Everyone knows this, and is counting on it to remain the case. While economist David Rosenberg at Gluskin Sheff believes government actions could be directly or indirectly responsible for as many as 500 points in the S&P 500, or 30% of its current valuation, traders have confidence in Ben Bernanke because betting that his policies will drive equities higher has been a profitable wager.
Bernanke, likewise, is undoubtedly pleased with these speculators for abetting his goal of asset price inflation, though we all know that he will not call them first when he decides to reverse direction on QE. Then, the rush for the exits will be madness, as today's 'clarity' will have dissolved, leaving only great uncertainty and probably significant losses. (my own highlights)"
~ Seth Klarman
Chart 1: Overbought and oversold global macro asset classes
Many readers have asked me to republish this chart on a weekly basis. It was also included in the recent Gloom Boom and Doom report by Dr. Marc Faber. Looking at the recent overbought and oversold levels, it is mainly equities that continue to dominate assets in favour. Investors should consider re-reading a quote posted above, by the exceptional investor Mr Klarman.
Nikkei, Singapore's STI, S&P, Nasdaq, Turkey's ISE and so forth, all find themselves in overbought territory. Furthermore, equity investments have performed amazingly well from March 2009 lows, with some indices up over 130% in the space of four years. US equities in particular, are now the best performing region moving towards a fifth annual gain.
On the other side of the spectrum, commodities remain out of favour with investors. Silver, Gold, Copper, Corn, Wheat, Coffee and Sugar all remain oversold. Contrary to equity performance discussed above, the majority of the commodities mentioned have underperformed since early 2011. Let us place the current inverse correlations between these two asset classes into context.
Chart 2: Has a risk of deflation become a consensus view?
The chart above displays four major global macro asset classes. Commodities and interest rates have been highlighted as one can focus on an interest development in progress. Investors have sold off commodities in favour of bonds, pushing interest rates lower.
Are investors acting on expectations of a potential deflationary shock directly ahead? US equities (light grey) do not seem to be paying any attention as of late, as they keep on marching vertically. This is usually common near market peaks. In similar context, equity investors were not moved by subprime issues in late 2006, but eventually the chickens came home to roost.
Looking at the deflation trade (long bonds and short commodities), there is also a possibility that we could now be at an important inflection point. Deflation trade sentiment has turned extremely negative towards commodity prices, as covered in both the Weekend Sentiment Summary post, as well as the recent issue of the Short Side of Long newsletter.
While investors believe rising commodities usually correlate with rising equity prices, I would like to remind readers of developments seen in early parts of 2007, near the end of the business cycle (red box in the chart above). A spike in commodities brought about the fall in consumer spending, resulting in a recession and a fall in earnings. In other words, rising commodities pushed equities into a bear market.
It remains to be seen whether the long bonds / short commodities trade will now be reversed or will raw material prices be forced even lower before the final capitulation. Making a simple technical observation on the chart above, we can see that so far at least, both commodities and interest rates have not yet made a lower low.