Sunday, November 4, 2012

Macro Analysis 11/2/2012

As everyone is aware, we had an abbreviated trading week due to extra tropical storm Sandy.  After Wednesday's flat trading activity I was wondering if there was going to be anything of substance to address in this week's commentary.  But that changed after Thursday's and even more so, Friday's price action.

The Monthly employment report on Friday morning put a positive slant on the S&P futures and the US Dollar but gold was already correcting in European and pre market trading.  Sure enough, when the market opened stock indexes popped and quickly put in their highs for the day and then faded into the close. Downside momentum picked up significantly in the last two hours of trading.

What changed the mood of the market?  I'll be addressing this in my analysis.

Stocks, on average, finished the week flat with the notable exception being the S&P 400 Mid Cap Index which surged 1.34% on the week and that was even after Friday's sell off:

(click on chart for larger image)
This is a daily chart of the Mid Cap index and I circled the week's price action.  The bulk of the Mid Cap's gains were on Thursday on the back of slightly better manufacturing numbers out of China and a better than expected US jobs and ISM manufacturing report.  Friday's swoon did not entirely retrace Thursday's gains and the two day candlestick pattern could be interpreted in a bullish or bearish way.  However, according to the textbooks, we would have to say that interpretation is bullish.  For those of you who are familiar with candlestick patterns I see a possible "dark cloud cover" formation.  But again, it's nowhere near what it should be to sway me toward a short term negative view of the chart.
Here's the S&P 500:
We're still in the midst of what can only be classified as a minor correction but the S&P has broken down under a support line that had been maintained since early September.  The black arrow highlights that Thursday's rally bumped into the support line but couldn't penetrate it.  The two candlesticks have formed a Harami candlestick pattern which has short term negative implications.
Stocks are being held captive to uncertainty.  The nature of that uncertainty will be addressed in my analysis.
Treasuries continue to bump along a downtrend line established in July and seem to be begging to break out to the upside:
Here's the iShares Barclays 20+ Year Treasury Bond ETF, an excellent proxy for the long end of the US yield curve.  I've pointed to the false breakout in mid October (grey arrow) and this week's price action (white arrow).  It would seem that the recent break out is also a false break out but Friday's candlestick was a hollow red candlestick meaning that the ETF opened lower than the previous day's close but rallied throughout the day still closing below Thursday's price action.  This trading activity speaks to accumulation.
Gold sent us the strongest signal on where risk assets might be heading:
That candlestick (blue arrow) is ugly!  I really don't see any significant support on the chart until we reach Fibonacci support at the 1630 level.  But why did Gold take a nosedive?  More in my analysis.
Commodities were down again this week.  Here's a daily chart of the Dow Jones Industrial Metals Index:
I circled the price action this week and the two candlesticks (green with red positioned above it) is sporting a dark cloud cover formation and is a short term bearish signal.  Regardless of short term price movements, the chart is indicative of tepid economic strength.
Now on to the Dollar:
 The dollar is moving markets and according to the chart above it should continue to do so.  The Relative Strength Indicator (top panel) has penetrated the 60 level which is very bullish and the price action is strong.  A number of factors are contributing to Dollar strength and I'll be addressing them in my analysis but I'll sum up, for now, the reason for Dollar strength in one word: deflation!
Let's take a peek at China where the street is getting ever hopeful that there's a turn around being engineered there after some marginally positive economic reports:

The improvement in their stock market is tentative and the official positive economic data emanating out of the country is tempered by other data that suggests the slowdown continues. From Sober Look (

"Thermal coal inventories at China's power plants continue to grow. This is an important leading indicator that analysts look to in order to understand inflection points in power demand and ultimately output growth."

So is the official data right? As I've stated before, no one really knows what's going on in China. Like elsewhere on the planet, financial markets are hopeful that the new regime, set to take over this week, will provide more stimulus to a moribund economy.  For reasons that would take too long to articulate here, I don't believe the Chinese government will provide the amount of stimulus the street is expecting and so the financial markets are setting themselves up for disappointment.

As a student and ardent follower of inter market analysis, gold's sell off spooked me.  While it's always true that a stronger Dollar means weaker stock, commodity and gold prices, the gold plunge on Friday was inordinate given dollar strength.  The dollar finished Friday up .68%; gold finished the day down 2.17%.
The price action in Treasuries (a risk off asset) was also noteworthy given the fact that as the trading day went on prices gradually strengthened.  As measured by the Treasury ETF TLT, treasuries started the day down .87% from Thursday's close but by the close of trading on Friday afternoon had recouped the vast majority of those losses to close down a mere .07% from Thursday's close.
As our inter market relationships dictate, stocks and commodities were held captive to the dollar's strong showing which precipitated the gathering downside momentum going into the close.
So, what gives?  What's the reason for the stronger dollar?
There is a technical reason and there are fundamental reasons but, as I stated above, the reasons can be summed up in one word: deflation!  Let me explain.
Technically, the Dollar is strengthening as traders position themselves for a sell off in the Japanese Yen, long held to be a safe haven currency.  The Japanese government is putting unrelenting pressure on the Bank of Japan (BoJ) to print massive amounts of yen in order to stem the persistent and virulent deflationary forces which have gripped the Japanese economy since 1990.  Up to now, the BoJ has been hesitant, even reluctant, to pump this liquidity into the Japanese economy.  Previous liquidity injections have been half hearted and market participants have correctly deduced the BoJ's lack of commitment to stem the deflationary tide .  But "push is coming to shove" as a strong yen continues to strangle Japanese exports and demand at home is vanishing under a deflationary psychology that has been unconsciously embraced by the Japanese population after 22 years.
With the Japanese Yen comprising 13% of the US Dollar Index this has been a supplementary factor supporting dollar strength in the short term.  But the other much bigger factor behind a strengthening dollar is Europe.
As an aside, I'm not buying the rationale on the street that dollar strength has to do with uncertainty over the election.  If that was the case, I don't believe gold would have sold off on Friday.  If anything, in times of geopolitical uncertainty, gold tends to retain its value or rally.  And while I will not dismiss uncertainty over the fiscal cliff that's looming, that issue has not caused the disproportionate weakness in gold we saw on Friday.
So what's going on in the never ending saga in Europe?  Well, for starters, my thesis regarding revolution/secession is finally gaining credence on the street.  Catalonia votes for independence from Spain at the end of November.  It appears that pro independence factions in that region are gaining momentum.  I'm not necessarily predicting secession for the most productive state in Spain but the reverberations of a significant political shift toward secession would rock Madrid and global markets.  The implications of a possible break up of Spain are multi faceted and none of them are good.  Which dovetails into the next problem brewing ...
Greece!  After finally gaining agreement with the troika (a monitoring committee made up of representatives of the European Commission, the International Monetary Fund, and the European Central Bank) on a package of austerity cuts the Greek government must implement before these organizations hand over the next tranche of financial aid that the insolvent country desperately needs, the coalition government under Prime Minister Antonis Samaris is having trouble garnering the necessary majority in the Greek parliament to approve negotiated austerity measures. 
A recent news story out of last Thursday had the Greek Finance Minister Yannis Stournaras expressing optimism over the outcome of this crucial parliamentary vote in the coming week. But haven't we heard these optimistic reports before?  Additionally, the western financial press is not as sanguine as the Greek Finance Minister on the prospects of a positive vote. The bill containing 13.5 billion euros ($17.5 billion) of spending cuts and reforms will be presented to the parliament on 11/5 (Monday) and supposedly will be ratified on 11/7 (Wednesday).  Any perceived hesitancy by the coalition government to approve the bill will create market volatility commensurate with the negative news.
Third, we have the Rajoy government in Spain still unwilling to ask for a bailout from the ESM/ECB.  As I have predicted, I don't expect the Spanish government to request the aid until or unless they are forced to.  And the only catalyst that would force them to come to feed at the ESM/ECB trough is rising Spanish bond yields.  Up until last week, those yields were relatively benign but they have started to move up since that time as the international community starts to lose patience over the inevitability of Spain being rescued and as the Catalonian secession vote draws near.
Everything I've addressed thus far in this analysis is deflationary.  And I would submit to my readers that this is why gold has been experiencing downward pressure recently and essentially experienced a micro crash on Friday. 
And let's not forget our fiscal cliff.  I've already pointed out in past commentaries/posts that, in a sense, the cliff is inevitable.  Everyone is focused on sequestration but whether there are forced cuts and tax increases or voluntary cuts and tax increases, by law, they have to happen!  This too is deflationary.
I know I'm painting a rather dismal picture.  Deflationary pressures are very negative for the global economy and the financial markets.  But what has all the liquidity pumped into the world economy by central banks accomplished other than to stabilize a financial system that was teetering on the edge of a deflationary collapse?  For those readers who did not read last week's commentary I'm re posting the same stock and commodity charts that show the impact of the Fed's QE on our stock and commodity markets.  The first chart is a multi year chart of the Wilshire 5000, the total US stock market.  The second chart is the Dow Jones US Industrial Metals Index over the same time period:
(click on charts for larger images)
These charts speak to the diminishing effects of the Fed's liquidity injections better than I ever could.
We now have a Fed policy committed to pouring 85 billion/month into MBS (Mortgage Backed Securities) and treasuries between QE3 and the probable extension of "Twist" and our markets are flat to swooning.  What else is there to prop up our markets?
The theory behind providing liquidity into debt ridden economies is to buy time so that the debts can be unwound in an orderly fashion and over a long period.  In that way "boom/bust" cycles hopefully can be avoided.  Indeed, one of the main motivations for the founding of the Federal Reserve Bank was this very reason.  But it's apparent, at least to me, that we're running out of time and that a more severe global economic contraction will have to take place before we can possibly reverse the deflationary slippery slope we are on.
What could change this?  Global concerted and meaningful fiscal programs that address infrastructure spending and pro growth policies.  The austerity policies out of Europe are only feeding the deflationary behemoth.  Although I don't hold out much hope that world leaders could effectively coordinate such pro growth policies, if the US could get the pro growth engines running it would be a big start.   Obviously, the implementation of such programs will not turn around the direction of our economy in the short term.  But if we could get these policies coming from Washington we could see our way out of this mess in a few years, certainly before the next presidential election cycle.
In the short term we should get some volatility this week.  Obviously the election will take center stage in Wednesday's trading and a cliff hanger result will be the impetus for downside pressure on stocks.  A strong Romney victory will spark a rally, if only because of the strong showing and the hope that a new administration can break the gridlock in Washington.  An Obama victory will provide downside pressure on stocks but only for a day.  I'm probably positioning myself for a stronger than expected win by Romney.

We may be exposed by a "double whammy" on Wednesday if the Greek Parliament does not ratify the austerity measures the Samaris coalition government negotiated with the Troika.  If that were the case, this event would override any news about the US election and stocks would sell off.  At the time of this writing, reports out of Greece speculate the coalition has enough votes to approve the austerity package by a count of four.

As always, there are a lot of moving parts to next week's market action and it's never simple. 

Lastly, our hearts and prayers go out to those in the Northeast who got hammered this week when Sandy came ashore.  Here's a photo taken in the village of Babylon, Suffolk County, south shore of Long Island, last Monday night.  The Babylon Volunteer Fire Department in action:
By this time next week we'll have a new President!  (hopefully)  :-)
Have a great week!