Saturday, February 22, 2014

The Fed Spooks the Market

The major averages finished the week mixed with tech and small caps staging impressive gains.  Their large cap brethren, however, struggled for momentum amid a series of economic reports which suggested that, at the least, our economy had hit a "soft patch" very much akin to the pattern of the past five years.  And the release of the January FOMC minutes on Wednesday afternoon provided yet one more worry for market participants as the first discussion on the possibility of raising short term rates sent chills through the market.

Nevertheless, when all was said and done, the market took the weak economic reports with a grain of salt; attributing much of the weakness to the weather.  And while I do believe people don't shop for cars and homes in snow drifts and 30 degree below zero temperatures, the weakness cannot be all attributed to the weather.  As an example, the January Housing Starts report on Tuesday was dismal with new housing starts down 26% but housing permits in the west were down a whopping 23%.  Zerohedge quipped, "that's where the snow must have been the strongest".

The market is obviously coming down on the side of the multitude of economists who are saying that the recent spate of data is an anomaly and that we will start to see a strong recovery coming into mid year.

I'm ambivalent as to the direction of the economy so I'll take my cues from the markets.  It's pretty clear that stocks still want to go higher despite all the volatility but there is just no catalyst to push them to new all time highs.  Small caps had an impressive week gaining 1.34%.  Here's a daily chart of the Russell 2000:


(click on chart for larger image)

The Russell is still trapped under an "inside" trend line established from the November 2013 low.  However, it's performance last week tells me it may be reclaiming the leadership that led equity markets higher through 2013.

The mid caps had a good week as well:


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The S&P Mid Cap Index is bumping up against it's all time new highs set late last year.

And, of course, the S&P 500 is also hovering near it's all time highs:


(click on chart for larger image)

I left the outlines of a "Head & Shoulders" pattern thesis I posited a few weeks ago because I do believe that theoretically it is still valid.  However, as I stated last week, we are much more likely to see a triple top if the S&P is going to roll over.  In any case, I don't think we're going to see a rollover.  Any news or other catalyst that is interpreted positively by the market will trigger a break out to new all time highs which will send the "shorts" scurrying for cover, lending more fuel to the rally.  We could see a significant pop in the averages.  

I want my readers to understand however, that this is a solely momentum induced rally.  The perception of the Fed having the market's back (which I believe is now suspect after Wednesday's release of the FOMC minutes), mediocre earnings reports regardless of what the fundamentalist "wonks" are saying, and tepid to outright horrible economic reports are hardly the pre-conditions for a healthy market.  In my opinion, we're running on "smoke and mirrors".  Here's a chart to support my statement:

(click on chart for larger image)

This is a weekly chart of the percentage of stocks trading on the NYSE (New York Stock Exchange) above their 200 day moving averages going back to 2007.  Notice the obvious divergence between the chart and the panel above which is the NY Composite Average.  This is a warning sign and because we're looking at the 200 DMA and a weekly chart it has more significance.  

It's not possible, with this breadth indicator, to predict when stocks would enter a serious correction.  It is simply flashing a warning signal to beware.

What would change my mind on the health of the stock market?  Stronger top line (revenue) growth and corporations starting to spend the trillions of cash they're hoarding on capital expenditures that promote money velocity and labor growth.  So far, no cigar ...


Certainly, Treasuries are not as sanguine about our economic prospects as equities are:

(click on chart for larger image)

This is a two hour chart of the Ten Year yield and I've delineated short term resistance based on a double top at around 2.78%.  

And here's a daily chart of the iShares Barclays Seven to Ten Year Treasury Bond Fund (IEF):

(click on chart for larger image)

While the chart doesn't get me excited about a "new dawn" for bonds, if the economy were doing as well as the economists have been stating we'd be seeing much more upside pressure on interest rates.  The message of the chart above is that the bond market is in "wait and see" mode and any movement lower in interest rates will be a clear signal that this economy is not nearly as healthy as some would want us to believe.  And conversely, if we would see upside pressure on rates (above 3% on the Ten Year T-Note) it would signal a strengthening economy.

The riddle of the bond market must take into account the weak inflation numbers we've been consistently seeing and which I've been writing about for the past year.  Disinflation is a sign of weakness in any economy.  Everyone got excited about the .1% uptick in inflation we saw in the overall CPI (consumer Price Index) report released this week but a closer look into the detail of the report showed a strong disinflationary trend in different sectors of the economy.  We've seen some higher commodity prices in the past few weeks which would suggest that inflationary pressures are igniting. Here's a weekly chart of the Reuters/Jefferies Commodity Research Bureau Index ($CRB) which has broken out of a long term down trend line:

(click on chart for larger image)

However, when we look into the reasons for the commodity rally we see that it has much to do with the incredible rally in Natural Gas (NATGAS) and coffee!  There has been some upside pressure in Crude Oil as well but it hasn't been significant.  Industrial commodities are generally moving higher but are still mixed with copper up marginally and steel down.  These metals have not gotten to the place on the weekly charts where we can say a definite uptrend is taking place.  Here's a weekly chart of Copper (still below its downtrend line):

(click on chart for larger image)

The recent run up in commodities has had more to do with a weaker Dollar than a strengthening global economy.  And the same is true for Gold which continued higher this week but appears to be losing momentum:

(click on chart for larger image)

This is an update of a weekly chart of the yellow metal which gives my readers the broad outlines of where we've been and where we might be going.  The short term uptrend remains intact but we still have formidable resistance at around $1350.00/oz.

I thought it was a telling indication that gold traded normally this week, seemingly ignoring a brewing civil war in the Ukraine.  I keep on asking myself why gold has been rallying since the beginning of the year.  I've stressed the "chameleon" qualities that the metal has been manifesting recently and I still believe that gold will be our forward guidance on the health of the global economy and our markets in 2014.

Right now, gold is predicting one of three things:

1.  Inflationary pressures (cost push inflation)
2.  Inflationary pressures (demand pull inflation) and a healthy global economy
3. lower interest rates (gold thrives in a low interest rate environment) which correlates well with a weaker dollar.

I'll let my readers decide which one is the right answer.  I certainly have a proclivity towards Item # 3 because I don't see any "demand pull" inflation which would manifest itself in sustained higher labor costs.  Secondly, for all the "cost push" inflation that central banks have tried to ignite there is simply none to be found (witness here and Japan).

The concerns surrounding Emerging Markets have seemingly evaporated in the past few weeks but I'm not sure why.  Certainly China is noticeably slowing down.  Here's the latest Daily chart of the Shanghai Composite:

(click on chart for larger image)

The Shanghai has been unable to penetrate the resistance line on the chart above and was decisively turned away this week.  And here's a ratio chart I'm following that I use to track the health of the Chinese banks and financial institutions to the general Chinese economy:

(click on chart for larger image)
Courtesy of Michael Gayed @pensionpartners

With all the press surrounding the Chinese "shadow banking" system and the loan over-leveraging in the system I believe if we see a break below the support line above it will not bode well for either China or Emerging Markets in general.


Just as I've said many times that China is the "tail" that the dog" (developed economies in the West) wags, so it is also the "dog" that wags the Emerging Market "tail".  Here's a daily chart of the Wisdom Tree Dreyfus Emerging Currency Fund (CEW):

(click on chart for larger image)

We saw some signs of life in the past few weeks and we did break out of a downtrend line established in late November but we can't seem to get a bounce off the line.

Until we start seeing some meaningful upside on the three charts above my opinion is that Emerging Markets are not "out of the woods" yet.


Analysis

I just want to touch on two points this week.

The FOMC minutes released on Wednesday spooked the market and triggered a sell off that day.  My take on the FOMC minutes is that forward guidance will change "on a dime" regardless of whether the market is projecting rates to stay where they are until 2016. My perception is that the market has grown accustomed to the Fed being it's "friend" and it trusts the FOMC too much not to change their tone entirely based on what they see as changing economic conditions. Don't misunderstand, I'm not predicting they will raise short term rates anytime soon. As a matter of fact, I could see them actually temporarily ceasing the taper based on the persistently low inflationary pressures in the economy manifested in the details of Wednesday's CPI.  But the fact that there was an actual discussion on the topic of when short term rates should be raised was, in my opinion, a warning sign that the market should not listen to what the FOMC says but should be attentive to economic conditions that would necessarily warrant raising short rates.  And I see no such conditions that now exist.  If this economy does pick up in the spring this will be yet another worry and catalyst for volatility the market will have to contend with.

Secondly, I believe this market is going higher in the short term but we better get a break out soon.  The longer we sit at these lofty levels the more precarious stocks become.  Market participants have "written off" all the weak economic data of the past two months and are hanging their hats on "better weather" in March and April to vindicate them.  And they might very well be vindicated.  But watch out below if they're not!

Have a great week!