Inaugural Issue - Markets on the move…

Our goal with the Macro Market Monitor is to keep you posted on key global market changes as they unfold that have the potential to impact your portfolios. If we’ve learned anything in the last two years it’s that when trouble strikes, all markets have a tendency to move together. And it’s at times like these that traditional portfolio theory will let you down when you need it most.  But some markets provide advance warning, alerting those in the know of potential trouble ahead. 

Each month we explore the intermarket relationships between commodity/resource, currency, bonds and stocks and their impact on both the economy and each other. Like the force of the moon on the tides, different asset classes and markets exert an influence on one another. The trick is in identifying which are leading and which are following behind. As emerging markets and economies have grown, so has their influence on larger developed markets. We’ll also discuss currency movements and carry trades that have the potential to lead stocks.

Our mandated is to keep you posted on which markets are moving, what that means for your portfolios and how to profit from it. For example, those who were following homebuilder stocks watched them peak in the summer of 2005 and then fall got advanced warning that the broader housing market was nearing a top long before the housing fundamentals turned sour.  Find out when gold stocks are outperforming the metal, when oil stocks offer the greatest probability of rising or falling and which energy groups provide the best value and momentum potential.  We also explore leading market and economic indicators from some of the great guest traders and analysts.

Markets on the move…
Is this a ‘made in China’ recovery?

Since the turn of the millennium, China has been a rapidly growing economic powerhouse that has increasingly impacted markets around the world. In October 2007, stock markets were soaring and the S&P500 Index (SPX) hit a new all-time high of 1565 on October 9. Exactly one week later on Tuesday October 16, the Chinese Shanghai Composite (SSE) hit its all-time high of 6124.

Although the SPX high was never bested, the index stayed above 5000 until January 2008 but then rallied back above this psychological level again into May before falling off a cliff in September.

However, once the Chinese SSE had peaked, it wasted no time in heading for the basement.  A year later it had lost a whopping 72% compared to a loss of 41% for the SPX over the same period.

Figure 1
Figure 1 – Daily chart of the Shanghai Composite (SSE) in red, the S&P500 (SPX) in blue, the Indian Nifty Index (NFTY) in green and German DAX (GX) in magenta showing the SSE and SPX peaking within a week of each other but then the roles apparently reversing with the SSE leading the SPX, NFTY and GX lower from January through October 2008. Chart courtesy of www.GenesisFT.com

But then an interesting thing happened. In November 2008, the SSE hit bottom and started moving higher. Other global indexes including the SPX bounced but continued to plumb for a bottom putting in lower lows. And while the SSE and NFTY were moving up, it wasn’t until early March 2009 that the SPX and German DAX finally bottomed.

As we see from Figure 2, the SSE gained more than 100% between November 08 and September 09 compared to a 56% gain for the SPX off its low on March 6 to September 15.

Although the relationship is not perfect, it is apparent that the Shanghai Composite has been leading the S&P500. The big question now is whether the SSE drop is a warning of a similar move in the SPX or just an over-reaction on the part of Chinese investors to a market they believe had risen too quickly for its own good?

It will take time before the answer to that question is known but one thing is clear. Given the growing importance of emerging markets, and especially China, where these markets go is becoming increasingly influential on developed markets.
If the SSE turns back down, the probability of a similar move in the SPX increases substantially. We will be watching it closely. You can track the Shanghai Composite, S&P500 and German DAX free by typing the symbols SSEC-X, SP-500 and FDAC-X at http://www.freestockcharts.com/

Figure 2
Figure 2 – Daily chart of the Shanghai Composite (SSE) in red, the S&P500 (SPX) in blue, the Indian Nifty Index (NFTY) in green and German DAX (GX) in magenta from July 2008 to September 15, 2009 showing the SSE bottom four months ahead of the SPX then peaking in August 2008 after which it lost 23%. But since putting in a bottom September 1, the SSE has rallied 14%. Chart courtesy of www.GenesisFT.com

For more information on these markets, please see http://tradesystemguru.com/content/blogcategory/34/68/

Carry on with the carry trade
Rumors that the carry trade is dead are exaggerated. But does it still drive markets?

When markets were flying high, talk in the media swirled around the carry trade and how it was helping propel stocks into the stratosphere. A carry trade occurs when an investor borrows in a low-yielding currency (in a nation where interest rates are low) and uses the proceeds to buy high- yielding investments in nations where interest rates are high. One of the most popular carry trades was selling the Japanese yen (JPY) and buying the New Zealand dollar (NZD). Currency traders profit by buying the NZD and selling the yen. 

As the next chart shows, the New Zealand dollar/Japanese yen cross (NZD-JPY) peaked during the last week of July 2007 (vertical dark red line) well before the S&P500 peaked during the week of October 12. This move presaged the beginning of the credit crisis and stock melt-down by more than three months.

Many believed that the fallout that followed reduced the appetite for risk and with it interest in the carry trade. But the charts tell a different tale. As we see, the New Zealand dollar/Japanese yen bottomed February 6, 2009 (vertical green dashed line) a full month before the SPX.  Since then, the NZD-JPY has rallied 43% and shows no sign of slowing as investors again pile into the carry trade. The euro is another beneficiary of this appetite for risk.

This is another example of an intermarket relationship that provides advanced warning of a change in the risk appetite of global investors and a drop in stocks. As long as the NZD-JPY is moving up, it will be bullish for stocks since it is an important source of investment capital. But when this currency-cross rolls over, look out below! For a free quote and charts of the NZD-JPY go to http://finance.yahoo.com/q?s=NZDJPY=X

Figure 3
Figure 3 – Weekly chart of the New Zealand dollar/Japanese yen currency cross (NZD-JPY) showing its relationship and correlation with the S&P500 Index. Chart courtesy of www.GenesisFT.com

Market Mythbusters
Do high-priced stocks perform best?

There is a saying in market circles that high-priced stocks perform better than cheap stocks. It is based on the belief that higher-priced stocks are more established and represent companies that are less speculative and therefore safer bets. This month’s mythbuster, Eric Crittenden, co-founder, research director and trading operations managers of Blackstar Funds, put this belief to the test.

“Over the years we’ve occasionally heard the “rule of thumb” that high priced stocks make better investments.  We calculated total annual returns for all U.S. stocks (including those delisted) between 1991 and 2008. For the purposes of this analysis we focused on the 3,000 most liquid stocks each year. 

Figure 4
Figure 4 – Chart showing annual returns of stocks in different price ranges. 

“It turns out this “rule of thumb” hasn’t been particularly true.  The evidence does not suggest that stocks priced above $50 have been better investments than stocks priced below $50.  Furthermore, the average next-year return for stocks priced above $95 has been close to zero over the last 18 years.”   

So not only is the belief that high-priced stocks perform better false, the reverse is in fact true. On average stocks above $95/share were the worst performers. As the chart above shows, the best performers were stocks trading around $10. Second best were stocks trading around $65 and third, those trading around $55/share. This is certainly not intuitively obvious. It also raises the question why do stocks trading at $55 and $65 do so much better than those trading at $60?

Next Eric and his team examined actual versus theoretical returns on the best and worst performing stocks compared to expected returns based on normal expected returns for the same universe of stocks – all U.S. stocks between 1991 and 2008 with special focus on the 3,000 most liquid stocks each year.

Figure 5
Figure 5 – Distribution graph of theoretical random (in brown) versus actual returns (in blue).

As this theoretical return chart shows, the worst performing stocks did far worse than expected losing more than a random distribution model would suggest. On the positive side, there were more stocks with returns between break-even and 50% per year (but fewer star performers with returns in excess of 50% annually) than expected based on the random distribution model. 

“A random number generator was used to create an equal number of hypothetical annual returns.  Comparing actual stock returns to random returns yields a disagreement with respect to extreme negative annual returns.  Randomness suggests that only 0.5% of annual returns should be worse than -75%. 

“However, the actual historical record shows that this number has been greater than 4%. These findings suggest that “stop loss” methods could add value to an investing or trading strategy.”

There are two lessons from these findings when looking for stocks in which to invest. Contrary to popular belief high-priced stocks do the worst compared to their more moderately priced counterparts and the best performers were stocks have historically been found in the $10/share price range.

But when things go wrong and stocks lose money, losses are greater than theory would suggest, which means that investing without a clear exit strategy in the event your stock falls off a cliff is a bad idea.

Your opinion matters.
Tell us what you’d like covered in upcoming issues.

Do you have questions about markets or market relationships you’d like answered? Click here to take this short survey and tell us what they are.

In return, we’ll send you the link to an excellent report entitled Does Trend Following Work on Stocks? written by the Eric Crittenden and Cole Wilcox at Blackstar Funds as a thank-you gift.  

Click Here to take survey

Have a question or comment for our editor? (Please send your email to Matt Blackman at investorinsightsmb [at] gmail.com (remove spaces and insert @ symbol where you see [at] )

Stories of interest

Breakout! A closer look at gold
http://www.chrismartenson.com/blog/breakout-closer-look-gold/27535

Global economic crisis to continue: IMF chief
http://www.reuters.com/article/GCA-Economy/idUSTRE58B0K620090912

U.S. Economy May See Its Slowest Recovery Since 1945
http://www.bloomberg.com/apps/news?pid=20601068&sid=aBj5AeyQqun8

Shock May Put Global Relapse Odds as High as 1-in-3, Roach Says
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a9odwc3.kFwM

Gold bulls see safe haven in economic straits
http://www.reuters.com/article/ousivMolt/idUSTRE5894PI20090910?sp=true

AngloGold Risks Congo Jungle, Mining’s Last Frontier
http://www.bloomberg.com/apps/news?pid=20601109&sid=aUxKD0SRvQVo

Poverty Deepens as Recession Cuts U.S. Incomes, Census May Say
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aw6DvG14bU6s

U.S. Economy: Trade Deficit Widens Most Since 1999 on Imports
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZcN_BCvBsAE

 


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Posted 09-18-2009 3:22 PM by Matt Blackman