Saturday, September 13, 2014

A return to normalcy? & Scottish referendum

Over the past few weeks traditional inter market relationships have dominated the financial markets and even stocks, in desperate need of a rest, are grudgingly starting to succumb to the pressure of a surging US Dollar.

As a student of inter market relationships I get excited when markets validate these relationships in such a strong way.  Markets have been confusing for much of 2014 as these relationships have been skewed but as these historical inter relationships once again "kick in" it allows us to draw more definite and convicted opinions regarding market direction.

We'll start by looking at stocks as represented on the daily chart of the S&P 500 SPDRs ETF (SPY):

(click on chart for larger image)

There are a number of points to take away from the chart.  First, we had some selling pressure on Tuesday and Friday but secondly, I have pointed out on this "candlestick" chart (blue arrows) where there are tails or wicks on each daily candlestick. This denotes consistent "nibbling" (buying) by market participants going into the close of business every day.  The bulls aren't giving up!  The "buy the dip" mentality is very strong!  Thirdly, we are still butting up against all time highs in the S&P.  Nevertheless, momentum is waning as can be seen in the MACD momentum indicator (second panel on top) and KST indicator (bottom panel) where the indicator is ready to cross over it's red signal line.

Although there has been some deterioration in market breadth it is hardly anything to be concerned with at this point.  We're seeing some short term weakness that might suggest further consolidation or even some type of correction but there is nothing frightening going on.  The chart below is a daily chart of the S&P 500 with measures of advancing and declining stocks in the index.  There is some deteriorating breadth as reflected in the first two lower panels but the advance/decline and more importantly advance/decline volume lines are in strong up trends:

(click on chart for larger image)

As stated in my opening comments, all markets have been moving in lockstep to traditional inter market relationships as the US Dollar has surged leaving in its path the litter of falling commodity prices. 

 As a primer for some of my readers, the cost of commodities drop when there is a strengthening dollar because you don't need as many dollars to buy the same commodity as before.  And since the US Dollar is still universally and formally recognized as the world's reserve currency, this impacts prices globally. 

 Here's a daily chart of the popularly traded proxy for the US Dollar, the Powershares DB US Dollar ETF (UUP):

(click on chart for larger image)

The dollar has absolutely exploded and has gapped higher twice in the past two weeks.  The chart has characteristics of a "blow off" top and I identified a possible "island reversal" pattern which is bearish on Twitter on Monday.  However, it's pretty clear from the chart that the dollar is just consolidating before another attempt higher.

With the European Central Bank (ECB) committed to expanding its balance sheet by another trillion euros and the Bank of Japan (BoJ) on an enormous campaign to devalue their currency in order to win a two decade war with deflation, it is no wonder that, with formal QE (quantitative easing) ending in the US and the inevitability of higher short term interest rates, global money flows are being directed to the dollar.  The following chart is a ratio chart of the three day exponential moving average of the US dollar compared to the other major foreign currencies:  

(click on chart for larger image)

When might the Dollar rally stop?  I'll have some answers in my analysis below.

The Dollar continues to rally because short term rates are moving higher as can be seen in the Two Year Treasury Note yield below:

(click on chart for larger image)

This price action and attendant increase in yields as the market prices in the inevitable move by the Federal Reserve to raise short term rates has been flattening the yield curve as the gap between the Two Year yield and Ten Year yield is compressing (see chart below).  In "normal" economic times this compression is healthy for the economy and stocks.  But is it now?  I'll have some answers in my commentary below:

(click on chart for larger image)

The impact across the entire US Treasury yield curve is becoming more apparent as the long end ( ten plus year duration US debt) is selling off.  The chart below is a daily chart of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) which many traders use as a proxy for the long end of the Treasury yield curve:  

(click on chart for larger image)

I identified an "island reversal" pattern (black circle) on Twitter two weeks ago and right now TLT ended the week resting on Fibonacci support.  The momentum indicators suggest more downside.  Another indication that the selling in Treasuries is not over was the price action in the Dow Jones Utility Average ($UTIL) on Friday.  Utilities are interest sensitive stocks that often move inversely to the direction of short term interest rates.  As seen in the chart below, the utilities had an inordinate move lower to the rest of the market on Friday which isn't a good harbinger for bonds in the short to intermediate term:

(click on chart for larger image)

And so, true to inter market relationships that have persisted in different magnitudes for the better part of sixty plus years and specially since the Asian Currency Crisis of 1997, Gold is taking a drubbing as seen in the chart below.  Even the gold miners (bottom chart) are signaling more downside as they are often a predictor of the yellow metal's price direction:

(click on chart for larger image)

Oil is also taking a beating as West Texas Intermediate Crude and Brent Crude take a nose dive.  See below:

(click on chart for larger image)

Even "stodgy" basic materials as measured by the Dow Jones World Basic Materials index have broken through a major uptrend line on the weekly chart below:

(click on chart for larger image)

And industrial metals have also been impacted by the Dollar's meteoric rise.  Below is a weekly chart of the Dow Jones UBS Industrial Metals Index ($DJAIN).  The index had a big "down" week:

(click on chart for larger image)


There are many moving parts to this commentary so let me start this analysis by identifying the traditional inter market relationships that have persisted for decades.  Some of these relationships have persisted in different magnitudes since the end of World War II.

Generally speaking, the US Dollar moves inversely to all commodities and gold.

Generally speaking, prior to 1997, a strong currency was reflective of the economic strength of the country which issued the currency and the impact on stocks was generally a positive one.

Generally speaking, between 1997 and 2008, an inverse correlation between stocks and the Dollar persisted due to the effects of "risk aversion".

Since 2008, there has been a very strong inverse correlation of the US Dollar and Treasuries to stocks and commodities because of pronounced "risk aversion".

Now that the parameters have been set, it's been my thesis (and that of others) that a return to "normalcy" after the momentous and near catastrophic events of 2008 would be signaled by the return to pre 1997 inter market relationships.  

The inverse correlation of the US Dollar to commodities will always stay the same but what of the Dollar to stocks and Treasuries?

Well, we're starting to see the breakdown of the positive relationship of the Dollar and Treasuries.  In the past, because of the two significant market downturns we experienced (2000 and 2008), Treasuries especially and then the Dollar benefited from global flight to the "safe haven" of Uncle Sam's debt.  It can also be said that gold benefited from this "flight to safety" but I see gold's rally in the first decade of this century as more of a reaction to the Greenspan Fed's efforts to inflate away the crash with low interest rates with the anticipation of inflationary pressures which never materialized.

This breakdown of the positive correlation between treasuries and the Dollar is a healthy development if it persists.  It signifies a lessening among global market participants of fear and the constant need to be hyper vigilant regarding "risk aversion".  

Since 2008, the inverse correlation between the US Dollar and equities has been just about absolute.  A move in the US Dollar such as we had in the past two weeks would have been met as late as mid 2012 with significant selling of stocks.  But we are seeing a resilient stock market (so far) in the face of a strong dollar and incrementally rising interest rates.  This too, is a healthy development.

If we continue to see a rising equity market in the face of a strengthening dollar and rising interest rates we will be able to say that the distortions created by central bank interventions of the past five years are working themselves out and we are returning to "normalcy".

As far as the Dollar rally goes, it's been a function of a greatly depreciated Euro, Yen and to a lesser extent the British Pound.  With Mario Draghi's (President of the European Central Bank) announcement about a week ago that the ECB intends to expand it's balance sheet by a trillion Euros, the Euro which is about 57% of the Dollar index, has nosedived.  The Japanese Yen (about 13% of the index), continues to tumble as the Bank of Japan continues with their historic quantitative easing which actually proportionally dwarfs our and the European's QE.  The British pound (about 12% of the index) has weakened considerably because of all the "noise" over the Scottish referendum on independence.  The Canadian Dollar (about 9% of the index) has weakened because it is a commodity based currency and commodities are currently sliding because of Dollar strength.

Make no mistake, the Dollar's strength still speaks to global deflationary pressures, especially in the Eurozone.  But even here, there may be light at the end of the tunnel.  I had the opportunity last week to interact on the internet with Marc Chandler, chief currency strategist with Brown Brothers, Harriman in New York, over my concerns that the European Central Bank (ECB) was not doing enough to stimulate Europe out of deflation.  Marc is a gracious guy and his comments are always informative and "spot on".  Excluding the comments about ABS (Asset Backed Securities) which I would not expect most of my readers to understand, I highlighted the comments that most struck me in his response:

 "I think euro zone inflation is near bottom. I think that there has been further convergence in borrowing rates between core (Germany) and periphery (Spain and Italy). I think ABS/covered bond purchases will expand the ECB balance sheet and need to be understood in the context of TLTROs and negative deposit rates. The divergence between its monetary policy and US will push euro lower still and that will also help boost inflation and on the margins stimulate growth. Does it address all that ails the euro area, no. Will it make thing better or worse? I say better, but difficult to quantify, especially as details of ABS not known. Hope this helps spur yours and others thinking."

So, the question becomes, will there be any break to the Dollar's rise?  I think the answer can be found in the Euro.  With Draghi's intent on driving the European currency lower to spur exports and growth here's where I see possible bounces in the Euro:

(click on chart for larger image)

There is some support in the 128-127 area but I see the possibility of the Euro testing 120.  

With the Scottish referendum on Thursday, 9/18 we may see a Dollar correction as I am expecting a "no" vote to prevail concerning Scottish independence.  The Pound took a beating after a YouGov poll last weekend indicated that the "yes" vote may dominate on Thursday.  However, I expect saner minds to prevail among the voting populace as all the major banks have indicated that if Scotland votes for independence they will be moving their offices to London and becoming British banks.  Additionally, Shetland and the Orkney Islands have indicated they would probably stay with the UK.  This development would take away any economic clout Scotland would have as all that oil in the North Sea would stay under the British crown.  Thirdly, an independent Scotland would not have an easy time being admitted to the European Union for a variety of political and financial reasons and they desperately need admittance to remain economically viable in a world of growing global economic blocs.

A rally in the British Pound would spill over to the Euro which would be the catalyst for a Dollar correction.

Finally, there may be some longer term concerns regarding the market but I've said enough already in this commentary so I'll save those concerns for future "musings".  I'll leave my readers with one more chart that I find fascinating and I'm developing a thesis around:

(click on chart for larger image)

The Shanghai Composite has been surging recently and I overlaid the US Dollar price action (thick black line) over it.  I find it fascinating that the dollar has been positively correlated to the Shanghai since May and has been moving in lockstep with Chinese stocks since July.  What's my take away?  

So far, I'm thinking that the positive correlation can be attributed to the world's two largest economies recovering in lockstep and the mutually beneficial aspects to both economies of stronger Chinese growth as they transition to a consumer based economy.   Add to this the irrefutable fact that the US economy continues to grow slowly but with a more solid foundation under it with every passing day.  The Chinese Renminbi has also been weakening against the Dollar since the early part of the year which could also be impacting the relationship.

Admittedly, my thesis is incomplete and ignores certain relationships that would hurt Chinese exports.  But I'm watching the chart and will be thinking through my thesis in the coming weeks.  Stay tuned!  

Have a great week!

The statements, opinions and projections made in this commentary are my own and do not represent the views of my broker/dealer.  Additionally, these commentaries are published as information only and are not published for the purpose of utilizing the information for short term trading or long term investing in stocks, bonds, ETFs, mutual funds,currencies, indexes, index or stock options, LEAPS, and stock or commodity futures.  Seek the personal, face to face guidance of a registered investment advisor before entering any trade or investment.  Anyone who trades or invests based on the information in this commentary does so at his/her own risk.  

Warning!  you can lose some or all of your principal (money) investing in stocks, bonds, ETFs, mutual funds, currencies, indexes, index or stock options, LEAPS and stock or commodity futures!

Saturday, August 30, 2014

A Recovery With Lower Interest Rates

August turned out to be a great month for stocks as many of the major indexes hit multi-year new highs or all time historic highs.  Early August saw a shallow pullback only to be met by new buying as the "buy the dip" mentality still holds sway in US financial markets.  While stocks have just rallied 5% in three weeks, it is prudent to expect some type of pullback.  However, we must always remember that stocks don't necessarily "pull back" to work off an "overbought" condition.  In strong bull markets (of which this is one) overbought conditions can be corrected by side ways action which we have seen this week.  Nevertheless, there are some divergences developing that could be an early signal of a pullback.  But first, let's get an overall picture of this market:

Here's a weekly chart of the S&P 500 from the March 2009 bottom:

(click to enlarge)

The S&P cracked the 2000 level for the first time this week on light pre-holiday volume and I expect it to maintain these levels and possibly move higher on light volume next week as many traders will stay in the Hamptons after Labor Day, not coming back until September 8th.  

The daily chart of the S&P looks equally as strong although we are getting mixed signals on some of the momentum indicators I follow:

(click to enlarge)

As readers can see, the Relative Strength Indicator (RSI) in the top panel has diverged from price while the nature of the KST indicator suggests we have more room to run.  The Price Momentum Oscillator in the bottom panel looks strong also but with the very faintest hint of a rollover.

When we look at the entire US stock market as captured by the Wilshire 5000 Index the divergences are more apparent:

(click to enlarge)

The second panel above the chart measures net new highs and the indicator has crossed it's signal (red) line meaning that new highs in individual stocks are not keeping up with the price action.  The PMO (Price Momentum Oscillator) in the bottom panel also speaks to a growing divergence in momentum as new all time highs are being reached.

When looking at these divergences it must be remembered that regardless of the divergence, none of these indicators are below the "zero" line which would indicate a much more serious divergence.  So, what we can gather from these divergences is that the market may be setting up for some corrective action but nothing more than the "garden variety" type of correction.

For the fundamentalists out there that do not trust technical analysis the following chart may be helpful in assessing the future direction of this market:

(click to enlarge)
chart courtesy of Sarhan Capital

The chart is instructive in that it shows the PE Ratios of the S&P 500 at the two previous tops in 2000 and 2007 and the P/E Ratio presently.  Any short term corrections aside, this market definitely has more room to run!

Treasuries are acting counter intuitively to the price action of equities as interest rates should be rising on the prospect of greater economic growth which are reflected in stock prices.  But there are some global concerns out there and some technical factors that are presently feeding this latest surge in Treasuries and the attendant drop in interest rates.  I will be addressing these concerns below but let's look at some charts:

Here's a daily chart of the Ten Year Treasury yield going back three years which captures the lowest interest rates we've seen on the Ten Year Note since 1942 and the highest rate registered on 12/31/2013:

(click to enlarge)

As you can see, technically we've breached a major support line which overlaps with the Fibonacci levels I put on the chart.  How low can rates go?

It's important to understand that fundamentally interest rates are a very accurate gauge of economic growth.  But the picture gets "fuzzy" in our current world of global financial interrelationships.  Certainly, events in the Ukraine have something to do with the "flight to safety" trade but it is not impacting Treasuries as much as some might think.  Global deflationary pressures are still very much with us as whole areas of the European Union slip into outright deflation (regardless of the rationale that "internal devaluation" is effective in correcting imbalances in a system where there is monetary union without political or fiscal union).  And then there are purely technical reasons for the recent pressure on interest rates.

With yields on German 10-year bunds at 0.90% and Japanese government bonds yielding around 50 basis points,  US Treasuries are comparatively attractive (our Ten Year Note closed at 2.342% on Friday).   Also, the perception that both Japan and the European Union will be forced to implement further quantitative easing measures makes it reasonable to expect that global capital will continue flowing into Treasuries, pressuring Treasury yields down even as quantitative easing draws to an end.

There's also a much more esoteric technical factor that may be driving rates lower:  as interest rates drop it normally spurs a wave of refinancings.   Prepayments will spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.

Certainly, commodities have been reacting in a consistent matter with the drop in global yields.  The CRB (Commodity Research Bureau) Index composed of 19 different commodities from agriculturals, oil and industrial metals has only now found some support after close to a swan dive in the past month:

(click to enlarge)

The fact that the CRB has bounced off of Fibonacci support is an encouraging sign as Europe appears to be descending into deflation.  Commodities will normally turn up later in the business cycle after stocks.  The fact that these cycle relationships are presently skewed owes much to the efforts of global central banks to stem the tide of the threat of the debt deflation of 2008.

Gold is signalling that global economies are slowly strengthening with insignificant inflationary pressures:

(click to enlarge)

The main take away from this chart is the relationship between Gold and the Gold Miners (GDX).   The bottom panel is a price relative comparison of GDX (Market Vectors Gold Miners ETF) to the price of the precious metal.  Historically, Gold Mining shares have led the metal higher and we are seeing relative strength in the bottom panel.  Also, the bottom chart is a daily chart of GDX and I highlighted a major support area when the ETF gapped higher in late June.  Nevertheless, the chart for the metal is decidedly bearish as the down trend remains intact with waning momentum (top panel).

Gold can't get a rise anywhere!  The Ukraine crisis was a perfect example of a metal that "can't get out of it's own way".  But we need to continually watch the chart above because Gold will be the predictor of any inflationary pressures when they finally arrive on the global financial scene.

When will that be?  I'd have to write another commentary to support my thesis but I believe global demographics in the developed world will foster low growth and contained inflationary pressures for the better part of the next decade. 

Part of the reason for the weakness in commodities and gold as well as the strength in Treasuries can be traced to the rally here:

(click to enlarge)

This is a weekly chart of the Powershares DB US Dollar ETF which is the popular traded proxy for the US Dollar if you don't want to trade the currency itself.  The Dollar has been in rally mode since early July as the market's perception of the inevitability of QE (quantitative easing) in the Euro zone has reversed the strength in the Euro, which is roughly 57% of the Dollar Index.  And because of the rally here, commodities and gold have been under pressure.

What I want my readers to notice is the positive correlation between the Dollar and equities identified in the panel directly below the chart.  Since 1997, and especially since 2008, there has been a strict inverse correlation between the USD and equities but we are seeing something different in the last two months.  Now, "we've seen this movie before" but a continuation of this positive correlation would validate a return to normalcy we haven't seen since the Asian Currency Crisis of 1997. 


As we consider where we are in the market what are the possible events/circumstances that can possibly derail the present rally?

1.  Ukraine? Outside of a commitment by the Obama administration to putting US troops on the ground (chances are absolutely zero) even a commitment of NATO troops to "maintain peace" is not going to cause any significant reverberations in financial markets.

2.  A commitment of US troops to battle ISIS in Syria will not shake financial markets.

3.  Deflationary pressures in the Euro zone can possibly have an economic impact on global economic growth but even here the outcome of a deflation scenario and it's impact on our market is uncertain.  It must be remembered that we have been in an environment in which the one time second largest economy in the world, Japan, has been continually been dealing with deflation since its onset in 1990.  Even "Abenomics", the conscious effort to create inflation in that country, is having at best, mixed results.

Euro zone deflationary pressures may also not be what they seem.  The latest CPI (Consumer Price Inflation) report showed that the main drivers of the deflation were food and gas prices while core inflation remained unchanged.  Now, the overall number is still extremely low and borders on deflation which is the result of extremely weak growth, especially in the peripheral economies of Spain and Italy.  However, if the ECB (European Central Bank) implements QE (Quantitative Easing) next week as some expect, markets will rally as the Euro initially will rally driving the US Dollar lower.

I personally do not believe the ECB will act yet as there is considerable opposition from the Germans against any implementation of QE.  All things being equal, Europe can still muddle along without much of an impact on our markets.

4.  The biggest concern I have is the effect that rising interest rates will have on stocks once rates start to rise in earnest.  The Fed is projected to start raising short term rates in June, 2015 although some on the street believe this will happen sooner.  The "short end" of the yield curve is already backing up in anticipation of this eventuality but the long end ( longer dated maturity bonds) are rallying for the reasons I cited above which is causing a flattening of the entire yield curve.  However, I suspect this will change quickly when we get closer to the first official announcement by the Fed.

If long term rates start to back up quickly we will have a significant correction in equities.  Don't misunderstand, I'm not calling for an "Armageddon scenario"; it's just that after 5 years of Fed manipulation of the markets there will be significant technical and psychological readjustments to the market.  

Fed policy has driven many "yield hungry" investors into the market and once rates rise some of these investors will move back into more traditional interest bearing alternatives.

How and when this all shakes out is the big question for the market.  If the market can gradually adjust to this Fed induced transition there may not be much of an effect.  And admittedly, the first increase of short term rates will be insignificant in itself.  It's how the rest of the yield curve, especially the long end (10 to 20 year maturities) react.

We will gather more clues on this quandary as time goes on but I don't see this having any significant effect on our markets in 2014.  I can easily see the S&P at 2300 by the end of the year with perhaps a small correction in the interim.

Next week will be a big week for employment numbers with the culmination on Friday of the Monthly Employment Report.  Fed Chair Janet Yellen has made the statement repeatedly that wage growth matters and the street will be scrutinizing the measure of hourly pay for production workers that the Fed monitors.  

And, of course, events on Thursday in Europe will be watched as the ECB meets.  Any decision to implement a "shock and awe" QE will be met with a global market rally.  But I wouldn't expect it.  Mario Draghi has his hands full politically with the Germans.

Have a great week!

The statements, opinions and projections made in this commentary are my own and do not represent the views of my broker/dealer.  Additionally, these commentaries are published as information only and are not published for the purpose of utilizing the information for short term trading or long term investing in stocks, bonds, ETFs, mutual funds,currencies, indexes, index or stock options, LEAPS, and stock or commodity futures.  Seek the personal, face to face guidance of a registered investment advisor before entering any trade or investment.  Anyone who trades or invests based on the information in this commentary does so at his/her own risk.  

Warning!  you can lose some or all of your principal investing in stocks, bonds, ETFs, mutual funds, currencies, indexes, index or stock options, LEAPS and stock or commodity futures!

Sunday, April 6, 2014

about my weekly commentaries

The purpose of this note is to let you all know that I will not be publishing any more weekly commentaries.  I've been afforded an exciting opportunity advising an established clientele at a major financial institution.  Part of my terms of association with them is that I will not publish or distribute any written or electronic information that may be construed as giving investment advice under their auspices on the direction of financial markets.  

I'm looking forward to having access to almost limitless resources in assisting investors in achieving their financial goals with one of the largest organizations in the financial world.  However, I will miss composing these weekly commentaries for an ever growing readership.  

I do appreciate everyone's support and kind words over the years and if you ever need a chart (without commentary) or "official" investment advice don't hesitate to contact me.  We specialize in retirement planning and have many vehicles to maximize portfolio performance through a vast array of financial products and professional money management intermediaries that will fit any investor's investment objectives and risk tolerance.

Saturday, March 29, 2014

Emerging Markets & Treasuries rally?

Stocks had another choppy week and most major indices finished lower.  The uptrend hasn't been violated and the "experts" are speaking of a sector rotation into cyclicals and there is some indication that that is occurring.  However there are also indications that this market is losing momentum and that we may be setting up for some type of corrective price action.  Determining the severity of such a correction is impossible, especially with an incredibly accommodative central bank supporting the market.  Additionally, traditional inter market relationships that have served as a compass to market direction have gone haywire due to a confluence of geopolitical and economic events.  I'll be outlining my concerns and attempting to read the market "tea leaves" in this commentary.

Here's a chart of the Wilshire 5000 which represents the total US stock market:

(click on chart for larger image)

US stocks are in a clear uptrend but the two panels above the chart reflect waning momentum and the Wilshire presently sits on a trend line established from the November 2012 lows.

 Small cap stocks were pummeled this week and finished a whopping 3.51% lower as measured by the Russell 2000.  Here's a daily chart of the Russell as of Friday's close:

(click on chart for larger image)

Notice the very bottom panel under the chart.  The Russell's price relative to the S&P 500 has fallen off a cliff!

As I had commented yesterday on Twitter, the Russell tends to overshoot to the upside and undershoot to the downside because of the volatile nature of small cap stocks.  However, as we look at sector ratio charts we can see a clear movement by investors into defensive issues.  Here's a daily ratio chart of the Utilities Select Sector SPDR (XLU) and the Materials Select Sector SPDR (XLB).  Utilities are seen as a safe haven as they are low "beta" (not volatile) and return higher dividends than the general market.  Additionally, they weather market corrections fairly well.  The Materials ETF is a bet on stronger economic fundamentals:

(click on chart for larger image)

Utilities have been outperforming Materials since the beginning of March as investors seem to be migrating away from economically sensitive stocks.  Here's another ratio chart of the Consumer Staples Select Sector SPDR (XLP) and the Consumer Discretionary Select Sector SPDR (XLY).  The thesis behind this ratio chart is that when economic activity picks up consumer discretionary stocks tend to outperform as the public simply has more money to spend for items other than what they need to subsist.  Conversely, when they are feeling pinched they stick to what they need (consumer staples).  We can also see here that consumer staples are outperforming their discretionary counterparts:

(click on chart for larger image)

Lastly, here's some evidence of the sector rotation that many on the street that they say explains the market choppiness of the past few months:

(click on chart for larger image)

This chart is a ratio of the Industrial Select Sector SPDR (XLI) and the S&P Biotech Index ETF (XBI).  The Biotech sector has been responsible for leading the entire market weakness over the past few weeks after their incredible run up over the past year.  Many on the street attributed "bubble like" qualities to the sector which engendered a wider discussion on the excess liquidity which continues to "float all boats" in this market.  Well, it would appear that some air is being let out of the Biotech bubble and that capital may be moving into Industrials.  The problem with the chart is that everyone is bailing out of the Biotech sector and if I substitute any of the other ETFs for XLI in the chart above I get the same result.  However, in comparing different economically sensitive sectors it does clearly show there is a movement into industrial stocks.  Here's the Select Sector Industrials SPDR ETF (XLI) and the Select Sector Consumer Discretionary SPDR (XLY) which I used in a comparison above:

(click on chart for larger image)

The chart clearly shows that there has been a steady movement into industrial stocks over the past year and that it has accelerated in the last month.

The take away from all this is that investors and traders are concerned about present valuations but not concerned enough to be "running for the hills".  Positioning in defensive sectors and economically sensitive sectors tend to be running in tandem.

Now, the bond market is telling us another story and it's interpretation is not kind to stocks.  Bonds are being stubborn at present levels and prices refuse to drop.  If the economy is truly gaining momentum we should be seeing a commensurate rise in interest rates across the yield curve.  Instead, interest rates dropped week over week on longer duration maturities as the short end gained because of Janet Yellen's pronouncements the week before last.  Trying to understand why longer duration bonds are rallying would require an explanation which would keep me typing all weekend and so I'll just posit some reasons why this is happening:

1. China is buying Treasuries in order to continue to devalue their Yuan
2. Geopolitical events are keeping a bid under Treasuries
3.  And this is an outlier, the Fed may be getting a new customer, the ECB (European Central Bank).  

I'll be discussing point number three in my analysis below but the primary thematic take away from the three points above is that mammoth disinflationary and deflationary forces still reign in the global economy.

Here's a daily chart of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) and we saw a significant short to intermediate term breakout this week on the chart which speaks to even lower interest rates going forward:

(click on chart for larger image)

TLT penetrated gap resistance this week and although it's performance was weak on Friday it did manage to decisively bounce off of gap support.

The bond market has traditionally been inversely correlated with stocks since 1997-1998.  Whenever it runs in the same direction with stocks there has to be a resolution and that resolution is normally resolved in bonds favor.  Remember, lower interest rates signal economic weakness and is not good for equities.

Commodities seem to be telling us a different story relating to the prospects for global economic growth.  Much has been made of the rally in the CRB Index (The Reuters/Jefferies Commodity Research Bureau Index).  I've dismissed this rally in the index as largely due to "one off" events in the agricultural commodity space because of weather or geopolitical issues which are disrupting supply and demand in certain key commodities such as wheat.  I've taken some "heat" for holding to my thesis but I still stand by it.  I will say this: if my thesis is wrong and we don't start to see a reasonable uptick in global economic activity in the spring then the specter of "stagflation" confronts us as central banks will finally have accomplished their mission of perpetuating "cost-push" inflation.  However, I will stand be my thesis and that is still that deflation remains the primary danger to the world economy.

Here's two charts; one of the CRB Index and right below it is the SPDR Gold Trust Shares (GLD):

(click on chart for larger image)

There was a potential Island Reversal pattern on the CRB chart but that has been reversed.  At the same time, I've been looking for Gold to start it's turn around to validate all these inflationary pressures everyone seems to be emphasizing.  So far, no cigar.

Industrial metals had a good week mainly because Copper recovered from multi year lows.  Here's a monthly chart of "Dr. Copper" which clearly shows it "has returned from the abyss":

(click on chart for larger image)

I don't want to minimize the incremental price pressures we have seen in the industrial commodity space.  Another notable mover has been nickel.  But even nickel has been rallying on supply/demand issues as Indonesia, a major nickel exporter, has placed export restrictions on the metal.  My point is that just because we're "coming back from the abyss" doesn't mean all is well.  As a predictor of global industrial activity, we need to start seeing some significant upside pressure in industrial commodities.  So far, this has not been the case.

All was not neutral to negative this week.  Emerging Markets came alive as things seemed to stabilize in China after it's major banks reported strong earnings.  The Shanghai Composite has stabilized above the 2000 level as rumors of additional government stimulus run rampant in the market:

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And the Chinese banks as a ratio to the broader Chinese stock market are making a comeback:

(click on chart for larger image)

The main concern in China has been the smattering of defaults that the Chinese government has recently started to allow in order to address "moral hazard".  Investors want to know who will be left holding the bag if/when their shadow banking system implodes and the banks have been primary candidates, in investors minds, to "hold the bag".  

The fact that copper stabilized this week and we're seeing strength in the Chinese banks is an indication that things in China are not liable to get out of control.  But you never know!  Chinese markets are not exactly transparent.

Nevertheless, with a seemingly stabilized situation in China the iShares MSCI Emerging Market ETF (EEM) exploded on Monday and never looked back:

(click on chart for larger image)

I circled the week's price action and although Friday's price action was a disappointment (a sickly candlestick) the ETF tore through the 50% Fibonacci resistance level and is now poised to assault the 61.8% level.  After Friday's price action I expect a bit of a pause here and some consolidation.

The move in EM this week is certainly a positive for our markets as there is a strong positive correlation between EM and US stocks.  They are either coincident to each other or one leads the other.  It appears that EM will now play "catch up" with US equities in the weeks and months ahead.  That assumes, of course, that we're not going to have the annual Spring "head fake" we've experienced since 2010.


All the market activity I've addressed above is symptomatic of confusion and indecisiveness in where the global economy is headed.  The consensus among many on Wall Street is that we are truly going to see our way out of this mess in 2014 and with that, the commensurate rise in interest rates will take place that will validate a stronger recovery.

No one is predicting a "gangbusters" year but the positioning into industrial stocks I've illustrated above cannot be denied.  Of course, the debate over market valuation in the face of extraordinary monetary stimulus continues to rage.  

In the meantime, leaders in the EU (European Union) have decided to admit and address the deflationary juggernaut they are facing instead of dismissing it as "internal devaluation".  This week French, Italian and Spanish inflation numbers came in below expectations (read deflation) as did German inflation numbers.  In addition, French consumer spending has deteriorated significantly.  Even the inflation fearing head of the Bundesbank, Jens Weidmann, has agreed to some sort of quantitative easing, if only in theory.

Of course, with all the regulatory strictures placed on the ECB due to a monetary without fiscal union, how QE gets accomplished has been the challenge since the dark days of 2008-2009.

Many are talking about establishing negative interest rates which supposedly would spur European Banks to lend.  The assumption is that banks would lend and that there would be lenders.  My position is that negative interest rates, besides distorting Money Markets, would drive liquidity from the EU as banks would simply move assets offshore to other banks that would give them a return on their capital.  What is needed is a way around their regulations in order to effectuate liquidity injections.  Marc Chandler of Brown Brothers Harriman has suggested what I call "the Swiss solution".  In 2010 as the Swiss started facing deflation from a stronger Swiss Franc, the Swiss central bank, unable to pump liquidity in the system by buying up their own debt (the market being too small) went out into the global debt markets and started buying foreign bonds.  Buying foreign bonds with Swiss Francs expanded their money supply thereby deflating the value of their currency and easing deflationary pressures.  The ECB could do the same as there appears to be no prohibitions to such purchases.  Whether the fickle Germans go along with this would be one question although they could not stop Draghi from these purchases if there are no restrictions on these type of purchases.

If the ECB were to pursue "the Swiss solution" who would be the main benefactor of their purchases?  The US Treasury market!  This would assist in driving rates lower, regardless of any counter forces that would push them higher.

My point in bringing all this up is that these deflationary pressures in one of the two largest developed consumer oriented global economies are the predominant danger to the world economic system.  And we are right behind the Europeans, regardless of what the "experts" say.  Here's the latest update on the Velocity of M2 Money Supply released by the St. Louis Federal Reserve:

(click on chart for larger image)

It is still clocking it's lowest readings since the Fed started tracking it in 1958.  How strong can an economic recovery be when the pace at which a dollar changes hands has been it's lowest on over five decades?

Here's another chart that measures the three components of inflation:

- the CPI (Consumer Price index)
- Compensation & Salaries
- Velocity of M2

(click on chart for larger image)
chart courtesy of
All three components are headed lower.

Here's another way to analyse the data.  This is called the "High Inflation Index" which tallies Year over Year CPI (Consumer Price Index), wage growth and M2 Money Velocity :

(click on chart for larger image)
chart courtesy of

So, what does all this have to do with stocks?  In an environment where the world's largest and most powerful central bank is starting to drain liquidity from the global monetary system, Europe is facing outright deflation and disinflationary pressures are mounting in the US.

As stated above, the debate has raged for years regarding the extent to which the Federal Reserve's extraordinary liquidity programs have effected equity markets.  And while there can be no denying that, in their efforts to spur a "wealth effect" there has been an artificial inflation to equity prices the question is, how much?  And how much of the current disinflationary pressures we are dealing with will exacerbate a downturn in the stock market when it occurs?  For occur it must!  The market never goes straight up or down.  And these five to six percent corrections hardly qualify as corrections.

In the meantime, we have an active economic calendar coming up next week culminating with the Monthly Employment report on Friday.  Everyone will be watching this report as an indication that the much awaited turn around in poor economic data as a result of the inclement weather in January and February was an aberration.  But to me, the ECB's announcement next Thursday may be more important.  If they are unwilling to aggressively address the deflationary spiral they are clearly caught up in then inevitably it won't matter over the long haul how well our economic stats are in this country.  We're all inter-connected and you can't have a healthy global economy with a major sector of that economy in the throes of deflation.  It can be likened to trying to swim with a thirty pound weight around your waist!

Have a great week!