Sunday, February 12, 2012

Market Analysis 2/10/2012

Macro Analysis

A confluence of factors came together this week and stocks started a long awaited corrective process on Friday’s with the day’s performance being the biggest down day so far in 2012.  However, our breadth indicators and the price action are still giving us a strong indication that this will be nothing more than a garden variety correction before the uptrend resumes.

Stocks – have had quite a ride since the beginning of the year as reflected in the Histogram below:
This chart captures the performance of all the major averages since December 19th, 2011, two days before the European Central Bank conducted their first LTRO (long-term repo operation) which pumped 489 billion Euros into Europe’s banking system.  Has my thesis been vindicated?!  J
Notice that Small Cap stocks (Russell 2000) and Tech (NASDAQ) are leading the rest of the indices.  This is an extremely healthy indicator for the following reasons:

·       Investors are buying growth stocks which shows they are gaining confidence that the economy is on sound footing and growing stronger and

·   Investors and traders are getting comfortable  in taking positions in more speculative equities

 Earlier this week I posted a few charts on my blog that seemed to indicate that we were getting closer to this correction (  And just as the Russell 2000 started to show relative weakness to the S&P 500 prior to the correction I suspect that when the Russell 2000 starts to show relative strength to the S&P it will signal that the uptrend will resume.

As I said above a confluence of factors came together this week to stop the advance with the media blaming the Greek debt saga as the main culprit.  And while I cannot deny that the problems surrounding Greece did not contribute to Friday’s down day there are at least two other factors that must be taken into account in understanding Friday’s price action.  The first factor can be easily explained by the chart below (double click on chart for larger image):

As you can see the S&P has reached an area of significant resistance.  The arrow points to the July highs and this is an area where, if you bought the market in July and you rode out all the volatility in the second half of 2011 you’ve finally made back most if not all your money and some investors will unload their stocks here.  Others are hesitant to deploy new money at these levels because they know others are unloading and will await a break out above resistance. 

Secondly, individual investor sentiment is extremely bullish.  In the latest AAII (American Association of Individual Investors) survey of Wednesday, 2/8/2012, 51.6% of investors polled were bullish on the market for the next six months while the historical average has been 39%.  At the same time, those with a bearish opinion were only 20.2% (historical average is 30%).  This survey on the street is known as the “dumb money” survey and is useful as a contrarian indicator.  The concept behind the numbers is that if the reading is extremely bullish then everyone is “in” the market so who’s left to continue buying the market up?

We’ll see what next week brings but if we get a downdraft because of Greece it will be a buying opportunity as I expect the market to bounce right back.  I believe the concerns surrounding a disorderly default are overblown under the premise that markets are aware of this possibility have been preparing for it.  It’s not what we know that will hurt us but what we get blindsided with … I’ll have much more on this topic in my analysis below.

Treasuries – I addressed Treasuries extensively on my blog this week and I do believe we will see higher rates in the coming months.  Even Friday’s price action on news that a Greek debt deal was still in limbo did not spur the kind of sell off we used to see in 2011 under similar circumstances.  Here’s an updated chart I posted on my blog on Thursday which shows where the Ten Year yield is as of the close of business on Friday.  I redrew the consolidation triangle lines so I wouldn’t support my bias.  Under the new configuration, based on a shorter time frame, rates have dropped back into the triangle with Friday’s price action.  However, under the longer time frame (more valid) it has broken out of the consolidation triangle.
In any case, a move above the 2.1% level (red line) would be predictive of a move to the 2.4 to 2.5% level (yellow area).  Why is this so important?  Higher rates in our current environment mean that the economy is strengthening and that, even more importantly, fear in the market is receding.  Virtually all the action in Treasuries on Friday was a result of the stalled Greek negotiations and the concurrent fears of a global financial implosion.  But as I said above, this move was much more benign considering the moves we experienced in the latter half of 2011 when we were on the receiving end of similar type news events.  Even with the FED buying up the long end of the yield curve (Operation Twist) if we can get the Euro Zone monkey off our back yields should spike to the aforementioned levels if not higher:
Commodities –   are still the “canaries in the coal mine” and we are not seeing the kind of price appreciation we need to confirm the economic fundamentals higher stock prices are pointing to.  Here’s a daily chart of the PowerShares DB Base Metals Fund which is an index composed of futures contracts on some of the most liquid and widely used base metals in the global economy (aluminum, zinc and copper).  The index is intended to reflect the performance of the industrial metals sector:
This chart is representative of the entire commodity complex.  There’s absolutely no price pressure in commodities!  As you can see, we had a sharp run up that coincided with the move in stocks that started around December 19th but then we stalled in late January and are trading in a tight range.  But my concern is with the momentum indicators (RSI & MACD in the top two panels) which I’ve circled in black.  These are showing significant weakening and do not bode well for commodities going forward. 
I have concerns about this state of affairs which I will be addressing in my analysis.
Gold – is also struggling as the worries of a financial implosion because of the Greek mess is heightening deflationary concerns:
As with the commodity chart above Gold is trapped between Fibonacci retracement lines.  The yellow upward sloping line is a multi year support trend line that originates from an early 2009 low.  It’s still too early to predict where Gold might be headed from here but if we see a breakdown below the 61.8% Fibonacci retracement level and through the yellow lines I believe it would force me to question my long term bullish thesis for the yellow metal.
The Dollar - as we study the chart of the Dollar we have to say that it is in an uptrend.   However, as someone who watches these markets constantly I’m not impressed by the Dollar’s price action recently.  Maybe I’m letting the fundamental picture influence my biases but for all the noise coming out of Europe, concerns over a slowdown in China and the popularly held belief that the U.S. economically is the best looking house in a slum (which I agree with) I would have thought that we would have seen a lot more strength than the Dollar’s lackluster performance has manifested.
The two year daily chart of the Dollar below reflects what I consider to be dull price action.  First and foremost, the black arrow highlights where we presently are as of Friday’s close and as you can see we are barely hanging on to 61.8% Fibonacci support.  And we’ve been hovering at this level for about two weeks!  The two momentum indicators in the panels above and below the chart are showing some gathering momentum but it’s certainly nothing to “write home about”.  All we can say is that the Dollar has been able to make a series of higher highs and higher lows.  A weak Dollar has been supportive of higher equity prices as per our inter market relationships so this continued action or further weakening will support my bullish thesis going forward. 


I’ve maintained the thesis since the beginning of the year that stocks were going higher.  I predicated this opinion based on the following:

·         The immediate impact of the December 21st LTRO implemented by the European Central Bank that pumped 489 billion Euros into the European banking system.  This “repo” operation went a considerable way in easing the tight credit conditions which prevailed in Europe for most of the second half of 2011.  This move, in conjunction with the upcoming LTRO of February 29th serves to insulate Europe’s banks from all but the largest sovereign default (i.e. Italy).  And this “opium” should “float all boats”, including our stock market.

·         Secondly, our economic reports are improving by the month.  Everything from auto sales to employment to commercial credit has shown steady improvement which makes the US “the best looking house in a slum”!

But we have divergences in the inter-market relationships that we track.  Stocks are attempting to tug all asset classes higher while commodities and Treasuries refuse to confirm.  The market is vacillating between fears of a deflationary implosion and the prospects of normal (albeit post crash) economic growth. 

Commodities are my main concern.  At a time when they have consistently moved in lock step with stocks they have been lagging.  What’s going on?  As I survey the economic landscape the problem is not here in the US.  We’re maintaining a balanced growth pattern with growing credit formation and improving unemployment.  As far as employment goes, we’re starting to find out that the numbers may have been skewed by demographic factors that had nothing to do with the problems of 2008.  In the “new normal” economic environment we find ourselves in, it would seem that demographics are having a more significant impact on the employment situation than conventional wisdom might think.  I’m not saying there isn’t an unemployment problem; I’m just saying it may not be as disastrous as many think. But that doesn’t answer the commodity dilemma. 

The answer I think that is most viable is that China has slowed to the point where commodities are treading water.  That doesn’t mean that the Chinese economy is going into recession.  It just means that instead of double digit growth the Chinese economy is chugging along at about an 8% rate.  Of course, the economic slowdown in Europe doesn’t help but the main driver of commodity pricing is Asia and in particular, China. 

Here’s a chart of the Shanghai Composite Index with Friday’s close circled in black:

In many ways the Chinese economy suffered greater economic contraction in the last year than any other country on the globe and the November/December period on the chart above was devastating.  But we are seeing a sustained uptrend (coincident with the ECB LTRO J) and we are on the cusp of penetrating a long term resistance trend line (pink dashed line) as well as Fibonacci resistance.

My point in posting the chart above is that if the uptrend in the Shanghai continues then commodity prices will strengthen.  If, however, the Shanghai Index backs off of the resistance line above then it may be a confirmation that the weakness in commodities is foretelling a weakening global economy and my thesis may be incorrect.

Let’s talk about Greece.  Will Greece default? And what would be the result of a disorderly Greek default?  The short answer to both questions, in my opinion is “yes” and “no one really knows”.  The long answer is a bit more complicated and I’m not proposing a timeline for such a default.  I’d wager that they get this next tranche of 130 billion Euros but will default sometime in the second half of the year.  However, this is all speculative.

Greece’s situation is unsustainable.  The goal imposed by the European Union (EU) that Greek debt must be 120% of Greek GDP by 2020 is not a realistic target.  They are already running behind the projections they made for growth and will most likely need more money than they are already projecting.    And meanwhile social discontent is mounting and there are real concerns that wholesale poverty is taking hold in the Greek population.  It is said that 60,000 small Greek businesses have failed in the past six months.  Greeks are burning German flags in Athens!  Could there be a coup d’├ętat?

One wonders, with recent statements out of the EU, whether the Germans and others in the European Union are trying to force Greece out of the union.  Everyone says no to this but the way “the troika” (International Monetary Fund, European Central Bank and European Commission) is putting a gun to the head of Greek leaders makes me wonder.  Certainly, there is a high level of mistrust in the EU given Greece’s past record in not implementing the austerity measures they’ve already promised.  But to be fair to Greek leaders, part of the problem the government is having surrounds the fact that tax receipts are plummeting due to the severe austerity being imposed.  The Greek economy is quickly descending into a “black market” economy where the Greek population, being squeezed by deflationary forces, are doing everything they can to make every Euro count.  And this means, first and foremost, avoiding the tax man.   

All indications are that the Greek parliament will approve the austerity plan provisionally agreed to this week in Brussels.  Indeed, although they are going to vote on Sunday night to ratify the austerity plan (a requirement that the EU is demanding ahead of Greek elections in the spring), they are already looking to borrow an additional 15 billion Euros to recapitalize their banks and have to address a 320 million Euro “hole” in the plan where the Greeks apparently have not explained how they’re going to make up that shortfall. 

All in all, the situation is quite fluid and anything can happen at this point.  But if EU officials are playing such “hard ball” with Greece in the hopes they will default and leave the EU then maybe they know the end game of a Greek default and are not worried?  Or are they playing brinkmanship with the Greek government in the hopes of wringing as many concessions out of them as possible?  Or maybe a combination of both?

Which leads me to the next important topic; the next LTRO is February 29th and Mario Draghi has announced more liberal collateral requirements.  Some are predicting as much as another trillion Euros will be pumped into Europe’s banks.  Mr. Draghi is proving himself to be a very capable Keynesian as the first LTRO stabilized the global economic system and the second LTRO will effectively put to rest the fears of a global meltdown if Greece or even Portugal defaulted.  Most importantly, the second LTRO will guarantee the solvency of the European banking system which is what everyone is really worried about anyway. 

I mentioned above that I thought the Greeks would get the next tranche of aid and I believe that the reason will not be that European Union leaders actually believe that the Greek government will live up to its austerity promises but that the ECB needs more time  to “pad” Europe’s banks with enough money to withstand any reverberations from a Greek default.

So, how will a Greek default impact our markets?  I’m looking at a possible Greek default as a buying opportunity.  If Greece defaults there will be a “knee jerk” sell off that will provide an opportunity to buy high quality stocks at bargain basement prices.  The market will immediately bounce back.

I’ll leave you with one more chart that supports my bullish thesis as articulated in this commentary.  The chart below is the St. Louis Fed’s Financial Stress Index (STLFSI).  It is constructed using 18 weekly data series from interest rate series to yield spreads, bond indexes and volatility indicators.  The goal is to measure stress in the global financial system.  As you can see, even the seeming crisis we lived through late last summer was nothing compared to the stress in the system during the Great Financial Crisis (red arrow).  More importantly, after a slightly elevated reading the index is dropping at a pretty quick pace.

Is all well?  With the mountains of debt that developed economies on the planet are carrying, the answer is “no”.  But are we at the precipice of financial Armageddon?  Those who believe we are have to refute the mounting information and data points that belie such a thesis.

Have a great week!