Saturday, January 11, 2014

Changing FOMC = Nervous Market

For all the seemingly lackluster price action, almost all the major averages finished in the black this week   The lone exception was the bell weather Dow Jones industrial Average which finished the week down 0.20%.  The S&P 500 gained .60% on the week and here's an update on the index based on Friday's closing price:


(click on chart for larger image)

I've outlined some support zones including one labeled "Target support for meaningful correction".  However, I don't want my readers to think that I'm expecting an imminent correction.  Regardless of how I "feel" about this week's price action, all my technical indicators are pointing to higher highs in the weeks ahead.  Breadth numbers are all positive with cumulative new highs/new lows regaining momentum and we have no indication from volatility indicators that a correction is anywhere on the horizon:

(click on the chart for larger image)

The chart above is a seven year weekly chart of the CBOE Volatility Index.  Often referred to as the fear gauge, it represents a measure of the market's expectation of stock market volatility over the next thirty day period.  The VIX is quoted in percentage points which equates to investor expectations of the movement of the S&P 500 over the next month.

It's important to remember that the VIX is a unique sentiment indicator because market participants literally "put their money where their mouth is".  In other words, unlike other sentiment indicators which are nothing more than polls trying to gauge investor sentiment, the VIX moves on investors spending money to protect their portfolios.

The thing to remember about the chart above is that it is counter intuitive.  That is, the higher the VIX,  the lower the S&P was at the time of the reading.  In other words, in a very simplistic sense, higher volatility usually means a lower stock market.

I've identified on the chart the major catastrophic events of the past seven years that made the VIX spike.  The circle in the lower left hand corner is where the lowest recordings ever made in the VIX since it started trading in 2004 are recorded.  The arrow on the right is where it finished trading on Friday.  What I want my readers to notice is the arrow and legend just right of the circle in the lower left area of the chart.  As stocks approached their intra day all time high in October, 2007, the VIX was rising, meaning investors were buying put options in greater amounts to protect against downside exposure.  Today, in spite of stocks being within spitting distance to new all time highs the VIX is registering some of its lowest readings since the halcyon days of 2007.

What does this mean?  No fear!  Investors as a whole do not believe there is enough danger for significant downside action to buy protection (even though it is presently VERY cheap).  If there was some upward pressure in the VIX I'd be more willing to speculate on the timing of a correction but at this point that is not the case.


Here's a testimony to the strength of the US economy:

(click on chart for larger image)

The Dow Transports went on a "tear" this week amidst the relatively lackluster price action in the general market.  The airlines certainly helped as they rallied in anticipation of lower oil prices but the trucking index outperformed the airlines!  This is incredibly positive action for our economy and lower oil and gas prices are fueling the momentum.


If you follow the markets then you know the two premier events this week took place on Wednesday when the Fed released the minutes of their December meeting where they decided to start unwinding their QE and Friday morning when the Monthly Employment report was released.  I'm going to focus on the significance of these two events in my analysis but I introduce them here because the Treasury market gapped higher on the dismal employment report which many are labeling an "outlier":

(click on chart for larger image)

This is a daily chart of the iShares Barclays 7 to 10 Yr Bond ETF and I've pointed to the candlestick that just leaped over almost three months of resistance on Friday.  Bonds certainly reacted the way they should have to the poor jobs report.  Now whether this is just a "blip" on the radar screen or the start of another trend is something we need to monitor.  From a weekly perspective the direction of interest rates is still higher.

Gold continues to confound market pundits by its march higher and attempting to fit it's rally into a coherent market paradigm is a challenge. I presented a thesis last week about gold possibly anticipating future inflationary pressures but admittedly, in the face of the data we have, this is at best, a minority event.

I've heard it said on CNBC that gold and silver will take the ride higher until January 28th after the next Fed meeting and once it is clarified that the Fed is not pulling back on its taper program the gold bear market will resume.  But this explanation does not seem viable as there is no preponderance of economic evidence thus far that would motivate the Fed to reverse course at this point.  Here's a daily chart of the gold spot price:

(click on chart for larger image)

I've put another group of Fibonacci lines on the chart in order to determine short term price targets.  Gold is actually closing in on short term Fibonacci resistance at about $1250.00.  The metal was relatively weak in the spot market this week but soared on Friday on the horrible employment report; obviously anticipating the Fed's hesitancy to continue their tapering plans.

If gold can punch through the $1250.00 level then we should have an "all clear" up to the $1272.00 level.  If you're holding gold and silver and looking to sell just be nimble.  Gold's fortunes can change literally on a dime. The price can drop under $1,200.00 in a day!  There is presently no rational or fundamental reason for gold's rally other than a technical bounce off of oversold levels.


There's not much to report on commodities this week.  Any of the industrial metals that have broken through resistance points are holding their breakouts but price action was stagnant this week.  Here's a long term weekly chart of the Powershares DB Multi Sector Commodity Trust Metals Fund (DBB) which is composed of futures contracts on copper, aluminum and zinc:

(click on chart for larger image)

The only positive I can glean from this chart is that industrial commodities continue to consolidate.  Will they ever break out?  Not unless something changes on the following chart:

(click on chart for larger image)

Here's another update on the Shanghai Composite Index and as conditions deteriorate over there the "bleed" continues.  I've highlighted the major issues that are plaguing the Chinese economy in past commentaries: over leverage in their financial system, an out of control shadow banking system, and now broad based weak services and manufacturing PMIs.  

Notice the top panel on the chart above which is the Relative Strength Indicator (RSI).  I've plotted three arrows there to highlight how we read the indicator.  There are two horizontal lines, one at 40 and one at 60.  If the indicator drops under the 40 level the index is in a bearish trend. Unless/until the RSI subsequently exceeds 60, any upward fluctuations in the indicator are just temporary blips in a bearish momentum trend.  The RSI dropped under 40 last June only to surge close to 60 early last September but it never exceeded the 60 level.  Since that time it has trailed off and is now under 40 again.  The significance of this is that this is a weekly chart where momentum is even more important than a daily chart!  China is not looking well, folks!

Neither were Emerging Markets until Friday when they surged for the same reason gold did; the weak monthly employment report raised the prospect of the Fed altering their tapering schedule:

(click on chart for larger image)

I circled the week's price action on this daily chart of the iShares MSCI Emerging Markets ETF (EEM).  I had identified what seemed to be "capitulation" selling last week in the ETF (see red arrow in lower panel).  The ETF drifted lower during the week but formed a "hammer" candlestick pattern on Thursday.  On Friday, after the employment report, the ETF surged on heavy volume (blue arrow in lower panel).

I'm intrigued by the technical pattern of the chart and just on that strength I expect to see follow through to the upside next week.  However, fundamentally, nothing has changed for emerging markets as liquidity dries up thanks to Fed tapering and now Chinese weakness.

Finally, let's take a peek at the Baltic Dry index which is a measurement of how much shippers charge to move major raw materials by sea:

(click on chart for larger image)

The Index can't break out above long term Fibonacci resistance.  In my opinion, the Baltic is predictive of Chinese economic conditions and the Shanghai Composite.


Analysis

As I pondered the price action during the week I was much more concerned on Monday and Tuesday than at the latter part of the trading week.  Part of every one's apprehension about the first full trading week of 2014 was that we didn't see the day after day new highs we had grown accustomed to in 2013.  Nevertheless, when we break down the week there were some recurring patterns that have been prevalent throughout 2013.  Here's a Five minute chart of the S&P 500 for the whole trading week:

(click on the chart for larger image)

Upon closer study the only weak day we had was Monday.  After an initial surge higher at the open we traded flat on Tuesday.  On Wednesday there was some buying into the close but we gapped higher on Thursday only so see the same pattern on Thursday and Friday afternoon we saw dozens of times in 2013; a buying surge into the close.

When I look at my sentiment and breadth indicators they correlate well with the technicals and unless we have an exogenous event that sparks a "knee jerk" sell off I don't see a correction unfolding in January.  Based on historical data we could see one in February and I do agree we need to watch all aspects of the market for clues as to when this much needed correction will occur.  For occur it must!  The market is due for a healthy pullback and if we did get a meaningful correction the excesses would be cleaned out of the market and we could move forward on a fresh note.

But the market was choppy this week and the new trading year has been a disappointment from those "heady" days of 2013.  As I asked last week: what had changed from 12/31/2013 to 1/2/2014 other than a new year?

I'll try to encapsulate what I see as the problem in a moment during one of Ben Bernanke's last public appearances that took place shortly before the Christmas holidays.  He was being quizzed on the Fed's commitment to a steady incremental unwinding of QE and forward guidance holding down short term interest rates until at least 2015.  While the Fed Chairman has become quite accustomed to reciting the policy the Fed has been promoting for months as though it is a mantra, when asked whether these policies will remain intact when the present organization of the FOMC changes he did not answer the question.

Indeed, we have a new chairman (Janet Yellen) who the street has labeled as a monetary dove (although they really don't know what she is; they just know what she's done) and now President Obama has named Stanley Fischer as the number two person on the Fed to replace Yellen.  Fischer ran the Bank of Israel for eight years and is known for his independence.  There are already questions on how well the two can work together.

But even more importantly, the stage is set for the line up at the FOMC to be more hawkish than at any time in the recent past.  Two monetary hawks will be voting members of the committee: Richard Fischer and Charles Plosser.  In addition, former Treasury Undersecretary Lael Brainerd will be coming on board and she is largely a monetary question mark.

The market has been inundated with some of the best economic data it has seen since 2007 (except for Friday's employment report) and with a new reorganized FOMC what are the chances that the committee will alter the tapering schedule and its forward guidance on interest rates?

Admittedly, the market calmed down after the awful monthly employment report on Friday and finished higher as the prevailing opinion seemed to be that the Fed will stay the course that it set in December with the objective of unwinding QE by the end of 2014.  And to this I don't disagree ... for now.

However, the fact that the personnel on the FOMC is changing has made market participants nervous.  The reality is setting in that the Fed is not so much on the market's side as it is on no one's side.  These people are central bankers who will do what they think needs to be done to address continuing and changing situations in the US economy.  And this is what the market is concerned about.  The Fed assurances of the past that it has the market's back are not as dependable now that the US economy seems to be gaining traction.  And I believe that gold's rise may be due to this situation.  The market hates uncertainty.  Uncertainty breeds fear and fear breeds sell offs!

Now, the Fed also knows that it has to be consistent with the forward guidance it has already offered to the market but there is still no guarantee that they would never change the rules in mid stream.  For instance, everyone on the street is fixated on the prospect that the Fed will continue to taper at regular intervals by only 10 billion dollars.  What if they accelerated their tapering? What if they cut back by 20 billion one month?  How would the markets react?  

I've heard it said that as we get back to "normal" that the street will start focusing on earnings as the main driver of market direction.  I agree with the statement in principle but it was made on the assumption we're back to "normal".  I disagree with the thesis that we're back to "normal" yet and that, at this point, this market will turn either way on earnings.  As long as all that liquidity is still sloshing around in the markets, courtesy of Fed largess, the issue of QE will dominate the minds of market participants.  I agree that if the market can prove that it can take continued tapering in its stride then earnings will become the main catalyst for movement in the market.  But all the price choppiness since January 2nd can be attributed to one issue and it's not worry over earnings!

Next week there will be some economic reports that folks will be watching closely:

Tuesday - Retail Sales - this is liable to be a big one as the retailers suffered a dismal Christmas season
Wednesday - Producer Price Index - watch inflation; we're nowhere out of the woods on this one yet
Thursday - Jobless claims & Philly Fed Survey (always a mover)
Friday - Housing Starts, Industrial Production and Consumer Sentiment

As market participants continue to bite their nails over the possibility of a newly reorganized FOMC possibly changing their forward guidance and tapering schedule all these reports will create some volatility on a daily basis with a bias to the upside.  A great environment for swing traders!  :-)

And keep an eye on China.  Developments there are getting very little press but things seem to be deteriorating quickly.

Have a great week!