Market Sells Off after New Year Rally: Long Term Technical Outlook

After a strong start to the new year, the market has given bulls a wild ride. Since the minor sell-off ending on 12/30/2005, the SP tacked on 3.68% in a mere 7 trading sessions, with that rally ending on 1/11/2006. Technology issues in the Nasdaq sprinted to a 5.72% gain during the same period. Small caps, to the surprise of most market analysts, continue to outperform, and posted a 5.64% gain, and are at all time highs.

How quickly things can change. On 1/20/06, all of the major averages were down in excess of 1%, Large caps, especially the Nasdaq, led the way down, losing 2.35% The SP-500 lost 1.83%, and the small cap Russell 2000 lost 1.45%, leading Reuters to describe it as the worst single day decline in 3 years.

Despite all of the talk about great earnings, low interest rates, and good economic numbers, the financial markets, and the global economy, are in a very precarious position. The technical factors as I see them are as follows:

Long Term:
1. Breadth negatively diverging from the major indices: This weekly chart below compares the percentage of NYSE stocks above the 200 day moving average to the Russell 3000, a broad based index.

There are 2 ways to interpret this indicator. The oscillator method looks for extreme highs and lows in the indicator. Technicians and fundamentalists alike use the 200 day moving average as a long term trend measure. If the price is above the average, the stock (or index) is considered to be in an uptrend. Likewise, when below, it is assumed to be in a downtrend.

When the market advances, you want a majority of stocks to go up with the market. But you can have too much of a good thing. The oscillator method attempt to determine when too many stocks have advanced, which suggests the market uptrend should pause, if not decline outright.
There are some interesting ways to use this indicator in conjunction with volatility bands. But I will save that for a future post.

The method I prefer is the divergence method. Breadth should expand with the market. If the market is making higher highs, breadth should also. When it does not, that signals some signs of a weakening trend. This is what we see when plotting this indicator against the Russell 3000–a series of declining peaks for breadth, and a series of rising peaks for the index. Fewer and fewer stocks are carrying the market higher.

The advantage of market breadth is that it can give significant advance warning of a weakening trend, particularly on longer time frames. Long term breadth divergences are often early by many months, the 1998-2000 market shows.

2. Price momentum diverging. This monthly chart of the Russell 3000 shows a significant divergence in momentum. One of the major technical principles is that momentum leads price. A significant reversal in trend is much less likely if there are no momentum divergences. Like cars, price needs to slow down before it can reverse.

3. Price formation is a rising wedge. Price is the technicians most important indicator. On all time frames, you can see a converging set of trend lines connecting highs and lows. Rising wedges suggest a sharp sell off when the lower trend line is broken.

A look on shorter time frames will show similar technical deterioration. When there is a convergence of technical signals on different time frames saying the same thing, it is time to listen.

Next installment: Intermarket technical analysis and global economics.

Charts: Courtesy of Worden Brothers Inc. Telechart 2005 Gold.

Stocks at 4 1/2 Year Highs: What Does It Mean?

It has been an exciting start to the new year for the bulls. Since 12/30/2005, the SP-500 rose 2.98% to 1285; the Nasdaq leads advance among large caps by gaining 4.55% to 2305, while the Dow Jones Industrials improved by a more modest 1.26% to 10,959.31.

With the exception of large cap technology, small caps continue to outperform large caps. The Russell 2000 gained 3.73% this week. Small caps are known to outperform during this time of the year.

Two reports came this week: the Federal Reserve minutes from mid-December and the employment report. What is important to monitor is not necessarily the numbers themselves, but the market reaction to them. The response of different asset classes to the same economic information can reveal divergent perceptions as to the state of the underlying fundamentals. This is a prime example of information having a different outcome, depending upon the context it is presented.

The first thing to remember this about the payroll and unemployment numbers: unemployment is a lagging indicator, while payroll is a coincident indicator. This makes the payroll indicator slightly more important, in that it will form peaks and troughs which roughly coincide with economic activity. Second, payroll numbers are volatile and hard to predict. Typically, economists, and especially Federal reserve members, focus on a 3 month average of payroll numbersm as opposed to monthly numbers themselves. Third, payroll numbers are subject to frequent revisions as well as seasonal adjustments, and these adjustments are sometimes able to move the markets.

The action of the bond and stock markets will differ, depending upon the state of the market cycle. The bond market reaction is fairly straightforward. Unexpected increase in payrolls and decreases in the unemployment rate are bearish for bonds, which means yields go up. Conventional economic wisdom suggests strong employment means strong economic growth, which could signal increasing inflation.

The stock market reaction to the employment numbers is more complicated, in that it depends upon the state of the market cycle. If stocks have been in a prolonged downtrend, strong employment numbers are bullish, as that implies improved economic growth and improved corporate profits. Yet, stocks can also sell off on strong employment data. If stocks have been trending up (or at least not declining), unexpectedly strong employment data would likely lead to stocks selling off in anticipation of increased inflation and Federal Reserve short term interest rate hikes.

The market reaction to the release of the Fed minutes demonstrates, to me at least, that the market was worried about Federal reserve perceptions of inflation risks. Stock market bulls desperately want an end to the Fed tightening.

Stock bulls received further encouragement with the weaker than expected jobs report. The market appeared to interpret the weak jobs numbers, coupled with low unemployment, as a sign of a so-called "soft landing" where the Federal Reserve can quit with the rate hikes, while the economy coasts along with low inflation and solid growth.

Bonds reacted differently. The 10 Treasury year yield increased 23 basis points, 5 year yields increased 33, while 30 year yields increased 18. This steepening of the yield curve has put many market watchers a bit more at ease. But it begs the question: why were weak employment numbers interpreted negatively by the bond market?

There one possibility I see is that bonds still fear some inflation. Hourly and weekly incomes were up 3.1% from last year. (Bloomberg report).
Keep in mind that both the Fed data and the employment data is somewhat ambiguous. The Fed didn’t really state anything new, and only indicated that future policy would be contingent on future data. The jobs numbers, while somewhat weak, still showed strong enough growth that one could make the case that the Federal Reserve should continue to worry about inflation. At least the bond market response suggests as much.

Regardless, my initial bearish stance should be modified somewhat. The market continues to interpret ambiguous data in a bullish way, telling me that it wants to go up. In a future post, I’ll give a more detailed technical look at how I come to that conclusion.

Yield Curve Inversion: Time to Worry?

In a slow news week for the financial markets, the reporters at Bloomberg have made a big deal about yield curve inversion:

Yield Curve
The yield on the benchmark two-year Treasury yield ended the week at 4.40 percent, according to bond broker Cantor Fitzgerald LP. The 10-year note yielded 4.39 percent. An inverted curve, where short-term yields exceed long-term yields, last occurred in December 2000 and has come before each of the past four economic downturns.

The Federal Reserve has spurred the climb in short-term yields by raising the benchmark U.S. interest rate eight times this year to 4.25 percent. Investors are optimistic that policy makers will end their rate increases next year, sparking bigger gains for the stock market. Bloomberg News

There is dispute over the significance of the 2 year and 10 year inversion. Historically, inversion has been measured by the 3 month T-bill vs. the 30 year. That has been the most predictive section of the yield curve for recession. (See this article by Fidelity Fixed Income). Despite this, inversion between 2 and 10 year yields is predictive of slower economic growth, if not recession.

There have been many economists, including Greenspan and Bernake, who argue that "The yield curve is no longer a useful gauge of the economy" (Greenspan's Testimony) The first argument: the notion of a "savings glut" where foreigners buy long term U.S Treasuries, forcing yields down. This is a technical factor that doesn't reflect underlying economic activity.Second, the spread is not wide enough to be statistically meaningful. From the above link:

Statistical analysis indicates that the first factor--the gap between the current and long-run levels of the real federal funds rate--is a key component from which the yield curve slope derives much of its predictive power for future GDP growth. When the level of the real federal funds rate is pushed well below its long-run level, economic stimulus is imparted and the yield curve steepens. The economic stimulus influences output growth with a lag; as a result, the steepening of the yield curve in this scenario is a predictor, albeit not the cause of, stronger economic activity ahead. Conversely, when the level of the real federal funds rate is pushed above its long-run level, economic restraint is imparted and the yield curve flattens. Once again, the economic restraint influences output growth with a lag, so the flattening (inversion) of the yield curve in this scenario would signal weaker economic growth ahead, but would not itself be the cause of the weakening.

Let's put the "savings glut" theory to rest. There is no global savings glut. There is, however, lots of U.S. dollars floating around, looking for a place to park themselves and earn a return. Interest rates around the world have been at historical lows. Just 2 years ago, the Fed was commenting on an "unexpected and uncomfortable" decrease in inflation--(aka. deflation). In order to combat deflation, the government did the following:

• the Fed lowered the Fed funds rate to 1%. Japan has had 0% interest for years.
• In addition, the Bank of Japan (BOJ) and Minister of finance (MOF) created 35 trillion yen, out of nothing, to buy long term, U.S. bonds, forcing down yields in the U.S. Low interest rates in the U.S. sparked a housing bubble, and kept consumer spending strong.
• The president also passed a tax cut, further stimulating the economy
• Ordered the invasion and rebuilding of Iraq, increasing government deficits, further stimulating the economy.

As Richard Duncan, author of The Dollar Crisis observes, the action by Japan alone was "money creation on a scale never before attempted during peacetime."

What has all that money bought? A housing bubble in the U.S, as well as other parts of the world (see also U.K, and Australia, as well as China and Europe). It certainly hasn't done much for stocks. For all of that money and credit creation, since December 2003 the strongest U.S. market--the Russell 2000, has risen at about 10.7% compounded--roughly in line with the long term historical average of the U.S. market. The SP has compounded at about 7% for the past 2 years--below the typical 10% long run return.

The failure of the markets to respond to such massive credit creation tells me we are fast approaching a point where further increases in credit are not going to be able to keep the global economy going. Any slight restriction in credit (ie. a flat or inverted yield curve) will likely signal a sharper than normal recession down the road.

The Chairman's second point, the difference between long and short term yields, is slightly more valid. What needs to be kept in mind is that the best predictor has been a 90 day average of the yield spread. John Mauldin from Save Haven writes:

In September 2000 the yield curve was seriously inverting. I called Estrella to talk about the importance of the curve. I wrote then:

'First, he told me he had done another study in 1998 comparing even more predictors. The latest study involved 30 potential predictors of a recession. The conclusion of that study is that the 90 day average of the yield curve was the most reliable predictor of the 30 they studied, so score one for taking this current situation more seriously."

What message is the Yield curve currently giving? Considering it had inverted during a week of slow trading, there is some merit to holding off on drawing any conclusions until more data from normal trading activity comes in.

What would be a mistake, in my view, is to ignore a sustained mild inversaion, say less than 30 basis points. Those probability charts are based on yield differences, and do not take into account the fact that basis point changes (hundreths of a percent) are more meaningful at lower yields than at higher yields.

As is described in the bond market classic: Inside the Yield Book:

"Common sense says that yields fluctuate according to pecentages of starting yields; that is to say, a yield change from 6% to 8% is as likely as change from 3% to 4%, or that a yield change by 100 basis points from 8% to 9% is less significant and more common than a 100 basis point change from 3% to 4%

The interpretation of the indicator needs to be adjusted to historically low interest rates. If average long term yields are about 7.3% and inversion occurs when short yields are 50 basis points above long yields, that would put a short yield at 7.8%, or 7% higher than long term yields.

At interest rates at these low levels, an equivilent spread indicating recession would be about 30 basis points.

What I expect to see: a sell off in stocks of about 10% the first half of the year. Don't be surprised if the Wall St. cheerleaders look surprised at the weakness with all of the "good" economic data. There will likely be indicatons of a recession in the lagging economic data late in 2006.