The market took the whole "crisis" in stride as it correctly understood that, human rights violations aside, this was a financial non event that was not liable to morph into a full blown geopolitical crisis. As I listened to some commentators on CNBC this week who were warning that "it wasn't over yet" I kept asking the question: Well then, what's next? Is the UN going to intervene militarily? Is the Obama administration going to send troops? Are the Europeans going to threaten Russia that they will stop buying their NATGAS if they don't pull out of the Crimea?
Outside of an escalation that, at this point, could just as easily be provoked by the West as Putin, the results of the referendum vote will show (either fairly or fraudulently) that the majority of those in the Crimea wish to be part of Russia. And once that occurs, additional sanctions will be implemented (if the West has any options) and the saber rattling and geopolitical showmanship will continue but with lessening ferocity until you have to find a story about it in the B section of your favorite newspaper.
Geopolitics aside, the market showed some impressive strength this week that speaks to a mature bull market which is still very much intact. Small cap stocks resumed their leadership in earnest and surged 1.95% on the week which is a harbinger for future gains in the entire market. Here's a daily chart of the Russell 2000:
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The financials rallied an incredible 3.04% on the week! Here's the Financial Select Sector SPDR (XLF) comprised on the money center banks, American Express, Berkshire Hathaway and other financial notables:
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With small caps and financials leading this market higher there is little doubt we have much more room to run in the market. Certainly, markets are over extended in the short term. There are some signs of froth when we see the TESLA's of the world reaching dizzying heights based on their valuation, high levels of margin debt and an IPO (Initial Public Offering) market heating up as investors seem willing to bid up new issues I wouldn't touch with a ten foot pole. However, I can't argue with the technicals. Until the charts tell me something different the direction of stocks is higher. I addressed last week a thesis posited by Scott Minerd of Guggenheim Partners that is an excellent rationalization of stock prices and their valuations in the current interest rate environment we find ourselves.
The bond market started acting like the bond market this week as it foretold by it's lackluster price action that the Crimean crisis was not really a crisis and as it sold off later in the week, fulfilling a traditional inter market relationship which has been with the market since 1997 - 1998. Here's a daily chart of the Ten Year Treasury yield:
(click on chart for larger image)
It's interesting that the Ten Year yield backed away from that Fibonacci line on Friday. As I've said before, those Fibonacci lines are almost mystical! In any case, yields are still at historical lows and while I become more comfortable every week in stating that the lows in interest rates we've seen in the past two years will never be seen again in most of our lifetimes, yields are not going to run away to the upside anytime soon.
Here's a much longer term perspective on where we are with interest rates. The following chart is a monthly chart of the Ten Year yield which encompasses the great bull market in bonds which started in 1982 when Paul Volcker broke inflation's back:
(click on chart for larger image)
As you can see with the red arrow, we're on the cusp of a second attempt break out above a down trend line drawn from the 2007 highs in yields. I'm not going to be dogmatic in stating that the bond market is in a primary bear market until the Ten Year yield penetrates the black dashed line drawn from the 1982 highs in interest rates.
The financial markets always give its participants something to worry about and this week was no different. I'm going to start with gold and then address the commodity market and these two asset classes will be the primary focus for the rest of this commentary.
I've had some inquiries regarding gold's price action this week. Regular readers of my commentaries know I had called a short term top last week based on technical indicators. That call turned out to be correct. The question I'm getting is, "where do we go from here".
First, the gold miners which are highly correlated to the yellow metal are sporting what's turning out to be significant Fibonacci resistance on both the daily and weekly charts.. Here are both the daily and weekly charts of the Market Vectors Gold Miners ETF (GDX):
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As I wrote last week, gold's turn was predicted by GDX on Tuesday, March 4th. Gold ran into it's own Fibonacci resistance and turned away the following day. The price action I'm addressing is in the "cone" or "megaphone" pattern I've drawn on the chart. See below:
(click on chart for larger image)
Since that time gold has struggled to break away from that Fibonacci level even though it did manage to penetrate it. On Friday, gold came back from a significant intra-day deficit and though it did finish near the lows of the week, it was able to keep it's head over that Fibonacci line.
My concern is the formation that's brewing on the chart. I labeled it as a broadening formation and we could argue whether that label is technically accurate but this kind of scattered price action is indicative of an extremely indecisive market as well as heightened nervousness among investors.
Gold has been one of those unsolvable riddles in the market that I've addressed a few times since the beginning of the year. Certainly, recent price action in the face of geopolitical turmoil was an indication that it was going to roll over this week. Additionally, we have issues brewing in China which I'm going to address below that would suggest that the chart pattern above may resolve itself to the downside.
Gold has exhibited "chameleon" qualities since the beginning of the year; at times violating traditional inter market relationships with other asset classes and sending mixed messages to investors. Is it's price action speaking to the inflation/deflation/interest rate paradigm that the market is presently struggling with? Is it's price action since the New Year predicting inflationary pressures? If so, why the sell off this week in the face of climbing agricultural and livestock prices and heightened geopolitical tensions?
I don't know where gold is going to end up. All I know is that the miners will be the key to its price action and we need to clear the present Fibonacci resistance on the GDX charts and then there is major resistance above that I've delineated on both charts that needs to be overcome.
Industrial commodities staged what can only be described as a violent sell off on Friday based on news coming out of China that a relatively small solar company had defaulted on its debt and that the Chinese government, for the first time ever, was not going to bail out its creditors. Shanghai Chaori Solar Energy Science & Technology defaulted on approximately 15 million dollars of its debt on Friday.
Market analysts hailed the action of the Chinese government as it addresses a longstanding problem in the Chinese debt market: moral hazard. Up to this point investors could throw their money at any company, knowing that inevitably the debt would be backed by the government. The action by Beijing sent a clear message to Chinese investors: due diligence is a part of investing and there is risk associated with investing in corporate debt.
I certainly applaud the action of the Chinese government on their decision. It is something that had to be done and it is decisions like this one that will eventually bring their economy into the mainstream of the global financial market place.
However, in the short term, there is another edge to this blade. The first and foremost consideration is whether the decision will immediately spark a sell off in their corporate debt market. If investors no longer have the Chinese government's implicit guarantee that they will be made whole, will they start dumping their portfolios of questionable companies, of which there are probably many given the over leveraged nature of the Chinese economy? Secondly and a more probable outcome, will the change in investor psychology impacted by the government's decision create an incredible drag on economic growth as investment is liable to literally dry up for the majority of corporate entities on the Chinese mainland?
Interestingly, a ratio chart which I've shown in previous commentaries was predictive of the problem:
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This is a ratio chart of the Global X China Financial ETF (CHIX) and the iShares FTSE China 25 Index (FXI). The ratio is designed to show the relative strength of the Chinese banking sector to the Chinese economy as a whole. As you can see, the ratio failed to hold support and broke down around two weeks ago.
But how has this affected industrial commodities? With the strength of the Chinese growth engine already in doubt and they being the driver behind commodity prices since 2000, here's what happened on Friday. First, here's copper:
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Candlesticks don't get much uglier than that! On the monthly chart Copper has fallen out of a multi year triangle and while still above significant support, a move like this on a long term chart is a warning sign:
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Here's a daily chart of the S&P GSCI Industrial Metals Index which comprises futures prices on copper, nickel, zinc and aluminum:
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These are just two examples of what happened in the industrial commodity space on Friday. Industrial commodities are telling us that the world's growth engine is going to substantially weaken in the coming weeks and months.
I've learned from the past not to predict or at least hedge my predictions so I'm not going to even gander where this is all going. All I know is what the charts are telling me. And the charts are telling me that China is having problems in their banking and industrial system. This cannot bode well for Emerging Markets and will serve as a significant headwind to the global economic recovery.
To be balanced, the Shanghai Composite took Friday's news in it's stride and while finishing down on the day actually finished the week up .08% (flat). However, the Shanghai is technically in a multi year downtrend as can be seen on the weekly chart below:
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Analysis
As I look at the data I've compiled above I cannot help but come away with the thesis that gold was predictive of and is responding to events in China. I can say that the fact that interest rates had a nice pop contributed to the precious metal's weakness this week but certainly gold is telling us that developments in southern Ukraine are a non event.
Secondly, and this is not new news, we have a tail of two economies; a relatively vibrant US economy (as tepid as it is) and a struggling global economy as seen in Europe and Emerging Markets.
The macro issue of central bank intervention and its effect on global financial markets will be the overwhelming concern of our markets in 2014 and well beyond as liquidity is drained and central bank's may be ultimately compelled to raise short term rates. The outcome of all this will be the test on just how strong the global economy is.
There is nothing revelatory in saying we will experience significant volatility this year but I'm very optimistic on the long term prospects of the global economy and our stock markets. However, there is a caveat. Markets don't go straight up and saying that a 5 or 6% correction is adequate to qualify as such ignores the basics of stock market price action. I understand the low interest rate argument and I indeed subscribe to it so I guess the party will end when rates reach some intolerable level; whatever that level may be.
I'll leave my readers with one more chart. This is a monthly chart of the S&P100 Index going back to 1984 with a correlating chart below it of the percentage of stocks on the S&P 100 that are above their 200 day moving average:
(click on chart for larger image)
The chart is instructive in showing the impact of Federal Reserve policy on equities but in particular, the effects of "QE infinity" (purple highlight) initiated in September, 2012. The prospect of an open spigot of liquidity not only sent the $OEX skyrocketing but also broke the downtrend of the internal metric in the lower chart. The recent sell off we had in January sent the percentage of stocks above the 200 day moving average below the trend line but it has since recovered and popped it's head above that line. However, it is looking a bit tenuous at this point. Aside from the fact that the chart can be describes as parabolic this will be an indicator for us to watch going forward. A long term divergence between price and percentage of issues above their 200 DMA cannot be sustained.
The party has to stop at some time! There's no getting around it. But so far, there is no indication on the horizon that it's stopping anytime soon.
Have a great week!
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