Titan Investment Partners – The “slope of hope”, caveat emptor and roosting chickens…

Over the last few days it seems that quite a number of chickens have come home to roost in both emerging and developed markets and whilst many commentators have drawn a direct correlation between this turmoil and the Federal Reserve’s decision to taper its asset purchase program, signalling the beginning of the end of QE, the causality may not be quite as clear cut.

Many of the emerging markets that have been most affected have in fact had a long list of domestic issues which they have failed to address. We are thinking here of the likes of Argentina, Indonesia and Turkey as examples. Emerging markets and their currencies as a whole have in fact been on the wane for at least two years and this is evidenced by the large collective underweighting of the sector by global fund managers (see chart below)

No doubt we will discover more about just how valid the link between the taper and emerging market performance is post this week’s Federal Reserve meeting tomrrow. In turn, the reaction of the emerging markets and their currencies may well offer guidance as to the future near term direction for US equity indices such as the S&P 500 and which has sold off sharply and, at the lows yesterday of around 1774, was nearly 5% down from its most recent all-time highs at the turn of the year – a very ominous sign for the remainder of the year given the saying “where January goes, so goes the rest of the year…”

Many investors will be tempted to view the recent sell off as a healthy correction and yet another dip that allows them to continue to buy the market. However, here at Titan, we feel that this is definitely a case of caveat emptor and that whilst a rally in the S&P (which we are experiencing as we write this) could quite conceivably take us back to 1810 -1820 and might well soothe investor fears and appear to vindicate those that bought the dip, the factors that gave us reason to move to a bear stance remain firmly in place. These include overvaluation, complacency, poor recent US earnings and most importantly, the early stages of liquidity withdrawal from the US market in particular (with Japan being the lone gung ho for now) and that has been such a strong support for equities this last 4 years.

We actually believe given the eagerness of many to buy this pretty shallow dip that we are in the classic stages of the start of a bear market. We are near the very top of the pole on the “slope of hope”. It is these very conditions where shallow dips suck buyers back in and add once more to the lop side boat all the while distribution of equities by insiders continue and the masses cannot comprehend the possibility of a continously falling market that bear markets are baked within.

One can in fact find examples of similar price action if we take a look at the S&P in the summer of 2007

What is evident in the chart is an illustration that the market sold off during the week of the 20^th July from highs around 1553 (highlighted in turquoise) and by the beginning of August was trading back at 1434 – a fall of around 7.5%. However, that sell off was quickly reversed with the market breaking out from a sideways pattern on the 20^th of September and by the 12^th of October new highs were posted at 1556.51.

You don’t have to look too far ahead on this chart though to see that this was what is called in market parlance, a “suckers rally “. By January the 4^th 2008 the market had established a lower low than in the July sell off (highlighted in orange) and by the 18^th of that month we had printed as low as 1312.51 – a peak to trough fall of some 15% plus.

The sell off seen since the end of last week has been less aggressive than the example taken from the summer of 07, not surprisingly as the issues today are not quite as severe as the implosion of capitalism that the world faced in 2008. Still, we have fallen by some 3.3% in just three trading days in a climate that has been perceived to date by the majority as positively benign if not continuingly favourable to equities… It is this very perception which may well entice buyers back into the market on any rally, and of which, already, there is a chorus of cheerleaders advocating such a stance. This may well prove to be a costly experience.

We note that more 25% of the S&P 500 constituents trade on earnings multiples of between 14 and 18 times ( source Y charts ) suggesting that the rising tide of QE has lifted all boats on the US equity seas. With the liquidity tide now receding, question will be what will it expose?

Our stance at Titan remains of a bearish bias on the wider market but we do not discount a modest rally in the S&P 500 back towards 1815/20. This rally should, as relayed here, be treated with caution and be used as an opportunity to neutralise further general equity exposure and in fact place selected shorts on the most extremely valued stocks (read NASDAQ).

With regards to certain of the emerging markets currencies, given the v high positive carry in being long the South African Rand, we have actually opened a bull exposure here and also in considering the extended nature of the decline in the rand now, we believe that playing this through adding to platinum plays like AAL & LMI could prove lucrative on a 12 – 18 months view.

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You should not take this piece as an advocation to trade in any of the instruments mentioned and should always take professional advice in relation to your own personal circumstances.

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