Of bubbles & deflation

Stocks had a rough week with most of the major averages closing down 1% + and small caps especially taking it on the chin with the Russell 2000 closing the week down 2.41%.

Thursday was a very heavy selling day with rumors abounding that there was significant hedge fund liquidation and even a rumor that the Swiss National Bank was behind the move as they were supposedly re-balancing their huge equity portfolio out of US and into European stocks.

Regardless of whatever reasons for the swoon, stocks were ripe for some kind of pull back and there is nothing yet reflected in the short term technical picture that speak to none other than a "garden variety" correction.  Here's the latest chart on the S&P 500:

(click on chart for larger image)

The S&P briefly traded below it's 50 day moving average on Thursday (blue line) only to bounce back above it on Friday.  The longer uptrend line established from July, 2013 is still intact (blue dashed line).  A drop below the 1950 area would signal further weakness to a target of 1910 - 1900 area.  

However, momentum is beginning to meaningfully diverge from price as reflected in the Relative Strength Indicator (RSI) in the top panel and the KST Indicator (3rd panel above chart).

I laugh when I read the headlines every time the market drops:  "Stocks drop on geopolitical tensions" or "global sell off sparked by US air strikes in Syria".  I feel bad for those folks that have to conjure up some reason every day why stocks swoon or even rally just to make a headline.  For the record, the market could care less about ISIS, Syria, Iraq or even Ukraine.  There is but one issue that this market is obsessed and concerned about:  Fed policy and how it's going to impact the bond market.  Because the bond market will determine the direction of global stock markets, PERIOD!

Former Fed chairman Alan Greenspan admitted that you can never identify a bubble until after it bursts and I'm not a "bubble" proponent regarding the way things are shaping up in financial markets.  And the main reason why is a simple one based on a "reversion to the mean" thesis.  Simply, we had our Armageddon moment in 2008 after a dot.com crash eight years before.  How many times has that happened in History?  

I can present charts that support my thesis that the events of 2008 were singular events, the likes of which financial markets had not experienced since 1929.  Nevertheless, there are obvious distortions in global markets caused by massive central bank intervention that must be adjusted and the market knows this. 

Underneath these distortions still lies virulent deflationary pressures which are still prevalent and is reflected in the price of gold, the Dollar, and other indicators which I will be showing below.

But first, here's some of the distortions:

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This is a weekly performance chart of the Nasdaq Composite going back to before 1995 (blue line) with the NYSE Biotechnology Index ($BTK) super imposed on the chart (red area).  Are biotechnology stocks in a bubble?  Maybe.  What would be the impact on the general market were this trade to unwind?  Not good.

(click on chart for larger image)

Chart courtesy of STREETTALKLIVE.COM

@LanceRoberts 

The chart above captures the S&P 500 at all time highs, margin debt (borrowing money from your broker to buy stocks for leverage and speculation) at all time highs and Junk Bond yields at all time lows.  This is an ongoing and obvious result of the massive infusion of liquidity that central banks, particularly our Federal Reserve and now the Bank of Japan (BoJ), have fed into the system to avoid the deflationary spiral that we were facing in 2008.

As I've written many times over the past few years, central banks have been on a mission to "paper over" the gargantuan deflationary impact of the loss of 34.4 trillion of wealth globally by March 2009.  The strategy has been predicated on "buying time" for the global economy to heal in the hopes that fundamental economic traction can take hold and that we could grow our way out of this mess.  But deflationary forces, while masked, have not been able to be contained as we are seeing in the Euro zone and even here in the US.  The recent strength in the US Dollar and the Dollar's inverse relationship to gold has parallels, however obtusely, with events in the 1930's when "cash was king". 


Gold's recent sell off must be seriously considered as a signal that something may be awry in global financial markets:

(click on chart for larger image)

It's easy to dismiss the sell off in gold to the easing of global fears regarding the status of fiat currencies or that gold is telling us that recent geopolitical tensions are not serious (a correct interpretation of the metal's price behavior) but if we can't maintain present levels in the yellow metal I would suggest to my readers something much more sinister is going on under the surface of the global economy.  Here's a weekly chart of gold with some important levels to watch:

(click on chart for larger image)

Here's another indicator that deflationary forces are gaining momentum in the global economy:

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This is a ratio chart of the iShares Barclays TIP Bond Fund (TIP) and the iShares Barclays Seven to Ten Year Bond Fund (IEF).  TIPs are Treasury Inflation Protected securities investors buy when they believe inflationary pressures are building.  As inflation builds (as measured by the Consumer price index-CPI) TIPS appreciate accordingly.  And when inflationary expectations wane TIPs lose their value.  The chart pits the price performance of TIPS against regular Treasury Notes with maturities of seven to ten years.  If the ratio is dropping (which it is) the bond market is telling us that there is lessening demand for TIPs and disinflationary forces are gaining momentum.  The green line is the S&P 500.

I've posted this chart many times over the years but my immediate concern is that the ratio has actually pierced a Fibonacci support line, breaking a pattern which has been prevalent since July 2013 where the ratio had been in a "Fibonacci Channel" .  The bond market is telling us that disinflationary pressures are mounting. 

When does disinflation become deflation? It depends on who you want to believe.  I watch the PCE (Personal Consumption Expenditure) Price Deflator which will be released again on Monday, 9/29.  Both the Core and and regular deflator are expected to drop 0.1 from the previous months readings.  While the indicator is not warning of outright deflation it is saying that disinflationary forces dominate and that the deflator is below the Fed's target for inflation growth.

Most are dismissing these deflationary signs as the result of a stronger dollar.  And I cannot deny that their thesis is tenable.  But the question must be asked, why is the dollar manifesting such strength?  There is slow to no growth in the Euro zone.  Japan, in an effort to "kick start" an economy that has been in a deflationary malaise for over two decades, has launched a money printing campaign that proportionally dwarfs any monetary stimulus that the Fed has implemented.  In a world of low to no growth, investors flee foreign credit markets to "park" their money in Uncle Sam's debt, willing to potentially tie up their money for ten years with a coupon rate under 3%.

On top of all this, the Fed has just about unwound it's direct monetary stimulus with attendant talk of inevitable short term interest rate increases.  

The Junk Bond market is already reacting to the Fed's change in policy as yields had become inordinately low as an indirect result of Fed policy:

(click on chart for larger image)

Above is a daily chart of the SPDR Barclay High Yielding Bond Fund (JNK). What market participants should be hoping for is a continuation of the decline.  Better that the market starts unwinding these distortions piecemeal because if it happens all at once, that's when fear and blood "run in the streets".

The situation with junk bonds I explained above is "part and parcel" of the market's concern.  How will the rest of the yield curve react to a back up in short term interest rates?  Will it spark a sell off across the yield curve?  And in an environment where it seems as though there's no place else globally to hide will investors attempt to exit in unison?  The reverberation in US stocks would be immediate and severe to a sharp, fast back up in interest rates.  

The message of gold, bonds and the dollar says my concerns are warranted and my thesis is credible.  Hopefully, the market can adjust ahead of the first rate increase which most "on the Street" expect in the second quarter of 2015.

That's it for this commentary.  The situation as it unfolds will be interesting to watch.  Advice to me readers: don't watch stocks; watch the bond market.  It is the "dog that wags the tail (stocks)."

Have a great week!

The 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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