Saturday, March 1, 2014

Of Black Swans & The Wall of Worry

Notwithstanding the Ukraine/Crimea crisis which shook the market on Friday, stocks had another banner week with most of the major indexes finishing north of 1% on the week and new all time highs in mid Caps, small caps and the S&P500.  Here's how the S&P looked after Friday's close:


(Click on chart for larger image)

Consternation entered the market on Friday afternoon as news hit the airwaves that either Russian troops and/or private militia hired by the Russians had landed at two Crimean airports.  I had been waiting for the news since early Friday morning after Reuters ran a story that Russian troops had seized the two major airports in the Crimea.  I posted the following on Friday morning on Facebook:


"Anyone with any military background knows that you need to seize transportation centers before you can move in a military force large enough to accomplish its mission. This is especially necessary for the Russians since the only way they can get anyone in there is by flying them in. Russian occupation of the Crimea is a certainty as Putin will protect Russian interests - the Russian Black Sea Fleet".

Regardless of any demonizing of Putin by the mainstream press (and he should be demonized; he's a thug) the occupation of an area around a vital military installation which has been a bulwark of Russian defense for hundreds of years was predictable.

The market came off it's highs at around 1:20PM and by 2PM was sporting a pretty serious reversal.  However, some buying came in the last hour and saved what would have been a negative close.  As we look further at the price action, examining the inter market relationships that indicate whether fear had entered the market, we see the following:

(Click on chart for larger image)

This is a five minute chart of: 
  • S&P 500 SPDRs ETF (SPY)
  • iShares Barclays 7-10 Yr Treasury ETF (IEF)
  • SPDR Gold Trust Shares (GLD)
  • Powershares DB US Dollar Index Bullish (UUP
The traditional inter-market relationship would see investors fleeing stocks for some combination of all three risk averse assets (Dollar, Gold and Treasuries).  As the news hit the wires at about 1:20PM (see the x axis on chart above) we did see the inter-market relationships come into play but the feeble nature of the response told me that this was mainly a stock event as traders were not taking a chance of going into the weekend "long".  The Dollar, which had been selling off all day did a "dead cat" bounce and while there was some buying pressure in gold the precious metal still ended the day down 0.45% as measured by the SPDRs Gold Trust ETF (GLD).

In the near term it appears what is going on in the Crimea, especially after Obama's speech Friday afternoon, is going to create some volatility in our markets. 

As stocks have been moving higher so have bonds with the commensurate lowering of yields.  Here's a two hour chart of the Ten Year Treasury Note Yield and I've highlighted the yield swoon that commenced on February 21st after the Ten Year yield effectively made a double top as well as what amounts to the last day and a half of trading (blue shaded circle):



(Click on chart for larger image)

The drop in yields on Friday is directly attributable to the events taking place in the Crimea but the drop in yields since February 21st is telling us that the bond market does not think things are as rosy as stocks do.

And here's a daily chart of the Ten Year yield from its May, 2013 bottom:


(Click on chart for larger image)

I could have delineated a "head and shoulders" formation on the chart above but I decided not to as they never seem to come to fruition anymore.  I think Fed policy has ruined it ...  :-)

Whatever the bond market is trying to tell us until we start seeing some upward pressure on rates (moving up to 3% on the Ten Year) stocks may be floating in the ether for any number of reasons but it's not because of a robust economy.

Gold's price action has stalled at Fibonacci resistance this week which was a revealing indication in the face of the geopolitical turmoil that came to the fore in the latter part of the week.  Certainly, we would want to see the yellow metal fulfilling its role as a safe haven with kind of bad news.  The price action suggests investor unconcern about the events in the Crimea and elsewhere but even more about  gold's future direction.  

Interestingly, the precious metal miners were predictive of gold's weakness by a day.  Here's a daily chart of the Market Vectors Gold Miners ETF GDX:

(Click on chart for larger image)
GDX ran into Fibonacci resistance on Tuesday and promptly did an about face.  The metal followed on Wednesday:

(Click on chart for larger image)

Unless we see an escalation of tensions over the Crimea next week we may be seeing a turn in the gold market.  Regular readers of my commentary know that I'm watching gold very carefully because it is predictive of future inflation which would be indicative of global economic strength.  Deflation has been the nemesis of the global economy since 2008 and central banks have been in a pitched battle in attempting to turn the huge deflationary and disinflationary forces around by sparking inflationary pressures.  There is some indications that they might be but the verdict is still very much out and any inflation is not in the right places.  This is maybe the reason why gold is pausing at it's present levels.

Here's a daily chart of the Reuter/Jefferies Commodity Research Bureau Index (CRB).  The CRB  comprises 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.

(Click on chart for larger image)

The CRB has gone almost parabolic since mid January but when we look at the commodities that are driving the index we see that they are mostly price changes in "soft" commodities like coffee and sugar which have had supply/demand dislocations from "one off" events like the weather.  Of course, NATGAS has impacted the index as demand surged due to the extremely cold winter we've been experiencing.  We are still not seeing any meaningful price pressues in industrial commodities.  The following chart will support my thesis regarding the disconnect between industrial commodities and the entire CRB Index:

(Click on chart for larger image)

This is a price relative chart of the CRB and six economically sensitive commodities or groups:

  • Copper
  • Aluminum
  • Nickel
  • The Dow Jones World Basic Materials index
  • The Dow Jones US Steel Index
  • Lead
I've smoothed the lines by applying a 20 day exponential moving average to the chart.  You can clearly see that the entire index is outperforming the individual industrial commodities which comprise it.  This is certainly not indicative of "demand pull" inflation (see last week's commentary for definition) which is healthy in the beginning phases of an economic recovery.  Neither is it indicative of global economic strength.


  Here's a monthly chart of the CRB which is gives us a macro perspective of the commodity complex:

(Click on chart for larger image)

The CRB has managed to pierce a multi-year downtrend line established from the June 2008 highs due to the factors I've identified above.  However, it slammed into Fibonacci resistance this month and is sitting right below that marker.

Finally, I just want to touch on China.  We had some important news on Friday night when the Chinese released their closely watched Manufacturing PMI (Purchasing Managers Index) report and it slightly exceeded expectations coming in at 50.2 versus 50.1 forecast.  The important fact is that it is still signalling manufacturing expansion (barely).  It certainly isn't helping the Chinese stock market which seems to be floundering; searching for direction.  Here's a daily chart of the Shanghai Composite:

(Click on chart for larger image)

The Shanghai is in the middle of a downtrend channel after being repulsed earlier in the month at a significant resistance level.

It's difficult to gauge what's going on inside the Chinese economy because economic reports are not generally reliable and there are many crosscurrents as they struggle with run away debt leverage, a shadow banking system that's feeding it and the Chinese government's objective of transforming that country from an export based to consumer based economy.  But the immediate concerns surrounding China emanate from their banking system and for that reason I pay particular attention to the following ratio chart.  This is a price comparison between the Global X China Financial ETF (CHIX) and the iShares FTSE China 25 Index (FXI):

(Click on chart for larger image)

We've broken below a support line on the chart which is speaking to relative weakness in their banking sector.  When I run the ratio with the total Chinese stock market it is not showing the same level of weakness but there has been a significant breakdown since the beginning of the year on that chart as well:

(Click on chart for larger image)

The debate has raged for years on whether the Chinese can stage a soft landing to their slowing economy.  The key to their success is how they manage their "shadow banking" system and the huge debt they are carrying on their books, thanks to the infrastructure development which served to keep them afloat after the events of 2008.  The two charts above will serve us well in coming weeks in assessing the success or failure of their efforts.


Analysis

As I stated above, recent events in the Ukraine/Crimea are liable to provide more volatility in global markets next week but I sincerely believe that it will be short lived and if there are any serious reverberations, stocks will soon regain their composure and move higher in the coming two months.

I am beginning to believe that the weak economic reports of the past two months are primarily due to the weather, and bond market concerns aside, the economy is on track to stronger yet lackluster growth.  

There is much chatter on the street whether present stock valuations are over extended and I found the following chart, courtesy of Scott Minerd of Guggenheim Partners, helpful in understanding the price/earnings ratio debate in the context of the interest rate environment we find ourselves:

HISTORICAL P/E RATIO IN DIFFERENT INFLATION ENVIRONMENTS

(Click on chart for larger image)

Scott makes the point here that "Low inflation tends to support larger price-to-earnings ratios, as the lack of price pressure facilitates easy monetary policy which encourages multiples expansion."  

I've found Scott's insights to be "spot on" many times and the chart above as well as his commentary has assisted me in sifting through the myriad of views on the street surrounding fundamental stock valuations.  

The chart above means we still have more room to run.  With an accommodating Fed and tame inflation that can't eat into corporate profits, the only thing we need be concerned with is the lack of "demand pull" inflation which is the result of subdued consumption.  I'm not minimizing this challenge but assuming the present rates of growth can be maintained stocks will march higher this year.  

Any number of events/issues can throw the markets a curve ball and the concerns articulated above regarding the price action of bonds, gold and China continue to tell us that we need to be vigilant in spotting the "bad pitch" should it come.  Understand though, that these concerns are all part of "climbing the wall of worry".

So, outside of a "black swan" event which, in my opinion, is a minority scenario and would most likely emanate from China, stocks are moving higher folks!



Have a great week!