Friday, February 14, 2014

Why the Rally Resumed This Week

Janet Yellen's first appearance before Congress on Tuesday morning was the catalyst for this week's 2.32% gain in the S&P 500 as well as many of the other major indices.  The Russell 2000 surged 2.92% on the week while the Wilshire 5000 which is the total US stock market finished at 2.41%

It's not as though Ms. Yellen said anything that anyone didn't know already but the market was soothed by validation of the continuity that was taking place at the Federal Reserve as the Bernanke/Yellen policy transition appears seamless.

The market ignored a spate of absolutely ugly economic reports, from new car and home sales to industrial production as the popular interpretation of said poor reports was that the frigid weather in December and January kept a good percentage of the nation house bound.  I tend to agree with these opinions as it would probably not be a good idea in fifty degree below zero weather in Chicago and go house hunting or shopping for a car.

Stocks took off on Monday and never looked back.  Here's an update of the S&P 500 as of Friday's close:

(click on chart for larger image)

For those who read last week's commentary I posed a thesis on a possible "Head and Shoulders" top on the S&P which I have still outlined on the chart above.  I was challenged on Twitter this week by someone who obviously did not read my commentary that I made an incorrect call on market direction.  I emphasized here that the thesis was a speculation; that without a "right shoulder" there was no pattern and that the S&P could just as well march to new all time highs.

It appears that, as of this time, the potential pattern is just that: potential.  I will say as I did last week that these patterns do not have to be perfectly symmetrical to be valid and we could still develop a "right shoulder" but that is now a minority scenario.  There's a better chance that if this rally is a head fake a triple top would be the more likely chart pattern to watch for.

I've been trying to reconcile some of the skewed inter market relationships that have existed and still do exist in the market this week and I believe I've found the answer to at least one of those inconsistent relationships.  The riddle that gold has posed to this market since the beginning of the year has puzzled many and I've addressed this issue a number of times in recent commentaries.  I've stressed that without any apparent inflationary forces to be detected, gold had to be signaling a "safe haven" trade of some sort.  The reason could have been the Emerging Market currency woes that initially started the recent shallow correction in stocks we experienced.  However that seemed an inadequate explanation for this significant upward move in the yellow metal, given the relative severity of Emerging Markets currency pressures.

Many have explained the rally based on the pick up in demand for the physical metal in China and now India as they lift recent import restrictions.  However, I also read somewhere that JP Morgan is now on the "buy" side of the trade and it all might have to do with Germany's recall of their physical gold reserves we've been holding since the end of WWII?  I don't know much more than this and I'll leave it to my conspiratorial friends to take the story from here but JP Morgan is a major if not the major player in the gold futures market and if they're on the buy side then gold is going higher!  Here's the latest weekly update on spot gold:

(click on chart for larger image)

Assuming the trend remains intact we could see $1400.00 gold in the near future.

What can't be explained away is the price behavior of bonds.  It's quite clear from the price action that Treasuries do not share the optimism the stock market has for the growth prospects of our economy.  Don't misunderstand, it's not as though Treasuries are pricing in a bad economy.  To me, the bond market is acting more tentative than anything else.  For instance, on Thursday the S&P rallied 10.57 points but the entire yield curve also rallied with the Ten Year T-Note dropping 38 basis points on the day.  This is a clear violation of the inter market relationship between Treasuries and equities.  Now, it was just one day but throughout the entire week interest rates stayed relatively anchored while stocks rallied.  This tells me that bonds are not on board with this rally; at least not yet.

Now, regardless of the inconsistencies I've identified above we do have many other indications that this correction is now over and that stocks are ready to rally to all time new highs.

The catalyst behind the recent weakness in stocks have been the currency pressures on some of the Emerging Market economies.  This has forced higher interest rates on these countries in order to defend their currencies with the commensurate drag that higher interest rates would have on their economies.  The main fear the market had was the contagion that could spread as healthier economies might be forced to adjust their interest rates to defend their currencies.  I'm going to post two ratio charts to show that this potential crisis appears to be abating.  The first is a US Dollar/ Wisdom Tree Dreyfus Emerging Currency Fund ($USD/CEW):

(click on chart for larger image)

I've delineated the major events which have impacted this currency cross since early May, 2013 and it is apparent that Federal Reserve decisions regarding QE were mainly responsible for EM currency woes.  However, recently there has been a precipitous drop in the US Dollar against Emerging Market currencies.  On the chart above, a weakening Dollar versus EM currencies signals then end of the crisis as EM currencies are regaining their balance after the events of the last month and a half.

Here's another chart that has more significance in that it is the Japanese Yen/EM cross ($XJY:CEW).  It's significance lies in the fact that the Japanese Yen is used universally in the famous "carry trade" where investors will borrow money in Yen and buy assets in other currencies which earn a higher interest rate.  This arbitrage is very lucrative but conversely, when markets get "dicey" like they did in the past few weeks investors will "unwind" these trades, effectively buying back the Yen they borrowed.  This, in turn, creates upward pressure on the Yen.

(click on chart for larger image)

As you can see, the Yen is also weakening against EM currencies and this is a more significant indication that the issues surrounding EM currencies are abating as hedge funds, traders and investors are resuming the "carry trade" .

Besides that, EM stocks had a big week and cleared Fibonacci resistance:

(click on chart for larger image)

We still have a ways to go before I consider this ETF a "buy" but the chart is certainly not telling me that EM problems are getting worse.

It's the same with the EM currency ETF (CEW) which gapped higher on Friday:

(click on chart for larger image)

If our markets are going to move higher, emerging market equities are going to lead the way.  Why?  Because they have been the most effected by the Federal Reserve's unwinding of their monetary accommodation and if they can weather that storm then it is indicative of a global economy that is truly on a firm and stable economic and financial footing.

I've attempted to be as unbiased as I can in laying out the thesis for a higher market.  As one who relies primarily on charts and technical analysis for making decisions I have to conclude that we've experienced an ephemeral correction which is now over.  However, I'm troubled because the bond market is not giving us an "all clear" yet.

Could the market be rallying on perception? While it is true that easy money policies are still intact thanks to Janet Yellen there is a generally accepted consensus that all the negative economic reports this week were the result of bad weather.  I'm also not convinced that Emerging Markets are finally adjusting to the Fed's unwinding of it's accommodation. However, my feelings are irrelevant.  The market is telling me something different.  I just wanted to articulate my opinion for the record.  :-) 

Emerging Markets are obviously inversely correlated to the US Dollar and Japanese Yen as seen above.  And the chart below shows that the inverse correlation between the Dollar and stocks has become prevalent in the past few weeks:

(click on chart for larger image)

The chart above is a daily chart of the Currency Shares Japanese Yen Trust (FXY) with the S&P 500 superimposed behind it.  The Yen strengthened this week as the S&P rallied.  This is an opposite relationship than has existed in the past.  Indirectly, the chart tells me. that a weak US Dollar was mainly responsible for the rally in stocks this week and the pop we saw generally in the commodity complex.

Here's another proof of my thesis:

(click on chart for larger image)

The S&P is represented by the green line while USD is the candlesticks.  

The market appears to be self adjusting itself to the "risk off - risk on" paradigm that was prevalent through the tumultuous times 2008 through 2012.  Remember, in "normal" times a country's currency tends to track it's equity market as it's equity market is a direct reflection of the economic and financial health of that nation.  Obviously, all the artificial bolstering of our economy mainly through monetary stimulus over the past five years has created aberrations that have impacted this economic paradigm but if the US is in a real recovery that will manifest itself in 2014, Federal Reserve withdrawal of monetary accommodation should assist the US Dollar in strengthening and the financial markets should be turning away from the "knee jerk" risk off/risk on paradigm that seems to have recently been embraced by the market.

My statements above are in no way comprehensive or inclusive of the wider issues that are effecting USD performance, like our huge deficits and runaway spending in Washington.  I've touched on these topics briefly in past commentaries and I have a decidedly more optimistic view of the Dollar and the long term health of the US than most others.  The purpose of this commentary is to only address immediate fiscal and political issues as they effect our markets on a short term basis.

Next week will be another busy week on the economic calendar.  Markets are closed on Monday in observance of President's Day.  We'll get some info on the health of manufacturing in our economy on Tuesday (Empire State Manufacturing) and Thursday (Philly Fed & PMI Manufacturing Index).  On Wednesday we will get the latest read on inflation with the PPI (Producer Price Index).  This report may throw a curve ball at us because the Labor Dept. is rolling out a new report that supposedly captures "final demand".  So unless the report comes in significantly below expectations I won't be taking it seriously.  On Thursday the CPI (Consumer Price index) will be a big report to watch given the falling inflation rate we have been experiencing.  Finally, the Federal Reserve releases the minutes from their January 28-29th FOMC meeting which will be parsed and analyzed to death by the street.  Many are looking for any comments regarding how the horrible weather in January may have impacted Fed decision making.

There will be some inflation and manufacturing data out of the Euro zone this week but after the modestly positive GDP reports last week the general market perception on Europe is that it is slowly coming out of its malaise and that deflationary forces are currently under control.

That's it.  Thanks for reading my commentaries and have a great week!