Saturday, January 5, 2013

Macro Analysis 1/4/2013

 Its been a few weeks since my last commentary and I hope and trust everyone had an enjoyable and peaceful Christmas season. 

The big issue for the market and the economy that had been building up to the end of the year, the "fiscal cliff", was finally resolved in a half hearted manner on January 1st when the House garnered enough votes to push thru stop gap legislation that saved the overwhelming majority of Americans from a tax increase.  We now have a brief reprieve until the second act of the "fiscal follies" starts sometime in early to mid February.

But any agreement that our dysfunctional lawmakers made to avoid the tax increases and sequestration that was scheduled to kick in on January 1st was enough to ignite a significant rally in stocks which we saw on Wednesday.  The market had a bit of wind taken out of its sails on Thursday afternoon after the Fed released their minutes from the December meeting which seemed to point to the possibility that the time frame for continued QE might be more limited than most think.  Nevertheless, the stage has been set for higher prices in the short term which I will be expanding on below.

Stocks had their strongest first day of the year in the entire history of the NYSE on Wednesday, January 2nd.  The chart below points to the large candlestick that represents that day:

(click on chart for larger image)
The S&P finished the first week of January up 4.57%!  Not to be outdone, its small cap "little brother", the Russell 2000 set historic all time highs and finished up 5.65% on the week .  Here's a weekly chart of the Russell:
(click on chart for larger image)
More important than the impressive weekly candlestick (red arrow), I want my readers to notice the lower panel which is the Russell's price action relative to the S&P500.  That performance had been in a downtrend since July, 2011 but has now turned up and has pierced a long term resistance line.  This is extremely bullish action and is predictive of market strength going forward.  The chart below is posted to give my readers a more historic perspective on the Russell's price action by showing its monthly performance.  There are some momentum divergences on this chart but the short term momentum in this market is like a steam roller you don't want to get in front of:
(click on chart for larger image)
To sum up, stocks had a powerful week and would have been higher had it not been for the December FOMC minutes which seemed to indicate that there was dissension on the FOMC (Federal Open Market Committee) on when the present QE (Quantitative Easing) facilities would end. It was enough to temporarily slow equities but they resumed a steady upward bias going into Friday's close.

Treasuries were weakening going into the week but took a nosedive on Thursday when the Fed released the notes on their December policy meeting.  The threat of the Fed taking their foot off the QE gas pedal sent both Treasuries and Gold into steep sell offs.  Below is the iShares Barclays 20+ Year Treasury Bond ETF (TLT):
(click on chart for larger image)
I've delineated the gap that was formed between Monday (12/31) and Wednesday (1/2) and then Thursday's price action on the heels of the Fed's release of the minutes.  I'll be addressing where I think Treasuries and interest rates are going in my analysis.
I haven't posted any charts on commodities since November because global economic activity has been either down or flat. However, since China seems to be in the midst of an economic turn around I'm posting a few charts.  First,  here's a daily chart of the Shanghai Composite Index:
(click on chart for larger image)
The Shanghai has gone parabolic since early December and has pierced a major downtrend line established in October, 2007.  The significance of this technical development cannot be overstated.  The older the resistance line the more significant the signal.  Nevertheless, even with the Chinese powerhouse gaining strength industrial metals seem to be going nowhere.  This is illustrated on the chart below which is the Goldman Sachs Industrial Metals Index:

(click on chart for larger image)
The only good thing that we can say about this chart is that the succession of lower lows has been broken but the price action has failed to penetrate an "inside" upward sloping resistance line established in October, 2011.
In contrast with the industrial metals Index above, here's a daily chart of the Morgan Stanley Commodity Related Equity Index which tracks shares of widely held companies involved in commodity-related industries such as energy (e.g. oil and gas production and oilfield services and equipment), non-ferrous metals, precious metals, agriculture and forest products.  I circled this week's price action: 

(click on chart for larger image)
Although the two charts cannot be correlated perfectly I believe there is a message in the price action of the equity index that may be foretelling a bull move in industrial commodities.  Now, we are still very early to start calling a turn in industrial commodities but I wanted to make my readers aware of this development.

The Dollar staged a turn around his week that cannot be attributed only to the Fed's release of their minutes on Thursday:

(click on chart for larger image)
The Dollar had been strengthening on the probability that our elected leaders in Washington would not commit economic suicide but would agree to avoid the "cliff".  The Fed minutes on Thursday was the catalyst for the "pop" we saw on Friday (white arrow).

The FOREX (Foreign Exchange) market is experiencing some historic developments as the Japanese Yen has been in the midst of an historic sell off.  The new government there is applying incredible pressure on the BoJ (Bank of Japan) to stimulate their economy out of a two decade deflation.  That, along with a weak Euro zone economy, is starting to change the dynamics in the currency market and may eventually threaten to change some of the FOREX inter relationships which have existed for over a decade.  The dynamics I allude to are complex and cannot be comprehensively addressed here but suffice to say that if the US can sustain steady growth in 2013 and the BoJ can succeed in turning the deflationary tide in Japan, a stronger Dollar and higher equity prices may not necessarily be inversely correlated.  Please understand, I'm not saying this is definitely going to happen but I'll be watching these relationships closely in the coming months.

In any case, I see a stronger Dollar for the next few months.  The inevitability of the "fiscal follies" guarantee this.

Here is a weekly chart of the Euro:

(click on chart for larger image)
 In December, the Euro broke out above a key Fibonacci resistance level and also broached a major resistance line (yellow dashed) established in mid 2011.  As can be seen on the chart (white arrow) the past three weeks has seen a retracement in the currency.  As a "risk on" currency and about 57% of the US Dollar Index, it must be watched closely.  All things equal, a weaker Euro is negative for stocks.
Gold was taken to the woodshed again this week as a result of the Fed minutes.  The prospect that the Fed would cease or even curtail QE sent the yellow metal reeling on Thursday but it recovered somewhat on Friday, hanging on to the 50% Fibonacci retracement level and sporting a potentially bullish "hammer" candlestick:
(click on chart for larger image)
The gold bull market is at an intermediate term or maybe a long term turning point. I'll be presenting my thesis on gold in my analysis. 
With all the focus on the "fiscal cliff" and its less than comprehensive resolution, another development that took place on Thursday will have long term implications for our economy and the macro financial picture going forward in 2013.  There are a lot of moving parts to all this so bear with me as I try to organize the pieces to this puzzle. 
First of all, there is no question that the muddle thru economy will persist thru 2013 with the caveat that our economy and even the global economy is slowly strengthening.  None of the structural issues are solved and the debt deleveraging will continue. But the key here has been that the debt bubble has shifted from the private sector to the public sector where classic Keynesian adherents believe it can be controlled and diffused.  What I'm saying is nothing new but I'm trying to emphasize that because of this the private sector and equities can still thrive in this slow growth environment.
Earning season starts next week and it has always been a tenet on "the street" that earnings determine the direction of stocks.  But I contend that in a zero interest rate environment where street earnings expectations are constantly adjusted to fit the economic environment, earnings no longer matter.  If Two Year Treasuries are yielding 0.252% (Friday's close) but Exxon Mobil yields an annual dividend of 2.60% and you have an accomodative central bank supporting equity markets, where are you going to put your money?
The tail risk in Europe has diminished significantly.  The ECB (European Central Bank) policy of OMT (Outright Monetary Transactions) has stabilized periphery debt and the interest rates these comatose nations have to pay.  At this time, the kind of Armageddon scenarios the global economy faced over the past three years have almost dissolved.  The ECB policy accomplished what it set out to do without printing another Euro (so far). ECB President Mario Draghi has been the best thing that has happened to Europe since the Marshall Plan!
Now, there might be a few hiccups in Europe in 2013.  For one, Spain and Greece are in very bad economic shape as they are in the throes of deep depression.  Additionally, the secession movements that have been simmering under or at the surface in 2012 are still with us.  In Italy, the technocrat government under Mario Monti was essentially voted out of office at the end of last year and Monti is now a caretaker Prime Minister.  However, with all the bluster that former Prime Minister Silvio Berlusconi has been engendering in his bid for re-election, it seems like the Italian people are shying away from the profligate political figure and his calls to undo the Monti reforms and leave the Euro.  It seems the Italian people are sensible enough to realize that a Berlusconi victory in the upcoming elections would be a disaster for Italian bonds. 
Economically, recent data out of the Euro zone has been more positive than expected though still in contractionary territory.  Eurozone composite output PMI (Purchasing Managers Index) rose to 47.2 in December from 46.5 in November, with the services index edging up to 47.8 from 46.7. Surveys across the region, such as in Germany, suggest that the downturn in Europe, though severe, may not ultimately be as bad as some feared.

China, as shown by the chart of the Shanghai Composite I posted above, is clearly on the mend, at least on an intermediate term basis.

I've painted a picture of overall tepid economic growth in the wider context of enormous public sector debt overhanging the developed economies of the world.  And this dovetails into a discourse on what I've called the "fiscal follies" in our nation's capitol.

The arrangement agreed to last week in Congress is widely and accurately acknowledged as a "band aid" at best.  It's the classic "kick the can" solution that will rear it's ugly head as soon as early February.  The agreement simply insured that tax increases on the vast majority of Americans would not take place, enabling the economy to avoid the inevitable drag on consumption and its attendant deleterious effects. The mandated sequester (spending cuts) that were to be effective on January 1st have been delayed a mere two months to March 1st.  We also need to raise the debt ceiling as Treasury Secretary Geithner has already announced that the Treasury has run out of money and they are manipulating their balance sheet so they can still pay their bills.  But these efforts can only stave off default until the end of February.

So the Republicans have plenty of leverage in getting Obama and the Democrats to the negotiating table.  The problem is that a contentious and often ugly confrontation over the "cliff" has only served to emotionalize already hardened ideologies in both camps.  The constant mantra we hear from "the street" is that saner minds will prevail and that this time too we will get some kind of agreement.  But what many don't seem to understand is that there are ideologues on both sides of the political spectrum that will make any agreement almost impossible. 

Obama and the Dems have already stated that further negotiations will have to include more tax increases while the Republicans state that they will not agree to any more tax increases.  Its apparent that the Dems only want to tax their way out of this mess, ignoring the wise counsel of people in their own party like Erskine Bowles who say there must be comprehensive entitlement reform.

So, how is this going to end?  The Republicans have two pressure points they can utilize in an attempt to get Obama and the Dems to cave: the sequester and the debt ceiling.  My personal opinion is that they should let Obama raise the debt ceiling.  The sequester should be their lever with the Dems.  After all, if sequestration is implemented on March 1st, the effects of the spending cuts would be felt within a month as hundreds of thousands of government employees would be out of jobs.  The Republicans would also get their cuts.  But will they do that?  I'd like to think they would for the sake of the country's credit rating, but I'm not sure some of them can see their way thru their ideological fog.

In any case,  stocks will be impacted to the extent that the bickering continues as we close in on the deadline of March 1st.  This means that I still see some upside for equities in January but I believe the smart money will start paring positions as we close in on February.  I don't believe the Republicans are going to balk this time around and if the sequester kicks in on March 1st any hope for a strong year for stocks is over.

To me, an even bigger event occurred this week that will set the  tenor for financial markets in 2013.  It was the release of the December Fed's policy meeting minutes.

As a background, it was decided at the Fed meeting in December to buy a combined $85 billion a month of Treasury and mortgage securities in 2013.  However, as reflected in the released minutes, of the majority of Fed officials favoring the additional purchases, there was an even split between those who thought the Fed would be likely to end the bond buying by "sometime around the middle of 2013" and those who thought the central bank would want to continue beyond then, the minutes said. Some saw the programs continuing until year-end.

The market was spooked by this news that came out around 2PM on Thursday.  Market reaction was swift and clearly evident on a five minute chart of the SPDRs S&P500 ETF:

(click on chart for larger image)
The street was quick to respond with damage control by stating that there was no imminent danger of the QE punch bowl being taken away (true) and that the next Fed chairman was liable to be just as "dovish" as Bernanke (also true) so that the chances of a modification of the present program in 2013 is minimal.  But here's where I disagree.
Assuming that we get past the second act of the "fiscal follies" (no where near a slam dunk) I believe that this economy will be surprisingly stronger in 2013.  And I think that the Fed governors are rightly concerned about the implications of unwinding their balance sheet. 
Gold and Treasuries responded to the minutes by staging a pronounced sell off.  The threat of higher interest rates abruptly stops the party for both asset classes. 
Here's my thesis on gold.  It's had an incredible twelve year run and despite its seeming weakness in 2012 it was still up 6.98% for the year.  However, no one can deny the volatility the precious metal has endured and its been in a downtrend since mid September.  The basis for owning gold has also confused investors throughout the trading year and it was difficult at times to determine whether it was an inflation hedge, a safe haven, both or neither. 
I believe that gold's reaction to the Fed minutes cleared up the confusion and may be a turning point in the decade plus bull market for the yellow metal.  And it's not just the fact that the prospect of higher interest rates make gold unattractive.  Investors are undergoing a psychological change as we transition from a post Lehman potential Armageddon environment to a more stable yet slow growth environment.  In such a world as I have described there is no need to park one's money in an alternative currency like gold as long as there's no discernible inflation. 
So, the question is, where's the inflation?  Aside from those who complain that food prices are going up there is no present threat of inflation.  Oil prices have stabilized and gas is the cheapest it's been in months.  Industrial commodities are flat as shown on the charts above.  However, here's the latest snapshot of the velocity of money from the St. Louis Federal Reserve.  This is a five year chart that should hearten my "Inflationista" friends:

(click on chart for larger image)
Remember, 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. 
I've explained ad nauseum that money supply alone cannot be an indicator of inflation but must be accompanied by an uptick in the velocity of that money.  This indicator has been in a steep downtrend since 2008.  Notice on the chart above that the trajectory of the downtrend is flattening out.  I've stated many times that when that line starts to turn up we will start having to concern ourselves with real inflation.  We're getting close. And I would wager that if I could discuss the December meeting minutes with those who  participated in that meeting some of their concerns might surround what this chart seems to be signalling. 
The chart below gives a historic perspective of this indicator going back to before 1960.

(click on chart for larger image)

This is where things get tricky for gold.  Assuming we get past the "fiscal follies" without a sequester or a US debt default (default is extremely unlikely), gold's only chance to maintain its bullish stance is a bet that the Fed cannot unwind it's debt in an efficient way when the time comes to stop their highly accommodative monetary policy.  It is projected that the Fed balance sheet will be in excess of three trillion dollars in Treasuries and MBS (Mortgage Backed Securities) by the end of 2013.  And it is indeed a plausible thesis that they will not be able to unwind their book in an orderly manner.  In such a scenario, rising interest rates and inflation would create upward pressure on gold prices.  The problem the Fed has is that once the inflation genie is out of the bottle its virtually impossible to contain it.  But just how much inflation would manifest itself in the real economy?  Admittedly, theorizing at this point becomes ethereal.
And we still have headwinds to the bullish thesis for gold.  Deflationary pressures still run rampant in the global economy.  Public sector debt is so huge as to be insurmountable.  The only thing that can get fiscal authorities out of the deep hole they are in is economic growth which increases tax receipts.  We do have the potential to dig our way out of this hole with the recent oil and NATGAS discoveries in this country but we do not have the infrastructure in place to take full advantage of this future boon to our economy.  Soon ... 
Treasuries will react similarly to gold in the scenarios I've described above.  Falling off the "sequester cliff" would keep rates at their present low level as the Fed would continue to play "pac man" in the Treasury and MBS market while an avoidance of fiscal disaster in an increasingly growing economy would put pressure on interest rates to go higher.  And any inflation thesis that came to fruition would exacerbate an increase in rates.
So, there you have it!  Expect a strong market for most of January but look to protect yourself as act two of the "fiscal follies" opens right around the first week of February.  Gold can go either way.  I've considered selling at least some of my holdings as I've been convinced for years that this bull cycle is very different from the 1978 - 1980 bull market and recent developments as articulated above may signal a turn in the yellow metal's fortunes. 
Have a great week!