Liquidity Cycle

The weekly chart of the SPY ETF essentially treaded water this past week leaving a narrow almost doji pattern on the chart. Such a candle indicates congestion or a pause in the market and potentially a minor peak. The upward run has been so relentless since the first of the year a pause or correction would not be surprising. But the Liquidity Cycle Indicator shows no sign of any pause in the markets progress.

The chart following is our Stage 1 aggregate versus the SPY and clearly this is very strong at the moment. In fact this collective is so strong it is carrying the entire load the past 2 weeks while the Stage 2 mid cycle aggregate has been weak on the downward re-rating of Chinese market prospects recently.

Once again this week the ECRI weekly leading indicators has started moving higher with our Liquidity Cycle Indicator confirming what had been divergent behavior. The ECRI has been expecting the US to go into recession by mid-year. and that may yet develop as they have a very impressive forecasting record over the years, but for now, the direction is up on a tide of central bank easy money and modest but steadily improving economic statistics.

As always, of course, there are dissenting opinions and some are from people I respect. I will post some of those comments in the articles and commentary section of this letter.

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SECTORS
The rotation chart from Bloomberg depicts the past couple of weeks of sector rotation. The defensive sectors have stayed weak and the technology and financial sectors stayed in uptrend though the latter slowed down some. Materials and industrials on China concerns cropping up again.

The rotation chart from Bloomberg depicts the past couple of weeks of sector rotation. The defensive sectors have stayed weak and the technology and financial sectors stayed in uptrend though the latter slowed down some. Materials and industrials on China concerns cropping up again.

Bespoke Investments conveniently posted the following coverage of international markets this weekend.

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Bespoke charts of the markets discussed.

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I will use one other page of the Bespoke weekly review on the next page as their matrix of ETFs clearly shows in the one week versus one month performance comparisons that practically every market corrected last week.

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Fixed Income
The previous week we had a very significant break of 17 or so weeks of support in the 30 yr bonds and in other durations as well. This week after reaching another important level of support the fixed income market held and posted a small rebound. The breakdown was a warning shot for me that while the bear market in debt interest markets may not have started yet, the highs are probably in place. Only a real catastrophe is going to push this market up through the highs. The central banks are still fighting the good fight and may be able to postpone the bond bear market but personally I am allocating away from fixed income and fishing for shorts.

The last chart above is the Japanese Government Bond and this is an especially instructive chart to watch. The interest cost of government debt in Japan is very near 50% of the government budget and should the super low interest rates in Japan begin to increase then the precarious financing of the government may finally trigger the collapse that many have been forecasting for years.

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Commodities
The CRB moved back into the middle of the broad range of the last several months breaking a minor little trend up.

Grains all down on the week and most of the softs and the meats also down over the period.

Crude still churning amidst rumors regarding Iran and changing expectations for growth rates.

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Spreads in Brent and WTI crude rose this past week supporting the bull case short term.

Foreign Exchange

The Dollar and Eurocurrency continue to almost mirror one another while most other markets jostle around based on commodity prospects, or Chinese growth/slowdown, or austerity. The focal point of my interest is the Yen. I find myself in the same camp as the hedge fund manager who claimed I have a recurring nightmare that I awake one morning to find the yen has moved to 200 to the dollar and I havent made a billion dollars.

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Volatility Environment

Articles & Commentary

Basic Points by Donald Coxe Insider Selling Finally, we address a major objection to our somewhat bullish stance: insiders in US corporations are selling at prodigious levels, week after week. In general, insiders know more about their companies near-term outlook than public investors or street analysts do. As the stock market continues to climb, this group seems to be the most conspicuously bearish. What do we think we know that they dont? Answer: we dont. But the selling has accelerated along with Obamas poll rankings and the bets on Intrade about his re-election. The insiders know that if he is re-elected and the Democrats also do well in the Congressional races, the capital gains tax rate in the Bush tax cuts will be among the first to be dumped. If they go up to the 40% range from 15%, that would be a huge hit for those with big stock options. Well go out on a limb and predict the insider selling will plummet if Romney moves into a sustained lead in the pollsand Intrade. But dont bet big on that happening.

UKRAINE FLIRTS WITH DEFAULT From Variant Perceptions Following the pattern we have identified in other countries in the region, Ukraine is once more getting itself into a deeper and deeper mess. Part of the problem is political, part of it is economic, and part is a combination of the two. Moreover, Ukraine has one of the most severe demographic problems in the CEE, which is itself a region of grave demographic problems.

Ukraines working age population is in terminal decline, both in absolute terms and as a share of the total population. Indeed, given the almost extreme forecast of population decline in Ukraine it is remarkable that the working age share of the population is declining this fast. The size of the prime working age (30-50 year age group) is a measure of a countrys total growth rate the future looks bleak for Ukraine.

Ukraine was one of the worst affected countries following the onset of the global financial crisis. Industrial output slid by more than 30% due to a massive overdependence on steel, the price of and demand for which had fallen off a cliff. The country is now getting into ever deeper problems since elections are due later this year, and while the IMF is demanding increases in the energy tariff the government is stubbornly resisting.

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Weeks When Decades Happen Talking about the Russian Revolution, Lenin once said that there are decades when nothing happens and there are weeks when decades happen. The last quarter of 2001 looks in retrospect like one of those exciting periods: three events occurred which set in motion the main economic trends of the ensuing decade. Successful investors latched on to at least one of these trends. The problem is, all three trends are now over. The investment strategies that worked over the past decade will not continue to work in the next. What comes next? The three big events of 2001 were: The terrorist attacks of 9/11. This unleashed a decade of bi-partisan guns and butterpolicies in the US and produced a structurally weaker dollar. China joined the WTO in December 2001. Chinas full entry into the global trading system signaled a re-organization of global production lines and Chinas emergence as a major exporter. Export earnings were recycled into the mother of all investment booms, which drove a surge in commodity demand and a wider boom in emerging markets. The introduction of euro banknotes. The introduction of the common currency unleashed a decade of excess consumption in southern Europe, financed unwittingly by northern Europe through large bank and insurance purchases of government debt. But today, all three trends have stalledand this perhaps accounts for the discomfort and uncertainty we find in most meetings with clients. Indeed: US guns and butter spending is over. For the first time since 1970, real growth in US government spending is in negative territory: Chinese capital spending is slowing. China still needs to invest a lot more, but future growth rates will be in the single digits. Excess consumption in southern Europe is done. Money is clearly flowing out to seek refuge in northern Europe. Thus, like British guns in Singapore, investors whose portfolios still reflect the above three trends are facing the wrong way. Instead of lamenting over the past, investors should be coming to grips with the trends of the future: the internationalization of the RMB, the rise of cheaper and more flexible automation, and dramatically cheaper energy in the US. Click here to see the entire article.

The country needs a deal with the IMF, since it faces external debt servicing costs of $52.5bn (around 30% of GDP) this year alone. A large chunk of this debt is in the banking system, but roughly $5.4bn is owed by the government ($3.5bn of which is due to the IMF). Put together, Ukraines external financing needs could be close to $58bn this year equivalent to 34% of GDP. This is why CDS prices on the country have been rising sharply this year, against the global risk trend. Recent rumors that Ukraine wants to postpone paying back the Fund for the 2008-09 bailout for as long as 10 years will obviously not happen, but this is the problem for the IMF, in a nutshell. Bailed out economies are fine until they need to pay back. And the country has one more problem to confront the construction slowdown in China, which could easily send global steel prices hurtling down.

The March 2012 edition of Donald Coxes Basic Points research report (subtitled All Clear) has just been published. His investment recommendations, as summarized in this document, are listed in the paragraphs below, but I do recommend you also read the full report at the bottom of the post. (Also note that Donalds weekly webcasts can be accessed from the sidebar of the Investment Postcards site.) 1. Income investing is here to stay in a deleveraging, slow-or-no growth world. Collapse of the CAPM means bond investors should runnot walk away from government bonds and seek quality corporatesand find new equity-based income vehicles. 2. Emerging Markets stocks and bonds look relatively attractive. The vast oversupply of debt means economic growth in the industrial world will be, at best, modest. The relative scarcity of debt in the Emerging Economies means their growth rates relative to the First World will improve. 3. Go with growthbuy commodity stocks. Emerging Markets citizens spend more of their earnings on commodities than we do, and their demography is more favorable for economic growth than ours. A world in which EMs share of growth continues to increase is a world in which commodity prices will be strong relative to other prices. 4. Within the industrial commodity stock groups emphasize oil stocks over gas stocks, and emphasize copper stocks over aluminum stocks. As the Freeport McMoRan debacle shows, miners in Third World countries sometimes face worse risks than commodity price risks. 5. Record-low Treasury yields and record-high real fiscal deficits have combined to produce 2% economic growth. Those stimuli are unsustainable but they should sustain the Obama Presidency. He will have to deal with the problems in his second term, and that will mean much higher taxesif not higher interest rates. US economic growth will be closer to Continental growth rates next year. Invest for dividendsnot growth. 6. Golds yield is now roughly the same as T-Bills. It was an excellent investment when T-Bills yielded 5%. Its relative value continues to improve, as economies struggle and governmental finances deteriorate. It belongs in all portfolioseither as bullion or stocks. Bullion has been better for a surprisingly long time. The next time gold is nearing $2,000, investors will take the stocks more seriously. Those with virtually no political risks are astonishingly cheap. 7. The really oily Canadian and US stocks are excellent value, particularly the oil sands companies. Oil stocks havent kept up with oil prices, mostly because of the drag from collapsing gas prices. Obama is losing big with voters on Keystone, and he may need to disappoint his deep-pocketed environmentalist backers who invest in government-backed windmills that slaughter birds and bats, and in government-backed, money-losing solar panels, and cars that catch fire. Naturally, they hate profitable pipelines that supply low-cost, reliable energy with near-zero impact on animal populations. 8. Grain prices remain strong, despite mostly good crops worldwide and a mild winter in the US corn belt. The agricultural sector has the best blend of profitability and economic variability in an uncertain world. It is also the sector that has the greatest offering of great global companies at modest cost. (The risk of crop disappointments due to Colony Collapse Disorder in apiaries continuesas does the absence of certainty about the cause of the annual destruction of at least one-third of the honeybee population.) 9. An Israeli attack on Iran need not lead to strangulation of Gulf oil flowsas long as Irans oil production facilities and the mullahs cash flows are left largely intact. The surprise could be that Israel launches a surgical strike, and Irans Hezbollah minions launch hundreds of rockets from Lebanon and Gaza, and oil prices spikethen fall back. In other words, investment programs should not, perhaps, be held hostage to Armageddon fears.

My Mind Is Made UP. Dont Confuse Me With The Facts.

The Second Differential Of The ECRI Last week the Economic Cycle Research Institute (ECRI) affirmed their call made last fall that the U.S. economy would soon be in recession. The ECRIs main business focus is to try and predict the ups and downs of the business cycle, and they have had an outstanding record over the years. Right now the absolute level of the index may suggest economic weakness, but the second differential has suggested an improving stock market is also in the cards. The ECRI has developed a weekly indicator where they have combined various economic statistics into a series that they publish. Details are not provided on the specific of the composition of this index, but they include broad measures of output, employment, income and sales. When describing the weekly ECRI index, they always emphasize that these metrics are based on leading indicators rather than coincident indicators, so their data should carry more weight. No argument here, as wed agree with this assessment. Note: This article is several pages long so I will not lift it entirely but click through to ZeroHedge to read in full.

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Japan approaching the tipping point By Chris Becker Market Strategist Tradition Analytics Japans Ministry of Finance and the Bank of Japan face some major headwinds in coming years. It is worth pulling back the lens on government finances to see what faces the Japanese government going forward, especially in light of the announcement of further quantitative easing by the BOJ this week. GOVERNMENT FINANCES: PULLING BACK THE LENS The BOJ purchases JGBs (Japanese government bonds) at an annual rate of 21.6 trillion in regular monetary policy operations. On top of this, the BOJ buys JGBs through the Asset Purchase Programme (APP). The regular bond buying, plus another 15.2 trillion that remains unspent in the APP, means the BOJ will buy a total of 36.8 trillion worth of JGBs until the end of this year. The Japanese Finance Ministry announced that it will run a budget deficit of 44.24 trillion in 20122. This means that the BOJ will monetize 81% of the annual government deficit this year. Total government tax revenues excluding bond issuance is expected to equal 46 trillion this year. The Japanese governments debt service bill will take up 22 trillion, or 24% of total spending in 2012. This with interest rates at 1% or lower all the way out to 10 years, and below 2% out to 30 years on the bond yield curve. Social security spending by the government is projected to equal 26.4 trillion, or 29% of total government spending. Debt service and social security spending together, will account for 49 trillion, or 54% of total government spending in 2012. This is 3 trillion more than actual tax revenues, excluding bond issuance. Now, bear in mind that some 95% of Japanese public debt outstanding is held by the public. The total amount of Japanese government bonds outstanding will be 709 trillion at end 2012, or 1538% of annual tax revenues (excluding bond issuance). This is equal to 148% of GDP. The government can only pay back its debts, or service its debts, with actual revenue raised in the form of taxes. To pay for debts by issuing debt is not paying back debt, but adding to debt. This is why it is a better gauge of debt servicing ability to look at debts relative to tax revenues. However, the median age of the Japanese population is 45. The media age in China is 35, and in the US it is 37. The global median age is 28, according to the CIA. The majority of Japanese people are approaching retirement, which means they will soon start to liquidate their bond holdings in order to raise cash with which to fund their retirement. As these bonds are liquidated, and people start to enter retirement, the countrys savings rate will automatically decline. As the savings rate declines, there will be less domestic funding available to finance government bonds, which will tend to drive interest rates higher to attract more savings. A high Japanese savings rate and domestic funding of Japanese government debt has in the past kept interest rates suppressed, however, all indications are that this support structure for JGBs will be pulled out from under JGBs in years ahead.

This document is getting rather lengthy but here are a few interesting links from this week. Tungsten-Filled 1 Kilo Gold Bar Found In The UK http://mjperry.blogspot.com/2012/03/how-advances-in-drilling-technology-are.html http://wattsupwiththat.com/2012/03/10/saturday-silliness-joshs-wind-energy-fact-sheet-global-wind-power-to-the-nearest-whole-number/ Hatzius On The Three Reasons The Recovery Is Overstated What Goes Up Must Come Down -- James Montier

The quarter ends this week so there may be some fun and games from those lovable fund managers trying to paint the tape or to match their benchmark. I am looking forward to the 2nd quarter which I believe may be eventful. We have elections in France, and Greece, planting season in the AG markets, the end of retirement account investment season, continued provocation between Iran and Israel, and toward the end of the quarter Operation Twist is scheduled to end. That is a lot of potential market moving news and I am sure I left out many other sources of turbulence. So here is to a good finish to the quarter and a spring cleaning of the positions. Bruce Lawrence March 25, 2012

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