Saturday, May 26, 2012

Macro Analysis 5/25/2012

Stocks had their best week in a month with the Dow rising 0.7% to 13,454.83 and the S&P 500 rallying 1.7%, to 1317.82. The Nasdaq Composite gained 2.1% to 2837.53. The Russell 2000 small-cap index rose 2.6%, to 766.41.

All asset classes are being held captive to news events coming from the Euro zone and to a much lesser extent China.  There are fundamental reasons that support a choppy market to the end of June or even beyond.  I say this with the caveat that any announcements from central banks that are seen as supportive to weakening economic conditions will easily ignite a worldwide rally in equities and commodities.  I'll be laying out my short term to intermediate term theses on the financial markets later on in this commentary.  But let's do what we do best; look at the charts! 

I'm going to start with a chart I normally have not started with in the past:
(click on chart for larger image)

This is a daily chart of the US Dollar going back to April 2009.  The Dollar has been on a tear since the beginning of May when it bounced off its 61.8% long term Fibonacci retracement level, broke out of a long term consolidation triangle and is now approaching the 38.2% Fibonacci retracement level which will act as resistance.  Just how much resistance is another question.  The momentum and slope of the rise from May is not sustainable and conventional wisdom says we're overbought and in need of a correction.  To this I agree but there's nothing fundamentally brewing in the global financial/political sphere that would precipitate a correction in the Dollar.  Technically, we have a near record number of speculative "shorts" in the Euro which is about 57% of the Dollar Index and normally with this sized short position any upward pressure on the Euro would force the "shorts" to cover their position, sending the Euro significantly higher and inversely, the Dollar lower. 

Remember the relationship between the Dollar and stocks and commodities.  A stronger Dollar equates to cheaper stocks and commodities because it takes less Dollars to buy those commodities and stocks. 

It's surprising that stocks have not taken more of a beating given the Dollar's precipitous rise.  Here's the Russell 2000 Small Cap Index which had the best week among all the major indexes:

The Russell has stabilized at the 38.2% Fibonacci retracement level which is acting as strong support for the index.  Momentum indicators are turning up but are not predictive of powerful upside momentum. 

Here's the Wilshire 5000 which is the broadest index of stocks traded in the US:

The Wilshire also bounced off a double Fibonacci retracement level in the past week and is now attempting to penetrate the 38.2% retracement level. 

Lastly, here's the S&P 500:

The S&P too has bounced off of Fibonacci and technical support but momentum indicators are lackluster. 

Stocks are maintaining their support levels at this point and we'll need to watch for a breakdown of the following levels for a more significant decline:

S&P500: 1292
Russell 2000: 754 - 755
Wilshire 5000: 13480

A decisive break on the S&P below 1292 will most likely drag the other indexes down with it. 

Will stocks break down from here?  In the current environment we're in anything can happen but all things equal, I see more of a trading range in the coming few weeks. 

Treasuries back filled a bit this week after their record breaking performance last week:

Here's a weekly chart of a Treasury ETF we monitor frequently on this blog.  The iShares Barclays 20+ Year Treasury Bond Fund (TLT) is used by many as a proxy for the long end of the yield curve.  I've put more than the usual momentum and volume indicators on it and we're starting to see some incremental weakening in these oscillators.  I'm especially watching the 20 and 40 week Chaikin Money Flow. 

The Chaikin Money Flow indicator measures the amount of money flow volume over a specific period.  It's a way of measuring the balance of buying or selling pressure on any stock, ETF or index.  I've highlighted on both panels below the price chart with brown dashed lines the divergence between the buying pressure and the price action in the ETF.  We must always remember that price action is the primary way to evaluate these charts while momentum indicators are clearly subsidiary indications in these evaluations.  Volume indicators are,at best, tertiary in analyzing the chart.  With that said, I've found Chaikin Money Flow helpful in the analysis of weekly charts in the past.  I've had the learning lesson of ignoring this kind of divergence on this ETF back in 2010 to my detriment!

I've been suspicious of the rally in Treasuries for some time now and the Chaikin Money Flow divergence suggests that the party in Treasuries will end soon.  Nevertheless, as long as Europe threatens to implode investors will continue to flee to the safety of Uncle Sam's debt paper.  I'm not fighting the trend here; I'm just watching things very closely.

Gold has been showing some signs of life and I believe it is clearly in a basing pattern:

I like the price action here and the clear support right around the 1525 level.  Gold is finding its footings and I believe we will see all time highs in the metal by year end.  If we don't it will be because Europe does implode!

And commodities are still basically dead in the water:

Here's Brent North Sea Crude which is used as the benchmark price for oil almost everywhere in the world.  We've stabilized in the last week or so and this stabilization is also apparent on the dozens of commodity and basic material charts I monitor.

This is the Goldman Sachs Industrial Metals Index and it too seems to be stabilizing a tiny bit.  Whether the faintest hint of a stabilization in the commodity complex is the beginning of a turnaround or simply a pause before resuming the downtrend is something we'll have to monitor.

Greece seems to be the overriding concern of the market these days and rightly so.  I already sited in another post's estimate that a Greek exit from the EMU (European Monetary Union) would convert a half a trillion in debt presently in Euros into Drachmas, essentially making the debt worthless.  Now Charles Dallara, managing director of the Institute of International Finance (IIF), states that a Greek exit from the Euro zone would cost a trillion Euros and render the European Central Bank insolvent!

When I start seeing estimates and projections a half a trillion Euros apart it tells me that no one really knows what the backlash from a Greek exit will be.  More important in my eyes would be whether such an exit would be orderly or disorderly.  A disorderly exit will be an ugly event for risk assets worldwide.

But maybe we're getting ahead of ourselves?  I was pretty adamant last month that Greece would leave the EU but I've tempered my opinion in the past week or so based on polls out of Greece that suggest the Greek people are shying away from the default precipice.  And although I believe the June 17th vote in that country will be a cliff hanger I'm willing to step out on a limb once more and say that "pro austerity" parties will overcome the leftists in that election out of fear of the unknown if the country did default and exit the Euro. 

Lest you think my changed opinion is nothing other than just that I do have some technical reasons to support my new thesis.  This is a weekly chart of the Three Month T Bill Discount Rate:

I posted a variation of this chart on Wednesday evening and I believe it's important to understand what institutional investors are doing in the current global environment we find ourselves.

Short term Treasury bills are a global "safe haven" where institutional investors can park their assets when they are afraid to put them anywhere else. These bills are extremely liquid and backed by the full faith and credit of Uncle Sam. To understand the chart above you need to understand that yields on bonds, notes and bills move inversely to prices. As Treasury Bill prices rise their yields drop and when their price drops yields rise.
In the upper panel is a weekly chart of the CBOE Volatility Index, popularly known as the "fear gauge".  It captures the market's expectation of 30-day volatility using a wide variety of S&P 500 Index options.  Simply, when the VIX rises the market becomes more prone to a correction, and when it drops it signals stability in the market. The bottom panel is a weekly line chart of the S&P 500.

I've constructed a red dashed vertical line on the three charts to delineate the nose dive in the Three Month yield in December 2008. The Three Month T-Bill yield quickly recovered, and in this case, predicted the "V" bottom in March 2009 and the subsequent bull rally.
The two vertical solid blue lines are meant to capture the period from April to December 2011 when the rate on the T-Bill tanked again. But this time the yield stayed at record low levels for the entire period as frightened money created such a demand for this "safe haven" trade that yields stayed anchored at these extremely low levels.  It was during this time that fears of financial implosion in Europe roiled global risk assets as I point out on the bottom chart of the S&P 500.

But for all the talk of a Greek exit and bank runs in Greece and Spain, look where the yield closed on Friday!  We are not seeing the flight to safety that we saw last year in spite of the fact that there's a better than even chance of Greece exiting the Euro within a month. 

Here's a closer snapshot of the chart above:

I've highlighted support with blue and red horizontal lines.  Until we break below these two levels in my opinion there is no significant or substantial fear in these markets yet and the big money is betting on Greece staying in the Euro zone.

Please don't misunderstand.  All is not well out there and even if my thesis about the Greek vote is right it may only provide a sharp short term bounce in the market.  And that depends on whether expectations build on the possible direction of a Greek vote based on polls that come out intermittently before the event.  All financial markets will be held captive to these opinion polls leading up to the actual vote on June 17th.  And as the polls show a leaning toward "pro austerity" ( New Democracy/Pasok parties) or "anti austerity" (Syriza party) the market will react either up or down.

But it would seem we still have the problems with Spain and Italy.  Spain has been capturing any headlines after Greece but Italy seems to be ignored by the mainstream press.  Here's a chart of The Powershares DB Italian Bond Futures ETN:

I've circled the 2011 Euro crisis and you can see the recovery in the Italian bond market since then.  I've drawn two long term support/resistance lines and the parallel to the daily chart of the Three Month T-Bill yield may seem uncanny but I believe the correlation is significant .  Are both charts trying to tell us something?  Why is institutional money not running for the hills this time?

One could argue that European firewalls are stronger and more comprehensive now than last year but I'm not convinced that is the reason.  If Spain or Italy were unable to finance their debt in the public marketplace these firewalls are grossly insufficient to support these countries.  In my opinion, institutional money is betting that the EU (particularly Germany) will capitulate and allow the ECB to do what everyone else has been begging them to do: prop up periphery debt by buying as much of it as necessary to stabilize European bond markets and the financial system as a whole.
My personal opinion is that the Germans will only go along with this if debtor nations surrender their fiscal sovereignty.  And I have a difficult time believing these nations would be willing to do this.  I wish I could take up residence for six months in a place like Rome, or Lisbon or Madrid or even Berlin to get a sense of the European mindset in this matter.  My knowledge as a historian of European history suggests that the European psychology would be fundamentally against a surrender of individual national sovereignty, especially with Germany dictating the terms. 

In any case, the Three Month T Bill rate is telling me that for all the scary news stories and daily events seemingly predictive of financial apocalypse, the attitude in the market toward these events is decidedly different this year.

China is still weighing on risk assets and the HSBC China May Purchasing Managers Index (PMI) fell to 48.7 which was the seventh straight monthly decline.  A reading under 50 means the economy is contracting.  I've stated before that I'm in the "soft landing" crowd on China but we better start landing soon!

The Chinese slowdown has negatively impacted Australia, which imports most of its natural resources to that country:

Here's a stack of multi year weekly charts of the Australia All Ords Composite Index, the Shanghai Composite and the Goldman Sachs Industrial Metals Index.  The All Ords has broken down below ascending support while the Shanghai Composite is treading water in a tight range.  The Industrial Metals Index is approaching crucial support.

The correlation between the three indexes, while not identical, certainly rhyme, especially the All Ordinares and the Shanghai. 

So, what's next?  As I said above, choppy markets will prevail through the month of June with volatility accelerating the closer we get to the Greek vote.  Watch for central bank announcements that are supportive to bolstering economic weakness with liquidity.  Assuming the continuing decoupling of our economy and Europe's (much depends on this week's monthly employment report) and that my thesis about Greece is accurate, we could see a significant summer rally in stocks in mid to late June.  More fuel for the rally could come from the Chinese government pumping fiscal stimulus in their economy.

So far as the longer term situation in the Euro zone, much will depend on the efforts of France's Hollande and Italy's Monte convincing Germany's Merkel that pro growth policies (aka stimulus) must be in the European deleveraging formula.  Don't bet on this happening and ignore any media reports that Germany is considering Euro bonds or the ECB buying up periphery debt.  This is the equation for the Germans to go along with any relaxation of austerity:

Relaxation of austerity must equal relinquishing national fiscal sovereignty.

The US economic calendar this coming week doesn't get interesting until Thursday when we get:

- weekly jobless claims
- quarterly GDP (will move markets if it comes in below or above expectations)

and on Friday we get some potential market movers:

- Monthly Employment Situation Report (this will be a "biggie")
- Personal Income and outlays
- ISM Manufacturing Index

In Europe it appears it will be a fairly quiet week except ECB President Mario Draghi speaks on Wednesday and depending on whether any news events take place in Europe between now and then he could move markets in addressing those events (if he indeed decides to address them).

Finally, let's remember our veterans, both fallen and alive:

Have a great week!