Monthly Archives: January 2012

­­Our Two Cents – Week of 1/30/12

As January flips to February this week, U.S. economic optimism continues prevailing, while Europe strides toward economic reform.

Focusing on the economy, President Barack Obama delivered his State of the Union address, outlining a path to constructing “an economy built to last.” On the heels of the president’s speech, The Wall Street Journal and NBC released a poll showing that Americans view the economy a bit brighter. According to results, 37 percent of respondents said the economy will get better in the next 12 months. One sign of economic restoration is consumer confidence. The U.S. Consumer Confidence Index climbed to 75 from 69.9 at the end of December—the highest level in almost a year. Experts said an improving jobs market and higher stock prices helped fuel the increase. Additionally, about two-thirds of economists who participated in the National Association for Business Economic survey believe the nation’s gross domestic product will bump to a rate of more than 2 percent. The week ended with the economy growing at an annual pace of nearly 3 percent in Q4 of 2011.

While the U.S. received economic assurance, Europe remained focus on its fiscal matters. At the Jan. 30 summit, European Union leaders agreed to a permanent rescue fund for the euro zone. Leaders will sign a treaty establishing the European Stability Mechanism (ESM), “a 500-billion-euro permanent bailout fund that is due to become operational in July, a year earlier than first planned.” Summit participants also discussed ways to create more job opportunities and financial growth. Aside from the treaty, Spain still faces recession as tourism is expected to remain low in the winter. Factors such as austerity measures and higher taxes also might bruise the country.

 

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Concerns that the Chinese economy might ‘crash land’ in 2012 ranked high on the list of potential negative tail events that troubled investors in risk assets as they returned to their desks for the New Year.  These fears were eased if not removed altogether, once the Middle Kingdom’s National Bureau of Statistics revealed that the economy expanded 8.9 per cent year-on-year during the fourth quarter, comfortably above expectations and far removed from levels of growth that could be considered consistent with a hard economic landing in the immediate future.

However, the positive sentiment generated by the headline numbers would appear to be decidedly naïve given that the annualised growth rate quarter-on-quarter dropped to 8.2 per cent from 9.5 per cent in the third quarter – a troubling rate of deceleration – while, the ongoing correction in the property market still has the potential to provoke further downside momentum.  The fact of the matter is that the debt-financed, investment-led growth of recent years has significantly increased the potential for greater economic turbulence in the months and years ahead than most analysts currently envisage.

It is important to note that China’s fundamental strategy since reforms were first introduced in the late-1970s has been large-scale investment in physical capital, facilitated by high gross domestic savings rates and through state control of banks.  China emulated the precedent set by its high-achieving Asian neighbours during their corresponding periods of development and, through most of the subsequent three decades its investment rate has not been out-of-line with the capital spending booms of previous great economic transformations.

Gross fixed capital formation (GFCF), a broad measure of investment, averaged 34.5 per cent of GDP during the latter half of the 1970s, 35.4 per cent during the 1980s and 38.5 per cent during the 1990s.  This compares to an average investment rate of 33 per cent of GDP for Japan between 1961 and 1973, almost 40 per cent for Singapore during the 1980s and, 31.5 per cent for South Korea from 1983 to 1991.

However, the close parallels between China’s economic renaissance and previous great transformation periods comes to an end during the most recent decade, as the Middle Kingdom’s capital spending boom continues to grow in magnitude and duration.  GFCF jumped from 32 per cent of GDP in 1997 to near 50 per cent in the most recent calendar year and, has been above 40 per cent for nine straight years.

In contrast, of its high-achieving neighbours, only Singapore managed to register a peak investment rate during its corresponding period of growth anything close to the level currently reported in China and, even then the GFCF to GDP ratio was sustained above 40 per cent for a brief period.  Indeed, the investment rate dropped sharply from an average of 46 per cent of GDP between 1981 and 1985 to 33 per cent in the subsequent five-year period.

Neither Japan nor South Korea registered investment rates above 40 per cent during their respective periods of high growth – the former peaked at 36 per cent of GDP in 1973 and the latter at 39 per cent in 1991 – while, rates above 30 per cent did not persist for long in either case.

It is abundantly clear therefore, that China’s capital spending boom is unprecedented in modern economic history but, a relatively high investment ratio of itself does not necessarily imply that it is excessive and predetermined to end in a bust.  That depends on how efficiently resources are allocated and, in this regard, the omens are not good.

The incremental capital/output ratio (ICOR), the quantity of new capital required to generate an additional unit of growth, is commonly used to measure investment efficiency, where a reading of three is considered normal and a ratio above four is considered inefficient.

The trend in China’s ICOR is far from reassuring given that it was above four during most of the past decade and jumped to a reading of six in 2011 following the most recent surge in capital spending.  Of note is the fact that the efficiency of capital investment is at the worst level since the Middle Kingdom’s last hard economic landing in 1989/90.

The marked deterioration in the marginal return on investment is troubling since it has been fuelled by a credit boom that has seen total domestic credit – private and government – jump from 121 per cent of GDP during the fourth quarter of 2008 to an estimated 180 per cent by the end of 2011 – a level that is notably high compared to countries at a comparable income level.

The almost sixty percentage point jump in credit relative to GDP – with much of the increase emanating from the large unregulated banking sector – would appear to be symptomatic of the increasingly speculative nature of the investment boom and a financial crisis could well ensue should the boom turn to bust.

Official data for economic activity during last year’s final quarter has convinced many investors that a hard landing is not in store for the Chinese economy.  Close examination of the facts however, suggest that such a call is far too early to make – the probability of significant economic turbulence is far from non-trivial.

 

Previously posted on www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

We sat with our Currensee Trade Leaders and asked them three questions on volatility, trading strategy and the euro. The interviews give a brief glimpse inside the minds of our traders and shines some light on the coming year. The first post in this series starts off with Gabor Asirikuy Trading.

Currensee Trade Leader Gabor Asirikuy Trading (Ticker: GAFLL.B and GAFLL.C) uses a distinctive automated system that leverages the signals of 10 trend-following trading systems, each leveraging different trading tactics. The system leverages the work of an international trading community that analyzes systems using purely statistical methods, and is built to take advantage of the long-term investment horizon. The system is built on the foundation of the Turtle Trading System, with volatility adjusted profit/stop targets and position sizing.

Do you believe 2012 will be as volatile as the end of 2011 has been?

The global economy is not in a good shape at the moment and probably this will be the situation for the whole year. Usually markets are less volatile when investors are optimistic and central banks gradually increase interest rates. This kind of environment usually starts carry trading in the currency markets.

However, 2012 is probably not about that, especially if Europe does not manage to find a credible solution for the sovereign debt problems. The solution would need the member countries to partly give up their political sovereignty, which is a very hard decision for them and won't happen overnight. If the EU debt crisis extends and the EU finally breaks up, then that might lead to a quite chaotic situation in the financial markets. This would surely increase volatility as investors would escape to safe haven currencies.

Elections in the US and France won't help either, because world leaders will be more concerned with domestic political battles then with the global economy.

On the other hand as a systematic trader I can only say that future is unknown and instead of predictions I keep looking at the statistical numbers of my systems, trade consistently and manage risk properly.

What types of Forex strategies will continue to prevail in 2012?

Well, that's hard to answer, carry trade probably won't for the reasons listed above. However a trader had better not to try to predict market conditions, but to trade strategies that can survive the unfavorable periods, which always come sooner or later. Some markets/periods are better for trend following systems and others for counter-trending (or mean reversion) systems, but that might change over time. Consistency and risk management are the keys.

At Currensee, I trade short-term trend following systems (H1 swing trading) on the major pairs. Major currency pairs tend to build up larger trends, because they are rather moved by global fundamental events than speculation, so for that reason trend following seems to be more apt for these instruments. But this doesn't mean that range bounded periods would not come from time to time even during volatile periods.

What would a breakup of the euro mean for your strategy?

This is an interesting question, indeed. It already occurred at Asirikuy before, and we made experiments to model this problem. The introduction of the euro in 1999 gives us the opportunity to model the impact of an instrument change. We created a few daily trading systems with the help of our genetic algorithm framework, that were optimized on the historical price data of the DEM/USD pair during the 1990 - 1999 period. These systems were then backtested on EUR/USD from 2000-2010. Those systems that were stable during the original optimization period - which means that their performance didn't deteriorate dramatically when we changed slightly their entry/exit parameters or the spread - did well on EUR/USD in the 2000-2010 out-of-sample period, in fact most of them did a bit better.

What that means is that before 2000 it was the Deutsch mark which represented the best the economic performance of the continental Europe, no wonder that Germany is called the economic engine of the EU. After the birth of the euro the characteristics of the market didn't change much: the same traders in the same institutions / banks / corporations in the same time zone speculated or hedged on fundamental events of the same economic conglomerate. In addition the EUR/USD became more liquid than the DEM/USD, which means that technical trading works a bit better in this market.

The same can be assumed in the opposite process when euro ceases to exist. The economic environment won't change dramatically, but the new currency (maybe the euro of a smaller group of countries or the Deutsch mark) will be less liquid, so technicals will work less, and this might mean slightly worse performance.

Of course if the breakup happens in a chaotic manner that might mean that the new currency pair will not be accessible for the retail traders for some time. In that regard we don't have experience - and I personally would be glad not to have one - but time will tell.

 

Next week: TCM Spencer Beezley (Ticker: SPBJP.A)

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The topic of stops and their placement is a regular theme of discussions among traders and investors. It is pounded into the heads of everyone coming into the markets that you must have a stop to protect against a large loss. This comes mainly from the idea that if you don't have a stop order in place you will be inclined to let losses run, which is something which happens far too often. This is a big enough problem with market participants that academics have given it a name – the Distribution Effect, which is the tendency to cut winners and let losers run.

Should you even use stops?
Before I address the strategy for stop placement, let me first tackle whether you should use them. Some will argue that you should have mental stops rather than standing orders to avoid any funny business from the markets (stop running, flash crash, etc.). I tend not to go for that, but what I'm really talking about here is whether you employ stops at all. Some strategies actually see degraded performance when stops are employed. As a result, it's always worth testing a system with and without them to see their impact.

Now, on to where to place your stops should you decide using them makes sense.

The case against fixed stops
First of all, realize that any strategy which employs fixed distance stops – either in terms of pips or % of current prices – runs the risk of not reflecting current market conditions and suffering for it. If, for example, you have a 50 pip stop but the "normal" volatility for the period in which you are operating is 100 pips, you're almost certain to be stopped out on what's a relatively insignificant move within the market's current context. This is something that burns traders quite frequently.

Some traders employ volatility based stops to account for this. Using a multiple of the Average True Range (ATR) is a common strategy. The one caution is that ATR, or any other reading of that sort, is going to necessarily be historical. It may not account for expected future volatility that could be anticipated during the span of you holding your position, such as from news or data releases. You'd want to factor that sort of thing into your stop.

Where do you no longer like the trade?
In my own trading I actually don't even think in terms of stops. I think in terms of negative exit strategy. By that I mean determining what market action would tell me that the trade I'm in is likely no longer going to perform the way I'd been expecting. This applies to both initial trade strategy and to on-going management (think trailing stops).

In other words, I don't think in terms of "I don't want to lose more than…" That comes later, in the position sizing decision. As a result, my stop is merely the order that takes me out of a position I no longer want to be in, just as a limit order takes me out of a winning position I no longer want to hold.

So where does that exit point come from?

It's based on my underlying reason for the trade. If I think the market is going to turn down when it approaches key resistance and I put on a short, if the market instead goes through that resistance then clearly the market isn't acting as expected, so I want out. If I get in on a long trade because I think a new uptrend is developing and the market starts trading negatively, then something isn't right and I want out.

It's also worth noting that a negative exit strategy isn't always about the market going against you. It can also be about closing a trade that just isn't going for you the way you thought it should when you got in. This is why I tend to steer clear of thinking just in terms of stops. They only reflect one side of the equation.

The right approach for you

The bottom line is that you need to take a look at the type of position entry strategy you are employing and develop a complimentary strategy for getting out of those positions. This goes not just for losing trades, but for winning ones as well. This will be different for trend following approaches than for ranging or mean reversion ones, and if you have a fundamental aspect to your trading or investing that will have to be incorporated as well.

 

Our Two Cents – Week of 1/23/12

There’s nothing better than kicking off the week on some high notes—especially coming off last night’s victory from the New England Patriots, sending them to the Super Bowl.

In the U.S., optimism remained the key theme last week. Jobless claims dropped 50,000 to 325,000—down from 402,000 last week—marking the lowest level since April 2008 and the biggest drop since September 2005. Experts said the sharp decrease illustrated signs of an upward-ticking economy. According to new survey results, 40 percent of wealthy Americans have optimistic thoughts about the U.S. economy in 2012, the highest level of optimism in six months. The findings came from the December 2011 Ipsos Mendelsohn Affluent Barometer, which examines lifestyles, spending patterns and media habits of wealthy Americans (those whose household income is $100,000 or more). While wealthy Americans signaled their optimism for 2012, the hedge fund industry also displayed early signs of a good year. In terms of inflows, more than half of investors planned to boost their hedge fund investments this year, according to a Barclays survey. In the Forex world, U.S. client profitability has increased on average 6.4 percent in Q4 of 2011.

Signs of economic confidence even transcended the Atlantic to Europe. Spain enjoyed a successful auction of benchmark 10-year bonds that investors gobbled up. In Italy, Prime Minister Mario Monti said Germany—in its own self-interest—must assist Italy and other embattled euro zone nations to help lower borrowing costs. Monti heralded Germany’s

“culture of stability” as “a precious German product [that] has been marvelously exported.” In Greece, officials and private creditors continued to devise solutions for its debt, nearing agreements to write down 50 percent of the face value of the country’s debt by exchanging existing bonds for newer ones with longer maturities and lower interest rates. Officials are expected to meet Jan. 23 to further discuss and resolve Greece’s debt.

 

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Major stock market indices have managed to eke out impressive gains during the first two weeks of the New Year – albeit on relatively low volume – as bearish concerns have failed to dampen investors’ enthusiasm for common stocks.

Amid the large uncertainties that hang over equity markets – from a potential disintegration of the euro-zone to the risk of a hard landing in China – the bulls argue that America’s corporate sector has rarely been in better financial shape and, insist that this strength is not reflected in stock prices.  Is such opinion grounded in indisputable fact or just another example of Wall Street’s wishful thinking?

The bulls point to the fact that the non-financial sector’s outstanding debt relative to both the book and market value of equity is below the historical average, while cash as a percentage of total assets is at the highest level in more than three decades.  Thus, it would appear that casual inspection of balance sheet data confirms bullish opinion.

However, it is important to appreciate that an informal glance at the headline numbers alone is not sufficient to make the bullish case, since major developments in the corporate sector over recent decades are simply ignored.  Put in context, corporate sector balance sheets are not as stellar as the bulls would have the misinformed believe.

The American corporate sector has undergone a profound transformation since the 1970s, as the economy has de-industrialised and become increasingly services-based.  This trend is confirmed by balance sheet data, where tangible assets such as property, plant and equipment, have dropped from more than 70 per cent of total assets in the early-1980s to below 50 per cent today.

All else equal, a service-based corporate sector would be expected to carry relatively low levels of debt for a number of reasons.  First, the absence of hard assets to provide as collateral to lenders means that debt capital is often difficult to obtain at a reasonable cost.  Second, and perhaps more importantly, the costs of financial distress are typically quite high.

The costs of financial distress include not only bankruptcy costs, but also large indirect costs that can have a material impact on a firm’s stock price.  For example, the value of computer software is determined not only by the software, but also by the company’s implicit promise to provide continued support and development.

Should rumours of financial distress arise, this promise would be called into question and customers could decide to do their business elsewhere.  The loss of revenue and resulting decline in the company’s share price could prompt key staff to leave and, the downward spiral well could become self-reinforcing.  Thus, to minimise the costs of financial distress, companies whose value consists primarily of soft assets typically carry low levels of debt.

The corporate sector’s optimal capital structure is determined not only by the nature of its business but also the volatility of its cash flows.  In this respect, it is important to note that the ‘great moderation’ in the volatility of economic activity observed in the years before the ‘great recession’ struck did not translate to more stable corporate cash flows.

Indeed, the volatility of cash flows was running at generational highs even before the global financial crisis unfolded, and the subsequent reduction in corporate leverage should be viewed as a rational response to the ill-advised debt build-up in advance of the economic meltdown, which saw debt to net worth jump from below 63 per cent in the summer of 2006 to almost 79 per cent by the end of 2008.  In light of near-record cash flow volatility, today’s ratio of 66 per cent would appear to be far more reasonable than the high ratios witnessed through the debt-financed booms of recent decades.

A meaningful analysis of the corporate sector’s debt position reveals that balance sheets are not as stellar as the bulls believe and, the argument is weakened even further once the combined deficit on defined-benefit pensions and other post-employment benefits are considered.  The inclusion of these two items pushes the ratio of debt to net worth up by roughly five percentage points to 71 per cent, which is close to previous cycle highs.

The bulls remain undeterred however, and note that cash as a percentage of total assets is at the highest level since the 1970s.  However, the ratio of liquid assets to total assets is only three percentage points above its recent trough and two percentage points above historical norms.

A move of this magnitude is to be expected given that the unavailability of debt finance to all but the best of credits is likely to have prompted an upward shift in the desired level of precautionary cash balances.  Thus, excess liquidity is likely to be far lower than the bullish consensus believes.

The strength of corporate balances sheets is widely touted as a reason to hold stocks.  Investors should be aware however, that the argument does not stand up to close scrutiny and reflects Wall Street’s wishful thinking rather than hard analysis.

Previously posted on www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Do you remember when the Swiss National Bank (SNB) came out with a declaration that it would no longer tolerate EUR/CHF trading below 1.20? That was back in September. That announcement saw the cross rate move up above 1.2400 by October after having been down near the parity level in August, as you can see in the chart below. It's worth noting from a technical analysis perspective how the market stalled out near the early 2010 lows, but that's a side discussion at this point.

EUR/CHF Chart

What we've seen in the last few weeks is EUR/GBP dipping down below the range it has been in since the SNB made its intentions known. In other words, the cross is now getting to the point where the resolve of the central bank may be tested.

No doubt, some market participants had expected to see the 1.20 floor tested well before now. Challenging the SNB was a discussion point as soon as the floor was announced. That never really happened at the time, though, because the move was timed pretty well. It came when the market was already in rebound mode. The Japanese did the same sort of thing back when USD/JPY was making its first foray below 100 in the 1990s. They didn't fight the move too hard on the way down, but really kicked it in the tail when the selling was seen to have abated and as a result really pushed the market back up.

The issue for the SNB, though, is the euro. No longer are we talking constantly about the franc being a safe haven currency attracting loads of attention as was the case earlier. Now it's just a function of a weak EUR, which we can see in EUR/USD, EUR/GBP and EUR/JPY as well. In other words, it's not the same kind of speculative froth as was the case in EUR/CHF back in the summer. That could make things a bit more challenging for the SNB in defending the floor.

In theory, the SNB has unlimited funds available to it. All the central bank need do to support the 1.20 floor for EUR/CHF is to print as many francs as required with to buy all the euros necessary to support the rate. At some point, however, inflationary concerns will start to become an issue. That would tend to put upward pressure on Swiss interest rates, which would only further support the franc, especially in a situation where the ECB is tilted toward an easing policy.

Now that we're getting close to 1.20, I wouldn't be surprised at all to see the market give that level a run just to see how aggressive the SNB really is going to be in defending it. My guess is the initial defense will be quite stout. It will be more a question of follow-through under sustained attack.

 

­­Our Two Cents – Week of 1/16/12

While we saw Tom Brady lead the New England Patriots to an outstanding playoff victory, we watched world leaders attempt to continue restoring economic confidence through consumer spending, market performance and fiscal activism.

In the U.S., economic optimism continues to rise as America displays more signs of employment and consumer confidence. The National Retail Federation has predicted that U.S. retail rates will growth 3.4 percent to $2.53 trillion in 2012. NRF President Matthew Shay said Americans should be confident about consumer spending—“Our 2012 forecast is a vote of confidence in the retail industry and our ability to succeed even in a challenging economy. Over the last 18 months, retailers have been on the forefront of the economic recovery—creating jobs, encouraging consumer spending, and investing in America.” Additionally, U.S. retail Forex capital grew by $3 million in November 2011. Though the growth is surprisingly smaller than October, which grew by 30 million, experts believe lower volatility and the year-end slowdown might have contributed to the diminished growth.

Throughout the world, last week began with booming markets. The Italian market increased more than 2 percent, and France’s CAC-40 Index posted a bump of a little more than 1 percent. Even one of the weakest world markets—the Shanghai Composite—jumped more than 2 percent. Unfortunately for Europe, market confidence reversed by week’s end. Ratings services Standard & Poor’s downgraded credit ratings of nine countries—including Italy and France—as political and financial leaders continue to devise solutions to the euro crisis. The Jan. 13 downgrade resulted from the December warning that S&P might decrease credit ratings of 17 nations because politicians had been moving too slowly with reforms for the crisis. As a result of the news, European leaders have vowed to focus on “progress” to restore economic growth. Italian Prime Minister Mario Monti and European Council President Herman Van Rompuy met in Rome Jan. 16 to discuss economic restoration. Monti said S&P applauded Italy’s fiscal acts, and Van Rompuy said he believed leaders should refocus their aims by establishing “sustained, committed” efforts. Southeast from Italy in Greece, officials and residents discussed a possible return to the drachma if the country can’t save its membership in the euro zone. According to polls, nearly 80 percent of Greeks say they want to stick with the euro and avoid reinstituting the country’s former currency. Prime Minister Lucas Papademos has vowed to do whatever it takes to keep his nation in the euro zone.

 

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

The world’s financial markets have entered the New Year just as they left the last – weighed down by myriad negative influences that threaten to send asset prices into a tailspin.  Reasons to be bearish are not hard to find, yet the bulls remain undeterred and continue to argue, albeit unconvincingly, that risk assets will deliver healthy returns in 2012.

The list of potential catastrophes or ‘black swan’ events is unusually high and urges caution.  First, the seemingly never-ending crisis in the euro-zone refuses to ease and could well gather in intensity – if not come to a head – in the near future, as a deepening recession is set to test the capital markets’ ability to absorb the large, scheduled supply of new debt issues from the monetary union’s shaky sovereigns.

It is already quite clear that the euro-zone’s monetary union is not viable in its current form and, further market stress would almost certainly increase fears of an eventual euro break-up – a potentially devastating event – with a concomitant rise in the return premium required on all risk assets.

Second, China’s stellar growth rates are now an historical artefact and, the demise of the Middle Kingdom’s notorious property bubble, in concert with the damaging side-effects of ill-advised credit creation – not to mention the downward pressure on the export sector reflecting the euro-zone’s economic malaise – could well provoke a hard landing.  The potential adverse impact on worldwide economic activity should not be under-estimated given the large share of global growth captured by the Chinese in recent years.

Last but not least, tension in the Persian Gulf continues to mount, as Iran flexes its naval muscles in the Strait of Hormuz, the world’s most important oil transit chokepoint with flows through the strait amounting to more than one-third of all seaborne traded oil.  The Iranian actions have been taken in response to tougher trade sanctions imposed by the West, who have grown increasingly concerned over the Islamic Republic’s nuclear enrichment programme.

The stand-off looks set to continue given the strong rhetoric on both sides and, could well result in an unwelcome incident that precipitates a surge in oil prices and plunges the global economy into recession.

Indeed, Intrade, the world’s largest prediction market, has seen the odds of an overt air strike by the US and/or Israel against Iran before the end of the year, rise to more than one-in-four in recent weeks.  The probability of a strike can hardly be viewed as trivial at this juncture and, and the potential for a ‘black swan’ event originating in the Persian Gulf is a very real possibility.

The bulls dismiss the worst outcomes in all of the above as hyperbole and, believe that disaster will be averted in each case simply because policymakers cannot – and therefore, will not – allow the worst to happen given the economic carnage that would result.  Recent history however, suggests that confidence in officialdom’s ability to deliver favourable outcomes is misplaced.

One need look back no further than three to four years to observe how American policymakers failed to prevent a supposedly containable problem in an inconsequential segment of the said country’s residential mortgage market from morphing into a full-blown global financial crisis.

More recently, Europe’s leadership did not demonstrate any greater wherewithal to insulate the euro-zone’s core from the difficulties that beset the periphery.  As for the foreign policy arena, America’s historical record suggests the less said the better.

Given historical fact, it is clear that the potential worst-case scenarios cannot and should not be excluded from the decision-making process.  Unfortunately, advocates of high allocations to risk assets do not concur and, are quite obviously, gambling on the most probable rather than probability-weighted expected outcomes.

The year ahead could well prove kind to the employers of such faulty decision-making but, should that prove to be the case, the favourable outcome should be considered a function of good luck rather than a solid investment process.

The bulls will undoubtedly counter that valuations are already cheap and, have thus discounted most of the potential bad news.  However, the measures of value employed are clearly flawed given that reliable valuation indicators such as the cyclically-adjusted price/earnings ratio or Tobin’s Q, which have historically demonstrated a statistically meaningful ability to predict future returns, suggest that most of the world’s major stock markets are far from cheap.

The investment world’s perennial bulls continue to expect risk assets to generate solid returns in the year ahead and, appear oblivious to the vast array of potential negative scenarios that threatens to undermine their asset allocations.  As Warren Buffett once quipped, “Forecasts tell you little about the future but a lot about the forecaster.”

The astute investor will know to emphasise a disciplined investment process over the most probable outcomes.  Indeed, the sub-standard investment performance delivered by many investment professionals over the past ten years or more confirms that good luck cannot outdo sound decision-making indefinitely.

Previously posted on www.charliefell.com

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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One of the things that's gotten a fair bit of chatter in the press of late has been the idea of a de-coupling between US markets and those in Europe. It is suggested that traders and market participants are taking a comparative look at the two economies and seeing better opportunities in the US, which is leading to better performance for US stocks and also for the dollar. Let's take a look at the numbers to see how that's really playing out.

The chart below looks at the correlations between the USD Index and the S&P 500 (red), US 10yr Note yields (green), Oil (purple), and Gold (yellow). The correlation figures are based on a 20-period look-back calculation using daily closing data.

Dollar correlation

 

 

What immediately jumps out is that the dollar has become much more positively correlated to all of these major markets in the last several weeks. In the case of the stock and bond markets, this has been developing since mid-November, meaning the commentators talking about this stuff recently have actually be rather late to the game, which is often the case.

Interestingly, just as stocks and bonds were shifting toward more positive correlations in mid-November, the commodities were moving toward more negative ones. They have obviously since turned that around again, very sharply in the case of gold since the start of the new year.

Be aware, though, that there's a difference between "more positively correlated" and being actually positively correlated. In all these cases we're talking about markets having gone from very negatively correlated (the closer you get to -1 the more directly opposite the two markets tend to move). At this point these markets have only reached near the 0 correlation level, meaning the markets haven't really been trading in unison at all of late.

The move in the S&P 500's correlation to the USD Index is the most interesting in that we're seeing the most positive reading we've seen since June of last year. What makes this really interesting is that in the past the higher correlations between the two markets have come when the dollar was falling. The last time the two markets were positively correlated during a USD rally was during the latter part of 2009 and early 2010.

USD correlation

 

 

Notice how there was a kind of choppy positive correlation between the two markets (S&P 500 in green) during December 2009 that broke down in January before things turned back again in February. Now consider that we've got a choppy kind of positive correlation between the two markets working now. Could be we're setting up for some kind of repeat performance.