Saturday, October 25, 2014

The Tension of Dichotomy

Amidst Ebola scares and concerns about global deflationary pressures stocks, which had looked like they were about to fall off a cliff in the traditionally volatile month of October, did an abrupt "about face" and had a huge reversal day on Wednesday, October 15th, and it now appears the rally is on. 

The fundamental impetus for the move was a statement from St. Louis Fed President Jim Bullard who publicly stated that if disinflationary pressures persisted in this country we could have more "QE" (quantitative easing). The PBoC (People's Bank of China) helped by injecting additional liquidity in their banking system.  Like a junkie who just had his fix, the market sprung forward in euphoria!

Seasonality is taking over and with economic news out of the Euro zone this past week that suggests that, for now, things aren't getting any worse over there, it looks like we're going to come out of October on a strong footing going into the seasonally strong months of November and December. A chart of the NYSE Composite which represents 1900 stocks traded on the NY Stock Exchange is representative of the turn in equities:

(click on chart for larger image)

The NYSE managed to close above neckline support turned resistance (red dashed line) on Friday which I consider to be a significant positive development for stocks generally.  If we look at the Wilshire 5000 Index which is a composite of all US equities the positive development is more apparent:

(click on chart for larger image)

We can see here that the Wilshire has decisively cleared a similar resistance area that coincides with a Fibonacci retracement level.

Technically, we can say that all indicators point to an assault on all time new highs for US stocks.  Of course, anything can happen, and in a world with geo political tensions, Ebola and whatever else pops up, volatility is liable to be with us into the strong seasonal months of November and December.  However, it is hard to ignore what the technicals are telling me. 

Treasuries remain elevated in this environment and this inter market anomaly remains cause for concern.  In a world flirting with deflation, interest rates are anchored and remain near historic lows; not a positive indication for global economic growth.  Here's a daily line chart of the Ten Year Treasury Note yield:

(click on chart for larger image)

The chart is instructive as it points out the post World War II lows in the Ten Year yield back in July, 2012 and the recent plunge in yield which started in late September (green circle).  We're coming back a bit from that plunge and October 15th was a huge reversal day for Treasuries as well as stocks so that could be the "flush out" that was needed for a sustained trend higher in interest rates.  But that is mere conjecture on my part as interest rate sensitive utilities which correlate well with bonds have been resilient throughout.  Here's a daily chart of the Dow Jones Utility Average that tracks the performance of 15 well known utility companies.  Utilities rise when traders/investors anticipate falling interest rates. That's because utilities are big borrowers and their profits are enhanced by lower interest costs. Conversely, utility prices tend to decline when investors expect rising interest rates. Because of this interest-rate sensitivity, the utility average is regarded by some as a leading indicator for the stock market as a whole.:

(click on chart for larger image)

Utilities have surged to all time new highs and on a price relative basis they have drastically outperformed the S&P 500 since late September.  Money continues to flow into the defensive sectors of this market as investors remain caught between a rock and a hard place.  Everyone wants to take the ride higher but in relatively safe sectors (utilities, healthcare and consumer staples). 

As I had outlined in my previous commentary, the distinction of a growing economic recovery in this country along with a European deflationary slowdown has created a tension in global financial markets which makes the idea of a healthy stock market problematic to many.  Even in the US with the positive earnings season we are having which is one of the main drivers of this recent rally, earnings continue to increase on declining revenues:

(click on chart for larger image)
Chart courtesy of Bespoke Investment Group

If stronger earnings are being driven largely by operating efficiencies,how healthy can the US and global economy be?  It's been my thesis for awhile that declining revenues are an indirect result of changing demographics in the developed world (US & Eurozone).  Welcome to the "new normal"!

And then we have oil!  The recent sell off has spurred both positive and negative arguments for economic growth.  On the one hand, consumers benefit significantly from a drop in gas prices as more discretionary income becomes available to them.  On the other hand, the oil and gas boom in this country will abruptly stop if oil drops below $80.00/barrel, as anyone who lives in Texas knows.  It's not profitable to take it out of the ground for prices below that mark.  Here's a monthly chart of West Texas intermediate Crude oil going back to mid 1996:

(click on chart for larger image)

We've penetrated a support line going back to mid 2010 while a larger trend line going back to 1999 (blue dashed) is intact.  Fracking technology and the boom have created an over supply and politically, it is said the Saudis are cutting production in order to punish those they see as their geo political opponents, particularly Russia.  This situation is having an unsettling effect in global markets not only for it's deflationary implications but because it is destabilizing nations like Russia and Venezuela who derive most of their wealth from oil production.  We here in Texas need to be especially concerned because we have weathered the global economic downturn since 2008 very well, largely due to the oil and NATGAS boom.  

Inevitably, the overriding concern I've outlined in many commentaries persists and it's origin lies in the Eurozone. With persistent deflationary pressures emanating out of Europe can there be a dichotomous global growth picture?  Can the US go it alone and grow while the rest of the globe continues in a disinflationary to deflationary low to no growth economic state?

Michael Gayed, in a recent piece here, has consistently argued that inter market relationships continue to warn us that this party cannot go on much longer without some sort of "flush out".  Michael is fond of using the TIP:TENZ ratio to measure investor expectations of future inflation/deflation which is posted below:

(click on chart for larger image)

This ratio measures the iShares Barclays TIP Bond Fund in relation to the PIMCO 7 to 15 Year US Treasury Index.  Investors buy TIPs (Treasury Inflation Protected Securities) when they are concerned about mounting inflationary pressures.  Conversely, regular Treasuries tend to rally in a lower inflationary environment when investors are concerned that economic growth is slowing.  Thus, the numerator (TIP) in the ratio drops when inflationary pressures are waning.

The ratio above plunged in the recent market slide in early to mid October only to recover above a support line established in August, 2011 when markets suffered a serious correction due to concerns over the US credit rating and especially the fear that the Eurozone was set to implode.  

I prefer to use the TIP:IEF (iShares Barclays TIP Bond Fund: iShares Barclays 7 to 10 Yr Treasury Bond Fund)  ratio because it has a longer track record but the theory behind using the chart is the same as Michael's:

(click on chart for larger image)

This ratio continues to drop.

In a brief email interaction I had with Mike in response to his article I cited above I wrote on October 19th:

I believe it can get worse.  I believe in inter market correlations (both inverse and positive).  I don't believe TIP/TENZ can break support without ultimately causing a sell off in equities.  But as I tried to articulate in our interaction on Twitter, as soon as the junkie (the market) gets a whiff of positive central bank news, risk assets turn around on a dime and go higher.  

There's an obvious breaking point in all this.

The other end of the equation is the balance between an obvious yet tepid recovery in US and an EU looking more and more like its going into a deflationary spiral.  Japan is already there.  I ignore China because it is simply the "tail the dog wags".

Can the US go it alone and prosper (relatively) while EU and Japan wallow?  I say no but stranger things have happened and even the brightest among us do not have a definitive answer until after the fact.

As long as the market continues to get it's "fix" and think central banks "have it's back" then investors will focus on earnings and the earnings so far this quarter are beating street estimates (never mind that this is a big game in and of itself).  And that's why I think we could see a year end rally.

As long as central banks prolong the global economy taking its medicine they forestall the inevitable.  The Central Bank experiment to buy time has about run it's course.  Some day soon even "Fed speak" will not move these markets.  And then watch out ...

Have a great week!

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