Saturday, December 6, 2014

What's ahead for the market in 2015?

Stocks continue their ascent to new all time highs though, from the looks of the charts, the air seems to be getting thin up here:

(click on chart for larger image)

Above is a daily candlestick chart of the S&P 500 covering the last six months and there a few points I want my readers to notice:

  • The small candlesticks in the green shaded areas with black arrows on the main chart highlight the indecision in the market as the S&P moves into new high territory.  When candlesticks are that small with "tails" on the candlesticks it delineates ambivalence and uncertainty among participants regarding future market direction.  Contrast this price action with the larger candlesticks in the earlier advance from the October lows (blue arrows) where the tall candlesticks spoke to conviction in the advance higher. 
  • Also notice momentum indicators are waning with a divergence in the upper panel (black arrow)
Still, the S&P is riding its five day moving average higher (red dashed line on the chart) and there is no indication that a pause in the rally is imminent.  Momentum indicators on daily charts can signal divergences for protracted periods of time before any corrective action can set in.

Sentiment has been extremely bullish in recent weeks which is usually a contrarian indicator.  The idea behind extremely bullish sentiment readings is that if everyone is in the market who is left to buy it?  Below is a chart of the Rydex Total Asset Ratio going back to late 2011.  The ratio measures investors who are in bullish funds versus those in money markets or in bearish funds.  It gives us a snapshot of what investors are doing with real money; not just surveys about how they feel about the market:

(click on chart for larger image)

The three bottom panels on the chart above measure the amount of money in bearish mutual funds, money markets and bullish mutual funds.  Money has moved drastically into bullish mutual funds (bottom panel) since the October 15th low but has backed off a bit in the past week or so which may be giving this market additional breathing room to move higher.  However, the readings are the highest they have been since 2011.

The big question pertaining to the ratio above is how much new money is still sitting on the sidelines waiting to get in.  The prevalent opinion on the street is that there's a lot more.  This factor could provide more levitation to stocks going into the new year.  We shall see ...

With employment numbers coming in better than expected on Friday and various other economic reports signalling a strengthening US economy, any possible corrective action could be worked off with side ways price action before another leg higher.  We also have seasonal factors which are serving as a tail wind to this market.  If we're going to see any weakness in this market it better come in the next week.  Otherwise, the Christmas spirit is going to kick in on the street and we will get our year end rally with the S&P easily piercing the 2100 level.  

If we give any credence to post 2008 crash history, the rally could even persist into February before any marked weakness manifests itself.

With persistent good news about the US economy the market is bracing itself for the seemingly inevitable "normalization" of interest rates and is anticipating that the Federal Reserve will raise short term rates in 2015.  This week, short term rates spiked in the futures market after the non manufacturing ISM came in stronger than expected and the monthly employment report blew away expectations.  Below is a daily ratio chart of the US Two Year Treasury yield and the Ten Year Treasury yield.  The white arrow signifies the yield performance of the Two year compared to the Ten Year while the top panel shows the relative performance of the two yields:  

(click on chart for larger image)

The significance of the chart may be lost on most readers but it is signalling a flattening of the yield curve.  For readers who might not understand the implications, a steeper yield curve signals a healthy economy and when the curve starts to flatten it means that credit conditions are deteriorating as lenders demand higher interest rates for short term money as concerns grow they might not be paid back on time or at all.  

However, in a world where central banks have done all they can to manipulate credit conditions to fight off the gargantuan deflationary forces that are trying to take down the global economy, the traditional interpretation of the yield curve can only be implemented with significant caveats.

With the US economy picking up momentum and the rest of the world in a stagnant economic situation, the market is still anticipating that the Fed will commence raising interest rates next year.  Thus, the futures market is pricing in this supposed inevitability.  However, longer term Treasury rates are barely budging as money in search of yield and more importantly, safety, is still fleeing to the long end of the curve due to continuing weakness in the Euro zone, Japan and China.

And then we have the ongoing argument concerning the precipitous drop in oil prices which is stirring a debate on whether this is good or bad for the global economy.  Some are heralding a deflationary boom next year as lower gasoline prices act as a tax cut, adding more discretionary income to strapped consumers in the hope that they will kick start a still relatively moribund economy.  But it is still an open question as to whether changing demographics and their attendant economic implications will allow this "tax cut" to have much effect on the global economy.

The other side of the argument is that regardless of any particular supply imbalances which may have caused the precipitous drop in oil prices, the price action in "black gold" is speaking to a deteriorating global economy where demand for the backbone commodity which every economic entity needs to fuel growth is seriously waning. 

Who wins the argument?  I take the "other side of the argument" because I believe that changing demographics in the consuming economies in the West is the predominant driver for the deflationary forces we are presently dealing with and I would submit to my readers that these changing demographics were the backdrop to the 2008/2009 financial debacle that almost undid the global financial system.  In any case, here's a weekly chart of West Texas Crude after Friday's close:

(click on chart for larger image)

We have some support at $65/barrel.  The Saudis made a statement this week that they see oil (in their case Brent crude) settling at $60/barrel.  In fact, no one knows where oil will settle at.  I believe if we break the $65/barrel level we will move quickly to the $48 to $54/barrel band on the chart (labeled potential drop zone).

Fundamentally it must be remembered that as demand slackens for any commodity the seeds of higher prices are planted as production recedes because producers cannot make money with such low end prices being offered.  And the RSI momentum indicator in the top panel of the chart above is deeply oversold.

Nonetheless, the "knock on" effects of these significantly lower prices which have dropped so suddenly over a very short time period are not a healthy sign in my opinion.

Gold has had some volatility recently and the "bugs" got excited again when the price popped over the past week.  But the prognosis for the "yellow metal" is still negative and is yet another sign of a weak global economy.  Here's a weekly chart of Gold going back six years:

(click on chart for larger image)

Could gold be forming a significant bottom?  Let's hope so!  Because if it drops thru the $1150 - $1100 level and into the potential target area on the chart above it will signify a radical weakening of the global economy.  I've stated many times in past commentaries that, given the preconditions set by global central banks, a sustained bounce in the price of gold will be a verifying signal that the global economy is finding it's way out of this mess.  But, for now, the trend in gold is clearly down.

The rising dollar is having the effect I predicted in past commentaries as money gets sucked out of emerging markets and into the coffers of the safest currency and government bond market in the world.  The following chart is a daily chart of the Wisdom Tree Dreyfus Emerging Markets Currency ETF (CEW) and I've highlighted all the major policy decisions of the Federal Reserve and their effects on Emerging Market currencies:

(click on chart for larger image)

What's readily apparent from the chart and the recent Fed history is that every time the Fed even hinted that US monetary accommodation might be taken off the table emerging market currencies tanked.  The recent weakness in currencies is spilling over into emerging market equities in spite of the worldwide rally in risk assets:

(click on chart for larger image)

This is a daily chart of the iShares MSCI Emerging Market ETF (EEM) and you can see that the ETF never really recovered from the worldwide correction in stocks that took place in September into mid October.

And what about China?  I was challenged this week by a thoughtful investor regarding the recent almost parabolic rally in the Shanghai Composite Index.  I would submit to my readers that the recent spike in the Shanghai Composite is the result of the newly approved link up between Hong Kong and Shanghai that allows easy accessibility for foreign investors to freely trade on the Shanghai; something that has never happened before.  Shanghai-Hong Kong Stock Connect is a securities trading and clearing links program for establishing mutual stock market access between Mainland China and Hong Kong.  This has facilitated an influx of trading volume by investors which is driving prices higher.  Another factor is the ongoing hope that the Chinese government is willing to continue stimulative monetary measures (similar to QE). Their surprise announcement two weeks ago regarding lowering a benchmark interest rate has market participants on the edge of their seats waiting for more monetary accommodation; all the result of a continuing housing bubble deleveraging, continued corrupt market practices and the ongoing challenges inherent in changing their export driven economy into a consumer based economy.  I would submit to my readers that rather than watch the Shanghai composite Index for signs on how China is faring, watch the Baltic Dry index.  This index is one of the purest leading indicators of global economic activity. It measures the demand to move raw materials and precursors to production.  China, being a leading importer and end user of these same raw materials, should be the main catalyst in driving this index higher:

(click on chart for larger image)

The Baltic Dry index is the top chart.  It never really recovered from the Great Financial Crisis of 2008.  It did bounce as did the Shanghai Composite (second panel) as the result of the initial quantitative easing program the Federal Reserve implemented in order to stave off depression.  Since that time both indexes have meandered  flat to lower.  So, where is this sudden strength in Chinese stocks coming from?

I've said it so many times that my regular readers are sick of hearing it but I'll say it again:  China and emerging markets are "the tail the dog wags!"  In our current environment, if you want to know which way the global economy and risk assets are heading in 2015 you need to look to Europe.


The Federal Reserve is in a quandary.  With a seemingly strengthening US economy making ZIRP (zero interest rate policy) untenable they are faced with raising interest rates with inflation significantly under their target rate of 2% and with the rest of the globe flirting with deflation!  

Indeed, the Euro zone seems to be losing the battle against the deflationary juggernaut as can be seen in the chart below:

(click on chart for larger image)

With the annual change of the inflation rate only 0.3% the EU could fall into deflation and recession if its economy literally just tripped.  Germany, who carried the EU thru the past five years is also suffering serious disinflationary pressures:

(click on chart for larger image)

German CPI has flat lined at 0.8%

The German manufacturing giant has also fallen into contraction:

(click on chart for larger image)

With all this going on, market participants still continue to "grasp for straws" when any economic report comes in above expectations as a sign that Europe is finally turning around. The market got excited yesterday when German factory orders came in above expectations, as though one reading of this volatile series speaks to a developing trend.

The other "straw" investors and traders seem to be hanging on is the supposed inevitability that the ECB (European Central Bank) is inevitably going to break down and buy European sovereign debt, much the way our Federal reserve brought Treasuries over the past five years.  

The weakness in stocks we had during the first hours of trading on Thursday were the result of Mario Draghi, the President of the ECB, comments during his press conference after the ECB governing counsel met.  It was clearly apparent and he even stated that there was significant division among the members of the governing counsel on implementing any other measures that might mitigate the ongoing deflationary pressures building in the Euro zone.  The press conference was decidedly down beat with the further comment that the ECB would monitor the progress of the other stimulus measures already implemented and reassess the situation "next year" and that did not meaning January either.

I've got news for everybody.  The ECB will NEVER buy sovereign debt for the reasons that the Germans, who are the deep pockets in Europe, will never agree to finance their poorer and sometimes profligate southern neighbors.  And if I'm right about this, and I have hardly ever felt so sure of something as this, then Europe is going to have to "pull a rabbit out of a hat" to get their borderline recessionary economy going.

Can they do it?  Anything is possible in the realm of economics and the financial markets but it clearly is not probable.  If US consumption could make the kind of gains that spur emerging market and Chinese economies then our economic steam engine could keep chugging but I cannot say I have a lot of confidence that we could carry the global economy alone.

In the meantime, the Fed seems to be on track to start raising short term rates sometime in the second quarter of 2015 (most think in June).  What would be the implications if they raised rates in an environment where the Eurozone was barely growing?  Well, we're seeing it now as the market is currently pricing in the first raising of short term rates but I suspect that the long end of the yield curve (10 and 30 yr. yields) would also finally jump.  Such a move in the Treasury market would cause the US Dollar rally to continue with the following results:

  1. Deflationary pressures would mount due to the continue strengthening of the Dollar.
  2. Money would continue to be sucked out of emerging market economies but at a quickened pace.  You'll almost be able to hear the sucking sound ...
  3. The strengthening Dollar would negatively impact earnings of US companies doing business overseas by making their goods more expensive in foreign currencies.

So, maybe the Fed will keep ZIRP?  I agree with Jeff Gundlach of DoubleLine that the Fed really has no choice but to start the process.  Jeff even stated that they'll probably do it just to see what happens.

The principle behind raising rates is that the economy is strengthening, allowing creditors to charge more money to lend it.  But we live in a global economy and what we, the Germans, the Chinese and the dozens of emerging market countries do, effects all of us together.  We're no longer silo'd in our own economies. There are "knock on" effects when the largest and most powerful central bank on the planet decides to raise interest rates.  In our present economic environment, even more so ... 

So, the markets in 2015 will be largely and substantively held captive to the economic progress or lack there of in Europe.  

This is my last commentary for 2014.  Have a Merry Christmas and a great holiday season!

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

The information contained in this writing should not be construed as financial or investment advice on any subject matter. This writing is not published for the purpose of utilizing the information for short term trading or long term investing in stocks, bonds, ETFs, mutual funds,currencies, indexes, index or stock options, LEAPS, and stock or commodity futures. I expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.  Seek the personal, face to face guidance of a registered investment advisor before entering any trade or investment.  Anyone who trades or invests based on the information in this commentary does so at his/her own risk.  

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