Part 2: Lessons, Conclusions
Having reviewed the prior week in Part 1, here are the key lessons and conclusions.
Rally On? Three Things To Watch
As we mentioned last week and in our 2013 forecast, the fate of global markets likely rests on the twin fundamental pillars of:
- QE continues and continues to work at propping up asset prices, repress interest rates low enough to force the added liquidity into risk assets like stocks.
- Continued complacency about EU crisis risk (and no other surprise crises, of course)
We watch for any material news on these.
Then there’s a third thing we watch carefully.
- Price Action – What The Markets Think: Regardless of what we think is happening with the fundamentals, we base decisions to enter or exit positions based on actual price action on the charts of our chosen risk barometers, whether they’re the S&P 500 or something else.
First, let’s look at those two fundamental pillars.
QE Continuation In Doubt: Fed Feeds Tapering Speculation
Fed Chairman Bernanke’s comments in the Q&A session following his prepared statement to Congress, and the FOMC minutes last Wednesday were together the undisputed chief market mover this week, because they clearly raised expectations about the pace and extent of the Fed’s tapering of QE.
Why the big deal? There are good reasons to shrug these off:
- First, taken together they were ambiguous. The message was that any Fed tightening would depend on continued improvement in the US economy.
- Second, as Josh Brown pointed out here, Bernanke believes a key cause of the Great Depression was that the government tightened too quickly, so any coming moves to reduce QE are likely to be very gradual. The Fed would rather err on the side of caution.
The reason markets reacted so strongly is simply that, as we stated in our 2013 forecast, markets believe that QE, with its continued flow of cash seeking a home and low yields, is the only thing holding up risk asset prices in the face of headwinds that would normally prevent a long term rally:
- weak global economic and earnings growth
- ongoing risk of contagion from the EU
The pullback in the days that followed confirmed our belief that the rally still lives or dies on continued QE.
The Fed knows that too. As long as inflation isn’t a threat that means any meaningful tightening isn’t coming until unemployment gets near its 6.5% target and other growth metrics like consumer spending reflect that improvement.
Ramifications Of Fed Moves
Pullback More Likely Than Reversal
Until we see more evidence that there is going to be a sustained curtailment of QE, or that markets are starting to pay attention to the weak global and earnings growth or EU contagion risk which has persisted in past years (no evidence of that thus far) then we’re not likely to see more than the long anticipated normal bull market correction.
Japan Rally Gets First Big Test
The Fed news sent USD and Japanese 10 year note yields higher, and that sparked the first big selloff and down week for the Nikkei since November 2012.
USD Continues To Evolve, Show Risk Currency Characteristics
Any hint of fed tightening should send the USD soaring, yet it was down against a number of currencies, even the EUR. There are no fundamental explanations. Europe continues to look awful, especially compared to US data. This was a technical move, likely driven by the Japan stock selloff. Those long Japanese stocks were hedging their risk of continued declines in the JPY by being long the USDJPY pair. When Japanese stocks sold off, so did those USDJPY hedges.
Complacency On EU Crisis
Calm about the EU was the other requirement for the rally, and that remains firmly in place. Never mind that the EU economy continues to deteriorate, as shown by the past week’s PMI showing further contraction, or that Spain remains a genuine contagion risk. GIIPS nations’ bond yields have been overall steady or falling, as was the case for Italy and Slovenia this past week. EU is likely to stay quiet at least until after German elections this fall. A further sign of easing concern about the EU came from Citi Bank economist Willem Buiter, who pushed off his 2012 prediction that Greece would leave the EZ in by no later than mid-2014. He still believes there is a high risk of a Greek exit at some point in the coming years.
Nothing in the EU has improved, but calm remains. We don’t believe it, but we’re unlikely to know of the next crisis until it’s already hit.
Bigger Black Swan Risk In ME?
Actually at the moment you could argue that the bigger source of market scaring black swan risk is the Mideast. No less than three of Israel’s neighbors’ central governments have limited meaningful control over their common border with Israel (and their countries in general). Israel is coping with its own budget problems, and boy do wars mess up a budget, but the threat of WMDs leaking into Hizbollah’s hands on Israel’s Northern border could force Israel’s hand. Four more years of Obama only makes Israel feel more like it must act on its own, given Obama’s ambivalent attitude to a viable Israel or to the need to recognize the global Jihad threat as a global threat rather than the acts of an isolated few.
The Other Big Market Mover To Watch: China Recovery Deferred
A disappointing Chinese Flash PMI report of 49.6 in May vs. 50.4 showed the first sub-50 reading (contraction) in seven months, confirming fears that the second largest economy is decelerating, and that dampened hopes of a Q2 China recovery.
This report suggests that the official manufacturing report due out next week on June 1 will also print below the 50 contraction line. As long as China’s central bank remains cautious about easing, the most likely source of hope comes from reform progress. The next big event on that front comes in the weeks ahead, when new leaders will hold a high-level meeting on China’s urbanization strategy.
Given China’s role as the prime commodity consumer, the news had more impact for commodity economies like Canada and Australia, and their currencies, the CAD and AUD, than for global markets. Both their stocks and currencies felt the pressure.
Technical Picture: Risk Trends Healthy, A Scary Signal
The weekly S&P 500 shows a typical picture of other major global stock indexes.
S&P 500 WEEKLY CHART DECEMBER 2011 – PRESENT
Source: MetaQuotes Software Corp, thesensibleguidetoforex.com
01 may 26 1245
As we noted last week, all time resistance around 1556 has been decisively broken, and long term momentum remains very strong. For example:
All weekly moving averages continue to trend higher from the 10 week EMA (blue) to the 200 week EMA (violet).
The index remains firmly in its double Bollinger band buy zone, the area bounded by the upper orange and dark green lines. That suggests the trend still has strong upward momentum. See here for a quick look at how to interpret these.
If we zoom in on the daily chart below, however, there is reason to believe that some kind of pullback is coming.
S&P 500 DAILY CHART MARCH 15 – PRESENT
Source: MetaQuotes Software Corp, thesensibleguidetoforex.com
02 MAY 26 1247
As Josh Brown noted here Thursday:
The very frightening statistic that’s been making the rounds overnight is that the last two times the S&P 500 touched a record intraday high and then closed down more than 1% from that high were October 11, 2007 and March 24, 2000, the last two major tops for the market, both of which occurred before historic crashes.
Meanwhile, the uptrend is still intact. However the index has left its upper double Bollinger band buy zone, suggesting that short term momentum is neutral.
Currency Wars: Smaller Central Banks Strike Back
The China data, especially in combination with the past week’s contracting PMIs from Europe, reinforces the weak global growth picture. That fact in turn will reinforce the spreading trend of central bank easing. Last month, 14 central banks cut their rates, either in response to the overall slowdown or to specifically protect their exports. See here for details. As the author of the only book I know of that shows investors safer, simpler ways to cope with a world of debased fiat currencies, my thanks goes out to them all.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.
