The Fault is Not in the Stars

As usual, most market participants are asking themselves the wrong question. After a slight rally in risk assets last week, including US equities, there has been a barrage of talking heads asking some variation of the question, “Is the bottom in?”

Anyone asking that question is focused on the trees, not the forest.

Humans – in general - are innately poor decision makers. One of the classic mistakes people make is getting caught up in what’s happening right now and losing all ability to step back and evaluate what’s currently happening in the context of the large picture. Being a prisoner of the moment leads to mistakes.

However, this flaw can be used to our advantage, if we're able to avoid this weakness ourselves.

The Myth Of Traditional Diversification

There are only 2-3 drivers of asset prices at any one time. Meaning, that no matter how many positions you may have in your portfolio at a given time, the direction of each position is being driven by 1 of 3 things. This is why people make the mistake of believing they are diversified when in fact that simply have multiple trades expressing the exact same catalyst. But that’s a conversation for another time.

There are two primary themes driving asset prices right now. The Fed’s policy trajectory and global growth, or at this point, the lack thereof. Obviously both these themes are interconnected, or at least should be. Since Q3, I’ve been making the case that even if the Fed raises rates, they will go back to full easing by the end of this year or Q1 2017, at the latest. I stand by that and frankly, all of the critical fundamental developments, both globally and domestically, over the first month of this year are reinforcing my prediction.

US Storm Clouds Gather

US data so far this year has been hugely disappointing and it continues to paint the picture of an economy that is slowing. Everything from retail sales to industrial production and manufacturing are showing chinks in the US economic armor. This has led to a massive re-evaluation of the expectations that most market players have regarding the number of rate hikes we'll see this year.

Over the last couple of weeks, the number of participants expecting no rate hikes this year has tripled, while the number expecting more than 1 hike got cut from 50% down to 25%. This is real-time market data based on the Fed Funds futures contracts.

Something else to keep an eye is the weekly unemployment claims. I know everyone gets hyped up for the monthly US labor reports, but the real juice is in the trend of the weekly unemployment claims. Historically, despite the fact that most people pay little attention to them, the weekly claims have done a better job of gauging the real health of the labor market and the economy than either of the monthly labor reports.

Despite the high frequency of the report and the accompanying noise, weekly claims are the one jobs number to watch. After falling week after week for most of the last 5 years, there has been a new trend the last 6 months. The claims have been trading sideways and last week’s report almost pushed the claims out of their downtrend.

Now, on its own, this isn’t necessarily an ominous sign. You would expect a period of consolidation after such a long run down. That said, I can tell you that this is the type of development that no one cares about – until everyone cares about all at once. Especially when you consider it in the context of everything else that's developing across the economy.

So we have a good picture of the US forest, what about globally?

The Two Key Global Factors

There are two primary concerns: China and oil. Absolutely nothing has changed on either front and in fact, have gotten worse.

China reported its Big 3 last week: industrial production, retail sales and fixed asset investment. All three data points slid from the previous month. They also released Q4 GDP growth numbers, which were the weakest since right after the Crisis.

At the margin, China’s GDP growth rate has slowed in 70% of the quarters over the last 3 years and has now slowed the last 3 consecutive quarters. This, after massive stimulus over the last 2 years.

As for oil, there’s not much new to say: It’s an all out disaster. Short of violent counter trend rallies, its downtrend shows no signs of ending.

A couple of interesting tidbits about oil for you to file away. First, oil is down 75% from its peak. This has never happened before. Ever. And 'ever' is a very long time.

The world is being faced with something it's never seen before. OPEC has never had to manage this situation. Central bankers have never had to manage this situation. Corporations have never had to manage this situation. I think you get the picture.

This is not your run of the mill bear market. What we are witnessing and trading is epic.

The second little tidbit that isn’t getting much press is the movement of a little known crisis indicator. The ratio of the barrels of oil to an ounce of gold has been a decent indicator of an environment that is pro-crisis. Since the early 1980s, this indicator has only traded above 25 on 6 occasions. Each of the previous 5 times, there was a crisis of some magnitude. From the OPEC oil crisis in the mid '80s, to the Financial Crisis of 2008.

The 6th occasion is happening right now. The indicator stands at 37, an all-time high. The previous high was 30 years ago, when the indicator hit 32.

The beauty is this, markets haven’t started to price in the fact that the probability of another Fed rate hike is declining precipitously. This means it's not too late to position yourself for when the market has it’s epiphany and everyone rushes to reallocate assets. While there are multiple markets to watch and I will be pointing out those developments in our Focus Market commentary section, the one market that will be most telling is the US Dollar.

So far, the USD is up year to date. Once the market begins to realize whats unfolding, I expect the USD to show significant weakness. Keep in mind, that the price action of the USD is not just dependent on Fed policy but it’s also being impacted heavily by the fact that the rest of the world is still in an easing stance. So, don’t expect a full on collapse of the USD to be the signal that things are beginning to shift. That said, a close below $97 and a decline to the $93 area would be a pretty good indication.

Let the gurus, talking heads and blog writers focus on the day to day price action and the other proverbial trees that the market offers up. If you keep your eyes on the forest, you’ll be able to tell when a particular market’s price is diverging and providing you with an opportunity.

Focusing on the forest and trading opportunistically is how TWR’s trade ideas are up over 2% in the first 3 weeks of the year. Focusing on the trees, being a prisoner of the moment and asking “is it over yet?” is how you end up like the average mutual fund, down 5.1% so far.