Trading Lesson: Going Back to the Bar with iShares MSCI Germany ETF

04/25/2018 12:40 pm EST


Landon Whaley

Editor, Gravitational Edge

EWG fell 4% in the two days immediately following my market call, but has now rallied for the last week and is 2% against me. This recent price action leaves us with the $64,000 question: am I wrong, or just early, asks Landon Whaley of Whaley Global Research.

Regular readers are well aware of the guilty pleasure I derive from reality TV. I’m not ashamed nor defensive of my desire to watch rich chicks from Beverly Hills yell at each other at a fundraiser for sea otters while clutching $200,000 Birkin bags.

These shenanigans are all my brain can handle after I spend the day traversing the globe avoiding risks and hunting down opportunities that most investors miss.

On my must-watch TV list is “Bar Rescue,” which has a slightly more redeeming quality than the Real Housewives, but only slightly. Jon Taffer fixes up bars around the country while providing the less experienced people running these establishments with the advice and tools they need to be successful.

In this regard, Taffer and I are kindred spirits. Each week, I convey through Gravitational Edge the experience and knowledge I’ve garnered over the last 20 years, in order to help investors fix their portfolios and stack the odds of investing success in their favor.

At the end of each season, there is a “Back to the Bar” episode, where Jon revisits bars he’s rescued to see how they’ve fared since his first visit.

This week, we are going “Back to the Bar” Whaley Global Research-style, and re-visiting my short German equities call.

On March 21, I made the call that eurozone growth is slowing, and that the way to play this Fundamental Gravity reality is to short German equities via the U.S.-listed iShares MSCI Germany ETF (EWG). EWG fell 4% in the two days immediately following my market call but has now rallied for the last week and is 2% against me.

This recent price action leaves us with the $64,000 question: am I wrong, or just early?

Fundamental Gravity says what?

There are two chief variables that impact the risk and return of asset classes: one is economic conditions, and the other is how central banks respond to those conditions. Together, they drive what I call an economy’s Fundamental Gravity.

In my last Germany-related commentary, I sauntered through a slug of economic data which indicated that both growth and inflation were slowing. Since then, the growth-related data has continued to deteriorate.

Germany’s Composite PMI, which is a combo platter of service and manufacturing activity, has fallen for two straight months and right off a cliff. The primary driver of this decline has been manufacturing activity, which has fallen for three consecutive months, and is widespread.

Construction output looks as ugly as homemade sin, and the media continues to blame the weather. Dude, it’s winter in Germany; the weather has sucked in January and February since 962 AD, when Germany became a country. So why is this year special?!

The slowdown is not isolated to the construction industry. Economy-wide industrial production growth fell 60% in February and is now sitting at two-year lows. Mining production: slowing. Steel production: slowing.

It’s no wonder the ZEW Indicator laid an absolute egg in March, falling 13 points in one month. This latest reading marks the first negative reading since 2016, and the 13-point decline is the largest monthly drop since 2013.

The ZEW Indicator of Economic Sentiment is a survey that aggregates the opinions of approximately 300 economists and analysts. The indicator is used as a proxy for the outlook for the German economy over the next six months.

Bottom line: It’s been five years since Germans have been this pessimistic about their economic outlook. Bearish equity confirmation signal, anyone?

Quantitative Gravity says what?
As a reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is both ineffective and misleading. Rather, we use quantitative measures that are based on the reality that financial markets are a nonlinear, chaotic system.

Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price. Crucially, price is the last aspect of a financial market to move, quantitatively speaking.

We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying/selling pressure), and a market’s irregularity, which helps us gauge the probability of drawdown risk.

To analyze the first dimension—the energy (trend) of a market—we use a measure called Social. This measure helps us identify when the market is in one of four states: party (bullish), hangover (bearish), taking a breather, or completely asleep.

After having a hangover for two straight months, EWG is currently sleeping it off. Only time will tell if it wakes up partying or still hungover. Given the current Fundamental Gravity, my money is on the latter.

To analyze the second dimension, we use a measure called Momo, which helps us understand the amount of force (momentum) behind the current state of the market, which we identified using Social. EWG’s Momo has fallen for six straight trading days, while price has meandered higher. Whenever Momo diverges from price, price converges 77% of the time in the direction of Momo within 10 trading days.

To analyze the third dimension—the rate of force (buying/selling pressure)—we use a measure called Barometric. This measure gives us immensely more information about investors’ degree of conviction than a simple measure of volume alone. EWG’s Barometric has built bullish pressure after bottoming deeply in bearish territory in late March. However, this bullish buying pressure wasn’t enough to break through neutral to outright bullish, and it’s now declined for five straight trading days. Barometric is telling us that price may be going higher, but the bears are in control of the selling pressure.

To analyze the fourth dimension—the irregularity of the market and the probability of a drawdown—we use a measure called Topo. This measure is currently giving us a neutral reading, indicating an unclear level of drawdown risk in this market.

Remember, these four dimensions of the underlying market structure typically move before price, giving us a nod as to where price might be headed.

Actions speak louder than words
The behavioral aspects of financial markets are just as important as the fundamental and quantitative because human beings are innately flawed decision makers. Remember, markets are driven by human beings making human errors, which is what gives rise to both opportunities and risks.

Our proprietary Behavioral Gravity Index (BGI) is our approach to quantifying investors’ perception of a market at a given point in time and how that perception is changing as we move through time.

EWG’s BGI has been building bullishly all year and is currently sitting in a neutral area. The trajectory of the BGI tells me that investors are paying too much attention to the “eurozone is fine” narrative being spun about recent data, rather than the clear picture being painted by the data itself.

The Bottom Line
A critical habit of all successful investors is constantly evaluating what could be wrong with your Macro Themes, which is what I call “going back to the bar” as per Jon Taffer.

Fundamentally, the broader eurozone, and specifically Germany, continue to slow in both growth and inflation terms. From a Fundamental Gravity perspective, it doesn’t get more bearish for equity markets than an environment characterized by slowing growth and inflation. The Germans themselves think the economic outlook is as dim as it’s been in more than five years!

Quantitatively, price has been moving higher, but the current rally is strongly contradicted by all four underlying dimensions of EWG. This divergence tells me there is a high probability that price will align itself with our QG framework and head lower. Behaviorally, market participants are getting more bullish at exactly the wrong time, and it is their false belief that is pushing up the price.

As is usually the case, investors are being led by storytelling and EWG’s price chart, rather than the three Gravities. The best market opportunities come when investors’ perception of a market diverges from that market’s Gravitational reality. That is exactly what is happening with EWG right now.

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