A Little Perspective
File this with more qualitative thoughts and reasonings - a space we find ourselves frequenting lately as the US equity markets tempt fate for a third time. With glass on our shoulders (see Meridian), we would be fooling ourselves if we did not consider scenarios A through G of what could happen should the other panes break with conviction - or if we should continue to focus on trends we have had the strongest reads on and ignore what they eventually should mean to the equity market cycle. Translation: (Insert overused quote on irrationality from Keynes here)
Granted, the intuitive trades for us have come from the liquidation corners of the market, namely, the precious metals complex - buttressed by the currency differentials between the US dollar and the euro - and what we have perceived to be a rather rational unwind in Apple. Of course, the follow up question, "Why is Apple unwinding so diligently in a teflon tape?", likely resides closer to the same dog that's sniffing around and wagging the precious metals complex. Needless to say, we consider it anything but benign and scented for canine satisfaction.
From our perspective, world markets (ex-US) have been discretely rolling over throughout the first quarter. Europe, the BRICs, Canada - you name a major equity market and it very likely turned down before or during the month of March. Collectively, that balance is expressed in the MSWorld market chart shown below and to the left. Perhaps we are colored by a certain bias, but see the dynamic primarily motivated by the US dollar's newfound dominance, namely, in the face of a wounded euro and Europe. Downstream of the euro's Q2 pivot (see Here) - world markets have yet to find the same traction the SPX has enjoyed. It isn't a causal coincidence to find the correlation, considering the burgeoning emergent economies so closely tied to the commodity cycle - and the fact that Europe is China's largest trade parter.
From a comparative performance perspective, the current market landscape most resembles the topping process in 2000, where the negative divergence in performance between the SPX and the rest of the world grew steadily - until the US equity markets exhausted in late March. While some will certainly ignore this divergence or even sugar coat it as simply a safe-haven equity flight to the US; the simple truth is world growth - of which the financial markets are the the tip of the spear - are more entangled than ever. The US may outperform for a spell, but we'll still catch the same bug should the world get ill.
As we've discussed over the past several weeks in various notes (see Here & Here), the conditions we are most concerned with in the broader macro context is the persistence of disinflationary momentums that under the right conditions could exasperate a turn in confidence in our monetary handlers mettle to fight underlying deflation. We feel these concerns are evident in the inflation data in the face of considerable monetary stimulus and our focus on assets that not-so-long-ago were the darlings of the cycle - such as the precious metals complex and Apple.
We also continue to focus on the silver:gold ratio, because historically its contraction has marketed the end of a reflationary drive in equities. The ratio can be used either as a proxy for risk appetites, whereas, the higher beta asset of silver is contrasted with gold; or as a leading indicator of economic conditions, considering silver's industrial demand versus golds perception as a safe-haven in certain market conditions.
Below is a longer-term chart of the SPX and MSWorld indexes contrasted with a smoothed silver:gold ratio as expressed by its 50 week SMA. In the previous two equity market tops, the silver:gold ratio peaked and turned down before the credit and equity markets got the memo that risk management has left the building.
The two charts below paint somewhat similar momentum profiles in which both cycles had large indiscriminate bids in risk appetites (as expressed by the parabolic nature of the silver:gold ratio), sandwiched between two smaller financial crises - before the broader cycle turned down.
Following up on the silver:gold/SPX performance spread, the construct exhibited the widest inversion since the start of the secular bear market in equities in March 2000. Considering our expectations that weakness in silver will persist (see Here), we see no reason in joining the party and chasing the equity markets on the long side here.
Back in September, immediately following the commencement of QE3 - I wrote a note that addressed some of my concerns pertaining to what I perceived to be a double edge sword with the great commodity unwind (see Here):
"I like to remind myself that it's much easier to rekindle economic growth across the globe, when all that is required is a large shovel, boat and a frothy marketplace.
Although commodity inflation has provided the US consumer a painful transition in the pocketbook over the past decade, we likely do not fully appreciate how beneficial that same knife has smoothed the impact of our own financial stumbles - in a world more than ever financially dependent upon the health of the majority."
In light of the continued downturn in the commodity sector and the slowing growth evident throughout both the emergent and developed world, I find myself considering aspects of our Constructive Interference Theory - through the prism of what could happen if both the commodity and equity market cycles turned down together against the backdrop of a declining to troughing interest rate environment. It would be the backside of the global constructive interference wave that began over 40 years ago. As evident from the long-term chart which depicts these three asset cycles - it would be new territory. With that said, and with the perspective of 200 years of market history - the Everest slope of a declining interest rate environment over the past 30 years which helped imbibe the greatest equity market returns - were never in the same league. In many ways - ignorance until proven guilty has been blissful capital management in the equity markets. Certainly easier said than done, considering the range and trauma the equity markets have traveled over the past 13 years. But within the broader historical context - well within reason.
As always - Stay Frosty.