A Mountain from a Mediterranean Molehill

You could be forgiven for thinking that the last few economic/financial “crises” haven’t felt very crisis-like. The dreaded sequester came and went without causing so much as a hiccup, and even the Italian election fiasco proved insufficient for more than a minor stumble in the market’s trajectory. But Europe seems intent on maintaining their new annual tradition of stirring up investor anxiety every spring. Enter: Cyprus.

Cyprus may be bigger than a molehill, but not by much. The fact that this much digital ink is being spilled worrying about a country with a GDP the size of mid-sized US city shows just how far we have to reach to find something dire to talk about these days. The country’s entire economy is a rounding error compared to the US federal budget…

Nevertheless, the airwaves are filled with concern that this could spark contagion, reignite the European debt crisis, and so on and so forth. Next verse, same as the first. At the end of the day, Cyprus matters precisely as much as people believe it matters, regardless of how much we think it ought to. And that means the possibility of choppy markets that have been the bane of many CTAs over the last several years.

But amidst the noise, we were pleased to see someone else who shared our frame of mind on such matters:

If you’re a trend follower like me, well this is one of those times when you need to be all over your risk management, because events like this have a habit of reversing or rapidly accelerating existing trends, so you need to stay alert for stops, and let your winners run until you get your exit. Stay focused. Despite the drama, this market is still in a solid uptrend.

Don’t expect this to die down quickly either. Right now the market doesn’t like this. If the vote doesn’t pass it will be a relief, but then that will put the entire aid package in jeopardy and then we’ll be back to the whole news cycle of waiting to hear it’s solved before we can move on. The media loves that stuff. Don’t be a slave to it.

The fact is, you have no edge trading off of news from Cyprus. You only have your system, your strategy, your process, your discipline. Stick with it. Follow whatever it gives you. Ignore the noise. Don’t watch TV. Watch price.

Sound advice in our book. Whatever comes of Cyprus, some prognosticators will be correct and some will be incorrect. But the traders with a sound system and solid risk management will be ready to capture a big trend if it arrives, or cut losses short if it doesn’t. Whether Cyprus causes just another ripple in the ocean or the tidal wave that the bears have been predicting for years – we’ll be glad we have our seat belt fastened.

Italy Goes Greek, Markets Go Haywire

We had to double-check our calendars a few times today to make sure we hadn’t somehow traveled back to the summer of 2012. Back then markets were riding the risk on/risk off roller coaster thanks to fears that Greece’s elections would deal a catastrophic blow to Brussels’ efforts to hold the Eurozone together. Less than a year later, and we find ourselves watching the recent relative calm in the markets turned on its head thanks to the same fears – but this time, it’s thanks to Italy’s election.

As a quick recap: after former Italian Prime Minister Silvio Berlusconi (of bunga-bunga infamy) was essentially forced out of office last fall, the technocratic (and unelected) government of Mario Monti arrived. After few months spent implementing “Brussels consensus” policies to stabilize Italy’s (and by extension, the EU’s) debt crisis, Monti was extremely unpopular with a huge swath of the Italian public.

As a result, this weekend’s election had 3 major players: the center-left party of Peir Luigi Bersani; the center-right party of Berlusconi; and the populist anti-elite movement created by the comedian Beppe Grillo. Most of the world was hoping for a Bersani victory, which would essentially signal a continuation of Monti’s reforms. The morning’s news suggested a big win for Bersani, but that optimism was shattered once the vote counts started rolling in, and it quickly became apparent that Italy was probably headed towards an ungovernable gridlock.

And the ripples throughout the markets were enormous. The early morning rally collapsed into the biggest single-day loss of the year for US equities:

Chart courtesy Finviz.com. Disclaimer: past performance is not necessarily indicative of future results.

We witnessed a huge spike in the VIX while setting a new one-day volume record for VIX futures contracts:

Disclaimer: past performance is not necessarily indicative of future results.

The stalwart of safe-haven currencies – the Yen – saw a huge spike before settling back down somewhat:

Chart courtesy Finviz.com. Disclaimer: past performance is not necessarily indicative of future results.

We could go on (and on and on). The point is, Europe came roaring back into relevance thanks to Italy’s election results, and with it reminded us of those risk on/risk off news driven markets which per our recollection were disliked by nearly all market participants.

It will be a few weeks before we know whether Italy will be able to form a government, and if so, what that government will look like. But we don’t really care if they do or not. What we’re looking at is what this may do to the markets managed futures track. If this brings back the news-driven highly correlated market moves, that could spell trouble. If it is the start of a more substantial crisis, well – managed typically love a crisis and the outlier moves they bring.

Newsletter: Managed Futures Outlook – 2013

Our weekly newsletter is out, and sadly we must add 2012 to the list of poor managed futures years. It wasn’t supposed to be this way. 2012 was supposed to the bounce back year for managed futures after a negative 2011. Managed futures as an asset class had never had back to back losing years, so it surely wasn’t going to happen this time… right?

Wrong. As the disclaimer says – past performance is not necessarily indicative of future results.  Managed futures did indeed put in back to back losing years, with the main managed futures indices finishing down between –1.65% and –3.21%. And the bigger problem – that’s three out of four losing years for the poster child for portfolio diversification after 2008. What’s worse, it’s not like managed futures losses came in the context of larger losses for stocks or bonds or real estate. Nope, they performed poorly on a relative scale too, coming in last among the asset classes we track.

The main culprit, a lack of trends – with our Average % Trending Days  indicator clocking in at the lowest level in 13 years:

Disclaimer: past performance is not necessarily indicative of future results.

 

The question is – what’s next? What does 2013 hold? Do we give up? Is trend following really dead? Has high frequency trading (HFT) really changed the game for non trend followers?

Well, it’s pure folly to pretend we can say with any accuracy where managed futures will end up over the next 12 months. We’re not interested in playing that game. No, we’re interested in analyzing the conditions which caused managed futures as an asset class to perform the way it did in 2012, and discussing whether those conditions will persist in the new year, reverse course, or yield to different conditions. Click through to see what we found.

If a Credit Rating Falls in the Forest…

The latest “big” development in Euro-area debt crises came yesterday as Moody downgraded France’s credit rating from Aaa to Aa1. Obviously, this was a massive event for the Euro, and for global markets.

Just kidding.

It was a pretty boring day, leading us to wonder what use these ratings agencies are in the first place.  Remember August of last year, when S&P cut the US credit rating? Or how about when S&P stripped France of its AAA rating in January, along with issuing downgraded credit ratings for eight other European countries: single-notch downgrades for Malta, Slovakia, Slovenia, and Austria; two notches each for Italy, Spain, Cyprus and Portugal? Markets reacted then pretty much like they have today.

Nothing. Nada. Zilch. Zippo.

It’s starting to make us wonder… other than the fact that certain entities are only allowed to invest in “investment grade” bonds, why do we even bother with the ratings agencies? They are, after all, the ones who stamped their AAA seal of approval on those mortgage-backed securities… right up until they imploded the global financial system.

If you’re counting on Moody, Fitch, or S&P to warn you of impending financial problems… well, let’s just say you might do just as well looking for warning signs in next years’ history books.

Bucking Vacuum Mentality

Traditionally, when you read a story, the moral comes at the end – a sound bite takeaway that justifies the time spent. We’re going to try something a little different, though, and provide the moral of the story up front. See, this story has a lot of moving pieces, and it can be all too easy to focus on one point, missing the forest for the trees. So before you even get started here, remember:

Nothing happens in a vacuum.

Chaos has erupted in the Middle East, and there’s no easy way to stem the tide. In Afghanistan, terrorists disguised in U.S. uniforms infiltrated our military bases, resulting in suspended joint operations that inevitably extend the conflict. In Libya, premeditated attacks resulted in the death of a U.S. ambassador. Anti-western sentiment has fueled protests in 20 separate nations. In Syria, what started as a small uprising is now full-blown civil war, with various actors in the region providing weapons and support to the rebels. Iran has shown renewed defiance in the face of international pressure regarding their nuclear program, repeating threats of wiping Israel off the face of the map, and the U.S. has begun to ramp up their language about consequences.

This kind of unrest and violence has the potential to upend an already volatile region, and that’s putting it lightly. With so much uncertainty, one would typically expect oil to be surging to new highs, yet oil today dips below $90 a barrel.

Nothing happens in a vacuum.

Yes, the violence and uncertainty in the Middle East may present concerns about supply, but there are serious questions about global consumption in the coming months and years, and with good reason.

For a very brief, beautiful window of time, it appeared as though we might be done talking about the Euro Crisis. After months upon months of turbulent debate over how best to stabilize the economies in the region, leadership announced a bold bond buying program, spearheaded by the ECB, and a reticent Germany was likely to provide support, however tepid. The markets, finally, had stopped responding to every little rumor on the continent as though they had mood altering drugs being piped in through a direct line.

Those were the days! Well, maybe “the minutes.”

The thing is, the discussion of these Euro Crisis solutions, how they might be implemented, and what their impact would be, took place in a very controlled environment. The markets held onto the belief that leadership would ultimately do whatever necessary to fix the situation, regardless of how many ups and downs came in between. After all, if individual banks could be considered too big to fail, surely the economies of entire nations qualified for the same sort of consideration.

And in some ways, such expectations make sense. If you look at the big picture, analyzing economic realities from a distance, such decisions were, of course, inevitable, with austerity-conditioned aid a near certainty.  Political leadership would have to make decisions rationally, and in that case, the ending was predetermined. Except, such calculus ignored the one element that never depended on what is rational for everyone:

The people.

Austerity measures, on paper, merely represent a number in an equation, but for the people the austerity measures impact, that couldn’t be further from the truth. A budget cut in some of these nations could be the difference between employment and the bread line; between a roof over your head or a box in the street; between dignity and despair. With economically driven suicide rates on the rise across Europe, this isn’t about what’s rational in the long run or the big picture; it’s about what comes tomorrow.

So are the scenes we see rolling across our screens really all that surprising? In Greece, what started as a general strike has transformed into violent riots, where protestors hurl petrol bombs at police forces. In Spain, as leadership attempts to pen austerity proposals, thousands of protestors surround cops sent to control the masses. They say a picture is worth a thousand words…

… but even that doesn’t tell the whole story. While the violent images are a jarring reminder of why we can’t assume a rational decision making paradigm on these important issues, it’s not the only complication in this crisis. While protests erupt in Spain and Greece, Portugal is looking more like Greece by the day. Italy’s economy continues to contract, as the population feels the pain of austerity measures coming into effect without additional aid. France is far from strong, and even Germany – often regarded as the last, best hope for Europe – is seeing their economy start to soften. Commitment to maintaining the Euro Zone, while admirable in principle, almost guarantees more pain to come.

And nothing happens in a vacuum.

Europe is in crisis; there’s no denying that. But Europe isn’t the Alpha and Omega of the global economy, which brings us to the BRIC nations. Brazil, Russia, India and China may have been given the nod by Goldman Sachs 11 years ago, but today, their prospects for ongoing growth appear dismal. Inflation is plaguing the countries, with Brazil seeing consumer prices jump 5.2% in July, Russia 5.6%, and India a whopping 9.86% headed into Monsoon season after record drought conditions. China came it at much slower increase of 1.8%, but they’re not out of the woods, as they stare down their 9th straight quarter of economic slowdown, with their stock market plummeting to 2009 lows.

And this is just what we know. As the New York Times reported earlier this year, there are major concerns about the validity of data coming out of China – arguably the most important of the BRIC economies:

As the Chinese economy continues to sputter, prominent corporate executives in China and Western economists say there is evidence that local and provincial officials are falsifying economic statistics to disguise the true depth of the troubles.

Record-setting mountains of excess coal have accumulated at the country’s biggest storage areas because power plants are burning less coal in the face of tumbling electricity demand. But local and provincial government officials have forced plant managers not to report to Beijing the full extent of the slowdown, power sector executives said.

Electricity production and consumption have been considered a telltale sign of a wide variety of economic activity. They are widely viewed by foreign investors and even some Chinese officials as the gold standard for measuring what is really happening in the country’s economy, because the gathering and reporting of data in China is not considered as reliable as it is in many countries.

Indeed, officials in some cities and provinces are also overstating economic output, corporate revenue, corporate profits and tax receipts, the corporate executives and economists said. The officials do so by urging businesses to keep separate sets of books, showing improving business results and tax payments that do not exist.

The executives and economists roughly estimated that the effect of the inaccurate statistics was to falsely inflate a variety of economic indicators by 1 or 2 percentage points. That may be enough to make very bad economic news look merely bad.

This type of economic concern is shadowed by several years of highly publicized fraud in the private sector (Sino Forest, anyone?) in a heavily controlled information flow, leaving us to wonder what lies beneath the surface. In Russia, other vulnerabilities persist. As Reuters reports:

A lending spree by Russian banks may be piling up problems for the sector in future, especially if a sharp fall in oil prices puts a stop on the country’s economic growth, a senior central bank official warned on Tuesday. […]

Recent stress tests by the central bank show the number of domestic lenders that could face capital shortfalls under an “extreme” scenario – where a drop in oil prices drags down the economy – has risen 2.5 times since earlier this year, he said.

A sharp fall in oil prices? Poorly prepared banks with too much debt on the books? Sound familiar? There’s a lot of weakness in these regions- regions where consumer habits and juggernaut growth have been viewed as a safety net for the global economy.

And nothing happens in a vacuum.

In an election season saturated with economic laments, how ironic that the U.S. looks strong by comparison. Stocks are up over 95% since 2009, home sales are finally on what looks like a firm road to recovery, and consumer sentiment is soaring upward. But at the same time, unemployment is at 8.3%, and debate over how to buoy the job market is running hot. Still, those debates are taking place in the dreaded vacuum – with solutions and efficacy being placed squarely on the shoulders of the presidency, and perhaps, as Josh Brown explains, in a place far, far away from reality:

Which brings me to the US equity markets, which are coming off of a virtually uninterrupted melt-up since the end of June, with virtually every sector and stock participating regardless of economic sensitivity.  This in the face of eroding fundamentals for many bellwether stocks and industry groups, Fedex and Caterpillar being just the latest examples to tell us how lousy things are.

But we ignored the fundamentals and rampaged higher on sentiment. This is how you explain a stock market that runs up 15% with no change in earnings estimates for the forward two quarters. The improvement in sentiment – driven by the assumption and then confirmation of permanent Fed support – is responsible for virtually all of your portfolio’s gains since the Summer Solstice, no offense to the regard with which you hold your stock-picking abilities.  Even the most bullish strategists with the highest year-end S&P targets acknowledged that multiple expansion was the key ingredient for their forecasts, none of them were looking for an acceleration in fundamentals by year-end.

In short, we built a Castle on a Cloud, the accumulated moisture of performance-chasing and confidence were its only foundation. And now, with European markets back in turmoil – with all of the volatility and drama that brings – the only question is whether or not our Castle on a Cloud can remain aloft, above the disturbances at ground level.

That’s the thing about Castles on Clouds – a surrounding siege army is not required for them to fall, only a change in air current that dissipates the molecules.

But what on earth could change that air current? Setting aside the first thousand words here, there’s this little thing called the Fiscal Cliff. As a reminder, the Cliff references a combination of events that would play out over November and December of this year. With a redux of last August’s debt ceiling debate coming around, the lame duck Congress will also be trying desperately to avoid a series of tax cut expirations and scheduled spending slashes set to take effect on the first of the year – the cumulative impact of which is the shrinking of the economy and exacerbation of current pains. With Republicans firmly opposed to any form of tax increase, Democrats unwilling to cut spending without some offsetting revenue, and their “Do Nothing Congress” moniker based on a partisan gridlock without comparison, a change in the current isn’t all that hard to envision.

And nothing happens in a vacuum.

In his United Nations address yesterday, President Obama referenced the impact of technology on the connectivity of message and audience, but it’s not just the stories we tell that connect us. The best example of the shared narrative- the “common heartbeat to humanity”- is how synced up our economic heartbeat has become. Call it a castle on a cloud, house of cards, or personified Bon Jovi lyric, but things are far from stable or sustainable right now, particularly in a world where we delude ourselves into thinking all of these things happen in a vacuum and can be addressed in the same manner.

If you’re not thinking in a vacuum, portfolio diversification becomes more important than ever. But it’s not enough to pay diversification lip service with traditional allocation strategies – you have to make sure you have truly non-correlated exposure backing you up. We don’t make a secret of which asset class we think best fits the bill… and we’re more than happy to discuss options.

Germany stumbling?

In the midst of the Euro crisis, Germany has been the beacon of hope. Long the strongest economy in the eye of the storm, they’ve been leaders in the turmoil and the country to watch for hopes of a move forward. However, even with other nations buoyed by the ECB bond buying plan, Germany’s numbers are not all that encouraging. Reuters reports:

Stock index futures pointed to a lower open on Monday, extending last week’s decline as weak European data caused investors to question the prospects for global growth.

German business sentiment dropped for a fifth successive month in September to its lowest level since early 2010, showing the strongest of Europe’s economies is succumbing to a downturn despite the European Central Bank’s ambitious bond-buying plan. European shares lost 0.6 percent.

To be fair, the declines in both the European and U.S. stock markets have been paltry in comparison to the summer equities surge we commented on in last week’s newsletter. However, the continued negative data coming out of Germany may put a damper on things as investors warily eye potential economic stumbling blocks on the horizon. In a perfect world, the decline is not decidedly sudden, allowing managed futures to position themselves appropriately for a downturn, but with the risk on/risk off moves of 2011 still fresh in our minds, we know it could go either way. However, should economic data continue to trickle down in this manner, the former scenario is looking plausible.

The Case for Continued Downward Trends

We made the argument at the beginning of June that this month would be particularly important for managed futures, pointing out that a dissolution of the downward trends most trend followers were riding out could erase the meager gains achieved by the asset class YTD. No sooner did we publish the newsletter than did we see an uptick in the markets, followed by a roller coaster that would change direction at the drop of a pin.

Not what we wanted to see.

As of June 26th, though, the Newedge CTA Index, while down 1.89% MTD, is still just barely positive on the year at .57%. (Disclaimer: past performance is not necessarily indicative of future results.) CTAs struggled this month- no doubt about that- but they aren’t dead yet. More significantly, using the trend following proxies we unveiled earlier this year as a snapshot of the trend following space, we see that the majority of the models, despite the whipsaw climate, have not been stopped out of their short positions. This is the nuance – the plot twist – that has us biting our nails headed into July. Managed futures, in our opinion, is literally standing on the precipice of a year (and maybe decade? Or we’re just being drama queens?) defining move. If the sideways gives way to a large downturn, we may have a new case in point for discussing crisis performance with investors. If not… well, go read our newsletter on June.

However, we tend to believe at this point that we should see downturns across the markets in the coming months. Not for a reason that we can mathematically demonstrate, of course; the markets are far from rational these days. We just see enough potential catalysts for the downturn on the near term horizon that it’s what we’re expecting.

  • The Euro Summit- This Friday, the leaders of the European free world are convening to save the world from Greece, Spain, Italy and the rest of the Eurozone that no one is worry about yet but probably should be. The general feeling for months was that there was no way such leaders would let the world go to hell in a hand basket, but after months of shenanigans and hijinx, such confidence has waned. Those with nothing on the line tend to believe that these leaders are functionally worthless, and that the meeting will fail to generate the results needed to prevent a complete collapse in Europe. Those with money on the line are forcing a smile and hoping they’re wrong for agreeing. Given that Merkel has patently rejected any chance of life for the measures that would probably be necessary to get things anywhere close to back on track, we’re sending early condolences to those with money on the line.
  • QE Disappointments- Big Ben got the world all kinds of excited when indicating an extension of actions intended to boost liquidity. It was exactly what so many people wanted to hear. Unfortunately, most people have selective hearing, because the decision and resulting commentary clarified two very important things: 1) Maybe does not mean yes, and with very little substantial economic data coming out between now and the August meeting, the odds of there being a strong enough trigger to push the Fed into being more aggressive are slim to none, and 2) even if the Fed does act, their ability to make a substantial impact, by their own admission, is definitely in question. Great skepticism write up here.
  • Political Tomfoolery- Hey, guess what? It’s an election year in the U.S. Guess what? We’ve only just begun. We haven’t even had our first debate yet. Things are going to get ugly. And in an era where complex policy issues are boiled down to 140 character barbs and jabs with little effort made to give the assertions context or support, the chances of the national political dialogue resembling anything productive are laughable. That’s sort of a problem, because there’s a lot of work to be done on Capitol Hill, particularly in terms of that fiscal cliff we’re dancing towards.

This is the next couple of months. It does not account for extremes in Europe (collapse of the Euro itself, for instance), hormonal-teenager-like reactions to Fed inaction, or political pitfalls we never see coming. All of that could happen as well, but even without, there is, in our opinion, enough coming down the pipes that should stop the sideways motion and push us further down this trend. If we hit one of those extremes, forget about it. If those markets go to zero, we’ll be very happy indeed (though probably in a minority). If not, then we absolutely give up on trying to use our publications as a form of psychological warfare against the gods and goddesses of market trends. Seriously.