Clues to Market Direction

After a horrendous Monday where the S&P 500 sold off almost 41 points and the Dow Jones Industrial Average dived over 326 points, the equity markets fought back and actually finished higher for the week.

Rather than review the market events for the week I think it would be more helpful to detail some of the indicators and inter market relationships that can provide us with clues on the direction of stocks.

As expected, the dip we've experienced in the past few weeks and the volatility prevalent in the market since the very beginning of the year has been cause for much speculation on the resilience of this "mature" bull market.  For some, economic indicators have signaled a "soft patch" in the US economy while others blame the incredibly cold weather of December and January for the weakness.

The last two monthly employment reports that highlight NFP (non farm payrolls) have been dismal reports.  In Friday's report for January, NFP came in significantly below expectations at 113,000 versus a consensus estimate of 189,000.   What was worse was the expected revisions to December's horrible report were practically non existent.  December's NFP was originally only 74,000 and was only revised up by 1,000!

Some economists are still blaming the frigid weather for these terrible reports but this weakness for two straight months cannot be attributed solely to the weather.

In any case, when the report was released at 8:30AM EST on Friday the Dow Futures immediately fell 110 points lower and then did an abrupt "about face", fueling a rally on Friday during the regular trading session that finished strongly into the close.

Traders and investors who have their pulse on the market were left scratching their heads as the dismal employment report should have been a catalyst for a sell off.  The most logical explanation I've heard for this "screwy" behavior came from the financial press that attributed the rally on Friday to the belief that with the spate of recent weak economic reports the Federal Reserve would at least temporarily reverse course and cease tapering in coming months.

While no one can definitively attest to what Janet Yellen and the Fed will or will not do the prevailing opinion on the street (to which I agree) is that the Fed now recognizes that QE cannot do anything more to spur our economy on and the tapering will continue.

So, did the market get it right on Friday?  Well, regardless of what I think about "screwy" market behavior, traders and investors are betting with their money that this economy is getting better and this market is going higher:

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This is a daily chart of the CBOE Volatility Index ($VIX) otherwise known as the "fear gauge".  It is a measure of near term stock market volatility using the price fluctuations of options on the S&P 500.  A reading of over 20 on the VIX usually is interpreted as a "bearish indication", meaning the market may be turning lower.  On Monday we pierced the 20 level and closed at 21.44.  By week's end, the fear priced into "calls" and "puts" evaporated and we closed the week at a slightly elevated 15.29.  The VIX is clearly voting with the bulls on this week's market activity.

The Treasury market, however, did not perfectly follow the inter-market "script" that it traditionally has in the past.  Here's a three month daily chart of the Ten Year Treasury yield as of Friday's close.  I circled the trading week's activity:

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Bond yields followed the traditional inverse relationship to stocks this week with the exception of Friday.  The interpretation of the employment report that supposedly leaves open the possibility that the Fed will temporarily cease tapering caused a mild rally in the Treasury market with the commensurate suppression of interest rates.  

The Treasury market is our barometer on the health of the economy as well as the direction of equities.  Generally speaking, a resumption of upward pressure on yields will be good for stocks and predictive  of a stronger economy.  Lower interest rates will be a harbinger of trouble for our markets and the economy.

Gold continues to move higher but I'm ambivalent as to the reasons why.  Here's a daily chart of "spot" gold:

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Technically, gold is snagged on Fibonacci resistance at $1270.00 and we are near a "moment of truth" for the "yellow metal".  I mentioned last week that at this juncture in the market, gold can have "chameleon" qualities in that it can be implying inflationary pressures or it can be reflective of investor fears on a wider range of issues, notably challenges in Emerging Markets (EM).  I'm not willing to definitively take a position to which one it is other than to say there is still no inflationary pressures in either the US or the rest of the developed world.  I've chronicled the overwhelming deflationary and disinflationary forces in the global economy in many past commentaries.  

As we review Emerging Markets this week, we see that EM issues were marginalized although I don't know that any of the problems that were responsible for the "flight to safety" trade over the past few weeks have gone away:

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This is a weekly chart of the iShares MSCI Emerging Markets ETF (EEM) and technically the ETF has been siting on Fibonacci support for the past two weeks.  This is a chart to watch for the clearest clues on whether global markets are "out of the woods" so far as EM woes are concerned.  

And here's an update of the ratio chart showing the relationship between the iShares JP Morgan USD Emerging Market Bond Fund (EMB) and the iShares Barclays Seven to Ten Year Treasury Bond Fund (IEF).  Understanding the relationship is simple.  When the chart is rising Emerging Market bonds are outperforming Treasuries as investors are willing to leave the safety of Uncle Sam's debt for riskier "paper".  And when the ratio is falling there is an aversion to risk as investors leave riskier debt for the safest "paper" in the world. 

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The green line is the S&P 500 and both the ratio and the S&P are moving in tandem and higher.

Of course, all the positive price action in EM in the latter part of the trading week could be attributed to the fact that China, which is the overriding source of many EM problems, was closed all last week in celebration of their Lunar New Year.  

Here's another important chart I'm watching:

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 This is a daily chart of the Currency Shares Japanese Yen Trust (FXY) with the S&P 500 super imposed behind it (green area).  Notice the fairly tight inverse correlation between the Yen and the S&P 500.  This is primarily due to interest rates.  Japanese interest rates are the lowest interest rates in the world.  Because of this fact, when times are good investors will borrow money in Yen and buy assets in other currencies which earn a higher interest rate.  This arbitrage (known as the "carry trade") is very lucrative but conversely, when investors "run for cover" like they did in the past few weeks they will "unwind" these trades, effectively buying back the Yen they borrowed.  This, in turn, creates upward pressure on the Yen.  Hence, the inverse correlation we see above.

The Yen fell back this week as "risk off" quickly turned into "risk on".  But this relationship has been very valuable in determining market direction on even an hourly basis in the recent past.

Finally, here's a technical thesis I'd like my readers to consider:

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In posing this thesis I want to emphasize that it is a speculation.  We can say that if there's a Head & Shoulders" bearish formation that is developing there is clearly a "left shoulder" and a "head".  What we can also definitively say is that there is NO semblance of a "right shoulder" at this point.  A symmetrical pattern would call for the S&P 500 to rally up to the 1810 level then slowly roll over.  But these patterns do not need to be symmetrical to be valid.  And there is just as much chance that the S&P marches from here to all time new highs.

This coming week will tell us much about where stocks are going.  We have some big economic reports on Thursday (Retail Sales) and Friday (Industrial Production & Consumer Sentiment) but all ears will be listening to Janet Yellen in her first appearance on Capitol Hill as she testifies before the House financial Services Committee on Tuesday and the Senate Banking Committee on Thursday.  Her statements, phrases, words and where she places  adverbs and adjectives in sentences will be parsed by the street in an attempt to discern the inner most thoughts of the FOMC.  Expect another volatile week in either direction.

Thanks for reading my commentaries and your support!