Saturday, October 19, 2013

We're in rally mode!

Markets rallied this week on the news that our elected representatives finally negotiated a stop gap solution to avert a US credit default.  And just as I predicted here, stocks have already posted consecutive all time new highs on Thursday and Friday.

Of course, it certainly helped investor sentiment when Google turned in a stellar earnings report.  The stock gapped up $200.00 on Friday and joined Priceline (PCLN) in the $1,000.00 club:

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It is equally positive that, especially in the case of Priceline, momentum indicators are hinting there's more room to run in both of these stocks.  This is certainly a harbinger for more upside action, not only in these two stocks, but in the broader market as well.

Now that we've been able to shelve all the nonsense out of the Beltway until early next year, in this commentary I'm going to focus exclusively on the technicals in the market in an attempt to determine where we're going and how soon we'll get there.  In any case, let me state that, outside of an exogenous event that could rattle the markets, there is nothing in the way of equities moving substantially higher from here going into 2014.  Next year may be another story but, even then, I'm cautiously optimistic.

The possibility that the Fed will cut back on its asset purchases before 2014 has been greatly diminished by the US government shutdown and potential debt default.  The obvious concern is the drag on growth that the eighteen day shutdown and negative impact on consumer sentiment may have precipitated.  While no one can definitively predict the drain on GDP (Gross Domestic Product), a Reuters poll found a consensus among economists of 0.3% drag.  However, there's a concern that this may be underestimated.  GDP drag, along with the perilously low inflation rate that I've addressed a number of times in recent commentaries, will be sufficient reason for the Fed to delay any "tapering" until their March, 2014 meeting.  Add to that the fact that the new Fed Chairman nominee, Janet Yellen, might be more of a monetary dove than Ben Bernanke, and there's little chance that the central bank will ease their asset purchases anytime soon.  There is an opinion that they may start rolling back asset purchases after their December meeting.  In the absence of stellar economic stats which could come to the fore between now and December, the central bank will not reduce their asset purchases. And this is the main driver of higher stock prices going forward.

Some good economic stats out of China this week also helped investor sentiment in believing that the global economy is finally moving toward a fuller and healthier recovery.  Never mind that the Chinese "bounce" is the result of modest fiscal stimulus which may ultimately prove ephemeral.

The recent loss of confidence in our political system engendered by the circus we witnessed in Washington along with the prospect that the Fed will not be reducing asset purchases anytime soon is wearing on our Dollar:

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The US Dollar fell out of a gigantic rising wedge pattern on the weekly chart above five weeks ago and is now trading below its 200 day moving average.  There is some Fibonacci support at the 78.75 level and that may stop the bleeding temporarily.   However, if we don't get a bounce from there we're looking for a move down to the 75 area.  Obviously, this is good for stocks as the USD is inversely correlated with stocks, commodities and gold.  A weaker Dollar therefore will be supportive of stocks going forward.

Treasuries have been settling down as the market is getting acclimated to the continuation in the foreseeable future of continued Fed accommodation.  With asset purchases continuing and the central bank anchoring the short end of the yield curve, the prospect of a low interest rate environment is actually contributing to a mild rally in Uncle Sam's debt with the commensurate easing of interest rates.  Here's a weekly chart of the Ten Year Treasury yield:

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The Ten Year yield has backed off the almost 3% yield it reached in late August and is now sitting on Fibonacci support.  This is the outcome the Fed desires in order to maintain housing affordability as the Ten Year Treasury is the benchmark for determining mortgage rates.  Of greater import is the fact that the Ten Year yield still remains in a downtrend delineated by the descending black dashed line.

While we will never see the all time lows in yields we saw in July, 2012, there is nothing on the horizon that would suggest a spike in interest rates.  I've covered the implications of higher rates in many of my recent commentaries but for those who might want to understand why we will not see significantly higher rates in the immediate future (next six months) go here.

Gold had an interesting week.  The consensus view of the yellow metal (which I agree) believes that, with political tail risks subsiding, it has much more downside in the current economic environment we find ourselves in.  However, on Thursday morning, between 2:45 and 3AM EST, a wave of orders to purchase $2.3B worth of gold caused the futures to spike $40.00!  Some attributed this move to a credit downgrade of US debt by China's Dagong Global Credit Rating Agency.  And while I cannot dismiss this as a valid reason, the Dagong Global Credit Rating Agency and its pronouncements have very little clout in international markets.  Nevertheless, the spike breathed some life into gold and gave it a much needed bounce.  Here's a daily chart of the Gold spot price:

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Aside from the bounce, the chart speaks for itself.  Gold remains in a downtrend and if it breaks the $1200.00 level decisively, there is an "air pocket" to the $1050 - $900 area.  Here's a weekly chart of the precious metal:

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Goldman Sachs's has set a price target of $1,050.00 and I believe it has the potential to bounce off the $900.00 level.  I do believe that $900.00 is a "floor" and a fair price for an ounce of gold based on central bank manipulation of the fiat currency.

Anyone who reads my commentaries regularly know I've been following commodities, especially industrial commodities, very closely in order to determine whether the global "reflation trade" is gaining any traction.  There is really nothing substantive to report this week other than the fact that I believe commodities are stirring a bit.  Here's a weekly chart of the Dow Jones UBS Industrial Metals Index ($DJAIN):

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This index is comprised of futures prices of copper, lead, nickel and zinc.  It presently is on the cusp of penetrating a long term downtrend line (red dashed) but is in the midst of a basing pattern (black circle).  Now, we've seen this movie before but the reason I'm a bit more optimistic about this chart is because of the chart below:

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This is a weekly chart of the Dow Jones US Steel Index.  Steel has been rallying for four months and although it is highly correlated with Chinese economic activity, the momentum of this rally suggests to me there's something more going on elsewhere on the planet than just Chinese activity.  Now, there are a variety of reasons why I'm not too excited about the recent spate of good economic data emanating from China which I will address in subsequent commentaries.  However, I must take notice of this rally in a major industrial metal.

Before I address US equities, let's take a look at Emerging Markets.  They took a pummeling back in June when Ben Bernanke intimated that the Fed would be scaling back on their Treasury and MBS (mortgaged backed securities) purchases.  At that time, you could almost hear the "whooshing" sound as the easy money fled riskier emerging market countries for potentially higher yielding developed market debt.  However, as expectations of an imminent tapering have waned, the Treasury market has settled down and so has the liquidity flight from Emerging Market currencies and equity markets.  The weekly chart of the iShares MSCI Emerging Market ETF  below serves to illustrate what I'm talking about:

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EM equities have penetrated a significant resistance line and look to challenge the December, 2012 highs.  This is good news.  My only caveat is that Emerging Market strength has shown itself to be totally dependent on the Fed keeping the "liquidity spigot" open.  

The whole issue of investing in emerging markets at this time can be complicated.  Surely, a case can be made that buying now is generally a prudent decision as EM is largely out of favor at this time but with the entire emerging market complex dependent on Fed largesse, I see investment potential in this area to be selective rather than buying the entire market.  There's good value in Taiwan, Philippines and South Korea.  Stay away from India and Indonesia.

So, we have a low interest rate, low inflation, tepid economic environment with no political or known tail risks confronting us for the foreseeable future.  Where are stocks going?  Higher!  Here's a weekly chart of the S&P 500:

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Notice the two panels above the chart.  I've drawn white arrows to point out the momentum divergences that exist.  When I see these on a weekly chart I normally am concerned.  However, it must always be remembered that, regardless of momentum, price action is the main indicator in determining future direction.  Momentum is indeed a very useful tool but you can't run for cover every time a momentum indicator signals a divergence.

I'm comfortable with the momentum divergences above because of the chart below.  This is a daily chart of the Russell 2000:

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Small caps have been roaring lately and have been leading the general market higher all year.  I would like my readers to take away three points from the chart:

1.  Friday's price action formed a gap which, in a technical sense, has put a floor under the index.  Unless the gap is filled next week it essentially becomes new support.

2. The bottom panel is the price of the Russell relative to the S&P 500.  The white arrow delineates its out performance relative to large cap stocks which is a very bullish indication.  Since small cap stocks are more speculative, their out performance versus their large cap brethren indicates a confidence in the economy and that "animal spirits" are very much alive in the market which is a very healthy sign.

3.  The top panel is the RSI (Relative Strength Indicator) and although we're approaching overbought territory we are not there yet, which suggests there's more room to run.

So, here are my price projections for the S&P 500 based on Fibonacci price extensions.  First of all, I've predicted 1800 by year end but have reassessed that prediction just on Thursday and Friday's price action.  The divergences identified above on the S&P suggest a rest is due but there is no way to tell whether we'll get one.

My first Fibonacci extension has a price target of  1752.54 (1.272 extension).  At the rate we're going we may be there by Monday afternoon.

The second target is 1781.40 (1.618 extension) and the third target is 1864.79 (2.618 extension).  Considering that Fibonacci retracements and extensions are amazingly accurate but often not exact resistance or support levels, I am comfortable in raising my price target on the S&P to 1860 by year end.

In the short term, I wouldn't be surprised if we see stocks stall and consolidate at around 1752 which could be next week.  But I also sense that we're coming into a period of calm where we start to see the slow, steady grind higher we've experienced over the past few years when the market was not encumbered by "tail risk" events.

So, get ready for the Christmas rally!  Life is good!

Have a great week!