Right now we’re watching some interesting divergences within the commodity complex. Sean wrote a recent post about oil’s rise, and he mentioned that many analysts see this as a sign that the U.S. might avoid recession. What’s puzzling is that oil is currently diverging from other commodities that are typically seen as barometers of global growth, like the CRB Raw Industrial Spot Index (RIND), which tracks a basket of 15 economically sensitive commodities, excluding oil (see the chart below).
With signs that Europe is likely in the grips of recession due to their inability to adequately address their debt crisis, we’ve been trying to get a handle on how that will impact the U.S. economy. The reality that economies are more globally connected than ever hasn’t prevented some analysts from predicting that the U.S. will be fine, even if growth in Europe is contracting. We weren’t believers in the idea of “decoupling” when it was popular back in 2007-08, and we find ourselves skeptical again today.
>For months now I’ve been watching two charts very closely on my ticker screen — the Euro exchange traded fund (FXE) and the S&P 500 (SPY). It’s been amazing to see how movements in the FXE have correlated to SPY (approximately 84% since September). This may be not be much of a surprise since the market has been taken hostage by the European debt crises, to the point where every rumor coming from Europe seems to create a short term market move.
The chart below is the price of West Texas Crude, and you can see that the price has been climbing since the beginning of October. In fact, crude prices are up an amazing 28% in just over 1 month. Many analysts believe this is evidence that the United States has avoided a recession, and that the economies in China and Germany will be much stronger than expected from this point forth.
Yesterday the Investment Team met to discuss the state of the markets. The agenda was ambitious: We needed to assess Europe’s Grand Plan, recent economic data, technical conditions, and what smoke was coming from the independent analysts we follow. Ultimately we had to decide whether or not our allocation was consistent with the weight of the evidence.
In our blog posts we often mention the ISM Manufacturing Report on Business PMI and the ECRI Weekly Leading Index, which are usually at the front line of the many barometers of economic activity we watch regularly. While the ISM PMI is built so that a reading below 50 signals economic contraction, its historical track record in calling recessions is far from perfect. On the other hand, while the ECRI team has a stellar historical track record in calling recessions, their weekly growth index doesn’t feature an absolute threshold below which a recession signal is triggered, and its interpretation is not as straightforward, at least for outsiders.
It was just four days ago when the world celebrated the European rescue. Now that has all changed. Carl initially pointed out that the European bond market was not happy with the bailout, and now everyone has joined the party. Not only are 10-year Italian bond yields surging to a worrisome 6.25%, but the Euro is selling off heavily and European financial stocks are well below pre-bailout levels. This is all possible due to Greek Prime Minister George Papandreou. He has called a referendum on the new EU aid deal, which could backfire if his coalition loses the vote.
Let me be clear: Pinnacle’s investment mandate is to outperform over a complete market cycle, and that definitely includes outperforming in bull markets. Lately, however, the bull markets have been built on the back of extreme monetary and fiscal policy. It was just about this time last year that Pinnacle’s investment team found themselves on the wrong side of a rampaging bull market. The summer’s headlines about Greece and the frightening after-shock of the “flash crash” were receding in everyone’s memory and investors were beginning to anticipate a massive policy response. We were suspicious of the fundamentals of the market at the time, but our process forces us back into the market when technical considerations become overwhelmingly bullish, and so we looked for a place to enter. The market finally cracked in November to the tune of a 3% “correction” and we began adding risk back into the portfolio. The best I could say is that we were, at best, cautiously bullish. Well… it feels to me like history is repeating itself this year, with the same kind of rally coming off of a similar summer selloff, with the same type of hype regarding policy response that just doesn’t feel right. Once again we are trying to guide our clients through incredibly volatile markets that feel more like casinos than rational markets where participants try to allocate capital to profitable ventures in order to grow their wealth.
In the after hours yesterday, news leaked out about an apparent impasse between the banks and European leaders, and markets seemed poised to sell off again on another European snafu. By 9pm details emerged that a deal had been cut with the banks regarding haircuts on Greek bonds, and the mood in Asian markets quickly turned around. By the time I woke this morning, a plan had been hatched in Europe that put the markets into celebration mode. Risk assets love the fact that a tangible plan has finally emerged, and today markets are partying like it’s 1999.
Risk assets have been enjoying one heck of a rally the past few weeks. Stock markets around the world have been surging, with the S&P 500 up nearly 15% from its October 3rd low. The Russell 2000 Index of small cap stocks has exploded higher by more than 20%. Commodities have joined the party in recent days, with oil jumping by $18/barrel, to climb back above $93. The recent action in the stock and commodity markets seems to be giving the ‘all clear’ signal that a U.S. recession will be avoided and Europe is on the verge of solving their debt crisis.