Sunday, April 15, 2012

Macro Analysis 4/13/2012

Stocks had another bad week with most of the major indexes registering losses between 1.86% and 2.86%.  Commodities are continuing to weaken while Treasuries and to a lesser extent, the Dollar, benefited from the "flight to safety" trade.  The market's main concern was the recent flair up of sovereign debt woes in Europe and while this is most certainly a major headwind there is something much bigger afoot which I have alluded to in past commentaries and blog posts.

Let's go to the charts.  Here's the Nasdaq 100 Index, comprised of the top 100 capitalized stocks on the Nasdaq stock exchange:
(click on charts for larger image)
As you can see we've broken through the uptrend line (black dashed lines) that had been sustained since this rally began late last December.  Normally such a break with the index still way above its 50 day moving average (blue line) would be signalling nothing more than a normal correction in an uptrend but:

Here's the Nasdaq Summation Index with the Nasdaq McClellan Oscillator in the lower panel. The Summation Index and Oscillator are used to determine the internal strength of the entire Nasdaq Composite.  The Summation Index is a breadth indicator derived from the McClellan Oscillator, which is a breadth indicator based on Net Advances (advancing issues less declining issues).  It's clearly taking a swan dive and is now under the zero line which reflects much more weakness than the index itself is showing.  The summation index for the NYSE (New York Stock Exchange) is showing similar weakness but is not yet below the zero line.

I posted the Nasdaq 100 Index because it has been carrying the general market for the past month.  But it appears we are close to a more significant correction in the index.
I wouldn't normally be this bearish just from these technicals but the fundamental global backdrop is growing more negative by the day.  The Euro Zone debt saga has been renewed (it never really went away) and Spain is the major focus.  Ever since Rajoy announced the country could not meet its austerity and deficit targets yields on Spanish debt have been rising. 

The ECB's (European Central Bank) two LTRO's (Long Term Refinancing Operations) seemed to have backfired as Spanish banks borrowed 28% of the 1.1 Trillion Euros offered in order to bolster their reserves but also to buy Spanish sovereign debt.  This initially helped Spain when it went to market to rollover its debt in the first three months of the year with the attendant result of lowering yields.  But now, with foreign money unwilling to buy rollover debt coming to market and the Spanish banks running out of the LTRO money they borrowed, panic is starting to take hold in global financial circles.  The "double whammy" here is that not only are the Spanish banks running out of the money to finance their own country but the existing bonds they bought earlier in the year are losing value as fewer and fewer foreign investment entities are willing to take the chance and buy this paper.  This is having a negative impact on Spanish bank reserve requirements.   Remember, as yields rise, the underlying bond drops in value; as yields drop, the underlying instrument increases in price.

There's a LOT more to this story than what I've articulated above and Italy is being impacted by the contagion risk in rising yields as a result of the tensions in the bond market over Spanish debt.  It's becoming more and more evident that if the European Union wants to end the crisis they have to resort to measures they, up to this point, have been loathe to implement .

Treasuries were the beneficiary of this week's market action as investors ran for cover:

Here's a weekly chart of the 30 Year Treasury Bond Yield.  As you can see from the rising support line on the chart (black dashed line) yields have been steadily rising since last December and even with this week's price action (black circle) we're still above support.  The Relative Strength Indicator is showing incredible weakness (black arrow) while Rate of Change(ROC) has violated its support line.  MACD, which is a longer term momentum indicator, shows signs of rolling over.
If my bearish thesis on stocks is wrong, the 30 Year yield will bounce off of the black dashed support line and stay above it.  But if it violates that support line, long term rates could easily drop 40 basis points (around 2.8%) from Friday's close.

Commodity prices have been steadily declining with the street attributing the price action to the Chinese slowdown.  To this I will not disagree but China is not only slowing down because of it's own internal problems (property bubble, growing banking problems) but in large part because its biggest trading partner, Europe, is slipping into deep recession.  This is exacerbating global economic weakness.  Here's a weekly ratio chart going back to May 2007 of the Morgan Stanley Commodity Related Index divided by the S&P 500 Equal Weighted Index :

This is just another way of showing the significant weakness in the commodity complex.  The Morgan Stanley Commodity Related Equity Index (CRX) is an equal dollar weighted index based on shares of widely held companies involved in commodity-related industries such as energy (e.g. oil and gas production and oilfield services and equipment), non-ferrous metals, precious metals, agriculture and forest products.  Using equally weighted indexes gives further veracity to the chart above as both indexes are not skewed by higher capitalized stocks in the indexes.

The Commodity Related Index has been under performing the S&P since August 2011 and shows no signs of recovering.  The pink downtrend line is steep and normally such steepness cannot be sustained either down or up without an occasional "reversion to the mean" (a theory suggesting that prices and returns eventually move back towards the mean or average).  And this week we did see the slightest "blip" in the Commodity Related Index but until we see some pressure on that downtrend line commodities will continue their downward slide.
Gold is acting indecisively with a possible inverse head and shoulders formation in the making:

This is an update on the chart I posted on Wednesday and I've added a couple of trend lines.  We still have a possibility of consummating this potentially bullish pattern but notice the black arrow on the chart.  Thursday's price action formed a clear candle (up day) and Friday matched it with a black candle (down day).  This is known as a Harami pattern and is a bearish engulfing pattern.  It means we will probably see lower prices next week.  And if Gold is going lower, the chances are that the Dollar is going higher.  That bodes ill for stocks.
Gold is being held captive to statements and actions emanating from global central banks.  Essentially, the case for gold is this:  global central banks will do ANYTHING to avoid financial calamity and deflation, and as a result, will print as much money as they have to in order to maintain the credit based Keynesian economy that has existed for the better part of the last century.  And in the Gold bulls' defense, there has been very little evidence up to this point that central banks won't continue to exhibit this behavior.  Their track record of the past four years supports this thesis. 
Yet Europe, which has only grudgingly embraced the Keynesian prescription that Bernanke and company have implemented, seems to be resisting this seemingly popular solution.  In particular, the Germans, Finns and to a lesser extent the Dutch have opposed different forms of quantitative easing.  The LTRO was an exception and not readily welcomed by the Germans but they had little to say as Draghi implemented the program within the confines of his mandate.
But if pressure on Spain persists, it will be a totally new ballgame than anything we have seen up to this point.  The European Union can put a band aid on Greece or Portugal or even Ireland.  But they would have quite a challenge putting it on all three at the same time.  But Spain?  The printing presses would have to roll!  But in such a scenario would they?
It has been said by many astute observers that there is strong support for a continuation of the European Monetary Union and an eventual progression into a European political/fiscal union.  Assuming this is an accurate estimation of the European mindset, if Spain is forced to nationalize its banking system and absorb all the debt currently on Spanish bank balance sheets in order to avoid an implosion, the ECB will be forced to print "unsterilized" money to support the Spanish government.  It will have no choice unless it is willing to see the entire periphery (Portugal, Italy, Ireland, Greece and Spain) leave the Euro Zone. 
But will the Germans, who are the financial backbone of the European Union, support such a policy decision?  Any decision to pump "unsterilized" money (money printing without reserve-draining actions) in the EU all but requires German acquiescence.  The "gold bugs" seem to believe this is a "fait accompli".  I am not so sure.

It will truly depend on the German government's commitment to a unified Europe.  Coincident with that will be the German electorate's willingness to bankroll periphery nation debt.  I've written in the past about the German mentality and aversion to inflation along with the psychological scars that the Germans still carry with them over the hyper inflation during the Weimar Republic ninety years ago. 

Scott Minerd, Chief Investment Officer of Guggenheim Partners stated in so many words this week on CNBC that if the political will in the Euro Zone is truly committed to a unified Europe the Euro will have to go to parity with the Dollar.  Here's the Euro as of Friday's close:

The Euro closed at 1.3077 to the Dollar.  It's a long way to parity and anyone in the trading community who has been anticipating this 'short' coming to fruition in the past few years has been burnt by the resilience of the Euro.  I have to agree with Scott's thesis that 'if' the Northern faction of the Zone commits to a unified Europe in its present form then the Euro has to substantially depreciate.  It's the 'if' I'm concerned about.

Central banks have been printing money since the Great Financial Crisis and I've posted a number of charts over the past few months that depict that their efforts are having less and less of an impact.  Here's an updated 10 year chart of the velocity of M2 Money Supply from the St. Louis Federal Reserve:

 Velocity of M2 is the ratio of nominal GDP (Gross Domestic Product) to the measure of M2 which is money in circulation, saving deposits and money market funds .  It can be thought of as the rate of turnover in the money supply.  Simply, it is the number of times one dollar is used to purchase final goods and services included in GDP.  As you can see, in spite of all the money the FED has created since 2008 it's apparent from the chart above that their efforts to spark credit creation in the economy have failed up to this time.  Notice two things from the chart:

1. With all the liquidity the FED and the US government pumped into the system at the end of 2008 into early 2009 and then QE2 which commenced in the last quarter of 2010 that ratio has increased only .05 points from 1.65 to barely 1.70 (see the bottom in the grey shaded area on the right.
2. The most positive thing we can say from the chart above is that the steepness of the decline has moderated in the past six months.

This highlights the issue I've addressed in past commentaries and blog posts.  Global deflationary forces are incredibly powerful and the central bank stimulus of the past three + years has done nothing more than barely stabilize the teetering system.  Equities and commodities have been buoyed by the massive infusion of liquidity which have only masked the problem.  And now, the price action of the past nine months suggests the 'fix' on commodities has worn off.

The central bank effort is an attempt to buy time until the deleveraging can take place and normal credit creation can be sustained on its own.  Will central banks succeed?  The verdict is still out and what I'm seeing almost universally in the charts since last fall is that, at the least, deflation is winning this round in the championship fight for the salvation of the global economy.

This coming week:

1.  Look for the Chinese government to possibly ease bank reserve requirements.  An outright interest rate cut does not seem to be in the cards.  If any of the two occur it will provide a "pop" to global risk assets. 
2. And of course, any rhetoric out of the European Central Bank or the FED that intimates more liquidity infusion will have a greater effect, both in terms of the "pop" and its longevity.  But the question is, for how long? 
3. Spain has two bond auctions this week which threaten to ignite a global sell off in risk assets if they are not well received (which seems to be the consensus). But watch for any rhetoric out of the ECB which, in the environment we're in, will serve to roil markets further.
4. Earnings season continues this week and Wall Street's expectations are so low that any earnings surprises are seen as possible catalysts to spark a new bull leg.  However, I'm of the opinion that the concerns articulated in this commentary will predominate equities price action.  And remember, seasonality is upon us.  "Sell in May and go away ..."  I don't hold out much hope for a summer rally if events in Europe heat up as I believe they will.

Unfortunately, it looks like we are entering another phase of volatility in the market analogous to the last half of 2011.  If I'm right, this market will not be for the faint of heart!

Have a great week!