Saturday, May 11, 2013

Macro Analysis 5/10/2013

Stocks had another banner week with mid and small caps as well as the transports leading the charge higher.  The S&P 500 looked tired in the last two trading sessions which I attribute more to sector rotation than anything else but the Russell 2000 surged on Friday. 

The biggest swoon of the week took place on Thursday when rumors spread thru the market that the WSJ was about to release an article stating that the Fed was going to be curtailing asset purchases "sooner rather than later" (see my blog post ).  The unsubstantiated rumor sent stocks and commodities reeling and though there was a recovery from the lows the damage on the day had been done.  I'll be speaking more about this event below.

The chart below speaks to the incredible strength of this market.  It's a daily chart of the percentage of stocks in the S&P 500 above their 200 day moving average:

(click on chart for larger image)
We're almost at the highs reached in January, 2010 and this is an extreme bullish reading.

Small caps have retaken the lead in the advance since the beginning of the month and is characteristic of a bull market in its early stages.  Here's a daily chart of the Russell 2000 and I circled the week's price action:

(click on chart for larger image)
Notice the bottom panel which is a price relative comparison of the Russell 2000 to the S&P 500.  This is the kind of action indicative of a strong market, where investors are willing to put their money in more speculative issues.  The top panel is the Relative Strength Index (RSI) and I've identified a divergence which normally would be a red flag (and maybe it still is) but "does it matter"?

The reason I ask the question is because stock market and all risk assets are "the tail the dog is wagging" and that dog is the FOREX (Foreign Exchange) market.  And the FOREX is "the tail the dog is wagging" and that dog is central banks. 

Australia, Poland and South Korea all cut their key policy rates this week, and India's central bank did the same last week.   Save for Australia where opinions were mostly that the Reserve Bank of Australia would not cut, the street had not anticipated the other rate cuts.

While these countries (save Australia) are considered by many to be too small to significantly impact global financial markets, their actions speak to a much bigger issue which I've addressed in previous commentaries and which is becoming more evident: the race to the bottom in currency devaluation is building momentum.

With the Euro zone finally cut it's key lending rate last week and the Fed and the BoJ actively printing money in the effort to stimulate or to continue stimulating growth in their respective economies, the forced currency devaluation makes their exports less expensive to global consumers.  But this squeezes the "little guys" who are being pressured to meet the threat of weaker export and ultimately economic growth by devaluing their currencies in kind. 

An excellent example of this and the biggest event in the currency market this week was the USD topping 100 Yen.  The Bank of Japan's unprecedented effort to "kick start" inflation in their deflation ravaged economy has radically devalued the Yen.  Late last September one US Dollar was worth 77.43 Yen.  At the close on Friday it was worth 101.59 Yen!  This is a gargantuan move in such a short time frame.  But the impact on the region was exemplified by South Korea's rate cut this week.  How else can Kia and Hyundai compete with Toyota and Honda?

But even more of a concern is the impact on risk assets as investors, institutional or otherwise, awash in fiat currencies, are gobbling up paper assets as fast as they can get their hands on them.  Recent capital outflow reports show Japanese investors bought 310 billion Yen of foreign bonds last week and 204 billion Yen in the previous week.  How much of that is going to our bond market is only a guess.  My bet is that the Japanese are piling into Europe.  The rationale is that in spite of the economic malaise on the continent, the extreme "tail risk" has been taken out of the financial markets by Mario Draghi and recent economic data, though mostly in contraction territory, has actually been improving.  It's evident at this point that the EMU (European Monetary Union) is going to muddle thru and not implode.  How else can one explain Spanish bond yields trading at almost 52 week lows!

Our Treasury market backed up considerably this week and PIMCO's Bill Gross declared the start of the bear market in bonds as of 4/30/2013!  Now, I don't know if Bill is right but I'm starting to feel comfortable that we have seen the lows in interest rates for this grand super cycle.  Considering that the last time we saw interest rates at the long end of the yield curve this low was in 1942 (they were actually lower then), the only people that might see interest rates this low again are all under the age of 10!

Here's a daily chart of the iShares Barclays 20+ Year Treasury Bond ETF, a proxy for the long end of the yield curve.  I circled the week's price action:

(click on chart for larger image)
And here's an update of the 10 Year T-note yield:
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The arrow is where we closed on Friday but the arc encompasses the yield movement in the last two weeks.  On May 1st, the yield traded as low as 1.61%.  On Friday it closed at 1.90%

As long as the Fed maintains its asset purchases, rates will continue to be suppressed and there won't be a considerable back up in rates in the foreseeable future.  However, I can see rates trade up to the 2.4% area in the intermediate term. 

There are other motivations for the Fed to suppress rates that have to do with the three trillion of government debt on their books. There's also the concern surrounding the ability of the Federal Government to finance their debt at higher rates.  But this potential worry is becoming ephemeral as tax receipts have risen so much that the deficit has shrunk year over year.  Here's an excerpt from the Congressional Budget office:

"The federal government ran a budget deficit of $489 billion in the first seven months of fiscal year 2013 (that is, from October 2012 through April 2013), according to CBO’s estimates. That amount is $231 billion less than the shortfall recorded during the same period last year, primarily because revenue collections have been much greater than they were at this point in 2012. In contrast, federal spending so far this year has been slightly lower than what it was last year at this time."

The statement above as well as the weakness in Treasuries and the strength of the Dollar speaks volumes on the state of our economy and by extension, the strength of equities, with a caveat.


Stocks started to tell us that a new bull market was in the offing as early as June, 2012.  Here's a brief history using a weekly chart of the S&P 500:

(click on chart for larger image)
I've outlined some of the events of the past year so that my readers can relate to the chart personally.  The two key events that set the stage for the new bull market can be likened to a "one - two" punch.  The first was ECB President Mario Draghi standing up to the Germans and committing to back periphery debt.  I've made much of this event in past commentaries but I'm not exaggerating when I say that Draghi's action saved the threatened global economy from a fate similar to what befell the world when the Austrian bank Credit Anstalt collapsed in 1931.

The second event was when the Fed announced QE3 in September of last year. 

These two events were the underpinnings for the coming bull market and once we put the fiscal issues temporarily behind us at the turn of the year the markets took off.  We are now starting to see the evidences of a strengthening economy.  True, recent economic reports have been tepid but we need to consider that most of these reports have distortions and are constantly revised.  Last week's monthly employment report was a perfect example of this phenomena.  While the front month (April) beat expectations both February and March numbers were revised significantly higher.

I've been very concerned about commodities lately but we're starting to see a turn there also.  Here's "Dr. Copper" who's gone parabolic since May 1st:

(click on chart for larger image)
And here's the Dow Jones UBS Industrial Metals Index.  I circled the last six trading days price action and the breakout above the green downtrend line:
(click on chart for larger image)

While I seem to be painting a rosy picture here I don't want anyone to think that all is well because it's not.  We still have whole sections of the globe that are in varying stages of a slowdown if not recession.  Additionally, our economy is nowhere near it's pre 2008 levels and probably won't get there for years.  Nevertheless, when it comes down to a comparison between the US and the rest of the world we are, by far, the nicest house in a slum. 

Another potential impediment to global economic strength in the long term is excess central bank liquidity that I believe has inflated stock prices.  Thursday's reaction to the WSJ rumor gave us a small foretaste of what might happen when the Fed intimates taking the punch bowl away.  But even this concern may be transitory because as I compose this commentary the WSJ has released the "rumored" article and I'll leave my readers to read the details but the Fed apparently will taper and adjust its purchases as economic statistics dictate but has not decided on a start date.

The Fed's decision to start unwinding their book will be the moment of truth. In all probability there will be an immediate "knee jerk" negative reaction but if our economy is as strong as some are saying (and I believe it is) there will be no far reaching consequences to taking the training wheels off of our markets.  However, a more violent and sustained reaction will speak to an anemic faltering economy.

As far as other central banks are concerned, I hold no such confidence that the BoJ (Bank of Japan) will have the same finesse in controlling their liquidity program.  The ECB is hamstrung by political constraints which will make their two trillion Euro book a challenge to control as they eventually unwind.  Meanwhile,  the race to the bottom in currency devaluation must stop somewhere.

Obviously, the complexity of these markets preclude a coherent explanation from even the brightest minds on the planet and to theorize on what might or might not happen becomes an absurd intellectual exercise.  But I want to leave my readers with a daily chart of the June futures contract of gold. 

Gold took it on the chin again on Friday but if you don't look at a chart or weren't watching the price action as I was you missed the significance of the day:

(click on chart for larger image)
The wide arc was the move that took the yellow metal down over $200.00 in two days back in April.  I circled Friday's price action (black circle).  As the Dollar strengthened on Friday morning gold tanked and at one point was down $39.00.  But it came back closing out the day only down $10.50 (green arrow).  But notice the black arrows pointing to price action on previous trading days. The arrows point to candlesticks with pretty large tails.  This is traders and investors nibbling and accumulating!  If my thesis is right and we've seen the lows in Treasuries then my hunch is that gold will stop trading like a commodity which it has been doing for some time and will start trading like a currency.  When it starts trading like a currency it will augur mounting inflationary expectations.   And a stronger dollar won't stop gold appreciation unless the Fed "puts their money where their mouth is" and starts unwinding their book.

In the short term we'll have a fairly busy economic calendar next week starting on Monday with Retail Sales, Industrial Production and Empire state Manufacturing Survey on Wednesday, jobless claims on Thursday and consumer confidence on Friday.  Globally, Chinese Industrial Production and Retail Sales will be released early Monday morning.  Europe will have some significant data releases that will likely move markets.  Chief among them is German ZEW Economic Sentiment on Tuesday and German GDP on Wednesday. 

There will also be a lot of "Fed speak" as several Fed governors will be speaking in public forums and now with the Hilsenrath article published in the WSJ, there will be much scrutiny of these speeches.  Expect a more volatile but positive week unless a Fed governor surprises with a substantive projection on the Fed's exit from QE (not likely).

Have a great week!