Tuesday, December 29, 2015

Santa Claus rally or the start of something bigger?

Stocks are trying to live up to the expectations for a year-end “Santa Claus” rally.  Most of the market’s improving internal condition is due to the latest strength in the energy sector, with the NYSE Oil Index (XOI) rallying some 6% from its recent lows.

Although recent trading volume has been far lighter than normal, the NYSE advance/decline ratio for Dec. 23 was an exceptional 13:1 in favor of upside volume.  That completely reversed the 1:11 downside volume day on Dec. 11.  It also was the first time since Oct. 5 that the up/down volume ratio has been so high in favor of advancing volume.  While the Dec. 23 big volume ratio may have been a holiday-related aberration, if it’s followed by a 9:1 up/down volume ratio in the next few days it will qualify as a major volume reversal signal which would mean at least a temporary reprieve from the selling pressure of the last few months.

The key to the holiday rally has been short covering in the two biggest problem areas for the stock market: energy stocks and China ADRs.  The 6%+ rally in the XOI mentioned above was mainly the result of a rally in the crude oil price.  As you can see in the following graph, crude oil still hasn’t closed the two days higher above the 15-day moving average required to confirm an immediate-term bottom, but it’s testing this important trend line. 

A reversal of the oil price decline, even temporarily, would undoubtedly give the equity market a relief from the selling pressure that has plagued it for months.  Most of the stocks showing up on the NYSE new 52-week lows list have been energy sector stocks.  An oil price rally would result in spillover strength in oil/gas stocks, which in turn would almost certainly put the new 52-week lows below 40 on a daily basis.  Remember that we need to see a few consecutive days of less than 40 new lows to confirm that internal selling pressure has lifted.  For the last three days there have been fewer than 40 new lows – the lowest 3-day number since the first three days of November, which was the last time there were less than 40 new lows.

Here’s what the reversal of new lows in the last couple of days has done to the important NYSE short-term directional indicator.  As you can see, both the short-term directional (blue line) and momentum bias (red line) indicators are trying to reverse the decline of the past weeks.  A confirmed reversal of both indicators would mean that the stock market’s near-term path of least resistance has turned up in favor of the bulls.

Below is the dominant intermediate-term component of the NYSE Hi-Lo Momentum Index (HILMO).  This particular indicator is important for determining the market’s intermediate-term bias.  Note that after several weeks of declining, this indicator is also trying to reverse. 

While it’s still too early to get excited in light of the historical tendency for the market to rally in late December (the so-called “Santa Claus rally”), if the internal momentum indicators show continued and substantial improvement after January 1, the odds will finally tilt in favor of the bulls eventually regaining control of the intermediate-term trend.

Speaking of intermediate-term trend, our interim trend indicator has turned from bearish to neutral and is on the cusp of potentially reversing.  If at least four of the six major indices (Dow, SPX, NDX, NYA, MID, RUT) finish the week above the 60-day moving average, the trend indicator will tilt bullish.  It wouldn’t mean that the stock market’s troubles are completely over, only that a temporary reprieve has been granted for early 2016.  The next few days will at least tell us what we can probably expect for January.

Below is the SPDR Barclays High Yield Index (JNK) has been a major leading indicator for the stock market for 2015.  The decline to multi-year lows in high-yield bond prices was largely a consequence of the stress in the oil and gas industry, courtesy of plunging oil prices.  Note that JNK is testing its 15-day MA (below). 

The fate of high yield “junk” bonds also ultimately depends on the resolution of the oil/gas stock bear market.  High yield corporate energy bonds have been in a tailspin since the shale oil “fracking” bust began, and this has put dramatic pressure on the debt of oil/gas exploration companies.  This debt-related stress is captured in the downward trajectory of the SPDR Barclays High Yield Bond ETF (JNK) shown above.  As you can see, JNK hasn’t been able to close above its 15-day MA since October and, as such, remains firmly in the grip of the bears.  However, if JNK confirms an immediate-term bottom in the next few days it would provide another indication that near-term selling pressure for the stock market has lifted.  

Returning to the broad market outlook, a New Year’s rally largely depends on continued improvement in the internal condition of the NYSE.  The most important indicator of NYSE broad market health is of course the new 52-week highs and lows.  When traders and fund managers return from the holidays next week, we’ll have a much better idea of what the market’s near-term direction is likely to be since this will tell us whether the recent contraction in new 52-week lows is a holiday-related aberration or the start of internal recovery.  

Wednesday, December 9, 2015

Reversing the damage of global austerity

A significant undercurrent of internal weakness is plaguing the NYSE broad market.  This weakness is primarily visible in the dangerously high numbers of stocks making new 52-week lows.  Lately that number has exceeded 300 on a daily basis, though it has been above 40 for the last few months in a sign that the market’s health is less than optimal.  The best way of showing this internal weakness is in the following exhibit which graphs the cumulative new 52-week highs and lows on the NYSE. 

As you can see here, the new highs-new lows are in a sustained downward trend which suggests vulnerability to selling pressure in the stock market.  A reversal of this downward trend is required to put the market back on a healthy track.

As potentially dangerous as this internal weakness is for the broad market in the near term, I still don’t think it will prove fatal to the secular (long-term) bull market that began in 2009.  This opinion is based on a qualitative analysis of the new NYSE 52-week lows: most of them are in the energy and natural resource sectors.  The blame for the weakness in this area is mainly due to plunging prices for oil and other commodities.  This in turn has put strain on firms who produce or market these commodities with spillover impact to other areas of the broad market.

The residual influence of weak energy prices has also spilled over into the bond market.  Below is the chart of the SPDR Barclays High Yield Bond ETF (JNK), which I use as a proxy for junk bond prices.  Most of the weakness reflected in the junk bond market originates in the high-yield debt of energy companies. 

The weakness in the high-yield bond market is also spilling over into higher yielding corporate debt, as the Dow Jones Corporate Bond Index also reflects.  See chart below.

I’m reminded of the 1997-98 experience which witnessed a similar scenario.  In those days the U.S. stock market was in the midst of a powerful bull market, yet there was a negative undercurrent from the so-called “Asian contagion,” i.e. the foreign currency crisis as well as soft commodity prices.  Oil prices had plunged to $10/barrel while gasoline at the pump was just under $1/gallon.  This proved to be a bonanza for U.S. consumers but put tremendous strain on countries that heavily depended on energy exports, such as Russia.  The result was an increasing number of U.S. listed natural resource stocks which put strain on the broad market.  The end result was a quick-but-nasty mini-bear market in the summer of 1998.  

When finally the commodity market weakness was finally resolved in the fall of ’98, the U.S. stock market entered the final year of the glorious 1990s bull market.  In early 2000, the bull was over and a new bear market began.

What I’m suggesting is that we’re probably witnessing something at least remotely similar.  Most key industry groups which comprise the NYSE broad market are still in decent shape.  It’s primarily the commodity-heavy industries which are showing most of the weakness.  If the bear market in commodities can be “washed out” by early 2016, it’s possible the secular bull trend for equities can continue at least one more year. 

The other major reason behind the recent broad market weakness is a case of the chills thanks to the global market weakness.  Europe is one such area of global weakness.  The ECB recently cut its deposit rate by the minimum amount expected, which did little to encourage investors that the central bank is serious about bolstering continent’s economy and financial system.  One is reminded of how the U.S. central bank responded to the growing credit crisis threat in December 2007.  At that juncture investors were on edge and looked for guidance from the Fed.  Instead of aggressively attacking the problem, however, Fed Chairman Bernanke announced a tepid quarter percent rate cut in December ’07 which disappointed investors and which eventually catalyzed a plunge in equity prices.

Investors had hoped based on comments ECB President Draghi made in previous speeches that the ECB would increase its version of QE in order to help stimulate the euro zone financial markets, in turn helping the economy.  Yet the ECB responded in the tepid fashion we’ve all grown accustomed to seeing in recent years.  This is no way to calm the market and it’s not surprising stocks, bonds and commodities have responded the way they have lately.

Looking back at a commentary I wrote on Dec. 8, 2011 I was surprised to find how little things have changed since then.  I wrote, “If Mr. Draghi believes the euro zone won’t eventually be torn apart by the debt crisis he is sadly mistaken and would appear to be severely underestimating the severity of the problem confronting him.  And if he believes that ‘budget discipline’ (read austerity) is the key to successfully dealing with the debt crisis at this stage he is further mistaken.  The time for budget discipline is long since passed; now is the time for aggressive action.  One can only hope that the central bankers of Europe have learned something from our own credit crisis in 2007-2008, namely the importance of preemptive monetary policy action.  Failure to take action right now, when Mr. Draghi still has the option, will result in remorse down the road.”

China didn’t help matters by slamming on the brakes of its real estate market boom.  China’s leaders enacted their own version of tight money by increasing strictures on equity and real estate investors.  Japan’s government meanwhile proverbially shot its economic recovery in the foot by increasing taxes, essentially undermining a successful QE measure. 

When will the world’s central banks get their acts together and re-synchronize monetary policy for maximum global impact?  Your guess is as good as mine, but there are signs that at least the ECB, and possibly the People’s Bank, are slowly waking up to the mistakes of recent years.  How quickly they act upon this realization is a matter of speculation, though.  Hopefully the New Year will witness a renewed resolve on the part of both banks to reverse the damaging austerity and tight money policies which have caused so much grief.

In the meantime, the only safe remedy for global market instability is continued patience and prudence in one’s investing discipline.  The equity market will work through the commodity market and global economic weakness and will, I believe, resume its bullish trend at some point next year.  Until the NYSE new 52-week high-low index tells us that the broad market internal weakness has been completely reversed, however, investors should maintain a healthy skepticism for what may appear, at first glance, to be buying opportunities in the stock market.  Only when the internal condition of the broad market decisively improves will the odds favor embracing risk.

Friday, December 4, 2015

The cycle of debt release

To many investors cycles are the holy grail of the financial market.  Many investors have devoted years to the study of them.  Some have even claimed to have found the ideal cycles for consistently predicting price movements.  What no one can seem to agree upon is exactly which cycles are most accurate for anticipating market moves.  But what all studies of the cycles share in common is an unshakable conviction that cycles hold the answers for what is coming in the future.

If there’s one thing I’ve learned over two decades of studying cycles it’s that there is no holy grail when it comes to historical market rhythms.  Even if there is a “one-size-fits-all” cycle the true believers in cycles tend to forget that in the short term, factors such as trader psychology and news reactions can exert an outsized influence on markets and can temporarily whipsaw a cycle.  The influence of central bank intervention and government policy initiatives can also override, or at least mitigate, the influence of cycles for prolonged periods.

As with any technical discipline, however, there’s always the temptation to strictly adhere to the cycles in a rigid manner.  Alas, this is where many students of the cycles go astray.  By fixing one’s focus on the cycles to the exclusion of other forms of market analysis and liquidity studies, cycle traders are often disappointed when their cycles fail to produce an expected turning point in the market.  This failure can be explained by the influence of, for instance, Fed intervention which can produce cycle “inversions” or else reduce the impact of the cycle altogether.  Extremes in investor sentiment can also produce temporary countercyclical shocks to the market which frustrate the cycle trader.

A general rule when it comes to cycles is that the longer the period (i.e. time), the more reliable they tend to be.  Probably the most famous of these long-term cycles is the Kondratieff Wave, which tends to average 60 years in length.  The K-Wave as it’s called is the dominant cycle of inflation and deflation in the economy.  While it does influence stock prices, its major impact is on commodity prices which in turn influence the overall state of the economy. 

The 60-year cycle was to have bottomed around the year 2014, although the residual effects of a cycle this long can last beyond that time.  This is the most likely explanation for the continued deflationary undercurrent in the global economy.  Its effects are being felt most acutely in China and to some extent in Europe.  A visual aid which shows the effects of this cycle-driven deflationary trend is the Reuters/Jefferies Commodity Research Bureau Index (CRB), below.  As you can see, commodity prices have fallen to multi-year lows in the face of a drop in global industrial demand.  The effects of the 60-year cycle are clearly manifest in this chart.

Another longer-term cycle which tends to reliably repeat is the 20-year crisis cycle, otherwise known as the “Sheep Shearing Cycle.”  This rhythm manifests itself in the market plunges at roughly 20 year intervals.  (It’s not to be confused with the 20-year Kress cycle.)

The crashes of 2007-08 and 1987 are examples of this rhythm, as are the 1929 crash and the 1907 panic.  Major crashes tend to occur at roughly 20 year intervals, especially if there is widespread market participation among the public.  The explanation for this cycle is that a generation runs approximately 20 years and it takes about that long for the old generation to forget the pain associated with the previous crash.  By that time, of course, a new generation will have come along which doesn’t remember the last crash or depression and are therefore more risk averse.  Thus the entire cycle of boom and bust repeats itself as the next generation repeats the mistakes of its elders. 

Another reliable rhythm which manifests in both the financial market and the economy is the 7-year cycle known as the “Year of Release.”  This cycle was first ordained in the Old Testament book of Deuteronomy as a relief for indebted Israelites.  The law reads: “At the end of every seven years thou shalt make a release.  And this is the manner of the release: Every creditor that lendeth ought [anything] until his neighbor shall release it; he shall not exact it of his neighbor, or of his brother; because it is called the Lord’s release.” [Deut. 15:1-2]

Although the year of release is no longer formally observed, this ancient precept is unconsciously embedded in the financial dealings of Western nations.  The debt release cycle can be seen in the recurring price “corrections” of commodity prices, and to a lesser extent equities, at roughly seven-year intervals.  This cycle can be seen manifesting in the credit crash of 2008, the tech wreck of the 2000-01, the mini-bear market of 1994, the stock market crash of 1987, the inflationary/commodity peak of 1980, and the broad market plunge of 1973-74.

The most recent 7-year debt release cycle was scheduled to make its appearance around 2015; and indeed the cycle’s effects are still being felt.  Depending on how many price imbalances there are within the broader economy, the influence of the 7-year cycle can spill over into the following year, as was the case in 1973-74 and 2000-01.  The primary course of the latest 7-year debt release cycle is in the commodities market, with repercussions in the overall state of the global economy.  It would not be surprising if the residual impact of this cycle is felt in 2016.

The purpose of the 7-year release cycle is to wash away the negative effects of debt and other forms of financial enslavement from the economy.  This would also include artificially high prices, which was clearly a problem in recent years in the energy market.  That oil and gasoline prices have come down so sharply in the last year is indeed a godsend for consumers.  It’s also beginning to have the beneficial effect of increasing oil demand. 

One area in desperate need of correction is retail food prices.  Prices to U.S. consumers at grocery outlets are, in some food categories, at or near all-time highs despite falling diesel and agricultural commodity futures prices.  Before the course of the debt release cycle has completely run its course, it’s necessary that the financially enslaved among us experience a release from the heavy burden of high prices in this area.

A final point to be addressed is the impact of the 7-year debt release cycle on stock prices.  Since the 7-year debt cycle isn’t expressly aimed at equities, its impact on this area isn’t always sharply delineated.  The main effect of this cycle is on commodities, as previously mentioned.  It can be argued, though, that the 7-year cycle’s impact was felt in the stock market this year in the lagging nature of the NYSE Composite Index (NYA), which is arguably the best representation of the broad U.S. stock market.  The cycle’s effect is also reflected in the abnormally large number of new NYSE 52-week lows since earlier this year. 

Much of this broad market weakness is attributable to the weakness of commodity prices, especially in the energy and mining sectors.  Of course it can be argued that this is a spillover effect of the longer-term deflationary cycle previously mentioned.  In any event, the impacts of this cycle are still discernible in the internal condition of the NYSE broad market: new 52-week lows remain abnormally high as of this writing. 

In previous commentaries I’ve suggested that next year would likely witness a bottom in the commodity prices that have lately plagued the global economy.  The standard deviation of the 60-year cycle as well as the 7-year debt release cycle support this notion.  By the time both cycles have completely run their course, the oppressiveness of high prices in the economy should attenuate enough to provide some relief for the debtors who need it most.  Thus the Year of Release will have once again worked its magic.