Sunday, October 14, 2012

Macro Analysis 10/12/2012

Stocks and commodities this week failed to rebound from last Friday's listlessness with most of the major indexes losing around 1%. 

I feel as though we're on the precipice of a serious decline in this headline driven market and the only two news items that will turn the market around would be positive news on Spain or our fiscal cliff.  Unfortunately, I don't see the possibility of positive news coming this week. 

Most of the major indexes have penetrated multi month support lines on their charts:

(click on chart for larger version)
Notice on the charts that, so far, the S&P 500 ($SPX) and the S&P 100 ($OEX) are trading at or slightly above their 50 day moving averages while the Russell 2000 small cap index and the Nasdaq Composite are trading below their respective 50 day moving averages.  Small caps and tech stocks continue to show relative weakness to their large cap big brothers, an ongoing technical weakness I've been identifying for months.
 Treasuries have continued their stealth rally this week but they did look a bit tired by Friday:
Here's the iShares Barclays 20+ Year Treasury ETF which the street uses as a proxy for the long end of the yield curve.  The ETF has managed to clear a downtrend resistance line (yellow dashed) on Friday and I've circled the price action in blue.  Friday's candlestick was a "doji" that stopped right at 50% Fibonacci resistance so I can't get too excited about the prospects of a movement higher. 
Our inter market relationships tell us that a stronger Treasury market (risk off) equates to weaker equity and commodity prices (risk on).  Any follow thru to the upside on the chart above will not be kind to stocks and commodities.
Gold too, is turning down as "risk off" seems to be gaining the upper hand in international financial markets:
I've circled the price action and the break down below a steep uptrend support line established in mid August.  Gold has been anticipating central bank money printing and while our Fed has obliged the European situation is putting a damper on its upward momentum. 
The Gold market has been very challenging to understand in 2012 as sentiment has shifted from it being an asset that moves on fear to an asset that moves on inflationary concerns.  The fact that it is not continuing to rally after Bernanke has opened up the liquidity spigot tells me that the yellow metal is still concerned with the mammoth deflationary pressures that pervade the global economy.
Commodities are also weakening in the face of world wide economic contraction.  My regular readers will remember the updated chart below of the Dow Jones-UBS Industrial Metals Index that I posted two weeks ago.  At the time I identified a bearish technical pattern we call a "broadening top".  Since that time the index has broken down considerably as can be seen on the chart below:
Here's a weekly chart of the Dow Jones World Basic Materials Index.  While we started moving higher in late July prices have backed off their highs in the last four weeks concurrent to the announcement of QE3:

My regular readers know that I only focus on industrial commodities and basic materials to the exclusion of agricultural commodities because I'm trying to discern the direction of economic growth. Agricultural commodities as well as oil tend to move in either direction on factors that have little to nothing to do with economics.  However, for my friends concerned with food price inflation here's the S&P Goldman Sachs Agricultural Spot Price Index:
Notice the incredible run up on the chart over the summer due to the extreme heat and drought conditions in most of the country.  We've flattened out a bit since then but are still in an uptrend until we penetrate the black support line and Fibonacci support.
To sum up, commodities and gold are not reacting as they have in the past to central bank liquidity intervention. 
And here's our Dollar which I focused on in last week's commentary:
Dollar price action is pivotal to understanding where these markets are going in the short to intermediate term.  It seems from the daily chart above that it's moving down the steep downtrend line (white dashed) that was established from the late July top.  However, a weekly perspective gives us a more comprehensive understanding of its price action:
This is an updated version of last week's posted chart and I didn't even have to adjust the yellow arrow after this week's price action!  The Dollar is trading flat against the other major currencies and the Euro is the reason why.  The Foreign Exchange market continues to buoy the Euro in anticipation of a Spanish request that the ESM and ECB bail their bond market out.  But will the Spanish request the bailout everyone says is coming?  I'll address this in my analysis below.
Finally, here's a "tale of two charts".  It seems that China is waking up from its economic slumber; or is it?
The first chart is one that is familiar to my regular readers. It's a daily chart of the Shanghai Composite Index. It is composed of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange.
We can see above that the Shanghai has bounced off its lows and the momentum indicators are signaling a positive divergence (see blue arrows on the momentum indicators in the top and bottom panel versus the price chart.  Still, when we look at where we closed on Friday we are still at a price level not seen since February 2009. 
Now, here's the iShares FTSE China 25 Index ETF which is comprised of the top 25 largest capitalized Chinese corporations; names such as China Mobile, Bank of China and PetroChina. Financials make up almost 57% of the index:

We can see a triple bottom on the chart and momentum indicators are signalling more strength to come.  If we penetrate Fibonacci resistance (blue arrow) we'll be heading higher.
Certainly, the ETF is telling us a different story from the Index.  The largest capitalized companies are much stronger than the entire index comprised of many smaller companies.  Can we take the ETF's signal that a turn is going on in China?  The Chinese announce their 3rd Quarter GDP data on Wednesday evening and even though GDP is not a forward looking indicator the report may give us a glimpse on where the Chinese economy is heading.  News out this weekend showed China's exports grew at roughly twice the rate expected in September while imports returned to the path of expansion.  This may suggest a stronger fourth quarter.

In many ways, the issues I've identified in my two prior commentaries continue to haunt us.  QE3 is the "mother" of all QEs.  Draghi's program to save the southern periphery, though conditional, is the closest program the Europeans can get to the Fed's stimulus program.  Yet stocks, gold and commodities, after an initial bounce on the announcement of both liquidity programs, are starting to trend lower. 
A deeper explanation of the reasons for this, as always, are much more complicated than I can explain here.  And frankly, they are much more complicated than any finite group of minds on the planet can discern.  That's why understanding and making money in the financial markets is probably the most challenging vocation one can choose to pursue.  Nevertheless, I'll try to distill what Mr. Market is telling us within the context of the fundamental backdrop.
As I stated above, there are a couple of news events this week which, when taken in their sum, should move these markets in a big way.
The economic reports in our country this week include:
Retail Sales and Empire State Manufacturing - Monday
Industrial Production - Tuesday
Housing starts - Wednesday
Jobless claims and Philadelphia Fed Survey (probably the biggest report this week)
Existing Home Sales - Friday
The Chinese release a slew of economic reports on Wednesday evening but the eyes of all market participants will be on their 3rd Qtr GDP report where expectations are for 7.4% year over year (YoY) growth.
And then, in Europe, EU leaders meet in Brussels for debt crisis talks on the 18th and 19th where the main topic is going to be whether Spain needs to or should apply to the ESM and ECB for a bailout.
These important reports and events will give the market it's cue on direction. 
The presidential election is also adding some pressure to the indices as the market hates uncertainty and Romney's advance in the polls is fueling that uncertainty.  In spite of all the momentum the Republicans have behind them the election is Obama's to lose.  The economic reports above as well as news developments on "Benghazi gate" will ultimately determine who occupies the White House in January.  And the Republicans still have to defend their tax plan.  I posted an excellent article from the Wall Street Journal on my Facebook page that diffuses Obama's accusation of Romney's "five trillion dollar tax cut".  Why Romney and Ryan aren't incorporating that defense in their campaign is beyond me.
And then we have the fiscal cliff which will not even be addressed until after the November 6th election.  And, to me, this is the biggest anchor around the ankle of this market. 
I'm going to attempt to tie this all together as briefly and concisely as I can.
As far as the economic reports go, I expect Retail sales to exceed expectations as I don't believe the economy is as weak as the prevailing consensus thinks.  I believe we'll get mixed readings on Empire State and Philly Fed.  Jobless claims last week briefly moved the market higher on Thursday but the rally quickly faded.  I'll be looking for a weaker jobless claim report this coming week due to seasonal distortions.  I expect that any upside surprises in all these reports will have the same effect on the market.  I'll be looking to fade (sell short) any early morning rallies next week.
Europe, as usual, is just too complicated to comprehensively address here.  However, the expectation that Spain's Rajoy will ask for a bailout this week I believe is optimistic.  First of all, Draghi's plan has kept Spanish (and Italian) interest rates low without the printing of a single euro. Market participants are afraid to step in front of a freight train; that being a central bank's pledge to intervene in a bond market with potentially unlimited liquidity.
Coupled with market participant concerns are political considerations.  Specifically, there is growing backlash among politicians in Germany, Finland, Austria and the Netherlands over the continued support of their "profligate" southern brethren.  While my description in the prior sentence may not accurately describe the emotions Northern Europeans feel, it inevitably boils down to this.  Germany's Merkel and her Finance minister Schaeuble are actually encouraging Rajoy to fore go asking for the bailout the market knows Spain needs because of concerns that the Bundestag will not agree to more support. 
The Euro has been maintaining its strength on the hopes that Spain is going to have to seek assistance soon.  This outcome is seen as bullish for the currency.  And the foreign exchange market has been patient while all the political intrigues surrounding this situation are being worked out.  However, the closer we get to the end of the month the more impatient the market is going to become.  Some are believing that this week's meeting will culminate with a Spanish request for aid.  I'm of the opinion that nothing of importance will come out of this meeting. 
The market may react to this disappointment and if the Euro breaks down below the 128.30/128.00 level it may provide the catalyst for a deeper correction in equities and commodities.  Here's a daily chart of the Euro and I've highlighted in yellow the zone below which the Euro would have to fall below that would signal lower stock and commodity prices:
Remember, the inverse relationship between the Dollar (risk off) and the Euro, stocks, gold and commodities(risk on).  Any serious Euro weakness will equate to Dollar strength and thereby will be the catalyst for a sell off in risk assets.
No one can predict with accuracy the Chinese GDP data coming out on Wednesday night but if the growth estimate does not meet expectations this may provide the first precondition for a sell off in the market if the Euro meeting on Sunday and Monday disappoints as I predict it will.  And, of course, a much worse than expected GDP report might spark a correction by itself while and any upside surprise would be greeted with a rally that I think will fade fast.
Finally, the fiscal cliff weighs on the market, as I've described above, like an anchor. And this is the greatest uncertainty the market is contending with.  To the extent it is not addressed soon risks equities suffering a significant correction.
To sum up, there's a lot of moving parts on how the price action may shake out this week but in my analysis the risk is to the downside.  The fact that any good news we've received since the month began has had only a fleeting positive effect on the market is telling.  We can layer the issues with the top having the heaviest influence:
Fiscal cliff (no resolution this week)
EU Summit (most likely no resolution with Spain)
Chinese GDP (possibly a disappointing report but no one knows)
US economic reports (mixed)

Have a great week!