Sunday, October 28, 2012

Macro Analysis 10/26/2012

Stocks continued their correction this week but after Tuesday's sell off they traded flat thru Friday.  And this was a major accomplishment for the major averages as we were bombarded with hundreds of quarterly earnings reports, most of which were lackluster to disappointing.  Of the companies on the S&P 500 that have reported earnings so far for the quarter, over 70% have reported earnings above estimates.  However, only 36% of companies have reported sales revenues above estimates.  So profits are coming from expense cutting or other extraneous factors not related to demand. 

On top of all this, investors were schizophrenic in their reactions to the reports.  UPS earnings disappointed and it rallied more than a dollar?!  Apple disappointed and after an initial plunge in after hours trading closed the week fractionally lower than it's Thursday's close.  Perhaps the biggest example of the chaotic reaction to these reports was the reaction to Amazon's results.  The report itself was terrible!  What does the stock do?  It rallied almost 7% on Friday!  It's impossible to take a pre earnings report position and expect to make money when dealing with such incoherence!

Here's the Dow Jones Industrial Average.  As you can see it has violated its 50 day moving average and has been sitting on Fibonacci support for the past three trading days:

(click on chart for larger image)
The longer it sits on Fibonacci support the more likely it is to turn short term higher.
Here's the S&P 400 Mid Cap Index:
It too has penetrated its 50 day moving average and it is sitting on Fibonacci support but has yet to pierce the uptrend line established from the June 2012 low.
And here's the Wilshire 5000 Composite Index which is the total US stock market:
We have essentially the same chart pattern as the previous two charts.
Finally, here's a picture of market internals going back to May 2009.  This is a daily chart of the Percentage of stocks trading on the New York Stock Exchange that are on "buy" signals according to their point & figure charts:
The chart is informative for both short and long term perspectives.  I've circled the recent action in green.  The percentage of stocks on buy signals is presently at 66.82%.  As such, the chart is telling us that any short term weakness we're seeing in price action is nothing yet to be concerned about. 
The bottom panel is the actual price chart of the NYSE Composite Index.  From a longer term perspective the chart is sporting significant negative divergences between price and stocks that are on buy signals (notice burgundy dashed lines on the bottom panel versus the red dashed lines in the top panel).
My intent in posting this chart is not to make any grand predictions.  Mr. Market cannot be pigeonholed by any one or group of technical indicators.  Technical analysts utilize all the tools they have and attempt to formulate probable short term and long term scenarios based on what those tools/indicators are telling them.  And from a technical perspective price must be the primary indicator in determining market direction. However, we must continue to monitor this multi year negative divergence. 
Treasuries had another anemic week and I had outlined a divergence between them and the US Dollar earlier in the week on a short blog post:
Here's a daily chart of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) that I use as my primary measure of Treasury price action.  Notice that we finally penetrated the downtrend line (red arrow) established from the late July highs.  But I've also pointed to a false break out earlier in the month (grey arrow).  Also notice that MACD (bottom panel) is in bear territory.  We'll need to see TLT maintain price action above the 38.2% Fibonacci resistance line before we can take this break out seriously. 
From a longer term perspective here's a weekly chart of TLT going back to the historic crash of the financial markets in 2008:
I'm not trying to build a case that Treasuries are about to rally.  Indeed, the most recent relative weakness in Treasuries could be a harbinger of a strengthening US economy.  But when I look at the weekly chart and the momentum indicators in the top and bottom panel, I can only come away with the conclusion that any prediction that the bull market in bonds is about to end is premature.  As far as TLT is concerned, we have significant support at the 115 level and then the 110 - 109 level.  Only a decisive break of the 115 level on the weekly chart would force me to reconsider that a bearish reversal in bonds is imminent and a break below the 109 level would confirm it.  I'll have more on Treasuries in my analysis below.
Gold is acting just like stocks; sitting on Fibonacci support on the daily chart:
I'm still getting short term sell signals on other gold charts I use to trade with.  But there's still no doubt that the decade + long bull market in the yellow metal is still intact when we look at the weekly chart:
I still have concerns about Gold's direction through the end of the year and I'm not as dogmatic as others that we have years more to go in Gold's bull market.  It's hard to argue with the "gold bugs" that all the money printing by central banks won't stoke inflationary pressures but I will not make predictions on when or if this scenario will unfold.  The complexity of global finance and economics coupled with the still incredible deflationary forces that exist on the planet make predictions of $5,000.00 + gold implicitly arrogant.  And until the chart below, courtesy of the St. Louis Fed, starts turning up, gold's main driver, inflation, is virtually non existent:
This is a chart of the Velocity of M2 money stock; M2 being the most closely monitored measure of money supply in the country.  Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply--that is, the number of times one dollar is used to purchase final goods and services included in GDP.  As can be seen, velocity of M2 has been in decline since 2006 and included a waterfall decline in 2008-2009.  Regardless of any rhetoric to the contrary, there is no inflationary pressures to be concerned about at this time.
Commodities, consistent with present inter market relationships, were flat to down this week.  I'm posting a weekly chart of the Dow Jones UBS Industrial Metals Index ($DJAIN):
I circled the last seven weeks price action inclusive of this week (grey arrow).  When the Fed announced QE3 the index decisively broke through the downtrend line (red dashed) but since that time prices have retreated below the 50% Fibonacci retracement level.  We're currently sitting right on the downtrend line again.  The chart is telling us that the global industrial economy is extremely weak and the Fed's recent liquidity foray is experiencing accelerated diminishing returns. 
The Dollar finished the week higher with the bulk of the gain occurring on Tuesday.  For the rest of the week it gently trended higher:
Specifically, the Dollar has been benefiting from a weakening Euro. There's also the prospect that the Japanese Yen which is 13% of the Dollar Index will weaken if/when the Bank of Japan (BoJ) introduces additional stimulus into the Japanese economy.  If the BoJ does intervene to attempt to stem persistent deflationary forces in the their economy we should see a pop in the Dollar Index.  The Euro is taking care of itself due to the reluctance of Spain to ask for an ESM/ECB bailout as well as horrendous economic data coming out of the Euro zone.  Here's a daily chart of the Euro:
The Euro has broken down below an uptrend line established at the late July 2012 low.  I've identified the waning momentum in the two upper panels.
 When I survey the price action in all these markets this week I come away with four fundamental points that I want to make:
1.  Stocks, commodities and gold will probably trade flat to lower until the election is over.  The market hates uncertainty and as pundits build their cases on whether Obama or Romney is better for Mr. Market, until we get clarity after 11/6, there is no reason for hedge funds and institutional investors (the big money) to stake out a claim in this market.  This dovetails into my next point:
2.  A caveat: any news, positive or negative, related to the fiscal cliff will move the market in a commensurate way.
3.  With each passing day, the longer Spain waits to ask for a bailout from the ESM/ECB, the less of a positive impact it will have on the Euro when the announcement inevitably comes.  And if Spain waits until the new year which I place even odds on, the Euro will, in the mean time weaken considerably.  Watch Spanish sovereign yields for an indication when Madrid will move on the request.  So far, ECB President Mario Draghi's "jawboning" has kept rates low.
4.  The Euro needs to weaken much more in order to mitigate the contractionary forces gaining momentum in the Euro zone economy.  A weaker currency makes exports cheaper and right now all EU economies need a cheaper Euro.
Technically, the Dollar is telling us that global markets are grudgingly moving toward a "risk off" posture.  The price action on the Dollar chart and the Euro chart confirm this.  But we cannot make too much of this since there have been no decisive moves on either chart.  The Euro's breakdown under an uptrend line will have to be confirmed by next week's price action.  Otherwise, this might be a false break down.  But remember the weekly chart of the Euro I posted in last week's commentary.  Here's an updated chart:
 We've been in a bear market in the Euro since May 2011 but have been experiencing a counter trend rally since July.  I've pointed out the weakening momentum but also the big ugly red candlestick (white arrow) that's wedged in between two different Fibonacci levels.  A breakdown below the purple dashed uptrend line could be the start of the next leg down.  Such a turn in the Euro would not bode well for stocks and commodities.
Now, the other question mark is our Treasury market.  Treasuries are also starting to grudgingly confirm a "risk off" trade but we can hardly call the break out in TLT decisive.  And the price action in Treasuries, but for the last week, have been trending down.  In normal times, lower Treasury prices (higher interest rates) would be telling us that the bond market believes our economy is getting stronger.  If the breakout I identified above is a head fake can we believe that message now?  As I stated last week, we are the nicest house in a slum in terms of global economic growth but are we that strong to see long term interest rates at 3+% ? I'm posting a link that gives a cogent argument for the continued long term rally in Treasuries:
Gold will either tread water or continue to move lower until Spain requests a bailout and/or the Fed decides if it will extend "Operation Twist", scheduled to end at the end of December, by combining this bond buying program with QE3.  Right now, under QE3, the Fed has committed to buying 40 billion dollars in MBS (Mortgage backed Securities) per month.  Adding the "Twist" commitment to QE3 means they will be purchasing an additional 45 billion dollars/month of mid to long term Treasuries.  A decision on this issue will come after their December 11 - 12 meeting.  I expect the Fed to extend this commitment and if an extension cannot "goose" gold it would, in my mind, call into question the grand bull market in the yellow metal.
The fiscal cliff  continues to gnaw in the back of Mr. Market's mind  and the issue gets tricky because the law mandates that budgetary targets must be met, whether voluntary or through sequestration.  Everyone is scared of sequestration but even a compromise inside the Beltway still means there still needs to be cuts in the system.  Sequestration simply guarantees the mandated cuts will be made.  The fiscal cliff or a consensus agreement is ultimately deflationary and cannot be positive for stocks, gold or commodities.
As I survey the charts I've posted on this commentary I would call my readers attention to the  Dow Jones UBS Industrial Metals Index ($DJAIN) chart above.  I believe it is representative of the diminishing returns Mr. Bernanke is getting from successive liquidity injections into the system.  Here's a long term chart of the Wilshire 5000 Composite Index which is the total US stock market.  I've highlighted the successive QEs on the chart and their effects:
(click on chart for larger image)

 Admittedly, it could be argued that trying to draw conclusions on the latest Fed announcement is premature.  The reaction of Mr. Market to the other QEs had a lag time (the exception being QE2).  So maybe the market needs more time for the full effects of QE3 to manifest itself.  But the diminishing impact of successive QEs is pretty apparent. 
But let's look at the effects of successive QEs on industrial metals using a long term chart of the Dow Jones UBS Industrial Metals Index ($DJAIN) chart that I posted previously in this commentary:
(click on chart for larger image)

Utilizing the same time line, the results are frightening!  And I would submit to my readers that industrial commodities lead stocks and are predictive of their future price action.  Granted, this is a global index and some would say that the US is doing much better than the rest of the world.  Well, here's the Dow Jones US Industrial Metals Index over the same time span as the previous two charts (without timeline annotations):
(click on chart for larger image)
It's pretty much the same chart as the global industrial metals index with a bit less volatility.
Now, the bulls can make the argument that even though successive QEs have had diminishing effects on stocks, the Fed's recent liquidity incursions were not needed and this economy can stand alone without the Fed's help.  While I can respect the opinion and even anecdotally affirm it through what I see around me in the local economy I live in, the Government's reporting numbers do not paint that same rosy picture.  And a lot of people believe the Government fudges the numbers.  Well, if they are fudging the numbers to make them look better then the bullish argument that this economy can stand alone loses credibility. 
All in all, with a host of unresolved political/fiscal issues weighing on financial markets in conjunction with the technicals I've outlined in the charts above, it's hard for me to get excited about global economic and financial prospects into 2013.  Yet we have people on Wall Street simply glowing over the coming strong year we're going to have in stocks in 2013!  I'm decidedly bearish on the markets going into the first half of 2013.   But that's what makes a market!
Have a great week!