Saturday, March 9, 2013

Macro Analysis 3/8/2013

The U.S. equity markets continued their ascendancy with most of the major averages gaining in excess of 2% on the week.  On Friday the monthly employment report blew away expectations with non farm payrolls coming in at 236,000, handily beating the consensus expectation of 155,000.  Yet, the market on Friday looked tired in early trading.  The "scuttlebutt" on the street was that after the employment report some big names in the bond market chimed in that the Fed may be inclined to take away the "punch bowel" which pushed down the averages.  But I think we're butting up against a multi year resistance area on the S&P and a much needed correction is overdue.

But when will the correction come?  This rally has been dubbed the most hated stock market rally ever.  Even sentiment numbers are starting to turn negative, which as a contrarian indicator, means a higher market. 

I'm preparing this commentary on Friday afternoon so not all the charts will be reflective of closing prices.

Here's a multi year daily chart of the S&P500 and we can see that the index is in the middle of the last resistance zone (purple line) before assaulting the all time intraday high of 1576.09 set in October, 2007:

(click on chart for larger image)
I've charted the resistance zone between 1538.74 and 1555.10 based on highs set in July and November 2007. The S&P closed on Friday at 1551.18. 
The Dow made an all time high on Monday and here's a weekly chart that reflects the move:
(click on chart for larger image)
The big debate raging on the street is whether this rally is really reflective of better economic fundamentals in the broader economy or is it simply a Fed liquidity induced rally.  I'll be weighing in on the issue in my analysis.
Stocks were provided with a tailwind this week as Treasuries had a vicious sell off.  Here's the iShares Barclays 20+ Year Treasury ETF (TLT) which traders and investors use as a proxy for the long end of the US Treasury yield curve:
(click on chart for larger image)
In last week's commentary I identified the inter market divergences that existed and that it was only a matter of time before they were rectified.  Normally, however, it is rectified by stocks coming in line with the bond market by correcting.  But this week it was bonds that did the correcting. 

Here's a weekly chart of TLT.  Notice the ETF has broken a multi month Fibonacci support line (red arrow):
(click on chart for larger image)
 To me, there's a much deeper message in this downdraft in Treasuries. What's the message? Read my analysis below :-)
Commodities had a lackluster week after taking a beating in the past two weeks as identified in my last two commentaries.  Here's the Dow Jones UBS Industrial Metals Index which is representative of the economically sensitive space:
(click on chart for larger image)
The latest weight on commodities is investor concerns over China's property bubble.  Famous hedge fund manager and short seller Jim Chanos has been trumpeting the bearish theme of China's property bubble since 2010 and the Chinese government's radical tightening of property ownership requirements in that country this past week has spooked a fair amount of market participants. 
And for my China watchers here's the latest chart of the Shanghai Composite Index:
(click on chart for larger image)
Chinese stocks have broached a steep uptrend line and bounced off Fibonacci support.  It appears to be consolidating at this time.  The correction is normal given the parabolic move from the December lows but if the move lower was precipitated by the deeper issues I alluded to above and the commodity sell off of the past two weeks is predictive, Chanos, who's already made loads of money on this "short" in 2011, is set to reap more profits from his prescience.  
Gold is still hovering around it's lows set on February 20th.  Here's a daily chart of the SPDR Gold Trust Shares (GLD) which mimics the spot price of Gold:
(click on chart for larger image)
I've addressed gold's ongoing challenges in numerous commentaries this year but it does seem to be searching for a base at this time.  But with a stronger Dollar gold can't ascend.  And more importantly, I'm sensing more and more that the inter market relationships between the yellow metal and other asset classes, which have predominated since the end of the crash and recession, are changing.  If I'm right this has huge implications for the economy and all asset classes for the rest of the decade and beyond. 
And here's our Dollar.  I'm posting a daily chart of the Powershares DB US Dollar Index Bullish Fund (UUP) which tracks the US Dollar during the trading day:
(click on chart for larger image)
There's very little that we can say is bearish about this chart.  The most we can say negatively is that the last five trading days before today were volatile (white circle) and that today the index is sporting a "doji" which signals indecision. 
When we look at the Euro which is about 57% of the Dollar Index we can see it stabilized a bit this week but had a bad day on Friday (white arrow):
(click on chart for larger image)
Yes, it looks somewhat like the chart of the Dollar turned upside down.  The Euro did rally on Thursday after the ECB decided not cut its key lending rate but economic fundamentals on the continent put it right back on Friday where it was on Wednesday  Here's an update of a weekly chart of the Euro I've posted before:
(click on chart for larger image)

The Euro had staged a counter trend rally from July 2011 thru the new year but has been in a downtrend since.  Notice the "doji" candlestick formed this week (white arrow) delineating indecision.
The Euro's problems are easy to understand.  With the southern periphery in depression and the rest of the Euro zone not doing much better the currency is losing its strength under the perception that the US economy is gathering steam and finally pulling out of the mess of the past four and a half years.  But is the perception true?


 Much of what I'm going to address in this analysis is based on the inter market relationships that have been prevalent for up to 16 years.  I'm coming to the conviction that these relationships are changing and that perhaps we are nearing the end of the deflationary cycle that started in Japan in 1990 and spread to the rest of the world after the Asian Currency Crisis.  And so, I think it would give my readers a better understanding of what I'm going to say by posting those relationships again:
                                Inflation          Deflation

If Stocks                        rally                correct
Then Treasuries     will correct         will rally
Then Gold                will rally         will correct
Then Commodities   will rally        will correct
Then US Dollar       will correct       will rally
Now, as to our present situation, we've been seeing a weakening in Treasuries which accelerated this week.  We're also experiencing a strengthening Dollar.  So this inter market relationship is out of whack, at least for now.
A weaker bond market is consistent with rising equities but a rising Dollar and rising equities violates an inter market relationship. 
Commodities have been weakening since February, 2011 and took a nose dive in the past two weeks.  We can say they are basically "dead in the water" as global economic slack and potential China problems hold sway over the asset class.  So, this inter market relationship with other asset classes has been violated for some time.
Since its highs last September Gold has been giving us the signal that there are no inflationary pressures in the global economy or danger of financial Armageddon lurking in the shadows.  More importantly, gold is now moving inversely to equities, changing an inter market relationship that's been prevalent since 2003.  However, it must be remembered that from 1982 to 2003 gold and stocks were negatively correlated. 
From the observations above, the first thing we can say is that the Treasury market is signalling that the US economy is indeed improving and maybe improving more than the positive economic data lately would suggest.  Today's monthly employment report was a surprise and speaks to gaining momentum in hiring nationwide.  Likewise, data on the housing market and industrial data confirm a strengthening economy. 
Now, one thing must be considered with this positive data.  We have seen stronger economic statistics in the early part of the year for the last three years; only to be followed by weaker data in the second half of the year.   
The Treasury market might also be factoring in the possibility of the Fed withdrawing its QE sooner rather than later.
The stronger dollar is a reflection of the strengthening economic data referred to above as well as the fact that virtually all central banks are getting in to the "printing money" mania.  With universal weakening of fiat currencies and a strengthening US economy we can be likened to the nicest house in a slum!  These two facts coupled together as well as our reserve currency status makes our currency more attractive compared to the other major foreign currencies. 
It must be remembered that before the onset of the Asian Currency Crisis the Dollar and stocks moved in unison.  A strong currency and a strong stock market complimented each other as foreign money flooded into the strongest, safest economy in the world.  The currency crisis of 1997 and the failure of Long Term Capital Management in 1998 created the risk averse trade where the US Dollar was seen as the "safe haven" currency but paper assets were to be shunned. 
So, what's the take away here?  Continued strength in the US Dollar and a rising stock market may be auguring the beginning of a normal cycle after the deflationary trauma of nearly two decades.
One issue that's being debated on the street has been whether this huge rally since the March, 2009 bottom is solely a Fed induced sugar high that will disappear as soon as the Fed hints that it's slowing or stopping it's liquidity injections.  Indeed, proponents of this view point to the market's reaction in 2010 and 2011 when the Fed either curtailed it's bond buying programs or injected "sterilized" liquidity into the system. 
There's no question that the liquidity being pumped into the system is buoying equities.  Here's the latest picture of the adjusted monetary base from the St. Louis Fed which is the most accurate measure of currency in the economy:
(click on chart for larger image)
Some are arguing that the stock market may be the next "bubble" being created after the mania and housing bubble in attempting to avoid the depressionary crash that must inevitably come.
Obviously, this debate will continue until the Fed actually stops their bond and MBS programs. My opinion is that this economy is a lot stronger than the recent economic reports suggest and that, when the Fed inevitably takes away the "punch bowl" the economy will be even stronger.  Sure, at the first hint that excess liquidity is stopping  the market will initially act like a kid who's lollipop has been taken away and we'll see some volatility but the market will quickly adjust.  It's sort of like a child who's been riding his/her bicycle with training wheels until Dad decides they can do it alone and takes the training wheels off.  Panic and fear first; then confidence the child can do it on his/her own. 
As to the "bubble" thesis posited by some, I can't entirely discount such a thesis but there would need to be a catalyst to "pop the bubble" in a violent way.  Right now, I can't see such a catalyst as the Keynesian experiment seems to be working.  When I see such a catalyst I'll be sure to let everyone know.
How do commodities and gold fit into the new paradigm?  First of all, commodities are not a nation specific asset class.  Unlike the US Dollar and the US stock market, commodities reflect the strength or weakness of the global economy.  And that economy is still under the weight of enormous deflationary forces and feeble if not recessionary economic growth.  And as such, commodities will lag the other asset classes until global growth becomes stronger and more uniform. 
Gold is a different story.  With no intrinsic value other than the value the market gives it at any point in time, it's price is determined primarily by the emotions of men and secondly, by inflation.  But with huge deflationary forces still in control of whole areas of the world's economy there is no threat of inflation.  At the same time, policies emanating from the Fed and the ECB (European Central Bank) have taken the tail risk out of the financial markets and the Armageddon scenario which rightly caused universal fear right up to September, 2011 has dissolved.
But what about all the fiat currency being printed?  I've addressed this many times in my commentaries but money printing does not equate to inflation.  The comparison that "gold bugs" like to make of the 1978 - 1980 inflation to our present circumstances is like comparing apples to oranges.  In the 70's, wage/price pressures were the predominant driver of that virulent inflation.  There is no wage/price inflation today.  
Wage/price inflation causes the velocity of money to gain momentum as consumption increases and credit expands.  Here's the latest update of the velocity of our widest monetary measurement, M2.  It goes back to before 1960:
(click on chart for larger image)
For my readers who may not know what the velocity of money this definition is taken right from the St. Louis Fed's website: "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."
On the chart above notice the period around 1980.  That is when gold set a record price of around $800.00/ounce.  Look at today and notice the fierce descent since the onset of the 2008 recession.  I've made this statement so many times in my commentaries that my regular readers are probably sick of it but until the chart above starts to turn up there is no meaningful inflation in our economy.
I make this long winded explanation only to defend what I've been suspecting for awhile but am willing to categorically state now: the Gold bull market is dead!
There! I said it. Don't send me hate mail  :-)
I say this with the caveat that it may begin again as central banks start to unwind their QE.  But it is highly presumptuous to assume that the unwind will be messy for two reasons:
- the slack in the global economy from slow growth will prevent the   kind of inflationary pressures many of us have experienced in the past from building this time and
- aging demographics in the highly industrialized nations will continue to contribute to global economic slack as it will keep a lid on consumption, and subsequently, inflationary pressues.
I just want to say something about Gold's price.  Spot Gold closed on Friday at $1,576.40.  Many factors go into the price of an asset.  Chief among them are emotions and perceptions based in history.  I believe that at $1,576.40 gold is overpriced.  I see a lower price, perhaps as low as $900.00 but that's a guess.  Gold will never go back to $300.00 an ounce simple because in the wider context of history (outside of the last 16 years) we have experienced inflation. 
The present price is being buoyed by human perceptions based on inflationary assumptions.  Simply, all of us have always lived in an economic regime that's inflationary based (Keynesian economics) and have experienced that inflation in our lives.  As time goes on more and more investors will "throw in the towel" on gold until it finds it's fair price. 
So, to sum up, I'm considering that we may be embarking on a new economic cycle where inter market relationships return to normalcy.  The next two quarters of economic reports will either validate or negate my thesis.  Remember, we've had a track record for three years where economic fundamentals based on statistics seemed to be improving in the first two quarters of the year only to disappoint in the second half of the year.  However, I'm optimistic this time around.
In the short term I'm expecting a higher market.  Sentiment surveys are pointing to higher prices and until we start getting a dose of "irrational exuberance" there's no stopping this rally.  I had anticipated the stronger jobs report and had positioned myself for a powerful 20 or 30 handle rally in the S&P on Friday but the slow start of the trading session disappointed me.  However, the last four hours of trading on Friday picked up and I started to notice that slow, methodical grind higher we have experienced much of this year.  I expect we will continue to see this type of market action and that we will see new historic all time highs in the S&P 500 in the next week or two.  The only derailment to this thesis will be if the government shuts down.  So far, I'm seeing a concerted willingness in Washington to avoid this so all systems are go ... ! 
Have a great week!