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Is Risk Dead? Or Is This A Bear Market Junk Rally?

In our last post we discussed how we at The Macro Trader think that risk is vastly under-priced.  We looked at several different volatility indexes as well as Bill Luby and VixandMore.com’s JunkDEX.  The JunkDEX shows how well stocks like AIG, FNM, C, CIT, and BAC are doing.  As you can see in our previous post “Volatility Indexes, Risk Appetite, Mispriced Risk, And Where We Think We Are Headed” the JunkDEX  has had a monster rally.  Usually this would signal at least a short term top as speculative fever burns out.   Obviously the rally was not done and we are up since then.

To more quantitatively show the huge run up in risky assets we went looking for some factor based indexes that would show the performance of “good” and “bad” companies.  In our search we came across some custom stock baskets from Goldman Sachs that use Edward Altman’s famous Z-score to separate stocks into strong and weak balance sheet indexes.

The Altman Z-score uses 5 financial ratios.  Altman took the 5 ratios and using statistical techniques was able to build the Z-score which predicts a companies probability of failure.  The higher the score the safer the business is and the lower the score the more danger there is of insolvency.

As was to be expected the performance between the weak and the strong balance sheet stocks has been drastic over the last 6-months.  As you can see in the chart below the low Z-score basket has vastly outperformed the high Z-score basket.  In fact the weak balance sheet basket has done almost twice as good as the strong balance sheet basket of stocks. (click on chart to enlarge)

Goldman Sachs SP500 Strong and Weak Balance Sheet Baskets 6-Months

goldman-custom-strong-weak-balance-sheet-baskets-6-month

While the result is not too surprising it is an example of bad investor behavior.  Academics as well as practitioners have found time and time again that safe low volatility stocks outperform risky volatile stocks over a full market cycle.  In fact if you look at the chart below you can see how the roles between the strong and the weak balance sheet baskets are totally reversed.  The strong balance sheet stocks are positive for the last five years while the weak balance sheet stocks are still very negative.  Another thing to notice is that the junk stocks went down a lot faster and more consistently then the quality stocks when the market tanked over the last two years. (click on chart to enlarge)

Goldman Sachs SP500 Strong and Weak Balance Sheet Baskets 5-Years

goldman-custom-strong-weak-balance-sheet-baskets-5-year

So what are we to take from all of this?  We think that the market is far too speculative given the current economic backdrop.  Earnings while “better then expected” are at record lows, unemployment is at highs not seen since the depression, we are experiencing deflation for the first time in several decades, the consumer is retrenching and not consuming, and really the only true “green shoot” was that it is not yet the end of the world.

Yes, we can go higher from here but the odds do not favor being heavily long right now.  Our basic forecast at The Macro Trader is that in the not too distant future we will have a correction if not worse and we will be able to buy stocks at a better price then where they are currently sitting.

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-In The Macro Trader newsletter we are short some QQQQ-NASDAQ 100 ETF

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Title: Is Risk Dead? Or Is This A Bear Market Junk Rally?
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Where Did All The Contango Go?

For the first few months of the year West Texas Crude Oil was in an extreme contango situation.  In fact it got as high as 20% just four months out.  Looking at the 4-month contango/backwardization  in West Texas Crude Oil we can see that in just the past seven weeks it has dropped from over 15% to just 3.2%.

West Texas Crude 4-Month Contango/Backwardization

oil-contango

Most of the narrowing has happened in the near month futures, since over the past seven weeks the near month has rallied  27% and the 4th month only 14%.

Obviously the big question should be is demand really picking up? If so Oil should rise fairly quickly as we continue to see declining production as well as a decline in the ability to produce via the drop in rig counts over the last eight months.

Or is this a short term rise based on the notion that the economy is improving and this is just an extension of the risk trade?  If so then oil is to be shorted as are many other commodities as the reflation trade is put on hold.

We try not to fight the market and right now it is obviously in bull mode as it has moved up 75% from its lows.  That being said we tend to listen to the signals from economic indicators like capacity utilization, unemployment, and Fed minutes that show anything but an economic recovery.

West Texas Crude Oil

oil-bull

For now the trend is up and we are modestly bullish (that means we are flat) bulls.   However over the next few months we would not be surprised at all to be changing our view to the bear side and going short as the lack of demand likely overtakes these sorry excuses for green shoots and the economy, and therefore demand, roll over.

Happy Trading,

Dave@TheMacroTrader.com

Site Updates- Yesterday we installed Disqus to better  interact with our blog readers.  We welcome your views on energy, the economy, and any other financial topic.

EWY South Korea ETF

One of our current positions is EWY the South Korean ETF. We went long a few weeks ago in our model portfolio based on the trend, valuation, and economic characteristics of South Korean stocks.

EWY-South Korea ETF

ewy

Another factor that got us into EWY was the increasing number of Asian countries that have been coming up in our global stock model. Our global stock model looks at technical, economic, fundamental, and sentiment indicators to help find foreign stock indexes that meet our risk to reward criteria.

Apparently we are not the only ones to have found an opportunity in South Korea as the Oracle himself WarrenB apparently is getting long some South Korean stocks as well.

In order to catch our trades in foreign stocks as well as other asset classes like US stocks, bonds, currencies, and commodities then sign up for a quarterly or annual subscription to The Macro Trader weekly newsletter with frequent intra-week updates.

Happy Trading,

Dave@TheMacroTrader.com

A Simple SP500 Timing Model

We track hundreds of different economic, fundamental, technical, sentiment, and cycle indicators. Some are stand alone and only help us discern particular situations while others are full blown timing models that we use to get in and out of the market. Some are very complex with ten and even twenty inputs ranging from jobless claims, to put call ratios, to nickel, to the advance decline line. Essentially anything that we test that helps to give us an edge we use to some degree or other. As global macro traders we of course have several models for every market that we trade, as well as models that only point us to markets showing abnormal movement.

As of a few days ago we had one of our longer term SP500 timing models trigger a buy signal. This timing model is very simple and only uses the NYSE Advance Decline line and the SP500 closing price. This models esge is not huge but it is solid and historically you are risking about 1:1 meaning that the historical return is almost the same as the worst historical drawdown.

In our newsletter and in our own trading we rarely use a model as an automatic buy or sell signal but we do use them to tell us which dorection to trade. Right now this extremely simple model is showing that the advance delcine line has finally been able to have a sustained run and break above its long term trend, in this case the 150-day moving average. Again we don’t, and don’t recommend, trading directly off of these signals as almost every model we track can be improved upon by selecting better entry and exit points but they do helo us tremendously in our trading.

SP500-NYSE Advance Decline Line

sp500-advance-decline-model-4

As you can guess we are becoming increasingly bullish after being bearish for the better part of two years. Who knows if this rally will continue as there are a ton, and maybe a trillion tons, of harsh economic realities and hardships, but for now the trend is up and we are starting to lean to the long side.

Happy Trading,

Dave@TheMacroTrader.com

P.S. If you are getting value out of our posts, you can do us a favor by linking to us with your site or blog and mentioning The Macro Trader to any of your friends that trade.

Equity Risk Meter

Our Equity Risk Meter essentially measures how bullish or bearish we are towards the US Markets.   The higher the reading the less risk there is in the market and the lower it goes the more risk there is.

Right now for instance the meter is reading 12.5%, which is very bearish.  As you can see we have been bearish for some time now and very bearish since mid June, enabling us to avoid almost all of the downturn in the stock market.  When the meter starts to climb we become more and more bullish and look towards the longside.  For now we are essentially on the sidelines sitting in cash.

Equity Risk Meter

We will be posting our risk meter for US equities each week.  If you would like to follow it you can either come to the site each week or simply subscribe to our RSS feed.  Using RSS you will be able to either receive our posts as an e-mail or in your RSS reader.

Happy Trading,

The Macro Trader