Market Observations in 2010
By Chris Puplava, February 17, 2010
Co-Manager of PFS Group's Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account
Today’s commentary lacks a central theme and instead really is a “Market Observation.” Often at times it is useful to remove one’s opinions from the investment equation and instead listen to what the market is saying, gleaning useful information in the process, rather than having a preconceived notion of how the markets should be acting. Below are of few items that should be of interest on a range of topics. Let’s dive in.
Watch the Credit Markets
While reviewing the various markets (stocks, currencies, bonds) one thing that popped out at me was the potential for a head and shoulders bottom formation (H&S) in the long end of the U.S. yield curve. While there is the potential for a H&S bottom in long term interest rates, as Martin Goldberg often says, “A pattern isn’t completed until it’s completed.” While there is the potential for a H&S bottom we would need to see a decisive break above the necklines for both the 10-year and 30-year UST rates. If a H&S bottom does materialize in long term interest rates, it would have a dramatic ripple affect in the economy. For one, it would likely mean the nearly 30-year secular bull market in bonds is over and would lead to sharp losses for fixed income investors. It would also likely cripple any housing recovery as higher interest rates will decrease the affordability for housing, leading to higher interest rates in general which would increase the borrowing costs for debt for consumers and corporations, decreasing profitability and so on and so on. The implications for such a breakout would be huge and so keeping an eye on long term interest rates should be on every investor’s watch list. So far the 200 day moving average (200d MA) is rising for both the 30-year and 10-year UST, signifying that the trend is currently bullish for both rates, and the 200d MAs have held for both rates since the stock market bottomed last year.
What is interesting to note is that the recent rise in long term interest rates since last summer just so happens to coincide with a potential peak in Chinese holdings of US Treasuries (UST). Chinese holdings of USTs peaked at $801.5 billion in May of 2009 and have declined by $46.1 billion to $755.4 billion in December of last year. Could it be that the U.S. is just about to realize there is a limit to the amount of debt our government can dump on the market and expect foreigners to soak up? There is clear resistance on the 30-year rate between 4.7%-4.8% (red line) while there is also a bullish trend line support connecting the 2008 and 2009 lows, with both lines converging signaling we will have a breakout or breakdown in the 30-year rate soon.
The rate of Chinese purchases of UST holdings year-over-year (12-Mo rate of change) has slowed to the lowest growth rate since 2001, and for the first time since 2001 Chinese holdings of USTs have fallen below their twelve month moving average, possibly signifying a change in appetite by the Chinese for US debt. This would be a major development as the Chinese have been one of the biggest sources of soaking up the debt issuance by the Treasury. If the Chinese step up the decrease of the UST holdings, you can be sure that such a development would pressure long term interest rates higher, possibly helping to lead to a H&S bottom in long term interest rates. As mentioned above, the ramifications would be significant for such a development and so watching the monthly TIC flows will be important in the months ahead.
State of the States
While much of the financial press has been fixated on Greece over the last few weeks, others have rightly pointed out that the individual states within the U.S. are in even graver duress than Greece or any of the other PIGS (Portugal, Italy, Greece, Spain) countries. One barometer to measure stress in the credit markets is by looking at the level of credit default swaps (CDS), which are used as insurance against the default on debt instruments. As can be seen below, an equally-weighted composite of the CINN states (California, Illinois, New Jersey, New York) I created shows a greater degree of stress than is seen by the Euro Zone GDP-share weighted composite of the PIGS. While the recent rally in the stock markets over the last week has seen a decline in the CDS for the PIGS composite, the CINN states CDS composite remains elevated as investor concerns over municipal debt for the CINN states remains high.
Each day I browse over the details of the various economic reports that come out as well as a few of my own economic indicators and one development that stood out like a bright flashing red light was the sharp downturn in the Philadelphia Fed State Coincident Indexes (PFSCI). I’ve created a slight derivation of the Philly Fed’s data by looking at the percentage of states showing increasing economic activity over the prior month, which is shown below. What the PFSCI shows is that during a recession the percentage of states showing increasing monthly economic activity declines sharply and then also recovers sharply after a recession ends. Typically the recoveries are “V”-spike events in which the percentage of states showing rising monthly economic activity increases dramatically and then stays in elevated territory for the bulk of the next ensuing economic expansion. Mid-cycle slowdowns such as was seen in the mid 1980s and mid 1990s never saw the PFSCI dip below 75%, meaning less than 25% of the 50 states were showing decreasing activity while overall national economic breadth was strong and improving.
“The Great Recession,” as some call the recession that began in December of 2007 witnessed the lowest reading on record of 0% in February of 2009 for the PFSCI. Beginning in June of last year the PFSCI began to increase sharply as is the norm in post-recessionary environments. However, for the first time in the history’s data the PFSCI stopped dead at 48% in November and then plunged to 20% in December. Never in the prior four recessions did the PFSCI rally from a bottom and not breach the 50% expansionary mark, nor reverse course so quickly. While a single data point does not make a trend, we need to watch this closely because if the PFSCI remains in deeply depressed territory it would indicate that the recession that began in 2007 is not over; or if the recession ended in 2009 as some maintain, then we could be witnessing the quickest double-dip recession seen in the last 100 years.
When the PFSCI breaks above the 50% mark it symbolizes expansionary growth similar to the ISM diffusion indexes where levels above 50 mark expansion while levels below 50 mark a contraction. Below is a table that summarizes when the PFSCI broke the 50% demarcation line, both from above and from below, along with the dates for the beginning and end of the last several recessions. What the table shows is that the breaking of the 50% mark to the downside is often seen on average one month after a recession begins, while breaking above the 50% mark 1.25 months after a recession ends. As the PFSCI has yet to break above the 50% mark and is actually currently below prior recessionary troughs, it would tend to imply that the state of the states is not as rosy as some maintain and the economic headwinds that states have been grapping with since 2008 remain, such as high unemployment, declining sales and income tax receipts.
The title above came from an article penned in January. It was suggested that “this time may be different,” in which consumers and corporations do not follow the historical economic script in which they return to the debt trough once banks make credit easier to obtain by lowering lending standards and after the Fed helps drive interest rates lower. The Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices for January came out and showed a significant decrease in the net percentage of banks tightening lending standards as the credit crisis crescendo of 2008 eases. This is the hallmark that is seen as prior recessions begin to fade, but what we are not seeing is an equivalent improvement in the net percentage of banks reporting stronger demand for loans. Loan demand for prime mortgages did break into positive territory last year but has since fallen back down into negative territory, and loan demand for other types of loans remain depressed as the net percentage of commercial banks are showing weaker demand for loans despite easier lending standards.
Source: Federal Reserve
Source: Federal Reserve
Despite the allure of low interest rates and easing lending standards, the U.S. consumer has virtually no plans to go on a spending spree for autos, homes, or major appliances according to the Conference Board’s Consumer survey. The depressed demand for spending or taking on new debt has led to loans and leases on the books of commercial banks to decline by the steepest year-over-year rate of change in more than a quarter century. Not the stuff of a vibrant recovery.
Source: The Conference Board
Talk about a 180 degree “U-turn!” The extreme bullish sentiment for gold and the euro and bearish sentiment for the USD prevalent in middle to late 2009 has been completely reversed to show extreme bearish levels for gold and the euro and reached a bullish extreme for the USD. If one is in the bear camp these sentiment readings may indicate that the first leg down since the January 2010 top is nearing completion as the market was oversold recently and sentiment has swung to levels often associated with intermediate bottoms in gold, the euro, and indirectly the stock market. However, if one is in the bull camp then the current situation offers an opportunity to pick up stocks after a correction before the market heads higher. Whether you are in either camp it probably makes sense not to become overly bearish at this stage in the game as much of the bullish exuberance present at the January highs has now been completely wrung out.
Cyclical Bull/Bear Market Signals
To finish off today’s article, a quick peak at some indicators that have helped identify turning points between bull and bear cyclical markets to see if any signals have been given after the swoon to last week’s lows in the market. Looking at the S&P 500 15/40 weekly EMA signal system as well as the stock/bond ratio 15/40 weekly EMA signal system shows that no sell signals have been given and the trend remains bullish until proven otherwise. Additionally, bear markets are often associated with the 14 week RSI dipping into bear territory below 50 (red boxes below), and last week’s lows never saw the 14-week RSI on the S&P 500 dip below 50, with the 50 mark acting as support. The January 2010 top may in fact prove to be THE top for the March 2009 cyclical bull market, but it is perhaps wise to wait for confirmation before ringing any bear market alarm bells. A break of the 15 week EMA below the 40 week EMA for the S&P 500 and the stock/bond ratio, along with a decline below 50 on the 14-week RSI would provide solid corroborating evidence that the present cyclical bull market is over. However, if these indicators hold in bullish territory the bulls have the upper hand and the recent correction would prove to be a buying opportunity rather than the start of a new bear market.
© 2010 Chris Puplava