Monday, August 16, 2010

Just a copy and paste of something I wrote in January

In preparation to write an article on the Treasurys market (coming this week) I decided to review some of my previous analysis. Rereading the 1/12/10 issue of my defunct newsletter, I figure I might just paste the whole thing onto the blog. It's below, if you want to read it. All the words are here, but I didn't include the charts


January 12, 2010

1. US Dollar

First I want to acknowledge my poor timing on the dollar. In the email I sent Friday morning I anticipated a near-term breakout for the index, but a few hours later the index decides to break down instead. So, of course, I could not have been more wrong. Now I've made my share of bad calls, to be sure, but I don't remember ever being contradicted by the market that quickly.

With that out of the way, let's look at the dollar index again. Sometimes I should heed my own indicators more. One of my favorite momentum indicators is the relative position of a simple moving average to an exponential moving average, when both averages are set at the same number of periods. For shorter-term trends I often use a 21 day period. This works reasonably well, though not nearly as well as a 21/21 on a weekly chart, which I use to identify longer-term shifts in momentum.

The idea with this is pretty simple, and I'm sure I've explained it before, but here it is again: In a strong up-trend, the 21 EMA will be positioned above the SMA, because the EMA takes more account of recent prices than the SMA does. As a trend matures the SMA tends to catch up to the EMA, eventually crossing above it. This crossover is the signal that momentum is no longer with the advance. Strictly speaking it is not a sell signal, because as often as not the upward advance will start again, usually after a period of consolidation. The crossover should only be regarded as a sell signal when you already have a good idea that there will be a tradable move to the downside. If you use the indicator in isolation it is just as likely to generate whipsaws as profitable trades.

This 21/21 thing could very easily be made into a panel indicator like the popular MACD (if you pronounce that 'Mac Dee' in my presence I'm liable to slap you upside the head) but the major advantage of the indicator is that is part of the price chart itself. Looking at a bunch of different panels is a major distraction, in my opinion.

Anyway, with the dollar I acknowledged the potentially bearish cross of the 21 SMA over the 21 EMA, but dismissed it. I suppose the better way to have handled the situation would have been to consider the crossover as a warning sign that could be dismissed, but dismissed only after the index broke out to the upside. I jumped the gun, in other words.

But, despite the setback the past few days, I am quite certain that the US dollar is the currency to be in this year, and perhaps beyond. That is not to say that we turn a blind eye to its shortcomings, but let's be real, most of the scenarios are widespread by now and the currency is where it is.

A year ago, it was common knowledge that the Australian dollar was going to implode because of Something Really Bad that was to happen to the economy down under. I don't remember the exact theory but it had something to do with the Current Account. Or was it the capital one? Whatever, all I know is that while all this concern was being expressed AUD was selling for peanuts at the same time its major imports, petroleum and cars, were depressed in price. Meanwhile all the stuff getting shipped out of the country was down in price too, but not as much as the imports. So I'm like, wow, looks like the trade balance will move into surplus or at least the prevailing deficit will diminish. Sure, all the capital could decide to catch a flight out the country, but it just wasn't clear to me what made Australia's problems so much more dire than other countries.

A few years ago the Japanese yen was getting beat up. Everybody thought the currency could slide forever because its low interest rates had everybody borrowing JPY and buying higher yielding stuff, like GBP, AUD, NZD, MBS, whatever. Hey, for a time I was one of those calling for the nippy's demise. But eventually the yen stopped dropping. Well, not Everybody, many intelligent observers were aware of the carry-trade bubble at the time and called for a major rebound in the yen. But the bearish scenarios for the yen were well known.

About a decade ago, the euro was in a tight spot. People, intelligent ones at that, didn't think the currency would survive birth. So the currency sold lower. Eventually the euro stopped dropping, and before too long people stopped worrying about its viability.

My point is that these currency problems never seem to last forever. Seasons change, priorities change, prices change. If you are betting against the dollar right now you are essentially betting against the viability of the United States as a country. I mean, if the country collapses then yeah, sure, you'll wanna be short the dollar. But I just don't think that is the reality right now. Not for this set anyway.

Otherwise all you have pushing the dollar lower is a crowd of US based investors chasing foreign stocks and shit, and pretending they are 'putting on a carrytrade.' Like there is any actual carry trading going on. I doubt many players are holding on to any of this stuff long enough to earn a meaningful amount on the yield differentials. People are just out for the capital gains, the carry, where there even is any, is just a talking point.

I still maintain that the real, true carry trade is, and will be in Treasury debt. I'll get to that in the next section, but first I should explain the chart on the first page a little more. Heck, here it is again, so you don't have to flip back to the front page.

The horizontal lines are the full Fibonacci, Middle, and Padovan price retracements for the advance from 74.23 to 78.45. The diagonal lines are the speedlines based off of each proportion. I make these by drawing a vertical line (not shown) down from the top candle, and then drawing diagonal lines from the bottom candle, intersecting the price retracement lines and extending across the chart. I guess you could consider the speedlines hypothetical trendlines.

These are especially useful coming off a major bottom or top where there was no prior trendline to draw. I've taken to using all three of the main ratios as a way to anticipate a general area of support or resistance. Pinpointing precise price points is always a blast, but realistically our goal should be to identify a zone in which the correction will stop. It is normal for a market to drop into this zone before advancing again. If prices drop below the bottom of the zone, (we can call it a beacon, I guess) then we need to question whether the move was just a retrace or the beginning of a renewed bear market.

It happens that on this dollar chart the lower part of the beacon coincides with the current track of the 49 day moving average, which I suggested as a fallback support a couple weeks ago, even though at the time was looking for the dollar to move higher before testing the average. So, while I am eying a low for the dollar index 'any time now' if we don't get the turn around right away the lower portion of the beacon should be our next line of defense. Certainly I'll get frustrated if the the dollar doesn't hold around 76.

2. Treasurys

The correlation of Treasury notes and bonds to the dollar's movement has been practically inverse recently. It is not always like this, but it should be clear to everyone the fortune of the dollar in the currency markets and the fortune of the Treasury securities do not go hand in hand. Sure, buying Treasurys outright is one way to bet on the dollar, just as buying US stocks is in a sense a bet on the dollar. But from a speculative perspective you can (potentially) make money in bonds even if the dollar drops. This is the carry trade that I recommend you consider.

Thanks to ZIRP, Treasury futures are in substantial backwardation. Even if there is no movement higher in the cash market for bonds, you can make at least 3 or 4 percent a year holding futures contracts and rolling them over. That may not sound like much, but you have no foreign currency risk, no risk of default, and the opportunity to hold the position on leverage. That's where the carry trade comes in. turn 4 percent into 40 percent. As long as short-term interest rates stay low you can make a substantial return.

Oh, but of course if bond prices drop too much you could get a margin call, so the best time to try something like this is when prices aren't going to drop any further. I think there is a good possibility that we have seen most of the weakness in notes and bonds, but I could never say with certainty that this is the bottom.
While the Treasury index did drop below the 200 day moving average, it has held the 351 day, which served as support last summer.

Oh, and we're holding the .618 speedline too.

Yep, it's been a slow road for T-bulls, but so far this just looks like an acceptable correction within the primary advance that started last summer. If I had any real money (I don't because I'm a slacker who hasn't had a real job in well over two years) I would be establishing a good long position in bond futures right now. It's tentative, but my sense is that we could be making a major low. You'd want to have an exit strategy, in the event this support level doesn't hold, but Treasurys are a very under-appreciated speculation right now, and the gains for someone able to buy at the lower part of the trend, and then hold could be substantial. For those with less patience than it takes to run an effective carry trade operation, you might want to buy now and then sell when I start to get antsy about the price again. If I remember, I anticipated the last two major pullbacks. It's just the extent of the pullbacks that are hard to see ahead of time.

In the past I have suggested that another good way to play the bonds market is to short TBT, the double bearish T-Bond ETF. An outright short is still a good idea, in my estimation. You get a little of the carry trade benefit combined with the price erosion inherent in a leveraged ETF. As you can see from the chart on the next page, TBT is down 27 percent since it came out about a year and a half ago, while the 30 year bond is actually yielding a little more than it was at that time. Bond prices would have to drop substantially for someone to make money holding a long position in TBT.

But considering this price erosion over time, another trade suggestion I have is to sell call options on TBT. Yes, sell naked calls. Here you are betting not so much that bond prices will rise, but more that they won't go down, at least not much.
People are paying over $3.50 for at the money calls expiring in June. So not only are people willing to buy a product that will automatically lose like 7 or 10 percent (I don't know what the exact math is, that's not my department) in the next half year due to erosion factors, but someone is willing to pay a 7 percent premium to buy an at the money call for this privilege.

So that's an idea to evaluate if you don't think longer-term interest rates are going to rise. I know, everyone is saying interest rates are going up up up up. Eh, I just don't see it. Too much money to be made with rates where they are and lower.

To wrap up, I see the stock market as dangerously overbought now (see last couple posts on the blog, where I highlight some figures) with a decent reaction due 'any time now.' Commodities for the most part look tired, though I'll need to take a much closer look before I make any definitive statements. And gold I still think to be vulnerable, but we are really at the top end of the zone I had mind for a retracement, so naturally I am getting kind of nervous. The static Foreign Blend ETF basket we examined last week closed at 7386.5 yesterday. 7386 was one of the two main price targets I identified. It might just be a stop along the way to a higher number, but I still get a kick out of seeing a market hit exactly the price I wrote down.

Oh, and the triangle setup on the GDX:GLD ratio is still in play so far. Chart below.



(oh and I almost forgot that I pasted a
chart of the General Liquidity Index at
the top of the front page. Still
looking for it to back down to the
1020s. But if this is a top, they might
be able to keep it spinning a couple
more sessions. Who knows...)