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24/3/13 Until the bridge to cross

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Sometimes it pays to step back a little and see where we are in larger picture, and whets happening that we might be missing out on. We have been calling for caution for some time now, actually for about 7 months. And we have seen in past so many months markets reaching new highs in developed markets and hence this rally is aptly termed Idiot-maker rally. Our only consolation is that we join some very eminent investors, analysts and traders in the idiot team. So, lets step back and see what exactly is happening, how long can this continue and anticipate what could happen. However, lets us remind our stated position, which remains unchanged; this is not a market to be short but very cautious about. In other words, this is a time to do the Sell High part of the Buy Low Sell High paradigm. But this may not be a good time to initiate, unless comfortably hedged, the Sell High Buy Low paradigm. The chief cause of the Idiot-maker is liquidity, precisely about $85billion a month, or about $3billion every market-open day. As long as the tide is high, all the boats will rise. As long as FED is pumping this money, its waste of protection money to be short waiting for a collapse. However, we may have a slightly better guess that top should be in couple of months, more precisely, (and here goes the Idiot again) we do not think this rally will outlive the June-JulyAugust period. We expect every bit of sanity to return to the markets around this time, a more precise timing of which is hard to estimate. By this we assume the markets will keep rallying until then, which we everyday feel less likely hood of that happening. And importantly also assume that markets would not tank off sharply ahead of that period. A chief cause of the drop according to media, at that point of time will be that FED has scaled back on the free liquidity or something similar. That is half the story. The real half, the important half, is the fact we have barely seen a blip of correction in past 4 years and the

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remains imminent.

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mistakes that have been amply rewarded, have bred mistakes and sum total the correction

And let us reiterate the idea remains to be cautious and not too bullish nor outright bearish. The good trade right now is to wait for first signs of growing debacle, which likely to be accompanied by some fundamental shift in US like interest rates or slowing of QE or even fiscal prudence! To understand the sentiment currently we share some of excellent charts made by Bespoke Partners, Pragmatic Capitalism, and Short Side of Long

Note: There is a definitely decoupling between developed markets and emerging markets in past few months but it is unlikely to sustain as majority of funds in the EM markets are intrinsically linked to the risk-on attitude of developed markets. So though Indian markets are down and corrected, the chances that the bad patch in developed markets may definitely put a lid on any upsides if not accelerate the downside. Also, developed markets deserve a better market in comparison because of well-contained inflation where as inflation in Ems are running very high. So over to sentiments.

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1. How bullish are the markets can be gauged by how many bears are left standing. In this case not many. The bearish advisors have hit the historic support levels of around 20%. Simply put, 80% of people you meet on the Street will give you bullish or buy advice.

Chart 1

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2. The Liquidity infused complacency is again near highs. The last times we were here we had stunted corrections as you can see on the charts. The problem is the stunted corrections only build excesses and not releases them, which gets released in one massive blast of move. Three liquidity tops unsurprisingly coincide with QE and perversely a better economic condition is bad for stock markets!! Thats the consequence of liquidity induced mistake-rewards.

Chart 2

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3. Below is an interesting chart of how Cash-hold percentages. The Cash-balance currently is negative implying fund managers are borrowing to invest in the markets. Compare that with the previous two liquidity tops (above chart) and the cash-percentages are enormous. And for those saying there are enough cash on the sidelines this amply answers there isnt much. At least the fund managers do not have any excess cash on sidelines. Any extra investments have to come from borrowing, additional margining or new allocations out of bonds. Also compare that the cash allocations in 2008 were higher than what it is now. Yet we had a massive bear run. Imagine the scenario if any collapse were to start now.

Chart 3

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4. Going along with the above chart, the below chart shows the inverse of above in form of Bond allocations. Last time the allocations were this low was in June 2011 and what happened later is a familiar case. Also to note, the allocations currently are as low as in 2007-2008, and we have a long way to go into positive territory should something go wrong.

Chart 4

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5. The Equity to bond weighting is comfortably shifted in favor of equities and seems to be going up. Last time we were at this level is in early 2011, and also close to peaks of 2008. Though

Chart 5

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6. The commodity weightings of the Fund managers are near its lows. This is counterintuitive to the equity rally which envisages growth.

Chart 6 & 7

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Conclusion:

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There are huge risks involved to too many people if the markets start to go down, and every one of this risks ultimately end up at the doors of banks and central banks, in this case FED. The moot point is will FED or government do anything that will upset this apple-cart in anyway? Most unlikely. FED is likely to continue to pump money into perpetuity until there comes a bridge to cross... Until such a bridge comes on the way, its all fun and party for equity bulls. Marching under the constant protection and vigilance of Central Bank, the infinite money printer, must be a cozy feeling. However, bulls forget that Central Banks are not invincible and their weapons are useless if Interest rates rise against them. Central Banks therefore has to main tasks to do: to keep the bulls marching and keep the interest rates low. They cannot care too much for the rest of the economy now, because if do the glorious faade of bull-market comes down crashing. Further deeper, for the Central Banks to survive themselves they will have to sacrifice the market, a purge so to speak, once a while so that markets are can rally with a very long term view. It cannot be much of a coincidence that all corrections we have had since 2008 seem so methodical and symmetrical. The current mispricing and conundrums are well explained by Monument Capitals below quote: More likely, investors realize the knock-on effects from a Cypriot default are literally incalculable. But they are insensitive to bad news. They respond to those factors which would lead them to buy financial assets; they can do nothing with any other information. Central banks massive asset purchases have set up a situation where the markets normal signaling mechanisms no longer operate because investors have huge volumes of uncovenanted liquidity, created by the central banks, to commit to long-term assets. The central banks would, no doubt, claim this as a triumph for their asset-buying policies. They do not want to see economic recovery blown off course by recurrent financial crises. However, for those who believe free markets are the most efficient means of allocating capital, the impairment of the capital markets pricing function

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negative implications for future economic capacity.

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must be cause for concern. It presages serious misallocation of capital, carrying

The unconventional liquidity is a fog blocking our view of the real market. We do not know now if we are standing at a foot of a mountain or edge of a cliff. What we do know is Central Banks wants us to believe everything is fine, but it seems almost every body interested is already in the trade! Only time will tell which way the markets will move but the risks in market allocations have never been higher.

Chart Sources: Bespoke Capital Pragmatic Capitalism Macro Business Short Side of Long

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