Saturday, October 25, 2014

The Tension of Dichotomy

Amidst Ebola scares and concerns about global deflationary pressures stocks, which had looked like they were about to fall off a cliff in the traditionally volatile month of October, did an abrupt "about face" and had a huge reversal day on Wednesday, October 15th, and it now appears the rally is on. 

The fundamental impetus for the move was a statement from St. Louis Fed President Jim Bullard who publicly stated that if disinflationary pressures persisted in this country we could have more "QE" (quantitative easing). The PBoC (People's Bank of China) helped by injecting additional liquidity in their banking system.  Like a junkie who just had his fix, the market sprung forward in euphoria!

Seasonality is taking over and with economic news out of the Euro zone this past week that suggests that, for now, things aren't getting any worse over there, it looks like we're going to come out of October on a strong footing going into the seasonally strong months of November and December. A chart of the NYSE Composite which represents 1900 stocks traded on the NY Stock Exchange is representative of the turn in equities:

(click on chart for larger image)

The NYSE managed to close above neckline support turned resistance (red dashed line) on Friday which I consider to be a significant positive development for stocks generally.  If we look at the Wilshire 5000 Index which is a composite of all US equities the positive development is more apparent:

(click on chart for larger image)

We can see here that the Wilshire has decisively cleared a similar resistance area that coincides with a Fibonacci retracement level.

Technically, we can say that all indicators point to an assault on all time new highs for US stocks.  Of course, anything can happen, and in a world with geo political tensions, Ebola and whatever else pops up, volatility is liable to be with us into the strong seasonal months of November and December.  However, it is hard to ignore what the technicals are telling me. 

Treasuries remain elevated in this environment and this inter market anomaly remains cause for concern.  In a world flirting with deflation, interest rates are anchored and remain near historic lows; not a positive indication for global economic growth.  Here's a daily line chart of the Ten Year Treasury Note yield:

(click on chart for larger image)

The chart is instructive as it points out the post World War II lows in the Ten Year yield back in July, 2012 and the recent plunge in yield which started in late September (green circle).  We're coming back a bit from that plunge and October 15th was a huge reversal day for Treasuries as well as stocks so that could be the "flush out" that was needed for a sustained trend higher in interest rates.  But that is mere conjecture on my part as interest rate sensitive utilities which correlate well with bonds have been resilient throughout.  Here's a daily chart of the Dow Jones Utility Average that tracks the performance of 15 well known utility companies.  Utilities rise when traders/investors anticipate falling interest rates. That's because utilities are big borrowers and their profits are enhanced by lower interest costs. Conversely, utility prices tend to decline when investors expect rising interest rates. Because of this interest-rate sensitivity, the utility average is regarded by some as a leading indicator for the stock market as a whole.:

(click on chart for larger image)

Utilities have surged to all time new highs and on a price relative basis they have drastically outperformed the S&P 500 since late September.  Money continues to flow into the defensive sectors of this market as investors remain caught between a rock and a hard place.  Everyone wants to take the ride higher but in relatively safe sectors (utilities, healthcare and consumer staples). 

As I had outlined in my previous commentary, the distinction of a growing economic recovery in this country along with a European deflationary slowdown has created a tension in global financial markets which makes the idea of a healthy stock market problematic to many.  Even in the US with the positive earnings season we are having which is one of the main drivers of this recent rally, earnings continue to increase on declining revenues:

(click on chart for larger image)
Chart courtesy of Bespoke Investment Group

If stronger earnings are being driven largely by operating efficiencies,how healthy can the US and global economy be?  It's been my thesis for awhile that declining revenues are an indirect result of changing demographics in the developed world (US & Eurozone).  Welcome to the "new normal"!

And then we have oil!  The recent sell off has spurred both positive and negative arguments for economic growth.  On the one hand, consumers benefit significantly from a drop in gas prices as more discretionary income becomes available to them.  On the other hand, the oil and gas boom in this country will abruptly stop if oil drops below $80.00/barrel, as anyone who lives in Texas knows.  It's not profitable to take it out of the ground for prices below that mark.  Here's a monthly chart of West Texas intermediate Crude oil going back to mid 1996:

(click on chart for larger image)

We've penetrated a support line going back to mid 2010 while a larger trend line going back to 1999 (blue dashed) is intact.  Fracking technology and the boom have created an over supply and politically, it is said the Saudis are cutting production in order to punish those they see as their geo political opponents, particularly Russia.  This situation is having an unsettling effect in global markets not only for it's deflationary implications but because it is destabilizing nations like Russia and Venezuela who derive most of their wealth from oil production.  We here in Texas need to be especially concerned because we have weathered the global economic downturn since 2008 very well, largely due to the oil and NATGAS boom.  

Inevitably, the overriding concern I've outlined in many commentaries persists and it's origin lies in the Eurozone. With persistent deflationary pressures emanating out of Europe can there be a dichotomous global growth picture?  Can the US go it alone and grow while the rest of the globe continues in a disinflationary to deflationary low to no growth economic state?

Michael Gayed, in a recent piece here, has consistently argued that inter market relationships continue to warn us that this party cannot go on much longer without some sort of "flush out".  Michael is fond of using the TIP:TENZ ratio to measure investor expectations of future inflation/deflation which is posted below:

(click on chart for larger image)

This ratio measures the iShares Barclays TIP Bond Fund in relation to the PIMCO 7 to 15 Year US Treasury Index.  Investors buy TIPs (Treasury Inflation Protected Securities) when they are concerned about mounting inflationary pressures.  Conversely, regular Treasuries tend to rally in a lower inflationary environment when investors are concerned that economic growth is slowing.  Thus, the numerator (TIP) in the ratio drops when inflationary pressures are waning.

The ratio above plunged in the recent market slide in early to mid October only to recover above a support line established in August, 2011 when markets suffered a serious correction due to concerns over the US credit rating and especially the fear that the Eurozone was set to implode.  

I prefer to use the TIP:IEF (iShares Barclays TIP Bond Fund: iShares Barclays 7 to 10 Yr Treasury Bond Fund)  ratio because it has a longer track record but the theory behind using the chart is the same as Michael's:

(click on chart for larger image)

This ratio continues to drop.

In a brief email interaction I had with Mike in response to his article I cited above I wrote on October 19th:

I believe it can get worse.  I believe in inter market correlations (both inverse and positive).  I don't believe TIP/TENZ can break support without ultimately causing a sell off in equities.  But as I tried to articulate in our interaction on Twitter, as soon as the junkie (the market) gets a whiff of positive central bank news, risk assets turn around on a dime and go higher.  

There's an obvious breaking point in all this.

The other end of the equation is the balance between an obvious yet tepid recovery in US and an EU looking more and more like its going into a deflationary spiral.  Japan is already there.  I ignore China because it is simply the "tail the dog wags".

Can the US go it alone and prosper (relatively) while EU and Japan wallow?  I say no but stranger things have happened and even the brightest among us do not have a definitive answer until after the fact.

As long as the market continues to get it's "fix" and think central banks "have it's back" then investors will focus on earnings and the earnings so far this quarter are beating street estimates (never mind that this is a big game in and of itself).  And that's why I think we could see a year end rally.

As long as central banks prolong the global economy taking its medicine they forestall the inevitable.  The Central Bank experiment to buy time has about run it's course.  Some day soon even "Fed speak" will not move these markets.  And then watch out ...



Have a great week!


The statements, opinions and projections made in this writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is 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. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  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!






Wednesday, October 15, 2014

Capitulation selling day?

I don't normally send these out during the week but a few folks have been asking me about market crashes or whether this is the correction, etc. Well, it is a correction but we had an interesting day today as seen on the daily chart of the S&P 500 below:


(click on chart for larger image)

We had huge volume on a day where the S&P sold off, bounced off significant support and formed a near perfect reversal candlestick.

At the same time, small cap stocks, which have led this market higher and lower over the past few years, had their second "up" day and that, in the face of a market wide sell off.

These "telltale" signs tell me we've hit at least a short term to intermediate term bottom.  Don't misunderstand, Treasuries are definitely telling us the global economy is sick with deflationary pressures gaining momentum, but at least, for now, we may get a meaningful break from the selling.

I'll have more in my bi weekly commentary next week.


The statements, opinions and projections made in this writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is 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. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  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, October 11, 2014

Liquidity traps revisited

Anyone who has followed my writings in the past four years knows I have expressed the same macro concerns regarding the unprecedented efforts of global central banks to reflate a world that lost over thirty four trillion in wealth during the 2008 - 2009 stock market crash.  Many folks believe that this interference was unwarranted; that the market should have been allowed to sort it out for itself.  I've taken the opposite position: that doing nothing when Lehman imploded in September 2008 was to invite a depression that would have made the Great Depression look like a picnic.  I have written about this here . Nevertheless, I have given due credence to the thesis that excessive monetary stimulus would create its own distortions and that it was merely a band aid covering a deep gaping wound the global economy had suffered.  I have written about this extensively here and here.


My greatest concern is the inability of central banks to turn off the money spigots without inviting the kind of economic downturn that they made unprecedented efforts to avoid over the past six years and the commodity charts illustrate this ebb and flow battle against deflation in a clear way:


(click on chart for larger image)

The above chart is a daily chart of the Dow Jones UBS Industrial Commodities Index ($DJAIN) with the S&P 500 (green line) super imposed on it and the history of the Federal Reserve's QE programs.  Many regular readers have seen this before but I post the chart because I consider it an excellent illustration of the central bank battle against deflation.

With the Fed winding down QE3 and threatening to raise short term interest rates next year, markets are starting to factor in the impact of Fed policy in a world that otherwise seems to be losing the battle against the deflationary juggernaut.  

For sure, the release of the latest FOMC minutes on Wednesday sparked an impressive "short covering" rally on that afternoon which eased the US Dollar's inexorable rise (another deflationary indicator).  However, the market promptly did an "about face" on Thursday, erasing any gains and by the end of the trading week the Dow Jones industrial Average registered a net loss for 2014!  This five day 60 minute chart of the S&P 500 below shows the "whipsaw" the market experienced this week:


(click on chart for larger image)

The market initially loved what the Fed had to say in their September meeting.  From the Fed minutes:   

"During participants’ discussion of prospects for economic activity abroad, they commented on a number of uncertainties and risks attending the outlook. Over the inter meeting period, the foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants ex-pressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector. Several participants added that slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal."

Market perceptions that the central bank was "talking down" the Dollar and an actual statement that reflected that the Fed was considering the economy outside the usual parameters of the US excited market participants that the inevitable increase in short term interest rates might be delayed.  However, persistently bad data out of the Euro zone all week and some tepid data out of the US sobered up the market and the slide continued on Thursday and Friday.  The fact that we continued to sell on Friday was especially concerning to me because I expected a flat day as my indicators were signalling that the selling momentum was waning.

I was asked a number of times this week, "Where are we going from here?".  I appreciate the confidence others have in me to predict where these markets are going but sometimes my crystal ball doesn't work the way I like.  Nevertheless, I'm going to post some charts that will be helpful in determining broad market direction so my readers can make their own decision on what to do.  

What we can't ignore any longer is what I have dubbed "the deflationary juggernaut" that is attempting to strangle the world's economy.  To that end, we must focus on Europe where deflationary pressures are most apparent and appear to be mounting.  The following chart is a ratio chart that I "stole" from Michael Gayed of Pension Partners in New York City.  Michael is a student of inter market analysis as I am and he has much insight into the direction of global markets:


(click on chart for larger image)

The chart is a ratio chart of the Spain iShares ETF to the Germany iShares ETF.  The thesis behind the ratio to use Michael's words;

 " As a reminder, a rising price ratio means the numerator/EWP is outperforming (up more/down less) the denominator/EWG. Note that the ratio appears to be stalling out, and may be due for a reversal given concerns about on-going weakness across the Eurozone and an ineffective European Central Bank at juicing reflation.  I suspect that if this ratio begins to break down, a very meaningful signal on the market's expectations for deflation may result which in turn could quite negatively impact high beta stocks and cause heightened stock market volatility, which Treasuries tend to do well in. All along, the deflation pulse never left the system, and equities massively not only desynced from that reality, but also caused many false positives as to when to get aggressive or defensive based on historical cause and effect. With the end of Quantitative Easing in the US, and doubts about reflation in Europe, that may be about to change."  

The whole article can be found here.

While I respectfully disagree with Michael that the ratio is stalling I do agree that the ratio is a very helpful indicator in measuring the EU's battle with deflation and that it must be watched closely.  

I have been of the mounting conviction that Europe's battle with deflation is the key to the direction of the global economy and financial markets.  As a major consuming geo-political bloc its economic health is pivotal to recovery expectations in the US.  We're no longer an island.  We need Europe to consume or we hurt and Emerging Markets hurt even more.

Another chart that must be watched is the five year break even inflation rate in this country:


(click on chart for larger image)

Posted by the St. Louis Fed and updated regularly the chart measures the break even inflation rate between 5-Year Treasury Note and the 5-Year Treasury Inflation Protected Note (TIP).  It's a measure of market participants inflation expectations over the next five years.

The fact that the break even inflation rate is dropping is a warning not only of disinflationary forces gaining momentum in our country but a reinforcement that we cannot "go it alone"; we need Europe to participate in a global economic expansion.

Some would argue that the next chart is all we need in order to understand where inflation/deflation is heading:


(click on chart for larger image)

"King Dollar" has been on a rallying rampage since early July and had the wind knocked out of it's sails this week although the reasons were not readily apparent.  The selling started on Monday and appeared to be technically motivated as there was no fundamental reason for the move.  Wednesday's release of the FOMC minutes seemed to coincide with a selling climax for the Dollar as it bounced going into Friday.  It makes you think, "maybe someone had access to the FOMC minutes before Wednesday?"  :-)

In any case, the Dollars recent strength speaks of gaining deflationary momentum.  As the world's reserve currency, dollar strength depreciates commodity prices because you don't need as many dollars to buy the commodity.  This is also contributing to the slide in crude oil:

(click on chart for larger image)

While the sell off in crude oil has much to do with lack of global demand it also has as much to do with supply as Marc Chandler, chief currency strategist at Brown Brothers, Harriman explains here.  In a world clamoring to reflate, technological advances in "fracking" are also weighing on oil prices.  This, in turn, is fragmenting OPEC (Organization of Petroleum Exporting Countries)  in their efforts to maintain the price of crude.  When prices drop this fast and hard it's "every man for himself" in OPEC!

But let's look for some useful ratios that may be predictive market direction:


(click on chart for larger image)

Above is a ratio chart of the Consumer Staples Select Sector ETF (XLP) to the S&P 500.  The CBOE Volatility index is super imposed behind it.  Traders and investors will flee to consumer staples in a volatile market as these stocks are recession proof.  They represent the things we all need on a daily basis regardless of whether we have jobs or the economy is tanking.  It is clear from the chart that money is fleeing into this relative "safe haven".    However, if we look at the Consumer Discretionary Select Sector ETF (XLY) ratio to the S&P 500 we see a slightly different picture:

(click on chart for larger image)

We can see that Consumer Discretionary stocks have weakened in 2014.  These are stocks of companies that sell non essential products like autos, apparel, retailers and media companies. The relative weakness on the chart above seemed to be predictive of the present volatility.

Another indication of where the market is going can be found in the Utilities Select Sector ETF (XLU) to the S&P 500:

(click on chart for larger image)

Utilities are another defensive market sector that benefits from higher market volatility.  Market participants will flee into higher dividend paying stocks which also benefit when interest rates drop.  In the chart above, Utilities had been weakening in anticipation of higher interest rates but have suddenly spiked along with volatility.

Finally, here's a two year daily chart of the Russell 2000 Small Cap Index.  The Russell was the "star" of the 2013 bull run and just as it led the market higher then it is leading the market lower now:

(click on chart for larger image)

The Russell is sporting a double top and recently broke neckline support.

Market participants are "running for cover".  In the back of every one's mind is the searing memory of 2008-2009 and the ever present concern that we could be facing another nasty downturn.

ANALYSIS

It's becoming more apparent to me that the market's reaction is predictive of a coming recession.  The fact that, even after the Fed's most recent statement acknowledging global weakness and the possibility of delaying any interest rate increases, the market is factoring slower growth.  The fact that we have not had a "technical " recession since 2009 also comes into play because cyclically, we're overdue.

Central bank manipulations have bought as much time as they can.  With the Fed stopping their buying spree this month you would think there would be upward pressure on interest rates.  Instead, the supply that is available in the Treasury market is being gobbled up in a 'flight to safety" trade.  This is apparent when looking at any chart of the Treasury market  Here's a weekly chart the iShares Barcleys Seven to Ten Year Treasury ETF (IEF):


(click on chart for larger image)

IEF is approaching it's all time highs set in 2013.  This movement into Treasuries is hardly speaking to the strength of the global economy.

As money flows back into the safest and most liquid debt on earth, interest rates drop and the Dollar strengthens as our economy is relatively by far, the strongest on the planet.  This, in turn, literally sucks money out of those areas around the globe deemed as more speculative; the developing world.  Here's a weekly chart of the iShare MSCI Emerging Markets ETF (EEM) reflecting the nose dive emerging markets have undergone over the past five weeks:

(click on chart for larger image)

Interestingly, certain sectors of EM are holding up rather well (so far).  For my Filipino readers here's a daily chart of the iShares MSCI Phillipines Investable Market Index:

(click on chart for larger image)

So far so good, but momentum is waning (see MACD in bottom panel).  And Emerging Market bonds are holding up relatively well so far but their price relative to US Treasuries (black solid line superimposed on the chart) is swooning (not a good sign):


(click on chart for larger image)

Most relevant to this entire discourse is the future direction central banks will take to stop insidious deflation.  Already the European Central Bank (ECB) and the Bank of Japan (BoJ) are in various stages of monetary easing although the ECB is hamstrung because of EU political strictures.  Japan's QE actually dwarfs our QE proportionally.  At the same time the Fed is trying to normalize monetary policy but market price action is implying that they are flirting with the prospect of, at the least, recession, and at most, deflationary depression.  The proof of my radical thesis has been presented in the charts above.  

It appears that the classic "liquidity trap" that opponents of Fed policy warned us about when Bernanke and company implemented QE may be upon us.  The experiment to "buy time"  has ended.  All efforts so far to force feed growth thru monetary stimulus have not had the desired effect.  It may be time to take our medicine unless ...

... the Fed changes their forward guidance concerning interest rates.  But to do so implies that we are caught in "a liquidity trap".  After pumping unprecedented liquidity into our banking system which has overflowed into global risk assets, interest rates are so low that they can go no lower.  The analogy of "pushing on a string comes to mind".  The implication was not lost on Gold and is perhaps the implicit reason why Gold popped on Wednesday after the FOMC minutes were released:


(click on chart for larger image)

Indeed, the message of gold may be prescient if my thesis is correct.  Either way, it seems the Fed is caught between "a rock and a hard place".

I sincerely hope my thesis is wrong.

Have a great week!



The statements, opinions and projections made in this writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is 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. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  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, September 27, 2014

Of bubbles & deflation

Stocks had a rough week with most of the major averages closing down 1% + and small caps especially taking it on the chin with the Russell 2000 closing the week down 2.41%.

Thursday was a very heavy selling day with rumors abounding that there was significant hedge fund liquidation and even a rumor that the Swiss National Bank was behind the move as they were supposedly re-balancing their huge equity portfolio out of US and into European stocks.

Regardless of whatever reasons for the swoon, stocks were ripe for some kind of pull back and there is nothing yet reflected in the short term technical picture that speak to none other than a "garden variety" correction.  Here's the latest chart on the S&P 500:


(click on chart for larger image)

The S&P briefly traded below it's 50 day moving average on Thursday (blue line) only to bounce back above it on Friday.  The longer uptrend line established from July, 2013 is still intact (blue dashed line).  A drop below the 1950 area would signal further weakness to a target of 1910 - 1900 area.  

However, momentum is beginning to meaningfully diverge from price as reflected in the Relative Strength Indicator (RSI) in the top panel and the KST Indicator (3rd panel above chart).

I laugh when I read the headlines every time the market drops:  "Stocks drop on geopolitical tensions" or "global sell off sparked by US air strikes in Syria".  I feel bad for those folks that have to conjure up some reason every day why stocks swoon or even rally just to make a headline.  For the record, the market could care less about ISIS, Syria, Iraq or even Ukraine.  There is but one issue that this market is obsessed and concerned about:  Fed policy and how it's going to impact the bond market.  Because the bond market will determine the direction of global stock markets, PERIOD!

Former Fed chairman Alan Greenspan admitted that you can never identify a bubble until after it bursts and I'm not a "bubble" proponent regarding the way things are shaping up in financial markets.  And the main reason why is a simple one based on a "reversion to the mean" thesis.  Simply, we had our Armageddon moment in 2008 after a dot.com crash eight years before.  How many times has that happened in History?  

I can present charts that support my thesis that the events of 2008 were singular events, the likes of which financial markets had not experienced since 1929.  Nevertheless, there are obvious distortions in global markets caused by massive central bank intervention that must be adjusted and the market knows this. 

Underneath these distortions still lies virulent deflationary pressures which are still prevalent and is reflected in the price of gold, the Dollar, and other indicators which I will be showing below.

But first, here's some of the distortions:


(click on chart for larger image)

This is a weekly performance chart of the Nasdaq Composite going back to before 1995 (blue line) with the NYSE Biotechnology Index ($BTK) super imposed on the chart (red area).  Are biotechnology stocks in a bubble?  Maybe.  What would be the impact on the general market were this trade to unwind?  Not good.

(click on chart for larger image)
Chart courtesy of STREETTALKLIVE.COM
@LanceRoberts 

The chart above captures the S&P 500 at all time highs, margin debt (borrowing money from your broker to buy stocks for leverage and speculation) at all time highs and Junk Bond yields at all time lows.  This is an ongoing and obvious result of the massive infusion of liquidity that central banks, particularly our Federal Reserve and now the Bank of Japan (BoJ), have fed into the system to avoid the deflationary spiral that we were facing in 2008.

As I've written many times over the past few years, central banks have been on a mission to "paper over" the gargantuan deflationary impact of the loss of 34.4 trillion of wealth globally by March 2009.  The strategy has been predicated on "buying time" for the global economy to heal in the hopes that fundamental economic traction can take hold and that we could grow our way out of this mess.  But deflationary forces, while masked, have not been able to be contained as we are seeing in the Euro zone and even here in the US.  The recent strength in the US Dollar and the Dollar's inverse relationship to gold has parallels, however obtusely, with events in the 1930's when "cash was king". 


Gold's recent sell off must be seriously considered as a signal that something may be awry in global financial markets:

(click on chart for larger image)

It's easy to dismiss the sell off in gold to the easing of global fears regarding the status of fiat currencies or that gold is telling us that recent geopolitical tensions are not serious (a correct interpretation of the metal's price behavior) but if we can't maintain present levels in the yellow metal I would suggest to my readers something much more sinister is going on under the surface of the global economy.  Here's a weekly chart of gold with some important levels to watch:

(click on chart for larger image)

Here's another indicator that deflationary forces are gaining momentum in the global economy:

(click on chart for larger image)

This is a ratio chart of the iShares Barclays TIP Bond Fund (TIP) and the iShares Barclays Seven to Ten Year Bond Fund (IEF).  TIPs are Treasury Inflation Protected securities investors buy when they believe inflationary pressures are building.  As inflation builds (as measured by the Consumer price index-CPI) TIPS appreciate accordingly.  And when inflationary expectations wane TIPs lose their value.  The chart pits the price performance of TIPS against regular Treasury Notes with maturities of seven to ten years.  If the ratio is dropping (which it is) the bond market is telling us that there is lessening demand for TIPs and disinflationary forces are gaining momentum.  The green line is the S&P 500.

I've posted this chart many times over the years but my immediate concern is that the ratio has actually pierced a Fibonacci support line, breaking a pattern which has been prevalent since July 2013 where the ratio had been in a "Fibonacci Channel" .  The bond market is telling us that disinflationary pressures are mounting. 

When does disinflation become deflation? It depends on who you want to believe.  I watch the PCE (Personal Consumption Expenditure) Price Deflator which will be released again on Monday, 9/29.  Both the Core and and regular deflator are expected to drop 0.1 from the previous months readings.  While the indicator is not warning of outright deflation it is saying that disinflationary forces dominate and that the deflator is below the Fed's target for inflation growth.

Most are dismissing these deflationary signs as the result of a stronger dollar.  And I cannot deny that their thesis is tenable.  But the question must be asked, why is the dollar manifesting such strength?  There is slow to no growth in the Euro zone.  Japan, in an effort to "kick start" an economy that has been in a deflationary malaise for over two decades, has launched a money printing campaign that proportionally dwarfs any monetary stimulus that the Fed has implemented.  In a world of low to no growth, investors flee foreign credit markets to "park" their money in Uncle Sam's debt, willing to potentially tie up their money for ten years with a coupon rate under 3%.

On top of all this, the Fed has just about unwound it's direct monetary stimulus with attendant talk of inevitable short term interest rate increases.  

The Junk Bond market is already reacting to the Fed's change in policy as yields had become inordinately low as an indirect result of Fed policy:


(click on chart for larger image)

Above is a daily chart of the SPDR Barclay High Yielding Bond Fund (JNK). What market participants should be hoping for is a continuation of the decline.  Better that the market starts unwinding these distortions piecemeal because if it happens all at once, that's when fear and blood "run in the streets".

The situation with junk bonds I explained above is "part and parcel" of the market's concern.  How will the rest of the yield curve react to a back up in short term interest rates?  Will it spark a sell off across the yield curve?  And in an environment where it seems as though there's no place else globally to hide will investors attempt to exit in unison?  The reverberation in US stocks would be immediate and severe to a sharp, fast back up in interest rates.  

The message of gold, bonds and the dollar says my concerns are warranted and my thesis is credible.  Hopefully, the market can adjust ahead of the first rate increase which most "on the Street" expect in the second quarter of 2015.

That's it for this commentary.  The situation as it unfolds will be interesting to watch.  Advice to me readers: don't watch stocks; watch the bond market.  It is the "dog that wags the tail (stocks)."

Have a great week!



The statements, opinions and projections made in this writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is 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. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  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, 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)


Analysis

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 dot.com 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 writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is 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. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  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!