Friday, September 28, 2018

Tilray $TLRY and the Risk of the Penny and Cannabis Stocks

Why I don't trade penny stocks.

In my watchlist I only include Big-Mid-Small Caps companies, only those with MarketCap >500M. Must also have good daily volume of transactions, medium-high volatility (30-80%), with an accessible float (i.e shares in the hands of the public > 200M shares), and also be quite popular, those which make the news of the day . So, If you are looking for the also popular penny stocks, this blog is NOT your place. There are many investor webs or blogs that launch or "analyze" 5 to 10 pennies each day, of which only 1, with luck, get gainer. (And sometimes you have to pay for that info as a great offer!) Of course, having very high risk-reward, one of the characteristics of the pennies are its usually strong gains (or strong losses). So, it is very tempting to buy penny stocks and wait for the rise, but if one has a rigid risk management can and should avoid them. However, every trader is free to decide: go ahead if you like bets, and good luck.

In my experience of 10 years, the first of them with some purchases of penny stocks, finally I come to that conclusion: that buy penny stocks is simply a bet (I do not consider it an investment). Your final result is unpredictable, it's like throwing the dice. The idea is: I buy because others buy, which in turn buy because others bought ... They do not resist the least fundamental analysis because many do not publish their financial results: their basis for moving the price are the rumors. Also remember that pennies do not quote on the NYSE, they do it in risky parallel markets like the OCTBB.

To really make money the pennies, in addition to luck, you have to discover what entrepreneurship, among thousands, will really succeed, and also make the trade at the exact moment. And that is only achieved speculating, with privileged information only available to a few investors, as seen in movies like "The Wolf of Wall Street" or "The Big Short", both mandatory for every trader. As I'm already on the subject, I take this opportunity to recommend a Showtime drama (3 seasons, available on Netflix): "Billions". It theme is based on the life of the hedge fund manager Bobby Axelrod, a finance, investor, speculator and guru of the stock trading. A real abuser of privileged information and bribes to increase the enormous wealth of his company Axe Capital. Many of his scenes, dialogues and phrases are simply a delight for lovers of trading.

To my taste, Billions is one of the best drama of the Netflix catalog.
Required vision for those involved in the world of finance and stock trading.

The Tilray ($TLRY) case.

Since mid August, cannabis stocks were a mania in Wall Street. Not properly all these "pot stocks" are pennies, but if the vast majority. One that is in all the news is Tilray TLRY, a canadian company with only 2 years of existence, that invests and develops cannabis, both use for medical and recreation purposes, taking advantage of the recent legalization approving its use in Canada and some states of USA.

Their fundamentals, valuations, GAAP Income Rates prior to its IPO were analyzed and adjusted in this link from Forbes, that conclude that their numbers were unclear. Verbatim: "With only two years of history, it’s hard to draw any firm conclusions about the long-term trend in profitability for Tilray, but my adjustments show that growing losses are masked by GAAP numbers". 

Net Operating Profit After Taxes (NOPAT) decreasing
and GAAP Net Losses increases in Tilray last year finances.

And however, since its IPO in July Tilray increase its value by almost 1,700% (was the first "IPO cannabis" in the United States). After an initial month flat, the next its price soared from $17 to $300 in just 4 weeks, reaching a Market Cap that exceed Macy M or Ulta Cosmetics ULTA, just to name two giants in their sectors. In addition to the novelty that generated, a recent ad by the American authorities for approval a type of cannabis for medical trials, helped for its parabolic rise. Crazy: its PS Ratio (Price/Sales) came to overcome at some point to Facebook, Amazon, even Apple, as shown in the graph below. On the other hand, Constellation Brands, makers of Corona beer, announced an investment of 4,000M in Canopy Growth, another pot-company, for a line of drinks with cannabis. Wall Street and their traders are living days of pot-mania: the companies add the word pot, cannabis or weed to its business and inmediately its price pop. The comparison with the cryptocurrencies were immediate. And we know that what happened with the bitcoin later...

Wall Street had sometimes crazy charts as this: Tilray PS Ratio above the FAANGs !

Many explications for this behavior. The main, in my opinion, is its ridiculous float of only 18M of shares (to give an idea its competitor, the small cap Aurora Cannabis Inc ACBFF manages about 912M), made difficult shorting it, making the stock rises wild for several days. Few investors handle these shares and they can easy speculate with the stock by raising or lowering the price to their liking. Its 19th September session trade had to stop up to 5 times due the high volatility, reaching the psychological $300, its all time high, and then begin the progressive and expected correction of the price.

A chart with the history of Tilray after its IPO. The usual form of a bubble: flat, explosion and wild pullback.

Well, every party has its end, and this pot-mania fever seem relatively short, much less as the bitcoins did in 2017. In this case, the usual pullback that precedes all bubbles like this on Wall Street, only lasted a week. Today the stock is moving in ranges more stable (despite having a high volatility of 160%) in values around $120-140, even exaggerated in my opinion. I recommend this article by David Borun about this Canadian company and its future prospects. Therefore I usually expect that bubbles burst to operate then with lower risk. In my opinion, TLRY prices are still overvalued, but less volatile and more manageable for a swing trading.
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Tuesday, September 25, 2018

Stocks to Watch: Gold ETF $GLD

SPDR Gold ETF ($GLD), $113.77.

As I have usually written in this blog, I do not trade with futures, but I follow them daily, because they are the basis of all my analysis. For that reason, I think that the best asset to follow in for stock trading when there are FOMC meetings, like this week, is the Gold /GC.  Usually designated as the safe haven asset, together with the Japanese Yen, this week has a decisive test in Wall Street that will determine its behavior in the rest of the year.

This Wednesday 26th will be known the FOMC's decision and mainly its guidance and forecast, very important to know the behavior of the dollar in the next Q4, and therefore its antagonist, the gold. A Rate Hike, as expected by almost all analysts, would complicate the price of metal. If you add to this a probably hawkish outlook of the FED, the recovering in its price, which seems to be beginning, would become very unlikely, since it is known that historically gold suffers with rising interest.

On the other hand, there is another edge: the Trade War. It will depend a lot on the results of the China-USA agreements (if there are any!), to see the future  behavior of gold and commodities in general. Just look at the following chart to see intimate behavior that has been with the yuan for months, artificially devalued by the Chinese government to cope with the Trade War. A good deal would release the yuan and pull the gold higher.

Interesting: close as ever the correlation of prices of Gold and the Chinese Yuan.

In my weekly charts I usually plot the price with a EMA13 (exponential average of 13 candles) on it, as a key to determine the future movement of a stock. I observe the next two candles after cross this average, in conjunction with the Impulse System indicator (developed by Alexander Elder) which combines trend with momentum through the MACD. If I have two consecutive candles with green value I have the confidence of a bullish rise, at least for a few weeks, ideal for a swing trade. A later yellow indicator gives me the warning sign of possible turn in the trend. Similar behavior is for a bearish case.

Today, the weekly chart of gold shows its evident fall since April, at the beginning of the Trade War, even of a much steeper slope than the rise of the dollar, its usual antagonist. However, a month ago there are already clear signs that this strong fall may be decreasing: the impulse is in yellow for 5 weeks and the MACD, even in negative zone, begins to reach a bull crossover. The lower ADX indicator in 34.02 confirms the strength of this trend.

The EMA13 (in black) is my main indicator for weekly candle charts. The breaking of the channel (in yellow) in April coincided with the beginning of the Trade War and from there, the GLD chart comes in strong fall.

I usually pay attention to the exact moment of the announcement of the FED to speculate with a fast daytrade based on the news. And I do, as I say, with gold, through the GLD or IAU etf, the higher volume ones, or with the 3X triple speed ones like NUGT and DUST, bullish and bearish respectively, usually of extreme volume in those days, and with 80% of implied volatility. Something less volatile, but with a lot of trading volume is GDX the etf 1X that follows the mining companies. I do not intend to go long in gold in the short term, not even in a swing trade, until see the evolution of the trade war: if the effect of tariffs is felt in the economy, a significant increase could be expected.
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Thursday, September 20, 2018

Trader Notes: Sector Rotation

The Sectors.

Usually mentioned in my blog, diversifying by industrial sectors is one of the most intelligent ways to manage a portfolio of investments in shares. The Global Industry Classification Standard (GICS) is the one that defined the 10 existing sectors and groups, which today are 11 since a couple of years ago, Real Estate was added. Standard & Poor, creators of the main stock market index of Wall Street SPX, manages the most popular funds in the world based on industries, which appear in the following table.

Take into account: Technology and Health are the most capitalized industries in the US.

- The "offensive" sectors (bullish, aggresive) are: Financial XLF, Technology XLK, Materials XLB, Industrials XLI, Discretionary XLY.
- The "defensive" sectores (bearish, safe) are: Staples XLP, HealthCare XLV, Utilities XLU.
- I consider "neutral" sectors the Energy XLE and Materials XLBSome economists think differently, and consider them slightly offensive.

Relation between economy and sectors: the Sector Rotation

The most useful thing of the classification by sectors is to use its relation with the economic cycle (expansion or contraction), to determine which are the predominant sectors, and to look for companies to trade there, reducing the possibilities of loss. Another option is to trade "to the same sectors" through the S&P indices indicated above, as they are ETF (by definition, exchange-traded fund, a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund). The advantage here is that as they are sectors, and cyclical, they lend much better to technical analysis than a particular company.

The theory mentioned above is called Sector Rotation, and can be better understood in the following graph, taken from, where we see how some sectors behave better than others according to the economic cycle.

The green line is the economic cycle, the red one the market. Top: the sectors that best they behave according to the cycle. The intermediate line divides the economy into expansion and contraction. The blue circle is explain below.

Several interesting details: 

- See how the market anticipates the economic cycle.
- Finance, Technology and Cyclicals (or Discretionary) are sectors that behave better in a market bottom or in an economy in recession.
- Energy and Materials lead when the economy is at its highest point, favored by the rise in commodity prices and high demand. 
- This is where the early recession comes from and the FED lowering the interest rate to stimulate the economy in its arrival to an upcoming recession. And the cycle repeats ad infinitum.

Comparison between sectors in 2018

All of the above is theory, paper, reality always has its differences. And how are the sectors doing this year? I elaborated the following chart, using a timeframe of 9 months, beginning in january 2018, to establish a comparison between the 9 main sectors to determine which is behaving better, and in which cycle the economy is now  in the US. 

Comparison charts of the performance of the main 9 sectors during 2018. Shadow in grey is the SPX, the benchmark. Five sectors are above it: XLE, XLY, XLV, XLK and XLU.

You can get interesting readings of the graph: as can be seen, since the beginning of the month, the sectors with the best performance today are Energy XLE, Health XLV and Discretionary XLY, curiously one offensive, another defensive and the third neutral, so is difficult to affirm with certainty the economic cycle in which we move. Independently of this data, I think we are close to the end of the expansion cycle, near the beginning of an early recession (as show it in a blue circle in the graph above), with the Stock Market going down from its top. This is very variable, remember is a theory, never 100% reliable, because the main problem of the Sector Rotation is that it does not say how long each cycle lasts and another one begins...

The lower histogram shows the "Sector Rotation Model SRM" an attempt to integrate fundamental approach into a technical indicator. It is based on a premise that macroeconomic sectors behave differently in certain phases of uptrend and downtrend. , Since July 15th. the plot is green above zero, that signifies the market is in a uptrend.

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Monday, September 17, 2018

Stocks to Watch: Natural Beverage $FIZZ, Advanced Micro Devices $AMD

1. Natural Beverage Corp. ($FIZZ), $116.92.

About 4 or 5 years ago there was a fever due to the stocks of beverages. Stories of companies that started small and were evolving due to the quality of their products became viral, as was the popular Green Mountain Coffee Rooster (now disappeared when it was acquired by JAB Holding in 2015 for $ 13.9B in cash), Sodastream SODA (israeli group, which manufactures soft drink machines at home, recently acquired by Pepsi PEP at $ 3.2B) or Monster Beverage MNST (with its energy drinks, still maintains its growth after its merger with Coca Cola KO).

Today sounds pretty good on Wall Street, the case of National Beverage, which trades on the NYSE under the suggestive FIZZ symbol. Even a Mid Cap company ($5.4B of Market Cap), its products have a lot of acceptance in the US: energy and gaseous drinks and juices, among them the popular LaCroix (its flagship product) and Shasta. After a great 2017 came the natural correction, to again be close to their all time highs. 

a) In favor: nice fundamental numbers. The main: good cash flow with high revenues for 15th consecutive quarters, of increased growth. Also, net income and EPS increased more than 25% from the prior year, its 13th consecutive quarter of double-digit growth.
b) Against: the recent news. Gugghenheim iniated coverage last week with a low price target of $91. Also a recent Filing of Class Action, because they made false statements to the market between 2014 and 2018. Finally, its CEO was engaged in a pattern of sexual misconduct between 2014 and 2016.

The price is above all SMA levels and Ichimoku cloud, and its recover since May gives the stock near all time highs level ($129.82), achieved a year ago.  In the short term it has a recent double top to beat in $125.04. Also this week its MACD shows a bearish crossover. So, two important levels to overcome, both of them. If it doesn't, is a firm candidate to short. Otherwise, its bullish rally will continue unstoppable.

I believe FIZZ, in the short term, is a candidate for shortPut on your watchlist and wait next days its behavior in the face of those resistences.

National Beverage $FIZZ is candidate for short If it does not overcome both resistences.

2. Advanced Micro Devices Inc. ($AMD), $32.72

I remember in the 90s the indispensable requirement for a PC for home or office, was that the processor had to be 'Intel inside'. The alternative was the economic processor manufactured by a tiny company, AMD, but there was no guarantee of its proper functioning (something similar happened with Kingston memories, today a monster of the sector). The years passed and today AMD has become, along with Nvdia NVDA, a fierce competitor in the semiconductor business for the Santa Clara giant.

Since the arrival of Lisa Su as CEO in 2016 with her complete re-engineering of the company, AMD growth was exponential. Recently, its amazing entry into the design of the 7-nanometer chip before Intel INTC, usually ahead of everyone in this field, was one of the reasons for its current recovery, as these will be used in Artificial Intelligence, one of the sectors that more investors are bringing on Wall Street. Consequence of it, the stock explode the last two months (+144% YTD), and today is usually the stock with more trades on Wall Street, 170M shares on average!

However, the careful check of its fundamentals show that not everything shines there: its debt ratio is the highest in the industry (debt/capital > 60%), plus its profit margin (-12%) continues as one of the lowest in the sector, a worrying fact. Interesting data is that it maintains a high short interest of 15%.

With the stochastic in overbought more than 5 months (except a few days in July) and  above the Ichimoku's Tenkan for more than two months, it is difficult to even apply some technical indicator with such a strong trend. It seems only a matter of time the correction, which would be the healthiest for the stock. The most important thing is to see how he will behave after it, as its competitor Nvidia do in this 2018.  


It's not too late to enter long in AMD, with a jealous management risk.  It has still a long way to go upwards. But remember, that all growth very fast and exaggerated, falls, in some moment, has a correction (as has been happening with Nvdia since February) so I believe soon AMD will be in that situation, sooner or later. We will see if after that, it consolidate its growth. 

AMD stock growth resembles that of Nvdia in 2017: explosive and unstoppable for
almost a year to then reach a healthy correction, and then resume the rise.

Read more »

Friday, September 14, 2018

Trader Notes: the Ichimoku indicator

Among the many indicators used for technical analysis, one of my favorites for its versatility, since it brings together 'all in one': levels of support and resistance, trend of movement (trend direction), acceleration (momentum) of the price (that´s volatility), and trading signals (bull or bear), is the 'Cloud of Ichimoku', or simply Ichimoku, dating from 1969, today has become one of the
most used by traders for its effectiveness. Its development and operation are detailed in the main trading books, and in many internet sites dedicated to teaching, which is not the intention of this blog, but rather to mention it and use its power to make good trades. I suggest, fervently, study the theory of this indicator to better understand the philosophy of Goichi Hosoda, its creator. One of the best online explanation of the Ichimoku Clouds is in the StockCharts web, it explains calculations, signals and strategies. Briefly, the Ichimoku consists of the use of several lines: 

Tenkan: blue line of conversion 

Kijun: red line of base
Chikou: green line, backward
Senkou: A and B, which encloses the cloud between them 
Kumo: the cloud, which defines the trend

The cloud takes its color according to the relative location of these. Thus, Senkou A over B, green color, reinforces the upward trend), acting in turn the cloud as support or resistance. Looking at the graph of the price of a stock or index can be deduced if the trend is bullish/bearish/neutral (price up/ down/within the cloud), or if there is an upward/downward correction to it (cloud going green to red, or vice versa). 

Finally the crossing of the price of the stock with the conversion and base lines, or the crossing between the same blue and red lines, are those that indicate the strategies and signals of purchase/sale, and are reinforced if they are located above or below the cloud , respectively. That is, the Ichimoku makes trading in the direction of trending, never going against it, giving better results in stocks or indexes in trending mode.  So, the trading strategy could be summarized as follows: 

Bull signs for trading:

- Price moves above the cloud
- Cloud turns from red to green
- Price moves above the base line
- Conversion Line (blue) moves above Base Line (red)

Bear signs for trading:

- Price moves below the cloud
- Cloud turns from green to red
- Price moves below the base line
- Conversion Line (blue) moves below Base Line (red)

Nvdia $NVDA chart shows a bull bias for Ichimoku, with price moving yesterday above the Conversion Line. But always remember: a single indicator never guarantees a good trade.

Intraday"Breakout Strategy" using Ichimoku and ADX

This strategy was taken from the web which have many other forex strategies as this, for use in stocks. Analyzing many of them in the site, I think this one is  simple, inteligent and accurate. As a preamble, the Average Directional Idex ADX is another popular trending indicator, which ranges between 0 and 100 telling you, if its value is above 20 and the slope up, the stock is trending. In the other side, if its below 20 and the slope pointing up, its ranging. The indicator does not say if the stock is in bullish or bearish bias, only the strength of the trend.  

Over the years, one of the strategies I use is this one who combined the Ichimoku cloud and the ADX for intraday purchase of stocks, that is, quick buys that I usually sell the same day or the next. Work only on stocks that are close to having a breakout, ideal if you touch 3 or more times the resistance without exceeding it completely. I have seen that the timeframe that works best is 10 minutes, but also works well with the 5 minutes. As usual, I prefer stocks with Market Cap >1,000M, good volume >500,000 shares and implied volatility less than 80%.

For a BUY trading signal were going to look at key resistance levels.

- Wait for the breakout TO HAPPEN and if both, the ADX and Ichimoku Cloud, give bull signals in that point, you can place a BUY order at the open of the next candle after the breakout candle. 
- The ADX indicator must be above 20 (30 for more security) and with upward SLOPE at the moment the breakout happens and the price candle must have CLOSED ABOVE the cloud.
- Place the stop loss just below the Cloud and follow the trend (trailing up the stop loss if you want) and EXIT the trade only after we have two consecutive candle close below the BLUE conversion line.

For a SELL trading signal were going to look at key support levels. 

- Wait for the breakout TO HAPPEN and if both the ADX and Ichimoku Cloud give bear signals in that point, you can place a SELL order at the open of the preceding candle after the breakout candle. 
- The ADX indicator must be above 20 (30 for more security) and with upward SLOPE at the moment the breakout happens and the price candle must have CLOSED BELOW the cloud. 
- Place the stop loss above the Cloud and follow the trend (trailing down the stop loss if you want) and EXIT the trade only after we have two consecutive candle close above the BLUE conversion line.

The strategy, being intraday, requires constant vigilance and risk management, and is a good method to avoid one of the main causes of losses in stock trading: the false breakouts. Try it first on papermoney mode, because  requires practice. 
Take note that there's no infallible or magic indicator or strategy: all of them give sometimes false signals. Use your favorites indicators in a multiple timeframe (making the strategic decision on the weekly chart and the tactical choices on the daily chart), in conjunction with fundamental analysis for a best trade.

This 10-chart from Comcast $CMCSA show the main features of the BUY strategy Ichimoku + ADX: resistence breakout, candle above the cloud, ADX>30, stop loss place, exit and profit.

Read more »

Tuesday, September 11, 2018

Analysis of Emerging Markets: in the beginning of a crisis?

Are we already in a crisis of emerging markets? The slow but sure rise in the dollar plays a decisive role in this. Being reinforced in recent months, has been generating various collateral effects in emerging countries. Let's see it in parts.
As a preamble, this graph shows us a comparison of the different investment instruments and commodities since 2015. The emerging markets are followed by the etf EEM, in gray.

The graph is a comparison between the various investment and commodity instruments since 2015.

As you can see, this situation of falling in the emerging markets is not new (20% drop from it last peak in January). Recently it happened in 2015 when a greater concern about the market disturbances promoted by China gave way to a comforting restoration of capital flows, higher prices of assets and a much more favorable operating environment for emerging countries since 2016.
Since that year, EEM index (and general all the world stock exchanges) walked parallel with the US stocks represented by SPX, the S&P500 index. It is from March 2018, when comes the first news of the tariff that Trump plans to apply to imports of steel and aluminum, that the divergence in the graph begins as seen in the following, taken from the Wall Street Journal. The American stock market, too solid, almost ignores this and all subsequent events in this Trade War and moves unperturbed towards new maxima.

The US stock market and the rest of world stock exchanges
clearly diverge from March, date of beginning of the "Trade War".

Effect of the rise of the dollar in emerging economies

- Depreciate the local currency, the pair against the dollar loses, and forces the country to strong debt issues (happily even cheap for the low i-rate) that limit their reserves. It happened recently with Argentina.
- Increase the external debt. Luckily, the global interest rates are still low, making the debts somewhat more manageable for local central banks, but be careful: this is already changing after several years of cooling economies by the big powers. - Depreciate commodities, whose prices move inversely proportional to the dollar. Although this helps the exporter in the short term, in the medium term it discourages investment.

Macroeconomic decisions that complicate the panorama

The political and economic environment of the last months does not help the emerging markets:
- The rise in US interest rates seems to continue, which will further strengthen the dollar in detriment of the most vulnerable economies by increasing market volatility. And every time the FED raises its i-rate, the capitals are going to the USA, raising its price in the emergent country and depreciating its currency. - The oil comes in raising its price all year. This is an inflation generator par excellence. Only the emerging BRICS countries and the OPEC oil exporting countries will benefit from this situation. - Trump's trade war with China, increasingly aggressive on both sides, which in turn replicates by contagion in emerging economies ('when China sneezes, the world catches a cold'). A collateral effect occurred at the beginning of last month when applying US tariffs to Turkish imports, albeit a smaller economy. The fall of the Turkish lira was spectacular, and immediately contagion arrived in Argentina. The blow to the Argentine peso was brutal, because it is a very indebted country. President Macri had to raise the interest rate to an irrational 60% (today the highest in the world) to stimulate the purchase of pesos. The result is still unforeseen.

Influence of the corporate sector in emerging countries

I found a good article by Kenneth Rapoza on the latest report on emerging markets prepared by Moody's. I believe that the evolution of the situation of the EEM can be understood according to what the private sector does in these countries. In summary he says that the credit quality of sovereign bonds in emerging markets shows a 'limited vulnerability' to the exposure of non-financial companies to higher borrowing costs. In other words, if companies in the emerging country have to pay more for credit in dollars, that does not mean that their government -a bond market much larger and more important than the corporate sector- will have difficulties making payments.

"However, that does not mean that it is not a factor. Corporate leverage has increased in the last 10 years, as companies globally took advantage of low borrowing costs. As financing conditions tighten and risk premiums increase in some markets, financial stress in the corporate sector has the potential to weigh on the quality of sovereign credit. For now, most countries are fine. The risk to sovereign solvency is limited by economic, fiscal, capital and external reserves."

The Peruvian case

The fall in recent months in the BVL Lima Stock Exchange, as an emergent economy, is directly related to all those factors mentioned above. The global low price of the main commodities that make up the BVL (copper, gold and silver) due to the Trade War, lowers its index, despite the correct economic performance of the country (the political problems are usual and does not affect the development of the stock market). No mystery here, all very clear, in a eminently mining bias exchange: it will bounce when the international prices of these metals do.

The EPU index (in bars) follows the Peruvian stock market, which walks according to where the copper, gold and silver commodities go. Nothing new...

What can happen in the next months

So, we already in a crisis of emerging markets? I think not yet, but we can be on the way to it. At the moment the main world index markets, all China, Japan, Germany, France and the United Kingdom, move below the SMA 50 and 200 averages, which we know, technically, are important bounce points. While, the US Stock Market are an island apart sailing in all time highs. This may be a good sign for the EEM, as well as a recent slight rebound to lows in exchange rates. These positive developments arouse the hope that we are repeating in early 2016.

These slight improvements do not mean the end of the problem. Countries like Turkey, Argentina and South Africa will have to solve their economies to avoid contagion in their regions. It is also necessary to see the reaction of investors in portfolios of emerging countries. Next months are decisive for the EEM: world political and economic news will define their future behavior.
Read more »

Thursday, September 6, 2018

Trader Notes: Importance of the Yield Curve

Mentioned in several posts, the yield curve, returns to take importance in these weeks because its reaching a flat level that had not since 2007, with possibilities to invest for 2019, this with clear damage to the stock market. Why? Let´s briefly explain you.

The Basics:

Understanding how this curve is drawn, its types (normal-reverse-flat-humpback), its inclination (steep or flat) and its relationship with the market, will allow us to make better trades. Also knowing its basic principle: the direct influence of the short-term yield bonds is the i-rate assigned by the FED, while the long-term ones depend, also directly, on inflation and how it is eroding the value of the bonus in time.

The yield curve is formed on an XY chart with the maturity times of the US Treasury Bond on one axis and the interest rates on the other. In an expansive cycle, there is a growing slope, as it is obvious that, at a longer time, higher yield is expected through a higher interest rate. Flattening occurs when the differential or spread between the extremes approaches. 

In StockCharts you can observe the yield curve and the SPX index at any moment. Verify its flattened form today, here:

On the stockcharts link: just choose a year in the SPX to see how the yield curve was that moment.

Yield Curve behavior

Depending on the state of the economy, four cases can occur:

1. Bull steepener: occurred after the crisis in 2008 when the FED became dovish and in order to heat the economy, began to lower rates, so the short-term i-rate fell faster than the long-term. Notice that a bubble was created in the price of the short bonds, whose consequences are seen until today.

2. Bear steepener: it´s seen only the first months after Trump's victory, when an increase in inflation and FED Rate Hikes were foreseen. The steep slope was a sign of an expanding economy.

3. Bear flattener: occurs this year, when the FED adopts a more hawkish tone and short-term rates rise faster than long-term rates. The slow pace with which inflation advances flattens the curve, with the risk that it will reverse, which is a sign of the beginning of a recessive cycle.

4. Bull flattener: after a recession, reactivation is appreciated when the influence of inflation decreases in long-term rates and these fall faster than short-term ones. It is usually a good time to buy long-term bonds.

Understanding the rate curve is decisive to invest taking advantage of the inflation and i-rate data.

Divergences in Wall Street and a crucial chart

Already since January 2017 I wrote about the beginning of the flattening. With the months it was accentuated and today its investment is a worrying possibility. Some important FED members express their opinion: for example the dovish James Bullard consider the yield curve inversion a real possibility and a bearish signal for markets. On the other side, a hawkish John Williams said yesterday that FED shouldn't be afraid, because he considers that wages are still slow and with the field to continue growing.  Also Steven Mnuchin, the Treasury Secretary and promoter of the Trump's tax reform, said he´s perfectly content the flat yield curve...

The fact: a way to see graphically what can occur to economy, and therefore the stock market, is checking the differential between the bond rates. It is usually used as a spread data, the 2-year and 10-year bond yields, although other authors prefer to use the 3-month and 10-year bond. On this Bloomberg chart the spread is shown between the 2 and 10 year bonds since 1977. Look: whenever there was a recession cycle (in green) the spread became negative a few months earlier.

Also Wall Street main banks, Citibank C, Bank of America BAC and JP Morgan JPM, had been having a tough year, this flat yield curve not benefit them, despite the tax reform and the 10-year Treasury Bond TNX near to the 3% rate, its higher since 2013 . The financial etf XLF also had a negative YTD. 


Consider the following:
- The current flattening is due to successive FED Rate Hikes, in addition to the slow progress of inflation. 
- In the US more than 50 years ago, this behavior has meant the preamble of recession, which usually pulls down in the stock market. 
- There is almost consensus that two consecutive quarterly GDP decreases signals the start of a recessive cycle.
- Today the jump in Average Hourly Earnings (2.9% vs 2.8% consensus) tell us a lot about how inflation and wages are moving, and fears of more Rate Hikes.

From the point of view of the bonds, which always anticipate the stocks, it does not seem time to enter long on stocks, because the historical statistics shows that when the curve is reversed the recession begins, and that event is close to occur.So my best advice is to check the evolution of this spread in the next days and weeks. Swing trading, with risk management emphasis is, in my vision, the best option for the market today

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