The market may now be characterized as prone to technical bounces while remaining in a downward trend.  From a technical perspective, any time the market starts to move up, it is amplified by some short covering, and then takes a few days of a relief rally.  When the technical fade begins, the smart money starts to sell the rally and down again the market goes.

 

Any talking head who tells you that this market is a buying opportunity has his/her head screwed on backwards.  The only buys are the kind of value plays that the likes of Buffett are pulling off.  That is, it is very much a stock picker’s market.

 

Recession plus inflation plus a credit crisis plus a softening European economy plus an inflation-plagued Chinese economy plus Russian strong-arming in natural gas plus two leading presidential candidates who are ignoramuses on economics plus a rising long bond in the face of Fed rate cuts does not a bull market make.

 

Don’t Miss This

Now, you may find the following video of a speech I made in 2006 to be interesting for two reasons. First, it illustrates how you can be your own forecaster – a useful tool for macro traders.  Second, the forecast in the speech was eerily prescient regarding current conditions.  CLICK HERE for video or go to http://streaming.merage.uci.edu/faculty/navarro/WellTimedStrategy.wmv

 

 

The Well-Timed Strategy

                                                  

Economic & Stock Market Analysis for the Discerning Investor & Executive

www.peternavarro.com

 

Read it and Reap!

 

Announcements: Click here for my oped with Greg Autry on the Pentagon’s satellite shootdown…

This Week: Grading the Macrotrading Challenge

Last week, I issued a challenge to test your macrotrading mettle.  I asked you to indicate whether you would go long, short, or neutral over a broad range of assets in three different scenarios:

 

Scenario One: The United States goes into a recession.  This drags Europe into recession and slows Asia down significantly. Inflationary pressures abate.   This is the “US as locomotive” scenario.

                                                 

Scenario Two:  The United States economy goes into her recession, inflationary pressures abate in the US, but the recession does not spread to the rest of the world.  European growth is reasonably strong with mid to high inflation while Asia continues strong growth with inflationary pressures.   This is the so-called “decoupling” scenario.

 

Scenario Three: Both the US and European economies are characterized by recession and inflation – stagflation.  Asia slows down while experiencing inflation as well.  This is the “stagflation” scenario.

 

I want to emphasis just how useful such an exercise can be in the current climate of uncertainty when “buy and hold” in U.S. stocks is a dead 20^th century artifact.

 

The matrix below offers my view as to where the best direction of the trade lies.  Note that I do not allow for any secular trends in the trade, only short run cyclical movements in the asset classes.

 

I had many good responses to the challenge.  Much of the disagreement many respondents have with the chart below is the result not of bad macro thinking but rather of bringing secular trends into the calculus.  For example, energy is a clear short in the U.S. as Locomotive Scenario based on falling energy demand.  However, a secularist might argue that the market is supply-constrained and will continue to move up in a secular trend.  I don’t discount that rationale.  However, it is not part of the assumptions underlying the challenge.

 

Below the chart are my explanations for the boxes.  Clearly, the hardest part of the matrix is the currency pairs, as I shall explain below:

 

	U.S. as Locomotive Scenario	Decoupling Scenario	Stagflation Scenario
Commodities
Gold	S	L	L
Energy	S	L	S
Metals	S	L	S
BOND MARKET
U.S. Long Bond	L	N	S
Currency
Dollar/Yuan	S	S	N
Dollar/Euro	N	S	N
Euro/Yuan	S	N	N
Equity Index Funds
U.S. S&P 500	S	S	S
Europe	S	L	S
Asia	S	L	S
U.S. Growth	S	S	S
U.S. Residential Real Estate	S	N	S

L= Long,  S = Short,  N= Neutral   (No more than 3 N’s)

 

The Commodities

I view gold as primarily an inflation hedge.  While energy and industrial metals have some inflation hedge component, that component is assumed to be dominated by the cyclical nature of energy and metals demand.

Under these assumptions, in Scenario I, gold is a short as inflation moderates and energy and metals are shorts as cyclical demand moderates.

In Scenario II, robust global demand and inflation make gold, energy, and metals all longs.

In Scenario III, inflation makes gold a long while recession makes energy and metals shorts.

The Bond Market

The critical relationship here is the inverse relation between bond prices and interest rates while nominal interest rates rise with inflation.

While the Fed and ECB set short term interest rates, the market sets long bond rates based on expectations of inflation.  Falling inflationary expectations in the presence of recession lead bond investors to go long the long bond to lock in higher yields.  As inflation falls, interest rates fall and bond prices rise, rewarding bond investors.

In Scenario I with recession and low inflation, going long the long bond is clearly the winner while in Scenario III, inflation makes the long bond a good short.

Scenario II is the most difficult.  Recession and low inflation in the U.S. suggest going long.  However, as interest rates rise in Europe and Asia, bond investors may move out of U.S. bonds, causing bond prices to fall. 

The Currency Markets

Scenario II is the most clear cut.     With the U.S. falling into recession and cutting interest rates and both Europe and Asia growing, interest rate differentials between the U.S. and Europe and the U.S. and Asia will put strong downward pressure on the dollar.  Thus, both the Dollar/Yuan and Dollar/Euro pairs are shorts.  As for the Euro/Yuan pair, this has to be an N.  We just don’t have enough information about relative interest rates and relative growth rates.  Nor do we know how committed the Chinese will stay to the Dollar/Yuan peg.

As for Scenario I, this one is very sticky.  The Dollar/Euro is clearly an N as both the U.S. and Europe are in recession and rate-cutting modes.  However, it is unclear which entity will cut more aggressively.  

One can offer at least a weak argument to short both the Dollar/Yuan and Euro/Yuan pairs on the assumption that both the Fed and ECB will be more aggressive at cutting interest rates than China. This could easily be an N as well, however.

Scenario III seems to be a total spin of the macro wheel.  You could argue longs on the Dollar/Yuan and Dollar/Euro pairs on the U.S. as safe haven argument but shorts on the “Asia grows faster” argument.  

The Equity Markets

I assume that equity prices reflect profit expectations and that current growth projections are built into stock prices at the beginning of the period BEFORE the scenarios unfold.

In Scenario I, both U.S. and European equities are clear shorts as are U.S. growth stocks.  More subtly, Asia is a short as well because a slowdown is sufficient to trigger a cyclical bear movement.

Scenario II features shorts for both U.S. S&P and growth stocks on declining profits while Europe and Asia are clear longs.<