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AAM Viewpoints – Convergence of Divergence. Several Market Indicators Flashing Caution.


The Pain Trade is Likely Higher from Here

August appears to be the host to several crowded positions in key markets that are approaching records both in size and divergence and our contrarian value bent makes us curious as to how the next chapter of markets will be written. We point out the obvious that when a trade becomes too crowded, reversals tend to be the consequence. What is interesting is that we have a number of these diversions converging at the same time; and with the divergence so wide, we think it is high time to look at these lopsided positions as a whole. Let’s start by listing the number of lopsided trades built up in the system.

  1. The sell side of the market – as measured by the largest players – is very bearish of equities and favors a move to de-lever and de-risk client portfolios.
  2. We find that the size of the short positions by institutional investors and traders in the 10-year Treasury futures is massive indeed but accompanied by an offsetting huge short by commercial hedgers.
  3. Hedge funds and speculators have built a monster short in copper. Many of us watch copper as it tends to be a leading indicator of either economic expansion or contraction.
  4. The number of long-dollar bets is at nosebleed levels betting that the greenback continues its year-to-date strength. The strong U.S. dollar has often been blamed for weakness in emerging and international developed markets. Those bets would have been quite profitable if placed six months ago. However, the size of these bets has grown to mega proportions only more recently.

What can we say about these record or close-to-record bets? They generally lose. That is right; once a trade gets too crowded the risk of success shifts. In fact, commercial hedgers tend to get it right. Commercial hedgers are always in the market and their positions are not established out of greed but out of necessity. What is remarkable about the divergences we see today is that the size of that divergence is several standard deviations wide. We think the result will not be different this time and that the contrarian will win again.
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Let’s first look at market sentiment of sell side analysts. Above are two headlines from the past couple of weeks. They show bearishness at the largest and arguably best-known investment banks. What we do know is that these negative headlines should be very encouraging to long-term stock investors. Merrill Lynch runs a contrarian index called the “Sell Side Indicator” which was created in 1985 with a purpose to show when equities are undervalued and should be bought or are overvalued and should be sold. The index has been very accurate over the years. It operates by taking the position exactly opposite Wall Street’s sell side analysts. In other words, when analysts are suggesting a large allocation to equities the index gets bearish. When analysts get cautious or bearish on equities the index gets bullish. As you can see below, the last reading of the index showed that equities are not overvalued. In fact, far from it. This jives with the long-term history of the index and tells us that warnings from such big shops can be comforting to us long-term investors.

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Let’s next examine the 10-year note contract. As we can see on the chart below, the price of the note future has been dropping as yields have been slowly rising. However, looking at the Commitment of Traders (COT) positions on the bottom chart you can’t help but note the gaping difference between the net positions held by the Commercial Hedgers v. the Large Traders. Note the size of the divergence. What this tells us is that we are approaching a regression to the mean which will likely cause a fairly large short covering rally in the note future. Does that mean that we have changed our mind on our longer call that interest rates will rise? Absolutely not. What we are saying is that the note is poised for a rally in the short term and nothing more than that. Remember that long-term inflation expectations and credit trends fashion long-term interest rates. We are at a 10-year high on inflation (as measured by Core CPI (Consumer Price Index)). We do not see that changing.

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Let’s now examine copper. Copper is often called “Dr. Copper” because copper is used in so many goods and services. As demand rises and falls over time, there is a tight correlation to economic expansion and contraction. The Wall Street Journal reported on August 21, 2018 that, “The last time hedge funds and other speculators had as many net short positions in copper as they do now, late in 2015, the red metal rallied 19% in the next three months and 37% over the next year, according to Jefferies.” Once again, betting against the crowded trade has tended to be the better position. A similar divergence exists in the gold markets where the commercial hedgers are wildly long and the hedge funds and speculator are incredibly short.

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Finally, let’s look at the U.S. dollar. The investing world seems convinced that the dollar will continue its bullish strengthening well into the future. As indicated in the chart above by the record long position in long-dollar futures, traders have put their money where their mouth is. Should you follow them? Likely not. Remember your parents asking you, “If all of your friends jumped off a cliff, would you follow?” Most of us wisely didn’t follow the lemmings over the edge. The fact of the matter is that at historic peaks in bullishness or bearishness market bets tend to mark reversals. Remember that the dollar is roughly where it was this time last year. We see the record long position as an indicator that it is highly likely the dollar has exhausted its bullish move in the near term.

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We point to the current spike in Emerging Market volatility as displayed above. This notes the large gains that tend to occur after these spikes. It appears we are at one of those inflection points. If we are correct, the most hated of International and Emerging Markets are very ripe to for expanded investment allocations. They outperformed last year for the first time in many years. Generally, bull markets don’t last only one year but last through the economic cycle. A six-month correction should be expected after the almost 30% advance in 2017. Remember, as the dollar has strengthened, Emerging Market currencies have weakened. Thus, their exports are much more competitive as a result. This coupled with ongoing monetary easing and abundant credit should put the zip back in Emerging Market and International’s step.

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Finally, much is being made that the current bull market in U.S. equities is the longest on record. This is true but offers little logic to try to forecast an end. This market will end when it ends and not a moment sooner! Seriously, when we look at the sheer enormity of monetary – and now fiscal – stimulus that has been and is being applied to our economy, it is no wonder that the longevity of this bull market is a record setter. We keep looking for signs of an end, but at this point the contrarian eye points toward a continuation of this expansion cycle. Raymond James strategist Andrew Adams points out that this is likely a secular bull market vs. a cyclical bull market. He argues as displayed in the chart above that if this is a secular bull then we are merely in the first few innings. The bottom line is that trying to time markets is a fool’s game and results over time show it rarely, if ever, works. Time in the market is much more important than timing the market.

We are content with a continuation of our view that this bull market in equities is far from over. We favor late-cycle benefactors such as materials, energy, industrials, consumer discretionary, European markets and Emerging Markets. We want to lighten up on REITs (Real Estate Investment Trusts), utilities, consumer staples and bond duration.

 

CRN: 2018-0803-6818 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.

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