Defensive For Time Being (Alfred Lee)

Nobody said it was going to be easy. After surviving one of, if not the most catastrophic financial crisis in history, investors were perhaps under the false impression that we were set for yet another bull-run after last year’s massive rally. Heading into the new year, we expected a tug of war between good and bad news as market expectations were revised to more realistic levels, whereas last year, expectations were set very low making surprises on the upside easy. As we have discussed in previous reports, the use of margin is a key driver to higher equity prices in almost all bull-markets. This was especially true for the two bubbles we experienced in the last decade. As illustrated in the chart below, there is a strong relationship between margin usage (as indicated by NYSE margin debt) and the performance of U.S. equities (represented by the S&P 500 Composite Index). As a result, bull and bear markets have become processes of leveraging and deleveraging that are highly impacted by investor greed and fear. We aren’t arguing that markets have all of a sudden become irrational, as they clearly have always been as pointed out by Charles Mackay in his 1841 classic, Extraordinary Popular Delusions and the Madness of Crowds. However, access to easy credit, low interest rates and, to a much lesser degree, technological advances are making margin trading more accessible. These factors may be amplifying emotional investing in the market. While noting that this shows the relationship in margin debt and U.S. equities only, increased globalization has increased the correlation between markets. News flow out of the U.S. also continues to drive global markets.

(click to enlarge)

So how is this relevant to the current state of affairs in the market? While the use of margin is far shy of its 2008 highs, the run-up in equity prices last year, along with record low interest rates again encouraged market euphoria and the development of another asset bubble. Though currently we aren’t overly concerned about the level of margin debt in the system, the pace at which margin debt returned last year was indeed alarming.

1 comment
  1. You write: "While an increased allocation to bonds should provide capital preservation as we wait for the turbulence in the market to pass."

    I recommend that one have no allocation to bonds. I recommend gold, but for those who must be invested, I suggest they go short bonds and stocks both!

    The chart of emerging market bonds shows that these can experienced an abrupt and significant loss of value.

    I would like to present my view that holding debt of any kind, even high grade corporate debt, exposes one to the risk of loss of principle as interest rates go higher. I believe that interest rates were called higher by the markets on September 1, 2010, in response to the US Federal Chairman Ben Bernanke announcing intentions to buy mortgage backed securities on not only one occasion but on two occasions.

    High grade corporate debt, LQD, fell parabolically lower on September 1, 2010, with the purchase of the yen based carry trades, on September 1, 2010, which rallied stocks, ACWI; and turned the tide on bonds, BND, sending them lower, establishing August 31, 2010 as a high in bonds at 82.66, that is, ”establishing August 31, 2010 as peak credit” … bond deflation has been underway since September 1, 2010.

    High grade corporate debt, LQD, peaked on September 1, 2010 at 112.58. It has the same wave structure as BND; so any comments about bonds, BND, apply directly to LQD as well.

    Going over to and sorting on the 3 year returns, LQD shows 7.57%, which is quite good; going all the way to the bottom are such things as Natural Gas and Financial Services, which is quite bad.

    I believe that LQD’s returns will be influenced by a flattening of the 30-10 US Sovereign Debt Curve, and by CDS.

    The interest rate on the 30 Year US Government bond, $TYX, rose strongly September 1, 2010.
    And the interest rate on the US 10 Year Note, $TNX, also rose strongly September 1, 2010.

    September 1, 2010 marks the transition from “the age of neo-liberal Milton Friedman based credit liquidity” to “the age of the end of credit”; this also means ”the end of entitlements” and “the beginning of world-wide austerity”.

    The 30-10 yield curve,$TYX:$TNX, began to flatten on August 11, 2010, reversing a trend that goes back to early 2000.

    This signals risk aversion to sovereign debt. The flattening of the yield curve came as a result of the Federal Reserve Chairman's announcement of August 10, 2010 of the purchase of mortgage-backed securities. Then on August 27, 2010, the Federal Reserve Chairman stated the possibility of an even larger purchase of debt.

    This caused the bond rally in US Treasuries, TLT, and Zeroes, ZROZ, HIgh Grade Corporate Bonds, LQD, that began April 6, 2010, to fail September 1, 2010, sending bond prices lower and interest rates higher.

    The safe haven rally in debt, and the low-interest rates available to corporations, that began with the onset of the European Sovereign Debt Crisis is over, repeat over and done, through and finished. Investors see Mr Bernanke’s plans as monetization of debt; and have gone short US Treasuries, especially the longer out ones such as ZROZ.

    I believe a sovereign debt, read TLT, crisis, is coming soon, as well as a global financial collapse, where there will be no liquidity to buy or sell paper assets; I want something liquid like gold of silver as an investment.

    Systemic risk is quite high. Liquidity evaporation could happen quite easily, either coming through a failed Treasury auction or a situation where there may not be enough buyers of investment securities to meet sellers demand.

    I believe that soon, out of a liquidity evaporation and a bond, BND, liquidity crisis, stemming from a fast fall in bond and/or stock values, that here in the US a Financial Regulator will be announced who will oversee lending and credit, as well as money market and brokerage accounts.

    He will be what I call a credit boss or credit seignior who funds economic operations with an emphasis on seeing that the strategic needs of the country are met and that monies for food stamps keeps flowing. I believe the government will become the first, last and only provider of liquidity and money.

    I believe the intensity of onset of the coming credit crunch will come with a great rush and that the corporate bond market, LQD, will shut down very quickly. Like I say, I believe a lending boss will be announced and pretty much only natural resource companies and defense contractors and food producers will have credit liquidity.

    Furthermore, I see a coming ”see-saw” exhaustion of fiat wealth with stocks, ACWI, and then bonds, BND, alternatively falling lower. There may be days when both fall lower. The chart of Bonds, BND, for September 7, 2010 shows three black crows, with a fall in value to a head and shoulders pattern at roughly 82.00 and then a rise to 82.44.

    The chart of world stocks, ACWI, as well as the S&P, SPY, as of September 7, 2010, shows that the world stocks enter an Elliott Wave 3 of 3 of 3 down having completed a three white soldiers pattern, and a one day down --- ACWI closed down 1.28% and SPY closed down 1.13% on September 7, 2010.

    As the value of stocks falls lower, so will the value of corporate bonds, as they will fall under the influence of a flattening 30-10 US Treasuries curve, $TYX:$TNX seen in chart.

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