Sunday, September 16, 2012

Macro Analysis 9/14/2012

The Fed came out of its FOMC (Federal Open Market Committee) meeting this week with guns blazing, announcing QE3 with 40 billion dollars in purchases in MBS (mortgage backed securities) per month for the next year.  But most importantly, the Fed made the commitment that the purchases would be open ended until there was significant improvement in our economy, specifically in employment.  In addition, the Fed extended forward guidance for the current low interest rate policy out to mid 2015.  The market loved it and if you were on the right side of the trade you made a boatload of money this week.

We will look at some of the possible implications of QE3 throughout this commentary but especially in my analysis below.

Stocks had a second banner week with most of the major averages up in between 1.07% (NASDAQ 100) and 2.72% (NY Composite Index) due to the Draghi/Bernanke one-two punch.

Let's look at the charts:

(click on charts for larger image)
Here's an update of the same weekly chart of the S&P500 I posted last week and although I could not post any short term Fibonacci retracement levels the S&P has cleared them all and there is very little resistance up to the all time intraday high of 1576.09 set in October 2007.  I mentioned last week that the 1455-1465 area could slow the index down and we barely breached that level just with Thursday's and Friday's price action.  I'm expecting some consolidation at these levels in the near term and will be discussing the only remaining impediment to reaching the all time high in my analysis.

Here's a weekly chart of the Russell 2000 small cap index:

The Russell has been outperforming it's big brother, the S&P500 since the very end of July and is butting up against all time highs set earlier in the year.  As I've said before, we want to see stronger relative performance from the more speculative issues and we're getting that in the short term (see bottom panel).  I'll be more comfortable with the trend when we breach the red dashed resistance line.

And for a historical perspective here's a chart of the NASDAQ Composite going back 15 years"

I've highlighted the bubble and crash in 1999-2003.  The Nasdaq is trading at it's highest levels since the end of 2000!

A look at the breadth indicators reinforces the bullish tenor of this market:

This is a weekly chart of the percentage of stocks on the New York Stock Exchange trading above their 200 day moving average going back to late 2005.  I've outlined the effect on this chart of all the QE's as well as the presently announced stimulus.  As you can clearly see, we've penetrated a long term down trend line (green dashed) going back to 2009.  I've also highlighted with an orange dashed horizontal line a resistance area that was set in 2007 when stocks made all time highs and was successfully breached for a short while in 2009 but failed in early 2011.  We'll need to break thru this level (85%) to confirm the sustainability of a long term rally. 

True to our inter market relationships,treasuries sold off this week.  Initial reaction from the futures pits in Chicago was disappointment that the bulk of purchases by the Fed would be MBS and not Treasuries but then fears of inevitable inflation seeped into the market:

Here's an update on the chart I posted last week of the iShares Barclays 20+ Year Treasury ETF and we've penetrated all short term Fibonacci support levels and are on our way to the 115 level which is significant intermediate term support.  Notice the momentum indicators in the top and bottom panel that are signalling that the ETF is oversold.  But that doesn't mean we're necessarily in for a bounce. 

Many are stating after two days that the Fed's plan is already backfiring because rates are backing up but it's too early to say that the Fed's intentions have been thwarted.  The following chart was not created by me but by Arthur Hill of and it shows that the initial reaction in the Treasury market after the announcement of the other easings was a back up in rates:

This is a weekly chart of the Ten Year Treasury Note yield.  Ignore the numbers on the chart; they are Elliot Wave counts.  You can see that at the onset of QE1 & QE2 yields surged as the Treasury market anticipated future economic growth and attendant inflationary pressures as a result of Fed liquidity.  But as the effects of the easings wore off yields came down on weakening economic fundamentals.

The question the market has is:  the last two easings were in the face of deflationary pressures and terrible economic fundamentals.  This time around Fed asset purchases will be open ended and in the face of an improving yet tepid economy.  Will inflation start to rear its ugly head?  I'll be attempting to provide an answer in my analysis.

Gold had been rallying in anticipation of this latest announcement by the Fed but after Thursday's pop it consolidated in Friday's session (black arrow):

  This is a daily chart of Gold going back to the all time highs set last August.  It's very difficult to argue a bearish case for Gold when you look at this chart.   And the Fed's announcement after the ECB's decision last week put the final touches on the start of another bull leg in the yellow metal.

We are short term over bought (top panel) but both momentum indicators below the price chart, especially the ADX indicator (bottom panel), are signalling a powerful rally brewing. When you see that black line in the ADX panel on that kind of trajectory get on board!

Fundamentally, I don't see anything that can stop this rally.  Indeed, anything that is on the skyline (Israeli attack on Iran, fiscal cliff, etc.) with the exception of a Greek exit from the EMU, can only fuel this move higher.

Commodities are finally starting to move in anticipation of either stronger economic activity, greater inflationary pressures, or both, depending on which thesis you subscribe to.  Here's a weekly chart of "Dr. Copper" that has a PhD in Economics:

We've penetrated a resistance line going back to April 2011.

Here's the Goldman Sachs Industrial Metals Index which includes metals such as aluminum, copper, and zinc :

And finally, for all my friends who are concerned about food prices and other staples here's a monthly chart of the CRB (Commodity Research Bureau Index) going back to 1998.  It's a basket of nineteen commodities comprised of agriculturals, livestock, industrial metals, basic materials and oil:

We've yet to break a downtrend line set in 2008 but I have no doubt that we will. 

And here's our beloved Dollar:

It's a picture perfect swan dive, isn't it?  Almost everyone is calling for more Dollar weakness and Gold's price action is also speaking to the trashing of our currency.  But this weakness can't last for long because of the chart below:

This is a daily chart of the Euro.  Readers need to understand that the US Dollar Index measures the performance of the US Dollar against a basket of currencies: the Euro, Japanese yen, British Pound, Canadian Dollar, Swiss Franc and the Swedish Krona.  But the Euro comprises roughly 57% of the Dollar index.  Having such a high weighting in the Dollar Index insures that the Euro is inversely correlated to the Dollar. 
The Euro has had an incredible run up since it's lows in late July.  As a "risk on" currency it has fueled the rally in equities during the same period.  But economically, the price appreciation in the Euro is facilitating the economic strangling of the Euro zone.  Already suffering under a serious recession, the currency appreciation is making any exports out of the Euro zone prohibitively expensive.
Friday's candlestick (white arrow) is signalling some indecision but with no fundamental reason for a correction the Euro could run to the 1.33 or even the 1.35 level.  Continued appreciation of the currency puts another severe drag on a struggling Euro zone economy.  At some point this trend will reverse and, given the inverse correlation the Euro has with the Dollar, the Dollar will come back again, possibly to the detriment of risk assets.  See my commentary last week regarding my thesis in the possible change going on in the Dollar/Euro/Aussie Dollar relationship.
After a double dose of "hopium" out of the ECB and then the Fed, risk assets are flying high.  I didn't like Friday's price action though.  Stocks looked tired and I think we'll see a bit of consolidation this coming week, especially in the early part of the week.
But, by and large, stocks have a concrete floor under them and there is nothing save a Greek exit from the Euro zone or the "fiscal cliff" that are impediments to stocks reaching all time historic highs.
The Euro zone crisis is very much behind us for reasons I outlined in detail in last week's commentary.  And Bernanke's commitment to open ended purchases of MBS may eventually stoke inflationary pressures in the economy but there is no inkling that these pressures are prevalent at this time.
Some are making a big deal that the Producer Price Index (PPI) jumped to 1.7% in August (the latest read) from 0.3% the month before but the details reveal that food and energy costs led the surge.  It is pretty clear to anyone who follows the news and/or weather that the surge in food prices were caused by the severe drought and heat conditions in many areas of the country that led to record prices in soy beans, corn and wheat.  Oil is a slightly different situation but the fluctuations in pricing due to many exogenous factors and supply/demand fluctuations make it unreliable to gauge inflation by.  If you take out oil and food the PPI dropped .1% to 0.2%.  So where's the inflation?
I've made the case in past commentaries that until all the money the Fed has pumped into the economy since the onset of the Great Financial Crisis finally leaves bank vaults and actually gets into circulation there can be no meaningful inflation.  The best way to gauge this is by monitoring the velocity of money:
Here's a chart courtesy of the St. Louis Fed that shows money velocity of M2 since 1950.  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.  M2 is the benchmark measure of money in our economy.
As you can see from the chart above, the velocity of money has been in an extreme downward slope since the beginning of the last recession in late 2008/early 2009.  Also notice the period immediately preceding 1980.  This was the last great inflation we had and velocity was increasing during this period.  Consider also that the greatest surge in velocity took place in the 1990's; a period that was punctuated by significant economic growth with low inflation.  So while we can't always say that the velocity of money and inflationary pressures are always linked we can definitely conclude that inflation cannot coexist when the velocity of money is precipitously dropping as we see in the chart above.
Here's a five year view of the same chart above:

I've posted this chart in past blog posts and/or commentaries.  I submit to my readers that as the trajectory of this decline starts to flatten out and turn up we will have to start concerning ourselves about real inflation. 
One caveat:  the chart above is the latest reading from the St. Louis Fed and it is only up to April 2012.  We should be getting the newest release shortly.  I'll be posting it as soon as it is released.
All this is not to say that inflation is not on the way.  As my readers know, I have a great deal of respect for Ben Bernanke and anyone who has read my commentaries religiously knows that I believe he basically saved the world from a Depression that would have made the Great Depression look like a picnic.  And unlike many other folks, I believed that QE2 was the right move as deflationary pressures were taking over the economy at that time.  But this time around I think he's sticking his neck out.  Fed liquidity has succeeded in turning the housing market around (however tepid the progress) and we've dodged the deflation bullet.  But I don't see how this round of easing is going to facilitate higher employment. 
Bernanke is trying to do what fiscal policy should be doing.  But with the fiscal cliff looming in January our Congress is going home next week and not coming back until the election is over!  How nice! 
The fiscal cliff is the greatest potential impediment to risk assets and the economy.  If the spending cuts and tax increases that are slated to kick in on January 1st happen there will be a recession in 2013.  And going over the fiscal cliff is the greatest impediment to turning the dismal employment picture around in the country.
This is not a political commentary so I'm not going to expand on what the issues in Washington are but I want to say this:  Democrats can't hang on to their "sacred cow" and not expect significant cuts to entitlement programs.  And Republicans can't expect that they can just cut spending and not raise taxes.  And the key to our fiscal mess is revamping the tax code.
But we are only concerned about what the chances are that we will avoid the fiscal cliff and what will happen to risk assets if we do or don't avoid the cliff.
I have a decidedly negative view that we can avoid the cliff.  The stalemate in Washington is apparent and both sides are to blame.  There will be a day of reckoning on this issue and I believe we will fall off the cliff.  Congress may attempt to shove thru some last minute legislation that can "kick the can" down the road once or twice but I see no way to dodge the bullet.  And this outcome will not be good for risk assets.
The other event that could give us a rattle is the potential for a Greek exit from the Euro zone.  Right now, the Greek government is negotiation with the "Troika" or a panel of negotiators from the IMF, ECB and the EU on a package of austerity measures in order to insure the next tranche of aid will be forthcoming.  It has already been announced that the decision on approving the aid is being deferred until the end of October after the Troika submits their report.
It's certainly difficult to say whether Greece can stay in the Euro zone but the political rhetoric out of Euro zone politicians, including those of Germany, has turned surprisingly dovish in the past month.  Expect some tough talk going into October but the EU relenting and giving the next tranche of aid.  It is said that Merkel has decided that a Greek exit would be more injurious to the German economy than continued propping up of the Greek economy.
The issues surrounding Spain formally requesting assistance from the ESM and ECB I addressed in last week's commentary.
I've also discounted an Israeli attack on Iran's nuclear facilities in last week's commentary.
I would be remiss if I didn't post the chart of the Shanghai Composite Index, representing the world's "work horse" economy:
There is much concern in the financial markets regarding the ongoing slowdown in China.  And I too share those same concerns but probably for different reasons than most pundits.  I've stated in recent commentaries that when considering China we need to look at it as primarily an exporting economy and so it is "the tail the dog is wagging". It's economy is a mirror reflecting back the present image of the economic plight of developed "first world" economies (Europe, US).  But even so, this too is a simplistic analysis of the challenges the Chinese are facing.
The reasons behind a continuing Chinese slowdown are multi faceted, taking into consideration present politics, changing demographics due to enforced birth control, and a forced transition from an exporting based economy to a consumer based economy.  Pile on top of that the recession in China's largest trading partner, Europe, and you get a chart that looks like the one above. 
There are no quick fixes to the challenges there.  And the Chinese government is wisely avoiding pumping money into the system which would stoke inflationary pressures and consequent social turmoil.  The "blip" at the bottom right of the chart was the result of the Chinese government announcing a 175 billion dollar infrastructure project weeks ago.  But we've yet to penetrate a multi month down trend line (red dashed) and the multi year down trend line (green dashed).
To sum up, we still have problems but Draghi took the extreme tail risk of a Euro zone financial implosion off the table and Bernanke's commitment to unlimited liquidity has put solid support under stocks (for now).  The fiscal cliff will be the growing concern of our markets as we move into the Autumn but my impression is that the market will not start reacting to the paralysis in Washington until after the election. 
An Obama victory is built into stock prices at this time and if he does win the market reaction will therefore be muted.  If Romney is seen as gathering momentum going into election day this will be a positive for the market and a Romney win will bolster risk assets world wide.
So, enjoy the ride for the next two months!