Sunday, July 29, 2012

Macro Analysis 7/27/2012

What a difference one week makes!  On Thursday's blog post my title was, "what a difference a day makes".  In the headline driven market we find ourselves where fundamental and technical analysis count for little, the impending deflationary death spiral we were confronting early in the week melted away with one comment from ECB President Mario Draghi: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."  That last sentence sent global risk assets skyrocketing into the weekend.

We'll be examining Mr. Draghi's comment and what could possibly happen next, not only in the Euro zone as the ECB meets on Thursday to deliberate on interest rates but also in our country as the FOMC (Federal Open Market Committee) meets on Tuesday and Wednesday and some market participants are expecting an imminent announcement of QE3.

Stocks had a good week thanks to Mario Draghi and leaks out of the FED to the Wall Street Journal that suggested some sort of QE was imminent:

 (click on chart for larger image)

Here's a daily chart of the S&P 500 and I've pointed to Thursday's (blue arrow) and Friday's (black arrow) price action.  As stated above this was largely a Mario Draghi induced rally and I expect follow through on Monday as the market anticipates more good news (hopium) emanating from the upcoming FOMC meeting this week. 
Technically, the two purple dashed lines in the chart above delineated a rising wedge formation that normally has bearish implications.  We fell out of the wedge on Tuesday and formed a "doji" on Wednesday.  Thursday's and Friday's price action pushed us right back into the wedge.

The S&P is getting close to some formidable short term resistance (black dashed line) in the 1390 - 1395 level (it closed Friday at 1385.97).  If it can punch thru that level it could assault the post crash intraday high of 1422.38 set on April 2nd of this year.

Let's step back and look at the weekly chart:

We are showing an uninterrupted long term uptrend from the March 2009 bottom (purple dashed line) but on decreasing volume with mixed momentum.  So, all is well, right?

Nothing is ever that easy in the market.  Remember, last week I was bearish on these markets and very little changed on this chart from last week to this week.  Unlike many other market prognosticators I'm not concerned with decreasing volume.  To me, decreasing volume in these indexes are indicative of the changes in investment strategies in the largest demographic group of people to ever course its way through our economy, the baby boomers.  No, I'm not concerned about volume.  This is what I'm concerned about:

These are two weekly performance ratio charts comparing the S&P 500 to the Russell 2000 Small Cap Index (upper chart) and the S&P 500 to the Wilshire 5000 (total US stock market-lower chart).  Both the small cap index and the total market index have been under performing the large cap index since July, 2011 (purple dashed line).  The troops (small cap stocks) are not following the generals (large cap stocks).  There can be no secular bull market in stocks while this technical state of affairs exists.  These charts are also speaking to the waning effects of central bank induced stimulus.  Notice the inexorable rise in both these ratio charts from early 2009 to 2011 when both plateaued. So, enjoy the "hopium" that's coming (maybe) but the secular bear market is very much intact!

With Draghi's comments sparking a "risk on" rally Treasuries, true to their inverse relationship to stocks and commodities, sold off:

Here's the Dow Jones Chicago Board of Trade Treasury Index which is a compilation of duration-weighted prices of the U.S. Treasury bond, 10-year Treasury note and 5-year Treasury note futures

contracts.  I've highlighted Thursday's as well as Friday's price action.  Thursday's price action suggests the futures market didn't believe Draghi.  On Friday, they became believers! 

Notice the momentum indicators (top and bottom panels).  I've highlighted the negative divergences with the red dashed lines.  As I've stated in past commentaries Treasuries have sported these negative divergences before only to turn around and bite those who bet against them based on those divergences.  But here's a weekly chart of the same Index:

The divergences manifest themselves on the weekly chart as well which is much more significant. 

More and more pundits are foretelling the imminent end to the great bull market in bonds based on these indicators and the coming inflation they see from central government money printing.  While I think it is quite premature to start calling an end to this bull market the divergences must be heeded and Treasuries watched closely.  There are fundamental factors beneath and at the surface of the present economic landscape that could impact Treasuries negatively in the coming months (fiscal cliff; our debt, etc.)

Let me digress on the deflation and inflation issue.  All my friends who hold to the inflation thesis point use as evidence the growth in money supply as the problem as well as anecdotal evidence that prices at the grocery store are rising.  Aside from the temporary price shocks that manifest themselves because of droughts or supply disruptions all of us have a myopia regarding deflation since we all have had experience with only inflation in our lifetimes.  But you can have all the money supply growth in the world and still not have significant inflation.  You need velocity of money to complete the equation to give you inflation.

Here's a chart of the velocity of M2 Money stock going back to 1960 from the St. Louis Federal Reserve:

Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply--that is, the number of times one dollar is used to purchase final goods and services included in GDP.  We're at an all time low in velocity of the biggest measure of money supply in our country. 

But to be fair to my misguided friends (:-)  here's a close up of the same chart for the past three years:

The steepness of the descent is lessening and starting to level off.  This chart must be watched closely because when it turns up then my inflation friends day will have arrived!

This dovetails into Gold.  I addressed Gold's move this week in conjunction with news of probable easing out of the FED and Draghi's comments in my Thursday blog post.  Here's the daily chart of the spot price:

I circled Wednesday thru Friday's price action and Gold approached the yellow line on the chart ($1,625.00 level) first in a very aggressive way (Wednesday) but then timidly into Friday's close.  It made a half hearted attempt to take out $1,625.00 but was rebuffed. 
What happened?  Gold doesn't believe the FED or Draghi (yet).  But if Bernanke and company signal another round of QE this coming Wednesday (not very likely for reasons I'll stipulate in my analysis) or if Draghi delivers on Thursday on his "it will be enough" comment (far more likely) I predict Gold will cut thru the $1,625.00 level like a hot knife thru butter!
Gold along with the Dollar is the key asset to watch as we gauge whether inflationary or deflationary forces are taking over the global economy.

And speaking of the Dollar:

I know the chart is a bit busy so I pointed to Friday's close (red arrow).  I've shown this chart in the past and addressed the negative momentum divergences before and commented that, for want of news events that continue to drive global money into the "safe haven" of our currency, the Dollar wants to weaken.  We got a whiff of that this week as the Dollar sold off significantly on Thursday and was incredibly volatile on Friday, forming a lopsided "doji" spelling indecision. 

As we look at the Dollar weekly chart the weakness on the Daily chart looks a lot more benign but price comparisons with some other major currencies are starting to speak of general dollar weakness:

The three bottom panels on the chart above are price relative charts.  The Australian and Canadian Dollar are resource based currencies and have been outperforming the Dollar since June 1st.  The Yen is a "safe haven" trade and it too lately (in the past month) has been outperforming the Dollar.  Is this just a temporary phenomenon or is there a change in sentiment toward the dollar?  I'll be addressing this in my analysis.

Finally, let's take a peek at commodities:

Here's a weekly chart of the Dow Jones UBS Industrial Metals Index and while it's flirting with lows set in June 2010 I've pointed out the positive momentum divergences on the chart.  Still, industrial metals are seriously under performing the S&P 500. 

It's difficult for me to embrace the notion that the weakness that's been exhibited in commodities is about over when I look at the Shanghai Composite:

I circled this week's price action and the Shanghai closed just below the lows set at the turn of the year.  Momentum indicators are flat. 

If the positive divergences identified on the Dow Jones UBS Industrial Metals Index are real then we should start seeing the Shanghai Composite bounce off these lows.  A confirmation of a double bottom on the Shanghai Composite would be an incredibly bullish indication for the Chinese economy and by extension, the global economy.

Lastly, I want to touch on oil.  Many are bottom fishing and indeed others have proclaimed a bottom in "black gold" but I'm not so sure.  If I saw more life in China I'd be more convinced.  Here's a daily chart of West Texas Intermediate Crude:

Friday's close is highlighted with the white arrow.  Crude has made a nice move to the upside since the beginning of July and is now bumping into the 38.2% Fibonacci retracement level from the late June lows.  Momentum indicators are generally positive but have backed off from stronger readings. 

Here's the Market Vectors Oil Services ETF which tends to be predictive of the price of oil:

Rather than being predictive it seems to be mimicking the price of oil.  It too, is bumping into its 38.2% Fibonacci retracement level.  Momentum is stronger than on the West Texas Crude chart but I'm still ambivalent on the prospects for oil so long as Europe and China are economically contracting.


My whole commentary has been a thinly veiled attempt to explain away the technical evidence that we are turning the corner from a deflationary to inflationary environment and by extension, better economic growth and higher stock prices.  Am I fooling myself?  Maybe. 

I guess I can approach this issue by asking another question:  Is this a liquidity induced rally?  Are market participants simply positioning themselves for the next round of "hopium" which will send the markets "higher than a kite"?

And those of you who know me know my answer.  I've stated so many times over the past few years and I've shown evidence thru many charts detailing that the efforts of central banks in papering over the mounds of global debt that exist are garnering less and less results with each successive round of easing.

But between the announcements out of the FED thru John Hilsenrath of the Wall Street Journal and Mario Draghi's bold statement on Thursday quoted above it appears that central banks are priming the market for concerted action.  Now Bloomberg wrote an article on Saturday evening that U.S. Treasury Secretary Tim Geithner will meet with German Finance Minister Schaueble and ECB President Mario Draghi in separate sessions on July 30.  Something is brewing.  The statements being made are uncharacteristic of anything we've seen since the onset of the Great Financial Crisis in 2008.

So, we have the FOMC meeting on Tuesday and Wednesday, the ECB meeting on Thursday and then on Friday the monthly employment report for July is released.

First, will the FED initiate another round of QE?  The Hilsenrath article in the Journal could only be interpreted as it's not a matter of "if" but "when".  But will they announce they are easing on Wednesday?  My opinion until I read the Bloomberg article was that they wouldn't but would wait for another month's economic data before pulling the trigger.  But the Bloomberg article has made me rethink my opinion. 

There are also political reasons to move sooner than later.  At this point in the Presidential campaign, Bernanke is damned if he doesn't ease and damned if he does.  The closer to the election he implements QE the more he is perceived as trying to influence the election.  Certainly he has no political motivation not to ease.  Romney already stated that if he's elected he will be firing Bernanke.  Still, to ease in September looks more like trying to effect Obama's chances of reelection.

But the other question that has to be asked is what more can the FED do to stimulate our moribund economy?  Even the suggested buying of mortgage backed securities is seen as pushing on a string.  How low can mortgage rates go?  And all other options mentioned would be less effective.

Now the Euro zone can do more than it is doing and it appears that Draghi might be ready to re implement the SMP (Securities Markets Programme) in order to take pressure off of Spain and Italy as their funding costs have skyrocketed.  I'm not going to get into the politics behind these probabilities but the forcefulness of Draghi's comment on Thursday, subsequent meetings with the President of the German Bundesbank and now Geithner's trip tomorrow certainly implies that we are going to get a substantial intervention from at least the ECB if not both the ECB and the FED.

These moves are coming just in time.  Greece will be leaving the Euro soon and Spain is lining up to be another Greece, albeit a much larger one. 

Now, don't misunderstand.  Nothing central banks will do this week will fundamentally change anything.  The debt problems we face globally are solvency issues, not liquidity issues.  And depending on the size of the "bazooka" central banks throw at us this week, this might very well be their last "hurrah".  And that's why I'm hesitant to say the FED will move on Wednesday.

Bernanke needs to save something for the coming crisis that is looming regardless of how many times European leaders "kick the can" down the road.  And he doesn't have much left in his arsenal.

So, what do I think is going to happen?  I can't speculate about Geithner's trip to see the Germans and Draghi.  It might only be an informational trip.  But Draghi better come out on Thursday with a pledge of large scale purchases of Spanish and Italian bonds.  Anything less than that will send the markets reeling.  Nothing else but a pledge that the ECB, within its mandate, will act like our FED did in 2008, will do the trick.  And I'm believing more and more we will get this pledge.  If we don't a full blown Spanish bailout is only weeks away and the probability of the European Union unravelling are almost guaranteed. 
The dollar's relative weakness identified above has as much to do with our own fiscal problems than anything else.  The only difference between us and Europe is that we have both fiscal and monetary unity while Europe doesn't.  But that can't mask the trillions in debt we owe and the political stalemate in Washington which makes developing a coherent plan to attack that debt impossible.  In the short term, the Dollar's movement will track the anticipation that the FED will move to rescue the US economy yet again with another round of money printing.

So, it will be another momentous week.  I normally list upcoming economic reports but everything this week will be focused on three events:

1.  The FOMC Meeting on Tuesday and Wednesday
2.  The ECB Meeting on Thursday
3.  Friday's monthly employment report (which will be ignored if the FED moves on Wednesday).

My prediction:  The Dow will be at new post 2008 crash highs by Friday!

This is a market for very short term traders or very long term investors.  If you don't have at least an 8 to 10 year investment time horizon step aside. 

Have a great week!