Saturday, May 25, 2013

Macro Analysis 5/24/2013

It seems as though we may be on the verge of the first meaningful correction equity markets have seen since last October?  Probably not.

 All the major indexes sported an "outside reversal day" on Wednesday (see my blogpost at ) and reverberations from the Japanese stock market (the Nikkei) "limit down" session on Thursday drove volatility higher the last three days of the trading week.  But in spite of the volatility and what I consider a serious problem developing in global financial markets everyone continues to "buy the dip".  Here's a daily chart of the S&P 500 and I circled the last four days price action:

(click on chart for larger image)
We've penetrated a short term uptrend line established in mid April but the blue arrow is pointing to the 20 day moving average which has acted as support for the past two trading days.  In addition, both Thursday and Friday's candlesticks are sporting long wicks below the body.  The message?  Buying power is still strong. 

Here's the Russell 2000 small cap Index:

(click on chart for larger image)
The same pattern emerges as the S&P 500 but the Russell had a positive close on Thursday after Wednesday's sell off and was flat to the penny on Friday.

Here's a daily chart of the Tokyo Nikkei Average which took a 7.3% tumble on Thursday purportedly after China announced that for the first time in seven months their PMI (Purchasing Manager's Index) dropped to 49.6 from 50.4 in April, missing expectations:

(click on chart for larger image)
The blue arc on the chart highlights the radical swings the Index endured on both Thursday and Friday.  I'll be addressing this price action below.

The price behavior of all asset classes in the past few weeks has become skewed and the traditional inter market relationships that typically guide traders and investors have gone awry.  The market has now focused on the Japanese Yen as the new dominating indicator of future stock market trends (and I believe there's an important warning in this fact):

Yen up = stocks down
Yen down = stocks up

I want to use the rest of the commentary to focus on the "whys" of this very dysfunctional market activity.  But first let's recap two recent events that I believe are catalysts for the price action.

Ben Bernanke's testimony before Congress on Wednesday and the FOMC April minutes which were released later that same day were initially responsible for the abrupt mood swing in equities. 

Stocks immediately reached all time new highs on Bernanke's prepared remarks before the Joint Economic Committee that morning but when the Q&A started equities started backtracking.  In essence, Bernanke was non committal on when asset purchases (QE) might stop, stating such a change in Fed policy was data dependent.

 About an hour before the FOMC minutes release the market started to roll over as though someone had privy to the contents of the minutes before the release?  In any case, the minutes revealed several members of the committee pushing to curtail asset purchases starting next month (June) while others were concerned that "bubbles" were forming in equity and bond markets.  Still others were apprehensive about disinflationary data that has recently come to the fore. 

The market hates indecision (although it hates more the idea that asset purchases could be curtailed in June) and promptly sold off into the close and the price action signaled a "key reversal day".  The price action on Thursday and Friday confirmed a short term reversal. 

Earlier in the month, on Friday, May 10th, Bernanke, in a speech at a conference in Chicago, stated, "we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals."

The chart below is one example of what he was referring to.  This is the Bank of America Merrill Lynch HY (high yield/junk) Index:

(click on chart for larger image)
chart furnished courtesy of
Junk bonds have been on a tear and their yields have fallen to record lows as investors scramble and search the globe in their reach for decent yield.  At the same time, corporate issuance is at an all time high as companies clamor to sell debt at record low interest rates.  The result?  Extremely high prices and record low yields.  And this is the reason why European periphery debt has caught a bid as well. 
The situation above has been exacerbated not only by the Fed's bond buying programs of the past four years which has artificially depressed interest rates in this country but by the Bank of Japan's (BoJ) program to pump the equivalent of about 75 billion dollars per month (ten billion less than the Fed's program) into an economy one third the size of ours!
Paper assets are on a trajectory that can be described as almost parabolic as exemplified by the three charts I posted at the beginning of this commentary.  A planet awash in liquidity cannot avoid asset bubbles.
Interestingly, the influx of paper money has not moved commodities.  Regular readers of my commentaries know I've beat this dead horse many times in the recent past and nothing has changed since I last mentioned it.  Here's a weekly chart of "Dr. Copper": 
(click on chart for larger image)
After a bounce in early May it's gone nowhere and the last candlestick has a bearish wick on top of the body.  Flat to negative global economic growth continue to pressure commodity prices, forcing central banks to administer the only medicine they know of to the financial system.
Key inflation data in this country is pointing to a disinflationary environment which the Fed stated this week they are not yet concerned about based on the public perception of future inflation expectations?!  Here's a chart of five measures of inflationary pressures in our economy:
(click on chart for larger image)
 Of the five indicators that measure inflation, only one is above the Fed's target inflation rate of 2% (barely) while the others are under that threshold and the Core PCE (personal consumption expenditures) that measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices is under 1.5%.
As we look at the global economy we see regions that are manifesting moderate growth to others that are either in recession or are experiencing anemic growth.  I firmly believe that our economy is experiencing moderate but deliberate growth and even Europe is starting to show glimmers of a recovery.  The chart below shows the latest PMI (Purchasing Managers Index) numbers from the Euro zone.  France is clearly struggling and Germany's growth is stagnant. But the rest of the Euro zone, while still in contraction mode, shows an improving trend:
(click on chart for larger image)
chart courtesy of Markit
As we put all these facts together we can deduce that the global economy and financial markets are in a major transition.  And if we had arrived at this point in history without central bank intervention (not likely) we would not be dealing with the threat I see looming for the financial markets.
The main concern I have is the current situation in Japan.  The BoJ, in an effort to break the back of a two decade plus deflation in that country, is pumping so many Yen into the system that it is creating major distortions in the global bond and currency markets that inevitably have to be resolved.  Along with destroying traditional inter market relationships, below is the first major distortion.  In spite of the unprecedented purchases of Japanese government bonds by the BoJ, yields on government debt have spiked higher:
(click on chart for larger image)
Remember the relationship of bond prices to bond yields.  As prices rise, yields drop.  In our country, Fed bond purchases have limited the supply of Treasuries so that prices had to go higher and yields were driven lower.  Universal perception that US Treasuries are a safe haven in times of financial or geopolitical turmoil have also assisted the suppression of the entire US yield curve.  Exactly the opposite is happening in Japan that has also been known as a safe haven trade and where the BoJ is purchasing about 75% of all JGBs issued.  Why?
It's apparent that investors in Japanese government bonds (JGB), if they haven't fled the Japanese bond market altogether, are demanding a higher yield in the aftermath of the BoJ's unprecedented bond buying program.  Evidently, printing money is not friendly to bond yields; at least not in Japan.  Moreover, it's absurd to announce a 2% inflation target as an explicit policy goal (as the BoJ has done) and not expect that nominal yields will have to rise in anticipation of higher real yields in the future, assuming the target is achieved. The market obviously bought that argument over the alternative that JGB purchases by the BoJ would keep a lid on yields.  As much as central banks think they can control their debt markets the Japanese example above proves they cannot. 
The sell off in the Nikkei this week had a lot more to do with the spike in government bond yields than with the Chinese PMI.  I submit in support of my thesis the market action on Friday.  The Nikkei was actually getting a significant bounce from Thursday's lows until BOJ Gov. Haruhiko Kuroda, in a prepared speech, said that the stability of the government's debt markets was "extremely desirable".  Investors were naturally disappointed in such wishful thinking with no apparent solution on the part of the BoJ and the index fell out of bed while the drop coincided with a steep rise in the yen.
Where's the money that was going into JGBs now moving into? Look at the first three charts at the top of the commentary and also look at European bond yields (especially periphery debt; Italy, Spain, Portugal).  The "reach for yield" as Bernanke put it, has lured investors into debt they would ordinarily not touch with a ten foot pole!  And central bank monetary policy is, by default, forcing liquidity into paper asset classes.  This liquidity being pumped into the global economy continues to "float all boats" as seen by the  US market comeback and stabilization on Thursday and Friday.  But the message of commodities is that the global economy is largely stagnant!
Just as I stated last week that the stock market was on crack as it continued to new all time highs, so this week the crack addict started getting a little crazy thinking about how its liquidity drug might be taken away from it (US) and that it may be overdosing (Japan). 
We'll see how it all shakes out but my other worry is that I'm not hearing the same concerns emanating from the investment community (save for a few lone wolfs like Kyle Bass).  Just as everyone seemed to miss the and housing bubble, so it seems these distortions are being kept "under the radar" or are being "swept under the carpet". 
Next week's economic calendar has a number of manufacturing reports (Richmond and Dallas Fed manufacturing Indexes), jobless claims and 1st Qtr GDP on Thursday followed by Personal Income and outlays, Chicago PMI and Consumer sentiment on Friday.  Globally, on Wednesday there will be a battery of data releases on the German economy including CPI (Consumer Price Index) numbers.
Have a great Memorial Day weekend!