AWASH in Liquidity
By Frank Barbera CMT. May 8, 2007
What A Week! Lousy employment numbers, lousy GDP numbers, and of course, new all time highs in the Dow with the index up 24 of the last 27 days, the longest winning streak since the late 20’s. Pretty funny, huh? Say, haven’t we played out this script before? Doesn't there seem to be something all too eerily familiar about this? Remember early 2000 when the Fed was tightening, the yield curve inverted, the economy slowed, and yet the rabid liquidity monster kept expanding multiples on Tech Stocks? Cisco and Yahoo to the Moon! And then, ... well, we all remember that one… down, down, down through the floor!
Seems we’ve just been on some stock market version of “Ground-Hog Day,” like Poor Bill Murray reliving the same day over and over again. OK, this time we have small twists. Google, instead of America Online as the new media darling, rumors of a Yahoo! buy-out by Microsoft (fat chance), and wild speculation orbiting Amazon.com, driving the stock up nearly 50% in two days. Some things never change. Anyway, there can be no doubt that it is the massive sea of liquidity that continues to keep the stock market aloft, with broad money supply measures advancing at double digit rates. Even the imputed, re-pieced together and guess-timated M-3, which experts believe is now growing close to 14%. Well, Well, Well! With all the hot money sloshing around, no wonder some folks are worried about a rerun of the recent past. Did you see the headlines flashing on CNBC last week quoting the NY Fed?
“Hedge Fund risks worst since 1998 LTCM Crisis” by Reuters
“Hedge Fund Study suggests parallels with LTCM Crisis” by CBS Marketwatch
The study in question was penned by Fed economist Tobias Adrian entitled, “Measuring risk in the Hedge Fund Sector” in which he attempts to draw some conclusions noting that “recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998.” Ah, were it only that simple. Truth be told, today’s numbers positively dwarf anything seen in 1998 or 2000, as hedge fund assets back in 1998 totaled $240 Billion, with that figure now closer to $1.50 Trillion. This doesn't even begin to describe the order of magnitude differential, since 1998 the mortgage and asset backed bond markets, the GSE’s the Credit Default Market, and holdings at Broker-Dealers have all ballooned in parabolic fashion. Back then, the real concern was disinflation and not enough liquidity. Today, we see just the opposite condition with a runaway global liquidity boom driving up prices of all asset classes, both financial and tangible in all corners of the world. Anyone notice the unprecedented advance taking place on the Shanghai Stock Exchange in recent weeks? Rarely have I seen a more steeply ascending parabolic curve (see Bloomberg chart at this link).
Note: To those who do not tolerate high levels of financial pain, we have not left our “Collapsing Chinese Stock Market” days behind us. At the present rate of ascent, my guess would be that yet another big shock wave should be coming from the Shanghai Market within the next few weeks. Judging from the extended nature of the chart, a sell off back down toward 3,200 should be in the cards by mid-June at the latest, about a 20% haircut in the Shanghai Composite. That means we are virtually sure to see a few hair-raising days for the Dow and maybe other world markets. Yet before venturing into the sorted technical details on the subject of a runaway liquidity driven boom, I quote none other than perhaps the most esteemed expert on the subject, Prudent Bear’s top Credit Market Analyst Doug Noland.
In a recent editorial, Noland stated,
“I tend to view the gross distortions emanating from now out of control global systemic liquidity excess as today’s critical issue. From this perspective, the unparalleled $500 Billion increase in foreign central bank reserves year-to-date is indicative of the inverse of 1998’s liquidity-constricting biases and dis-inflationary forces. Today, powerful expansionary biases foment only greater financial excess and historic asset and commodities inflation. At this point, the risk of irreparable system damage comes not from an unwind of leveraged speculation, but rather an all encompassing frenzied expansion of global finance. One can think liquidity excess-induces market place dislocation or perhaps, Mises “Crack-Up Boom” on a synchronized global scale.”
Noland then concludes,
“when the eventual reversal of flows and dislocation arrives, it should be expected to have profound effects on the maladjusted US Economy and fragile US and global credit systems. On this score, I’ll venture a prediction that hedge fund de-leveraging will pale in comparison to the widespread tumult that will likely engulf currency, securitization, and derivative markets and in risk intermediation generally. The derivative markets are poised to falter into absolute liquidity nightmares, and this will not be a hedge fund deleveraging issue easily resolved with aggressive rate cuts. And the longer the current destabilizing flows are allowed to run roughshod, distorting prices, risk perceptions, and economic structures in the process, the more arduous the unavoidable adjustment period. That’s just the way it works.”
Not a cheerful thought, but a hard one to ignore. When you stop and think about it when you look around, the symptoms of historic excess are all around us, as are gentler hints that “an end” is approaching. Take the Commodity Indices for example; take a look at these charts, and tell me they are not heading for a major fall sometime fairly soon.
In the chart above, we see the Dow Jones Spot Commodity Index with its 200 day moving average and three sigma Bollinger Bands. That’s right, instead of two standard deviations, we are plotting three and where is the index? Heading right for the upper band. Of course, the spot commodities have been booming on the back of base metals with gains in zinc, lead, and nickel pacing the advance. Looking at other commodity indices, the picture is less extended, but really no better on a technical basis. In the next chart, we see the CRB Index which has been moving to the upside in spite of the sell off seen earlier this year in Energy, and a lack luster Precious Metals complex. To this point, the CRB appears to be tracing out a five wave wedge, with fairly strong bearish divergences developing on the medium term 14 day RSI. While there is no rule that says this chart must go down, it does look quite shaky at this juncture and simply highlights what could be a period of heightened investment risk dead ahead.
Above: The CRB Index with the 14 day RSI — not acting at all well.
Yep, it is a scary new ‘globalized’ world we live in, and in that vein we ask the question, “How ‘bout those Emerging Markets?” Bovespa in Brazil new highs, Mexico new highs. Since the recent March 5th panic low, the Brazilian Bovespa is up 23%, the Mexican Bolsa 16.38% and the Shanghai Market up 36%. Yet to date, the recent torrid advance in these foreign markets is showing mixed signs on the momentum front, with the potential for more important bearish divergences to emerge in the weeks ahead. When that juncture is reached, odds are high that the ensuing set backs will be an order of magnitude worse, and the subsequent downtrend not so easily reversed. For now, it is still too early to be ultra bearish, and instead we adopt a 'watch and see' approach keeping a close eye and trailing mental stops behind open long positions in both metals and energy markets in which we are involved.
Brazilian Bovespa with Medium Term MACD.
MACD still rising but has yet to reach levels seen at prior peaks in 2006 and 2005.
Above: Mexican Bolsa IPC Index with MACD failing and not keeping up with current advance.
I last highlighted the Latin American and Asian markets just before the last collapse (“Oh What a Tangled Web We Weave” 2/13/2007) in mid-February, and while it is possible this liquidity binge could allow markets to “hold up” another few weeks, at some point an even more severe and sustained downside roll-over is very likely. In this specter, Shanghai and China take center stage, and I would note that while Shanghai has gone to decisive new highs, placing it at the very epicenter of the global speculative orgy, other China-led indices have not including the FTSE Xinhua-China 25. In my March 6th article entitled “Markets Hit Bottom: (and they did) But will it last?, I showed the following chart of the China 25 ETF which at the time was at panic low just under 90.00. In the article I pointed out that the odds favored that
“In the case of the China and Shanghai Market, odds are high that a recovery rally will closely approach the former highs in coming weeks. For the China 25 ETF, a .618 fibonacci retracement of the most recent decline would target prices back up to the $107 to $109 area.”
Above: The excerpted chart from the March 5th report, forecasting a strong recovery in the China 25 ETF toward 107, and now, a few weeks later (see below), the unfolding of that recovery with prices now challenging the former highs.
As things have turned out, the strength of the global recovery in all markets has surpassed even the most optimistic of expectations with “blow-off” style advances leading to one-directional markets week in and week out. Folks, these conditions simply cannot last and when they change, it will likely usher in a much darker period of time. While I am not suggesting that this reversal is imminent now, this week, or even this month, I do believe that a larger trend change will produce more evidence ahead of time, and over the next few weeks, there will be many important road signs to be watching for.
Before ending, I want to highlight one potential leading change and that is in the area of the REITS. Over the last few years, the REIT Index, Real Estate Investment Trusts, have been among the most consistent bull market leaders.
Above: the GST
REIT Index and the S&P 500 — last few years;
note the important and potentially bearish divergence here in recent weeks.
Note how time and time again during virtually all corrections, the REIT Index bounced back quickly and led the S&P 500 back to new multi-years highs. That is, until recently. Over the last few weeks as the market has advanced, the REIT’s have begun to lag badly and have been under consistent selling pressure. In our short term technical work, we would note that it is now likely that this group is sufficiently oversold such that we will soon see a meaningful trading bounce. In the chart below, we show the McClellan Oscillator based on our Index of 30 REIT stocks, which is presently sporting a distinctly positive divergence.
Above: The GST REIT Index with Daily McClellan Oscillator showing a positive divergences. REIT ETF’s anyone?
Yet, in the bigger picture, we just can’t see how the intense selling pressure evident in this group over the last few weeks is anything but an important warning of larger problems ahead. Within Commercial Real Estate, job creation has been strong as Cap Rates have plunged to levels never before imagined. Signs of a major top abound, and for our part, the recent preliminary break in the REIT’s seems to have an ominous message attached. In our view, it is likely suggesting that the problems in the Housing market are far from over and that the long ‘super boom’ in commercial Real Estate may now be, at long last, drawing to a close. In this circumstance, an already slowing economy will only cool even further.
At the close the DJIA ended lower by 3.90 points at 13309.07, with the broader S&P 500 finishing down at 528.16, losing 1.76 points. Crude oil gained 0.79 closing at 62.26, and gold lost 3.50 to close at 685.25. The 10-Year Treasury Note ended at 4.634%. That’s all for now,
© 2007 Frank Barbera