Saturday, November 8, 2014

Global Economy at a Crossroads

Stocks managed to squeeze out new all time highs on Friday afternoon after the S&P bounced between gains and losses for the entire day.  A one minute chart of the S&P illustrates the nature of the indecisive price action.  The horizontal blue dashed line delineates the day's trading activity:

(click on chart for larger image)

The market seemed to be held captive to a seemingly weaker than expected monthly employment report although the report was not, to me, any weaker or stronger than any other monthly report we have seen in the last year.  Employment continues to grow five years after the Great Recession with the same challenges we face in terms of weakness in hourly earnings and wage growth.

I interpret the surge into the close as a short term bullish indicator as the price action is indicative of the "smart money" taking positions in preparation for next week.  Moreover,that traders were willing to take positions over the weekend is a sign of confidence and probably complacency among market participants.

A long term divergence is manifesting itself on the weekly charts that folks should be cognizant of.  Below is a weekly chart of the S&P 500:

(click on chart for larger image)

While the S&P continues its march higher, momentum has significantly diverged (top panel) from the price action.  While these divergences can persist for long periods of time while the market moves higher it is important to note the divergence because it is usually predictive of some type of corrective action.

There are sector divergences that have me puzzled since other fundamentals would suggest that these sectors should be strengthening.  For instance, the Consumer Discretionary Select Sector SPDR ETF (XLY) has been weakening all year and while the descent relative to the S&P 500 ETF (SPY) has moderated it is still in decline.  The chart below is a daily chart of the Consumer Discretionary Select Sector SPDR ETF (XLY) and the relative price action relative to the S&P 500 ETF (SPY) is in the panel below:

(click on chart for larger image)

With the price of gas as low as it has been for years one would think we would see strengthening in this area.  

Also of note is the price action of Utilities, a defensive sector of the market, which has been outperforming the S&P on a relative basis for weeks:

(click on chart for larger image)

The bottom panel shows the price relative to the S&P and I circled the week's price action on the chart.  Of note technically was the price action on Wednesday and Thursday where the utilities swung wildly and while the two candlesticks on the chart in the green circle I outlined cannot be classified technically as a bearish engulfing pattern, it is close.  Bearish engulfing patterns are predictive of a turn to the downside.  

Still, it's hard to argue against the position that the trend in equities is higher.  With seasonal factors in the market's favor and earnings season being a good one, I'd still have to side with those expecting a surge in equities going into the Christmas season.  However, 2015 may be a different story.

As Treasuries continue to stay levitated while equities rally higher it seems investors are trying to position themselves on both sides of the fence.  And I suspect for good reason.

While the economic recovery from the Great Recession continues to gain momentum in this country it is evident to all but the most uninformed that the rest of the world wallows in flat to no growth conditions.  Indeed, as the European Union continues to teeter on recession and Emerging Markets are held captive to the consuming countries in the west, the US is the only shining economic light on the planet.

The rest of this post will dissect the title of this commentary.  And I'll state my thesis up front:  fundamentally speaking, Europe is the key to the direction of financial markets while the Dollar will serve as the technical catalyst for that direction.

The Europeans have been "hamstrung" by the unique relationships they have in that union.  Those relationships can be summarized as "monetary union without fiscal union" and so as everyone shares the same currency they all go their own way as separate political and fiscal entities.  

The Germans, who have been essentially the glue (aka money) that keeps that union together, are loathe to support their southern neighbor's profligate ways.  This, in turn, has prevented the European Central bank (ECB) from implementing the kind of monetary accommodation that the US and Japan have implemented in the attempt to turn their economies away from the deflationary pressures wrought by the loss of 34 trillion in global wealth in the 2008 - 2009 downturn.

Mario Draghi, President of the ECB, keeps on promising more stimulus but unless the Germans acquiesce and allow the ECB to buy sovereign debt (country specific sovereign bonds comparable to US Treasuries) the effects of any other stimulus they have attempted since 2010 has had diminishing effects.  There has been some talk that as recessionary conditions start to spread to the core EU countries (Germany, Netherlands, France, Finland) that Germany may give in and allow such purchases.  Don't hold your breath!  Germans still suffer the scars of the Weimar hyperinflation of 1922-1923 and are not likely to agree to any policy they see as potentially inflationary, like a US style QE.  But this is precisely what is needed to remedy the situation in the EU.

There are some signs that the deflationary pressures may be relaxing.  Money supply there is incrementally improving:

(click on chart for larger image)

And private loan demand is also marginally improving although still negative:

(click on chart for larger image)

Clearly, these glimmers are not enough for me to "hang my hat" on a European recovery.  Others on the street agree with me.  Scott Minerd, Chairman of Investments and Global Chief Investment Officer for Guggenheim Partners believes the Europeans and particularly the ECB must act now to prevent their slowdown and growing deflationary pressures from taking over and dragging the rest of the global economy along with it.

The strength of the US Dollar has been the result of the weakening picture in the EU and is exacerbating the deflationary pressures we are seeing in commodities and particularly gold and oil.  As the Euro, as the result of in some cases negative real interest rates on the European continent, continues to drop, the Dollar index, made up of a basket of currencies of which the Euro is 57%, continues to rally.  As the world's reserve currency, a strengthening Dollar necessarily equates to a depreciation of all other currencies making everything more expensive in those currencies.  This, in turn, only serves to aggravate any economic slowdown in those economies.

For now, the US Dollar seems as though it might have reached a temporary plateau:

(click on chart for larger image)

As seen above, USD is meeting some significant resistance and Friday's price action in the Dollar could be taken as just a rest in response to market perceptions that the monthly employment report was not up to par or it could be interpreted as the beginning of a corrective phase in the Dollar.  I'm going to opt for the latter because I don't believe these markets move that much anymore on these monthly employment reports.  

Fundamentally, the Dollar might be meeting resistance because the US trade deficit, if broken down to petroleum and non petroleum trade deficit, has diverged significantly:

(click on chart for larger image)

Big trade deficits are antithetical to a strong currency.  If this is impacting USD and the Dollar goes into corrective mode it will be supportive of global stock markets.  However, with everyone on a crusade to debase their currencies in order to ignite growth, the US is still the best looking house in the slum and any slowdown in the appreciation of the Dollar will probably be short-lived.

Japan, which announced another mammoth liquidity injection in their economy a week from this past Friday, also adds fuel to Dollar appreciation.  Bank of Japan (BoJ) is going all out to break the hold deflation has had on their economy for over two decades and is flirting with monetary accommodation many see as reckless:

(click on chart for larger image) 

The chart above shows the comparison between the Fed's QE program with projections into 2015 along with BoJ's stimulus.  How can the Dollar not continue to rally in the face of Japanese currency debasement and European inability to stem the deflationary tide seemingly overtaking them?

A stronger Dollar equates into profit margin pressure in US multi national corporations as their products become more expensive overseas in markets with deteriorating global growth.

And what of Emerging Markets?  Many on the street are touting their value in this sluggish global environment.  Not me!  The argument that says that as the Fed attempts to normalize monetary policy by raising short term rates, there will not be a commensurate global shift of assets from the more speculative emerging market complex to the safer haven of the safety of Uncle Sam's debt is misguided.  While it is true that some Asian nations have strong external balances and may be able to fare better than they did in 1997 when the Asian Currency crisis crushed emerging markets, to invest in emerging markets in the face of a strengthening US dollar is a fool's game!  The chart below is a weekly chart of the WisdomTree Dreyfus Emerging Markets Currency ETF (CEW).  This ETF measures the performance of a basket of Emerging Market currencies relative to the Dollar:

(click on chart for larger image)

As can be seen, CEW has been posting a succession of lower highs and is now sitting on major support.  A breakdown under this support is in direct contra distinction to the US Dollar chart I posted above and I would submit to my readers that such a breakdown in CEW and a break out in USD will spell an ugly start to 2015 for global equities.

The iShares Emerging Markets ETF (EEM) is already starting to discount the coming weakness in emerging markets due to a strengthening Dollar.  The chart below is a daily chart of EEM with the S&P500 ETF (SPY) superimposed on it (solid black line) as well as a price relative comparison in the top panel:

(click on chart for larger image) 

In the near term, the massive Japanese stimulus measures announced about a week ago should continue to buoy US equities in the near term and that's why I'm comfortable with predicting a continued rally into year end.  However, there are enough technical divergences and fundamental problems that must be resolved that the new year may auger renewed weakness in global financial markets.  

Make no mistake, Europe is the key to 2015.  Unless, the ECB is given free reign to truly stimulate their currency bloc then we must hope that the few glimmers of economic growth I posted above will evolve into a full blown recovery for the EU.  Absent these two scenarios, a strengthening Dollar will strangle global economic growth to the detriment of everyone, including us in this country.

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 or my broker/dealer 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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