Saturday, September 28, 2013

Fiscal Follies & the Fed's quandary

Markets reacted in kind to the increasing tension in Washington this week but the major indexes exhibited amazing resilience in spite of an impending government shutdown.  Here's the Russell 2000 small cap index which has been showing relative strength in the overall market as equities marched higher:

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The Russell has managed to trade in a tight range all week and is still above a key long term support line formed from the November, 2012 lows.  There is a clear divergence in momentum as reflected in the Relative Strength Index (RSI) and MACD is signalling underlying weakness although it is still positive.

Here's a daily chart of the S&P 500 Index:

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The S&P closed the week with a "hammer" candlestick which is usually a short term positive going into next week.  However, with the possibility of an ugly budget fight culminating in an imminent government shutdown not too much should be made of this technical signal.

Yields are grudgingly dropping as the message is sinking in that the Fed may not "taper" any time soon.  Here's a weekly chart of the Ten Year Treasury Note yield:

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And here's a daily chart of the iShares Barclays seven to Ten Year Bond ETF which is a popularly traded ETF that tracks the performance of Treasuries from the "belly" to the long end of the yield curve:


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IEF is sporting a "shooting star" candlestick which is the exact opposite of the "hammer" candlestick on the S&P500 above and these signals from charts that have been inversely correlated is usually a confirmation that there will be a short term turn in the market.  However, I don't like the position of this "shooting star".  Normally, I'd like to see these candlesticks in "break away" positions, that is, a position where it has gapped noticeably higher than the surrounding candlesticks.  So, I'm suspicious of this technical signal.

Industrial commodities are still struggling.  Copper is begging to break out on top of a long term resistance trend line as can be seen on its weekly chart below:

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As can be seen, Dr. Copper is on the cusp of a breakout but so far, no cigar!

When we look at copper along with aluminum, nickel and zinc, the picture hasn't changed from last week.  Here's an update of the weekly chart of the Dow Jones UBS Industrial metals Index.  Industrial metals are still dormant:

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And here's what steel is doing after all the "hoopla" over China in the past two weeks:

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Steel, a commodity highly correlated to Chinese economic activity, was turned away at Fibonacci resistance last week but had what technical analysts call an "inside" week which is still potentially bullish.  And what about China?  Here's a daily chart of the Shanghai Stock Exchange Index:

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The Shanghai retrenched this week and is sitting on resistance turned support.

Finally, for my faithful readers and followers in Asia, particularly the Philippines, here's a weekly chart of the Wisdom Tree Dreyfus Emerging Currency ETF (CEW):

(click on chart for larger image)

This chart particularly disturbs me.  As EM currencies go, so goes their stock markets.  After the Fed hinted that they might take away the "punch bowl", emerging market currencies were seriously devalued as liquidity fled the more speculative sovereigns for the "safe haven" of developed markets.  Now interest rates are moving lower again but we're not seeing the commensurate strengthening we should see in these markets.  I wish I could impart a more upbeat message for my friends in Asia but this chart tells me EM equities and debt are not out of the woods yet.

ANALYSIS

It's easy to get caught up in the immediate events that are shaping these markets and everyone is focused on the budget battle in Washington.  Obviously, events in the beltway will shape our markets in the coming weeks and the ride will be volatile, but once this "noise" is out of the way, I feel very comfortable predicting a strong year end rally in stocks.  

The real important issues and matters that effect these markets are often just below the surface and are not clearly seen by the masses for many reasons; they are not obvious or they're being ignored by those who have vested interests to maintain the tempo of the party.  I'm not going to be one of those who do the same. We've got problems.  And they're not getting better; they are deteriorating.  And I sincerely hope that I'm wrong and/or, these problems melt away.  

For instance, the final revision for second quarter GDP was reported on Thursday.  Growth for the second quarter was left unchanged at an annualized rate of 2.5%.  However, when we "look under the hood" of the report we find the following:

- the annualized GDP Price Deflator in the second quarter dipped to 0.6%.  For my readers who want to know what the GDP Price Deflator is, the definition is here.  Simply, the inflation rate is moving closer to zero.  After that, deflation!

- PCE (Personal Consumption Expenditures) inflation has averaged just 1.5% since December, 2007.  

Now,  the data cited above was for the second quarter.  But there's been no appreciable change in these indicators since.  There can be no meaningful and substantive economic growth in a fiat currency system with these low inflation readings.  This is disinflation.

It's really not difficult to understand why this is happening.  A combination of changing demographics (baby boomers moving into retirement - if they can afford it), a malignantly weak job market and the impact of Obamacare which is stifling full time hiring, are impacting consumption.  

Corporations are as profitable as they ever have been.  However, earnings, the lifeblood of a bull market, are declining as top line growth (revenues from sales) deteriorate.  There's simply no more fat to trim off the bone.  Byron Wien,  a senior advisor to the Blackstone Group, in an article from Friday's edition of Barrons, continues "to believe earnings in the U.S. will be disappointing. Profit margins are at a high and rising interest rates and other cost pressures should begin to show up in the third quarter reports. More than three-quarters of the companies providing guidance to analysts are encouraging them to adjust their estimates lower. Revenues so far this year have been disappointing, and that should provide a clue to possible earnings weakness as the year develops. Whether this will be enough to send the market lower remains unclear".

 The last sentence from Mr. Wien's quote is noteworthy because if lower earnings, which in the past, have been accurate predictors of stock market strength or weakness, cannot move this market lower, then what is keeping it afloat?  

Simply, the Fed is the only remaining game in town, "floating all boats", and last week's decision to fore go a reduction in Treasury and asset purchases speaks to the quandary the central bank faces.  They can't take their foot off the gas pedal without feeding deflationary pressures and yet, continued monetary stimulus is getting less bang for its buck.  They are "pushing on a string ..."

I'll end here.  The chart of CEW above disturbs me because it is showing, on a weekly basis, that lower interest rates are no longer giving central banks the desired outcome.  Here's another chart I've been watching for signs that we truly are in a lasting recovery independent of central bank manipulation:

(click on chart for larger image)

This is a weekly chart of the iShares Dow Jones US Construction Index, comprised of the major home building stocks traded in the US.  As mentioned in previous commentaries, this ETF is an excellent indicator of not only the strength of this recovery but whether the "poster child" of the Fed induced recovery can withstand higher interest rates.  As with CEW above, the ETF has broken down below support/resistance in the face of lower interest rates in the past week.  Now, the ETF is also strongly correlated with stock prices as well.  So, I can't attribute the same concern here as I can to the Emerging Market currency (CEW) ... yet.  But we better see a turnaround soon.


Looking to the week ahead, there will be some European PMI stats that will be released on Tuesday which could create ripples in the market as that continent struggles to gain some economic traction.  On Wednesday, the US Durable Goods report will be released and Ben Bernanke speaks in St. Louis that afternoon at 3PM EST.  And on Friday, the Monthly employment report for September will be released which is always good for some fireworks.  However, in the short term, global stocks will continue to be captivated by every news blurb and syllable from politicians mouths emanating out of Washington.  

Have a great week!