Tuesday, June 21, 2011

What Are the Markets Telling Us?

I track four broad markets: equities, treasuries, commodities and currencies. I do this because -- thanks to ETFs -- we can now trade in these broad based asset categories. In addition, each of these commodities has a different part of play during different parts of the economic cycle. So, let's look at the price action over the last few months to get an idea for the picture that traders are seeing of the economy.

Equities: Equities are a leading indicator of economic activity (they hold a 3.7% weighting in the Conference Boards leading indicators). The reason is simple: traders will start to bid up shares in advance of an economic rebound as they anticipate recovery. They will be looking for various indicators regarding the future expansion on which they will base their trades. Right now the markets are in the middle of a sell-off which has also occurred at the same time economic numbers have been weakening. This tells us that traders are doing two things. First, they are taking profits off the table. Remember -- the rally has been occurring for over a year now; for traders that got in near the beginning, the rally is getting long in the tooth. Second, they are selling into the weakness of the economy, waiting for further confirmation regarding the economic direction.

Bonds: the bond makes has been rallying for the last few months. Bonds rally for several reasons. First, low inflation expectations. Inflation eats away at the return on bonds, so high inflation leads to low bond prices (and higher yields). The low bond yields tell us inflation is not a concern. Second, the rally indicates there is little concern the Fed will be raising rates anytime soon, as a rate hike would lower the value of currently issued bonds. Third, the rally indicates people are concerned, largely with the EU situation, but also with the pace of the US expansion. In short, bond rallies are not good harbingers as they indicate people are concerned with the economic expansion.

Oil: Once oil moved through the 96/98 area, prices dropped hard. This tell us that traders are concerned about growth prospects as well. Remember -- strong growth means higher fuel demand while weak growth means less demand. In addition, technically speaking, prices are now below the 200 day EMA, which is the standard line between a bull and bear market.

Gold: There are two primary drivers of gold demand: inflationary concern and overall economic concern or uncertainty. From an inflationary perspective, it's important to note that gold prices have not moved above previous highs. In fact, while still in an uptrend, momentum (the MACD) is showing an overall decrease. I believe the inflationary buy is less important right now, an argument which is furthered by the Treasury market rally (if the treasury market were concerned about inflation, we'd be seeing a sell-off). However, I also think the uncertainty trade is still a big part of the gold trade, and uncertainty is currently very high. So I believe the gold market indicates uncertainty is high.

Dollar: the dollar is still considered a safe haven. Thus, while we have seen the tensions regarding the EU situation increase, the dollar has benefited. In addition, the US overall is still considered the safest place to invest, which has provided support for the dollar.

The drop in equities signals a concern for the overall macro-environment which is confirmed by the Treasury rally. Inflation isn't a concern, but uncertainty is. In short, the unknown is a big issue right now with most everybody in the market. The economic numbers are weakening, but we're not seeing enough information to warrant a total sell-off.