Sunday, April 29, 2012

Trouble In Stocks, Focus On Commodities

It is Sunday night, the 29th of April here in Asia. I have literally been working the whole weekend, reviewing the health of stocks, bonds, commodities, currencies and credit markets. From what I see right now, there are early warning signs of a trouble brewing in the stock market, which I will discuss in this post. But first let us get to the business cycle.

Early next week, we can expect the following data to greet our screens:
  • South Korean IP, HSBC PMI & CPI
  • German Retail Sales 
  • Canadian & Spanish GDP
  • Chinese Manufacturing PMI
  • US Chicago PMI & Dallas Fed Manufacturing
  • RBA Interest Rate Decision
  • US ISM Manufacturing PMI
  • Swedish, Norwegian & Spanish PMIs
Economic data from developed economies continued to disappoint in the week that ended, as can be seen from the group of Citigroup Economic Surprise Indices. Italian Business Confidence disappointed at the end of the week, just like Italian Consumer Confidence disappointed at the start of the week. European Manufacturing PMIs were very negative while French Consumer Spending fell off a cliff at -2.9% from previous month. Spanish Retail Sales didn't do too much better either, as they also disappointed at -3.7%. The BTP bond auctions in Italy send borrowing costs higher again. Certain parts of Europe are slipping into a stronger recession than earlier expected. 
We also received an onslaught of Japanese data this week, with Manufacturing PMI still expanding at 50.7, unemployment rate remaining unchanged at 4.5%, Core CPI coming in at 0.2%, Industrial Production disappointingly coming in at only 1.0% from expectations of 2.4% and finally Retail Sales (YonY) printing a 10.3% reading as Japanese consumer slowly recovers from earthquake disaster of last year. In the US, Michigan Consumer Sentiment beat expectations coming in at 76.4. We should all know that a rising stock market usually tends to create positive or rising consumer confidence, so this is not news. However, Initial Jobless Claims disappointed... yet again. This is now the fifth week in the row. United States employment picture, which is a part of Fed's mandate, is weakening without a doubt and the negative trend, even though mild currently, is establishing itself.
The US GDP also disappointed, which signals not only to the Fed - but to the rest of us, that current sluggish growth will not be strong enough to continue posting Non Farm Payrolls above 200,000 as economists have been expecting. On top of that, sluggish growth will most likely not push down the unemployment rate as the Fed would like to see. Unemployment rate currently stands at 8.2%, but the participation rate has been dropping since 2009 as well. Therefore, unemployment is not actually improving, it is just that people are giving up trying to get employed. This is also shown in the average unemployment during of 39.4 weeks. In my opinion, if the Fed wants to even try and achieve unemployment rate closer to 7%, which they are projecting in their latest Press Conference, they will have to bring QE3 or another form of easing / stimulus back onto the table without a doubt - a super bullish outcome for a secular commodity bull market.

With expectations of further Fed easing, that is precisely why I have been arguing for months that the US Dollar is about to break down. US Dollar bulls won't have any of it, but before you stay perma-bullish on the Dollar and of a view that the DXY Index is still in an uptrend - let me put forward some very interesting points I have noticed in the last couple of weeks in the currency markets:
It is very strange that the US Dollar is failing to rally with abundance of good news coming its way and the US economy outperforming its European counterparts. In my investment experience, I have learned that financial assets price in or discount news / data ahead of time. When an asset fails to perform positively on constant favourable news, than most likely that asset has discounted just about all of the good news and is ready to reverse the trend to start pricing in a changes in market conditions.
Certain currencies like the Pound have already left the Dollar in the dust. GBP is now up 10 days in the row and trading almost 3 standard deviations above the 50 day MA - the last time we saw such a winning streak was back in 1992. As we can see in the chart above, the Pound is approaching the upper end of its long term triangle consolidation, so I would be cautious buying the Pound right now. After being net short since August 2011, hedge funds have now turned net long as well. Public Opinion on the Pound is also quite high, signalling a potential correction could be in the cards. I would expect a consolidation or a pullback, but I wouldn't be overly bearish by buying the US Dollar. I think a major Dollar breakdown is coming up and the Pound could break out of its three year consolidation pattern to the upside, especially if Bernanke re-starts easing to improve the employment picture in the US.

Moving on to the stock market, as the post title states, I think there is trouble brewing in this asset class. Stock market bulls constantly point to strong earnings season and famous investors like Blackstone’s Byron Wien sees the S&P 500 reaching 1500 on strong earnings moving above $100 a share, coupled with expanding multiples towards 15 P/E. Personally, I think that there is a possibility of that occurring, especially if the Fed engages into further easingas discussed above.
On the other hand, stock market bears point to insanely high Corporate Profit Margins and believe that a mean reversion is in the cards eventually. During every investment cycle, bulls believe that corporate profits margins will never mean revert, just like they didn't in 2006/07 and 1998/99. Wise men like Jeremy Grantham have previously stated that “profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” So in my mind, it is only a matter of when (timing), not if. Speaking of timing, traders and investors should not use record margins as a timing tool, so lets dig dipper underneath the stock market to see where the trouble is brewing.

First of all, I do think that bull market leader stocks like Apple, Price-line, Starbucks, Hermes, Wynn Resorts, Ralph Lauren and many others have either started to top or are more than likely to top in coming weeks and months.
Looking at the sector breadth in the table above, at first glance we can conclude that breadth looks quite healthy for majority cyclical sectors and the overall stock market. First and foremost, early cyclical sectors like Semiconductors, that are very economy-sensative, are displaying very weak breadth and have failed to make a new bull market high giving us a S&P 500vs Semiconductor non-confirmation signal. We saw a similar type of a signal during the topping equity market phase in 2007 and also in early 2011 as well. Financial sector also falls into this category, having so far failed to make new bull market highs above May 2011.

On the other hand, short term breadth in the Utilities Sector (super defensive) is expanding in a bullish manner. We currently have over 96% of the sector above the 10 day MA and over 84% of the sector above the 50 day MA. Readings above 50 day MA at 84% is the highest Utilities breadth reading since late December 2012, when the S&P 500 started its runaway move from 1,250 towards 1,400. That means safety defensive sectors are now attracting inflows. There are several clues we can derive from this:
  • We are entering a late cycle of the equity rally, where defensives take lead from cyclicals
  • Utilities never rise strongly in an interest rate rising environment, but more so in an easing environment, so QE3 could be back on the table
  • There is a possibility of a current correction not being over just yet, so Utilities are being used as a hiding spot
Refocusing back on the overall equity market, we can see early breadth deterioration starting to show its ugly face, just like in early 2010 and early 2011. Consider the chart above and note that S&P 500 tends to cycle between breadth improvement and deterioration, when it comes to stocks making 50 day new lows. In recent times, during the current cyclical bull market, we tend to see two initial smaller corrections prior to a major sell off. The hints can be seen in the increasing  50 day new, as the chart above shows.

For example, we saw the number of stocks making new 50 day lows slowly increase leading into April 2010, just prior to the flash crash. Than, we saw a similar event occur in July 2011, lead into August 2011 crash. Currently, the number of stocks making new 50 day lows has started to rise above that of November / December 2011 correction. That signals to me that not all is well within the stock market and we could be at the start of the topping process, before a more meaningfully sell off occurs in up and coming months. Of course, in the meantime, stocks can and most likely will make a new bull market high.
I discussed non-confirmtions with the different sectors above, but there are also non-confirmations starting to pop up in the cross asset space. The chart above shows that we now have a US corporate CDS Index failing to make new lows despite S&P 500 making new highs - a similar type of an event to the topping process of 2007. Other non-confirmations and early warning signals include:
Furthermore, while the short term sentiment might be slightly bearish, these types of indicators are very volatile and more trader-related than anything else. Sentiment indicators that focus on the longer term view, like the Money Market Assets or cash levels as I like to call it, are flashing warning signals. There is currently just above $600 billion sitting in Money Market Funds which is the lowest reading since 1998. On percentage basis it is equivalent to about 5% of the S&P 500, which is the among the lowest readings in over 30 years and down by almost 10% from the early 2009 stock market bottom.

Bernanke has forced majority of investors out of cash due to ZIRP (zero interest rate policy), but from a contrarian point of view, do you really want to be buying equities for a longer term investment with cash levels so low? If the great stock market bottoms over the last 30 years occurred in 1982, 1991, 2002 and 2009, than today we are at the opposite side of the spectrum. Finally, seasonal weakness from May to October is now upon us, so do keep in mind that equity markets tend to under-perform during this time frame.
Having said all of that, I am not ready yet to short the stock market. While I see cracks appearing similar to that of 2007 and 2011, the internal breadth of the S&P 500 still remains quite strong with 81% of the S&P 500 above the 200 day MA and 73 out of 500 S&P stocks having made a new 52 week high this week. Cyclical sectors are still holding up decently as well. This leads me to think that we are now in the "Late Expansion" of the investment cycle, where the leadership assets become Commodities over Equities, and where late cyclical sectors like Energy & Materials outperform Semiconductor, Retail and Financial stocks. I have already discussed the commodity picture enough in recent posts, including PMs like Gold, Silver and Gold Miners. But, what I haven't talked about recently is Agriculture.
Rogers Agriculture is now on the verge of breaking out of its downtrend (chart above). Sentiment is extremely negative within the sector with Public Opinion reaching bearish extreme levels or close to extreme levels on Wheat, Corn, Sugar, Coffee, Cotton and Live Cattle amongst others. We are still sitting close to hedge fund record net short positions in the Wheat market. Price is in the prices soy making a first higher low, despite media news constantly telling us the globe is oversupplied with Wheat - nonsense! The longs have been cut considerably in the Corn market recently as well. Contrary to the rest of the grains sector, Soybeans are extremely overbought now.

However, sentiment is especially negative in the Soft complex side of Agriculture, where the Dow Jones Softs Index (JJS) posted a 52 week new low on Friday. Sugar has now crashed, due to expectations of Brazilian output recovery in 2013. Hedge funds are cutting their net long positions in a hurry. The price is down 5 weeks in the row and approaching the physiological 20 cent support level. Coffee is down more than 40% over the last year and is now finding support on a 10 year rising trend line. Hedge funds are net short the Coffee market for the first time since 2008. Finally, Cotton and Coco are now building bottoms after being slaughtered last year and will soon rally. For those that do not use the commodity futures, another way to participate in the Agricultural story is through fertiliser names like Mosaic. Consider the chart below and notice that there have been now new lows since the selling climax of September 2011. Mosaic is currently down 40% from its peak in February 2011 and offers great value for a longer term investor who believes in the Agriculture fundamentals.
Overall, I would expect the Agricultural sector - as well as all other commodities - to move up in coming weeks and re-enter a cyclical bull market. Commodities should be boasted by upside surprises in the Chinese economy, as infrastructure spending picks up in coming months. We could also see potential easing by the PBoC as inflation has now returned to more modest levels. Shanghai Composite could be discounting just that, as it flirts with the 200 day MA setting a stage for a break out higher. That too, would be very positive for commodities. Recent technical analysis newsletter I read from Jeffrey Zhang of Hong Kong based Trading Central Asia, suggested that "the index may be forming a so-called inverse head-and-shoulders pattern that could drive it [Shanghai Composite] up 17 percent should it break its 200-day moving average of 2,470."

Summary
We are in a "Late Expansion" of the investment cycle. I think there are cracks starting to show within the equity market, despite its potential to make new bull market highs above 1,420 in coming weeks. Therefore, I do not agree with Byron Wien's extremely bullish call. At the same time, stocks are not yet a short either, so I do not agree with Gary Shillings super bearish call either  right now (written about last week). 

As an investor, what I am interested in is late cyclical assets like Agriculture and Precious Metals that are oversold, Energy sector that is oversold relative to the rest of S&P 500, fertiliser stocks and finally in the breakdown of the US Dollar, where Commodity & Asian currencies should benefit. For more safer investors amongst us, purchasing high yield defensive sectors like Utilities, which have been out of favour for the last quarter, could also be a smart way to preserve capital and gain some modest returns. Defensive high yielders are currently a better play than the overpriced Treasury Bonds too.

Finally, for those that do not believe commodities can rally while stocks top out and decline, re-visit the recent events of 2007 and into middle of 2008, where the CRB Index went almost vertical and S&P 500 declined by 20%.