The Return of Trouble
Did it ever leave?
By Frank Barbera CMT. September 22, 2009
Get ready -- the world is about to start spinning upside-down again. Not sure, believe it. Below the surface economic data is still heading down, the recovery, and exit from recession is a pleasant myth, and instead a double-dip contraction lies ahead for 2010. Things are actually going from ‘bad’ to ‘worse’ as some of the leading indicators needed to sustain a recovery are simply not turning around. Take Bank Credit, for example. If the Banks are so convinced that a strong recovery is dead ahead, then how come they continue to hoard cash, resulting in the latest data for Bank Loans hitting nearly 40 year lows. Or what about Consumer Credit -- if the economy is about to reverse higher, then why isn’t consumer credit moving up and reversing it’s major down turn as consumers loosen up on the proverbial wallet? Answer: Unemployment is still surging and is nearly double the stated headline rate on both a national level and in the great state of California, which is usually a pretty good directional gauge for the U.S. economy as a whole.
Consumers are trying to de-lever and save up, and as a result credit card delinquencies are still surging, mortgage foreclosures remain at record levels and Real Estate continues to move down (especially on the high end with Prime Mortgages) as unreported inventories remain robust and are acting as dead weight. Where the Rate of Change for Consumer Credit is concerned, we are talking about an accelerating down trend and fresh multi decade lows. On the trade front, Port activity remains moribund as do the statistics for exports/imports with China. None of this suggests the beginning of a recovery with any lasting traction. Instead what we have is the ‘Foam Latte’ recovery, some foamy fluff at the top of the brew coming from a few transfer programs and statistical magic, wherein with one good sip it simply all disappears. It is an anemic inventory re-building cycle, a typical counter trend bounce for the economy that unfortunately is very likely in its final month or two. To that end, no one should be surprised to see the inventory build in the months ahead following Cash for Clunkers lending Q3 GDP a statistical bounce into the black. Will we get a few more positive headlines? Absolutely, but remember, below the surface the core data is not turning the corner, and that means a nasty reconciliation period likely lies ahead starting in the next few months.
For the stock market, the recent technical readings have moved the equity market to values that are stupendously overbought. This is “begging to get punched in the nose” – overbought. In my view, it means that a correction is likely dead ahead that could take 4% to 5% off the S&P, and 6% to 8% off the beloved NASDAQ. Gold, Oil, Copper, Aussie Dollars, Canadian Dollars, Shanghai Stocks, European Stocks, other Base Metals and basically everything except the Dollar and the Bonds are now vulnerable to a meaningful setback. In my view, the setback will last a few weeks and could then be followed by a final advance in these asset classes into a potentially more important peak later this year. Since asset classes tend to top out at different times, it may well be that some assets are near their final peak right now, and as was the case in 2007-2008, we could see a sequential “Top Out” Parade (one asset class after another) in the days and weeks ahead. For investors, it is time to put the guard up and get the defense out on the playing field. That means intense risk control and ‘hard’ stops.
Want to see the signpost of a liquidity driven market, or perhaps more aptly put Central Bank bubble blowing at work? Just look at the high degree of correlation between Asset classes such as the stock market, commodities, and resource currencies. See any difference in the basic trend?
The point here is that when this liquidity driven advance does come to an end, it is very likely to cause a wide number of so called ‘diversified’ assets to sell off at the same time. On the other side of the teeter-totter stand two positively correlated markets, the US Treasury Bond and the US Dollar. Now we know that in these pages I have made no secret as to the idea that the US Dollar is likely road-kill in the years ahead. That said, there has been a distinct inability for the Dollar to follow thru on the downside, and when markets that should be going down don’t go down, it can be a warning that the trend is about to change. In my work, I am now looking at the strong possibility of a near term low and a bounce in the greenback. This could also be accompanied by a major sell off in US Treasury yields. That would be the flip side of a sharp pull back in most other markets. Could we be a few days early? You bet. I wish I had the proverbial crystal ball, yet the extremes in these markets seem to be present in equal and opposite degrees and that is a major red flag, at least for the short term trends.
In the case of the US Stock Market, I could go on all day about the technical extremes. In today’s action, within the S&P 500 only about 59 stocks were able to close at new recovery highs, or a bit less than 12% of the index. That’s a huge change from action seen in recent weeks where the character of the market advance was a lot more uniform in nature. Put simply, the stock market looks tired and as mentioned earlier, is ultra overbought. To tie things up with a neat bow I include an updated view of one of my favorite medium term indicators, the CBOE Options Advance-Decline Line, along with other gauges based on Options A/D Line. In the first chart, we see the weekly Options A/D line with the 9 week Wilder RSI plotted on the lower clip. As of last week, the 9 week RSI for the CBOE Options A/D Line closed at a reading of +78.09. Over the last 27 years, a period covering 1,443 trading weeks, there have been only 25 other weeks when the 9 week RSI for the Options A/D Line was at +78.09 or more. A good number of those readings were seen just before the stock market began very meaningful consolidation and/or corrective patterns including the highs of 1/20/2004 +81.22, +76.46 04/03/98, +83.81 03/14/86, 03/04/83 +76.81, 06/08/89 +84.03.
Above: the CBOE Options A/D Line and the 9 week RSI.
Above: the S&P 500 and the CBOE Options A/D Line Detrend Oscillator
Yet another gauge that is also reflecting an ultra-extreme overbought value is the weekly Detrend Oscillator for the CBOE A/D Line. This gauge is simply the spread, or difference between the CBOE A/D Line and its own 39 week moving average. Typically, +100 and –100 are fairly standard overbought and oversold values. However, from time to time we see much larger extremes which can range above and below +175 and –175, the dashed horizontal lines on the chart above. Near the worst of last year's selling, we see two weeks back to back below –200 with a reading of –237 on 11/28/08 and –244 on 12/5/08. Now we are 180 degrees in the other direction, with a reading last week of +204.34 and this most recent value at +196.45. Like the RSI there have been only 25 weeks above +200 in the entire history of the data, so its strongly suggests that a market pull back lies dead ahead. Prior high readings on this gauge which immediately proceeded the beginning of lengthy corrective periods were seen in 4/26/91 +156.36, +163.07 on 8/25/89, +201.49 on 4/3/87, +181.67 on 4/25/86, and +182.11 on 7/1/83. In my view, the current high reading does NOT imply that the stock market rally is concluded as readings this high virtually never correspond to final peaks. Much more common is (1) a correction and then (2) a second advance, which is accompanied by (3) lower values on the Detrend Oscillator at which point a more important top is seen. Right now that looks like a year-end type event. Another gauge that is warning of a potential trend change is the VIX Index, which on Monday closed just above its 50 day lower Bollinger Band. That is usually a caution sign and marked the peak in January of this year, and even gave a more recent hint of corrective action only a few weeks ago.
Above: top clip the S&P 500, Middle: the VIX Index, Lower: RSI on VIX
This time, I believe the very low levels of implied volatility in the market more likely than not suggest complacency, and that is classic backdrop preceding a downside correction. Among sector indices I also see signs of a potentially important juncture. Take the Housing stocks for example. They have been market leaders all year having gained 28% so far on a year to date basis, and 112% from the March lows. Yet on the big picture trend, the Home Builders are not stalling out in the zone of a .382 fibonacci retracement. This means that what we have most likely been observing is a large bear market rally that is simply taking back some of last year's losses.
Above: The GST Homebuilding Index with .382 Fibonacci Retracement.
Above: GST Homebuilding Index with Medium Term A/D Ratio
What’s more, Homebuilding, along with the REITS, may be one of those sectors to keep an eye on as an important ‘tell’ as to whether or not a substantive recovery is really getting underway. Right now we see alarm bells sounding in the Homebuilders, where the GST Homebuilding Index has pressed to three higher highs in recent weeks against the back drop of three distinctly lower peaks in the A/D Ratio. Values are as follows: 8/4 GST Index 207.78, A/D Ratio 1.86, then 8/25 GST Index 225.13, A/D Ratio 1.56, 9/16 GST Index 239.03, A/D Ratio 1.42. The same story is evident in the Up to Down Volume Ratio, A/D Line, Net New Highs, and Cumulative Money Flow. A lot of Divergence creeping into the Homebuilding space.
Above: GST Homebuilding Index and Up to Down Volume Ratio. Again, more divergence.
The same circumstance does not yet apply to REITS where technical factors are at major extremes, but where divergence has not yet set in. Homebuilders may be leading a peak in the general market while REIT may end up aligning with the major averages. That said, I did notice that at the absolute all time high in REITS some of my technical gauges just finished with a massive overbought value, which happens to be where the market is right now a little more than 18 months later.
Above: GST REIT Index with Medium Term A/D Ratio, massively overbought.
On other gauges like the ARMS Index for our basket of 30 REITS, there is divergence AND very pronounced overbought values, so the picture of REIT’s is unsteady at best, with possibly a correction near term followed by a retest of the highs later on. All of these gauges have one thing in common. They point toward a general absence of selling pressure in these key sectors and in the market in general, and our take away on that boils down to the idea that the easy money for now has probably been made with the next few weeks likely to see the turn of a more challenging market climate.
Above: the GST REIT Index with the ARMS gauge.
Finally, if there were one additional chart out there that stands up and shouts a message of caution from the roof tops, it absolutely has to be that of the GST Junk Bond Index. Ladies and Gentlemen, I suggest a rapid stride in heading for the exits as RSI is at the absolute highest levels ever seen; this is the most uninterrupted advance ever seen and when this turns, something tells me it won’t be Emily Post Polite.
In the grand scheme of things, a trend reversal in the Junk Bonds will help us as an important marker for this cycle. If the bonds really break down sharply, and the ensuing recovery is weak, that would speak volumes as to a lousy 2010, while continuing robust action, i.e. small sell off, quick recovery, will tell us that maybe the cycle can extend. For now, I think the near term message is one of strident excess with a counter trend reversal an overwhelming possibility. Maintain good defense, keep stops tight under open long positions, and be quick to raise cash.
That’s all for now,
© 2009 Frank Barbera