Market Analysis 2/17/2012

Macro Analysis

2/17/2012

If you watched the market closely this week you might have thought that perhaps stocks were stalling at these levels.   Yet all the major indices save the DOW Transports finished the week over 1% higher.  Transports were reacting to information suggesting that there was less demand for coal being transported to energy suppliers due to the abundance and cheapness of natural gas.  Commodities remained relatively weak and Treasuries are still stubbornly refusing to confirm the rally in stocks.  But even here, there are glimmers of hope.  I’ll have this, an update on Europe and much more in this week’s commentary.

Stocks – a picture is worth a thousand words so all I’m going to do is post charts and, where necessary, explain their meaning. 

Here’s the Consumer Discretionary ETF(Exchange Traded Fund).  This ETF tracks a basket of stocks from the likes of McDonalds to Bed, Bath and Beyond.  As you can see, it’s on a tear …

Support is at 40 and there is just the slightest indication that momentum may be starting to wane.  Nevertheless, the chart is representative of strong consumer spending in the economy.

The next chart is also an indication of a strengthening economy.  This is the Technology Select Sector ETF.  XLY has also been on a tear that suggests that not only is the economy strengthening but speculative juices are starting to stir in the market.  This is just the kind of action we want to see in a bull market.  Notice the momentum.  It doesn’t get much better than this!

Let’s look “under the hood” of the market.  The following two charts are ratio charts of advancing volume compared to total volume on the NYSE and NASDAQ respectively.

As you can see, advancing breadth in this market is very strong and we have surpassed the July 2011 highs by a wide margin.  Aside from the strength these charts are manifesting the market is showing resilience against selling pressure even on weak days.  But we are also getting close to significant resistance in the S&P at 1370.  I’ve been saying for awhile that any correction we might experience may just evaporate into side ways action as there are tons of liquidity on the side line and with every passing day more and more investors (institutional and individual) are becoming believers that this rally is for real.  I believe the two charts above support this thesis.  I’ll have more on this subject in my analysis.

Treasuries –   Treasuries are stubbornly refusing to confirm the rally in stocks but the pressure is mounting and they are starting to crack.   Here’s the iShares Barclays 20+ Year Treasury Bond ETF which tracks the long end of the yield curve: 

As you can see, TLT is straining to stay inside the consolidation triangle (blue dashed lines) and the Relative Strength Indicator above is getting dangerously close to bearish territory (under 40).  Some of the resilience in Treasuries can be attributed to FED activity in the bond market.  I’ll have more on this in my analysis.

Commodities –   are also not confirming the rally in equities and, at this point, we have to concede that this divergence must inevitably catch up with stocks and pull them down.  If economic conditions are indeed strengthening then there should be upward pressure on commodity prices, especially industrial commodities.  But industrial metal prices such as copper, aluminum, steel and coal have stalled and retraced some of their gains in recent weeks.  Oil has been the exception but has its own unique dynamics that is driving its price. 

Here’s a one year daily chart of the Market Vectors Steel ETF and it continued to rally with stocks until late January when it turned over.  Now it’s stuck between Fibonacci retracement levels and the Relative Strength Indicator in the top panel is showing a significant loss of momentum.  However, if you look closely you can see that the indicator bounced around the 50 level and if momentum can stabilize at this level the worst may be over for Steel.

The chart below the Market Vectors Coal ETF ( KOL) which is showing the same characteristics as the other commodity charts I’ve posted.   Coal rose with equities in late December but not with the same momentum as the rest of the commodity asset class.  It rolled over like all the other commodities at the end of January but is showing some more signs of life than many other commodities.  Notice the Relative Strength Indicator in the top panel.  Nevertheless, the most we can say for coal is that it had a false breakout above the 61.8% Fibonacci retracement level and to resume its uptrend it would need to penetrate that retracement level and exceed the 37.40 level set on February 6^th (black arrow).

Below KOL I’ve posted the daily chart for Copper.  Again, the price action rhymes with the other charts.

The weakness in commodities can be attributed to China’s slowdown and while this weakness has not yet caught up with U.S. stocks it will if economic conditions do not improve there soon.  As of this writing (Saturday, 2/18) the PBOC (People’s Bank of China) has cut its bank reserve ratio requirement another 50 basis points effective February 24^th.  This is the second such easing in the past 90 days and we will know when these actions by the PBOC are effective when we start seeing the prices on these charts start rising again.  I’ll have more on this in my analysis.

Oil – West Texas Intermediate Crude has been stuck below its 38.2% Fibonacci retracement level for the better part of four months and popped its head above it on Friday.  I’ve been intrigued with its price action since many pundits are predicting $150 to $300/barrel oil based on a possible international crisis over Iranian nuclear capability.  Yet, “black gold” has been relatively stable as we look at the West Texas crude Chart.  However, the Brent North Sea Crude chart has taken off to the upside!  The dynamics of the Oil market must be addressed separately in order to analyze its impact on the equity market.  In a general sense we can say that stocks and oil are positively correlated but that is only a cursory assessment of the relationship.  I’m going to be dedicating a number of my blog posts this coming week to oil and where I think it might be going.  You can look for those posts at equitymaven.blogspot.com.

Gold – Gold seems to have lost its identity since its vicious sell off in September 2011.  In many ways, its price action since late December has mimicked stocks and commodities but since the end of January the price action has turned flat.  This is puzzling since it has reacted in a bullish way since 2009 whenever any central bank pumped liquidity into the financial system.  Certainly the ECB’s (European Central Bank) LTRO of December 21^st that effectively added 489 billion Euros into the European banking system would qualify as such an action.  However, as you can see from the chart the yellow metal is going nowhere:

The Dollar -  finally, let’s look at the US Dollar.  I’ve highlighted the price action on the chart below with a grey circle:

The Dollar also traded flat this week.

ANALYSIS

As I surveyed all the asset classes this week the first word that came to my mind in attempting to sum up the week was “indecision”.  The market doesn’t know what to do given all the crosscurrents manifest in the global financial system.  Many are still fearful of a Greek default and possible global financial implosion.   However, I would submit that these fears are overblown given all the liquidity the ECB pumped into their banking system on  December 21^st of last year and what they will adding to it at the end of this month. 

As I said last week, a Greek or even Portuguese default was never the real concern of the financial markets.  It was the European banking system!  And with 489 billion Euros already added and the addition of possibly another Trillion Euros on February 29^th this will serve to insulate Europe’s banks from any sovereign default (save Italy).  I’ll even stick my neck out and state what the ECB did on December 21^st and what they will do on February 29^th has made the Euro Zone debt saga a non-event.  As I stated a few commentaries ago, in the Keynesian world we live in, what is needed to get ourselves out from under the enormous debt load that’s burdening us is time.  And 1.5 trillion Euros buys an awful lot of time for Europe. 

The LTRO (long term repo operation), as stated last week, “floated all boats” and you can see the effect of this liquidity on virtually all the charts I’ve posted in my commentaries and on my blog since December 21^st.  My thesis asserts that this will continue and assuming a 1 Trillion Euro LTRO on February 29^th, will serve to propel US stocks to new all time highs. 

From what I hear in the media, many professionals are not convinced that my thesis is correct.  And I believe this is why we’re seeing the indecision we’re seeing in the Dollar, Gold and to a lesser extent Treasuries.

Treasury price action is being influenced by the FED in two ways:

·         Their commitment to keeping short term interest rates at near zero for the next few years and

·         The effects of “Operation Twist” which is their buying up securities in the “belly” of the yield curve, thereby affecting the 10 year Treasury rate (mortgage rates key on this rate).

Additionally, a third factor moving the Treasury market is the “fear trade”.  That is, Treasuries are known to be a “safe haven” for investors in times of financial stress.  With all the concerns about Europe and weak economic growth out of China, investors are hiding their money in Treasuries thereby suppressing interest rates.

We need to consider that even the FED only has the money and power to influence prices in the global bond and Treasury market on a short term basis.  The global debt market is gargantuan!  No single entity or group of entities can dictate pricing in this market.  And that’s why, even with the influences I categorized above, interest rates are grudgingly moving higher even with the FED’s activity in the market.  At the moment the pressure seems negligible.  But it is there and the chart above of TLT isn’t lying!  Higher rates are on the way and if the “fear trade” dissolves according to my thesis we could see a significant back up in rates.

Right now, I’m predicting a rise in the 10 year rate to between 2.4 to 2.5%.  It closed on Friday at 2.01%.  But if the “fear trade” dissipates we could se a more substantial back up.  If this back up in rates occurs it will initially be good for stocks, maybe for the Dollar (the inverse correlation between the Dollar and stocks may be broken), and maybe bad for Gold depending on how commodities act in the coming weeks and months.

What about commodities?  I believe more and more their price action is being driven by economic fundamentals out of Asia, especially China.  I’ve read stories in the financial press that stockpiling of copper by the Chinese has served to skew the price action of the metal in the futures market.  And when you have this kind of activity it’s difficult to assess global economic fundamentals based on charts.  Nevertheless, China has always had a significant influence on the commodity market based on its massive production based economy.   Therefore, when I see this asset class lagging other asset classes that it has been traditionally positively correlated with I have to believe, the copper story I alluded to above notwithstanding, their economy is slowing to the point where it could affect other asset classes.

Now, as I said last week, it’s not as though China is going into recession.  We’re talking about going from a 13% growth rate to an 8 or 9% growth rate!  But given the fact that the market has become accustomed to double digit growth, a slowdown of this magnitude could impact us.

As I stated above, the Chinese have eased monetary policy twice in the last three months and this gives me much hope that the Chinese production machine will continue to buoy the global economy in 2012.

I’d like to address the belief by some that the FED will once more step into the market with another QE (Quantitative easing) facility.  I don’t believe we will see the FED intervene the way they did in 2009 and 2010 unless something unforeseen happens that would necessitate an emergency injection of liquidity into our financial system.  The economy is showing some real signs of recovery and I suspect that Bernanke may already be concerned that he has provided a little too much liquidity.  I wasn’t worried too much about inflation until the FED announced their intention to keep short term rates where they are for the next few years.  I believe that, in spite of the massive deflationary forces we are presently dealing with, this action will have significant long term inflationary implications.  I also believe the FED may eventually have to “eat its words” and backpedal on its pledge to keep rates at essentially 0% for that long.  When they made the announcement I thought to myself, “Does anyone really believe they will keep their promise”?  But the market seemed to believe it.  I did and do not.  I have much more to say about the new FED policy of “transparency” but suffice to say I believe “the street” is going to get burned if they believe the FED is going to keep to their timeline in this regard.

Looking ahead, what would derail this market?  There are only four events that could negatively impact this rally (from least likely to most likely):

A Greek default -  For reasons stated above I don’t believe that, other than a knee jerk panic sell off, that this would signal the death knell of the global financial system.  In fact, I think such a correction would be a buying opportunity for investors.  In any case, we’ll know whether the EU is going to approve the 130 billion Euro package on Monday.  All indications as of now is that the package will be approved which will push the possibility of a Greek default out to at least April or beyond.

The upcoming presidential election -  The election as a market mover will be a function of how the economy progresses between now and the election.  My personal opinion is that if the economy continues to improve whether Obama, Romney or Santorum win the presidency it will have very little impact on the market.

President Obama’s budget -  I really believe this could be a major market mover this year.  It’s clearly a fantasy budget and the expansion of the deficit could threaten the U.S. with another downgrade from the rating agencies.  It’s unclear how the market would react to another downgrade of U.S. debt but maybe the price action in the Dollar this week took its cue from the budget announcement?  In any case, we must consider that if the February 29^th LTRO in Europe “does its magic” in Europe who will the bond vigilantes go after next?  I know this concern might be a stretch at this point of time but when we do comparisons on sovereign debt there is NO ONE more indebted than Uncle Sam! 

Now, there are some significant factors that need to be taken into account regarding the statement I made above.  Unlike Greece, our productive capacity is second to none.  Our entrepreneurial spirit is also second to none.  These two things alone could go a long way in narrowing any deficit we presently have.  But with a budget that’s tacking on another trillion dollars of debt, in the short run, we could be exposed to another debt downgrade.   This issue, if focused upon, could roil markets as it did in the summer of 2011.  

Lastly, the event that could do the most damage to our markets would be a spike in the price of oil.  An Israeli attack on Iranian nuclear facilities would be the catalyst but at this time it’s pretty clear that they will not attack without American cooperation which the present administration will not countenance in an election year.  I’m not concerned about a gradual increase in the oil price because I’m beginning to believe we are starting a transformation in our energy usage.  I’ll be elaborating on this thesis in future blog posts and commentaries but I’ll give you a hint where I’m going:  WPRT!  J

Have a great week!

NOTHING IN THIS COMMENTARY SHOULD BE CONSTRUED AS AN OFFER OR ADVICE TO BUY OR SELL ANY SECURITIES, OPTIONS, FUTURES OR COMMODITIES. THE OPINIONS ARTICULATED ARE ONLY THIS AUTHOR'S WHO IS NOT A LICENSED INVESTMENT COUNSELOR OR BROKER.