Sunday, September 25, 2016

The Risk Of Dismissing The Data: The TED Spread And Baltic Dry Index

No single variable or statistic provides clear insight into the future direction of the economy or stock market. When a data point does not fit ones narrative though, justification to eliminate it seems to be gaining among some strategists. Recently, the market has seen a fairly significant spike in LIBOR and a resultant increase in the TED Spread, i.e., 3-month LIBOR minus 3-month Treasury.

It seems, and probably accurate, the increase in the spread can be attributed to money market reform taking place in the U.S. effective by mid October. The reforms remove the $1 fixed net asset value for institutional prime money market funds to a floating rate structure. In addition to a floating rate, funds will be permitted to suspend withdrawals for a period of time or assess redemption fees. The money market changes have resulted in fund redemptions in the so-called prime funds and a move to money market funds that invest in government debt.

Source: Blackrock

Clearly, the new regulatory rules impacting money funds are having an impact on LIBOR as well as the TED Spread. The TED spread is a measure that provides insight into credit risk within the economy. As noted by Wikipedia,
"An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases."
Prior to the financial crisis in 2008 the widening spread was a signal about the lack of health of the banking system. Problematic is the ease with which some are dismissing today's widening TED Spread and attributing its widening simply to the money market reform legislation. A case in point is an article that appeared in The Wall Street Journal on Thursday suggesting the TED Spread might just be dead ($$). Could there be more to the spread widening though?

If the TED Spread widening points to issues with interbank loans and counterparty risk, one needs look no further than issues facing some European banks. Most recently are the issues facing Deutsche Bank and discussed in this Zero Hedge article. The stock price performance of the STOXX Europe 600 Banks Index versus the SPDR Regional Bank Index (KRE) and a couple of select banks can be seen below. Is the European Bank Index performance signalling issues within the banking sector in Europe and thus contributing to a wider TED Spread?

Lastly, the Wall Street Journal article link above also commented on the Baltic Dry Index no longer being useful noting.
"It isn’t the first time an indicator of financial and economic stress has stopped being useful." 
"The Baltic Dry index, which measures shipping costs for dry bulk commodities, was once used as a bellwether of conditions in trade and the world economy and successfully warned of impending crisis months before Lehman Brothers collapsed in 2008." 
"More recently, it has surged and dipped so much that it no longer seems to be signaling macroeconomic events. The index fell to its lowest ever level early this year before surging again, with no noticeable boom or bust in the global economy."
In actuality, the Baltic Dry Index (BDI) may be more useful today them it was from 2011 through 2014. However, the Baltic Dry Index weakness during this period was likely due to slowing in the emerging markets and the fall off in demand in the developing world. As the bottom half of the long term chart below shows, it appears there is a disconnect between the performance of BDI and the MSCI all Country World Index since 2009. Since 2014 though, the correlation of the BDI versus the MSCI ACWI has been positive. The second chart below is a shorter term view and the increase in the BDI is associated with a move higher in the MSCI ACWI.

LIBOR rate setting has had issues that arose in a lead up to the financial crisis. A timeline of these events can be viewed in this New York Times article/timeline. Nonetheless, as with the Baltic Dry Index, relevant information continues to be projected by that index and I believe the TED Spread as well. With the TED Spread, factors beyond money market reform just might be bubbling up and contributing to the spread widening. Dismissing the TED Spread, and the Baltic Dry Index for that matter, simply because they may not fit ones point of view, comes at ones own potential peril. Globally, the world is growing at a below trend pace and central banks' continue to influence economies, both of which make some of the data difficult to interpret, but not factors justifying dismissing the information being provided by these two indicators.

Thursday, September 22, 2016

Sentiment: Investors Not Believing The Rally

This morning the American Association of Individual Investors released their Sentiment Survey showing a 3.1 percentage point decline in bullish sentiment to 24.8%. The bullish sentiment reading reported by individual investors remains below the -1 standard deviation level of the sentiment measure which is 28.3%.The 8-period moving average of the bullish reading declined as well to 29.6%. 

A vast majority of the decline in bullish sentiment showed up in bearish sentiment (+2.4 percentage point increase) with a net impact of widening the bull/bear spread to -13.5. This is the widest the bull/bear spread has been since late May when the spread was -14.8. Since that point in May the S&P 500 Index is up 5.6% on a price only basis. As individual investors continue to doubt the markets this year, they continue to move higher nonetheless.

Monday, September 19, 2016

Heightened Market Volatility Would Favor Low Volatility Strategy, But It Looks Expensive

A little more than a year ago we wrote about the outperformance of the low volatility strategy versus a more risk on/high beta strategy. At that time it was noted low volatility could persist; however, if the broader market reached new highs, the high beta strategy would likely outperform low volatility. This has essentially played out and as the calendar turned to 2016 the early year market pullback saw the high beta strategy succumb to significant selling pressure and was down 20% into the February low, almost twice the broader market's beginning of year decline. Once the market began recovering from the February low though, high beta has outperformed the low volatility strategy, 25% versus 9%, respectively.

Sunday, September 11, 2016

The Dogs Of The Dow And The Risk With Exchange Traded Notes

Three quarters through the year, the Dogs of the Dow strategy continues to be a winning one, outpacing the Dow Jones Industrial Average and the S&P 500 Index by nearly three times. The average return of the 2016 Dogs of the Dow equals 16% versus the Dow Index return of 5.7% as of Friday's close. As noted in earlier posts, the Dogs of the Dow strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds them for the entire next year.

With the popularity of indexing, some investors have pursued the Dow Dogs strategy via an exchange traded note, the ELEMENTS "Dogs of the Dow" Linked Note (DOD). The return of this note has varied greatly from the performance of the Dogs of the Dow themselves. There are peculiarities with these types of exchange traded products investors should be aware of. More detail on the risk of exchange traded notes can be read here. Two important ones are the fact these investments are essentially bonds of the sponsor of the exchange traded note. In the case of DOD, the issuer is Deutsche Bank AG and an investor in DOD has unsecured credit exposure to Deutsche Bank AG. Secondly, the return on these notes are 'based' on some underlying index or basket of investments. In the case of DOD the ETN's return is based on the Dow Jones Select 10 Total Return Index. Because the issuer is not required to issue more shares of the ETN, the price of the ETN can diverge from the value of the underlying Index and in some cases the divergence is significant. This has occurred with DOD as can be seen in the below chart.

Year to date through early June DOD was up nearly 60% while the underlying Dow Jones Select 10 Index was up only 11.3%. As is typically the case, the large premium at which DOD traded quickly narrowed to the actual return of the underlying index.

Lastly, in this low interest rate environment, investors have a heightened focus on income generating equities. From a total return perspective though, the Dogs of the Dow strategy has had mixed results from year to year.

Friday, September 09, 2016

Transports Leading Industrials A Bullish Market Signal

As early as about six weeks ago, some technical strategists were projecting a near trigger of the Dow Theory sell signal. In short, when the Dow Industrials and the Dow Transport Indexes are in an uptrend together, i.e. higher highs and higher lows, the market is in a bull market uptrend. Conversely, when both indexes are making lower highs and lower lows, a bear market trend is in place or developing. If one sees divergence in the indices, this can be a signal of a change in direction of the market and this was occurring in July of this year when the transports were weakening.

As of the close yesterday though, the year to date return of the transport index return now surpasses that of the Dow index return as can be seen on the below chart. The transport index weakness in late July has been quickly reversed in August and early part of September.

Additionally, positive chart setups have triggered which portend potentially higher prices ahead for both indexes. For the transports an inverted head and shoulders pattern has triggered with an upside target price of about $162 and cup and handle trigger with a lower target than the inverted H&S trigger of $150. Additionally, in spite of the near sideways trading action in the Dow Industrials Index, bull flag formations are in play and are suggestive of potentially higher prices as well.

The industrial and transport segments of the market seem to be indicating an improvement in the operating environment over the next 6-12 months. If earnings prospects continue to improve, as we have discussed in earlier posts, the odds of higher equity prices over the course of the next year seem likely.

Friday, September 02, 2016

Another Month Of Equity Outflows

Individual investor sentiment continues to show a low level of bullishness and this has translated to continued outflows in equity mutual funds and exchange traded funds. Almost a month ago I noted the strong outflow from equity funds and ETFs that occurred in July and this selling trend continued in the month of August.

The outflows have caused assets in equity mutual funds to decline while equity ETF assets have increased on a year over year basis as of the end of July. The increase in ETF assets is largely due to the strong equity market returns from a year ago, for example, the S&P 500 Index is up over 12%.

Sunday, August 28, 2016

Higher Oil Prices Must Contend With Too Much Inventory

Crude oil prices spiked above $50/bbl in early June and have fallen back to $47/bbl as of Friday's close. The high $47 level remains above the early August low of $39.52. Further weakness in oil prices is likely as a result of stubbornly high crude oil inventories (excl. the Strategic Petroleum Reserve.) On Wednesday last week, the Energy Information Administration (EIA) reported weekly inventories increased 2.5 million barrels and is a reversal of the 2.5 million barrel decline in the prior weekly report. Not that one or two weekly reports tell the entire story, but, as the below chart shows, inventories remain at very elevated levels and prices are not likely to move higher until this elevated inventory is reduced.

Saturday, August 27, 2016

Income Focused Investments Continue To Show Weakness

Janet Yellen's Jackson Hole comments on Friday did not do any favors for the performance of income focused investments. The Fed chairman's comments($) led market participants to believe a rate hike for September is back on the table and at least more likely in December. The rate hike fear continues to put downward pressure on income focused investments which some investors view as bond substitutes. So far in the month of August the SPDR Dividend ETF (SDY), the iShares US Real Estate ETF (IYR) and the SPDR Utilities Sector ETF (XLU) are all underperforming the broader S&P 500 Index. Also, for the month of August these three ETFs are showing negative total returns with XLU down 2% on Friday alone.

The site,, reported the utility sector ETF was among the top 10 ETFs experiencing outflows for the week, withdrawals totaling $263 million.

Monday, August 22, 2016

What A Difference A Day Makes: The Calendar Roll

The S&P 500 Index was essentially flat today, down .06%; however, an investor's one year price only return will increase over three full percentage points from last Friday's close to today's close. For an investor invested in the S&P 500 Index, Friday's (8/19/2016) one year price only return equaled 7.28% and one day forward to Monday's close, the investor's one year return increases to 10.74%. The reason for this is the calendar rolling forward one day, weekends result in some nuances, and August of last year was a volatile month to the down side for the market and this is contributing to the magnitude of the change in return.

This same impact is resulting in large spikes in the one year rolling return for energy as energy prices were in the upper $30 range versus today's $47.41. As time moves forward to year end, energy was falling into the mid $20/bbl area and if oil prices stay near current levels, the year over year price increase will be significant, nearly a doubling of the price of oil.

Saturday, August 20, 2016

Some Favorable Market Technicals But Awaiting A Resumption Of Earnings Growth

For the better part of a month the S&P 500 Index has traded in a very narrow range. Some strategists believe the market has come too far too fast since the June low and a correction is necessary before the market moves higher. We have noted from time to time that corrections can occur in price, i.e., a decline or in time, i.e., trade sideways for an extended period. At this point in time it appears the S&P 500 Index is attempting to go through a corrective phase by trading sideways over time. Of course, the length of time required to qualify for a correction over time is unknown. I believe one key determinant for this market is earnings over the course of the next four quarters which I will discuss later in this post.

One positive indicator on the above chart is the On Balance Volume indicator. The OBV measures volume on up days and volume on down days and accumulates the data over time. It is the trend of the OBV line that is important. If the line is trending up, trading volume is higher on up days versus down days and is an indication of buying demand. Up until this week equity fund and ETF flows were strongly negative. In Lipper's fund flow report earlier this week it is noted investors turned more favorable towards equities as equity flows turned positive with money market flows a negative $20.8 billion. The Money Flow Index (MFI) in the above chart is a volume weighted version of the Relative Strength Index (RSI). The MFI is not at a level indicative of an over bought market and similarly, the RSI is not at an over bought level either as can be seen in the below chart.