reaching its ceiling once again, persistently high unemployment, huge debt-to-GDP ratios for both the US and European countries, global trade imbalances between China and the US and so on and so forth. So, while things may be looking rosy for the next few months the can is just being kicked down the road and when the ECRI WLI turns downs and the euro future rally looks toppy once more, risk management will be the name of the game, but for now the bulls remain firmly in control and a breakout in the euro would add yet another arrow to their quiver.
