Saturday, January 3, 2015

All eyes on Europe!

As we commence a new year, stocks still hover at all time new highs and while cracks seem to be forming in the market there is still no indication that any type of significant correction (over 20%) is on the horizon.

The following is a daily chart encompassing the last year and eight months of the Wilshire 5000 which is the entire US stock market:


(click on chart for larger image)

The chart is instructive in that it identifies a series of short term corrections (tan arrows) that punctuated the inexorable rise higher.  In spite of successive new highs momentum indicators have deteriorated (top two panels above the chart) and with the October down draft we broke a long term uptrend line (blue dashed) that started in July 2013.  The subsequent rally to new highs and then the December weakness has created an "ascending triangle" (tan dashed lines) which is a bearish formation.  

Nevertheless, the size of the triangle and the time it's taking to form suggest that, even here, any pullback will be relatively shallow.

Discussions and decisions are being made in the policy rooms of central banks which will have profound consequences for all financial markets in 2015 and in the meantime is wreaking havoc with traditional inter market relationships that have prevailed in some cases for up to almost eighteen years!

Let me lay a foundation for the rest of the commentary by making a statement everyone already knows: the entire bull market in equities over the past six years has been predicated on central bank largess; the deliberate inflation of risk assets in order to buy time for the global economy to heal after the loss of tens of trillions of dollars in wealth as a result of the 2008-2009 crash.

That regime has now ended in this country and the Federal Reserve is actually preparing to start a tightening cycle by reversing their zero interest rate policy (ZIRP) by raising short term interest rates.  In a global economy where the US Dollar is the reserve currency this can be problematic if other economies are not in a recovery phase of their business cycle.  And frankly, at this point, no one is but us.

The impact of Fed policy is already having a huge impact on emerging markets which is only exacerbated by the mammoth global deflationary forces that still exist.  With the anticipation of higher interest rates in this country, our currency is strengthening with the commensurate effect that money is being sucked out of emerging markets.  The following is a weekly chart of the Wisdom Tree Dreyfus Emerging Markets Currency Fund (CEW) with the US Dollar super imposed on it.  The almost lockstep inverse relationship is quite obvious:

(click on chart for larger image)

As the US Dollar strengthens, all debt denominated by dollars in the emerging market complex becomes more expensive in their currencies and it is only a matter of time before defaults take place and economic growth slows even further:

(click on chart for larger image)

Above is a daily chart of the iShares MSCI Emerging Market ETF (EEM) and you can see that while US stocks fully recovered from the nasty October down draft, emerging markets stocks did not and they were turned away from gap resistance last week in the midst of our "Santa Claus" rally.  This is all the result of a stronger Dollar.  

There is no end in sight to the Dollar's incredible rally.  This is a monthly chart of the US Dollar going back to the late 1990's and we are in the midst of piercing key multi-year resistance.  Fundamentals suggest we will be surpassing this level shortly:

(click on chart for larger image)

The reason for the Dollar rally is simple enough. While we have completed our monetary easing cycle in this country it is apparent that the other two countries whose currencies make up the majority of the Dollar Index are just starting their easing cycles.  

The Japanese Yen, which makes up 13.6% of the Dollar Index is literally being trashed by a quantitative easing program which proportionally speaking, dwarfs the Fed's easing efforts of the past six years.  And now, with the possibility that the European Central Bank (ECB) is  finally going to do what they have to in order to expand their balance sheet to facilitate easy credit conditions, the Euro, which is 57.6% of the Dollar Index, is precipitously dropping, possible to parity (one to one) with the US Dollar.

Because global central bank policies cannot synchronize policy, technical distortions are starting to manifest themselves in the market, turning traditional inter market relationships on their head.

Here's a chart of the German Ten Year Bund yield (green line) with the Commodity Research Bureau (CRB) Index (a basket of 19 commodities-yellow area))  super imposed upon it which highlights the direct effect of deflationary forces on global interest rates:

(click on chart for larger image)

And yet, with global commodity prices still dropping which is the classic sign of weak economic conditions, the Fed is preparing to raise short term interest rates!  

In a normal economic and business cycle, the so called "yield curve" (a line that plots interest rates at a set point of time) should steepen in a healthy economy and gradually flatten until it becomes inverted as an economy deteriorates and slips into recession.  However, the US yield curve has been gradually flattening for the past few months as the futures market prices in the supposed inevitability that the Fed will raise short term rates while the "long end" of the curve stays anchored and moves lower:

(click on chart for larger image)

And why is this happening?  With so much slack in the global economy and the prospect of rising interest rates in the US, global money flows are still reaching for "safe yield" and Uncle Sam's debt is the safest place to park your money in a world where most economies are flirting with economic contraction.

At the heart of the situation is a virulent deflation which is manifesting itself to the public in incredibly lower gasoline and producer prices.  While seemingly a boon to our wallets, dropping commodity prices in the environment we find ourselves in is a "double edged sword" that can have very negative implications

And so, divergent policies emanating out of Japan and the US and a stubborn Europe which seems unable to make a commitment which would create the necessary conditions to facilitate global growth are creating a tension which must be unwound.  We may start to see the unwinding later this month when the European Central Bank meets on January 22nd.  The expectation is growing in the market that the ECB will be compelled to start sovereign bond purchases in the market in order to ease credit conditions in the Euro zone.  While I still have my doubts on whether this will occur, others who I greatly respect think that some sort of sovereign bond purchase program will be announced after the meeting.

I had the opportunity to interact with Marc Chandler, Senior Vice President and Global Head of Currency Strategy at Brown Brothers Harriman in New York on line a few days ago, and he believes the ECB may elect a 500 billion euro program in which the national banks carry the debt on their balance sheets rather than the ECB; a policy that would appease the Germans (somewhat).

I believe that the results of the January 22nd meeting in Europe will have a determining effect on the direction of equities in 2015.  With a Federal Reserve ready to raise interest rates in this country, a sovereign bond purchasing program in the Euro zone would fit "like a glove" to soothe the tensions both in the global economy and in the financial markets.  The fundamental ramification of such a policy decision would be the expectation that global economic conditions would start to normalize, allowing the rest of the planet to commence growing as Europe starts consuming again, thereby providing the catalyst for growth in the emerging economies of Asia and the Pacific Rim, regardless of a strengthening dollar.  Whether this expectation is ultimately viable without structural economic reforms in the Euro zone is irrelevant to the markets over the next year.

Remember the simple formula: the emerging markets and China, being primarily export driven economies, are held captive to the consuming economies of the developed world (US & Europe).  With a firm commitment in the Euro zone to truly implement a significant monetary easing program, I believe emerging market economies and their stocks would take off to the moon!  Moreover, I predict another year for US equities similar to 2013, where the S&P500 returned north of 29% for the year.

And speaking of China, I've had a few inquiries regarding the Shanghai Composite's incredible rally.  This is the daily chart and it is certainly impressive!:


(click on chart for larger image)

  Here's the weekly chart:

(click on chart for larger image)

So, given my grand thesis articulated in this commentary, how can China be rallying when the rest of the world, save the US, is floundering?  A simple answer: Chinese government stimulus.  In a deflationary environment and with an economy that is still export based (regardless of the  desires of Chinese officials for a consumer based economy which is still years away), the economic numbers coming out of that nation are either flat or in contraction  territory which is just what we would expect in a world still dominated by the consuming economies of the west.

What would change my mind about China?  A breakout on the weekly chart above would compel me to rethink my thesis not only on China but my grand thesis on what will be moving our markets in 2015.

So the outcome of the ECB meeting on the 22nd and the details of any sovereign bond purchase (if there is one) will be pivotal to the market's reaction, either good or bad.  With the Fed ready to raise interest rates in the world's reserve currency, any indication that the ECB is waffling or holding back will precipitate a world wide sell off in equities with emerging markets and China taking the brunt of the beating.  And this is why volatility is starting to enter equity markets (along with over-bought conditions and unbalanced sentiment readings).

We'll see what happens on the 22nd!  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

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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