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We have a suspect

02/07/2010

One of the more frustrating components of investing is when your investment plan is challenged by an aggressive sell-off in the market. Over the past few months, I have written about the likelihood that those occasions will become more frequent in 2010. Investors will continually be tempted to abandon their investment plan throughout the year as the capital markets struggle to sustain "recovery price levels."  Clearly, we are in the crosshairs of one of those moments. Candidly, I am surprised it presented itself so quickly, but the market never allows you to make a reservation, that's for sure.

So, a difficult week it was, in particular having to appear at 5pm each night to face the music from market bears with their Ochocinco celebrations. I just wonder if those bears truly discount the recovery enough to plunk down their families' own greenbacks playing the capital markets from the short side.  If not, I find their "fear celebrations" rather disingenuous.

I myself have a core portfolio of holdings in corporate and municipal bonds and cyclical equities in energy, technology, natural resources, and materials. Do I tinker?  Absolutely, I am a trader. But, when I tinker, I move from "overweight" to "market weight" to "underweight." Right now I am underweight in those equity names waiting to move back up the weighting scale.

After last week I am confident that I will be doing that rather soon. At least I know what to look at for the indicator. A market sell-off is tough, and a market sell off without a number one suspect is even tougher. But, happily, I think we have our number one suspect - THE UNWIND OF THE CARRY TRADE.  That "risk off" market phenomenon is brilliantly explained in Max Bublitz's latest blog on our site.

In terms of how investors can identify it, let's look at and talk about 3 critical commodities that are so tethered to the global economy, growth, and investment demand - copper, gold and oil. All three have been highly desired assets over the past few years.  I suggest that, in terms of importance, oil is clearly the most favored and viewed as the crown jewel. When fear overtakes the market and the phenomenon of the unwinding of the carry trade occurs, the psychological element of that unwind says "sell last what we want to hold the most."  Clearly, that is oil.

Therefore, we are looking to identify when oil enters "liquidation territory."  That occurrence will signal that we are at the end of the carry trade unwinding process - the most desperate, fearful, capitulation moment. Looking back upon last week, I believe Friday's oil price action suggests just that. Oil sold-off on Thursday and again Friday morning in an extremely aggressive, heavy volume fashion. Once that selling abated, the liquidation ended and oil recovered $2 in the afternoon.

I have been the liquidator of many of those liquidations over the past 20 years, so I think having that front row seat gives me the knowledge to identify the beginning, middle, and end of the process.  I believe we are past the capitulation moment.

Take a look at the three charts below - as you can see, the carry trade unwind is reflected first on Wednesday in a copper sell off, next on Thursday in gold, and finally on Friday in oil.

All of this is about keeping to my strategy; I want to move back to overweight energy, natural resources and materials at some point. Now that we have our suspect, I will be much more comfortable moving back up the weighting scale if the next few days confirm that the unwind of the carry trade is over.

WEDNESDAY'S COPPER FUTURES TRADING
Source: Bloomberg

THURSDAY'S GOLD FUTURES TRADING
Source:  Bloomberg

FRIDAY'S CRUDE OIL FUTURES TRADING

Source: Bloomberg

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