By Jonathan Barratt
At the moment we can see there is a lot of pulling and pushing on behalf of the market to try and work out which economy will grow the fastest and which economy will fall by the way side. We are comfortable with our assessment so far, that European economic activity will remain subdued, US economic activity will be mixed, and generally positive and China/ India will continue to bounce. However when you discuss the outlook with those closest to the market, traders remain nervous and hesitant to fully commit at these levels.
Why? It looks simple: perhaps it is that the Dow is approaching levels not seen since 2007 and it is hard to buy at the top end of the range and a level of tough resistance; the VIX is trading at historic or seven year lows and looking weak which confirms a level of complacency; and companies in the S&P have an average PE 14.8. If you dig a little deeper on the US PEs you will see that non-dividend paying stocks have an average PE of 35.8 and high dividend paying stocks have an average PE of 17. So it could be argued that if you where long, in some instances it would be wise to take some profits. Further, if we take a good look at other markets, such as the commodity complex, we can find clues that the current rally might not have the legs to be sustained.
Trading in the commodities markets remain volatile and it has been amazing to see the movements. At the beginning of the year you could do no wrong buying the commodities sector as everyone thought the economic recovery was on track. Now some questions are starting to work their way into the trend and we are seeing clear divergence between price actions in the equity markets verses price action in the commodities markets. The commodities market perhaps represents the true picture in working out the state of the global economy, as it is through the purchases of primary inputs that we get a real sense of what is actually happening in the market.
In order to get a look at what is happening we need only look at the Thomson Reuters CRB Index. This index comprises 19 major commodities, which can broadly be broken into four groups. Petroleum based, Liquid assets, Highly Liquid and Diverse commodities. It is generally accepted as the index that tracks global commodity prices. Over the last eight days this Index has weakened whilst the equity markets continue to climb, presenting us with a diverging market. Intuitively it does not make sense , as commodity markets should be leading equity prices. Although we have discounted this price action for the last few months it is starting to accelerate. The take home on this we feel is that if commodity markets do not start to represent fair value then the elastic band the equities markets are on cannot last.
When comparing the Dow with the CRB, you come up with a interesting scenario. Commodity prices are coming off indicating limited demand, the Dow keeps trading higher on stimulus-injected earnings and the VIX tells as the market is complacent about the recent rally.
In a nutshell, we continue to have a bullish bias towards valuations, and the market, however we are still adopting a cautious approach when adding to positions. We continue to advise the purchase of Index puts as protection.
Edited by Jonathan Barratt, Barratt's Bulletin is a weekly subscription newsletter that provides expert analysis of commodity markets, global indices and foreign exchange movements. Click here to take a no obligation 21-day trial to Barratt's or to learn more visit www.barrattsbulletin.com. Content included in this article is not by association necessarily the view of FNArena (see our disclaimer).
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