Bad News For A Commodities Breakout

After more than two years and a half of downtrend, many analysts and pundits were calling the end to the cyclical commodities down wave this year. Since many of its components, in particular gold and agricultural, were already breaking out to the upside, I tended to agree with that analysis.

Though, this week FOMC meeting shifted my view on what to expect in the next few months for commodities and inflation. Why?

• Wednesday press conference shifted the narrative.
• Emphasis changed from near-zero interest rate to eventual hikes.
• The Federal Reserve revealed a post meeting hawkish bias.
• Bellwether price action deteriorated.
• US economic strength has been re-emphasized. 

From a macro perspective this change in tone is what George Soros refer to as "playing changes in the rules of the game" because that is the kind of event that changes market participants perception of the market place and creates orderflow that speculators can profit from.

In her press conference on Wednesday, Fed Chair Yellen accidentally caused the market to focus, laser-like, on the seemingly casual phrase “six months.” Prior to the presser, the narrative was focused on near-zero interest rates and their positive effects. “The US economy is recovering nicely,” the line of thinking seemed to go, “and we will have super-low rates for quite a while yet.” To hear SIX MONTHS was the needle scratching across the record.

This event is even more damaging for commodities as it happened right at the moment when the market seemed to wonder if it was more concern about inflation or deflation. See below chart of the ratio between bonds and gold, one of the best inflation/deflation indicator:

Just when the ratio was trying to break out to the upside, this week FOMC decision seemed to kill any hope for commodities bull as it created a bearish engulfing candlestick pattern right at the downtrend resistance line.

Some commentators inclined to shut their eyes tight and wish a dovish Fed back into existence, next-day comments from Fed members Fisher and Bullard are a blast of cold water. Consider these wire headlines (Zero Hedge):

*BULLARD SAYS YELLEN'S '6-MONTHS' COMMENT IN LINE WITH SURVEYS 

*BULLARD SAYS FED WATCHFUL FOR 'ANY KIND OF REPLAY' OF BUBBLES 

*FISHER SAYS FED HAS EXHAUSTED EFFICACY OF U.S. QE POLICY

*FISHER SAYS ASSET-BUYING TO END BY OCTOBER AT CURRENT PACE *FISHER SAYS SOME MORE VOLATILITY IN MARKET WOULD BE HEALTHY 

Here is another great comment from Joe Kalash, Chief Global Macro Strategist at NDR,  “Although Fed Chair Yellen cautioned against reading too much into the so called “dot plot,” we can’t get it out of our head that the median year-end values rose compared to three months ago.  The median year-end fed funds rate target of FOMC participants for 2015 is now 1.00%, up from 0.75%, while the year-end target for 2016 is 2.25%, up from 1.75%. This suggests the FOMC will begin hiking rates sooner and/or more aggressively than previously expected.”

Now the picture should be abundantly clear. Wednesday’s press conference, plus follow-on information, has revealed that the men and women of the US Federal Reserve are significantly less dovish than many anticipated (including me). Combine this cold-water dose of narrative sea-change with a slow growth global economy, and commodities are in danger. 

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Dow Theory Remains In Buy Mode

The most well known 'mechanical' system in the world of technical analysis is still in buy mode since December of 2011. The Dow theory, formulated from a series of Wall Street Journal editorials authored by Charles H. Dow, is the grandaddy of all technical market studies. 

Although it is frequently criticized for being "too late", it is known by name to nearly everyone who has had any association with the stock market, and respected by most. The track record is certainly impressive, and continue to provide its user an advantage over the unaware Buy-and-Hold investor. 

According to "Technical Analysis of Stock Trends, Ninth Edition / Edwards & Magee" an investment of 100$ following the theory recommendations from 1897 would have grown $345'781.94 by December 21,2005 just from the long side. By contrast, the investment of $100, if bought at the low, 29.64, and sold at the historic high, 11762.71, in January 2000 would have grown to $39,685.03.

I always like to know what the Dow theory say about the current market environnement as I think it is the best major technical trend indicator at the US equities trader disposal. Below is the current record of the major trend (click to enlarge):

Dow theory not only provide buy and sell signals, it also advise on the current stage of the Bull or Bear market. Of the 3 stages presented by the theory, my guess is that we stand in the second phase, approaching the dangerous third face where the "public" enter the scene and where the financial news is extremely good. But we are not there yet!

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Chinese Economy Sluggish But Hard Landing Risk Contained

Chinese monetary trends are stable and consistent with continued subdued economic expansion.

Real narrow money works best as a leading indicator for most economies followed here but in China’s case the broader M2 measure has performed equally well in recent years. Six-month real M2 expansion was stable in February and close to its average over the last two years – see first chart.

The six-month change in real narrow money M1 had turned negative in January but this was attributed here to Chinese New Year’s Day coinciding with the end-month reporting date. A rebound duly occurred in February, although real M1 expansion remains weak by historical standards.

Monetary trends, therefore, suggest continued sub-par growth but no increase recently in the risk of a “hard landing”.

On the credit side, six-month expansion of real bank loans has been stable over the past year but the broader “total social financing” measure has slowed as the authorities have clamped down on off-balance-sheet lending – second chart. The broader measure is still growing faster than bank loans, suggesting no early relaxation of credit restrictions despite low inflation.

Money market conditions, however, have eased since the New Year, with the one-month repo rate now close to its level at the same stage of the last three years* – third chart. This easing has been accompanied by some narrowing of spreads between interbank swap rates and government yields, although these remain elevated – fourth chart.

In other Chinese news, exports slumped in February but much of the weakness was probably due to New Year timing effects and a reduction in disguised capital inflows, the latter reflecting both an official crackdown on fake invoicing and (correct) expectations of a weaker exchange rate.

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A Warning On Junk Loans

Record margin debt is not the only dangerous sign of the overly leveraged and speculative atmosphere the Fed has encouraged.  Now the head of the world’s largest distressed debt fund, Howard Marks of Oaktree Capital, is warning of the dangers as retail investors gobble up distressed debt.

Oaktree’s Marks Urges Caution as Money Flows into Junk Loans

Here is a pretty scary line…

“You can’t go on strike and refuse to buy the securities you’re paid to invest in, because the market may not turn for months or years,” Marks said. “Never forget the old adage, being too far ahead of your time is indistinguishable from being wrong. So you have to buy but with caution.”

So in other words, the thing just keeps going until one day… it just ceases to go.  Yeh, that’s a great fundamental underpinning right there.

From Sentimentrader.com:

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RBA Hints Cash Rate May Not Fall Further From Here

The Reserve Bank of Australia provided one of the strongest hints that the cash rate may not go further down from here, saying it remains unclear if a shortfall in demand can be made up quickly through monetary policy action.

The hint was delivered by Governor Glenn Stevens in his opening statement to the House of Representative Standing Committee on Economics in Sydney and later while answering their questions.

Stevens said monetary policy is very accommodative and based on current indications, the RBA expects to keep the cash rate stable for a while.

He admitted "the outlook contains many uncertainties, not least the 'hand over' from mining investment spending to sources of demand outside mining," even as there are signs that handover is happening.

"The question then is: will the additional demand likely to be generated outside mining as a result of these trends be just the right amount to offset the large decline in mining investment spending, so keeping the economy near full employment?"

But even if there was a shortfall in demand, Stevens said, it "could not be assumed that a shortfall in demand could necessarily be made good in short order by monetary policy. Monetary policy can have a powerful effect on the general environment, but it cannot hope to fine-tune the quarterly or even annual path of aggregate demand,"

Later Stevens repeated he expects the cash rate to remain stable for some time but added the RBA hasn't specified "how long" the cash rate will remain stable because "I don't know."

The guidance to keep the cash rate stable for some time is a change from the previous signal there could be a scope for easing, Stevens said. But the change indicates that based on the current outlook, the RBA doesn't see scope for more easing, even as he emphasized that the guidance is based on "current indications" and could change if the outlook changes.

In short, Stevens seemed to suggest there was no scope to lower the cash rate further based on the current outlook but even if the outlook didn't come to pass as the RBA now forecasts, there isn't much scope for monetary policy to step in and make up for the shortfall in demand.

At the same time, Stevens provided no hint that the RBA was in any rush to raise the cash rate.

He said the unemployment rate is expected to drift higher in the quarters ahead. Asked specifically on how much the labor market lags the growth in the economy, Stevens said it may be "one or two quarters."

Assistant Governor Christopher Kent elaborated on the labor market, saying "roughly speaking, we see the unemployment rate drift up a little bit from here, but probably sometime early 2015 peak and stay there for a while."

An improvement in economic growth is not likely to make inroads to the labor market until late 2015, Kent said.

On the housing market, Stevens didn't show any discomfort with the rise in prices or the increase in buying interest from overseas investors.

Stevens said foreign investors have a role to play in the housing market. "In a way, we tend to feel we want to be open to foreign investment.. this is a form of that."

Stevens said foreign investors were buying new structures as it is easy for them to do this. "If there was a supply side constraint, the issue is worth addressing. Beyond that, the question is how welcoming we want to be... this is a matter for the Parliament to manage."

On the effect of restrictions in Canada on the housing market here, Stevens said there will be some effect but "I cant quantify the extent of spillover in our direction"

But if house prices continue to rise further, would the RBA consider macro-prudential tools, Stevens was asked.

Stevens said he has previously stated the RBA has had preliminary discussions with the prudential regulator about macro-prudential tools for housing. While he recognizes such tools are useful, he said, "we should use them with a bit of realism."

Deputy Governor Philip Lowe also said macro-prudential tools can be useful but can also create distortions, especially harming first-home buyers when tools like a cap on loan-to-value ratios are used.

A better tool would be tighter lending standards, where a home loan application is tested for scenarios of 300 basis points higher interest rate than around 200 basis points as is currently donr, Lowe said. This would be more useful than raising the cash rate as current mortgage borrowers and other sectors of the economy could continue to enjoy the benefit of lower rates.

On inflation, Stevens said the higher-than-expected fourth quarter inflation data may have contained both noise and signal for future inflation. But the RBA's overall assessment is "that inflation is not quite as low as it might have looked six to twelve months ago, but nor is it accelerating to the extent a literal reading of the latest data might suggest."

Still, the RBA's view remains that the "outlook for inflation, while a little higher than before, is still consistent with the medium-term target," Stevens said.

Stevens said monetary policy is very accommodative and is doing the sorts of things that is normally expected to result from low interest rates, including promoting a rise in asset prices, construction of dwellings and depreciation in the exchange rate.

However, he added, the exchange rate "is still high by historical standards."

Later, on a question on the meaning of "jawboning" that the RBA is said to be doing for the exchange rate, Stevens said they refer to the fact that "we made remarks about levels of exchange rate" and the assumption is "these remarks were made in an effort to move it."

But Stevens said jawboning has a limited effect in lowering the exchange rate and in theory a central bank could take other steps like intervening in the foreign-exchange market or lowering the cash rate in an effort to bring the exchange rate down.

On the current level of the exchange rate, Stevens said his view is unchanged from that expressed in an interview with the Australian Financial Review newspaper back in December.

He said, "($)0.90 or higher is rather higher than any plausible assessment" of the economy.

In the AFR interview, Stevens had said: "I don't think the extent of our knowledge about what's correct is that good, but I did think ($0.95) was rather too high. I thought ($0.85) would be closer to the mark than ($0.95) at the time we started to make some comments some months ago, but, really, I don't think we can be that precise."

"I just think that if things over the medium term evolve as we're presently assuming - and I think it's reasonable to make these assumptions - it's going to be surprising if a nine at the front is the right number."

A high school student asked Stevens a question on what policy step he would take if inflation rises above the target band and the unemployment rate also rises to, say 7%. Stevens said it depended on what caused that combination but if inflation was higher, he would focus on the outlook for inflation.

"I hope the combination remains hypothetical," Stevens said.

On a question on where future growth in the economy would come from, Stevens said the mining sector is likely to contribute positively to growth in to the long run, after the initial downturn in the near term. But based on history, it is likely the economy will evolve in the direction of services.

"That's where most opportunity lies, included trade in services," Stevens said.

Steven was asked his view on the U.S. Federal Reserve's tapering plans. He said he believes that a "fair bit" of weakness in the labor market may be needed there for Fed to change its path on tapering.

He reminded that even with tapering, the Fed's balance sheet is still expanding, so in effect it is "still easing monetary policy" but easing at a slower pace.

A question was asked about monetary policy comments made by RBA board members to which Stevens replied he's the only one authorized to speak on behalf of the board. He admitted the RBA can't stop board members talking about things they know about, including in their own field. 

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Real Earnings Of Private Employees Rose In February

Real average hourly earnings, or the unit purchasing power of the employed, is one of the most reliable indicator of consumer spending which in turn is strongly correlated to the stock market. 

I like following this indicator on a monthly basis to get a sense of what is coming next and where we stand in the current business cycle.

Today data is showing a strong expansion that is boding well for consumer sentiment in the next few months.

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Draghi Boosts Euro, Rebuffs Disinflation

Another euro-positive ECB presser highlights the reasons for lower inflation, with the implication that low prices are of temporary nature. The conference re-affirms the ECB is in no hurry to use up its eroding interest rate armory to tackle disinflation risks without first considering unsterilising its money market operations.

The chart below reminds that the last time extreme lows in Eurozone inflation were accompanied by multi-year highs in German business and macro data was in mid-2009, a period propped by optimism in global equities rather than a manifestation of broad Eurozone improvement. Less than 6 months later, the Eurozone was dragged into a 3-year slump of debt defaults, bailouts and austerity.

Today, 3-year lows in Eurozone inflation are not only occurring simultaneously with 3-year highs in Germany business confidence, but also backed by broadening stabilisation of growth dynamics in the periphery, four upgrades in the Eurozone since Nov alongside robust performance in equities and the single currency.

Draghi offered fresh data attributing low inflation to the euro's appreciation and the growth spillover from high austerity policies in "stress nations". Draghi quantified the effect of the euro rise on inflation at -0.4%, while stating that 2/3 of the 1.9% decline in inflation from 2012 Q1 to have been caused by lower energy prices, or -0.3% impact.

The ECB lowered its CPI forecasts for 2014 to 1.0% from 1.1% in December and held its 2015 forecasts at 1.3%. These forecasts may reflect the central bank's commitment to improved transparency but they prove of little value to the markets, especially as the accuracy of these forecasts is constantly challenged by revisions.

More importantly, the 1.0% rise in preliminary core Eurozone CPI for February showed a 25% rise, which was the biggest since September 2011. The main difference between now and 2011 is the dissipation of sovereign debt factor (four upgrades in periphery nations since November) and improved macro dynamics in those economies. Considering that the euro's sole handicap over the past 6 months anticipation of a forced rate cut, any indications that the ECB will abandon such this solution, will maintain the pair supported above 1.3600 and make $1.40 a reality.

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Money Managers Aren’t Paid to Forecast; They’re Paid to Adapt

It seems we can’t go a week without someone predicting the end of the world and stirring up everyone’s fears of a market meltdown. These apocalyptic warnings are becoming routine and the sad thing is that it does cause the squeamish individual investor to run for the hills and liquidate their investment portfolio. Just look at the market calls for a crash over the last few years:

• Dow Could Crash to 3,000 in 2013 — Harry Dent (09/12/2011)
• Dow Dropping to 5000 Starting This Year: Charles Nenner (03/04/2013)
• S&P 500 May Fall More Than 40% By Fall: Chris Martenson (04/10/2013)
• Look Out! A 1987-Style Crash is Coming — Marc Faber (08/08/2013)
• The Case for a Crash: And for Staying in Cash Until 2015 — Charles Hugh Smith (12/10/2013)
• The Next Two to Three Days Are ‘Extremely Critical’ For The Stock Market — It May Crash 40% - Tom DeMark (02/5/2014)
• Get Ready for the Dow at 6,000 by 2016 — Harry Dent (03/03/2014)

Whenever a client refers me to an article of someone calling for a crash I like to respond with a question: How many crashes can you list over the last century? I’m not talking about a 20%+ bear market, but a market crash as defined by Investopedia:

Definition of 'Stock Market Crash'

A rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, economic crisis or the collapse of a long-term speculative bubble. Well-known U.S. stock market crashes include the market crash of 1929 and Black Monday (1987).

Think about that, we have had two real market crashes occur in the last 100 years, which works out to about one every 50 years. If they are so infrequent, then why do we hear so much about them? I'll give two reasons: One, people often crave attention and can easily gain it by making bold forecasts (whether they turn out incorrect or not) and, two, people assign a higher probability to market crashes now than they have in the past.

For example, shown below is the S&P 500 along with a Bloomberg story count for articles that have the words “market crash” in them. Since the early 1990s, we saw a spike on the 10-year anniversary of the 1987 market crash, then another around the September 11th 2001 terrorist attacks, and then again on the big October swoon of 2008. I want to draw your attention to the first two spikes in 1997 and 2001 and point out that, once they calmed down, fears over a “market crash” returned to normal levels. However, after 2008, there has been a continual and ongoing spike in calls for a market crash unlike anything we've seen over the prior two decades. 

Source: Bloomberg

This brings up an important point—a theme really—that I try to stress again and again: To be successful as investors we can’t fixate on the recent past, nor complain about what should be happening, but rather focus on what is taking place and why.

I typically write one to two articles a year on the subject of being flexible and want to include an excerpt from an article I wrote back in 2009:

Where Is the Humility? (12/09/2009)

All investors will be wrong at some point and the trick is to admit your error in judgment early rather than being a broken clock that is eventually right well down the road. Being wrong is human; being stubborn in the face of changing facts is foolishness. Another pearl of wisdom summing up this thought comes from famous investor Peter Bernstein who said the following after a long and successful investment career (emphasis added):

After 28 years at this post and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown. Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.

Remain Bullish Until the Market and Economy Undergo an "Identity Crisis"

In light of the above, it is important not to extropolate out too far in the future, but to focus on how fundamental drivers of the stock market and economy are changing on a daily, weekly, and monthly basis. For example, if the majority of stocks are in strong uptrends across most time-frames (as measured by short to long moving averages), I have to conclude the bull market in stocks is alive and well. Similarly, if the bulk of U.S. states are showing increasing economic growth, it’s logical to assume the economic recovery remains in place. What investors must understand is that market tops and economic peaks are a process and do not occur overnight. Rather, there is a period of time in which fewer and fewer stocks participate in the bull market and fewer and fewer states showing increasing economic growth.

There comes a point where the number of stocks rallying versus the number of stocks in their own private bear markets is roughly equal. The same is true for the economy where eventually there are an equal number of states participating in a recovery versus those that are not. This is the identity crisis point in which you have the potential transition from a bull to a bear market and from an economic recovery to a recession. However, until you reach the identity crisis point you have to adhere to the Wall Street maxims, “The trend is your friend” or “Don’t fight the tape.”

Consequently, much of my research is focused on looking for clues as to how close we are to that identity crisis point. On Fridays, I throw the stock market under the microscope with my “Weekly Bill of Health” report to gauge the level of participation in the bull market; as long as the bulls have the upper hand I remain bullish. An example of this is by looking at the percentage of stocks within the S&P 1500 that are within 2% of their 52-week highs versus those that are down more than 20% from their 52-week highs. This builds on the study done by Lowry Research Corp. in which they found that at major bull market tops, on average, only 16.54% of stocks were within 2% of their 52-week highs while 22.26% of stocks were 20% or more below their 52-week highs. This highlights the fact that market tops have an identity crisis when they peak as there are roughly an equal percentage of stocks near new highs as those already in bear markets.

Below is data from Lowry’s showing the average breadth of stocks at market tops compared to the 2007 top and the recent breakout to new highs on February 28th in the S&P 1500 (the S&P 1500 encompasses nearly 92% of the entire US market cap). As we can clearly see from the columns on the far right, there is absolutely no identity crisis present in the markets as bullish stocks clearly outnumber bearish stocks, with overall breadth quite healthy.

Given the bulls clearly have control of the stock market it makes sense that the economic bulls hold control of the economy. This can be seen when looking at the Philadelphia Fed’s Coincident Diffusion Index for all 50 states. Referring back to the identity crisis moment I mentioned, typically we see the onset of a recession when the Philly Fed’s Diffusion Index is zero, meaning there is an equal number of states expanding as those contracting. These periods are highlighted by the blue arrows below and what is most important is the fact that the Philly Fed Diffusion Index rested at 74 as of the end of December, well above the zero line associated with recessions.

Given the strong economic breadth seen in the Philly Fed data, it comes as no surprise that our own recession probability model shows only a 4% chance the U.S. is in or near a recession.

We truly live in interesting times and we need to open our minds to make sense of how to navigate as an investor while also avoiding falling into the "perma-bear" or "perma-bull" camp. If we are to succeed and thrive in this climate we have to be able to adapt and remain flexible, which was a key concept in a great book written by Louis-Vincent Gave, “Too Different For Comfort.” Louis was recently interviewed by Jim Puplava on the Financial Sense Newshourand you can listen in to the four key themes Louis believes will drive the markets over the coming years by clicking on the following link:

Louis-Vincent Gave: Four Macro Changes Investors Must Deal With - Global Central Banks Waging War Against a Deflationary Outcome

I’d like to end this article with the concluding remarks by Mr. Gave in his book, which are as priceless as they are timely:

This leads me to conclude with the words of my departed friend Clay Allen: “Remember Louis, money managers are not paid to forecast. Money managers are paid to adapt.” Unfortunately, adapting to this ever-more rapidly changing world is not always easy — but there is no other recipe for making money in today’s world.

http://www.financialsense.com/contributors/chris-puplava/money-managers-not-paid-forecast-paid-adapt

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Short Interest Surges To New High

Incredibly, the recent short interest data showed the total cumulative short interest on SPX components surged 4% to it’s highest point since mid-2012.

We keep hearing how there are signs of ‘froth’ and everyone is bullish.  I don’t totally agree, but there are some warnings signs – sure.  Yet, when I see the shorts continue to pile on, I find that very bullish.

Let’s get one thing straight, those shorts very well could just be hedges and not outright bearish plays.  None the less, keeping things very simple, going back the past few years – high short interest hasn’t been bearish.  Late 2011 and Summer 2012 were great times to stay long.  They were also the last two times short interest was this high.  Could it happen again?  I wouldn’t bet against it.

Considering the last time short interest was this high the SPX was around 1,350 (or 37% ago), that very well could represent some major potential buying pressure for this rally to continue.

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