Sunday, September 2, 2012

Macro Analysis 8/31/2012

Well, Ben Bernanke's speech came and went on Friday morning and after the dust settled the market came to realize that the Bernanke "put" was very much still in place when he stated near the end of his talk "... the Federal Reserve will provide additional policy accommodation as  needed to promote a stronger economic recovery and sustained improvement  in labor market conditions in a context of price stability".

We're moving into a potentially very volatile time in the markets over the next two weeks with the following events:

September 6th - ECB policy meeting and Dutch elections

September 7th - US Employment Report

September 12th - German supreme court ruling on the constitutionality of the ESM (European Stability Mechanism)

September 12th & 13th - FOMC (Federal Open Market Committee) meeting

We'll try to get our arms around these important events and discuss some not so obvious issues that are currently "under the radar".

Stocks had a mixed week with the large caps suffering minor losses while the small caps were higher and resilient.  Speculation in small cap issues is usually a bullish indication in that these are riskier equities and investor's willingness to buy them means fear is dissipating.  Here's a weekly chart of the Russell 2000:

One challenge with this chart is in the lower panel which is the price of the Russell relative to the S&P 500.  In spite of small caps performance relative to large caps this week we can see by the red dashed line that small caps have been under performing their big brothers since July 2011.  Here's the S&P 600 Small Cap Index going back to shortly before the March 2009 bottom:

The same relative under performance is manifesting itself here.  We'll need to monitor the price relative charts because I'm sensing a turn in the market over the next few weeks.  Of course, with important announcements out of the Euro Zone anything can happen and we have some technical divergences in the market, not least of all is the under performance of the Transports:

Here's a weekly chart of the Dow Jones Transportation Average and we can see in the bottom panel that the price relative to the S&P 500 has taken what can almost be described as a nose dive.  But if you look closely at the main chart you will see I highlighted in yellow what amounts to multi week support at the 38.2% Fibonacci retracement level.  To me, the fact that the Transports are holding at support is more important than the price relative to the S&P.  So, until I see a support break on this chart and as long as small caps are performing they way they are, I'm going to take a positive stance to stocks over the short term.

Treasuries surged on Friday on the tail of the Bernanke speech with yields plummeting as a result. 

Here's a weekly chart of the iShares Barclays 20+ Year Treasury Bond ETF used by traders and investors as a proxy for the long end of the yield curve.  TLT broke a steep uptrend line early in July and turned down.  I've circled the last three weeks price action and the candlesticks have formed a "three outside up" formation which indicates a technical turn in the Treasury market. 
Many continue to anxiously await the end of the great 30 year bull market in bonds but I'm of the opinion that while we may be getting closer to the end of this incredible run in bonds we've still got some room to run to the upside.  And it appears from the price action above that if we see follow thru from this reliable pattern Treasuries may attempt to assault recently established all time highs again.

With all the rumors coming out of the ECB this week and then Bernanke's comments on Friday Gold made a big move this week:

I've been posting updates on this same chart for months and I left the yellow resistance line that kept a lid on the spot price of the yellow metal since May.  Gold jumped almost $35.00 on Friday alone (black arrow).  And the weekly chart is also sporting a breakout:

Gold is telling us that the "handwriting is on the wall" and that inflation is a certainty.  But is it?  We'll know whether Gold is right starting on Thursday.

Commodities are giving us mixed signals with the indexes that measure agriculturals and livestock along with industrial metals generally showing signs of life.  Here's a weekly chart of the Commodity Research Bureau Index composed of a cross section of nineteen different commodities; agriculturals, livestock and metals:

It will be clear from the next chart that the drought and severe heat conditions we had in many areas in the country which drove the price of wheat, corn and soybeans were the main contributors in driving the CRB index higher:

This is a weekly chart of the Dow Jones UBS Industrial Metals index which is composed of four futures contracts on industrial metals, three of which (aluminum, nickel and zinc) are traded on the London Metal Exchange and the other of which (copper) is traded on the COMEX division of the New York Mercantile Exchange.  What's impressive about this chart is that support has been holding at the 140 level for 11 weeks.  This is potentially bullish as the longer support holds the more likely the index will turn higher.  Still, there's historically a mixed signal here in that since the GFC (Great Financial Crisis) Gold and commodities tend to move in lockstep.  We're not seeing this now.  Who's right?  Or are they both right?

Finally, here's a weekly chart of the US Dollar:

The Dollar has been weakening as traders anticipate additional quantitative easing from our FED.  We're at the cusp of penetrating an uptrend line that starts back in August 2011.


Different asset classes are giving us mixed messages so that our correlations cannot give us the clues they normally do to help us determine where markets are going.  I'm going to categorize these classes by also designating them as "risk on" or "risk off" assets:

Stocks (risk on) are stuck in a trading range with a bias to the upside.

Treasuries (risk off) are rallying as Bernanke has assured the market he will be suppressing the yield curve for some time to come.

Gold (risk on) is rallying on hints of money printing by central banks while industrial commodities (risk on), ordinarily inflation sensitive, are flat.

The Dollar (risk off) is weakening as it always does as the possibility of more money printing threatens currency debasement.

These skewed correlations are the result of all the headline risk that has driven these markets since late April and will continue into the historically volatile month of September.

I've highlighted the major events that are coming up in the next two weeks and if nothing else, having a punch list to address assists me in trying to determine daily and weekly moves in these markets.

Let's start with the Dutch elections.  Dutch elections?  Yeah.  This event in  itself will not be an immediate market mover but it is a subtle yet important indicator on sentiment in the "northern periphery" (Netherlands, Germany, Finland).  The Dutch are presently descending into the throes of a property deflation.  The present government is in danger of losing the election to the socialists who are anti European Monetary Union and against any bailout of their southern neighbors.  If the socialists take the election it will be yet another indicator that the fragile union is getting more brittle.

The ECB (European Central Bank) has their policy meeting the same day and this will be one of the big events of the week.  Many are expecting Draghi to announce specific plans to buy"southern periphery" bonds in order to lower the prohibitive interest rates these countries are paying on their debt.  But there are a lot of issues and challenges surrounding any bond buying plan:

1.  Some of the Germans are against this. Bundesbank President Jens Weidemann who sits on the ECB policy committee has been an outspoken critic of any bond buying program and has threatened to resign his position over the issue.  By all indications, Draghi who can override Weidemann and has the votes with the rest of the policy committee to push thru a bond buying program, is going to move forward anyway.  The fact that German Chancellor Angela Merkel has publicly supported the ECB in this matter means that Weidemann has been hung out to dry.  Merkel knows the EMU cannot be saved unless Draghi implements unsterilized bond purchases of southern periphery debt.  So, it would seem the fix is in, but ...

2.  Draghi will also impose conditionality to any promise to support a country's bond market.  This means that if Spain needs the ECB to prop up its bond market it will have to meet a number of financial conditions or commitments to control its spending in order for the ECB to intervene.  But this is an implicit loss of fiscal sovereignty which has been the rub on all negotiations regarding EMU support for periphery nations for the last year.

3.  Countries that need assistance in keeping a lid on their borrowing costs will be required to ask for assistance from the ECB.

There are other issues regarding whether the ECB would give up it's senior status as a lender (important for those willing to stick their necks out and buy periphery debt)) and whether the ECB is violating it's mandate but at this point it's pretty clear Merkel has given Draghi the green light to buy periphery debt.

Any bond purchases will be in conjunction with the ESM.  The ESM will support the new issue market while the ECB would be active in the secondary market.  This tandem approach would be most effective. 

Expect Draghi to announce a plan that would secretly target specific interest rate levels of a country's debt so at least the market will not immediately know where the ECB will defend a country's bonds.  This will keep the "bond vigilantes" at bay, at least for awhile.

But the fly in the ointment on this plan is that Germany's Supreme Court, as stated above, has not ruled on the constitutionality of the ESM and Germany is the fund's biggest contributor!  That decision will be announced on September 12th.  While it is expected that the outcome will be positive there is an outside chance that the court may defer the ruling until next year!

So, while Draghi may announce something substantive on September 6th they would have to await the German high court decision on the 12th for the plan to work.

Nevertheless, if Draghi announces a bond buying program on September 6th there will be a massive rally in risk assets with Gold and stocks vying for the biggest gains.  If he doesn't, watch out below!  My opinion is we will see a significant one day rally on Thursday.  The reason why I say one day is because even if the ECB is ready to intervene in bond markets, until a country asks for assistance nothing is going to happen.  And so far, the primary candidate, Spain, has stated that they want to know the terms before asking for assistance.

Just a caveat on anything I say about the Euro zone.  Virtually any and all pronouncements made over there cannot be counted on.  Draghi has provided some relief from this phenomenon but even he must be held suspect.  The only comfort on giving these projections comes from the fact that if European leaders want the European Monetary Union to survive now is the time to act.  I know Merkel knows this and so I'm reasonable comfortable in my prognostications.

On September 7th, the labor Department releases it's monthly report on the employment situation.  This is always a market mover but especially so this week because many FED watchers believe the results of the report may be the final determiner on whether Bernanke and company will come in with further asset purchases.  In a rather perverse way, the chances that a bad report will spark a market rally are high.  Counter intuitively, a bad report would mean more QE, and the market loves "hopium"!  However, I'm expecting a better report than last month in which 172,000 non farm payroll jobs were created.

I don't place the same emphasis on the FED reaching a decision on more easing as a result of this report.  I think that further easing is already "baked into the cake".  Bernanke has a much longer time horizon on these issues than the market and another monthly employment report, good or bad, isn't changing the much larger picture. 

My opinion is very different than the consensus on the type of QE the FED will implement.  I don't believe the FED is going to buy more Treasuries or mortgage backed securities.  I think the FED will give further rate guidance and is going to announce a program designed to loosen credit conditions and spur lending to corporations and small businesses.  It must be remembered that the FED lent money directly to businesses during the Great Depression, bypassing the banks.  This, in my opinion, would have a two fold benefit:

1.  Credit conditions would immediately ease.
2.  Banks won't like the competition and will start soliciting business.

Folks, a program like this could be a real game changer.  If the FED were to implement a plan like this American business would only need to get Obamacare off of their backs and the cancellation of tax hikes going into effect in 2013!

So, on September 12th, expect positive news out of the FED that will move these markets higher, at least in the short term.

I say short term because the global economy is markedly slowing.  Europe is in deep contraction and emerging markets, led by China, are floundering:

 Here's the Shanghai Composite and it broke thru support last week and is at lows not seen since February 2009.  When you look at this chart realize that this is not so much just a chart of China's economy but is a mirror to the world.  China, being the world's largest exporter, is the "tail the dog is wagging".  And Europe is China's biggest trading partner.

While the rest of the emerging markets are not doing as badly, there's nothing to write home about.  Here's the Brazilian Bovespa Stock Index:

The index took a dive in April and May, recovered with side ways if volatile price action in June and July and turned up in late July and is now appearing to roll over again.  Frankly, I can see hints of a head and shoulder formation; not good ...  It must be remembered that Brazil was one of the growth engines that led the global economy out of the hole in 2009.

I'm watching the Shanghai and Bovespa charts closely looking for a bottom.  So far, there is none ...

We're getting ready for another eventful week.  I wouldn't want it any other way!