WIth all of the hoopla about economic recovery still filling the airwaves, it is curious indeed why the market is losing ground this earnings season when earnings are coming in better than expected across the board.  The explanation is very simple.  This rally since last March has been about the banks having access to free money and funneling it into the market through their trading desks.  Earnings, GDP, etc. have nothing to do with it. 

World governments have been trying to spend their way to prosperity, but of course that never works.  The thinking was to keep things going until the world economy rebounded, but just one look at the U.S. unemployment rate shows that things are, in fact, not getting better. 

China has been the leader in this recovery attempt due to their loose monetary policy and their propensity to stockpile raw materials.  Two announcements in January, however, show that China is now beginning to tighten their monetary policy for fears of stoking widespread inflation.   The draining of the liquidity pool is beginning to show up in the shares of the Shanghai Composite.  In the chart below, I have plotted the Shanghai Composite (black line) along with the S&P 500 (red line).

Notice how the Shanghai Composite actually bottomed in October 2008, a full five months before the S&P 500.  After testing the low in December 2008, the Chinese market began making a succession of higher highs and higher lows.  Speculation ran rampant as liquidity flooded the marketplace.  In August, the Shanghai made its final high.  After a sharp sell off, the rally resumed, but the August highs were never eclipsed.  That was telling is that something was on the way, namely tighter monetary policy.  Notice how the S&P pushed out to new highs last month while the SHanghai was breaking down, making a succession of lower highs, forming a triangular consolidation pattern.  Just this week the Shanghai broke down out of that pattern signaling trouble ahead.  This is an important leading indicator for our market as the S&P 500 has been responding merely to excess liquidity, not market fundamentals.  With India now saying that they are undertaking steps to drain liquidity, it is just a matter of time before other nations begin to tighten and this party is declared over. 

        

The recent selloff in equities has produced the worst market stretch since early 2009, before the liquidity induced rally began last March.  Does this mean that buyers have finally exhausted themselves, or will free fed money continue to be funneled into this market? 

One of the trademarks of this rally has been the lack of volume which has been pointed out on numerous occasions in this blog.  The fact of the matter is that from a momentum perspective, this rally hit is peak last fall and the continued push higher over the last four months has been more of a drift higher than anything.  The chart of the Nasdaq Composite below illustrates that point.

The chart consists of a daily price plot in the upper pane, with a 14 period money flow index (MFI) in the middle pane and normalized volume in the lower pane.  Since money flow is price momentum multiplied by volume I thought it was the best tool to analyze the momentum of this rally as it allows volume in its calculation. 

Notice first how the MFI peaked back in September and while price continued to grind and drift higher, the MFI made lower subsequent peaks before showing a very weak negative divergence which preceded the recent selloff.  Now take a look at volume in the lower pane.  The volume levels at the recent top and subsequent selloff are the highest since the rally began in March.  This shows a change in sentiment among traders.  The only question is will the selling run its course before one more push to new highs, or is this a signal that the rally is over?  With the breakdown in the Risk Flow Indicator (see previous blog post), this may be the end of the line.  

   

        

When using technical analysis, one is prone to 'head fakes' and other situations that arise from using single dimensional analysis of prce and volume.  A tool I have developed to allow a deeper look into the market is the Risk Flow Indicator (RFI).  The RFI measures flows between sectors and groups to give a plot that easily identifies whether or not investors are embracing or moving away from market risk.  Very simply, risk is the fuel that sustains rallies.  When investors shun risk, rallies die.  When they ambrace it, rallies flourish.  Indicators such as this can help gauge the strength underneath the rallies to determine whether or not a rally is likely to continue or fail.  Using simple technical analysis indicators can provide valuable insights, but are also prone to divergences and false moves lower as the rally continues. 

In the chart below I have plotted the Nasdaq Composite along with the RFI in the lower pane.  Notice how the RFI topped out on January 8 and began to deteriorate while the Nasdaq Composite struggled to post its closing high on January 19.  RFI weakness told us that investors were shying away from risk, ths leaving the door open for sellers to take command just as we saw last week. 






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The biggest driver of our economy historically has been real estate.  In the past, consumers used their homes as piggy banks, cashing out funds as their values rose.  We all know that the bursting of the real estate bubble is what brought our financial system to the brink of disaster.  I believe we are still close to the 'edge of the abyss', in spite of what our government says.  As I pointed out a couple of days ago, the bond market is suggesting that Fed manipulation of the money supply could careen out of control should they continue to try and hold rates down.

At any rate, the PHLX Housing Index (HGX) has moved lock step with the S&P 500 most of the time.  When it diverges, there is trouble on the horizon.  Notice in the chart below how the housing index hit its all time peak in the summer of 2005.  At that time there was a frenzy of relaxed loan standards, with many banks and mortgage companies following the Countrywide model of simply writing the mortgages with no regard for the facts.  That type of bubble mentality takes time to work through the system, which was evident by the S&P continuing on for two more years before the bubble finally burst.  Take a look at October 2007 and you can see that as equities topped, HGX was already in a firmly established downtrend. 

Now fast forward to today - you can see that HGX moved higher with the S&P off of the March low, making higher highs through this past summer.  HGX is lagging which is not good news for the overall economy or for equities.  Some may argue that this divergence can go on for a couple of years as it did in the past, but I believe it is 'different this time', to coin a popular phrase.  Since last December, the Fed has injected trillions into the economy to keep it afloat.  That activity compressed everything into a much smaller time window that will unwind in a much smaller time frame than when natural market forces have the S&P the inertia to continue higher even when cracks were evident.  Given the fact that the government continues to support key industries while unemployment remains near all time highs, this is not our average garden variety recession.  The housing market is saying that the government initiatives are running out of steam, and the bond market will tell us when the party is over.





Happy New Year!

        

As this remarkable equity rally continues seemingly unabated, there are warning signs in the bond market that the end may be near.  Those of you who read the Weekly Navigator at http://www.marketperspectivesllc.com/ know that our proprietary Risk Flow Indicator (RFI) is still showing positive flows, so the long side should continue to be favored.  There are signs, however, that interest rates will be heading higher soon as a pending breakdown in 30 year T-Bonds indicates.

The chart below is a monthly chart of 30 year T-Bonds dating back twenty years.  I have also plotted a 90 month moving average which was briefly breached only one time back in late 1999.  If that moving average gives way decisively, that is the signal that the rally in equities is finally drawing to a close. 



Notice that historically equities continue to rally for an average period of 18 months to two years after bonds turn lower before either a significant correction or a trend change takes place.  What is interesting in this case is that this latest equity rally was driven purely by the quantitative easing policy of the Fed, not due to honest earnings and economic growth.   The easy money has found its way onto bank balance sheets and into treasuries and the equity markets.  Consumer and small business loans?  Why would the banks take that kind of risk when they could either take that free money and buy treasuries, or better yet take that money and keep pumping it into equities?  So while the economy continues to struggle - just ask the millions of unemployed - the equity markets continue on their merry way.  From the looks of things however, the clock may be ready to strike midnight and Cinderella may be stranded with no ride home from the ball.

For now the trend remains up as the risk flows are positive.  If investors begin pulling back from risk, that is a sign that change is in the air. 

        

November retail sales showed a  0.3% decline over the year ago period according to the International Council of Shopping Centers, That number took analysts by surprise along with those that are wholeheartedly believing in the economic recovery story being spun by the media and the government.   As expected during a recession, sales increased at the discount chains, but dropped off sharply at the higher end stores.  

One area that was most telling with regard to the economy was the steep decline in sales at stores that market teenage clothing and accessories.  That shows two things.  First, it shows that parents have less disposable income to keep their teens 'fashionable'.  Second, it shows that part time positions for teens old enough to work  may not be as plentiful as in years past.  Neither of these scenarios scream economic recovery.  

The weak November same store sales report was forecast by the drop in relative strength in retail shares vs. the broader market.  In the chart below, I have plotted a spread chart of XRT (SPDR S&P Retail Index) vs. SPY (S&P 500).  I have also plotted the XRT itself as the red dashed line as a reference.  When the black line is moving higher, that means that XRT (retail) is outperforming or leading the broader market.  When the black line is falling, XRT (retail) is lagging the broader market. 

Notice how XRT led the market higher off of the March low as investors piled into retail stocks due to lean inventories and hope of an economic turnaround.  That theme played on until October 26, when XRT hit its relative strength peak vs. SPY.  Since then, as we have entered the most important time of the year for retailers, XRT has lagged, pushing the  black line lower.  That shows distribution in retail shares as the broader market has continued to push higher.  The difference is really evident when the black line is compared to the red dashed line which is the actual price of XRT.  Notice how XRT itself (the red dashed line) has traded in a range while XRT loses relative strength vs. the broader market (the black line is falling).  This is not a positive signal for retailers or for the economic 'recovery' in general.   



So while there are still many out there telling us how good everything is, let the subtleties of the market tell you how good things really are.  Yes we have rallied tremendously off of the March low due to the cheap, easy money provided by the Fed, but what happens to the rally when the excess liquidity is reigned in?  That will be about as cruel to oblivious longs as kicking the crutches out from a one legged man.   The trend is still up and long positions are advised, but keep your hedges on and stay away from retail for now.  The stock market is still the best discounting mechanism around and right now it is saying that this will be a dismal holiday season for retailers.

        

On November 19, I wrote about the Dow being ripe for a correction based on the Fibonacci resistance band high at 10,466 and a weakening volume profile.  Following the action of the last couple of weeks, that picture still has not changed. 

Notice in the chart below that the Dow has not yet been able to break cleanly through the Fibonacci resistance band since entering the band on November 11.  Now take a look at the volume oscillator in the window below price.  This oscillator is simply the difference between the 10 day moving average of volume and the 25 day moving average of volume.  When volume surges, the 10 day moving average moves higher faster than the 25 day moving average, causing the oscillator to move higher.  When volume declines, the oscillator moves lower, as the 10 day moving average falls faster than the 25 day moving average. 

The pattern being traced out by the volume oscillator is not encouraging for the bulls.  Notice how the highs and lows from July through September (the black arrows) showed a normal, healthy volume pattern.  The volume oscillator rose into the highs (higher volume on rallies) and dropped into the lows (lower volume on pullbacks).  Now take a look at the two red arrows at the right side of the chart.  See how volume increased heading into the October low, showing increased selling pressure, followed by a reduction in volume heading into the November high, showing weak buying interest.  This flip flop in highs and lows on the volume oscillator vs. price is not a good sign as the Dow struggles to hold a close above 10,466 (the upper end of the Fibonacci price band).   That fact coupled with the visible decline in daily volume (bottom pane) off of the October low says that there is more risk here than the media would have us believe.

The trend remains up, and as I have said previously, you can not fight the weak dollar, cheap money policy of the Fed, but the risks in this market are increasing.

        

One of the most maddening things about this advance off of the March low is that conventional momentum indicators have been showing negative divergences for weeks or even months while this market grinds higher.  Volume analysis has also been an exercise in futility as liquidity just keeps being funneled into equities - common sense be damned. 

Those of you who have read my posts in the past know that I like to use a wide variety of indicators that do not mimic each other.  For example, I always try to use a volume based indicator with a price momentum indicator.  I almost never use stochastic with an RSI, for example, because they measure the same thing - price momentum.  A multi dimensional look at the markets is always best. 

One of my favorite indicators over the years has been the Nasdaq Oscillator which measures the strength of Nasdaq advances and declines.  That can give an accurate picture of the strength that is behind price moves.  If prices are moving higher, yet the Nasdaq Oscillator is diverging, that is usually a good indication that a pullback is developing, as market internals are not backing up price movement.  If any of you have paid close attention to this indicator, it tracks very closely with the 14 period RSI, yet it is based on a totally different data set. 

I have also paid attention to how firmly market participants are embracing risk by measuring money flows underneath the market between sectors, styles, and even fixed income.  After much thought and trial and error, I have developed an indicator that I believe quantifies these flows.  It is an indicator that trends well, gives great signals on trend line and support/resistance breaks, and has certain bull market and bear market characteristics. 

In the daily chart of the Nasdaq Composite below, first notice how the risk indicator fell out of bull market territory (below the green dashed line) right off of the market top in November 2007.   That showed that investors were moving away from risk even as the market pushed to new highs.  The risk aversion among investors kicked off the horrific decline that culminated in the now famous March 2009 market low.   The indicator then gave a buy signal in March when it broke above the reactionary high it posted in early January.  Since then the risk indicator has trended higher right along with price until it broke its uptrend line about a month ago, and is now in danger of sliding back into bear market territory.  Since then I have been advising my newsletter readers to reduce overall equity market exposure.  Today the market opened to news that Dubai is having major financial difficulties, but it remains to be seen how this plays out. 

Will this be THE top?  My gut says no, that the world will once again crank up the printing presses to cover up yet another global financial mess.  This can only go on for so long, however.  If they can once again push this market higher good for them, but based on investors once again moving away from risk I want no part of it.

        

I know that many have been reluctant participants in this eight month old uptrend (including me), but I believe there is enough hard evidence to believe that a correction at at least equal in magnitude to the June-July correction is ready to unfold.  Calling for corrections or reversals during this uptrend has made many an analyst look bad and this rally has no doubt cost some in the industry their jobs if they did not fully participate in the move.

This rally started in March when the mark to market rule (FASB #157) was abolished for banks, allowing them to set whatever value they wanted to the worthless debt clogging their balance sheets.  The world of make believe combined with massive liquidity injections by the Fed have proven to be a lethal combination to any rational players looking for ebb and flow in this market.

Now that economic reality finally seems to be setting in again (no economic growth without massive government spending along with continued job losses), let's take a technical look at the Dow which has been the market leader.  The mere fact that the Dow has been leading over the past month is a huge red flag on this rally as small caps and tech (measurements of risk tolerance in the market) have faltered badly in comparison.   The outperformance in the Dow is driven by those looking to benefit from a weaker dollar and also looking for the 'safety' of highly liquid multinationals.

In the chart below I have plotted a daily chart of the Dow with the Fibonacci support/resistance bands I have shown in the past.  These bands are not retracement levels, but are computed using actual swing points in the market.  In the windows below, I have plotted normalized volume, which just means that volume is scaled differently so the 50 day moving average looks like a straight line across the volume histogram.  This gives an easier 'at a glance' look at volume to determine whether or not volume is above or below average.  I have also plotted an standard 14 period RSI in the middle window along with a volume oscillator in the lower window.  the volume oscillator is simply the difference between a 10 period moving average of volume and a 25 period moving average of volume.  Volume surges cause the oscillator to move higher, while tepid or weak volume cause it to move lower. 

Notice how the June - July correction was started when price rallied into the Fibonacci resistance band in the 8775 - 8934 range.  Notice also how volume was weak heading into the high and both the RSI and volume oscillator were showing negative momentum divergences.  Price corrected 10% over the next four weeks.  Now fast forward to today.  You see that price has managed to rally up into the next Fibonacci resistance band on weak volume and momentum divergences.  We will see how this next correction unfolds.  For now I would suggest keeping your strongest longs but using hedges for protection.  This market looks ready for a correction but it is hard to fight the easy money/weak dollar policy of the Federal Reserve.
  

        

November 16 Weekly Update