Sunday, January 29, 2012

Macro Analysis 1/27/2012

Stocks posted a marginally positive week although price action was lackluster.  But at least the volatility has subsided.  And while I could never say we’ll never see volatility again like we did in the second half of ‘11 I do believe that the constant nerve wracking market action we’ve experienced is over.  Euro Zone fears still seem to dominate small investors psyches as we still do not see significant money flows out of the safe haven trade (Treasuries, bonds) and into “risk on” assets but the market continues to trudge along, climbing that “wall of worry”.

I haven’t posted our inter market relationships in a few weeks so here they are:

Inflation              Deflation
If Stocks                                 rally                       correct
Then Treasuries               will correct         will rally
Then Gold                           will rally              will correct
Then Commodities         will rally              will correct
Then US Dollar                  will correct         will rally

Stocks – as measured by the broad Wilshire 5000 Index were up 0.41% this week.  Here’s a weekly candlestick chart of the Russell 2000 Small Cap Index which was up 1.81% on the week:

What I want you to take away from this chart is the fact that Small Cap (capitalization) stocks are starting to outperform the bigger multi-nationals (bottom panel) which is predictive of a stronger market going forward.  Also note the strong trajectory on the MACD indicator (top panel) and the price action itself is very deliberate.  This is the kind of price action reminiscent of the last halves of 2009 and 2010.  I’ll be discussing why I believe the market is acting like this in my ANALYSIS. 

I posted a number of breadth indicators last week so I’ll just put one more up to show you how strong this market really is:

This is a four year chart representing the percentage of stocks on the NYSE that are trading above their 200 day moving averages.  As you can see we closed on Friday at 65.10% and are fast approaching the 70% level (purple dashed line).  This is very healthy action and represents the internal strength of this market.  All we are missing is volume which hasn’t been what it should be for the reason I addressed at the beginning of this commentary.

There was some churning this week in that TRIN (Short Term Trading ARMS Index) has been over 1.00 which is signaling that many stocks were weaker during the week.  Most pundits have been saying the market is overextended here and many are looking for a correction.  But the fact that TRIN has been in bearish territory and the market has finished positive for the week is telling me that we’re liable to see this overbought condition work itself off in sideways price action rather than a correction.  I posted a chart on my blog this week ( that further supports this thesis. 

In my mind, stocks are set to move significantly higher in the next few months.  I’ll extrapolate on this thesis in my ANALYSIS.

Treasuries – got a shot in the arm after the FED announced on Wednesday that they intended to keep short term interest rates low until at least 2014.  Rates had been creeping higher up to that point which was signaling an incrementally strengthening economy.  This artificial “put” on interest rates is starting to skew our inter market relationships which have served us well for the past few years.  But as you will see on the first chart below of the iShares Barclay 7 to 10 Yr. Treasury Bond Fund (IEF), pressure is building on the long end of the yield curve.  There is significant resistance at the 105.75 – 106.00 level and the MACD indicator in the panel above is showing significant momentum deterioration.

 No one, not even the FED, can control long term interest rates save for short time frames.  The bond market is just too big for any one entity to manipulate it.  Nevertheless, while I think long rates will back up there will be no significant move to the upside.  There are just too many global deflationary forces impacting these markets and we must remember that the FED is still active in buying up securities in the 7 to 10 year range.  Remember Operation Twist?

Assuming continuing improvement in economic fundamentals how far could rates back up?  I could see a back up on the 10 Year Treasury Note at around the 2.35 to 2.40% level and perhaps as high as 2.5%.  The Ten Year closed on Friday at 1.893%.  The second chart below shows how I determined these projections.

In any event, we’re in a low interest rate environment which will continue to be supportive of equities (unless they get too low; like less than 1.692%). 

Commodities –   were mixed this week, with livestock (except cattle) and grains basically treading water while industrial metals and precious metals reacted positively to the FED announcement.  The industrial metals have been in a steady uptrend since mid December as a result of the ECB’s LTRO which I’ve addressed in previous commentaries.  The FED announcement just gave an additional “goose” and the trend is firmly entrenched.

Gold and Silver took off on the FED announcement and many are heralding a resumption of the bull market in precious metals.  To this I will not argue as I believe this time the FED has it wrong and this move will fan the inflation fires going out to the mid decade (if not before).  But the real story with the precious metals was the boost that the Gold mining stocks received this week after the FED announcement.  Below is a chart of GDXJ (Market Vectors Junior Gold Miners ETF).  The mining stocks have been lagging the metals for most of the multi year rally in the precious metals, which has confounded many market pundits.  Various excuses have been given why they are not reacting the way they did in the last bull market in Gold (1979-1980).  Probably the most plausible reason has been the fact that with the advent of ETFs it has become much easier for the small investor to take a paper position in Gold or Silver.  In the past, if you didn’t physically buy the metal then you had to take a position in the futures market which many small investors are loathe to do (and for good reason).  So, investors would use the mining stocks as a proxy for the metal. 

In any case, last week’s price action is highlighted with the green circle.

Notice the long clear candle inside the green circle.  That was Wednesday’s price action after the FED Announcement.  The ETF jumped $2.00/share!  This index captures the price action in the more speculative, smaller cap mining stocks which is an excellent indicator of the future direction of all the miners.  Is this the beginning of the big rally in mining stocks all the gold bugs have been waiting for?  I’ll wait until the ETF penetrates the 50% Fibonacci retracement area I highlighted with the black arrow.  Ideally, I would like to see a filling in of the gap that formed in mid September (black circle).  Something to keep our eye on …

US Dollar – I haven’t addressed the dollar much in my 2012 commentaries but those of you who regularly read me know it was a regular topic in 2011.  And I wouldn’t want anyone to think that the Dollar is no longer important.  As I’ve said many times, if you want to know where risk assets are going, watch the Dollar! 

The FED announcement wounded our currency which had been weakening considerably since the successful European debt auctions earlier in the month.  As things are perceived to be getting better in Europe the Euro is strengthening and since the Euro is roughly 57% of the Dollar index as the Euro moves higher the Dollar weakens proportionally. 

A weaker Dollar has been good for stocks in the deflationary environment we find ourselves in as its weakness stirs inflationary pressures.  However, this is a double edged sword because as prices rise it squelches consumer demand.  No greater example of this can be seen than in the price of oil and gasoline. 

In past commentaries I’ve posted charts of West Texas Intermediate Crude showing significant resistance at the $104.00/barrel level.  Oil’s price action has been muted recently and even the Oil Service Holders (OIH) have had a lackluster performance in recent months.  This state of affairs cannot continue.  There is an inverse relationship between the price of the Dollar and oil.  Either Oil has to start rallying or the Dollar has to stop its decline and strengthen.

There are signs of an inverted head and shoulders formation on the West Texas Crude chart which is predictive of higher prices and on the chart below we can see the spot gasoline price has broken out of an eight month downtrend (blue line) and on Friday took out another intermediate term resistance line (red line) going back to September. 

All this is supportive of more dollar weakness which coincides with the fundamental picture after the FED’s action this week.

A weakening Dollar will initially be supportive of stocks but if we start seeing significantly higher gas prices, consumption will become constrained with a corresponding deleterious effect on the economy.

I’ve made the case in the past two commentaries that the “fix was in” after the European Central Bank pumped close to 500 billion Euros (about 640 billion dollars) of liquidity into European banks.  This action has effectively neutered the threat of a European sovereign debt implosion.  We’ve seen yields on Italian and Spanish debt drop since the December 21st LTRO and although Portugal is starting to have problems in controlling their financing costs the contagion looks like it’s contained.  At this point, based on the action in the European bond market, if I had to bet which countries would leave the EU in 2012, I’d say it’s a safe bet that Greece is a definite and Portugal is a prime candidate.
  We’re not out of the woods yet but I think Mario Draghi is going to administer the “coup de grace” to the crisis next month when the ECB extends another LTRO (Long Term Refinancing Operation) to the European banking system with even more liberal credit terms (allowing bank loans as collateral).  Rumors are out there that the ECB may offer up to a trillion Euros this time around which will expand the ECB balance sheet even more than the FED’s.  If this next LTRO unfolds according to the rumors the Euro Zone debt saga will dissolve.
Now the FED has stepped in with talk (jawboning) of keeping short term interest rates low until the end of 2014.  Liquidity abounds!  And the market loves liquidity!  I would submit to my readers that at this point, regardless of economic fundamentals, this extraordinary liquidity has put a floor under equity prices and can be the catalyst for significantly higher prices going forward. 
With the attention now off of European debt woes, much has been made that earnings will be the main driver for US stock prices going forward.  And, as it stands right now, only 57.9% of all US companies that have reported this quarter have beaten analyst earnings estimates.  During the August to November market turbulence, the correlation among stocks was high at 0.9, meaning most stocks were moving in unison, either up or down. Now, that correlation is 0.15.  So, we’re now in a market where you’ve got to pick the right stocks but the trend is still pointing to significantly higher prices. 
The key, in my mind, to understanding this market is the incredibly low yields on risk free money.  The yield on the five year Treasury note closed on Friday at a record low of .75%!  Who, in their right mind is going to tie up their money for five years for such a paltry return? 
So where do you put your money?  If you know you’ve have central bank support in terms of liquidity the only viable option to making money in these markets is to buy high dividend yielding, preferably multi-national companies that can withstand any sudden downdrafts that may unexpectedly surface in the next few months.  Stocks like IP, MRK, PFE, KFT, T, VZ and GE.  These will continue to appreciate and pay you handsomely to wait out any downside or sideways price action, regardless of earnings report surprises.
I want to leave you with some thoughts on what I see as the bigger picture.  Those of you who read me regularly can probably gauge that I write these commentaries with a three to six month window in mind.  And regardless of accuracy (or lack thereof) in my prognostications I know that no one can accurately predict what the financial markets are going to do.  I’m not telling anyone something they don’t already know but I only make this cautionary introduction to state the following hypothesis.
 I’m not an “Armageddon scenario” proponent and I normally eschew such predictions.  However, more and more, as I follow these markets on a daily basis and I see the interventions made by governments and central banks to stave off financial disaster, I come away with the feeling that we are more and more “pushing on a string”. 
Central banks, in their Keynesian understanding, are playing a very dangerous game.  And while I believe that the FED’s decision in late 2008 to pump the economy with money was the right one, subsequent interventions are more and more getting “less bang for the buck”. 
For the Keynesian “solution” to work time is needed.  Indeed, sovereign entities and their banks are gambling that eventually real growth will kick in which will eventually eat away the trillions of dollars in debt that the globe is buried under.  But this will take years to accomplish as leveraged debt is still being unwound.  And even if the Keynesian prescription is eventually successful, I don’t believe everyone can survive unscathed. 
So it’s a precarious balancing act that’s being implemented with a number of questionable assumptions that are held as sacrosanct.  We can only hope that we don’t get thrown a curve ball that knocks down this house of cards. 
We need time.  Will there be enough?
Well, it’s the world we live in and I wouldn’t want it any other way.  It gives me something to write about!  J
Have a great week!

Positions: PRPFX (long); SMH (long); ARR(long);CEF (long); CUZ (long);IP (long);MFA (long), NLY (long); XLU (long), EUO (long), COG (long)