On a regular basis (every one to two weeks), Live Feed members are greeted with a “weekly review” or “Macro View” clarifying the top down technical picture and key themes for the current environment.

The following is an actual Weekly Review, taken from the Live Feed archives.

Weekly Review: Theater Risk

8:01 am – June 6, 2011

Weekly Review comments for 06/06 below the jump. Highlights:

• Traditional risk on / risk off relationships are changing.
• E.M. outperformance may be due to U.S.-centric weakness.
• Hot money is abandoning both junk bonds and staples.
  
• Bulls place undue faith in the strength of the recovery.
• ‘Theater Risk’ still greatly favors the downside.
  

Risk-On / Risk-Off Decoupling

The prevailing “risk on / risk off” relationship is changing now. Here are a few examples:

• Last week was clearly “risk off,” yet the $USD went down too.
• Treasury bonds are strong, while junk bonds are breaking down.
• Utilities, consumer staples and blue chips have sold off.
• E.M. equities (EEM) did relatively well last week (except for China).

For quite some time, the dollar has fallen in “risk on” periods, and then risen during “risk off.”

This was a function of capital flowing out of the United States, into commodities and E.M. assets, and also of various players being short dollars (the $USD carry trade, popular with interest rates near zero).

A rising $USD and rising bonds also went hand in hand in “risk off” periods, as nervous capital would withdraw from E.M. equities, flowing back into $USD and into bonds.

But now, this latest weakness has been U.S.-centric, hitting the major U.S. indices harder than E.M. equities… a sort of “risk-off decoupling.”

The S&P, for instance, had a much rougher week last week than EEM did. Why? A few possibilities:

• Emerging market strength as new relative safe haven. A possible deeper shift in sentiment towards seeing E.M. strength as real, durable, and not going away in the face of Western weakness.

• E.M. equities having more ‘high conviction’ players at moment. Alternatively, it may be that emerging market bulls are more stubborn / more convinced of their case, thus lessening the sell-off pressure there relative to the rest of the market.

We lean more towards the second view. With data points on the U.S. economy coming in horrible last week, the relative strength of E.M. may simply be due to the fact that it was America’s time to take a beating.

S&P Broken

From a big picture perspective, it’s important to note the S&P uptrend, intact since “QE2″ from September 2010, is well and truly broken now.

The Japan disaster (Fukushima) was the first big violent disruption to this uptrend, and markets shook it off. Smug bulls are expecting yet another shake-off, some of them arguing this recent ‘dip’ in the data is just a little bit of Fukushima leftovers (supply chain aftershocks from earthquake disruption).

But this relaxed view is (1) dismissive of the charts, (2) blind to the end of QE2, and (3) grounded in the assumption that the recovery gains of the past few quarters are real, and not mainly stimulus illusion.

Another factor to watch is the outperformance of treasuries vs junk bonds (high yield corporate debt).

Last week, even as the 10-year note (IEF) powered higher, high yield bonds (JNK) were dumped over the side of the boat. This is a function if risk capital rushing to safety.

Staples Did Poorly Too

Another notable element of last week’s action was the poor performance of stodgy hiding places — parking lots for cash such as Utilities (XLU), Consumer Staples (XLU), and healthcare (XLV).

To us this speaks to another real risk: The danger that leveraged long-side capital, frantically seeking places to hide in the market, may just withdraw completely.

It is generally a bad idea to “chase” a market, and this goes doubly so when hot money is rushing around haphazardly — thus creating a growing risk of rushing ‘out’ (into treasuries or back to cash).

Theater Risk

At this point, the bull case for equities centers on an assumption that economic weakness is temporary. It does not take into account the following possibilities:

• The psychological (placebo) effects of stimulus are wearing off.
• The global economy may be far weaker than expected.
• Clear and present dangers may be greater than expected.
• The withdrawal of QE2 could have meaningful consequences.
• Europe, China, and a housing double dip are still major risks.

On China, consider the following from Bloomberg (especially for psychological effect):

A “sudden” slowdown in China may lead commodity prices to fall as much as 75 percent from current levels, Standard & Poor’s said.

Unexpected shifts in government policies or problems in the banking sector may trigger such a slowdown, S&P said in a report e-mailed [June 2nd]…

“Given the extent to which China has bolstered commodity prices, that’s something that we have to be concerned about,” S&P analyst Scott Sprinzen said by telephone from New York. “The efforts by the government in China to slow growth are having an effect on commodity prices. It’s been a pretty modest correction so far.”

In sum, it is possible that the bulls pull out a ‘stick save’ once again, but “theater risk” skews opportunity toward the downside in this market (someone yelling “FIRE!” in the crowded theater of leveraged long positions).

If we ‘muddle through’ yet again, further upside could be modest. But if sentiment cracks, the downside could be wide open…

To recap present thoughts:

• The traditional “risk on / risk off” relationships shifted last week, with the $USD selling off alongside equities (a strange occurrence) and E.M. ex-China showing relative strength.

• However, this shift is likely due to U.S.-centric worries on economic data and E.M. bulls having more temporary conviction (as opposed to some deeper change).

• The major U.S. indices are clearly broken. Remaining bulls attempt to shrug this off by citing Fukushima (and assuming that ‘buy the dip’ will work yet again).

• Internal risks are growing, though, as hot money flows become more erratic with both speculative assets (junk bonds) and stodgy assets (utilities, staples etc.) getting dumped.

The market may yet ‘muddle through’ once again, but reward to risk favors downside positioning due to ‘theater risk’ — the potential for a rush to the exits — and the still frighting, still unaddressed top down risks embedded in Europe and China.

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