THE

SENTIMENT REPORT
A CONTRARIAN VIEW OF GLOBAL MARKETS
STOCKS COMMODITIES CURRENCIES BONDS

12 issues per year - $199

June 2011

Remaining Nimble During Transitional Phases

Broadly speaking, markets are in a difficult state. Stocks, currencies and commodities are all either consolidating or reversing. The only exception for the most part is U.S. Treasuries, which remain strong. If stocks and commodities are indeed making a major top, it could take several months to complete. Any successful investment or trade will have to be very selective. The month of May witnessed the reversal of several highly profitable multi-month moves. As a whole, markets such as gold, silver, crude oil and many foreign currencies suffered the most during the month. From our point of view, there were some strong warning signals, both technical and psychological, for a reversal in the precious metal markets, particularly silver. Any time a market moves in a parabolic trajectory, the end is typically not too far off. Also, foreign currencies have rebounded nicely (some to new highs) from Mays sell-off; the Swiss franc remains the strongest while the British pound and Canadian dollar fail to keep up. The action of individual markets during this period can give hints to future opportunities. The fact that the British pound and Canadian dollar are lacking strength compared to their peers suggests they may decline the most when foreign currencies eventually reverse course.

Stocks
Stocks around the world are overvalued. The price movements strongly suggest that emerging markets are the weakest, followed by the European indices. At the moment, domestic stocks maintain the highest level of strength, but that could simply mean they decline to a lesser degree than their foreign counterparts. According to the data, the S&P 500 is heavily overvalued. As you can see in our Valuation Fig. 1 Our S&P 500 Sentiment Index shows extremely high optimism in late Index (p. 2), the S&P 500 reached overvalued December 2010 (74.5% bulls), enough to mark a euphoric high for the in April. Our Valuation Index measures the ratio current two year bull market. of stock yields to government debt yields and has historically been very accurate for major turning points. Due to this severe overvaluation, stocks look to have notable price vulnerability to the downside, particularly technology stocks. Looking at domestic stock valuations in a different light, one can see that those stocks are overpriced to a historic degree when viewing their PE ratios and the Q ratio (p. 2). Cyclically, this stock market rally that we all have enjoyed since March 2009 is beginning to look like a very old man. Most bear market rallies last an average of 25 months; the S&P 500 hit that duration point in March 2011.

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June 2011

So, although the picture looks negative for the medium and long-term, our shorter term Sentiment index (see previous page) looks to be rather one-sided, and a short-term relief rally could be seen in the next month or two. This sentiment index is a smoothed average of the publics opinion on the stock market. Clearly evident is the extreme optimism seen in late Fig. 2 S&P 500 (red) versus the ratio of the average stock yield to U.S. Treasury yields (blue). December 2010; this is an When the oscillator is above zero during a secular bear market a cyclical high is likely to form appropriate extreme for the and when the oscillator is below zero during a secular bull market a cyclical low is likely to final push in a cyclical bull form. market. In my opinion, major market moves need a consensus, a capitulation of the masses, in order to finally come to an end. Seeing the extreme reading of about 74.5% is enough unbounded optimism for me to feel comfortable in suggesting the end of this bull market has arrived.

U.S. Treasuries
U.S. Treasuries may be a boring market to some, but trading the futures can be just as profitable as any other more exciting market. We believe an opportunity currently exists in the government bond markets around the world. A more in-depth look at this trade can be found in my recent TheStreet.com article titled, Treasuries Riding Bull Market. In brief, their very nature as a safe haven combined with teetering global stock markets and an exceedingly public bearish perception makes the asset highly desirable. Its no secret that Treasuries are a hated Asset. Bill Gross, Jim Rogers and Marc Faber loathe the asset. This fact simply adds to the already heavily skewed contrarian trade. Although owning them for the next 20 years very well might not be very smart, a 3 to 12 month position could prove profitable, as you can see in Figure 4. The contrarian index shows a very negative view on the market. The maximum pessimism coincided with Bill Grosss negative public comments about the market and the bearish stance he assumed in his Total Return Bond Fund. Compared to historical levels, government Treasuries are a very under-owned asset in the average U.S. household. Households hold much more of their assets in bank accounts, stocks and real estate than in the safety of U.S. Treasuries. I have a feeling this will change before the 30-year secular bull market in government bonds comes to an end.
Fig. 3 Tobins Q Ratio show stocks overvalued to a historic degree. Aside from the final years of the Tech Bubble, we now stand at the most overvalued point ever.

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June 2011

Lastly, there are historical precedents for U.S. 10-year Treasuries to continue their decline in yield. For example, the 10-year Japanese Government Bonds declined to a 1% yield and interest rates here in the U.S. dropped to roughly 1.5% back in the 1940s, as well. Low rates have happened before and can easily happen again.

Precious Metals
The sell-off in metals last month was both dramatic and rational. The upward move in silver since last summer has been one for the history books. After a vertical rise, a vertical fall will typically follow shortly thereafter.

Fig. 4. 10-year Treasuries (red) broke out of their low in April when our Sentiment Index (blue) showed almost a maximum negative reading at -0.95.

Obviously, the long precious metals trade was quite one-sided. One didnt even need our sentiment indicators for evidence. The one-sided investor psychology was seen on TV and heard on the radio with companies eager to recommend an investment in gold or silver. The more interesting fact is the rapid change of tune for individual investors, who went from very long to almost completely flat within the month. Investors are now more bearish on gold than at any time in the last 10 years. Now, from several different points of view, I am bearish on gold and silver over the medium-term (1to 2 years), but I think we could see a rally in gold over the next month or two as markets work out this excessive bearishness. Ive mentioned several times that there can be large sell-offs in an asset during a secular bull market. The 1987 crash in stocks and the 2008 U.S. dollar rally are two examples of dramatic (but acceptable) relief moves counter to the major trend. Of primary interest is the price of gold during the 1970s. Gold declined by 50% over a two-year period before eventually rallying into its peak in 1980. The 50% decline was enough to curb the interest in the asset setting up the environment that would allow its price to rise by nine times over the next three years. There is absolutely no reason gold and silver cannot do the same thing this time around.

Conclusion
Asset markets cycle from period of tradable trends to periods of consolidation and rotation. Right now, we seem to be in the latter-not much fun for a position trader. Government bonds (U.S. Treasuries, Euro bund, British gilts and Canadian government bonds) offer just about the only macro trend available, and its very strong. Aside from bonds, any risk assets seem to be working themselves through a topping phase. That is my best conclusion. Shorting markets such as copper and emerging market stock indices will most likely offer very rewarding opportunities later in the year. Hopefully, more markets, like sugar, cocoa, cotton, coffee or the meat complex, will break to the downside. Disclosure: Andrew McCormick, MKC Global Investments, LLC and the MKC Global Fund, LP have long positions in Swiss franc futures, gold futures, U.S. ten year note futures and British gilt futures. They are also short London cocoa futures.
DISCLAIMER: The information, tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financial instruments. This research report is prepared for general circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should independently evaluate particular investments and consult an independent financial adviser before making any investments or entering into any transaction in relation to any securities mentioned in this report.

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June 2011