Friday, May 17, 2013

Macro Analysis 5/17/2013

Stocks had another record breaking week with all of the major indexes save the Nasdaq Composite and Nasdaq 100 hitting all time new highs.  And again, small and mid caps led the charge with another very strong week from the Dow Transports.  Interestingly, this was in the face of negative manufacturing, housing and employment reports.  We had a hiccup on Thursday afternoon because of the weak data but the market came roaring back on Friday afternoon when the S&P E-minis took off at around 2PM EST dragging the market higher.

Here's a weekly chart of the Wilshire 5000 which is the total US stock market:

(click on chart for larger image)
Notice the circle on the far right which encompasses the last five weeks of price action.  By any measure stocks are showing amazing strength and the rally is turning parabolic.  And parabolic moves cannot last.  But lest anyone think I'm predicting an imminent correction I am not.  More on this below.
The rally in equities is not just a US phenomenon.  Here's a grouping of European weekly charts which includes:
The Europe 350 iShares ETF
The Dow Jones Euro STOXX Index
The European Top 100 Index
The FTSE Milan (MIB) Index
The Dow Jones Euro Index
(click on chart for larger image)
All these indexes have penetrated their long term resistance lines.  In recession ravaged Europe stocks are pricing in a recovery.  As an aside, Greek bonds yielded 8% on Friday.  A year ago, they were 30%!
Here's a weekly chart of Japan's Nikkei Average:
(click on chart for larger image

Another parabolic move.  I wonder why ...   :-)
For anyone that follows the market closely what I've shown above is old news.  And I do believe that stocks in Europe and the US are pricing in better economic times.  But, as I've stated many times, this rally is first and foremost a liquidity based equity rally and I am not of the persuasion that US stocks are fairly priced based on company and economic fundamentals.  Yes, the recovery is real but the market is way ahead of itself.
 The rest of this commentary will be spent discussing one of the inter market relationships that has dominated global financial markets for almost sixteen years but is now changing. I'll also expand on a post I composed earlier in the week ( )
Let's look at the relationship between the Dollar and stocks which has changed since the beginning of the year.  Here's a weekly chart of the US Dollar going back to 2004:
(click on chart for larger image)
For the better part of the past sixteen years, the US Dollar and equities have been inversely correlated.  I believe that inter market relationship is changing and I highlighted that change on the chart above.  Notice the lower panel which is a correlation between the Dollar and the S&P500 on a twenty week moving average.  As you can see, except for brief periods during the past eleven years, the blue line has stayed under the yellow horizontal line, maintaining that inverse correlation.  The white circle highlights the surge that commenced in early February that measures the highest correlation in eleven years.
The change in this inter market relationship is, in my mind, a most important development for the financial markets and global economy.  As stated in my commentary on 4/26/2013, a strong Dollar has historically been good for stocks as the currency accurately reflected the economic strength of the nation.  A strong currency and a rallying stock market are complimentary.  All that started to change in the late 1990's when the "risk on/risk off" trade developed.  But it seems we are returning to the historic norm.  This significant change is telling me two things:
1. The extreme "tail risk" in the global economy (the Armageddon scenario) is fading in the eyes of market participants.  Sure, Europe is in deep recession but it's not about to implode.  With the "tail risk" gone the "risk off, safe haven trade" is fading from these markets.
Sure, if Iran attacked Israel next week we would see a global flight into the Dollar (and Treasuries) but the constant "knee jerk" charge into the Dollar because, of say, a European politician saying something stupid, is over.
2. More importantly, the change in this relationship is signaling a return to normalcy and is predicting better economic times for the reasons articulated above.
Now, let's look at Treasuries and Gold.  Interest rates have backed up significantly in just two weeks with the Ten Year yield closing on Friday at 1.949%.  On just May 1st, the yield traded as low as 1.614%.  Here's an update of the weekly chart of the Ten Year Treasury yield:
(click on chart for larger image)
Understand, historically we are still on the extreme lower end of interest rates.  Below is a chart to give my readers an historic perspective.  It's a monthly chart of the Ten Year yield showing the top in rates in 1981, which was the top of what some people (and I) call the top of the sixty year super cycle:
(click on chart for larger image)
My point is to show my readers that, despite the low rate environment we've existed in since 2009, rates are moving higher.  And this is in the face of Fed purchases of eighty five billion per month, forty five billion of which are Treasury purchases (mostly in the belly of the yield curve).  The Treasury market is starting to price in better economic times.  Now, some might say, no, the bond market is starting to price in inflation.  To that, my answer is this:

(click on chart for larger image)
 This is a daily chart of the gold spot price.  Gold is either an inflation hedge or a "safe haven" trade in the event of geopolitical tensions or natural disasters.  Gold's incredible rally in the first decade of this century was in response to central bank monetary easing and currency debasement. 
What gold investors and the investment community in general had not anticipated was the persistent and virulent deflation that was birthed in Japan in 1990, garnered momentum along the way and that gradually anchored itself in the global economy.  I'll add here that there is an incredulity among people alive today on the planet who have only known rising prices and have never experienced a deflation.  Only the very old have lived thru such a time and they were children then.
Japan, Switzerland and Sweden are experiencing outright deflation.  The rest of the Euro zone on a whole is dealing with disinflation with some of the periphery nations flirting with deflation.  The US is currently in a serious disinflation and there are actually murmurings at the central bank that if the stimulus that is presently supplied cannot arrest the downward pressure on prices as exemplified by recent producer price and consumer price indexes, there could be more stimulus. 
Gold's message, confirmed by industrial commodities and basic materials, is clear.  There is no inflation in the global economy.
That is not to say that we will not have to deal with inflation soon.  But the "soon" will depend on when monetary stimulus ultimately finds it's way into wages.  Wage/price inflation is what spurred the US flirtation with hyper inflation in the late 1970's.  Any inflation that "inflationistas" can point to now are the result of transitory issues/events, like a giant crop failure or temporary supply/demand disruptions, etc.  Until the following chart turns up there is no meaningful inflation in our economy:
(click on chart for larger image)
Simply put, a central bank can print all the money it wants but until that money is actually changing hands in the system it cannot spark sustained inflation.  And as can be clearly seen from the chart above, the velocity of M2, the most widely followed measure of our money supply, is lower than at any time the Fed started this statistical series back in the late 1950's.
I apologize to my regular readers who have read this many times in the past few years but I feel compelled to get on my "soapbox" every time I bump into an "inflationista" as I did in two different venues this week.  Aside from the conspiracy theories, inflationary psychology is so deeply embedded in the global psyche that it amazes me when I actually get people who try to argue that there is significant inflation in the economy.  Oh well, that's what makes a market ...   :-)
So, the message of Treasuries and gold (and stocks for that matter) is that the US economy is steadily strengthening and Europe is in it's recessionary trough and should start coming out of it later in the year.
Now, we still have this liquidity issue to deal with and I've already expressed my reservations on previous commentaries over the inability of central banks to unwind this unprecedented liquidity without significant reverberations to global currency and bond markets.  And if there are problems (which there very well might be) the "inflationistas" will have their day.  I'm not against the inflation thesis.  Heck, the monetary system we live in can only exist with incrementally rising prices.  Inflation is the inevitable byproduct of unlimited credit expansion.  Just don't tell me there's inflation when I can post a half dozen charts from aluminum to steel to copper to lumber that reflect steadily and sometimes violently dropping prices.
I'll address the deflation issue more comprehensively as well as "stocks on steroids" thesis next week or in my blog posts during the week.
The economic calendar next week would have some reports that could move the markets but with the world awash in Dollars and Yen any reports will have a transitory effect on this market. 
I'll be watching German producer prices on Tuesday, looking for telltale signs that the disinflation in that country is turning into deflation. 
Japan announces an interest rate decision on Tuesday and if there is a surprise rate cut (I'm not expecting one) that will fuel further US Dollar strength and will inject more rocket fuel in Japanese and US stocks.
We have existing home sales on Wednesday and new home sales on Thursday.  This may be the "canary in the coal mine" for this market.  Housing has led this economic recovery but there are signs that it may be weakening.  Please see my brief post here:
On Friday, we get German GDP, the German IFO Business Climate Index and then in the US Durable Goods orders. 
As I said above, these reports (save possibly the housing data) will be temporary blips in the market if they disappoint.  We had some terrible manufacturing numbers this week and a tepid housing report and any weakness in the market was seen as a buying opportunity. 
Stocks are on crack!  Have a great week!