"Green Shoots?": Touring the Periphery

By Frank Barbera CMT. May 19, 2009

While the stock market remains buoyant and optimistic that ‘green shoots’ are starting to take hold within the global economy, the technical side of the equity market now strongly argues for a “go-slow” approach. Yes, we know that the NAHB reported another uptick in the Housing Market Confidence data yesterday, with the Housing Market Index moving higher by 2 points in May to 16 from 14, and yes, we know that some of the employment data has at least on the surface improved in recent weeks. Yet without digressing endlessly into all of the nitty-gritty detail which lies below the economic headlines, we can report that thus far neither the bank earnings nor the improvements in economic data reflect what they seem to portray. So far, where earnings are concerned, we have seen carefully massaged numbers which actually convert huge bank losses into gains, all on the back of accounting rule changes and other contrived accounting devices. In the case of the economic data, we find the usual Birth-Death ARIMA Model grossly distorting the employment trends, and a classic case of easy ‘comps’ underpinning what some could deliriously interpret as ‘green shoots.’ We are having none of it, as the psychological urgency on behalf of US consumers to rebuild savings and personal balance sheets will assure that any meaningful recovery is still a long way down the road.

Above: the NAHB Housing Market Index along with the Next 6 Month Component.

Yet in this freshly ebullient market climate, a whole host of new hazards now confronts the unsuspecting investor. For investors buying into the ‘economic recovery’ theme this is very likely late in the game, wherein the risk-reward ratio is now in a bearish configuration. While I spent some time on the equity market last week, I thought I would take readers on a tour of the periphery this week to help gauge the manner in which other markets are perceiving the current ‘recovery.’ In most cases, these are markets that are far less observed then the S&P 500, NASDAQ and Dow Jones.

Take for example, the market for High Yield Bonds. In the case of High Yield, so-called “Junk” Bonds, any sign of a genuine recovery would be good news as recovery would aid these companies in continuing to pay out on the bonds. As an asset class junk bonds tend to be closely aligned with the stock market but often make very smooth transitions from up-to-down markets, and vice versa. In the chart below we see the GST Index of Junk Bond Funds, which plunged last year, but has experienced a large recovery rally in tandem with the stock market over the last few weeks. While there is no question that investors who ‘bought the fear’ in junk bonds back in December 2008 have made excellent gains, the question now becomes, ‘what’s next for junk bonds?”

In this vein, we hasten to point out that the Medium Term RSI, an overbought/oversold gauge, is now all the way back up to fully overbought condition. This highlights a major cross-roads for Junk Bonds directly ahead. While it is true that major bull markets can take this gauge to even higher levels, most of the time when the gauge approaches these levels it is time to go very slowly. While Junk Bonds may be able to provide some additional gains in the days ahead, the real question of the moment will be, just how robust will this market remain on a going forward basis? In ongoing bear market type conditions, the current readings would normally be rally killers and would cause the market to top in fairly short order. Alternatively, an extension from here to the upside might imply that junk bonds perceive a more sustained economic bounce. Thus, watching Junk Bonds in the weeks ahead may provide meaningful clues as to what is truly ahead. In my view, I lean toward the idea that the recent advance was a technical bounce, a counter-trend move and nothing more, and as a result, I believe Junk Bonds are probably getting close to a sell signal in the days and weeks just ahead.

Usually, within four to six weeks one can glean a lot about the true nature of a market once readings like this have been attained. In addition to Junk Bonds, another sector with a big vested interest in global recovery are the currencies of natural resource based economies; currencies like the Canadian Dollar, Aussie Dollar, and the Kiwi Dollar. In the case of Australia, much of the natural resource production these days is bound for Asia, which as a result of China’s strong growth trajectory has shown tremendous demand in better times. By contrast, Canada is still largely US centric and supplies the United States with a huge portion of its energy bill. While Canada is also shipping a great deal of resources to Asia, the close proximity to the US market still remains the largest influence on the Canadian Dollar. In my work I watch this sector on two levels. First, I monitor an index of the Natural Resource currencies. In the past, coming out of global crisis and recessions, this index has tended to experience an initial bounce back to the 200 day moving average followed by a test of the lows, and then a second upside cross above the 200 day average with the average flattened out.

In the chart above, we see action in 1993 where the natural resource currencies were weak following a economic slow down in 1993-1994. The arrow highlights the initial bounce off the low, which lifted the NatResource Currrency Index off the low and up to the presence of its declining 200 day moving average (see arrow). At the same time the Medium Term RSI moved up to a set of fully overbought readings (see arrow lower clip).

This was then followed by renewed decline with a final low in July-August 1993 and a breakout above the 200 day average in earnest in late 1993.

A similar outcome was seen in 2000 following the crash of Tech Stocks in 2000 and the bursting of the Internet Bubble. The initial recovery lifted the Resource Index back up to the 200 day moving average and the RSI back up to fully overbought condition. From there, the index then fell to a series of new lows ultimately rounding out a base and beginning a new major uptrend in early 2002.

Against these past experiences we see that the current chart (shown above) looks very similar to the two prior initial “rallies off the low.” In the case of the 200 day moving average, prices are now above the 200 day average which is still declining strongly. In both prior instances, prices upside penetrated the 200 day average for short periods of time, and in both prior instances the 50 day average ended up crossing/meeting the 200 day line just about the same time the rally in the NatResource currencies came to an end.

Again, there is no rule that says this time won’t be different, but using past as prologue we can argue that the current set of medium term overbought readings in this sector suggests that the initial bounce could be almost complete, with a major change in market tenor dead ahead.

Next I also like to watch the relative strength ratio of the Aussie Dollar to the Canadian Dollar as a rough proxy for the growth in China versus perceived growth in the US. Over the last few years, the Aussie Dollar has managed to slightly outperform the Canadian Dollar, and over the last many weeks, the Aussie Dollar has been rising versus the Canadian Dollar. Again, we see fully overbought values on Medium Term RSI and what could be a mature advance.

In addition to the Natural Resource currencies, another arena which bears close watching as an indicator of the recovery would be the stock markets of Southeast Asia. Without any doubt, if the world is heading for better times, these markets are likely to be important leadership and to that end, it is important to continuously evaluate their technical health. Here again we see potentially early warning signs that the multi-week rally could be coming into the final phases. Take China for example, where the Shanghai Index was one of the first indices to actually turn up, bottoming in Nov-Dec 2007 and making higher lows in 2009. In monitoring the relative strength ratio of the Shanghai market versus the S&P 500, over the last few weeks the ratio has been weakening, which seems inconsistent with the growing global perception that good times are right around the corner. Shown on the bottom clip, the R/S Ratio of China versus the S&P is just about to slip below the rising 50 day average with the 20 day average now in declining mode.

Above: top (Shanghai) middle (S&P 500) lower (Shanghai versus S&P R/S Ratio)

In addition to some relative strength weakness, the medium term RSI for the Shanghai Market is now all the way back up to fully overbought in an area where meaningful peaks have been seen in years gone by. On an Elliott Wave basis, Shanghai has now retraced .38% of the preceding bear market decline which could be an ideal zone for Primary Wave (B) to peak out. Typically, bear markets are three step, A-B-C affairs, and in the case of the Shanghai market, Wave A was a text book five wave decline. Over the last few weeks the advance in Shanghai has begun to look more and more ‘wedge like” with a rising wedge, a bearish chart pattern suggesting a loss of upside momentum.

Above: Shanghai Composite Index with Long range RSI

Above: Shanghai Composite with Elliott Count and Fibonacci Retracement and rising wedge.

In addition to China, South Korea’s Kospi market is also now back to fully overbought values and has retraced back to the 50% threshold of the prior decline. Nine times out of 10, the 50% threshold will provide a very big ‘tell’ in terms of yielding clues as to the real primary direction of a given market. For South Korea, it is now showtime, and what this market does from here or what it fails to do should be quite meaningful information over the next few weeks.

Above: South Korea Kospi Index with Medium Term Detrend Oscillator

Above: Korean Kospi Index with 50% Retracement Zone.

Above: Eastern European currency composite (Latvia, Poland, Albania, Lithuania, etc..)

Finally, having looked at some of the stronger beneficiaries of a global recovery, I also thought I’d end this week's update with a look at another corner of the world where trouble remains very high in terms of economic difficulty. To this end, Eastern Europe still looks badly damaged with the currencies of Eastern Europe unable to rally to any meaningful degree over the last few months. With this sector now back to overbought and showing bearish divergence, I believe this is one area where a fresh round of economic contraction and crisis could find a breeding ground. The chart of East European currencies sports a strong downside continuation pattern. In my view, this could be one area of the periphery that turns out to lead the way on the downside in the weeks ahead.

That’s all for now,

Frank Barbera

© 2009 Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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