Sunday, July 22, 2012

Macro Analysis 7/20/2012

Well, I was partially right about last week.  The market gave us a three day rally but sold off into the weekend.  However, my predictions regarding the Euro and the 126 level were dead wrong.  Events in Europe are quickly coming to a head and the efforts of European politicians to "kick the can down the road" are coming to an end.

Most of the major indexes finished the week up marginally from the previous week.  The notable exceptions were the Russell 2000 which underperformed it's large cap brothers and the Mid Cap index was also down close to 1/2 percent.

As the price action unfolded this week it was difficult to come to any other conclusion than stocks are straining to breach resistance levels and Thursday's action was a perfect example of this straining.  Here's a four month daily chart of the Dow Jones industrial ETF (DIA):

(click on chart for larger image)
I circled the week's price action and have pointed to Thursday's "doji", a candlestick which denotes indecision.  We breached a resistance line (red dashed) on that day and the candlestick signalled that there was at least a question whether the violation of resistance was genuine.  Well, as the week played out it was not genuine and we fell down under resistance.  So far, this is a classic "bull trap".  Equally telling is that momentum has not been able to sustain a bullish bias for the entire four months.  Notice the RSI indicator in the top panel.  It has failed to maintain a reading over the 60 level for the entire time.  Such a level is required if the ETF is to maintain forward and growing momentum.

Here's a weekly chart of the Russell 2000 which noticeably underperformed the general market this week.  Small cap under performance does not bode well for the general equity market.  The black arrow delineates this week's price action and more importantly the Russell has been unable to sustain a break through of a resistance line that goes back to May 2011!

Finally, let's look at the S&P 500.  It staged an impressive break out early in the week, handily taking out key resistance at 1362 only to fall back under that resistance line on Friday: 

I circled the price action from Wednesday thru Friday.  The resistance line coincides with the 61.8% Fibonacci retracement level from the June lows.  The S&P is in a rising wedge formation (grape colored dashed lines) and this is a bearish formation which usually resolves itself to the downside.  Also notice the RSI momentum indicator in the top panel which also shows the S&P's inability to sustain momentum above the 60 level.  The bottom panel is the MACD Histogram and it reflects weakening momentum with each successive new high; another classic divergence.

Am I bearish? Yes, but the question is irrelevant to me.  I can make money in up or down markets.  I'm not holding any stocks over the long haul.  This is a trader's market.  You need to have an extremely long term perspective if you are holding on to equities (in my opinion; 8 to 10 years) and be ready for roller coaster rides.   But the three charts above are speaking to ever increasing weakness in equities that will ultimately culminate in a decline unless central banks dispense more "hopium" (more on this in my Analysis).

Treasuries are consolidating from their recent gains last week and made a run for new highs again on Friday.  Here's TLT (iShares Barclays 20+ Year Treasury Bond ETF):

The chart is manifesting some significant momentum divergences that is indicative of waning strength in the Treasury market.  However, we've seen these divergences before only for Treasuries to resume their inexorable rise to new highs.  I read an article this week quoting Dr. Lacy Hunt of Hoisington Investment Management in Austin, Texas where he states that we're liable to see interest rates in or about these levels to the end of this decade!  Dr. Hunt is one of the most respected and keen observers of the Treasury market.  His thesis surrounds the fact that global deflationary forces are so pervasive that any economic growth will have a negligible effect on pricing pressures in the foreseeable future.

Gold had a flat week as Spanish and Italian bond yields spiked over 7 and 6 percent respectively:

There's nothing impressive about this chart.  The yellow metal is settling into a mundane trading range with significant resistance at the 1625 level (yellow line).  The most positive thing we can say about Gold is that there's a double bottom from the lows set in May and late last December.  The fact that we're consolidating near the lows could be construed as "the calm before the storm". 

As I've stated a number of times, the price of Gold will tell us whether inflationary or deflationary forces are taking over the global economy.  Given the price action since last August, deflationary pressures are predominant.  A break below the double bottom level ($1525.00/$1500.00) will go a long way in confirming my deflationary thesis.  Conversely, a break out above $1,625.00 will speak to Gold's sense that more money printing is near.

In a headline driven market no chart manifests the swings representative in such an environment than the Dollar:

Last week I wrote of the negative divergences on this chart and they are still there (red dashed lines) but the blue arrow points to Friday's price action which served to upend all "risk on" assets.  The catalyst for the sell off was the Spanish region of Valencia becoming the first region of that country to formally declare it's intention to seek Madrid's help to service its debt.  Five other regions quickly indicated that they would follow Valencia's lead.  The concern is that this will overwhelm the 18 billion euro fund the Spanish government has earmarked to help the regions.  This, along with new projections showing the economic contraction in that country would be deeper than originally estimated, sent Spanish bond yields soaring.  The ten year topped out in Friday's trading at 7.22% while the five year yield closed slightly under 6.87% and the two year closed at 5.75%.  The market knows these are unsustainable yields for any country to bear in the current global financial environment we find ourselves; let alone a country in deep economic contraction engaged in radical austerity measures.

And here's a daily chart of the Euro:

In last week's commentary I identified what I called bullish divergences between the actual price action and the momentum indicators.  But again, in a headline driven market these charts can change on a dime.  And so we see here.  The Euro managed to bounce off the 0% Fibonacci level but the momentum indicators have turned down.  Next stop for the Euro is the 119/118 level.  Here's a weekly chart going back to 2009:

The Euro will be targeting the previous low set in June 2010 (white arrow).  A weakening Euro means, generally speaking, a strengthening Dollar.  A strengthening Dollar means lower stock and commodity prices.

Finally, let's look at commodities by revisiting Dr. Copper.  But we're going to look at a weekly chart to give my readers an historical perspective:

It must be remembered that commodities gave us our first signal on weakening equity markets in late January/early February.  But when you look at this chart copper has had an incredible run up from its late 2008 lows and it's recent weakness seems a mere bump in its ongoing rise.  What gives?

I know that part of Copper's story surrounds the fact that the Chinese have stockpiled enormous amounts of the metal since early 2009.  This inordinate demand at the time of purchase has driven the price of the industrial metal higher.  Nevertheless, there's much more to this chart and it's price action than the Chinese.  We all tend to gravitate to one predominant thesis to explain away a particular phenomenon.  It's a natural consequence of finite minds.  News services do this all the time.  And using China as an explanation is very popular these days.  What I will say about this chart is that Copper will need to hold above the 38.2% Fibonacci retracement level it is sitting on if we're going to avoid further global economic weakening and my deflationary scenario from developing.


 I don't believe that I have once avoided addressing ongoing issues in the Euro zone since I started distributing these commentaries in 2010.  And I know I sound like a broken record but there's no way we can avoid any intelligent discussion regarding the financial markets without addressing the number one concern of those markets.

I've outlined the newest development this week in the Euro zone under the section above regarding the US Dollar.  While I won't repeat that here we must remember that Greece is still in the Euro exit danger zone and Italy is lurking in the shadows. 

In my opening statement I stated that things are quickly coming to a head in Europe and the market is presently testing the resolve of Euro zone politicians to maintain the present unity of the Euro zone.  It's apparent that Spain will need a lot more money than the 100 billion Euros the EU pledged to its banks at the last EU Summit in June.  I've read estimates that 400 billion Euros might put a big enough band aid on the situation to keep the country from eventual default.

But Italy is starting to rumble with more protests against Monti's austerity measures and former Prime Minister Berlusconi stating Italy should drop the Euro.  And Greek politicians, however humble, are hoping to renegotiate their austerity targets with the EU?  As I stated last week, the answer to that is going to be a resounding "nein"!

One of the biggest concerns the market has in all these complex problems is that no one really can get a handle on the seemingly myriad of scenarios which could develop surrounding these issues and their impact on global markets.  Some of the brightest minds on the planet are speculating everything from financial Armageddon to a benign outcome.  Various projections on how soon Greece might leave the EU are proliferating on the web and I've read how an Italian debt default wouldn't be that injurious to the global economy?! 

Since no one seems to know the impact of these possible scenarios I won't speculate either.  At this point all we need to do is be on the right side of the trade.  And the key to being on the right side is watching the Dollar and, to a lesser extent, Gold.

A stronger dollar is disinflationary or deflationary, meaning that it takes less dollars to buy any commodity or stock.  As the dollar strengthens, all other global currencies (generally speaking) weaken. As an example, the Euro, which is roughly 57% of the Dollar Index, will weaken against a strengthening dollar.  This means that while less dollars will buy a gallon of gasoline, that same gallon of gas will cost more in Europe as the Euro weakens against the dollar.  This negative impact on consumption is deleterious to economic growth, all other things being equal.

While my explanation above is very simplistic and there are many more variables to the equation, it serves as a foundational framework to understanding financial markets and their movements.

So, given my explanation, where are stocks heading?  Obviously, on a day to day basis, it's difficult to predict price movements.  Sentiment, news events and closely following the tape are more helpful in determining daily swings than chart watching.  But on a weekly or monthly basis the Dollar is giving us clues to the direction of these markets:

Here's a weekly chart of the Dollar and I've circled the last two weeks price action which have been variations of a "doji" which signals indecision.  When I consider the daily chart already posted above in the context of this chart it seems to me that the Dollar wants to weaken but it is being driven by short term news events similar to Friday.  If you recall, momentum on the daily chart was turning down but quickly reversed after negative news out of Spain.

Now here's where technical analysis can get esoteric and people start running down rabbit trails (and yes, me too).  However, if you believe the following two principles (as I do):

1.  That the market is the sum total of all the knowledge, stupidity, fear and greed of all its participants and therefore is more knowledgeable and more predicatively accurate than any sub total of those participants and

2.  Chart analysis is predictive of future events

... then I believe we must conclude that the Dollar wants to weaken and it's waning momentum on the daily chart is predictive of more central bank easing both here in the US and more importantly, in the Euro zone, which up to know, is disavowing any thought of the type of QE we have engaged in here in the States.  And this, in turn, will be good for global risk assets, at least in the near term. 

Now, the caveat here is the news driven impact of day to day price action which makes these markets treacherous to be active in.

I guess someone could say that it's easy to predict that central banks will continue to attempt to paper over the mammoth global deflationary forces that exist but I can assure you that I'm of the minority opinion that global central banks know they're pushing on a string and are resisting the kind of dangerous easing they've already engaged in.  Draghi of the ECB supports my thesis.  The ECB has been very guarded in its doling out of fiat currency as it refuses to be the kind of backstop for all periphery debt which has been the FED's "modus operandi" in our country. 

As far as Europe goes, if the European Union is to be saved in its current configuration, the ECB is going to have to backstop all periphery debt.  There's no other way out.  I believe the Euro's present price action is largely predicting this.  And I believe the Dollar is predicting more QE from our central bank.  If I'm right this will give us a rally in equities.  For how long?  That's a topic for another commentary but I'll just say here, not long ...

The US Economic calendar starts out quiet on Monday but builds to a crescendo by Friday. 

On Tuesday we have the PMI Manufacturing Index Flash, which ordinarily is not focused on much by the market but there will be many eyes on it this time as economists attempt to gauge the extent of the current economic slowdown.

On Wednesday we have new home sales.  This could be a market mover if it comes in markedly higher or lower than the expectations of 370,000.

On Thursday we have June Durable Goods orders and weekly jobless claims.  Both will be market movers, especially if they disappoint.

On Friday second quarter GDP numbers will be released.  The consensus is that growth in the second quarter will come in at a measly 1.2%.   And while that number may be an accurate assessment of US growth, my gut tells me this bar is too low and we may get a surprise to the upside. 

Consumer sentiment numbers will also be announced and while the market pays much attention to this report I've never been able to figure out why.  How can you depend on a report that is based on phone calls to people who might be just having a bad or good day?  Maybe they woke up on the wrong side of the bed?  Or had a rip roaring fight with their wife?  And then they get a call asking how they're doing financially?!

Worldwide there will be the normal economic releases, none of which strikes me as market movers.  But I will be watching the Spanish 3 month and 6 month bond auctions on Tuesday.

Have a great week!