In light of all the QE that has been implemented by our Fed and the ECB and now this week Japan, I'm going to identify some trends that are beginning to develop that I believe may be signaling a downturn in risk assets.
Here's a weekly chart of the Dow Jones Industrials Index:
(click on chart for larger image)
Stocks flat lined this week and although I predicted a rest in the beginning of the week due to an overbought condition I expected the indexes to start moving higher by week's end. But that did not happen.
The tenuous nature of the price action has been generally dismissed by the street as simply an extension of an over bought condition that may linger for a while longer. One trader on CNBC described it this way: "If the market is giving you this long to sell the highs, it's going higher".
Others believe the market needs more news as a catalyst for higher prices. We certainly saw some inkling that that might be true on Thursday when it was reported that Spain was in secret negotiations with the European Commission over seeking a bailout for the country. We had a mild levitation in the averages but nothing like the "old days" when we would get 30 point rallies in the S&P.
But look at the chart below:
This is a weekly chart of the Dow Jones Transportation average and while the Dow industrials are building up momentum to assault the all time highs set in 2007 the Transports are languishing and have broken down under multi month support (yellow line).
Pundits are trying to explain this away as a temporary phenomenon. The transports are made up of several sectors such as rails and trucking. The rails have broken down as the low price of natural gas has curtailed the massive production and movement of coal as nuclear facilities have switched to the less costly fuel. And experts state that's why the Transports are lagging.
But it's not just the Rails that are lagging:
Here's the Dow Jones US Trucking index which is another component of the Dow Transports. It's been in a significant downtrend since April.
What I'm identifying above is a Dow Theory divergence. The Dow theory is a very popular form of technical analysis founded over a century ago by Charles Dow. Without getting into specifics one of it's main tenets is that the averages must confirm each other. In this case, if factories are doing well then we should see a pick up in the transports since they need to ship their production to market.
A case can be made that the relevance of the theory is not what it once was because the companies that make up the Dow Industrials have changed. Today, information and communication technology companies make up a significant percentage of the Industrials. But still, at least 15 of these companies must move their products by either rail or trucks to distribution centers. So the theory carries some validity.
Here's another concern that I've identified in the past week. It must be remembered that the Fed has opened up the liquidity spigot with a potential amount of unlimited quantitative easing. The last two times the Fed implemented large scale asset purchases commodities, especially industrial commodities, took off. While we're only a week from the latest announcement I find the lackluster price action in industrial commodities and materials to be disconcerting:
Here's the Dow Jones UBS Industrial Metals Index:
We had a spike in the index when the FOMC announced QE a week from this past Thursday but last week we traded flat. And unlike stocks, commodities are not over bought. Look at the Dow Jones US Steel Index below:
Here's an example of what traders call a classic bear trap. Steel broke out above a multi month resistance line on the Fed announcement only to fall back below in last week's price action.
Lest my readers think this just might be a US phenomenon, here's a weekly chart of the Dow Jones World Basic Materials Index:
I circled the last two weeks price action and it's been very informative in telling us the global effects of the Fed's latest announcement.
I circled two candlesticks. The first candlestick was the week prior to last week and has a long upper wick which denotes that the price of the index shot up on the Fed announcement and uncannily touched Fibonacci resistance before dropping significantly. The second candlestick in the blue circle (black) shows that the index opened significantly higher than the prior week but finished the week below it's higher open. It too was unable to penetrate Fibonacci resistance.
While it's true that we cannot definitively call a trend after two weeks price action, the fact that commodities are not exhibiting strength after the two most powerful central banks on the planet within the past three weeks have announced the largest liquidity injections yet seen in the aftermath of the Great Financial Crisis of 2008 is, to me, a red flag.
What's going on with commodities? One chart is worth a thousand words. Here's an updated chart of the Shanghai Composite Index:
ANALYSIS
I stated this commentary would be brief so I'll be limiting my remarks in this section.
The identification of the two major divergences above (while we've experienced a weaker dollar at the same time) is signaling a weaker economy going forward.
Obviously, there's a lot more to this story than I'm going to cover in this analysis but let me identify two drivers that I believe are largely responsible for the warning signals identified above:
1. The fiscal cliff
2. China
1. On Friday night we had a good friend and his family over for dinner. He is in a consumer discretionary industry connected to home improvements and he has not had any work since August. His business caters to an "upper crust" clientele in South Texas. When I asked him whether his experience was particular to him he stated that his visits to the supply houses in the area reveal that all his competitors have been impacted by a radical slowdown in their businesses. Up to August they were all very busy. It was like business "fell over a cliff" ...
I know the story above can only be identified as anecdotal but I believe we are beginning to be significantly impacted by the inability of our government to avoid the mandated spending cuts and significant tax increases that have to start on 1/1/2013. And the gridlock inside the beltway only contributes to the inertia of small and large business to plan in a coherent way for what might await them next year. If I'm right the stock market will be reacting soon and the liquidity that Bernanke is pumping into the system will inevitably not be able to keep the present floor under stocks intact.
2. The chart of China above is showing more deterioration with every passing week. Without an improvement in economic activity industrial commodities cannot rise. It must be remembered that China has huge stockpiles of various commodities such as copper and cotton. And the Chinese government, in order to keep the populace employed, has been subsidizing factories and industrial mills in order to keep them open. So inventory is building against a back drop of less exports. Steel is as a perfect example of this. The Chinese continue to produce steel in the face of almost non existent demand but inventory is already at record levels! This is having an incredible downward pressure on the price of steel.
Last week I believed we would have a liquidity based rally into the election but now I'm not so sure. If we could get an announcement out of Washington that there was a chance of a compromise in avoiding "the cliff" these markets and the economy would take off. There was talk this week that members of both parties were in discussions regarding this issue but after the history of the last two years I can't hold out much hope that the gridlock in Washington can be broken. And obviously, American business doesn't hold out much hope either.
We'll see what next week brings. Risk assets appear to need some news to push them higher. The problem as I see it is that there's no news forthcoming. Even the decision on the next tranche of aid to Greece is being delayed until after our election and Spain's Rajoy is in no hurry to ask for a bailout from the ESM & ECB as Spanish bond yields are now manageable if still too high.
Have a great week!
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