Sunday, April 6, 2014

about my weekly commentaries

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

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

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

Saturday, March 29, 2014

Emerging Markets & Treasuries rally?

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

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

(click on chart for larger image)

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

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

(click on chart for larger image)

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

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

(click on chart for larger image)

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

(click on chart for larger image)

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

(click on chart for larger image)

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

(click on chart for larger image)

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

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

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

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

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

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

(click on chart for larger image)

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

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

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

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

(click on chart for larger image)

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

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

(click on chart for larger image)

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

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

(click on chart for larger image)

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

(click on chart for larger image)

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

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


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

(click on chart for larger image)

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

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

ANALYSIS

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

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

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

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

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

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

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


(click on chart for larger image)

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

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

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

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

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

(click on chart for larger image)
chart courtesy of dshort.com

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

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

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

Have a great week!

Saturday, March 22, 2014

The Yellen Effect

In spite of a midweek hiccup. stocks maintained upward momentum last week with the S&P 500 finishing the week up 1.38% and small caps as measured by the Russell 2000 up on the week 1.04%.  The NASDAQ Composite also finished the week 0.74%.

This will be an abbreviated commentary as I have a busy weekend.

Some pointed to Friday's price action as an indicator of impending weakness. I won't deny the possibility of weakness, although I would say it was not because of Friday's activity and that any weakness will be short term.  On Friday, the S&P went "ex dividend" and went through some sort of re balancing.  Additionally,  it was a "quadruple witching" Friday which is when stock index futures, stock index options, stock options and single stock futures expire.  These settlement days (settlement is actually on Saturday) are notoriously volatile and can go either way.  In fact, the percentage of stocks on the NYSE that finished above their respective 50 and 200 day moving averages were higher on Friday than on Thursday when the S&P rallied 0.6% on the day.  This told me that Friday's total activity was being held captive to internal market forces that had as much to do with options expiration and settlement than anything fundamentally changing in the direction of stocks.

Nevertheless, most of the major indices and their sub indexes are exhibiting minor divergences that spell either a consolidation at present levels or maybe another "garden variety" 5 to 6% correction?

The weekly and the daily charts of the S&P 500 I'm posting below are indicative of the loss in momentum in equities over the past month:


(click on chart for larger image)

Notice the top panel on the charts above and below:

(click on chart for a larger image)

 At the same time bonds seemed to have taken it on the chin after the new Fed chairperson, Janet Yellen, dared to give an actual time frame on when short term interest rates would rise.  In the Q&A after the FOMC meeting on Wednesday, when quizzed on when the first rate hikes would follow the end of the tapering by a "considerable period," Yellen defined a "considerable period" as "something on the order of six months or that type of thing."  

Whether Yellen's comment was an off hand gaffe (which is what I believe) or a thinly veiled message to investors, the S&P gapped down at least 18 points in the next minute only to recover 7 of those points before the close and short interest rate futures built in another 25 basis point increase into the first half of 2015 as the yield curve flattened.

Interestingly, although the entire yield curve backed up on Wednesday, by Friday interest rates did drop down again although not below Tuesday's lows.  Nevertheless, the concern I have is that interest rates are still hanging at relatively low levels in spite of all the talk that our economy is recovering.  Add that this is with all the talk that China and Japan is dumping our debt!  Well, someone is buying T-bonds and where there is enough buying to lower interest rates it's still a sign that something is amiss in the US and global economy.  Here's a daily chart of the iShares Barclays 20+ Treasury Bond ETF (TLT) used by traders as a proxy for the long end of the yield curve - long duration bonds:


(click on chart for larger image)

It looks like long duration Treasuries are mounting an assault on a level that's failed to have been penetrated three times before.  Noticeably, momentum is not backing the move (see upper and lower panels).

There's SO much more to cover this week but I just don't have the time.  My gut tells me that, outside of an exogenous shock, stocks will either consolidate this coming week at present levels or move higher.  With China hinting at new stimulus to bolster their flagging economy and more relatively good economic stats out of Europe we are setting ourselves up for a strong April in the markets.  Additionally, there's a lot of pent up sentiment in the US (call it cabin fever) as most of the country is anticipating spring.  All we need is some more good US economic stats like we did this past week to vindicate the "weather" alibi of January and February and we're "off to the races".

I'll leave my readers with an update of a chart I've been "tweeting" all week.  This chart speaks to whether the central bank experiment to ignite "cost push" inflation is finally coming to fruition :


(click on chart for larger image)

As I review what I've written above, I've posed more questions than provided solutions.  Inter market relationships this week were totally skewed, especially from Wednesday afternoon on.  Let's see if next week reveals any answers to the riddles I posited in this commentary.

Have a great week!




Saturday, March 15, 2014

China, Deflation & Lower Interest Rates

The Dow Jones industrial Average suffered it's first five day losing streak since May, 2012 and all the major indices took it "on the chin" as diplomatic wrangling over the Ukraine increased in volume as the trading week progressed and more bad news out of China lent impetus to the sell off.  The pinnacle of the week was Tuesday when the S&P attempted a renewed assault on all time highs only to be repulsed.  From there it was downhill as waning momentum culminated in Thursday's brutal yet methodical sell off.  Here's a five minute chart of the S&P showing Thursday and Friday's price action:

(click on chart for larger image) 

I've super imposed a five minute chart of the Japanese Yen to show the lockstep inverse correlation between the currency and US stocks.  The Yen has been very helpful in understanding the near term direction of stocks and Thursday was no different as stocks popped at the open only to turn down after the first ten minutes as the Yen surged at about 8:40AM.  It was all downhill from there.

All the major averages finished the week down 1.75% or more and gold was the big winner, ending the week up 3.11%.  Here's a daily chart of the S&P:

(click on chart for larger image)


We were told the reasons for the sell off on Thursday was events brewing in Russia as well as terrible economic news out of China which I documented in last week's commentary.  And while that these two issues were the catalysts that sparked the weakness this week it's never as simple than that.  So far as the crisis in the Ukraine goes, events are still very predictable mainly because, short of military intervention, there is nothing the West can do to stop Putin if he chooses to break up the Ukrainian republic.  Certainly, at this point, Putin has to be considering the enormous depreciation of the Russian ruble as money exits the country at a rapid clip and this situation, more than any other, may put the brakes on his imperialistic ambitions.  But when this is all said and done it will go down in the financial history books a a "splash in the pan".  The global economy has much bigger fish to worry about and it is China!

In the meantime, I'm looking for a bounce next week in stocks predicated on what I see as waning downside momentum in the indexes and Treasuries bumping into some resistance that could only be breached by another major negative news event.  In other words, both Russia and China have been priced into stocks at this point.  A proof of my thesis can be seen in small caps which also took a drubbing this week but had a surprisingly strong day on Friday before the weekend.  Here's a daily chart of the Russell 2000:

(click on chart for larger image)

I circled Friday's price action and while the candlestick doesn't give us much hope in the immediate term the fact that the Russell had an "up" day ahead of a weekend fraught with geopolitical risk told me two things:

1.  Investors clearly understand that events in Russia will have no long term financial reverberations to the global economy and
2. Investors were "bottom picking" in US stocks that have very little exposure to either global events or the global economy.  More importantly, investors were willing to expose themselves to further possible downside going into a weekend where news events were liable to dictate where equity markets could move on Monday.

Both points indicate to me that, in the short term, the bulk of the selling may be over.  

Certainly treasuries were giving us a similar signal in their own way.  Here's a daily chart of the iShares Barclays 20+ Yr Treasury Bond ETF (TLT).  TLT is a popular ETF traders use to place bets on the direction of long term bonds and interest rates (the long end of the yield curve):

(click on chart for larger image)

As you can see, TLT is at major resistance and has been turned away at this level twice before.  My hunch is that after it's incredible surge on Thursday it will at least hesitate here and probably be turned away in the short term.

For interest rates the line in the sand is 2.6% on the Ten Year Treasury yield.  A yield below this level would start to speak to much deeper problems in the global economy.  Here's a daily chart of the Ten Year yield:

(click on chart for larger image)

We traded as low as 2.61% intra day on Friday morning but bounced from there to close the week at 2.644%.

The bond market will continue to give us our clues on the direction of stocks as well as the health of the global economy.  The present level of interest rates are telling me that, Russia aside, all is not well with the global economy and even if the US economy is the "nicest house in a bad neighborhood" there are global headwinds which are creating a significant drag on our economy.

Gold is also sending the market strong messages that, in my opinion, don't have that much to do with geopolitical events or inflation (as some are surmising).  Here's a daily chart of the Gold spot price:

(click on chart for larger image)

The impressive surge gold has had is delineated on the chart and while it has bumped into Fibonacci resistance on Friday I expect it will cast this aside and continue to move to the major resistance I've marked on the chart ($1420 - $1430).

After three months of economic crosscurrents and trying to solve the riddle of gold in terms of inter market relationships, to answer that riddle with cliches about Russia or "inflation" are misguided in my opinion.  Gold is verifying the Treasury market's signal.  Simply, gold thrives in a low interest rate environment and its recent surge is predicting a lower interest regime going forward.  I know, how much lower can rates go?  I'm not willing to gander a guess but there is no justification for the "inflationista" argument that gold is responding to future inflationary pressures in the global economy.

Certainly, I'm sticking my neck out in presenting this thesis but let's look at the evidence that inflation is gaining ground in the global and US economy.  It is true that agricultural commodities have had quite a run up in recent weeks.  Here's a daily chart of the S&P Goldman Sachs Agricultural Commodity Index ($GKX) which penetrated a multi year down trend line in January and has been in a seemingly relentless bull market ever since:

(click on chart for larger image)

As we look at the reasons for the rally we see that the move in virtually all of these commodities are due to "one off" events, whether it was supply/demand issues due to weather events, geopolitical events in Russia (wheat), or the impact on livestock prices from higher feed prices.  And the chart of the Reuters/Jefferies Commodity Research Bureau Index ($CRB) bares out my thesis:

(click on chart for larger image)

The chart above is sporting a classic "island reversal" chart pattern.  If this pattern holds up (and I expect it will because it is very reliable) we will consolidate at the present level for the next week or so and then break lower.  Admittedly, penetrating the gap support I've marked on the chart is crucial to my thesis.  I've learned from past experiences never to be dogmatic when it comes to my opinions but I'm convicted about the correctness of this call.  I'll be providing further support for this thesis below.

I have concerns in the currency market that I believe will be pivotal to understanding the direction of all asset classes later this year and into 2015. However, I am going to delay an explanation of those matters as it's not pertinent to the short and intermediate term direction of financial markets. But I'd like my readers to see a weekly chart of the Euro:

(click on chart for larger image)

Euro zone leaders have been bemoaning the strength of the Euro in the face of the continued malaise the EU economy has been facing for years.  Right now the Euro is fighting through a resistance zone I have not highlighted on the chart.  If the currency can penetrate the 140 -142 level in coming months it will validate a grand thesis I've been considering that will have vast implications in the FOREX (foreign exchange market) and global economy.  Stay tuned ...

In a week where events in the Ukraine and Crimea took center stage, the real challenge facing the global economy was from China, which took a subordinate position to those issues.  

There are many charts I can display that substantiate the radical slowdown in the Chinese economy over the past few months and I've already highlighted in past commentaries the dangers in their corporate debt market that are only exacerbating that slowdown.  In many ways, what is going on in China ties in with the grand thesis I spoke about above in addressing the Euro currency.

As China takes the next steps to truly move their economy and country into the mainstream of the global financial system the growing pains are becoming self evident.  The questions remains whether their leadership has the necessary finesse to effectuate those changes without plunging their economy into recession.  So far the verdict is out as their banking system is taking a hit.  Here's a ratio chart of the Global X China Financials (CHIX) to the Shanghai Composite Index ($SSEC).  The chart is used to measure the strength of their banking system to the total economy as measured by stock performance:

(click on chart for larger image)

We've broken Fibonacci support but have stabilized in the last week.  If we look at the Shanghai Composite we can see that it too, has stabilized above crucial support at the 2000 level but the situation is tenuous at best:

(click on chart for larger image)

For anyone who wishes to see some charts detailing the serious breakdown in the Chinese economy I refer you to an excellent post by SoberLook.com

As we get past the noise emanating from the Ukraine, the China problem and Fed tapering will once again move to the fore of the market's attention and hold it captive for the remainder of the year.

Analysis

The weather and now geopolitical events have taken the market's attention away from the issues which will be major drivers going forward.  While it is true that China got some press relating to their slowdown I don't believe the street has come to grips with the possible implications a radical China slowdown would engender.  The latest developments surrounding corporate debt defaults in that country could have a frightening outcome as investors flee that market now that moral hazard has been addressed.  More likely, however, the result would be a progressive dry up of liquidity in that market which would only exacerbate an already rapid economic slowdown.

We have our own problems in this country as inflationary pressures continue to wane.  The Producer Price Index (PPI) for February came in on Friday below expectations once again, to which the street decided on a "glass half full" approach, mainly applauding "tame" inflationary pressures.  But in a world awash in fiat currency and deflationary forces clearly having a stranglehold on vast sectors or the global economy, applauding waning inflation as "tame" is tantamount to burying one's head in the sand.  The China slowdown is going to have a huge impact on these deflationary forces.

Here's the latest chart of the iShares Barclays TIPS ETF (TIP) - iShares Barclays Seven to Ten Yr Bond ETF (IEF).  The chart measures investors inflationary expectations.  TIPS are Treasury Inflation Protection Securities tied to the CRB Index (highlighted above).  As inflation expectations rise or fall investors will move in and out of TIPS and regular Treasuries that have no inflation protection.

(click on chart for larger image) 

The ratio chart clearly shows that inflation expectations have been waning since 2011 while the S&P 500 (black line on the chart) continues to move higher.  If inflation is a necessary by product of greater economic growth and velocity (and it is) why the divergence between the ratio and the S&P?  This is not a new story and the answer is simple: the Fed has made it so.  And this week we have another FOMC meeting which will finally take the market's focus off the Ukraine (good) and China (not good).  

The chart above validates the thesis I've presented above pertaining to the bond market, gold and commodities.  While I expect a short term bounce this week in equities for the reasons mentioned above, the China story will continue to haunt us and will eventually slow growth in this country to the extent that it has to impact US stocks.  How much will it do so?  Much will depend on the Fed's "generosity".  They are not going to change direction regarding the tapering of asset purchases at this time and I expect no new revelations from their meeting on Tuesday and Wednesday that will do anything but soothe markets.  But if the economic drag that I think the China slowdown will spawn comes to fruition, more Fed stimulus may be needed later this year to bolster equity markets.

While growth will still be tepid this year our economy is the strongest economy on the planet but to largely explain this bull market in terms of P/E ratios and balance sheet fundamentals misses the point of the divergence on the chart I posted above.  I'm not predicting a bear market in stocks but the divergences above must be reconciled at some point.  And I think the China slowdown may be the catalyst for this reconciliation.

In the meantime, I think we will see lower interest rates in the coming months for the reasons I've specified above but look for a short term bounce in stocks this coming week.

Have a great week!


Saturday, March 8, 2014

Stocks Rally & China Watch

Once again, most of the major indices finished the week at all time highs after we had our "black swan" moment on Monday after last weekend's saber rattling over the Crimea.

The market took the whole "crisis" in stride as it correctly understood that, human rights violations aside, this was a financial non event that was not liable to morph into a full blown geopolitical crisis.  As I listened to some commentators on CNBC this week who were warning that "it wasn't over yet" I kept asking the question: Well then, what's next?  Is the UN going to intervene militarily?  Is the Obama administration going to send troops?  Are the Europeans going to threaten Russia that they will stop buying their NATGAS if they don't pull out of the Crimea?

Outside of an escalation that, at this point, could just as easily be provoked by the West as Putin, the results of the referendum vote will show (either fairly or fraudulently) that the majority of those in the Crimea wish to be part of Russia.  And once that occurs, additional sanctions will be implemented (if the West has any options) and the saber rattling and geopolitical showmanship will continue but with lessening ferocity until you have to find a story about it in the B section of your favorite newspaper.

Geopolitics aside, the market showed some impressive strength this week that speaks to a mature bull market which is still very much intact.  Small cap stocks resumed their leadership in earnest and surged 1.95% on the week which is a harbinger for future gains in the entire market.  Here's a daily chart of the Russell 2000:

(click on chart for larger image)

The Russell spent the latter part of the week retrenching after Tuesday's surge and seems to be forming a bullish "bull flag" pattern, predictive of new highs very soon.

The financials rallied an incredible 3.04% on the week!  Here's the Financial Select Sector SPDR (XLF) comprised on the money center banks, American Express, Berkshire Hathaway and other financial notables:

(click on chart for larger image)

With small caps and financials leading this market higher there is little doubt we have much more room to run in the market.  Certainly, markets are over extended in the short term.  There are some signs of froth when we see the TESLA's of the world reaching dizzying heights based on their valuation, high levels of margin debt and an IPO (Initial Public Offering) market heating up as investors seem willing to bid up new issues I wouldn't touch with a ten foot pole.  However, I can't argue with the technicals. Until the charts tell me something different the direction of stocks is higher.  I addressed last week a thesis posited by Scott Minerd of Guggenheim Partners that is an excellent rationalization of stock prices and their valuations in the current interest rate environment we find ourselves.

The bond market started acting like the bond market this week as it foretold by it's lackluster price action that the Crimean crisis was not really a crisis and as it sold off later in the week, fulfilling a traditional inter market relationship which has been with the market since 1997 - 1998.  Here's a daily chart of the Ten Year Treasury yield:

(click on chart for larger image)

It's interesting that the Ten Year yield backed away from that Fibonacci line on Friday.  As I've said before, those Fibonacci lines are almost mystical!  In any case, yields are still at historical lows and while I become more comfortable every week in stating that the lows in interest rates we've seen in the past two years will never be seen again in most of our lifetimes, yields are not going to run away to the upside anytime soon.

Here's a much longer term perspective on where we are with interest rates.  The following chart is a monthly chart of the Ten Year yield which encompasses the great bull market in bonds which started in 1982 when Paul Volcker broke inflation's back:

(click on chart for larger image)

As you can see with the red arrow, we're on the cusp of a second attempt break out above a down trend line drawn from the 2007 highs in yields.  I'm not going to be dogmatic in stating that the bond market is in a primary bear market until the Ten Year yield penetrates the black dashed line drawn from the 1982 highs in interest rates.

The financial markets always give its participants something to worry about and this week was no different.  I'm going to start with gold and then address the commodity market and these two asset classes will be the primary focus for the rest of this commentary.

I've had some inquiries regarding gold's price action this week.  Regular readers of my commentaries know I had called a short term top last week based on technical indicators.  That call turned out to be correct.  The question I'm getting is, "where do we go from here".

First, the gold miners which are highly correlated to the yellow metal are sporting what's turning out to be significant Fibonacci resistance on both the daily and weekly charts..  Here are both the daily and weekly charts of the Market Vectors Gold Miners ETF (GDX):

(click on chart for larger image)

(click on chart for larger image)

As I wrote last week, gold's turn was predicted by GDX on Tuesday, March 4th.  Gold ran into it's own Fibonacci resistance and turned away the following day.  The price action I'm addressing is in the "cone" or "megaphone" pattern I've drawn on the chart.  See below:

(click on chart for larger image)

Since that time gold has struggled to break away from that Fibonacci level even though it did manage to penetrate it.  On Friday, gold came back from a significant intra-day deficit and though it did finish near the lows of the week, it was able to keep it's head over that Fibonacci line.

My concern is the formation that's brewing on the chart.  I labeled it as a broadening formation and we could argue whether that label is technically accurate but this kind of scattered price action is indicative of an extremely indecisive market as well as heightened nervousness among investors.

Gold has been one of those unsolvable riddles in the market that I've addressed a few times since the beginning of the year.  Certainly, recent price action in the face of geopolitical turmoil was an indication that it was going to roll over this week.  Additionally, we have issues brewing in China which I'm going to address below that would suggest that the chart pattern above may resolve itself to the downside.

Gold has exhibited "chameleon" qualities since the beginning of the year; at times violating traditional inter market relationships with other asset classes and sending mixed messages to investors.  Is it's price action speaking to the inflation/deflation/interest rate paradigm that the market is presently struggling with?  Is it's price action since the New Year predicting inflationary pressures?  If so, why the sell off this week in the face of climbing agricultural and livestock prices and heightened geopolitical tensions?

I don't know where gold is going to end up.  All I know is that the miners will be the key to its price action and we need to clear the present Fibonacci resistance on the GDX charts and then there is major resistance above that I've delineated on both charts that needs to be overcome.

Industrial commodities staged what can only be described as a violent sell off on Friday based on news coming out of China that a relatively small solar company had defaulted on its debt and that the Chinese government, for the first time ever, was not going to bail out its creditors.  Shanghai Chaori Solar Energy Science & Technology defaulted on approximately 15 million dollars of its debt on Friday.

Market analysts hailed the action of the Chinese government as it addresses a longstanding problem in the Chinese debt market: moral hazard.  Up to this point investors could throw their money at any company, knowing that inevitably the debt would be backed by the government.  The action by Beijing sent a clear message to Chinese investors: due diligence is a part of investing and there is risk associated with investing in corporate debt.

I certainly applaud the action of the Chinese government on their decision.  It is something that had to be done and it is decisions like this one that will eventually bring their economy into the mainstream of the global financial market place.

However, in the short term, there is another edge to this blade.  The first and foremost consideration is whether the decision will immediately spark a sell off in their corporate debt market.  If investors no longer have the Chinese government's implicit guarantee that they will be made whole, will they start dumping their portfolios of questionable companies, of which there are probably many given the over leveraged nature of the Chinese economy?  Secondly and a more probable outcome, will the change in investor psychology impacted by the government's decision  create an incredible drag on economic growth as investment is liable to literally dry up for the majority of corporate entities on the Chinese mainland?

Interestingly, a ratio chart which I've shown in previous commentaries was predictive of the problem:

(click on chart for larger image)

This is a ratio chart of the Global X China Financial ETF (CHIX) and the iShares FTSE China 25 Index (FXI).  The ratio is designed to show the relative strength of the Chinese banking sector to the Chinese economy as a whole.  As you can see, the ratio failed to hold support and broke down around two weeks ago.

But how has this affected industrial commodities?  With the strength of the Chinese growth engine already in doubt and they being the driver behind commodity prices since 2000, here's what happened on Friday.  First, here's copper:

(click on chart for larger image)

Candlesticks don't get much uglier than that!  On the monthly chart Copper has fallen out of a multi year triangle and while still above significant support, a move like this on a long term chart is a warning sign:

(click on chart for larger image)

Here's a daily chart of the S&P GSCI Industrial Metals Index which comprises futures prices on copper, nickel, zinc and aluminum:

(click on chart for larger image)

These are just two examples of what happened in the industrial commodity space on Friday.  Industrial commodities are telling us that the world's growth engine is going to substantially weaken in the coming weeks and months.

I've learned from the past not to predict or at least hedge my predictions so I'm not going to even gander where this is all going.  All I know is what the charts are telling me.  And the charts are telling me that China is having problems in their banking and industrial system.  This cannot bode well for Emerging Markets and will serve as a significant headwind to the global economic recovery.

To be balanced, the Shanghai Composite took Friday's news in it's stride and while finishing down on the day actually finished the week up .08% (flat).  However, the Shanghai is technically in a multi year downtrend as can be seen on the weekly chart below:

(click on chart for larger image)

Analysis

As I look at the data I've compiled above I cannot help but come away with the thesis that gold was predictive of and is responding to events in China.  I can say that the fact that interest rates had a nice pop contributed to the precious metal's weakness this week but certainly gold is telling us that developments in southern Ukraine are a non event.

Secondly, and this is not new news, we have a tail of two economies; a relatively vibrant US economy (as tepid as it is) and a struggling global economy as seen in Europe and Emerging Markets.  

The macro issue of central bank intervention and its effect on global financial markets will be the overwhelming concern of our markets in 2014 and well beyond as liquidity is drained and central bank's may be ultimately compelled to raise short term rates.  The outcome of all this will be the test on just how strong the global economy is.

There is nothing revelatory in saying we will experience significant volatility this year but I'm very optimistic on the long term prospects of the global economy and our stock markets.  However, there is a caveat.  Markets don't go straight up and saying that a 5 or 6% correction is adequate to qualify as such ignores the basics of stock market price action.  I understand the low interest rate argument and I indeed subscribe to it so I guess the party will end when rates reach some intolerable level; whatever that level may be.  

I'll leave my readers with one more chart.  This is a monthly chart of the S&P100 Index going back to 1984 with a correlating chart below it of the percentage of stocks on the S&P 100 that are above their 200 day moving average:

(click on chart for larger image)

The chart is instructive in showing the impact of Federal Reserve policy on equities but in particular, the effects of "QE infinity" (purple highlight) initiated in September, 2012.  The prospect of an open spigot of liquidity not only sent the $OEX skyrocketing but also broke the downtrend of the internal metric in the lower chart.  The recent sell off we had in January sent the percentage of stocks above the 200 day moving average below the trend line but it has since recovered and popped it's head above that line.  However, it is looking a bit tenuous at this point.  Aside from the fact that the chart can be describes as parabolic this will be an indicator for us to watch going forward.  A long term divergence between price and percentage of issues above their 200 DMA cannot be sustained.

The party has to stop at some time!  There's no getting around it.  But so far, there is no indication on the horizon that it's stopping anytime soon.

Have a great week!



Saturday, March 1, 2014

Of Black Swans & The Wall of Worry

Notwithstanding the Ukraine/Crimea crisis which shook the market on Friday, stocks had another banner week with most of the major indexes finishing north of 1% on the week and new all time highs in mid Caps, small caps and the S&P500.  Here's how the S&P looked after Friday's close:


(Click on chart for larger image)

Consternation entered the market on Friday afternoon as news hit the airwaves that either Russian troops and/or private militia hired by the Russians had landed at two Crimean airports.  I had been waiting for the news since early Friday morning after Reuters ran a story that Russian troops had seized the two major airports in the Crimea.  I posted the following on Friday morning on Facebook:


"Anyone with any military background knows that you need to seize transportation centers before you can move in a military force large enough to accomplish its mission. This is especially necessary for the Russians since the only way they can get anyone in there is by flying them in. Russian occupation of the Crimea is a certainty as Putin will protect Russian interests - the Russian Black Sea Fleet".

Regardless of any demonizing of Putin by the mainstream press (and he should be demonized; he's a thug) the occupation of an area around a vital military installation which has been a bulwark of Russian defense for hundreds of years was predictable.

The market came off it's highs at around 1:20PM and by 2PM was sporting a pretty serious reversal.  However, some buying came in the last hour and saved what would have been a negative close.  As we look further at the price action, examining the inter market relationships that indicate whether fear had entered the market, we see the following:

(Click on chart for larger image)

This is a five minute chart of: 
  • S&P 500 SPDRs ETF (SPY)
  • iShares Barclays 7-10 Yr Treasury ETF (IEF)
  • SPDR Gold Trust Shares (GLD)
  • Powershares DB US Dollar Index Bullish (UUP
The traditional inter-market relationship would see investors fleeing stocks for some combination of all three risk averse assets (Dollar, Gold and Treasuries).  As the news hit the wires at about 1:20PM (see the x axis on chart above) we did see the inter-market relationships come into play but the feeble nature of the response told me that this was mainly a stock event as traders were not taking a chance of going into the weekend "long".  The Dollar, which had been selling off all day did a "dead cat" bounce and while there was some buying pressure in gold the precious metal still ended the day down 0.45% as measured by the SPDRs Gold Trust ETF (GLD).

In the near term it appears what is going on in the Crimea, especially after Obama's speech Friday afternoon, is going to create some volatility in our markets. 

As stocks have been moving higher so have bonds with the commensurate lowering of yields.  Here's a two hour chart of the Ten Year Treasury Note Yield and I've highlighted the yield swoon that commenced on February 21st after the Ten Year yield effectively made a double top as well as what amounts to the last day and a half of trading (blue shaded circle):



(Click on chart for larger image)

The drop in yields on Friday is directly attributable to the events taking place in the Crimea but the drop in yields since February 21st is telling us that the bond market does not think things are as rosy as stocks do.

And here's a daily chart of the Ten Year yield from its May, 2013 bottom:


(Click on chart for larger image)

I could have delineated a "head and shoulders" formation on the chart above but I decided not to as they never seem to come to fruition anymore.  I think Fed policy has ruined it ...  :-)

Whatever the bond market is trying to tell us until we start seeing some upward pressure on rates (moving up to 3% on the Ten Year) stocks may be floating in the ether for any number of reasons but it's not because of a robust economy.

Gold's price action has stalled at Fibonacci resistance this week which was a revealing indication in the face of the geopolitical turmoil that came to the fore in the latter part of the week.  Certainly, we would want to see the yellow metal fulfilling its role as a safe haven with kind of bad news.  The price action suggests investor unconcern about the events in the Crimea and elsewhere but even more about  gold's future direction.  

Interestingly, the precious metal miners were predictive of gold's weakness by a day.  Here's a daily chart of the Market Vectors Gold Miners ETF GDX:

(Click on chart for larger image)
GDX ran into Fibonacci resistance on Tuesday and promptly did an about face.  The metal followed on Wednesday:

(Click on chart for larger image)

Unless we see an escalation of tensions over the Crimea next week we may be seeing a turn in the gold market.  Regular readers of my commentary know that I'm watching gold very carefully because it is predictive of future inflation which would be indicative of global economic strength.  Deflation has been the nemesis of the global economy since 2008 and central banks have been in a pitched battle in attempting to turn the huge deflationary and disinflationary forces around by sparking inflationary pressures.  There is some indications that they might be but the verdict is still very much out and any inflation is not in the right places.  This is maybe the reason why gold is pausing at it's present levels.

Here's a daily chart of the Reuter/Jefferies Commodity Research Bureau Index (CRB).  The CRB  comprises 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.

(Click on chart for larger image)

The CRB has gone almost parabolic since mid January but when we look at the commodities that are driving the index we see that they are mostly price changes in "soft" commodities like coffee and sugar which have had supply/demand dislocations from "one off" events like the weather.  Of course, NATGAS has impacted the index as demand surged due to the extremely cold winter we've been experiencing.  We are still not seeing any meaningful price pressues in industrial commodities.  The following chart will support my thesis regarding the disconnect between industrial commodities and the entire CRB Index:

(Click on chart for larger image)

This is a price relative chart of the CRB and six economically sensitive commodities or groups:

  • Copper
  • Aluminum
  • Nickel
  • The Dow Jones World Basic Materials index
  • The Dow Jones US Steel Index
  • Lead
I've smoothed the lines by applying a 20 day exponential moving average to the chart.  You can clearly see that the entire index is outperforming the individual industrial commodities which comprise it.  This is certainly not indicative of "demand pull" inflation (see last week's commentary for definition) which is healthy in the beginning phases of an economic recovery.  Neither is it indicative of global economic strength.


  Here's a monthly chart of the CRB which is gives us a macro perspective of the commodity complex:

(Click on chart for larger image)

The CRB has managed to pierce a multi-year downtrend line established from the June 2008 highs due to the factors I've identified above.  However, it slammed into Fibonacci resistance this month and is sitting right below that marker.

Finally, I just want to touch on China.  We had some important news on Friday night when the Chinese released their closely watched Manufacturing PMI (Purchasing Managers Index) report and it slightly exceeded expectations coming in at 50.2 versus 50.1 forecast.  The important fact is that it is still signalling manufacturing expansion (barely).  It certainly isn't helping the Chinese stock market which seems to be floundering; searching for direction.  Here's a daily chart of the Shanghai Composite:

(Click on chart for larger image)

The Shanghai is in the middle of a downtrend channel after being repulsed earlier in the month at a significant resistance level.

It's difficult to gauge what's going on inside the Chinese economy because economic reports are not generally reliable and there are many crosscurrents as they struggle with run away debt leverage, a shadow banking system that's feeding it and the Chinese government's objective of transforming that country from an export based to consumer based economy.  But the immediate concerns surrounding China emanate from their banking system and for that reason I pay particular attention to the following ratio chart.  This is a price comparison between the Global X China Financial ETF (CHIX) and the iShares FTSE China 25 Index (FXI):

(Click on chart for larger image)

We've broken below a support line on the chart which is speaking to relative weakness in their banking sector.  When I run the ratio with the total Chinese stock market it is not showing the same level of weakness but there has been a significant breakdown since the beginning of the year on that chart as well:

(Click on chart for larger image)

The debate has raged for years on whether the Chinese can stage a soft landing to their slowing economy.  The key to their success is how they manage their "shadow banking" system and the huge debt they are carrying on their books, thanks to the infrastructure development which served to keep them afloat after the events of 2008.  The two charts above will serve us well in coming weeks in assessing the success or failure of their efforts.


Analysis

As I stated above, recent events in the Ukraine/Crimea are liable to provide more volatility in global markets next week but I sincerely believe that it will be short lived and if there are any serious reverberations, stocks will soon regain their composure and move higher in the coming two months.

I am beginning to believe that the weak economic reports of the past two months are primarily due to the weather, and bond market concerns aside, the economy is on track to stronger yet lackluster growth.  

There is much chatter on the street whether present stock valuations are over extended and I found the following chart, courtesy of Scott Minerd of Guggenheim Partners, helpful in understanding the price/earnings ratio debate in the context of the interest rate environment we find ourselves:

HISTORICAL P/E RATIO IN DIFFERENT INFLATION ENVIRONMENTS

(Click on chart for larger image)

Scott makes the point here that "Low inflation tends to support larger price-to-earnings ratios, as the lack of price pressure facilitates easy monetary policy which encourages multiples expansion."  

I've found Scott's insights to be "spot on" many times and the chart above as well as his commentary has assisted me in sifting through the myriad of views on the street surrounding fundamental stock valuations.  

The chart above means we still have more room to run.  With an accommodating Fed and tame inflation that can't eat into corporate profits, the only thing we need be concerned with is the lack of "demand pull" inflation which is the result of subdued consumption.  I'm not minimizing this challenge but assuming the present rates of growth can be maintained stocks will march higher this year.  

Any number of events/issues can throw the markets a curve ball and the concerns articulated above regarding the price action of bonds, gold and China continue to tell us that we need to be vigilant in spotting the "bad pitch" should it come.  Understand though, that these concerns are all part of "climbing the wall of worry".

So, outside of a "black swan" event which, in my opinion, is a minority scenario and would most likely emanate from China, stocks are moving higher folks!



Have a great week!