Saturday, November 22, 2014

Glimmers of reflation?

Equities continue to defy gravity as central bank largess continues and global economic data remains neutral to negative.  An announcement Thursday evening by the PBoC (People's Bank of China) that they were lowering their benchmark interest rats sent the S&P E minis spiking overnight and provided another gap in he cash chart for the S&P 500 and all the major averages on Friday.  Although buying pressure waned throughout the day the S&P came back sufficiently in the last hour of trading and this type of price action can only be classified as bullish.  Here's a one minute chart of the S&P 500 ETF (SPY) that encompasses Thursday and Friday's price action:

(click on chart for larger image)

I had concerns that the market could not hold onto the gains at the outset of the day but in the last hour the "smart money" came in to position themselves for the coming week.

The bullish tenor of this market cannot be denied and there are even signs that small caps may be stirring with the Russell 2000, which has been flat all year, may be ready for a break out to the upside.  Here's a daily chart of the Russell 2000 since the beginning of 2014.  We had a double top in the early part of the year and it is self evident from the chart that small caps have experienced significant volatility this year:

(click on chart for larger image)

I've identified a possible inverse head and shoulders formation on the chart which could be predictive of a break out to the upside if the right shoulder comes to fruition.  Although I've identified this formation on the chart I personally don't have much confidence in "head and shoulders" formations after the past five years since the pattern has often signaled a false break out.  But I post it nonetheless because if we're going to move meaningfully higher in equities in 2015 then small caps are going to have to participate.  They have led this market higher in the last few years and they're characteristics as high beta (riskier) stocks and indications of a healthy economy necessitate their participation in any market up trends.

As I look at market internals I get the sense that although this market is tired we will continue to move higher into the New Year.  Net new highs on the S&P 500 don't impress me but at the same time there's no cause for concern:

(click on chart for larger image)


Yesterday's price action I outlined above was, for me, a significant indication that there's still enough buying pressure in this market to insure a rally well into 2015, possibly into February when we've experienced some weakness every year for the past few years.

I do think Treasuries are signaling that we're going to seeing some significant moves in the financial markets in the coming months.  Below is a 60 minute chart of the Ten Year Treasury yield for the past two months:

(click on chart for larger image)

The pink shaded area are Bollinger Bands which is a chart overlay that shows the upper and lower limits of 'normal' price movements based on the Standard Deviation of prices.  The fact that they have narrowed this much normally is predictive of a significant move in either direction.  Which way that direction is will have implications for stocks going forward.  However, inter market correlations seem to be changing and it's not readily predictable that a spike lower in interest rates would create a sell off in equities as it normally has in the past.  

In a world where central bank accommodation has the planet awash in liquidity, sovereign interest rates are anchored on the short end of the yield curve by fixed government rates and the long end continues to be suppressed by the same liquidity and buying pressure.  Significantly, the threat of deflation has been the main fundamental of this monetary phenomenon and will continue to be until we see signs of global growth, especially out of the Euro zone.

The US Dollar seems to be continuing its inexorable rise as it broke out to new multi year highs on Friday which is part of the reason why equities reacted in the cash session that day:

(click on chart for larger image)

A stronger dollar aggravates deflationary pressures in commodity prices as the world's reserve currency strengthens.  But the Dollar is also telling the story of a recovering US economy while Europe and Japan remain mired in flat deflationary economic conditions.  And so, the inverse correlation we have often experienced between a stronger US Dollar and US equities has now been significantly mitigated.

Surprisingly, we've been seeing some buying pressure in Gold over the past three weeks  which also has seemed to give the weakened commodity complex some juice:

(click on chart for larger image)

The chart above is a weekly chart and I like the weekly candlesticks with the long wicks on the bottom of each for the past three weeks (red arrow).  This may be signifying a bottom in the yellow metal but it's still too early to tell.  Sentiment has finally started to get ugly for gold which is a good contrarian indicator that the "blood bath" in the precious metal might finally be abating.  But the chart tells me it's still too early to be dogmatic of a turn higher.  

It's important to watch gold in the current global economic situation we find ourselves.  Higher gold prices will be predictive that the global economy is starting to win the battle with deflation.  It will mean Europe is turning around, and as stated in my last commentary, as Europe goes so will the global economy and financial markets in 2015.

As stated above, the jump in Gold has also seemed to drag along the commodities complex.  Below is a daily chart of the Reuters/Jefferies Commodity Research Bureau Index (CRB) and the index has broken out of a multi month downtrend on the daily chart:

(click on chart for larger image)

Are we starting to see glimmers of inflation?  It's still too early to tell but let's hope so!

Finally, I had some concerns on the divergence between the junk bond market and stocks that had developed in recent weeks.  Much of the problem stemmed from the fact that the market was starting to predict that smaller, highly leveraged players in the oil/natgas industry were going to start having problems meeting their financial obligations as oil descended under $80.00/barrel.  However, with some recent buy outs by some of the bigger names in the industry the market seems to have stabilized a bit as seen below on a daily chart of the SPDR Barclays High Yield Bond ETF (JNK):

(click on chart for larger image)

The chart displays a classic reversal pattern.  The high yield market is strongly and positively correlated to equities and the anticipated recovery in this market is bullish for equities.

Regular readers will notice I've stayed away from any fundamental analysis in this commentary.  The reason is that there's simply a lot of "noise" in the financial press on the direction of the global economy.  I outlined the challenges in my previous commentary two weeks ago and nothing has really changed.  Sometimes the best thing to do is let the market speak to you thru the charts and that's what I've done in this commentary.


Have a great week and Happy Thanksgiving!


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 or my broker/dealer 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, November 8, 2014

Global Economy at a Crossroads

Stocks managed to squeeze out new all time highs on Friday afternoon after the S&P bounced between gains and losses for the entire day.  A one minute chart of the S&P illustrates the nature of the indecisive price action.  The horizontal blue dashed line delineates the day's trading activity:


(click on chart for larger image)

The market seemed to be held captive to a seemingly weaker than expected monthly employment report although the report was not, to me, any weaker or stronger than any other monthly report we have seen in the last year.  Employment continues to grow five years after the Great Recession with the same challenges we face in terms of weakness in hourly earnings and wage growth.

I interpret the surge into the close as a short term bullish indicator as the price action is indicative of the "smart money" taking positions in preparation for next week.  Moreover,that traders were willing to take positions over the weekend is a sign of confidence and probably complacency among market participants.

A long term divergence is manifesting itself on the weekly charts that folks should be cognizant of.  Below is a weekly chart of the S&P 500:

(click on chart for larger image)

While the S&P continues its march higher, momentum has significantly diverged (top panel) from the price action.  While these divergences can persist for long periods of time while the market moves higher it is important to note the divergence because it is usually predictive of some type of corrective action.

There are sector divergences that have me puzzled since other fundamentals would suggest that these sectors should be strengthening.  For instance, the Consumer Discretionary Select Sector SPDR ETF (XLY) has been weakening all year and while the descent relative to the S&P 500 ETF (SPY) has moderated it is still in decline.  The chart below is a daily chart of the Consumer Discretionary Select Sector SPDR ETF (XLY) and the relative price action relative to the S&P 500 ETF (SPY) is in the panel below:

(click on chart for larger image)

With the price of gas as low as it has been for years one would think we would see strengthening in this area.  

Also of note is the price action of Utilities, a defensive sector of the market, which has been outperforming the S&P on a relative basis for weeks:

(click on chart for larger image)

The bottom panel shows the price relative to the S&P and I circled the week's price action on the chart.  Of note technically was the price action on Wednesday and Thursday where the utilities swung wildly and while the two candlesticks on the chart in the green circle I outlined cannot be classified technically as a bearish engulfing pattern, it is close.  Bearish engulfing patterns are predictive of a turn to the downside.  

Still, it's hard to argue against the position that the trend in equities is higher.  With seasonal factors in the market's favor and earnings season being a good one, I'd still have to side with those expecting a surge in equities going into the Christmas season.  However, 2015 may be a different story.

As Treasuries continue to stay levitated while equities rally higher it seems investors are trying to position themselves on both sides of the fence.  And I suspect for good reason.

While the economic recovery from the Great Recession continues to gain momentum in this country it is evident to all but the most uninformed that the rest of the world wallows in flat to no growth conditions.  Indeed, as the European Union continues to teeter on recession and Emerging Markets are held captive to the consuming countries in the west, the US is the only shining economic light on the planet.

The rest of this post will dissect the title of this commentary.  And I'll state my thesis up front:  fundamentally speaking, Europe is the key to the direction of financial markets while the Dollar will serve as the technical catalyst for that direction.

The Europeans have been "hamstrung" by the unique relationships they have in that union.  Those relationships can be summarized as "monetary union without fiscal union" and so as everyone shares the same currency they all go their own way as separate political and fiscal entities.  

The Germans, who have been essentially the glue (aka money) that keeps that union together, are loathe to support their southern neighbor's profligate ways.  This, in turn, has prevented the European Central bank (ECB) from implementing the kind of monetary accommodation that the US and Japan have implemented in the attempt to turn their economies away from the deflationary pressures wrought by the loss of 34 trillion in global wealth in the 2008 - 2009 downturn.

Mario Draghi, President of the ECB, keeps on promising more stimulus but unless the Germans acquiesce and allow the ECB to buy sovereign debt (country specific sovereign bonds comparable to US Treasuries) the effects of any other stimulus they have attempted since 2010 has had diminishing effects.  There has been some talk that as recessionary conditions start to spread to the core EU countries (Germany, Netherlands, France, Finland) that Germany may give in and allow such purchases.  Don't hold your breath!  Germans still suffer the scars of the Weimar hyperinflation of 1922-1923 and are not likely to agree to any policy they see as potentially inflationary, like a US style QE.  But this is precisely what is needed to remedy the situation in the EU.

There are some signs that the deflationary pressures may be relaxing.  Money supply there is incrementally improving:

(click on chart for larger image)

And private loan demand is also marginally improving although still negative:

(click on chart for larger image)

Clearly, these glimmers are not enough for me to "hang my hat" on a European recovery.  Others on the street agree with me.  Scott Minerd, Chairman of Investments and Global Chief Investment Officer for Guggenheim Partners believes the Europeans and particularly the ECB must act now to prevent their slowdown and growing deflationary pressures from taking over and dragging the rest of the global economy along with it.

The strength of the US Dollar has been the result of the weakening picture in the EU and is exacerbating the deflationary pressures we are seeing in commodities and particularly gold and oil.  As the Euro, as the result of in some cases negative real interest rates on the European continent, continues to drop, the Dollar index, made up of a basket of currencies of which the Euro is 57%, continues to rally.  As the world's reserve currency, a strengthening Dollar necessarily equates to a depreciation of all other currencies making everything more expensive in those currencies.  This, in turn, only serves to aggravate any economic slowdown in those economies.

For now, the US Dollar seems as though it might have reached a temporary plateau:

(click on chart for larger image)

As seen above, USD is meeting some significant resistance and Friday's price action in the Dollar could be taken as just a rest in response to market perceptions that the monthly employment report was not up to par or it could be interpreted as the beginning of a corrective phase in the Dollar.  I'm going to opt for the latter because I don't believe these markets move that much anymore on these monthly employment reports.  

Fundamentally, the Dollar might be meeting resistance because the US trade deficit, if broken down to petroleum and non petroleum trade deficit, has diverged significantly:

(click on chart for larger image)

Big trade deficits are antithetical to a strong currency.  If this is impacting USD and the Dollar goes into corrective mode it will be supportive of global stock markets.  However, with everyone on a crusade to debase their currencies in order to ignite growth, the US is still the best looking house in the slum and any slowdown in the appreciation of the Dollar will probably be short-lived.

Japan, which announced another mammoth liquidity injection in their economy a week from this past Friday, also adds fuel to Dollar appreciation.  Bank of Japan (BoJ) is going all out to break the hold deflation has had on their economy for over two decades and is flirting with monetary accommodation many see as reckless:

(click on chart for larger image) 

The chart above shows the comparison between the Fed's QE program with projections into 2015 along with BoJ's stimulus.  How can the Dollar not continue to rally in the face of Japanese currency debasement and European inability to stem the deflationary tide seemingly overtaking them?

A stronger Dollar equates into profit margin pressure in US multi national corporations as their products become more expensive overseas in markets with deteriorating global growth.

And what of Emerging Markets?  Many on the street are touting their value in this sluggish global environment.  Not me!  The argument that says that as the Fed attempts to normalize monetary policy by raising short term rates, there will not be a commensurate global shift of assets from the more speculative emerging market complex to the safer haven of the safety of Uncle Sam's debt is misguided.  While it is true that some Asian nations have strong external balances and may be able to fare better than they did in 1997 when the Asian Currency crisis crushed emerging markets, to invest in emerging markets in the face of a strengthening US dollar is a fool's game!  The chart below is a weekly chart of the WisdomTree Dreyfus Emerging Markets Currency ETF (CEW).  This ETF measures the performance of a basket of Emerging Market currencies relative to the Dollar:

(click on chart for larger image)

As can be seen, CEW has been posting a succession of lower highs and is now sitting on major support.  A breakdown under this support is in direct contra distinction to the US Dollar chart I posted above and I would submit to my readers that such a breakdown in CEW and a break out in USD will spell an ugly start to 2015 for global equities.

The iShares Emerging Markets ETF (EEM) is already starting to discount the coming weakness in emerging markets due to a strengthening Dollar.  The chart below is a daily chart of EEM with the S&P500 ETF (SPY) superimposed on it (solid black line) as well as a price relative comparison in the top panel:

(click on chart for larger image) 

In the near term, the massive Japanese stimulus measures announced about a week ago should continue to buoy US equities in the near term and that's why I'm comfortable with predicting a continued rally into year end.  However, there are enough technical divergences and fundamental problems that must be resolved that the new year may auger renewed weakness in global financial markets.  

Make no mistake, Europe is the key to 2015.  Unless, the ECB is given free reign to truly stimulate their currency bloc then we must hope that the few glimmers of economic growth I posted above will evolve into a full blown recovery for the EU.  Absent these two scenarios, a strengthening Dollar will strangle global economic growth to the detriment of everyone, including us in this country.

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 or my broker/dealer 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 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:


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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:


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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:


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"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:

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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:


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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:

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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:

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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:

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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):


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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:

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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:

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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):


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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:


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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

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