A classic late-cycle rotation

Years ago, one of the first things that I learned when I ventured into technical analysis was sector and industry rotation. Technical (which are not necessarily economic) bull phases start with leadership from interest sensitive groups, such as banks and homebuilders. The leadership baton is then passed to consumer related sectors, capital goods and so on. The terminal phase is signaled by the leadership of deep cyclical resource sectors.

I believe that's what we are witnessing now.

First of all, there is little question that the leadership of homebuilding stocks are rolling over. The chart below shows the market relative returns of the homebuilding ETF (XHB), which is in a relative downtrend after breaking key relative technical support levels.

Meanwhile at the other end of the spectrum, we have seen a divergence between equities and commodity and commodity related plays. The chart below shows the SPX (in black) and the CRB Index (in red) for the last three years. For the first couple of years, the two more or less moved in tandem, but a divergence was much in evidence in 2013 as stocks went north and commodities went south, mostly because of angst over China.

In the last week or two, the data out of China has been more positive (though not everyone believes the official statistics) and commodity prices appear to have bottomed and they are starting to rally. Meanwhile, the equity uptrend remains intact. These are the classic signs of a late cycle rotation into deep cyclical sectors of the market.


A crowded short in commodities and EM
Commodity related plays have become unloved and sentiment has moved into a crowded short reading. These charts from David Rosenberg of the large speculator position from the Commitment of Traders report on copper tell the story:

Large speculators (read: hedge funds) are also in a crowded short on the China and commodity sensitive Australian Dollar:

The latest BoAML fund manager survey shows that the most unloved sectors are resource and emerging markets (via Business Insider):

Under these circumstances, give the market the slightly whiff of positive news and it would spark an oversold rally. That's what's happening now. Here is the relative performance of the metals and mining sector (XME) relative to the market. XME has rallied through a relative downtrend and there may be further relative upside. I have outlined the Fibonacci retracement levels as likely upside targets. Even the lower 38.2% Fibo level shows considerable potential upside from current levels.

Here is the longer term XME relative chart. XME remains in a downtrend relative to the market and the site of the relative downtrend line approximately coincides with the 38.2% Fibonacci retracement level from the previous shorter term chart.

Similarly, we have seen a relative rally from emerging market stocks (EEM) against US equities (SPY) as it bounced off a long-term relative support level.

A tactical bullish call
In the last couple of weeks, we have seen US equities pause and then weaken. Last week, it tested the 50 day moving average, which is considered by many technicians to be an important support level. Given what I am seeing in the change in sector and industry leadership, I believe that we are seeing a late market cycle rotation into the deep cyclicals and the bull may have one last gasp upward.

This is a tactical bullish call for a few weeks. The AAII's latest sentiment survey (via Bespoke) shows that bullish sentiment has retreated, which should be supportive of a rally.

Nevertheless, I remain concerned about the intermediate and longer term outlook for stocks for the following reasons:

• Valuation signals:  As I wrote before (see A new secular bull? Don't count on it!), private equity firms are cashing out their equity holdings, value investors can't find any good values and VLMAP, Value Line's Median Appreciation Potential for stocks, is signaling very low return levels for equities. Mark Hulbert also wrote about the VLMAP sell signal here.
• Smart investor trading signals: In addition to long-term oriented value managers feeling uncomfortable with stocks, George Soros' largest position is a bearish bet on SPX. I am not sure I want to be on the other side of a Soros trade, do you?
• The tapering risk-off trade isn't over, especially in the credit and foreign exchange markets. As we move into September and, in all likelihood, the Fed starts to taper down its QE purchases, I would expect further angst from the markets.
• Political headwinds: There are two items of note for the markets in September and October. First of all, the German elections are scheduled for September 22. Angela Merkel is expected to return as chancellor and there seems to be a tacit agreement to minimize the level of euro-angst until after the elections. After that, don't be surprised to hear more problems with the eurozone peripheral countries like Portugal. As well, we are going to see the usual Washington drama about the debt ceiling debate. While the consensus is that the politicians will reach a last minute deal, this Politico report suggests that September 2013 may be different from previous years because the GOP leadership is divided and Obama and the Democrats are spoiling for a fight:

The House GOP is hopelessly fractured on spending strategy. Senate Republicans who might otherwise broker a deal face primary challenges that make compromise potentially deadly. Other Senate Republicans are jockeying for 2016. And congressional Democrats have no appetite for any bargain — grand or otherwise — that cuts entitlement spending.

President Barack Obama at his Friday news conference before leaving for vacation lectured Republicans and mocked their threats to shut down the government rather than fund his signature health care law. Hardly a promising sign for the fall.

Understand that this call for a last gasp rally led by the vastly oversold deep cyclical stocks, a sort of Unternehmen Wacht am Rhein by the bulls, is a tactical call. My inner investor is lightening up positions now, while my inner trader wants to jump on board for the rally, which can be powerful especially for oversold stocks.



Full Disclosure: Long XME


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

How sustainable is the commodity rebound?

I have seen some buzz and excitement among technical analysts and in the blogosphere about a rebound in the commodity sectors of the stock market. While these sectors were highly oversold and a bounce was not unexpected, my analysis suggest that the sustainability of a rebound is unlikely. The more likely scenario is a sideways consolidation to digest the gains from the tactical rally.

Here is the chart of the metal stocks relative to the market. The group has rallied out of a relative downtrend, which is constructive, but faces some overhead relative resistance. My best guess is a period of sideways consolidation going forward:

Here are the gold stocks against the market. I'm not sure why people are getting so excited here. Sure, the short-term relative downtrend has been broken, but the longer term relative downtrend remains intact.

Here is the relative chart of the energy sector. It bears some semblance to the metals - rally out of a relative downtrend and exhibiting a consolidation pattern.

Longer term, I just get very excited about this sector unless it can show some sustained relative strength to break the pattern of lower relative lows and lower relative highs:

Here is the long term relative chart of Materials. The same comments that I made about energy applies to this sector as well:

The same thing goes for the metals. Well, you get the idea.

Tactically, I also like to watch the high-beta small cap resource stocks relative to their large cap brethren to measure the "animal spirits" of the market to give me clues as to the sustainability of this rebound. Here are the junior golds (GDXJ) relative to the senior olgds (GDX). Unless the juniors can show more strength to break the relative downtrend, it suggests to me that this rally is likely to be brief and fleeting.

Up here in the Great White North, I monitor the relative return of the junior TSX Venture, which is weighted towards the speculative junior resource names, to the more senior and more broadly diversified TSX Index.

Nope. No rebound in animal spirits here either.


The dreams of gold bugs
I also saw some analysis that is supportive of a strong gold rally, but upon further analysis I believe that the analysis could be interpreted in different ways and it is not necessarily supportive of a bullish position in gold. Consider this chart showing the relative performance of the Amex Gold Bugs Index against SPX, which has been rattling around in the blogosphere:

It was pointed out that we are experiencing bullish divergences on the 14-week RSI and in the past three occasions, the HUI/SPX ratio has rallied strongly in favor of HUI. Moreover, the ratio is sitting at a major relative support level and, given the highly oversold conditions and the bullish RSI divergences, conditions are highly suggestive of a strong rally for the golds.

While I would not rule out a tactical rally in gold and gold stocks, I question the sustainability of any bullish thrust. I would point out that the highlighted bullish RSI divergences occurred in a secular bull market for gold and other commodities. It is questionable whether gold remains in a secular bull today. Consider the occasions on the left had side of the chart, where oversold RSI conditions occurred in the HUI/SPX ratio in a bear market. On those occasions, the rebound was only a blip and the downtrend continued soon afterwards.

The key issue to the analysis that underlies the above chart is the question of whether gold is in a bull or bear market. Choose your interpretation and your own conclusion.

As well, there is the Commitment of Traders report showing an off-the-scale reading in the net gold positions of commercials, or hedgers:

The COT report seems highly supportive of a bullish impulse in gold, but consider what happened in 2008 when we saw a similar reading. The COT "buy" signal report date was September 16, 2008. Soon after, the gold price proceeded to tank, though it did recover for several months,

Oh well, back to the drawing board.

Fundamental backdrop is not constructive
It's not just technical headwinds that the commodity sectors face, the macro fundamental backdrop does not scream sustainable rebound for these late cycle sectors. Walter Kurtz of Sober Look highlighted this chart from Credit Suisse showing the relative performance of cyclical vs. defensive sectors by region. The US and eurozone ratios are fairly flat, while Japan shows a minor uptick and China, which is the major marginal buyer of commodities, is going south.

Can the commodity sectors rebound strongly in the absence of Chinese demand and a so-so performance from the major developed markets?

The signals from China are clear. The new leadership is intent on re-balancing the  economic growth from an export and infrastructure driven model to a consumer drive model. While the government appeared to have blinked last week when Premier Li Keqiang asserted that growth would not be allowed to go below 7%, it seems that any stimulus measures would be highly targeted and localized. In fact, Bloomberg reported that the government ordered 1400 companies to cut capacity in a highly targeted move to shift the focus away from infrastructure spending:

China ordered more than 1,400 companies in 19 industries to cut excess production capacity this year, part of efforts to shift toward slower, more-sustainable economic growth.

Steel, ferroalloys, electrolytic aluminum, copper smelting, cement and paper are among areas affected, the Ministry of Industry and Information Technology said in a statement yesterday, in which it announced the first-batch target of this year to cut overcapacity. Excess capacity must be idled by September and eliminated by year-end, the ministry said, identifying the production lines to be shut within factories.

China’s extra production has helped drive down industrial-goods prices and put companies’ profits at risk, while a survey this week showed manufacturing weakening further in July. Premier Li Keqiang has pledged to curb overcapacity as part of efforts to restructure the economy as growth this year is poised for the weakest pace since 1990.

Does this sound like a government that is panicked about growth falling below 7% and is anxious to stimulate at all costs? Do these measures sound like they are supportive of a short-term spike in commodity demand?

In short, the rebound in gold and other commodity prices appear to be temporary and the bear trend will likely re-assert itself after a short rebound. This does not look like the start of an intermediate term uptrend.

For commodity bulls, the current environment is like the unfortunate case of being locked up by the secret police and having your interrogator go home for the evening. You may think that the torture is over, but the beatings will continue when he returns in the morning.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Commodities poised for revival

Yesterday's stock market selloff was an event that we haven't seen in some time, as major averages fell over 1% across the board - and globally. Nevertheless, I saw a glimmer of hope for the bulls, as commodities were performing well despite the carnage. If a deep cyclical sector like that is displaying rising relative strength, it suggests that the end of this correction may not be too far off.


Commodities unloved and washed out
Simply put, the commodities complex is unloved, washed out and showing signs of investor capitulation. The chart below from BoAML shows the aggregate large speculator (read: hedge fund) net position from the Commitment of Traders report in the CRB Index. Large speculators have liquidated their net long positions from a near crowded long level to net short. Moreover, readings are consistent where declines have halted in the past.

Here in Canada, the junior resource companies are beyond washed out. The chart below of the relative performance of the junior TSX Venture Index against the more senior TSX Composite is at all-time lows - and below the level of the capitulation lows seen following the Lehman Crisis.

Here in Vancouver, which is the heart of junior mining country, I personally know of scores of well-qualified people who are in the industry who are struggling with the difficult environment.


Green shoots
In the midst of this bleak landscape, I am seeing nascent signs of recovery for the sector. What is encouraging was the positive performance shown during yesterday's ugly selloff. One of the top recent performers has been industrial metals, which has:

1. Rallied through a downtrend;
2. Staged an upside breakout through a wedge; and
3. Staged an upside breakout through a resistance level yesterday - which was impressive given the headwinds provided by the risk trade.

At the same time, gold seems to have made a temporary bottom and it's starting to grind upwards as the precious metal is displaying nascent upside strength.

I am watching carefully the Brent price, which is a better proxy for world oil prices, for signs of an upside breakout through a downtrend. We almost achieved the breakout yesterday, but not quite.

The relative performance of energy stocks against the market is starting to show positive relative strength, which is another early warning of shifting leadership.

Macro and market implications
While I understand that commodities and commodity related stocks are unloved, washed out and poised to rally. These combination of sold-out sentiment and early signs of rising relative strength are pointing to a recovery in these sectors.

From a macro perspective, the recovery of deep cyclical sectors like these are consistent with a relatively upbeat outlook for growth economic growth. In that case, the environment for equities is encouraging and any correction should be relatively shallow - barring any macro surprises,




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Commodity weakness is likely localized

The old Cam would have been freaking out. The first version of my Inflation-Deflation Trend Allocation Model depended solely on commodity prices as the canaries in the coalmine of global growth and inflationary expectations. The chart below of the equal-weighte Continuous Commodity Index is in a well-defined downtrend. The weakness isn't just restricted to gold, but other commodities like oil and copper are all falling.

However, we found with further research that adding global stock prices to commodity prices as indicators gave us a better signal, in addition to giving us a more stable signal.


Equities not confirming weakness
The three axis of global growth are the US, Europe and China. I am finding that signals from all three regions are not really confirming the signals of weakness given by falling commodity prices. Consider, for example, Caterpillar's earnings report yesterday. The company, which is a cyclically sensitive bellwether, reported punk sales, earnings before the opening bell and revised their outlook downwards [emphasis added]:

We have revised our outlook for 2013 to reflect sales and revenues in a range of $57 to $61 billion, with profit per share of about $7.00 at the middle of the sales and revenues outlook range. The previous outlook for 2013 sales and revenues was a range of $60 to $68 billion and profit per share of $7.00 to $9.00.


“What’s happening in our business and in the economy overall is a mixed picture. Conditions in the world economy seem relatively stable, and we continue to expect slow growth in 2013,” said Oberhelman.

“As we began 2013, we were concerned about economic growth in the United States and China and are pleased with the relative stability we have seen so far this year. In the United States, we are encouraged by progress so far and are becoming more optimistic on the housing sector in particular. In China, first quarter economic growth was slightly less than many expected, but in our view, remains consistent with slow growth in the world economy. In fact, our sales in China were higher in the first quarter of 2013 than they were in the first quarter of 2012, and machine inventories in China have declined substantially from a year ago,” said Oberhelman.

“We have three large segments: Construction Industries; Power Systems; and Resource Industries, which is mostly mining. While expectations for Construction Industriesand Power Systems are similar to our previous outlook, our expectations for mining have decreased significantly. Our revised 2013 outlook reflects a sales decline of about 50 percent from 2012 for traditional Cat machines used in mining and a decline of about 15 percent for sales of machines from our Bucyrus acquisition,” said Oberhelman.

In other words, CAT remains upbeat on US housing. China is weak-ish and mining is in the tank. It seems that much of this negative outlook has been discounted by the market. While the stock fell initially, it rallied to finish positively on the day on heavy volume.

For now, the US economy look OK. I agree with New Deal Democrat when he characterized the high frequency economic releases as "lukewarm". We are not seeing gangbusters growth, but there is no indication that the economy is keeling over into recession either. The preliminary scorecard from the current Earnings Season is telling a similar story. The earnings beat rate is roughly in line with the historical average, although the sales beat rate has been somewhat disappointing.


Risk appetite rising in Europe
Across the Atlantic, Europe is mired in recession. However, there is little sign that tail-risk is rising. I have been watching the relative performance of the peripheral markets in the last few days as stocks have weakened. To my surprise, European peripheral markets have been outperforming core Europe, indicating that risk appetite is rising. Here is the relative performance of Greece against the Euro STOXX 50:

Here is Italy:

...and Spain:

Well, you get the idea.


Weakness in China?
What about China? Chinese growth has been a little bit below expectations, such as the March Flash PMI released overnight. Shouldn't weakness in Chinese infrastructure growth would be negative for commodity prices? Isn't that what the commodity price decline is signaling?

Well, sort of. Maybe. We have seen a great deal of financialization of commodities as an asset class. An alternate explanation of commodity weakness is the unwind of the long positions of financial players . Indeed, analysis from Mary Ann Bartels of BoAML shows that large speculators have moved from a net long to a net short position in the components of the CRB Index:

One key gauge I watch of Chinese demand is the Australian/Canadian Dollar cross rate. Both countries are similar in size and both are commodity producers. Australia is more sensitive to Chines growth while Canada is more sensitive to American growth. As the chart below shows, the AUDCAD cross remains in an uptrend in favor of the Aussie Dollar, though it is testing a support region.

In conclusion, the preliminary verdict from the market is that commodity weakness is localized - for now. Barring further weakness in commodity prices and the other indicators that I mentioned, the implication is that US stock market action will be choppy because of the uncertainty caused by commodity weakness and Earnings Season, but any downside will be limited. As the point and figure chart of the SPX below shows, the S+P 500 remains in an uptrend and I am inclined to give the bull case the benefit of the doubt for now.

So relax and chill out.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Time to ride the commodity bull

Long time readers know that I am a long-term commodity bull. Moreover, I have been writing on the theme of global healing for a few weeks. Despite last week's disappointing US GDP report, I am seeing signs that it may be time to get on the commodity bull for a ride. Both sentiment and momentum indicators are lining up for another upleg in commodity prices.

First of all, sentiment measures indicate that commodity prices are at levels suggesting accumulation. This chart from Mary Ann Bartels of BoA/Merrill Lynch (Note: the depictions of bull and bear phases are mine, not hers) shows that large speculators, who are mainly hedge funds, have moved off a crowded long in commodity prices. The chart was produced by aggregating the Commitment of Data reports for all futures exchange traded commodities in the CRB Index.

My depiction of the bull and bear phases show that during the bear phases, neutral readings are good times to fade the rally. On the other hand, neutral readings are good opportunity to accumulate positions during the bull phases. The bull and bear phases is best exemplified by the chart of the bellwether of gold prices, which bottomed in 2002 along with the rest of the commodity complex.

Just because there is a neutral signal from this is a good time to accumulate positions doesn't mean that there isn't more downside to commodity prices. To see some near-term upside, you need a catalyst.


Bullish CAT guidance the bullish catalyst?
I have offered that one of the key indicators to watch for market direction is to watch the corporate guidance and the body language from management during 1Q earnings season. A bullish catalyst appeared last week when Caterpillar, which is a cyclical company that does business worldwide, reported and gave guidance that was very upbeat :

We expect improving world economic growth to increase demand for commodities. Our outlook assumes most commodity prices will increase slightly in 2012 and continue at levels that encourage investment. We expect that copper will average over $4 per pound, Central Appalachian coal about $75 per ton and West Texas Intermediate crude oil about $100 per barrel.

In particular, mining will be a source of growth in 2012 and growth will be so high that supply will have a tough time with meeting demand:

We expect mining to continue to be strong globally, and we have a sizable order backlog for mining equipment. We expect sales to increase in 2012 and are in the process of adding production capacity for many of our mining products. However, we expect sales to be constrained by capacity throughout 2012.

Moreover, the WSJ showed that the American economy continues to grow despite last week's disappointing GDP report:

CAT was bullish on the outlook for US housing:

We expect total U.S. construction spending, which, net of inflation, has declined since 2004, to finally begin to recover in 2012. We project a 1.5-percent increase in infrastructure-related construction and a 5-percent increase in nonresidential building construction. We are expecting housing starts of at least 700 thousand units in 2012, up from 607 thousand units in 2011.

They were sanguine on Europe because of ECB support of the eurozone:

The Eurozone public debt crisis has been a lingering negative, but it is unlikely to trigger a worldwide recession. The Eurozone will likely have at least two quarters of weak, possibly negative growth, but should begin to improve in the second half of 2012. For 2012, our outlook assumes economic growth for the Eurozone near zero and growth of about half of a percentage point for Europe in total.

Our expectation for improvement of European growth in the second half of 2012 rests on a continued easing by the European Central Bank (ECB). The ECB has recently lowered interest rates and could cut rates further in 2012.

CAT also saw sufficient growth in China to support construction demand and commodity growth:

China took its first easing action in late 2011, and we expect that further easing is likely. We expect China's economy will grow 8.5 percent in 2012, sufficient for growth in construction and increased commodity demand.

In addition, Joe Weisenthal highlighted some of the positive long-term fundamental drivers of Chinese commodity demand, namely a population that is rapidly becoming more affluent, which will raise demand for the consumer good life, such as electricity:

...and autos:

So there you have it:

• A long-term rising demand for commodity prices from emerging market countries like China;
• A neutral to moderately bullish sentiment environment for commodity prices; and
• A forward looking bullish outlook from a global company that is highly exposed to cyclical growth.

What more do you need?



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Crowded trades = Rising risk levels

Reuters reports that the latest Commitment of Traders report from the CFTC shows a crowded short in the US Dollar:

The value of the dollar's net short position rose to $34.9 billion in the week ended March 1 from $22.36 billion a week earlier, according to CFTC and Reuters calculations. It was the largest net short dollar position for which Reuters has data, dating back to June 2008.

The other side of the coin of the short USD trade has been the skyrocketing commodity price. Maryann Bartels of BoA-Merrill Lynch aggregated the COT positions for large speculators in the CRB Index and found that large speculators (read: hedge funds) are in a crowded long position in commodities.

In the short term, the news from Libya has also served to push up oil and gold prices. We are also seeing strong momentum and funds flows from traders continuing to pile into the cyclical or reflation trade. Despite the 3% drubbing taken by Dr. Copper yesterday, the CRB Index continues to rally to new recovery highs.

Nevertheless, this kind of sentiment backdrop represent high risk conditions for the stock and commodity markets. For traders who want to stay long, I advise a high degree of risk control in order to define the level of losses you are willing to bear. Meanwhile, enjoy the party.




What I am watching for: There have been rumors circulating that Qaddafi is negotiating the terms of his resignation. If that were to happen, oil and gold prices will crater and that will remove the geopolitical noise from commodity prices.

In the event that the Libyan risk premium contracts from recent levels, what I am watching more carefully is the price reaction of the entire commodity price complex to the market environment. It's not just energy and precious metals, but how the softs, agricultural and industrial commodities react for a sign of how market expectations of global growth and inflation are developing.

A fragile and frothy market

As the S&P 500 tests resistance at the 1100-1120 zone, which is the 50% Fibonacci retracement level, it is useful to think about market tone.

How the market reacts to news is often a useful guide to future direction. When the bulls were in full control of the market action, a downgrade by a single analyst on WFC wouldn’t have taken the market down dramatically in the last hour. When the bulls were in full control, news that the Chinese economy had grown by 8.9% would have been an excuse for further advances and not pullbacks. Moreover, the widespread skepticism over China’s official statistics would have been swept under the rug.


Technical divergences everywhere
Today there are technical divergences everywhere. I won’t go into every single one but the most glaring is the faltering leadership of small cap stocks, which led the rally that began in March 2009. As the chart below shows, the ratio of the Russell 2000 (small caps) to the S&P 500 (large caps) has broken its relative uptrend line, indicating that small cap leadership is rolling over.



Is the “risk trade” over-owned and over-loved?
Sentiment readings are getting more constructive for the bears. There is no doubt that the risk trade is coming back. The news that John Meriwether is staring his third hedge fund after blowing up two others in spectacular fashion could be the top tick for the market. Moreover, EPFR reports that investors are going out on the risk trade by buying emerging market funds: “the $4 billion of net inflows into Emerging Market Equity Funds in the week ending October 14 was the largest weekly total since December 2007.”

Mary Ann Bartels of BofA/Merrill Lynch reports that large speculators (read: hedge funds) are starting to sell their crowded long position in NASDAQ 100 futures, the high-beta vehicle of choice among the fast money crowd. As well, the AAII poll of individual investors is at an elevated bullish level, though not quite a crowded long reading.



On the other hand, Mark Hulbert wrote that newsletter writers are still skeptical of this stock market rally, which is contrarian bullish.


Watch how sentiment develops
On top of that, you have a market that is overvalued by Tobin Q standards and seriously intermediate term overbought. The inability of the market bulls to shrug off bad news and to advance in the face of good news, as well as faltering small cap leadership are signs indicative of an imminent pullback.

Given the still somewhat mixed sentiment picture, the key to future market direction would be how sentiment readings change should the market correct. Would investors be so convinced of a V-shaped recovery (see examples of stories here, here and here) that they would buy on dips and send sentiment readings into over-owned territory, which would be bearish? Or will they turn cautious, which may ironically limit the downside of any corrective action.

US bond market poised to rally

James Carville, advisor to then president Bill Clinton, famously said that he wanted to be reincarnated as the bond market so that he could intimidate everybody – that’s because the bond market is usually right.

So what is happening with the bond market?


Large speculators are in a crowded short
The CFTC's Commitment of Traders report shows that large speculators (read: hedge funds) are either in crowded short or near crowded short positions in the 10-year and the long bond. The chart below shows the net position of large speculators in the long T-Bond futures contract. Readings were in a crowded short and there has been some minor short covering.


Coincidentally, long bond yields have fallen through a support line and bond prices have begun to rally.


In the 10-year, large speculators remain in a crowded short.


…and yields are sitting right at technical support.


These sentiment readings are evocative of a stretched rubber band ready to snap back. You don’t often see crowded long or crowded short positions in futures contracts. The dual crowded short readings in both the 10-year and long bond are even more rare and confirm my belief that the bond market is poised for a tactical rally.

A sentimental warning for gold

With gold having shown a nice bounce in the last couple of months from about 700 and now moving in the mid-800s, sentiment models now show that the advance may be overdone in the short run.

First, via Barrons, Mark Hulbert’s reading of gold timers are show excessive bullishness, which is contrarian bearish

The Commitment of Traders data from the CFTC confirms the high level of risk for gold bulls. The chart below shows the net positions as a percentage of open interest of commercials, or hedgers, in gold. While readings are technically in the neutral zone, they are very near levels where a signal to go short is generated.
The chart of the net positions of large speculators, or hedge funds, is mostly a mirror image of the chart of the hedgers’ positions and tells the same story of excessively bullishness, which is contrarian bearish for bullion:

The blogger COTs Timer is also cautious:

My trading setup for gold is in cash for the third week in a row. Large speculator net positioning has climbed gradually since it collapsed in August, when a bullish signal was triggered. It hasn't yet climbed to what my setup considers any kind of bullish extreme. But the other signal I use for this setup - based on the large speculator total open interest - has been on a bearish signal for the past four weeks. This is owing to a 31-percent increase in the large spec total open interest in the past month - typically a sign of downward pressure on the price of gold. So since the two signals don't agree, the overall setup is in cash.

In my past post Giving inflation a chance, I remain of the belief that inflation is destined to rear its head, which will be commodity bullish, but commodity prices are probably in a trading range for the next year or so and need to base before making a sustained advance.

In the short term, it looks like gold prices are facing stiff headwinds.

Addendum: Mebane Faber at World Beta has a blog entry about the XAU/Gold ratio being at a historic low. I refer readers to my previous post on the analysis of gold stock vs. gold ratio and why it might be out of whack, i.e. are production costs at gold companies rising?