Saturday, March 29, 2014

Emerging Markets & Treasuries rally?

Stocks had another choppy week and most major indices finished lower.  The uptrend hasn't been violated and the "experts" are speaking of a sector rotation into cyclicals and there is some indication that that is occurring.  However there are also indications that this market is losing momentum and that we may be setting up for some type of corrective price action.  Determining the severity of such a correction is impossible, especially with an incredibly accommodative central bank supporting the market.  Additionally, traditional inter market relationships that have served as a compass to market direction have gone haywire due to a confluence of geopolitical and economic events.  I'll be outlining my concerns and attempting to read the market "tea leaves" in this commentary.

Here's a chart of the Wilshire 5000 which represents the total US stock market:

(click on chart for larger image)

US stocks are in a clear uptrend but the two panels above the chart reflect waning momentum and the Wilshire presently sits on a trend line established from the November 2012 lows.

 Small cap stocks were pummeled this week and finished a whopping 3.51% lower as measured by the Russell 2000.  Here's a daily chart of the Russell as of Friday's close:

(click on chart for larger image)

Notice the very bottom panel under the chart.  The Russell's price relative to the S&P 500 has fallen off a cliff!

As I had commented yesterday on Twitter, the Russell tends to overshoot to the upside and undershoot to the downside because of the volatile nature of small cap stocks.  However, as we look at sector ratio charts we can see a clear movement by investors into defensive issues.  Here's a daily ratio chart of the Utilities Select Sector SPDR (XLU) and the Materials Select Sector SPDR (XLB).  Utilities are seen as a safe haven as they are low "beta" (not volatile) and return higher dividends than the general market.  Additionally, they weather market corrections fairly well.  The Materials ETF is a bet on stronger economic fundamentals:

(click on chart for larger image)

Utilities have been outperforming Materials since the beginning of March as investors seem to be migrating away from economically sensitive stocks.  Here's another ratio chart of the Consumer Staples Select Sector SPDR (XLP) and the Consumer Discretionary Select Sector SPDR (XLY).  The thesis behind this ratio chart is that when economic activity picks up consumer discretionary stocks tend to outperform as the public simply has more money to spend for items other than what they need to subsist.  Conversely, when they are feeling pinched they stick to what they need (consumer staples).  We can also see here that consumer staples are outperforming their discretionary counterparts:

(click on chart for larger image)

Lastly, here's some evidence of the sector rotation that many on the street that they say explains the market choppiness of the past few months:

(click on chart for larger image)

This chart is a ratio of the Industrial Select Sector SPDR (XLI) and the S&P Biotech Index ETF (XBI).  The Biotech sector has been responsible for leading the entire market weakness over the past few weeks after their incredible run up over the past year.  Many on the street attributed "bubble like" qualities to the sector which engendered a wider discussion on the excess liquidity which continues to "float all boats" in this market.  Well, it would appear that some air is being let out of the Biotech bubble and that capital may be moving into Industrials.  The problem with the chart is that everyone is bailing out of the Biotech sector and if I substitute any of the other ETFs for XLI in the chart above I get the same result.  However, in comparing different economically sensitive sectors it does clearly show there is a movement into industrial stocks.  Here's the Select Sector Industrials SPDR ETF (XLI) and the Select Sector Consumer Discretionary SPDR (XLY) which I used in a comparison above:

(click on chart for larger image)

The chart clearly shows that there has been a steady movement into industrial stocks over the past year and that it has accelerated in the last month.

The take away from all this is that investors and traders are concerned about present valuations but not concerned enough to be "running for the hills".  Positioning in defensive sectors and economically sensitive sectors tend to be running in tandem.

Now, the bond market is telling us another story and it's interpretation is not kind to stocks.  Bonds are being stubborn at present levels and prices refuse to drop.  If the economy is truly gaining momentum we should be seeing a commensurate rise in interest rates across the yield curve.  Instead, interest rates dropped week over week on longer duration maturities as the short end gained because of Janet Yellen's pronouncements the week before last.  Trying to understand why longer duration bonds are rallying would require an explanation which would keep me typing all weekend and so I'll just posit some reasons why this is happening:

1. China is buying Treasuries in order to continue to devalue their Yuan
2. Geopolitical events are keeping a bid under Treasuries
3.  And this is an outlier, the Fed may be getting a new customer, the ECB (European Central Bank).  

I'll be discussing point number three in my analysis below but the primary thematic take away from the three points above is that mammoth disinflationary and deflationary forces still reign in the global economy.

Here's a daily chart of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) and we saw a significant short to intermediate term breakout this week on the chart which speaks to even lower interest rates going forward:

(click on chart for larger image)

TLT penetrated gap resistance this week and although it's performance was weak on Friday it did manage to decisively bounce off of gap support.

The bond market has traditionally been inversely correlated with stocks since 1997-1998.  Whenever it runs in the same direction with stocks there has to be a resolution and that resolution is normally resolved in bonds favor.  Remember, lower interest rates signal economic weakness and is not good for equities.

Commodities seem to be telling us a different story relating to the prospects for global economic growth.  Much has been made of the rally in the CRB Index (The Reuters/Jefferies Commodity Research Bureau Index).  I've dismissed this rally in the index as largely due to "one off" events in the agricultural commodity space because of weather or geopolitical issues which are disrupting supply and demand in certain key commodities such as wheat.  I've taken some "heat" for holding to my thesis but I still stand by it.  I will say this: if my thesis is wrong and we don't start to see a reasonable uptick in global economic activity in the spring then the specter of "stagflation" confronts us as central banks will finally have accomplished their mission of perpetuating "cost-push" inflation.  However, I will stand be my thesis and that is still that deflation remains the primary danger to the world economy.

Here's two charts; one of the CRB Index and right below it is the SPDR Gold Trust Shares (GLD):

(click on chart for larger image)

There was a potential Island Reversal pattern on the CRB chart but that has been reversed.  At the same time, I've been looking for Gold to start it's turn around to validate all these inflationary pressures everyone seems to be emphasizing.  So far, no cigar.

Industrial metals had a good week mainly because Copper recovered from multi year lows.  Here's a monthly chart of "Dr. Copper" which clearly shows it "has returned from the abyss":

(click on chart for larger image)

I don't want to minimize the incremental price pressures we have seen in the industrial commodity space.  Another notable mover has been nickel.  But even nickel has been rallying on supply/demand issues as Indonesia, a major nickel exporter, has placed export restrictions on the metal.  My point is that just because we're "coming back from the abyss" doesn't mean all is well.  As a predictor of global industrial activity, we need to start seeing some significant upside pressure in industrial commodities.  So far, this has not been the case.

All was not neutral to negative this week.  Emerging Markets came alive as things seemed to stabilize in China after it's major banks reported strong earnings.  The Shanghai Composite has stabilized above the 2000 level as rumors of additional government stimulus run rampant in the market:

(click on chart for larger image)

And the Chinese banks as a ratio to the broader Chinese stock market are making a comeback:

(click on chart for larger image)

The main concern in China has been the smattering of defaults that the Chinese government has recently started to allow in order to address "moral hazard".  Investors want to know who will be left holding the bag if/when their shadow banking system implodes and the banks have been primary candidates, in investors minds, to "hold the bag".  

The fact that copper stabilized this week and we're seeing strength in the Chinese banks is an indication that things in China are not liable to get out of control.  But you never know!  Chinese markets are not exactly transparent.

Nevertheless, with a seemingly stabilized situation in China the iShares MSCI Emerging Market ETF (EEM) exploded on Monday and never looked back:

(click on chart for larger image)

I circled the week's price action and although Friday's price action was a disappointment (a sickly candlestick) the ETF tore through the 50% Fibonacci resistance level and is now poised to assault the 61.8% level.  After Friday's price action I expect a bit of a pause here and some consolidation.

The move in EM this week is certainly a positive for our markets as there is a strong positive correlation between EM and US stocks.  They are either coincident to each other or one leads the other.  It appears that EM will now play "catch up" with US equities in the weeks and months ahead.  That assumes, of course, that we're not going to have the annual Spring "head fake" we've experienced since 2010.


All the market activity I've addressed above is symptomatic of confusion and indecisiveness in where the global economy is headed.  The consensus among many on Wall Street is that we are truly going to see our way out of this mess in 2014 and with that, the commensurate rise in interest rates will take place that will validate a stronger recovery.

No one is predicting a "gangbusters" year but the positioning into industrial stocks I've illustrated above cannot be denied.  Of course, the debate over market valuation in the face of extraordinary monetary stimulus continues to rage.  

In the meantime, leaders in the EU (European Union) have decided to admit and address the deflationary juggernaut they are facing instead of dismissing it as "internal devaluation".  This week French, Italian and Spanish inflation numbers came in below expectations (read deflation) as did German inflation numbers.  In addition, French consumer spending has deteriorated significantly.  Even the inflation fearing head of the Bundesbank, Jens Weidmann, has agreed to some sort of quantitative easing, if only in theory.

Of course, with all the regulatory strictures placed on the ECB due to a monetary without fiscal union, how QE gets accomplished has been the challenge since the dark days of 2008-2009.

Many are talking about establishing negative interest rates which supposedly would spur European Banks to lend.  The assumption is that banks would lend and that there would be lenders.  My position is that negative interest rates, besides distorting Money Markets, would drive liquidity from the EU as banks would simply move assets offshore to other banks that would give them a return on their capital.  What is needed is a way around their regulations in order to effectuate liquidity injections.  Marc Chandler of Brown Brothers Harriman has suggested what I call "the Swiss solution".  In 2010 as the Swiss started facing deflation from a stronger Swiss Franc, the Swiss central bank, unable to pump liquidity in the system by buying up their own debt (the market being too small) went out into the global debt markets and started buying foreign bonds.  Buying foreign bonds with Swiss Francs expanded their money supply thereby deflating the value of their currency and easing deflationary pressures.  The ECB could do the same as there appears to be no prohibitions to such purchases.  Whether the fickle Germans go along with this would be one question although they could not stop Draghi from these purchases if there are no restrictions on these type of purchases.

If the ECB were to pursue "the Swiss solution" who would be the main benefactor of their purchases?  The US Treasury market!  This would assist in driving rates lower, regardless of any counter forces that would push them higher.

My point in bringing all this up is that these deflationary pressures in one of the two largest developed consumer oriented global economies are the predominant danger to the world economic system.  And we are right behind the Europeans, regardless of what the "experts" say.  Here's the latest update on the Velocity of M2 Money Supply released by the St. Louis Federal Reserve:

(click on chart for larger image)

It is still clocking it's lowest readings since the Fed started tracking it in 1958.  How strong can an economic recovery be when the pace at which a dollar changes hands has been it's lowest on over five decades?

Here's another chart that measures the three components of inflation:

- the CPI (Consumer Price index)
- Compensation & Salaries
- Velocity of M2

(click on chart for larger image)
chart courtesy of
All three components are headed lower.

Here's another way to analyse the data.  This is called the "High Inflation Index" which tallies Year over Year CPI (Consumer Price Index), wage growth and M2 Money Velocity :

(click on chart for larger image)
chart courtesy of

So, what does all this have to do with stocks?  In an environment where the world's largest and most powerful central bank is starting to drain liquidity from the global monetary system, Europe is facing outright deflation and disinflationary pressures are mounting in the US.

As stated above, the debate has raged for years regarding the extent to which the Federal Reserve's extraordinary liquidity programs have effected equity markets.  And while there can be no denying that, in their efforts to spur a "wealth effect" there has been an artificial inflation to equity prices the question is, how much?  And how much of the current disinflationary pressures we are dealing with will exacerbate a downturn in the stock market when it occurs?  For occur it must!  The market never goes straight up or down.  And these five to six percent corrections hardly qualify as corrections.

In the meantime, we have an active economic calendar coming up next week culminating with the Monthly Employment report on Friday.  Everyone will be watching this report as an indication that the much awaited turn around in poor economic data as a result of the inclement weather in January and February was an aberration.  But to me, the ECB's announcement next Thursday may be more important.  If they are unwilling to aggressively address the deflationary spiral they are clearly caught up in then inevitably it won't matter over the long haul how well our economic stats are in this country.  We're all inter-connected and you can't have a healthy global economy with a major sector of that economy in the throes of deflation.  It can be likened to trying to swim with a thirty pound weight around your waist!

Have a great week!