Natural Gas ETFs: Trading as Closed End Funds

This extreme divergence in the oil to natural gas ratio has attracted a lot of investor interest in two exchange traded funds, UNG and GAZ (technically an ETN) which invest in near term natural gas futures. As a result of the huge amount of money pouring in, these funds have hit position size limits with the CFTC and have stopped issuing new shares.

As a result these funds now trade as closed end funds, with a healthy premium to their NAV. As of Monday’s close, UNG trades at a premium of $1.34, almost 12% above its NAV. GAZ trade at a premium of $1.19, about 8% above its NAV.

Natural Gas Forward Curve and ETFs

The natural gas futures market is pricing in a recovery in prices going forward. While the September ’09 contract is trading at $2.945 and the October contract is at $3.362, the December contract is at $5.155, more than $2.20 higher than the September contract. Going out to 2010, the October ’10 contract is at $6.018 and the December ’10 contract is at $6.8013. Notice how the forward curve is very steep in the near term and flattens out over the next few months.

However, investors buying these ETFs hoping to profit from a rise in the price of natural gas are in for a rude surprise. These funds hold near dated futures. UNG buys the next month’s futures and rolls them over monthly. GAZ buys futures two months out and rolls them over once every two months.

UNG currently owns October ’09 futures and will roll them onto November ’09 futures next month. The November futures are trading at $4.342, almost 23% higher than the October contract. If the roll were to occur today, the number of contracts which UNG will purchase will be 23% percent less than the contracts it sells.

Futures versus Physical Ownership

The example above illustrates how the NAV of UNG will not go up even though natural gas futures for November delivery are 23% higher than the October futures. This is an inherent feature, called negative roll yield, of any strategy which invests in futures to get an exposure to commodities. A primer for this effect can be found here. The NAV of UNG will not rise unless and until, the entire forward curve for natural gas rises AND the rise gets reflected in near term futures.

On the other hand an entity which physically holds natural gas, can buy the gas at the price of October futures, store it for a month, and earn almost 23% return on the investment.

Limited Storage Capacity: Big Risk of Spot Price Collapse

Since the ETFs use near term futures to get exposure to natural gas, they are highly susceptible to the volatility in the price of near term futures. Currently the spot market for natural gas is very depressed. New production brought online to harness shale-gas is flooding the market, while demand for natural gas is depressed due to the economic slowdown. As a result the amount of natural gas in storage is much higher than previous years. Due to storage capacity constraints, natural gas producers are being forced to dump the gas in the spot market at highly depressed levels. As a result the spot price of natural gas is under significant risk of collapsing. Some industry analysts say that natural gas spot price could fall below $2 or even $1 in the next two months, till demand kicks in, production slows down or spare storage capacity comes on line.

Any collapse of the spot price of natural gas will be reflected in near term futures contracts and adversely affect the NAV of UNG and GAZ. Further due to negative roll yield, the NAV will not bounce back even if the price a few months out does not collapse.

Difference between Oil and Natural Gas

The markets for natural gas and crude oil have dramatically different price dynamics. The price of Crude Oil is currently controlled by investor sentiment; it is seen as a hedge against the weak dollar. The infrastructure to store oil is a lot more extensive and global in nature, allowing speculators to ride out any short term supply gluts.

On the other hand, natural gas is primarily a market driven by supply and demand dynamics. When compared to crude oil, international trade and the supporting storage and transportation infrastructure is miniscule.

End customer usage patterns will adjust to massive imbalance in prices of natural gas and crude oil, but this may not get reflected in the spot prices till the supply overhang of natural gas diminishes.

How to Invest in Natural Gas?

Natural gas ETFs not only have a big premium to NAV, they also carry the risk of price collapse of the spot natural gas market. Further they are unlikely to benefit from the rise in the price of natural gas as predicted by the forward curve because of negative roll yield issue. They clearly are to be avoided.

Equity of companies in the natural gas space might be a better investment. The holdings of the First Trust ISE-Revere Natural Gas ETF, (FCG), are a good place to start looking for companies in this area. Due to the collapse of the price of natural gas, many companies in this space have balance sheet issues. So any investment should be preceded by some due-diligence on the fundamentals of the companies.

Many natural gas producers also hedged their production when prices were high and their share prices may already be reflecting that. But any rise in natural gas prices is likely bring in speculative traders back into the natural gas space and should provide a short term spark in equity prices across the board.

For those interested in arbitrage plays, the premium to NAV is less in GAZ compared to UNG. So a long GAZ, short UNG position is worth considering. Do note that GAZ currently holds November’09 contracts while UNG holds October’09 contracts. Due to the volatility of gas prices, the NAVs of GAZ and UNG will not move in lock-step. Further, since GAZ is much smaller than UNG in size, it might be able to issue new shares sooner than UNG which will shrink the NAV premium faster than UNG.

The S&P 500 has rallied almost 50% from the lows reached just five months ago. Under normal circumstances, such a move would be a sign of a raging bull market. However in spite of the historic rally, a lot of pundits still question whether this is a bear market rally or a true bull market.

Where is the Volume?

One major reason for their skepticism is the lack of market volume. Typically during bull markets, the volume of shares traded increases as the market moves higher. However in this rally of the March lows, the volume has been decreasing as the price moved higher. Proprietary indicators developed by Lowry’s Research show a lack of what they call buying pressure; the market moved is based primarily on lower selling pressure since the March lows.

However, at the end of the day, the only metric of real-world significance is the price-action. And the price-action has been very strong.

Technical Theories: Buy Signals Everywhere

Equity indices have been on a tear since the swing low reached in July, moving up double digit percentages in two weeks. During this period a lot of technical signals which indicate a bull market have turned green. The 200 day simple moving average (DSMA), an indicator of the long term trend, started sloping up in late July. The 50 DSMA, is also sloping up and is well above the 200 DSMA.
July was also an outside reversal month. Equity indices undercut the lows of June, but then reversed to close at a new high. During the recent bullish run, the number of stocks making new short-term highs has increased to new highs, signifying a broad-based rally. According to Dr. Brett Steenbarger, today 1829 stocks make a 65 day (13 week or 3 month) high, while just 105 stocks made a 65 day low. This is a new record for this bull market.

After the failure of the Head and Shoulder topping pattern in early July, the S&P 500 has broken the neckline of an inverse heads and shoulder pattern, which has been forming on a much larger time-scale. This article written by a trader I respect a lot, discusses different aspects of this pattern. Her target for the completion of this pattern is 1229, a good 23% above the current price.

The Slow Turtle trading system compares the 22 week moving average with the 55 week to capture long term trend changes. It generates a buy signal when the faster average crosses up over the slower average and a sell signal when the reverse happens. Nasdaq100 is making that cross this week, while the SPX is fast approaching that level.

Richard Russell’s Interpretation

This article discusses Richard Russell’s interpretation of the Dow Theory and the buy signal it generated. Quoting Mr. Russell’s letter, it states:

“… My interpretation? We are now in a cyclical bull market as opposed to a secular or primary bull market. In effect, we’re in an extended bear market rally. The true bear market bottom lies somewhere ahead.
“There is no way of knowing how high this bear market rally might carry. The question - is it worth playing this cyclical bull market? My answer is yes, but play it very conservatively and carefully.”

The last sentence captures the essence of investing in this market.

The Chinese Experiment: Reengineering Chinese Consumer Preferences

The rally has been driven by expectation of continued growth in emerging economies (primarily China) as a result of the massive government stimulus injected into those economies. It is based on the expectation that growth in the emerging markets will help cushion the effect of the credit-led slowdown in the developed economies. The roaring bull market in commodities and technology stocks is an indication of this bias.

The Chinese economy is joined at the hip to the Western consumer. The Chinese Communist Party is trying to separate the two using its fiscal policy as the scalpel. The CCP hopes that the massive stimulus spending on infrastructure will compensate for the loss of export jobs and incentives to encourage consumer spending will grow domestic consumption.

There are strong indications that many loans have been granted without due diligence about the viability of the investments. There are murmurs that at least 15% of the loan amount has been siphoned into Chinese equity markets which are up almost 85% this year. Whether CCP’s growth at all cost style of managing the economy will work is yet to be seen. Risking whatever is left of your nest egg on the potential success of CCP’s experiment of reengineering consumer spending attitudes is a dangerous game, which has to be played carefully.

Navigating the Markets

In my July 14 article after Intel’s earnings, I had expected another leg up in the equity markets with an initial target of 1000 on the SPX which has now been met. The now failed Heads and Shoulders pattern had trapped a lot of trading account short. This resulted in a massive-short covering rally with hardly any pullbacks, with the Nasdaq100 (QQQQ) closing up for 13 days in a row.

Once the stock indices made highs for the year, they have attracted more sideline money as the rally builds on itself converting more skeptics into believers. Though the initial burst was led by technology stocks, the rally has broadened with low P/E value stocks also participating.

The SPX is approaching a key Fibonacci Retracement and the highs of November 2009 around the 1007 level. It is likely that the market will face some resistance here, and pullback. The pullback may go back to the 950-960 level which forms the neckline support of the inverse head and shoulders pattern.

In April, I had written an article describing how more money will come into the market as it crosses key technical levels. Assuming the 950-960 level of support holds, I expect another bullish run, which is likely to suck in a lot of sideline money. The ensuing rally is likely to be strong and perhaps on better than average volume. However, I see this as a melt-up kind of rally where mutual fund money chases equities not because of some newly discovered confidence in the underpinnings of the economy, but because of the fear of underperforming the broad market.

Jeremy Grantham of GMO, who had correctly predicted a liquidity driven stock market rally this summer, feels that equity markets are at or near fair value and are starting to overshoot. In his quarterly letter (registration required) he is advising clients to go underweight in their equity portfolios if and when SPX is between 1050 and 1100.

Sentiment is Key

Given the shaky underpinnings of this rally, I strongly believe that investors should focus on the market sentiment more than anything else. When the market ignores bad news, but rallies on good news, it is relatively safe to be invested long.

During the July rally, the market shook of below expectation results (or forecasts) from major bell-weather stocks like Microsoft and Amazon. A downward revision in the first quarter GDP number or the continued high level of first-time jobless claims did not slow it down. The dollar continues to be sold, and risk appetite seems to be rising.

However, the wall of worry put up by the underlying economic figures looms high and sentiment can turn on a dime. While the rally is likely to continue, investors should follow their trading plan consistently and set hard stop levels, to limit capital-erosion. The market has also rallied almost 50% from its lows, and averaging down carries a lot more risk than it did a few months ago.

Meredith Whitney moves the Market
Over the past year and a half, former Oppenheimer & Co analyst Meredith Whitney has been moving the market down with her bearish calls on the financial sector. However, this Monday, she came out with a bullish call on Goldman Sachs and a not so bearish view on the rest of the banking sector. This triggered a strong rally in the banking sector, which was aided by Goldman’s blowout results on Tuesday morning. General wisdom suggests that the overall market cannot move up without the financials leading the way, and the healthy action in financial stock is music to the Bulls.

Intel Blows through Estimates

After the close of the market Intel announced its earnings which beat Wall Street estimates by a mile. To add fuel to the fire, their outlook for the next quarter was significantly better than the average street estimate. The markets have responded very favorably to these moves, with the Nasdaq100 futures (NQ) up more than 1.6% after hours.
Intel is attributing the strong performance to renewed growth in emerging markets, especially China. Since Intel’s chips power almost all computers sold today, Intel’s rosy forecast is seen as a sign of improving health for the entire semiconductor and technology sector.

Did Wall Street Underestimate China?

Recovery in China is a key component of Intel’s forecast. The Chinese government’s stimulus package has been focused on turbo-charging internal demand via very loose purse-strings. The total amount of lending in the first four months of 2009 has exceeded the total amount lent in 2008. Incentives to purchase new automobiles have led to a 35% surge in sales, to an annualized rate which may beat the US new auto sales figures. It seems that Intel is now seeing the impact of the massive spending binge and factoring that into its forecast.

Intel’s result and forecast suggest a mismatch between Intel’s expectations and current Wall Street expectations of the impact of Chinese stimulus. It is not obvious whether this mismatch stretches to other segments of the market. However, Intel’s forecast is likely to result in a thorough review of Wall Street’s existing view of the impact of Chinese stimulus. I definitely expect upward revisions of earnings estimates for other players in the technology sector; with some spillover to industrials and materials.

Liquidity driven Rally to Continue

Intel’s results and the market reaction to it suggest that pronouncement of Jeremy Grantham of a massive rally are likely to come true. Grantham believes that the massive coordinated stimulus injected into the financial system will create a liquidity driven rally. There is already some speculation that a significant amount of the Chinese stimulus has found its way into financial markets and is the driving force behind the meteoric recovery of equity prices in China. The bullish spring run in crude oil too is being attributed to excess liquidity finding a home in commodities.

But will it last?
Assuming the market rallies, the big question will be whether those levels can be sustained. Unless economic fundamentals catch up with the equity markets that is unlikely to happen. I believe that government action can delay or soften the pain, but cannot eliminate the effects of structural changes occurring in the global economy.
The US consumer will be weighed down by high unemployment, a lack of available credit and high taxes. China will have to engineer a massive shift towards domestic consumption from its export led growth model. The problem there is that the Chinese are habitual savers, and are unlikely to go into a spending binge when the collapse in exports is resulting in millions of lost jobs.

I agree with Mr. Grantham’s thesis that the global stimuli will do more to spruce up equity markets, with a little lasting impact on the underlying economic fundamentals.

Investment Plan

The SPX corrected almost 10% from its early June highs and held the key 875 level on a closing basis. Though many market technicians are pointing to a well formed Head and Shoulder pattern which suggests a downward move towards the low 800s, the earnings surprises are likely to weaken the bearish bias. Assuming that other technology heavy weights come out with strong earnings, I expect the tech sector to lead a rally in equities, which will test the recent highs. A clean break above the recent highs would put 1000, a key psychological level in play.

However, any bullish bias has to be tempered with the knowledge that the underlying economic situation remains precarious. This rally is going to be driven by high expectations which may or may not materialize. The key as always, but more so now, will be to observe the animal spirits: how equities react to news both good and bad. In a bullish tape, all news is bought; in a bearish tape, even good news is sold. As long as fundamentals remain questionable, sentiment will perhaps be the best guide in navigating the markets.

Disclosure: Vikram actively trades the US financilal markets and holds long and short positions in many instruments and securities mentioned in this article.

Reassessing Risk

The market is still digesting the implication of Friday’s jobs report. In spite of comments by the government that the recession is far from over, the market is pricing in a greater possibility of an end to the monetary easing policy of the Fed. The yield curve continues to flatten with many traders taking off the curve-steepening trade which has worked very well. The rise in short term rates is forcing a re-evaluation of many assumption underlying the current equity rally, which is primarily a result of excess liquidity in the system (cash on the sidelines, with low borrowing costs).

In my view this flattening is a pure technical reaction as traders exit the curve steepening trades (long short term, short long term treasuries), and does not reflect any sustainable shift in expectations. Regardless of how the non-farm payroll numbers are spun, the economy is still far away from a strong recovery, and higher long term yields are going to put an even greater pressure in keeping growth down.

As anticipated, the dollar continued to strengthen. However after reaching an early morning peak, it weakened through the day, with the Euro finishing almost 1c higher from its lows against the dollar.

Oil is showing remarkable resilience in spite of the strong dollar. Oil was supported by a bullish call by Morgan Stanley, following on the bullish statements by Goldman Sachs last week. Both GS and MS are major participants in the physical delivery oil market, and such calls which help sustain the speculative bias, are helping to strengthen their bottom-lines.

Market Outlook: Choppy Action Will Likely Continue

Late day spikes where the broad market rips up 1-2% in a matter of minutes are becoming very common. Many of these spikes are triggered by short-covering when the market gets over some key technical levels. This shows that though the bearish sentiment has not gone, it lacks conviction. The bears rush to cover at the slightest hint of a rally.

Some bears will take heart from the fact that the market sold off into the close after the spike. Though the inability of the market to hold higher price levels is not strongly bullish, what is the key here is the ability of the market to hold key support levels on the downside. In spite of the sell-off today at the open (and the close), the trend continues to remain bullish. The market did not violate any key technical levels and the sell-off was at a low volume.

I expect the market to continue to display the sideways choppy action as the gains of last week are consolidated and some participants reduce their risk exposure. We are likely to see more intra-day swings, and a retest of the 200 Day Moving average. However, unless the key technical levels of 903 and 880 on the SPX are violated, the trend remains up.

The rise in dollar was a result of perceived strength of the US economy. However as soon as the dollar started rising, equities started to sell-off. The selling took the ES (S&P Futures) from a high of 957.50 down to a low of 933.25. After some more ups and downs, the equity markets finished almost flat with a slight negative bias. Unlike last week there were no fireworks into the close, with the market staying in a narrow range in the final hour, a rare occurrence. Interest rates moved up across the curve, with the biggest changes in the shorter duration (1 to 2 years) leading to a less steep yield curve from the historic highs reached earlier this week.

Commodities performed reasonably well given the backdrop of the rising dollar today. Traders are now pricing in inflation and economic growth and not just a weak dollar in their analysis. Oil hit the $70 mark in early trading before pulling back to close with a slight loss.

A Closer Look at Economic Data

The surprise drop in the number of jobs lost, had a few dark clouds hovering over it. The hours worked dropped to a level which would have corresponded to another 350K jobs lost. The unemployment rate (U3) rose to a record high of 9.4% as more workers, especially recent graduates from schools and colleges joined the workforce. A measure of true employment which accounts for all under-employed workers, U6, reached a high of 16.4%; this rate was at 9.4%, a year ago.

The retail sales data earlier this week was weak as expected. What also surprised on the negative side was the much sharper than expected drop in Consumer Credit of 15.7B compared to the consensus of -7B.

Corporate Earnings and the Bottoming Economy

There is no doubt that the free-fall in economic activity has been controlled and the economy has likely reached the bottom or close to a bottom. However, what the new normal will be like is not clear.

In spite of hectic activity in the distressed homes market, organic sales of non-distressed properties are very week. The rise in long term interest rates is likely to hinder this market even further. Home prices may not free-fall too much further, but the activity in the non-distressed sector is likely to remain depressed for a significant time to come. Home sales trigger a lot of consumer spending and that component of consumer spending is going to be missing from the economy, apart from depressed construction activity.

Consumer spending will continue to remain constrained due to higher unemployment, lower credit availability and a greater propensity to save. This is likely to limit the upside to the profitability of companies which are dependent on US consumers. Though earnings estimates are likely to go up as analyst’ optimism catches up with green-shoots, the ability of companies to continue growing their earnings is going to be limited for quite some time to come.

Lack of Conviction Shows up in a Trigger Happy Market

The price action today showed how the equity markets lack conviction. The shock of the headline number of the NFP report sent the futures soaring, only for them to come down to earth as the rest of the report was digested. Such choppy volatile action is an indication of an uncertain market where participants lack conviction.

However, demand for equities will continue to be high purely from technical reasons. There are a lot of fund managers who are underinvested in equities and with the end of the quarter approaching in a few weeks, not many can afford to remain in cash as equity indices continue to outperform cash.

It is very likely that the market may continue to go higher but there risk of a major disappointment will grow as time passes, and the green shoots do not grow into strong trees. Art Cashin, the director of floor operations for UBS and a CNBC commentator said that another 1000 up move in the Dow will send him to the bomb-shelters.

Market Outlook

I expect the dollar to strengthen further next week as the anti-dollar trade unwinds. Unless the correlation between the dollar and equity prices reduces, equities are likely to be under pressure. On a technical basis, the SPX’ price action today corresponded to Trader Vic’s 2B Rule, which would also suggest that a pullback is likely. How long the pullback will last before the bulls rush is a different question all together. Treasuries are likely to be under pressure as more supply comes to the market and the perception of an improving economy increases risk appetite.

Treasuries, Mortgages and the Dollar Sell-Off
The currency markets had a particularly volatile day today. The Euro sold off after the ECB kept its rates and quantitative easing policy unchanged. The British Pound was hit by a false rumor that Prime Minister Brown had resigned. The dollar also strengthened after retailers reported large drop in sales. The Jobs Report came as expected, but in a bullish tape was interpreted quite positively, leading to a subsequent sell-off in the dollar.

The currency markets have ignored the failure of the bond auction in Latvia, and the re-emergence of risks associated with the non-Euro European economies on the European financial system.

Apart from equities, the story of the day was the sell-off in long dated treasuries and mortgages. Any chance of a pull-back in mortgage rates decreasing and will continue to have a negative effect on housing. The spread between 2yr and 10yr treasuries reached a new record today of 278.66bp, the steepest the yield curve has been for a long time.

Financial Markets and Economic Recovery
The financial markets are now pricing in either a very weak dollar or a very strong recovery. However the foundation neeeded to drive the economic recovery is being shred into pieces.

Energy prices are rising aggressively, based primarily on speculation of a supply-demand mismatch in the future. A weak dollar is aiding this run. This is eerily similar to last year’s run in oil prices, when a weak dollar, lead to oil spiking to $145, even though there was no sign of any real physical shortage of oil. Big banks have accumulated a lot of oil and are now driving the prices up with their reports. JPMorgan has hired a brand new super-tanker to store heating oil off the coast of Malta, the company’s first such booking in five years. As gas prices start approaching $3/gallon, they are again likely to pinch the consumer.

Long term interest rates are also likely to have a detrimental effect on mortgages and corporate spending. But the equity markets are ignoring all those signals. The market wants to go higher since there are a lot of underinvested managers. It is going up on hope that an economic recovery will materialize to justify the prices. It is ignoring the risks to economic recovery by collateral damage caused by the current market structure.

Market Outlook
The market continues to be in a very strong bullish trend. With Rusell2000 and the Nasdaq making new highs, it is very likely that the S&P500 will also make a new yearly high tomorrow. The SPX may have been waiting for the Non-Farm Payroll numbers to get out of the way before it charges ahead. Unless there a major negative surprise, I do not expect the bullish bias to change.

Inflation and the Anti-Dollar Play
In yesterday’s review I had written that the anti-dollar trade was going beyond what the macro-fundamentals suggest. The problems plaguing the financial system stretch to most of the developed world, and the effect of Fed’s monetary policies are being exaggerated. The Euro specifically is the default beneficiary of the anti-dollar trade, even though the schisms created by multiple political stake-holders tugging the ECB are hindering appropriate policy response. The trade reversed today, with the Euro taking a significant tumble along with oil. Though this is certainly not the end of the bullish run, it does highlight how chasing a crowded trade can hurt investors.

Bullish Sentiment Intact: 200 Day SMA Holds
In yesterday’s roundup, I had expected the SPX to test its 200 Day SMA from the upside, and it did so today. The bulls will take heart that buyers emerged when the SPX approached the 200 Day SMA at 923, and equities finished strong, wiping out a significant portion of the intra-day losses at the close.

It is fairly common for instruments to straddle the 200 Day SMA for many days, as the market tries to resolve its future direction. This average is sloping downwards and the average will continue to decline for some time to come. As a result the market can continue to remain about the technical level, even when it moves sideways or downwards.

Ever since the market closed above the 875 level on May 1, it has not fallen below it. As long as that level holds the bullish sentiment will remain intact.

My Portfolio: No New Positions

Though I had planned to open new long positions when the market tested the 200 Day SMA, I did not do so. This was because the strongest sectors so far, energy and materials showed a strong pull-back today. The anti-dollar trade is likely to be unwound further, and these sectors will continue to remain under pressure. As I had written yesterday, the chart of oil last year should be a reminder to anyone who wants to chase commodities, when the global macro picture is clouded.

Refiners Sell Off

Unfortunately, my long call position on the refiner TSO, took a big beating today as the entire sector was sold off due to concerns about capital needs and earnings. VLO has suffered from refinery shut-downs leading to a loss, which they pre-announced today, prior to a secondary equity offering to meet some urgent capital requirements. Refiners continue to trade at attractive valuations to their book value. However their earnings continue to remain volatile. They are great take out candidates for larger integrated oil companies but until that becomes a reality their share price will continue to be volatile. TSO closed below its 50 Day SMA today (15.78) and is likely to test its 200 Day SMA currently just above $14. That may provide a good longer term entry point for long positions.

Tomorrow’s Outlook
I expect cautious range bound trading tomorrow in front of the non-farm payroll report due on Friday. The market will likely consolidate it gains around the 200 Day SMA, perhaps retesting it.

Pending Home Sales Surprise: How Many Will Close?

The market got a shot as the pending home sales released by NAR beat expectations.

According to the WSJ:

The National Association of Realtors said pending sales of existing homes in April rose 6.7% — the biggest monthly jump in eight years. The data built on a flurry of other recent reports suggesting that the housing market and the broader economy are stabilizing.

The good news about the economy keeps on rolling in providing fuel to the rally. However this particular headline might turn out to be the most misleading.

Two must-read articles discuss the consequences of higher mortgage rates and their impact on the retail mortgage market the day after. Over the past few weeks, mortgage rates have spiked up. Though many prospective buyers would have locked their rates, a lot of others may not have been able to.

The jump in mortgage refinance applications over the past two months has created a jam in the mortgage processing pipeline. As a result, many mortgage originators were unable to process the applications, especially refinance applications, in time for them to make the rate lock (which they do by hedging their interest rate risk). So if this spike in mortgage rates does not recede, at least some of the current contracts may not close, due to the lack of mortgage credit at the right rate.

Market Sentiment Driven by Fear: The Fear of Being Left Out

Right now the market sentiment is being driven by fear: the fear of being left out. This is a strange phenomenon, since typically the fear is of buying too high, only to see the market fall. This is one of the pitfalls of bear market rallies since even though portfolio managers are not convinced about the underlying fundamentals of the economy they are forced to participate since they are paid to be in the market.

The rally is being driven by optimism about future recovery and is fueled by excess liquidity which has been pumped into the system by central banks throughout the world. Though there is no doubt that things will get better, the market is perhaps over-estimating the extent of the recovery in the face of severe macro-economic challenges. However, bull markets have to climb a wall of worry, so unless proven wrong, the markets will continue to rally. However once it is proven wrong, the correction can be vicious.

The Anti-Dollar Trade

The anti-dollar trade continues to be strong with even the beleaguered Euro continuing to charge ahead taking out the 1.43 level today. Oil continued to trade strong with the July contract trading as above $69 before pulling back.

Though there is a lot of talk about inflation due to the Fed’s monetary policy, there has been very little attention paid to the dynamics of how the Fed’s current policy will lead to inflation. There is a large supply of spare factory capacity and unemployed Americans to keep prices on the input side low. Though short term interest rates may remain low, longer term interest rates are likely to continue to be creep higher over time, as the bond market adjusts to the huge overhead of new treasury supply. Higher interest rates will put a cap on economic growth which could have driven inflation.

The Fed’s printing press is pumping money into the economy but so far that money has not translated to higher velocity of money. Most of the excess liquidity has gone to strengthen the balance sheets of banks allowing them to off-load assets to the Fed, cut their leverage, and raise their capital ratios. The new money being printed by the Fed is essentially filing in the gap created by the loss of wealth due to fall in asset prices.

This can change soon if the economy shows signs of a stronger recovery leading to loser lending standards. However, as of now, small businesses continue to be short of credit, and with tougher lending criterion becoming the norm, a return to the go-go days of the past is improbable.

Fed’s Silence does not Imply No Plan

Though the Fed has not yet outlined how it will reduce the amount of dollars in circulation that does not mean it does not have a plan. Till this crisis unfolded no one thought that Bear Sterns will be bailed out using the Fed’s balance sheet, or the Treasury debt will be monetized using the Fed’s printing press.

The Fed is unable to outline its strategies at this point since those actions are likely going to drain liquidity from the market. From the economic sentiment point of view, any perception of tightening liquidity can become a big damper. They cannot afford to take that risk right now when the economic recovery is in a nascent state. However, once they see the economy finding a firm footing, and asset prices recovering, they will be more willing to lay out the plan.

The Fed has already stated that when it comes to hard to value assets, they plan to hold them to maturity, essentially taking out the liquidity as the loans are paid back, or taking losses if the default. Other assets with short to intermediate term maturities too can be dealt with in the same manner. This gradual removal of liquidity is unlikely to create a shock. The challenge of course will be securities with a longer term but those are not a dominant portion of their balance sheet.

The often cited comparisons with the Weimar Republic are very much out of context. The ability to measure economic activity has increased by orders of magnitude over the past century. Not only is the data more accurate, it is also available real-time, cutting the reaction time of the Fed. The Fed is acutely aware of the risks, and will be monitoring them aggressively; there is no reason to suspect that they are asleep at the wheel.

With savings rate creeping higher and asset prices down substantially, the talk of hyperinflation, in my opinion, is pre-mature. It is driven more by trading houses moving away from the equities into the rally in inflation sensitive instruments like commodities. This anti-dollar rally is not based on measured economic data.

From a trading perspective I do not see any point in fighting the group-think in the markets, except with quick counter-trend plays. However, I see a much higher risk in jumping in on the inflation band-wagon since it happens to be the flavor of the month. One look at oil prices last year should fix those thoughts.

Market Outlook

Today, the SPX tested the 948-949 multiple times but was repelled. Though some may consider this market action as bearish, the fact that this is happening after a strong push over the past two days, means that the bullish sentiment is still very strong.

Others are referring to the relative underperformance of the Banking index (KBE) over the past few days. I presume that the market is reacting rationally to the pending new equity issuance from banks. However, banks have been leading this rally, so I will not be surprised if the weakness in that sector results in the market pulling-back to test the 200Day SMA from the upside. We are also approaching the release of market-moving economic data next week, and traders are likely to book profits.

If the test is successful, which I expect it to be it will likely pull in a large amount of cash parked on the sideline. I plan to do some buying when the market retests the 200 day SMA. However, I will be hedging the positions with either puts or bearish ETFs till a clean break of the current level (the yearly high) occurs.

Technical Buy Signals: Possible Explanation for Futures Spike?
The strong monthly close on Friday, coupled with the open above the 200 Day Moving Average (on the S&P) triggered a lot of technical buying in the market. Fund managers who were waiting for equities to reach the 200Day SMA jumped in with their cash. A lot of bears, who were shorting the market near the 200 Day SMA, had to cover.

The buying pressure was also aided by calls by several Market Guru’s including Michael Belkin indicating that we are now in a global bull market for equities. The Coppock Guide, one of the oldest Market Timing signal also issued a buy. This flury of technical buy signals might be the reason for the spike in future purchases at market close on Friday.

Economic Data Impresses the Market
The overnight session started off on a very positive note with both the Chinese PMI surveys coming above some cautious estimate.There were expectations that the PMI would show a renewal of contraction in China, leaving a lot of disappointed bears. In the US personal income and spending data, the ISM Manufacturing survey, and Construction spending all came above expectations.

Equities were led by energy and materials names which were aided by the weak dollar. Treasury bonds were sold hard as fear of inflation is finding a receptive audience; though oil finsihed up gold finished lower. Most major equity indices closed at the high of the year.

Banks Raise New Capital
During the past month or two, a capital raise by banks has been a remarkably accurate buy signal for the general market. Today JPMorgan and AmericanExpress announced that they will sell equity to repay TARP. Our trading experience would be much more profitable if the banks would pre-announce, their capital raising announcement.

Market Outlook
The equity indices finished strong, and it is likely that the momentum will spill-over to Tuesday. However rising treasury yields has led many to doubt the whether the economic recovery underpinning the equity markets rally will ever materialize. For today at least the markets ignored the yields and went-up across the board. The path of least resistance is up and there is no point fighting it. I plan to close out my short term bearish put positions on any sign of weakness.