Saturday, August 30, 2014

A Recovery With Lower Interest Rates

August turned out to be a great month for stocks as many of the major indexes hit multi-year new highs or all time historic highs.  Early August saw a shallow pullback only to be met by new buying as the "buy the dip" mentality still holds sway in US financial markets.  While stocks have just rallied 5% in three weeks, it is prudent to expect some type of pullback.  However, we must always remember that stocks don't necessarily "pull back" to work off an "overbought" condition.  In strong bull markets (of which this is one) overbought conditions can be corrected by side ways action which we have seen this week.  Nevertheless, there are some divergences developing that could be an early signal of a pullback.  But first, let's get an overall picture of this market:

Here's a weekly chart of the S&P 500 from the March 2009 bottom:


(click to enlarge)

The S&P cracked the 2000 level for the first time this week on light pre-holiday volume and I expect it to maintain these levels and possibly move higher on light volume next week as many traders will stay in the Hamptons after Labor Day, not coming back until September 8th.  

The daily chart of the S&P looks equally as strong although we are getting mixed signals on some of the momentum indicators I follow:


(click to enlarge)

As readers can see, the Relative Strength Indicator (RSI) in the top panel has diverged from price while the nature of the KST indicator suggests we have more room to run.  The Price Momentum Oscillator in the bottom panel looks strong also but with the very faintest hint of a rollover.

When we look at the entire US stock market as captured by the Wilshire 5000 Index the divergences are more apparent:

(click to enlarge)

The second panel above the chart measures net new highs and the indicator has crossed it's signal (red) line meaning that new highs in individual stocks are not keeping up with the price action.  The PMO (Price Momentum Oscillator) in the bottom panel also speaks to a growing divergence in momentum as new all time highs are being reached.

When looking at these divergences it must be remembered that regardless of the divergence, none of these indicators are below the "zero" line which would indicate a much more serious divergence.  So, what we can gather from these divergences is that the market may be setting up for some corrective action but nothing more than the "garden variety" type of correction.

For the fundamentalists out there that do not trust technical analysis the following chart may be helpful in assessing the future direction of this market:

(click to enlarge)
chart courtesy of Sarhan Capital

The chart is instructive in that it shows the PE Ratios of the S&P 500 at the two previous tops in 2000 and 2007 and the P/E Ratio presently.  Any short term corrections aside, this market definitely has more room to run!

Treasuries are acting counter intuitively to the price action of equities as interest rates should be rising on the prospect of greater economic growth which are reflected in stock prices.  But there are some global concerns out there and some technical factors that are presently feeding this latest surge in Treasuries and the attendant drop in interest rates.  I will be addressing these concerns below but let's look at some charts:

Here's a daily chart of the Ten Year Treasury yield going back three years which captures the lowest interest rates we've seen on the Ten Year Note since 1942 and the highest rate registered on 12/31/2013:

(click to enlarge)

As you can see, technically we've breached a major support line which overlaps with the Fibonacci levels I put on the chart.  How low can rates go?

It's important to understand that fundamentally interest rates are a very accurate gauge of economic growth.  But the picture gets "fuzzy" in our current world of global financial interrelationships.  Certainly, events in the Ukraine have something to do with the "flight to safety" trade but it is not impacting Treasuries as much as some might think.  Global deflationary pressures are still very much with us as whole areas of the European Union slip into outright deflation (regardless of the rationale that "internal devaluation" is effective in correcting imbalances in a system where there is monetary union without political or fiscal union).  And then there are purely technical reasons for the recent pressure on interest rates.

With yields on German 10-year bunds at 0.90% and Japanese government bonds yielding around 50 basis points,  US Treasuries are comparatively attractive (our Ten Year Note closed at 2.342% on Friday).   Also, the perception that both Japan and the European Union will be forced to implement further quantitative easing measures makes it reasonable to expect that global capital will continue flowing into Treasuries, pressuring Treasury yields down even as quantitative easing draws to an end.

There's also a much more esoteric technical factor that may be driving rates lower:  as interest rates drop it normally spurs a wave of refinancings.   Prepayments will spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.

Certainly, commodities have been reacting in a consistent matter with the drop in global yields.  The CRB (Commodity Research Bureau) Index composed of 19 different commodities from agriculturals, oil and industrial metals has only now found some support after close to a swan dive in the past month:

(click to enlarge)

The fact that the CRB has bounced off of Fibonacci support is an encouraging sign as Europe appears to be descending into deflation.  Commodities will normally turn up later in the business cycle after stocks.  The fact that these cycle relationships are presently skewed owes much to the efforts of global central banks to stem the tide of the threat of the debt deflation of 2008.

Gold is signalling that global economies are slowly strengthening with insignificant inflationary pressures:

(click to enlarge)

The main take away from this chart is the relationship between Gold and the Gold Miners (GDX).   The bottom panel is a price relative comparison of GDX (Market Vectors Gold Miners ETF) to the price of the precious metal.  Historically, Gold Mining shares have led the metal higher and we are seeing relative strength in the bottom panel.  Also, the bottom chart is a daily chart of GDX and I highlighted a major support area when the ETF gapped higher in late June.  Nevertheless, the chart for the metal is decidedly bearish as the down trend remains intact with waning momentum (top panel).

Gold can't get a rise anywhere!  The Ukraine crisis was a perfect example of a metal that "can't get out of it's own way".  But we need to continually watch the chart above because Gold will be the predictor of any inflationary pressures when they finally arrive on the global financial scene.

When will that be?  I'd have to write another commentary to support my thesis but I believe global demographics in the developed world will foster low growth and contained inflationary pressures for the better part of the next decade. 

Part of the reason for the weakness in commodities and gold as well as the strength in Treasuries can be traced to the rally here:

(click to enlarge)

This is a weekly chart of the Powershares DB US Dollar ETF which is the popular traded proxy for the US Dollar if you don't want to trade the currency itself.  The Dollar has been in rally mode since early July as the market's perception of the inevitability of QE (quantitative easing) in the Euro zone has reversed the strength in the Euro, which is roughly 57% of the Dollar Index.  And because of the rally here, commodities and gold have been under pressure.

What I want my readers to notice is the positive correlation between the Dollar and equities identified in the panel directly below the chart.  Since 1997, and especially since 2008, there has been a strict inverse correlation between the USD and equities but we are seeing something different in the last two months.  Now, "we've seen this movie before" but a continuation of this positive correlation would validate a return to normalcy we haven't seen since the Asian Currency Crisis of 1997. 


Analysis

As we consider where we are in the market what are the possible events/circumstances that can possibly derail the present rally?

1.  Ukraine? Outside of a commitment by the Obama administration to putting US troops on the ground (chances are absolutely zero) even a commitment of NATO troops to "maintain peace" is not going to cause any significant reverberations in financial markets.

2.  A commitment of US troops to battle ISIS in Syria will not shake financial markets.

3.  Deflationary pressures in the Euro zone can possibly have an economic impact on global economic growth but even here the outcome of a deflation scenario and it's impact on our market is uncertain.  It must be remembered that we have been in an environment in which the one time second largest economy in the world, Japan, has been continually been dealing with deflation since its onset in 1990.  Even "Abenomics", the conscious effort to create inflation in that country, is having at best, mixed results.

Euro zone deflationary pressures may also not be what they seem.  The latest CPI (Consumer Price Inflation) report showed that the main drivers of the deflation were food and gas prices while core inflation remained unchanged.  Now, the overall number is still extremely low and borders on deflation which is the result of extremely weak growth, especially in the peripheral economies of Spain and Italy.  However, if the ECB (European Central Bank) implements QE (Quantitative Easing) next week as some expect, markets will rally as the Euro initially will rally driving the US Dollar lower.

I personally do not believe the ECB will act yet as there is considerable opposition from the Germans against any implementation of QE.  All things being equal, Europe can still muddle along without much of an impact on our markets.

4.  The biggest concern I have is the effect that rising interest rates will have on stocks once rates start to rise in earnest.  The Fed is projected to start raising short term rates in June, 2015 although some on the street believe this will happen sooner.  The "short end" of the yield curve is already backing up in anticipation of this eventuality but the long end ( longer dated maturity bonds) are rallying for the reasons I cited above which is causing a flattening of the entire yield curve.  However, I suspect this will change quickly when we get closer to the first official announcement by the Fed.

If long term rates start to back up quickly we will have a significant correction in equities.  Don't misunderstand, I'm not calling for an "Armageddon scenario"; it's just that after 5 years of Fed manipulation of the markets there will be significant technical and psychological readjustments to the market.  

Fed policy has driven many "yield hungry" investors into the market and once rates rise some of these investors will move back into more traditional interest bearing alternatives.

How and when this all shakes out is the big question for the market.  If the market can gradually adjust to this Fed induced transition there may not be much of an effect.  And admittedly, the first increase of short term rates will be insignificant in itself.  It's how the rest of the yield curve, especially the long end (10 to 20 year maturities) react.

We will gather more clues on this quandary as time goes on but I don't see this having any significant effect on our markets in 2014.  I can easily see the S&P at 2300 by the end of the year with perhaps a small correction in the interim.

Next week will be a big week for employment numbers with the culmination on Friday of the Monthly Employment Report.  Fed Chair Janet Yellen has made the statement repeatedly that wage growth matters and the street will be scrutinizing the measure of hourly pay for production workers that the Fed monitors.  

And, of course, events on Thursday in Europe will be watched as the ECB meets.  Any decision to implement a "shock and awe" QE will be met with a global market rally.  But I wouldn't expect it.  Mario Draghi has his hands full politically with the Germans.

Have a great week!



TThe statements, opinions and projections made in this writing are for informational purposes and are my own.  They do not represent the views of my broker/dealer.  Additionally, this writing does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by me in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction

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