Saturday, February 23, 2013

Macro Analysis 2/22/2013

Well, we had a pullback this week which I was anticipating but I believe it may be over for now.  The market retreated on Wednesday after the release of the January Fed minutes which seemed to indicate growing dissent among the Fed presidents on when QE3 might start winding down.  The market reacted to the minutes negatively and sold off on Wednesday and after a weaker Thursday I sensed a turn in the market in the last hour of trading when the CBOE Volatility Index (VIX) dropped precipitously and buying power started to seep back into stocks.  As a result, on Friday, equities staged an impressive rally in the last five hours of trading.  Here's an hourly chart of the S&P 500 outlining the price action:

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Stepping back to a more macro view here's a daily chart the Wilshire 5000 Index which includes every US equity that's traded:
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As I've pointed out, US stocks are hovering around historic all time highs and Wednesday's and Thursday's sell off managed to push them down under the 20 day simple moving average which is a short term negative signal. But Friday's rally closed the index just over the 20 day. 
This market is extremely strong and is begging to go higher.  But will it?  There are some red flags out there that may be giving us signals that all is not well.  Here's a daily chart of the Consumer Discretionary Select Sector SPDR ETF (XLY) which tracks industries such as automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media, and retailing:
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It has not managed to get back over its 20 day moving average but more telling is the bottom panel where I've pointed to it's price relative to the S&P 500.  In a healthy market we want to see consumer discretionary stocks outperforming the major averages.  In fact there has been a pronounced downturn in the past week.  The retail sector is also exhibiting this short term divergence.
With all that said, price must still be our main determinant on where these markets are going and the trend is still irrevocably up and Friday's rally confirmed that.  And I expect, given coming news events in the next week, the uptrend will resume.  I'll have more on this in my analysis.
Treasuries have been holding their own in the past week in spite of any strength in stocks.  Here's the latest update on the iShares Barclays 20+ Year Treasury Bond ETF:
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As I stated in last week's commentary, Treasuries along the yield curve except for short term T-bills are that are anchored by the Fed are in pronounced downturns and the chart above illustrates that.  Notice the yellow downtrend resistance line and the shorter yellow dashed lines delineating "bear pennants" which are typically formed in a downtrend.  But it seems we may be forming a base (white circle) and are on the cusp of penetrating the downtrend line (white arrow).
As stated before, Treasuries are an excellent way to determine where stocks are going.  As they are inversely correlated to equities; as they move higher stocks weaken.  And more importantly, most of the time I've found their price action, even on an intraday basis, precedes moves in stocks. 
It's easy to get caught up in short term movements and "miss the forest for the trees".  Here's a weekly chart of TLT going back to March, 2009:
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I circled the price action and TLT has been sitting on a Fibonacci retracement level for the past four weeks. 
I'm only pointing these things out because of what I'm going to be saying in the commodity section below.  Again, price action rules and the daily chart is telling me that Treasuries are in a downtrend but the price action in commodities spooked a lot of people including me and Treasuries lack of recent weakness may be trying to tell us something.
This week I'm going to lump gold and commodities together.  I've written much about gold's weakness in the past and this week it was hammered again:
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Gold didn't like the Fed minutes because any intimation that the Fed is taking away the "punch bowl" means that inflation expectations are greatly diminished.  And actually, gold has been signalling this message for some time and that message has morphed into a sream!
But here's where a fair amount of market participants are spooked.  I'm going to post a series of daily and weekly charts to show my concern.  First up is a daily chart of "Dr. Copper" who has a PhD in Economics.  I circled the week's price action.  It fell out of bed:
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Here's a daily and weekly chart of the Dow Jones UBS Industrial Metals Index which is currently composed of four futures contracts on industrial metals, (copper, aluminum, nickel and zinc):
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And here's a daily and weekly chart of the Dow Jones World Basic Materials Index that tracks everything from iron to hemp:
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Here are my take aways on all the charts above including gold:
- Gold has been signalling an increase in deflationary expectations since last October although no one could have known that back then or even into this year.  But now we are getting some confirmation from the economically sensitive commodity complex.
-Notice on all the daily charts that all the indexes stopped at Fibonacci support.  That is not coincidental and it's a positive signal.  We need to monitor these charts to insure they don't break that support in coming weeks.
- Notice the weekly charts.  All the indexes have been in the doldrums for months as I've reported in past commentaries.  In the case of the World Basic Materials index, the price action has been turned away from at an attempt to breach resistance.  In the case of the Industrial Metals index, the weekly chart shows that the index is resting on a previously breached down trend line.  We're getting mixed signals.
There's been a rumor on the street this week that a hedge fund may be shutting down liquidating its positions and if the rumor is true then that fact that the three daily charts above found support at Fibonacci retracement levels lends support to that rumor.  Another factor that may be contributing to the weakness has been the Chinese government's move to tighten monetary conditions due to overheating in their property market.  Here's the commodity sensitive Shanghai Composite:
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  We'll need to monitor commodities in the coming weeks and if we see follow thru to the downside it will mean the specter of global deflation is still very much with us and is accelerating.  Not good for stocks and frankly, not good for anyone ...
The big story this week in the FOREX (Foreign Exchange) was US Dollar strength which is not surprising given upcoming elections in Italy, the sequester and a tightening on monetary conditions in China.  The inverse head and shoulders pattern in the Euro that I've made much of in the past three commentaries is negated as far as I'm concerned.  Here's the latest update of the chart I've been posting of the Euro:
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The most positive thing we can say about this chart is that the Euro sported a bullish "hammer" candlestick on Friday which bodes well for a short term bounce.  Now, we may get that bounce this coming week and I'll be addressing that possibility in my analysis below. 
And here's an update of the same chart I posted last week comparing the US Dollar with all the other major currencies on a three day moving average basis:
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As can be clearly seen, the Dollar has strengthened significantly against every major foreign currency in the past week and a half.  As per our inter market relationships a stronger Dollar equates to lower stock and commodity prices.  So far, we're seeing lower commodity prices.  Will stocks follow suit or will the Dollar stage a turn around?
It was apparent that the market spoke loud and clear this week that it's primary concern is not a potentially volatile situation building over the upcoming Italian election this weekend or China's recent monetary tightening or the abysmal GDP numbers coming out of Euro zone countries or even the coming sequester on March 1st. It is concerned by only one thing: when will the Fed start changing it's monetary policy? Wednesday's sell off as well as a similar short down draft we had in January after the release of the December Fed minutes attest to this.
Now, it's not that an Italian election result that might end in the inability to form a coalition government or the sequester wouldn't matter to the market.  But the focus is clearly on Fed policy as the prevailing opinion on the street is that we're seeing our way out of the economic malaise of the past four years and concerns surface as to the dependability of liquidity support.  Stocks are hooked on stimulus!
We sold off surprisingly hard on Wednesday as the market perceived that the Fed could possibly start to cut back on it's 85 billion/month of MBS and Treasury purchases.  But on Thursday, James Bullard, St. Louis Fed President, on CNBC clearly stated that Fed policy would "stay easy for a long time".  So, either the market overreacted to the Fed minutes on Wednesday or Bullard, a noted monetary hawk in the Fed, was attempting damage control.  I believe it is the former.  And I believe we will get verification of this on Tuesday when Fed Chairman Ben Bernanke gives his semi-annual testimony before the Senate Banking Committee in Washington.  He will also give testimony before the House Financial Services Committee on Wednesday.
In my opinion, all the banter among the Fed Presidents regarding the present unbelievably easy monetary policy in their monthly meetings is by design.  First, every one of them knows that unwinding this monetary policy is fraught with possible problems.  Second, they know that they may be feeding another bubble as they did in 2005 & 2006 but this time in equities.  As an adjunct, they know they are encouraging risk taking as interest bearing assets are yielding nothing.  Thirdly, by documenting their concerns they are intentionally dampening risk appetite, knowing market participants will temper risk taking because of concern that the "punch bowl" may be partly or totally taken away.
This is what I think Bernanke will say.  Given the present headwinds in the global economy, the grid lock in Washington culminating in an almost guarantee that the sequester will kick in on March 1st and still anemic jobs numbers, the present Fed policy will continue for the foreseeable future.  If pressed on when it may end he will respond that it will depend on future economic conditions, particularly the outlook for jobs and signs of possible inflation.
Simply, the Fed cannot start unwinding QE3.  The US Treasury and MBS market along with the economy could never withstand the back up in interest rates that would inevitably occur in an economy with GDP growth projected to be 2% in 2013.
And for this reason I believe that Mr. Bernanke's testimony on Tuesday will send the Dollar lower and consequentially, stocks and commodities higher.  And if I'm right in what "helicopter Ben" is going to say and we don't get a weaker Dollar as a result of his testimony, the recent weakness in gold and commodities I documented above portends some serious issues for the global economy and risk assets.
As far as the Italian election goes, there's been a black out on opinion polls but it appears Bersani's Center Left Party is going to carry the majority while Berlusconi and Pepe Grillo will vie for second place.  With almost 30% of the electorate still undecided anything can happen but a Berlusconi victory, which would be the kiss of death for Italian bonds, is an outlier outcome.  The real possibility is that the election results will render the possibility of forming a political coalition that can get anything done let alone continue to carry out the reforms of Monti's technocrat government impossible.  And this will inevitably pressure our markets as Italian interest rates rise as a result and fear of a Euro zone sovereign implosion grow. 
Everyone seems to be blowing off the sequester coming up and there are different views on how it will effect our economy, from those predicting almost apocalyptic consequences to others predicting a non event.  I'm in the latter group.  Sure, if you're flying anywhere in March you'll have to get to the airport four hours before your flight to clear security and if you're a young mother who sends her children to Headstart you'll have to find somewhere else to send them and if you're a Federal employee you'll have to cut back on your spending as you'll probably lose one day of pay a week.  But as I've stated in past commentaries, anything the wider economy loses from the "sequester" will be made up by the billions being paid out by the government and the P&C carriers to Sandy victims in the Northeast.  I'm not trying to be insensitive here.  People will hurt.  I'm just looking at the issue in terms of the market.
One issue that will roil global markets coming up is the funding of the "Continuing Resolution".  Simply, it's a series of appropriation bills that have to be approved by Congress in order to keep the government running.  This year, Congress adopted a six-month Continuing Resolution for all fiscal year 2013 appropriation bills, delaying final decisions until March 31st.  With the present political grid lock inside the beltway there's a fair chance the government could be shut down.  Anything can happen between now and March 31st but this may indeed be the grand finale of the "fiscal follies".  Unlike the sequester, the weeks running up to the deadline will be fraught with market volatility, often based on the comments of Obama, a senator or a congressman.
Finally, February has not been normally kind to the market and we still have another week to go but if Bernanke says what I think he's going to say on Tuesday, stocks will continue to rally into March, Italian elections notwithstanding.  Our correction may very well come in March.  We'll see ...
Have a great week!