Saturday, September 14, 2013

Fed tapering & reflation

With a relatively light economic calendar in the US this week along with some impressive data out of China earlier in the week, stocks surged thru several resistance areas but then leveled out to close above key resistance.  Here's a daily chart of the S&P 500 which illustrates this:

(click on chart for larger image)

The S&P surged through its 50 day moving average (red arrow) and a down trend line (blue dashed line)on Monday and then managed to clear key resistance at the 1683 level on Wednesday.  Trading on Thursday and Friday was flat but the S&P did finish the week above this key resistance area which is a positive going into next week.

Here's a daily chart of the Wilshire 5000 Index which is comprised of every publicly traded US equity:

(click on chart for larger image)

Momentum is waning as seen in the panel above the chart (blue arrow).  However, it would be wrong to extrapolate anything more to this indication than a pause in upward momentum and bias.  I have outlined a potential head and shoulders pattern which is a bearish formation but the operative word here is "potential".  Stock indices can very well spike from this level to all time highs given the right fundamental catalysts. 

Market participants are totally focused on the September 17th & 18th FOMC meeting in which it is expected that the Fed will announce that they are going to begin "tapering" QE; that is, they will commence an incremental cutback on the present 85 billion dollar/month asset purchases that they've been conducting since September, 2012.  Most economists on the street expect that an initial "taper" of 10 billion dollars will be announced on September 18th.

Interest rates seemed to have found a "top" and it appears any Fed tapering has been baked into bond prices.  Here's an update of the Ten Year US Treasury yield:

(click on chart for larger image)

The Ten Year yield attempted an assault on the 3% level on Monday but was turned away.  If you look closely on the chart there's a double top established from the September 5th high of 2.984%.

One of the concerns of the market has been the pummeling that US home builders have taken since it became apparent in May that interest rates were going to rise, either from better economic conditions, less Fed accommodation, or both.  There has already been a deleterious impact on the real estate market from the recent rise in rates and we're in a "wait and see" mode on whether further interest rate increases are going to cripple the housing recovery, which has been the "poster child" of the Fed induced general recovery.  Below is a daily chart of the iShares Dow Jones Home Construction Shares ETF (ITB):

(click on chart for larger image)

ITB has had a pretty good bounce after it sold off from it's May highs (red arrow).  However, that could very well be because interest rates have topped out (for now).  In any case, I've highlighted resistance on the chart where the ETF was decisively turned away on Thursday. 

I've stated in past commentaries that this ETF will tell us much on whether this economy can withstand and prosper in a higher interest rate environment.  If the thesis that says interest rates are rising because economic fundamentals are getting better is correct then we should see ITB blow through the resistance area I've identified above and resume it's march to new all time highs.

Many of the concerns I addressed here have not changed in the past week.  Industrial commodities all retreated this week and are under key resistance levels save steel, which is highly correlated with the Chinese market.  But even steel, after an initial surge, was unable to pierce Fibonacci resistance.  Here's a weekly chart of the Dow Jones US Steel Index:

(click on chart for larger image)

The blue arrow points to the ETFs failure to penetrate resistance with that long wick on top of the candlestick.

So, we're in an economic environment where interest rates are rising and commodities are weakening. 

Here's are two more charts for my readers consideration:

(click on chart for larger image)

Gold took another beating this week ostensibly because the Syrian crisis was cooling.  But oil continued higher this week.  Above is a daily chart of the SPDR Gold Trust Shares ETF with Brent Crude oil superimposed on the chart.  The bottom panel shows a correlation between the ETF and the commodity.  We can see that over a forty period time frame, Brent and gold have been correlated 79% of the time.  However, Gold's momentum is very weak and it would not be surprising to see more downside next week.  The only positive take away from this chart is that GLD sported a "hammer" candlestick on Friday (blue arrow) which usually signifies a short term bottom.

What's my point in bringing these seemingly arcane technicals to your attention?  I believe gold has become the indicator that will tell us whether the reflation trade is finally making it's long awaited debut.  The fact that gold and oil are highly correlated can assist us in solving the riddle of the reflation trade and the strength of the global economic recovery.  Gold and oil must inevitably move in the same direction.  Either a strengthening global recovery is going to create more demand and push oil higher which, in turn, will drag the yellow metal higher, or gold will resume its slide to my target of 1050 - 900 and take oil with it.

Here's the second chart which I believe was the biggest news this week:

(click on chart for larger image)

This is a daily line chart of the Baltic Dry index going back to the dark days of 2008.  The Baltic Dry Index (BDI) provides an assessment of the price of moving major raw materials by sea.  In 2008 it was watched very closely and was a concurrent indicator of the seriously deteriorating global economic conditions (left side of chart).  It seemed to recover quickly in 2009 and 2010 but then started a volatile descent to a February, 2012 bottom.  Interestingly, it presaged the ultimate low in Treasury yields in July, 2012.  Since that time it has been trapped under Fibonacci resistance.  Part of the slide had to do with an oversupply of shipping tonnage that had started to be built in 2007 as a result of the then economic boom.  But the index surged through Fibonacci resistance just this week.  And the move higher was remarkable.  

What's important to know about this index is that it is not an assessment of what investors think is going on in the shipping market.  It's a "bottom line" real dollars and cents measurement of the money shippers are collecting for moving raw materials around the globe.  Now, we'll want to see a lot more upside on the chart above but this move cannot be ignored.  It's a very positive sign that the global economy is truly healing.

This move in the Baltic is implying greater worldwide demand in raw materials and must eventually translate into higher commodity prices.   It is telling us that the "reflation trade" is stirring.  Let's hope that the signal is genuine or the concerns I've raised in past commentaries will rear their ugly heads.

Finally, I want to review the emerging market situation.  Emerging markets have been the most conspicuous victim of the prospect that our central bank is ready to unwind its liquidity program.  Easy money and low global interest rates have fueled emerging market growth since 2009 and now that capital is fleeing these more speculative countries for safer and rising interest rate products in developed nations, we've seen a mini crisis develop across the entire emerging market spectrum.  Here's the Wisdom Tree Dreyfus Emerging Currency Fund:

(click on chart for larger image)

EM currencies commenced their fall in May when murmurings that the Fed was planning to take away the punch bowl materialized.  However, the bleeding stopped right on major multi year support and the subsequent bounce has been encouraging.  When there's capital flight in a currency or group of currencies the debt instruments that are denominated in those currencies suffer as a consequence.  Here's a weekly chart of the iShares JP Morgan Emerging Market Bond ETF (EMB):

(click on chart for larger image)

And when a nation's debt suffers its equities normally follow.  Here's a weekly chart of the iShares MSCI Emerging Market ETF (EEM) comprised of large and mid cap stocks from emerging market countries:

(click on chart for larger image)

We've had a recovery from the June low but the ETF is presently snagged on Fibonacci resistance much in the same way the Steet ETF above.  

To sum up, I'm still waiting for the reflation trade to appear on the global economic scene.  I've attempted to lay out for my readers the indications that will signal whether that reflation trade is gaining traction.  Until it does, I can ride the liquidity induced equity rally that central banks have induced over the past five years but not with the same comfort level that I could when financial and economic fundamentals are in sync.  Simply, rising interest rates and flat to falling commodity prices are not consistent with a healthy economic recovery.  Indeed, the prospect that the very same liquidity that has "floated all boats" over the past five years is being taken away, even incrementally, has caused reverberations in all markets, especially those such as emerging markets that have benefited from such largesse.  I'm encouraged by the surge in the Baltic Dry Index this week and it may be the first piece in a puzzle that will lead to that healthy, balanced, consistent global recovery I'm looking for.  

All eyes will be on the Fed statement to be released on Wednesday, 9/18 at 2PM EST in anticipation of the initial cutback in asset purchases.  

There's never a boring week in the financial markets!

Have a great week!