Outside the Box

Investor fears got the better of them last week as the relative quiet gave them time to ruminate both on second quarter earnings and on whether the economy is strong enough to support its first rate hike in seven years.  The results were predictable as the markets began moving lower on profit taking following Monday’s attempt at a new high.  Thursday’s unemployment report, whose headline figure of 255k claims came in at the lowest level in 41 ½ years, sparked concerns that the July employment report could add more fuel to the rate hike fire.  Investors are going to be fighting that battle all week - first with the FOMC meeting on Tuesday and Wednesday followed by Thursday's advance release on GDP growth in the second quarter - and we’re noticing some investors already positioning themselves for the shape of things to come.

It would be hard to find a bull market that better exemplifies the old adage, “when the Fed sneezes, the market catches a cold” as investors continue to put all their hopes and dreams on the FOMC deciding that low inflation rather than low rates is the bigger threat to the economy.  Careful readers of those articles talking about how long it’s been since the last 10% correction will note that the dry spell happens to coincide with the introduction of Operation Twist followed seamlessly by QE3 and its supposedly unlimited nature.  Ben Bernanke’s promise to do whatever it takes to spark inflation (or at least to keep the cost of capital absurdly low) gave investors the shot in the arm they needed to buy equities with both hands and the results speak for themselves.  And we’re not talking about the 65% rally by the S&P 500 from the start of Operation Twist to the end of QE3 on 10/29/14 that’s taken us to all new highs; the latest J.P. Morgan quarterly guide to the market shows that seven of the ten sectors of the market are trading above their 15 average forward P/E ratio while fans of Schiller’s CAPE ratio become more apoplectic with every passing day. But the QE crutch was taken away last fall and is it any wonder that since then the S&P 500 has advanced a mere 4.9% with increasing volatility?

For some, the time for waiting is over as they prepare themselves for the possibility that investors don’t take the first Fed rate hike with a grain of salt.  One of the strongest performers among bond funds last week was former investor favorite turned 2015 whipping boy iShares 20+ Year Treasury Bond ETF (TLT) whose 2.25% gain last week sharply contrasted with the S&P 500’s 2.2% loss. Those who think the turnaround might be a one-off event should take note that TLT’s negative momentum has been slowing since the start of June as the economic outlook at home improved while global uncertainty waned and momentum wasn’t the only thing beginning to reverse as the fund pulled in over $836 million in new assets in the trailing one month period equivalent to a 20% inflow. While that inflow into long duration debt might see counter-intuitive on the cusp of a rate hike, there is a certain cold logic to play.  When rates are in the low single digits, there typically is a strong negative correlation between equities and bond yields so the smart money is wagering in the event of a rate-hike induced correction, Treasuries will see strong inflows on the flight to safety that could outweigh the impact of a potential rate hike.  TLT wasn’t the only fund to see inflows as the interest-rate sensitive REIT sector experienced strong relative outperformance as both the Vanguard REIT Index Fund (VNQ) and iShares U.S. Real Estate ETF (IYR) saw positive inflows for the week.

Those strong inflows got us curious about how some of the other funds favorited by investors during the long “will they hike or won’t they” phase have fared recently. The latest Commitment of Traders report showed an increase in negative Euro and Yen positions seemingly confirmed by positive inflows into the PowerShares DB US Dollar Index Bullish Fund (UUP) and slight outflows from the Currency Shares Euro Trust (FXE) but the strength of the move has us in doubt.  UUP managed a strong open on Monday before selling pressure close to recent resistance at $25.68 pushed the fund lower where it only just managed to close off the lows of the week and given that FXE is simply the negative of UUP, it had a weak Monday followed by small rally into Thursday before losing ground on Friday.

Treasuries weren’t the only unloved asset class to feel some love on Friday as the long derided gold miners finally caught a break with the Market Vectors Gold Miners fund (GDX) gained 3.3% on the day as investors found solace in the one-time refuge from equity market volatility. Outflows continued although at a slower rate while the fund’s behavioral scores have steadily improved off historic lows, but one sign that the miners might be due for a turnaround is focusing on the smart money. The latest COT report offered up the bravest investors another golden opportunity by showing that traders now report net short positions in gold for the first time since 2006, whether from anticipation of future rate hikes or simple capitulation given the latest vicious correction that began in May remains to be seen.  It’s way too soon to declare a turnaround is imminent, but every dog does have its day.

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