One More Bear Market, Please

Market Notes

• Volatility levels are extremely low and complacent globally. In the US, the VIX was recently at 5 year lows. In Asia, implied volatility (IV) on all major stock indices has approached multi year lows as well. Finally, in Europe volatility is also very calm, but more importantly credit default swaps remain elevated, signalling the crisis is not finished by any stretch of the imagination.

• The Junk Bond market is encountering a major technical supply zone (resistance) on the HYG ETF. Price levels from 91 to 93 have been major selling points during the last several years. Furthermore, despite US equities marching towards new highs in March and August 2012, the Junk Bonds have been sending us a warning non-confirmation signal.

• Despite low volatility, behind the scenes, commodity currencies are starting to weaken. In particular, the Aussie Dollar is losing its bid as investors watch prices of Iron Ore free fall (60% of Australian mining export). From a contrarian perspective, investors are extremely bullish on commodity currencies right now. Disclosure: I have shorted Loonie with OTM March '13 Puts.

• All eyes should be on the price of Copper in coming days and weeks, as it gets ready for a make or break technical decision. Its decision will be one of the critical leading indicators for the future state of the global economy, as already discussed in the previous article. Other industrial metals, including Iron Ore and Steel, have not performed well as Chinese demand slows meaningfully.

Big Picture

Industrial economic barometers like Copper and Crude Oil are failing to rise above their 200 day MA and more importantly are not confirming the S&P 500's new highs in 2012. The Emerging Markets, saviour of global growth in the post Lehman recovery, also continue to lag other equity indices indicating that not all is well with the BRICs. Furthermore, the short term rise in the DAX 30, Commodity Currencies and Brent Crude Oil (not shown here) has been almost vertical, so caution is advised. Finally, Gold, Silver and Platinum have technically broken out to the upside, but the real test will come as volatility of global risk assets rise and if the US Dollar starts to rally again.

Leading Indicators

We continue to see the Citigroup Economic Surprise Indices in mean reversion mode, which means the incoming global economic data continues to surprise economist's expectations. This has been a positive environment for risk assets. While the data has been positive relative to what economist's expect, the overall economic activity in the global economy is nothing to write home about. Let us focus on the main three economies, as we always do: US, Germany and China.

In the US, leading economic indictors continue to remain anaemic, with ECRI's Weekly Leading Index still below its 2 year moving average and in a downtrend of lower highs. It is important to note that there is a large disconnect between the WLI and the stock market. In my opinion, prospects of further easing have created a large price distortion relative to fundamental conditions (more on that in the featured article). However, as we well know the markets may misprice a security or an asset in the short run, but correct price will eventually be reached.

Besides ECRI's leading economic indicator, there are other indicators confirming significant divergence between Main Street and Wall Street. The chart above, thanks to Ed Yardeni's blog, shows that his own personal Fundamental Stock Indicator is in complete disagreement with the stock market over the recent multi-month rally out of the June lows. We've seen this many times before and should know by now how it ends: stocks usually play catchup to the downside.

Moving across the Atlantic, earlier in the week we found out that German business confidence, measured by the Ifo Institute, contracted for the fourth month in a row. Future Expectation (subcomponent) readings were extremely interesting, as it shows we are at levels where the previous German recession started in 1991, 2001 and 2008. In other words, Germany is on a cusp of another recession as we speak. Business confidence and the DAX 30 usually have very high correlation, but just like with US equities, the disconnect can clearly be seen here as well. That is because Super Mario has promised just as much easing on the right side of the Atlantic, as Helicopter Ben has on the left.

Finally, moving towards the biggest tail risk of the global economy: China. For weeks we have seen how leading economic indicators in this part of the world have continued to disappoint. The chart above shows a substantial slowdown in rail freight cargo volumes, which correlates highly with GDP figures (not that we can trust them anyway). The question I ask myself is; will the Chinese policy makers stay tight with monetary policy (in hopes of trying to deflate high property prices) or will they give in to fears of a hard landing and re-stimulate instead like they did in 2008?

Off Topic

Priceless wisdom from my favourite investment book, Reminiscences Of A Stock Operator:

His name was Partridge, but they nicknamed him Turkey behind his back, because he was so thick-chested and had a habit of strutting about the various rooms, with the point of his chin resting on his breast. The customers, who were all eager to be shoved and forced into doing things so as to lay the blame for failure on others, used to go to old Partridge and tell him what some friend of a friend of an insider had advised them to do in a certain stock. They would tell him what they had not done with the tip so he would tell them what they ought to do. But whether the tip they had was to buy or to sell, the old chap's answer was always the same.

The customer would finish the tale of his perplexity and then ask: "What do you think I ought to do?" Old Turkey would cock his head to one side, contemplate his fellow customer with a fatherly smile, and finally he would say very impressively, "You know, it's a bull market!" Time and again I heard him say, "Well, this is a bull market, you know!" as though he were giving to you a priceless talisman wrapped up in a million-dollar accident-insurance policy. And of course I did not get his meaning.

One day a fellow named Elmer Harwood rushed into the office, wrote out an order and gave it to the clerk. Then he rushed over to where Mr. Partridge was listening politely to John Fanning's story of the time he overheard Keene give an order to one of his brokers and all that John made was a measly three points on a hundred shares and of course the stock had to go up twenty-four points in three days right after John sold out. 

It was at least the fourth time that John had told him that tale of woe, but old Turkey was smiling as sympathetically as if it was the first time he heard it. Well, Elmer made for the old man and, without a word of apology to John Fanning, told Turkey, "Mr. Partridge, I have just sold my Climax Motors. My people say the market is entitled to a reaction and that I'll be able to buy it back cheaper. So you'd better do likewise. That is, if you've still got yours." Elmer looked suspiciously at the man to whom he had given the original tip to buy. The amateur, or gratuitous, tipster always thinks he owns the receiver of his tip body and soul, even before he knows how the tip is going to turn out. "Yes, Mr. Harwood, I still have it. Of course!" said Turkey gratefully. It was nice of Elmer to think of the old chap. "Well, now is the time to take your profit and get in again on the next dip," said Elmer, as if he had just made out the deposit slip for the old man. Failing to perceive enthusiastic gratitude in the beneficiary's face Elmer went on: "I have just sold every share I owned!"

From his voice and manner you would have conservatively estimated it at ten thousand shares. But Mr. Partridge shook his head regretfully and whined, "No! No! I can't do that!" "What?" yelled Elmer. "I simply can't!" said Mr. Partridge. He was in great trouble. "Didn't I give you the tip to buy it?" "You did, Mr. Harwood, and I am very grateful to you. Indeed, I am, sir. But --" "Hold on! Let me talk! And didn't that stock go up seven points in ten days? Didn't it?" "It did, and I am much obliged to you, my dear boy. But I couldn't think of selling that stock." "You couldn't?" asked Elmer, beginning to look doubtful himself. It is a habit with most tip givers to be tip takers. "No, I couldn't." "Why not?" And Elmer drew nearer. "Why, this is a bull market!" The old fellow said it as though he had given a long and detailed explanation. "That's all right," said Elmer, looking angry because of his disappointment. "I know this is a bull market as well as you do. But you'd better slip them that stock of yours and buy it back on the reaction. You might as well reduce the cost to yourself." My dear boy," said old Partridge, in great distress "my dear boy, if I sold that stock now I'd lose my position; and then where would I be?"

Elmer Harwood threw up his hands, shook his head and walked over to me to get sympathy: "Can you beat it?" he asked me in a stage whisper. "I ask you!" I didn't say anything. So he went on: "I give him a tip on Climax Motors. He buys five hundred shares. He's got seven points' profit and I advise him to get out and buy 'em back on the reaction that's overdue even now. And what does he say when I tell him? He says that if he sells he'll lose his job. What do you know about that?"

"I beg your pardon, Mr. Harwood; I didn't say I'd lose my job," cut in old Turkey. "I said I'd lose my position. And when you are as old as I am and you've been through as many booms and panics as I have, you'll know that to lose your position is something nobody can afford; not even John D. Rockefeller. I hope the stock reacts and that you will be able to repurchase your line at a substantial concession, sir. But I myself can only trade in accordance with the experience of many years. I paid a high price for it and I don't feel like throwing away a second tuition fee. But I am as much obliged to you as if I had the money in the bank. It's a bull market, you know." And he strutted away, leaving Elmer dazed.

What old Mr. Partridge said did not mean much to me until I began to think about my own numerous failures to make as much money as I ought to when I was so right on the general market.

The more I studied the more I realized how wise that old chap was. He had evidently suffered from the same defect in his young days and knew his own human weaknesses. He would not lay himself open to a temptation that experience had taught him was hard to resist and had always proved expensive to him, as it was to me. I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, "Well, you know this is a bull market!" he really meant to tell them that the big money was not in the individual fluctuations but in the main movements that is, not in reading the tape but in sizing up the entire market and its trend.

Hedge Fund Positioning In Commodities

Market Notes

• S&P 500 has managed to post a new marginal weekly closing high last week. However, this "break out" was accomplished on very low volume, indicating hesitation and non-commitment. Most importantly, momentum  is slowing as seen from measuring the distance between the S&P and its 200 MA. Historically, bearish divergence like that, usually indicates price weakness.

• According to the Technical Take blog, Rydex fund inflows towards the equity market are once again at extreme levels. From a contrarian perspective, the current readings were last seen in March 2012. What is also important to note is that the correction in May of this year failed to create enough fear (outflows), unlike the previous bottoms in July 2010 and August 2011.

• Despite the EU issues calming for the time being, corporate credit markets continue to show non-confirming signals towards the equity market. In particular, I am focused on Junk Bond spreads and Credit Default Swaps, both of which remain elevated. While the S&P has managed a new intra day bull market high this week, credit markets have not returned to 2011 lows.

• Leading into the Jackson's Hole meeting next weekend, hedge funds have cut US Dollar net long positions to a neutral level. Interestingly, if we disregard the extreme Euro positioning, hedge funds are actually heavily shorting the US Dollar. So where is the money flowing towards? Hedge funds absolutely love commodity currencies, with net long bets close to record highs.

• Gold and Silver are attempting to break above the 200 day moving average. Gold has spent half a year below its main trend, while Silver has spent almost a full year below its main trend. With prices now overbought in the short term, the next movement will signal whether bulls or bears are in control with either a consolidation of the recent gains or a quick reversal of the breakout.

• Iron Ore and Steel prices are crashing as Chinese economy continues to slow further. Iron Ore is down almost 50% from its peak in February 2011, around the same time that Copper peaked. The mining boom in Australia is now experiencing a serious downturn according to the CEO of BHP Billiton, posing further risks to the national housing bubble and over-leveraged consumer.

Big Picture

We continue to see that industrial economic barometers like Copper and Crude Oil are failing to rise above their 200 day MA and more importantly are not confirming the S&P 500's new highs in 2012. The Emerging Markets, saviour of global growth in the post Lehman recovery, also continue to lag other equity indices indicating that not all is well with the BRICs. Furthermore, the short term rise in the DAX 30, Commodity Currencies and Brent Crude Oil (not shown here) has been almost vertical, so caution is advised. Finally, Gold, Silver and Platinum have technically broken out to the upside, but the real test will be coming as global risk asset volatility rises and if the US Dollar starts to rally again.

Leading Indicators

The Citigroup Economic Surprise Indices are still in mean reversion mode towards the upside, which means the incoming global economic data continues to surprise economist's expectations. Majority of risk assets have done well coming out of the June lows. However, keep in mind that this indicator does not actually state whether or not the global economy is improving, but rather if the data is coming in below or above economist's expectations. In my opinion, despite the improvement in the chart above, economic activity tracked by leading indicators continues to decelerate globally.

The chart below shows the Philly Fed State Coincident Index, thanks to the Calculated Risk blog, which tracks cumulative economic activity in various states throughout the US. The indicator has an above average success rate in recession forecasting, even though it is of a coincident nature. The reasoning behind this is that the indicator breaks down the US economy into components, similar to the way one can break down the stock market into sectors. Just the way sectors start weakening prior to a bear market, dropping off one by one, a similar occurrence is seen with the Philly Fed State Coincident Index below.

The current July readings show that there are now 30 states within the US showing improvement in economic activity, which is only 60% of the overall economy. Historically, whenever readings dropped below 35 states or 70% of the overall economy, the US has always entered a recession (apart from the false signal during the summer of last year). Many would claim that since this indicator let us down last year, it can easily flash another false signal. That is true. However, there are two observations I would like to make:

1. This time last year, the global economy was in better shape, especially the core European nations as well as the Emerging Markets. This year that is not the case as Germany is on the brick of recession, the Netherlands is experiencing a housing crash, India and China are moving towards a hard landing, Brazil is not growing at all and finally Commodity exporters are feeling the slowdown due to industrial metal slump.
2. Focusing on the Philly Fed indicator itself, one can make a case that while last year's signal was false, two reoccurring signals in a row (summer of 2011 and summer of 2012) most likely reaffirm weakness in the economy and increase the probability of a recession just around the corner. Either that or the reliability signal has lost its charm. As the old saying goes... fool me once, shame on you; fool me twice, shame on me.

If I can be plain and general about the state of economic prospects, market bulls continue to claim that everyone, everywhere is extremely negative on everything - and that is why stocks can go up even if the economy remains weak. Let's face it, that has some merit to it, because the general state of the US economy is a far cry from the late 1990s and the stock market has gone nowhere for 12 years. Having said that, if we look at the chart above, we can see that consumers are much more positive than they were a year ago. A general rule of thumb I practice as an investor is to refrain from buying stocks when the public is optimistic about future prospects, unless of course the economy is coming out of a recession (2001/02 & 2008/09). Since we are late in the business cycle and a recession is most likely around the corner, I personally feel that the short term optimism shown by consumers is unwarranted and will most likely prove to be a contrarian indicator.

Copper Leads Global Growth

Market Notes

• Apple has become the world's largest company by market capitalisation... ever. It has now eclipsed Microsoft's market cap peak in late December 1999 during the technology bubble in nominal terms (not inflation adjusted terms). Amazingly, the parabolic run has created gains of 81 times over the last 10 years. Disclosure: I have started shorting Apple with OTM 2014 Puts.

• The Nasdaq Composite approached March highs on the back of some of the weakest and narrowest breadth I have ever seen. When we look at the number of tech stocks making 52 Week New Highs and smooth it out over an one month time frame, the results are flashing warning signals as majority of the tech companies are failing to confirm the rally.

• A few weeks ago I wrote about how the British Pound was a good short. I still believe this to be the case, as I think the Pound's major consolidation pattern will resolve to the downside. I believe that the UK is going to enter a more serious slowdown but I seem to be in the minority, as many traders turn very optimistic towards future prospects of the British Pound.

• Precious Metals are breaking out from their technical pressure points. We saw Platinum start the move, followed by Silver and finally Gold has now joined the party too. While gold bugs are celebrating, I think the real test is ahead of us. PMs need to prove that they can rally even if volatility rises, risk assets including stocks sell off and the US Dollar starts to rally again.

Big Picture

We continue to see that industrial economic barometers like Copper and Crude Oil are failing to rise above the 200 day MA and confirm the S&P 500's new highs in 2012. The Emerging Markets,  saviour of global growth in the post Lehman recovery, also continue to lag other equity indices indicating that not all is well with the BRICs. Furthermore, the short term rise in the DAX 30, Commodity Currencies and Brent Crude (not shown here) has been almost vertical and caution is advised. Finally, Gold seems to be attempting a technical upside breakout, but the real test will be coming as global risk asset's volatility rises and the US Dollar starts to rally again.

Leading Indicators

Global economic data continues to beat economist's expectations. Like previously stated, this is a positive for the time being and it has been helping global stocks and other risk assets move higher in the last couple of weeks. However, keep in mind that this indicator does not actually state weather or not global economy is improving, but just weather the data is coming in below or above economists expectations. During the middle of 2008, US economic data improved relative to economists expectations, and yet the recession just intensified and markets crashed afterwards.

Bulls from CNBC to Bloomberg are trying to convince bearish investors that the US economy is improving. Even some of the more respected investors are falling into the bullish trap as well. Some of them are even celebrating the fact that the ECRI Growth Index has risen from -3.5% to -0.6% (chart below) over recent weeks. Can I just ask, since when did a negative leading economic number deserve so much celebration and bullish speculation? 

Do not believe the hype, as there is no strong evidence to support economic improvements. Money printing is having less and less of an effect on the economy. The chart above shows that every one of the intermediate tops over the current secular bear market came during a negative divergence between falling leading economic indicators and rising equity prices. We currently have higher rising prices during falling leading economic activity (another bearish non-confirmation), so will this time be different?

The chart above, thanks to alsosprachanalyst.com, shows that Chinese electricity output remains flat at best. Chinese National Bureau of Statistics showed that hydroelectric power was the only reason that overall output growth remained above 0%. More importantly, thermal power output growth keeps sliding in July towards -4.5%. Why is this important, you ask? Because electricity production has high correlation with Chinese GDP (which cannot be completely trusted) and global mining sector performance. All in all, Chinese leading data continues to slow. China holds the key to future prospects of Copper prices, and the feature article below explains why.

Global Business Cycle In Charts

Market Notes

• Recent Merrill Lynch Fund Managers Survey showed that 8 out of 10 fund managers expect ECB to engage into QE by the end of the year, while 5 out of 10 expect Fed to re-start QE. Also to note was that managers increased equity exposure to overweight, increased exposure to commodities from underweight to neutral and finally decreased exposure in both cash and bonds.

• Bulls well and truly dominate the media space (CNBC, Bloomberg). That is usually what happens when US equities rise for six straight weeks and EU equities rise for 11 straight weeks. NYSE 10 day TRIN breadth measure has now become extremely low and joins other indicators like the VIX in signalling maximum complacency.

• Treasury Inflation Protection securities (TIPs) have done amazingly well in recent years. We have seen a very strong correlation with the overall business cycle since early 2009. TIPs have tracked the improvement in equity prices, industrial production and weekly jobless claims perfectly. Fast forward to today and we see TIPs breaking down. What is the message for other risk assets?

• Global risk appetite is usually best represented by the Aussie Yen exchange rate cross. Australian central bank is seen as a super hawkish inflation fighter during economic upturns, while capital naturally finds its way into Japanese Yen during downturns as a safe haven - a perfect risk on / risk off barometer. Aussie Yen cross continues to send a warning signal for other risk assets.

Big Picture

We continue to see that industrial economic barometers like Copper and Crude Oil are failing to confirm the S&P 500's new closing high this week. Emerging Markets, the saviour of global growth in the post Lehman recovery also continue to lag other equity indices indicating that not all is well with the BRICs. Furthermore, the short term rise in the DAX 30, Commodity Currencies and Brent Crude (not shown here) has been almost vertical and most likely overdue for at least a pullback.

Leading Indicators

This weeks economic update is not necessary due to the feature article.

Should We Expect More QE?

Market Notes

• In a sign of speculative activity, retail investors are chasing higher beta stocks on the Nasdaq exchange. Total volume on the Nasdaq has been triple that of the NYSE lately. Previous similarities occurred in May 2011, November 2011 and February 2012. The first two signalled an intermediate top, while the rally continued for another month in the last occurrence.

• Volatility Index (VIX) has closed below 14 yesterday. This is the second lowest price period since the Global Financial Crisis started in late 2007. Previous closes below 15 since the GFC occurred in middle of April 2011 and in early March 2012. S&P peaked two weeks after and lost 16% & 10% respectively into the intermediate lows of August 2011 and June 2012.

• Favourite investment for fund managers today is to hide in the defensive stocks, large caps and strong brand names that pay higher a dividend yield relative to Treasuries. Prime candidate is S&P 100, which has bulls celebrating with an upside break out and a new bull market high this week. However, alarmingly low breadth is not confirming the break out, in my opinion.

• European stocks have now gained for 10 weeks straight. I am very uncomfortable with that type of a streak for any asset class, let alone one like European stocks where the fundamental situation seems to be worsening. Gains are attributed to oversold stock prices, negative sentiment and most importantly "hope" that central bankers including ECB's Mr Draghi will deliver more stimulus.

• Gold & Silver have been in a tight trading range since May of this year. Furthermore, this trading range continues to narrow even further with Bollinger Bands seriously compressing to at least a 12 month low. A major resolution should be close at hand and interestingly some miners seem to be leading the break on the upside, with Silver Wheaton moving 11% this week alone. 

Big Picture

Short term, we can see that Copper and Gold has failed to rally with other risk assets like Equities, Currencies and Crude Oil over last several weeks. Furthermore, the short term rise in the DAX 30, Commodity Currencies and Brent Crude (not shown here) has been almost vertical. So far no major commodity has regained the 200 day MA.

Leading Indicators

Global economic data continues to beat economist's expectations. This is a positive for the time being and it has been helping global stocks and other risk assets move higher in the last couple of weeks.

Despite data improvements relative to economists expectations and despite the rise in the stock market, ECRI WLI refuses to move higher and remains in a downtrend of lower highs. It seems that each rise in the stock market, produced by central bank stimulus, has created smaller and smaller boosts to real  economic activity.

New OECD Leading Economic Indicator data shows Eurozone and China remain in a serious slowdown with economic contraction, while the US is now slowing and fading from positive growth. Japan is following the US into a slowdown too, while other BRIC countries are also losing momentum, with Russia recently entering negative growth on the LEI as well. In summary, OECD Total LEI's uptick in growth from the 2011 slowdown, is now rapidly fading.

Checking The Mood Of Mr Market

Market Notes

• Dow Jones Industrial index is now up for a fifth weekly gain, while Dow Jones Transportation has only managed one weekly gain in the last five. I continue to monitor what I believe to be a serious non-confirmational Dow Theory warning signal between these two indices, especially as the VIX remains at extremely complacent levels.

• The chase for yield continues from retail investors. If government bond yields at extremely low levels aren't already proof of that, one only needs to look at the euphoric buying in Corporate Bonds, Junk Bonds and Emerging Market Bonds. With a slowing economy, record fund inflows and historically low default rates, I'd argue that a storm is brewing in this sector of credit.

• British Pound has been struggling ever since March 2009 lows. It has been consolidating in a long term triangle pattern, from a technical perspective. Downside support has come from political and central bank intervention, while upside resistance has come from BoE QE programs, on going EU crisis and UK's double dip recession.

• Brent Crude Oil has rallied over 27% since it bottomed in late June at $88.50 per barrel. The bottom was a V trough reversal, which usually signals an oversold snapback rally at best. From the technical perspective, Brent Crude Oil is now trading at 200 day MA resistance, while it is 2 SDs away from the 50 day MA and the daily RSI is currently 70 plus overbought.

• On a side note away from markets, I have been changing the blog layout in recent times to organise it towards a different path. Chopping and changing has been evident with some pages removed and others added, but overall I'm trying to push towards a "newsletter feel". That way people can subscribe to the blog for free and receive weekly updates to their mailbox.

Big Picture

US equities remain the only risk asset trending towards new bull market highs in 2012. All major equities, currencies and industrial commodities do not look as good. Emerging Markets continue to under-perform the Developed Markets and European currencies continue to under-perform Commodity & Asian currencies. Copper, just like all other industrial metals, seems to be struggling the most out of all commodities. All in all, from an objective chart outlook, there are no signs that a major risk off trend has ended, apart from the current safe haven status US equities maintain.

Leading Indicators

Global economic data continues to beat economists expectations, with a stand out improvement occurring in Emerging Economies. This is a positive for the time being. On the other hand data coming out of Europe is signalling that the recession is intensifying further. According to the OECD LEIs Eurozone and China are trending deeper into slowdown territory, while United States remains in growth for now. Conference Broad's LEI's are looking troublesome too, with the worst readings coming out of South Korea and Japan (both down over 1% on the month). Remember that these two export powerhouses relay heavily on China as its main customer.

ECRI Weekly Leading Index has not changed much in recent weeks. It still remains well below the 2 Yr MA as well in a so called downtrend of lower highs. There is currently a strong divergence in place between this economic leading indicator (Main Street) and the stock market itself (Wall Street). Previous divergences between the economy and stocks over the last decade have always resulted toward the downside.

Bulls vs Bears: US Equities

Introduction 

When it comes to investing in equity markets, one of the most important rules is to invest at the right time. So what does that mean? Well shorter term traders will argue that timing can be when the RSI goes below 30 oversold, while some traders will argue that you need to follow shorter term cycle patterns and finally others will argue that you should buy into equities when certain moving averages cross above other longer term ones, etc etc. 

I would argue that the most important time to invest into equities is at the beginning of an expansion within the business and investment cycle and the most important time to be out of equities (especially during secular bears) is at the beginning of a contraction within the business and investment cycle. The only problem with all of that is that bulls and bears tend to debate when the business cycle is about to change directions, and many get it wrong over and over due to false signals. So let us discuss as many topics as possible in point form for both the bullish and bearish sides.

Bulls vs Bears: US Equities

• Bulls say that the current business cycle is still positive and growing. After all, the most important evidence is the fact that US GDP is still expanding on a quarterly basis, Industrial Production is still growing at a very healthy rate and while jobs growth is very slow, it is progressing with the recent data release showing a net gain of 160,000 jobs (chart above). Other data points worth mentioning for the bullish side are the fact that company capex remains strong and retail sales are positive. Bulls say, all of this points to a slow muddle through economic activity as the United States is the best house in a bad neighbourhood and is evidently de-coupling from a European recession.

• Bears say that while the current business cycle is expanding, the rate of growth is now at stall speed (chart above). Over the last six GDP quarters, five of them have been below 2%. Bears say that every time this has occurred since at least the 1950s, the US has always entered a recession. Furthermore, bearish points include the fact that payrolls are a lagging indicator, as job cuts only occur once CEOs realise we are already in a recession. Bears also argue that retail sales have now dropped for three months in the row. Over the last 60 years, this type of a statistic has only occurred 27 times (1 in 50 event), and 25 out of those 27 times have occurred either during a recession or a quarter before one began. Bears say, stall speed can only be maintained for so long until a recession starts and de-coupling is a very dangerous word last used in 2007 prior to a global bear market.

• Bulls say that the current manufacturing cycle slowdown, as seen in the chart above with the US ISM chart, is very similar to the previous two in the summer of 2010 and the summer of 2011. All we are going to see is seasonal summer dulldrums and slight disappointment in growth, before we see another pickup into years end.

• Bears say that a manufacturing slowdown is what we witnessed last year during the summer months. If the recovery was real, then the overall global manufacturing (heavily weighted towards the US) would have recovered already. The fact is, bears argue, that we are now entering a manufacturing recession around the world.

• Bulls admit that recently data has disappointed, but remain optimistic that it is about to pick up again. They point to the Citigroup US Economic Surprise Index (chart above) and say that on a mean reverting basis, data should start beating expectations as economists have become too bearish. 

• Bears say that previous data slowdowns mainly occurred in the Developed Markets, which were growing very slowly anyway. Similar occurrences can be seen in late 2007. On the other hand, Global Emerging Markets (GEMs) have been the pillar of strong growth and the major consumers of commodities, since the recovery began in '09 and bears argue that a slowdown in this part of the world is now a very worrying signal.

• Bulls say that the stock market is undervalued based on the most simplest of all tools - the Price to Earnings multiple ratio, which is currently trading well below its five decade average. They also argue that based on common sense, stocks are undervalued by at least 12% or more (chart above), because earnings are now sitting at record high levels. Therefore, stocks should be trading at 1,600 or even higher. Finally, bulls say that earnings continue to beat expectations in general and this is a positive for stock prices.

• Bears say P/E multiples expand during secular bull markets (1982 - 2000) and contract during secular bear markets (1966 - 1982 and currently from 2000 onwards). Therefore, further P/E contraction can be expected even if earnings rise higher. Bears also argue, as can be seen in the chart above thanks to short.com, that CAPE 10 (cyclically adjusted price to earnings ratio) places stocks in very expensive territory. Finally, bears say that the Gross Profit Margins have now peaked and are falling and if that wasn't bad enough, revenues are also disappointing expectations too.

• Bulls say that the US stock market is the best house in a bad neighbourhood when it comes to performance (chart above thanks to yardeni.com), with a better fundamental position than Europe and Emerging Markets, and that is why the S&P is experiencing huge outperformance. Furthermore, bulls say that we are currently in a US presidential cycle and that stocks should be able to post decent gains into year's end.

• Bears say that de-coupling in equity markets does not last. They argue that in early 2008, Emerging Market equities gave de-coupling a shot for awhile as US equities peaked, but they eventually caught up on the downside. This time around, US equities will be catching up on the downside too. Besides, the bad seasonal period for equities is now upon us, say the bears.

• Bulls say that the mood in the current market environment is pessimistic and this is best seen with the chart above showing that individual retail investors, as tracked by the AAII survey. The chart shows extreme bearish readings over the last three months, which is a strong buy signal. Furthermore, bulls show that various other sentiment surveys are quite bearish and that stock analysts are in total panic mode (chart #1 & chart #2). Also to note is the fact that retail money continues to sell stocks at the expensive of bonds and that is another positive contrarian signal. Finally, if all of that wasn't enough proof that we are going to rally much higher, bulls say that hedge funds are currently underexposed to US equities, so all in all it is time to buy and not sell.

• Bears say that surveys are less relevant than actual exposure, because it is the old "who said what versus who bought what" argument. Bears state that cash levels are extremely low in all major indicators from rydex mutual funds (chart above) to pension fund allocations and retail money market funds. Bears also claim that while AAII sentiment survey show an "opinion" of low bulls, the AAII asset allocation survey shows the "action" of very low cash levels. Furthermore, bears claims that the AAII survey isn't confirmed by other surveys, including the very low level of bears in the Investor Intelligence.

• Bulls say that as volatility remains low and financial conditions remain calm, equity markets can keep trending higher from these levels. Furthermore, the Junk Bond market which is a great barometer of overall risk, is not pricing in a recession nor a bear market (chart above). Finally, bulls state that from a technical perspective, Junk Bond prices look like they are in a healthy uptrend, which is pro-risk and a definitive positive for their equity counter-parts. Also to note is the fact that the VIX can stay very low for a prolonged period of time, according to the bulls.

• Bears say that the low volatility readings have been a contrarian indicator ever since the Global Financial Crisis started in late 2007, and currently we are in the danger zone again. At the extremely low levels of 15 on the VIX, bears say it is time to short equities with a potential to see lower prices in the months and quarters ahead. Finally, bears say that Junk Bonds tend to correlate very heavily with the VIX, so one shouldn't pay much attention to it as a leading indicator. Furthermore, Junk Bond ETFs are experiencing record inflows which from a contrarian perspective could mean lower prices ahead.

• Bulls say that the current trend is up. It doesn't matter what any other indicator says, because the most important indicator of all is the price. It has made new highs in 2012, remains above the 200 day moving average (basic uptrend / downtrend gauge) and is also currently trending with higher highs in the short term too. Furthermore, bulls say that the percentage of stocks above 50 day moving average is around 75%, which is quite healthy for an uptrend, while not overbought or extreme. Also to note is the fact that McClellan Oscillator and the Bullish Percent Index are not overbought either, so from an internal breadth point of view, a correction is most likely not due. Finally, the NYSE cumulative AD line is making new highs, so bulls claim it is only a matter of time until the S&P 500 follows.

• Bears say the equity price is approaching the major supply sell zone (technical resistance) from April 2012 highs, but this time around the internals are rather negative. Bears say one should consider that less than ⅔ of all stocks within the S&P are trading above the 200 day moving average (chart above). Bears also say that the percentage of stocks making new highs versus new lows is very low and is bearishly diverging with the current rise in price, advising a cautious outlook. Dow Theory shows a major non-confirmation between Industrial stocks making new highs, while economically sensitive Transports aren't following, so bears claim it is only a matter of time until the divergence is played out to the downside. Finally, bears claim that whenever cyclical sectors have under-performed the S&P by this much, it has lead to at least an intermediate top and a correction.

• Bulls say that Dr. Bernanke stands ready to act as early as the Jackson Hole meeting at the end of this month. Further quantitative easing (Fed balance sheet expansion a.k.a. printing of money) and other additional stimulus measures should support the US economy and risk assets through the current slowdown patch until the natural growth cycle picks up.

• Bears say that while Dr Bernanke will eventually act, he might not act immediately because of the US elections approaching. Furthermore, bears say Bernanke understands that expectations of inflation are currently too high (chart above shows 5 Yr break Evens need to approach at least 2%) and there are currently no risks of deflation as Core CPI is above the Feds target. Finally, bears say that the recent Non Farms Payroll report takes QE3 off the table, so lower prices are possible.

So... when it comes to the medium term time horizon (months to quarters), please let us know what you think on the direction of US equities in a survey poll below:

Survey Poll

After several days of voting, over three hundred traders and investors have spoken toward the first article on Bulls vs Bears debate, with a topic on US equities. About 30% are currently bullish over the medium term time frame, overwhelming 50% are bearish and finally 20% or so are neutral. Another way to look at this is to state that 30% would be buyers, expecting high prices; while 70% are neutral or would be sellers, expecting lower prices. 

I guess contrarians would argue that any polls majority is usually wrong, but this one will be a perfect test. In coming months, we shall truly see how smart and wise the underlying reader base of Short Side of Long really is, and will they be classified into smart money or dumb money. Stay tuned...

Market Breadth Sending Warnings

Topics Covered

• Equity market breadth spells more problems ahead...

Big Picture

Nothing new to report. Refer to the side menu for previous articles.

Leading Indicators

Citigroup Economic Surprise Indices, seen in the chart above, continue to show improvement global economic data beating expectations, especially coming out of Asia (blue line). This is obviously a positive development in the short term, especially because this is a mean reverting indicator. If mixed with central bank action of any kind, the rally in risk which started several weeks ago could have some more legs. ECRI Weekly Leading Index comes out Friday, so no new updates.

Business Cycle

Nothing new to report. Refer to the side menu for previous articles.

Equity Markets

I have decided to do a quick breadth update, specifically for the US equity market, as I see too many warning signals and alarm bells ringing with the current rally that started on the 1st of June 2011 at 1266 from a V trough bottom. Let us have a look at various tools to see what I mean.

First of all let us start with the overall look at the way the 500 components of the S&P 500 are performing. To do this, it is always valuable to have a look at an equal weighted S&P 500 index, which is also known as the Value Line. As we can see in the chart above, the rally from June lows shows the overall 500 equally weighted stocks are under-performing the S&P 500 itself, especially in recent days. This is a short term warning signal, where fewer stocks are making the overall index rise and are therefore marking the beginning of internal weakness.

When something like that becomes evident, I usually look at the short term breadth indicators for confirmation. In the second chart above, we can see that while the index itself is rising towards higher highs, there are less and less components within the index trading above the short term 20 day moving average. This is also a short term warning signal. However, it is not only a story of short term...

... but also a similar story appears if we check the longer term measures of breadth. While the S&P 500 has been advancing with higher highs out of the June lows, the number of index components trading above the 200 day moving average are not expanding and are currently capped. I repeat... the number of index components trading above the 200 day moving average are not expanding. This is a major warning signal in my opinion and what is even more alarming is that even though S&P is about 2% from its highs, there are less than two thirds of stocks above their respective 200 day moving averages.

Negative divergences are appearing elsewhere too, including 52 Week New Highs, as we can see in the chart above. The index moving into higher highs in July has not been accompanied with expanding breadth of more stocks breaking upwards to their new highs as well. As a matter of fact, a lot of cyclical stocks (common leadership in a healthy bull market) are breaking down and looking like they are at the start of downtrends. Recent major breakdowns include Starbucks, Yum Brands, Nike, Ralph Lauren and many others.

You are probably thinking, wait a minute, all of these stocks are from the retail sector. That is correct, and I would like to ask - which sector tends to break its leadership first and lead us into a bear market / recession? Usually retail is one of the first to break down prior to a recession.

Moving along, so I do not get side tracked with micro discussions of various stocks, we can see more bearish divergences above. Percentage of stocks that are trading in overbought territory (considered healthy for an index uptrend) are very low to start of with, which is not a good sign, and furthermore are also diverging bearishly, which tends to hint at a mild correction at best or a proper sell off at worst.

The longer term indicator of breadth that is confirming all of the clues above, is the S&P Bullish Percent Index. This indicator tracks the percentage of components within the index which resemble uptrend patterns using a XO technical method. For an index that is only a couple of percent away from its high, the breadth readings are alarmingly weak. They also hold very close similarities to July 2011, where the index was only a few percent from the high and yet it crashed straight afterwards due to weak breadth readings.

And finally, we look at the Summation Index in the chart above. If we consider all of the clues I've posted above and then focus our attention on the current chart, we can see that the recent correction rebound has been of totally the opposite nature to the previous two, one in the summer of 2010 and one in the summer of 2011. 

• Firstly, both bottoms in 2010 and 2011 were of a basing nature and the current is a V trough reversal. From a technical point of view, V trough reversals are considered much weaker than basing patterns (double / triple bottoms). 
• Secondly, the Summation Index produced bullish divergence patterns right after extremely oversold breadth readings, while this time around we just saw a V trough reversal in Summation Index without the divergence.
• Thirdly, during the first two major corrections of this bull market, the VIX spiked towards 40 or above (not shown in the chart above) creating capitulation and panic. This time around, VIX did not spike to those levels to signal that a major bottom was in place.

They say "investors shouldn't fight the Fed and the current promises by central bankers around the world make it almost impossible to short equities". I have heard that from just about everyone in the last week or so. Fair enough, I understand this point of view, even though I do not agree with it. 

All I can say is that regardless of what central bankers have promised all of us - do not believe in fairy tale stories until they actually do something major, instead listen and follow the market as it knows a lot more than Helicopter Ben and Super Mario. Don't be one of Pavlov's dogs and pay attention to the warning signals...

Bond Markets

Nothing new to report. Refer to the side menu for previous articles.

Commodity Markets

Nothing new to report. Refer to the side menu for previous articles.

Credit Markets

Nothing new to report. Refer to the side menu for previous articles.

Trading Diary

• Outlook: I believe that we in a bear market as the global economy starts slowing down meaningfully. US GDP has grown 6 quarters at around 2% or lower which tends to be stall speed. Over the last 60 years, whenever the economy grows at subpar levels it has always entered a recession. Recessions occur every 4 years of expansion during secular bear markets, so next year we are overdue for a slowdown. However, it could be much earlier as leading indicators show not all is well right now. At the same time corporate earnings and gross profit margins are at record highs, so I expect a mean reversion. On average earnings tend to fall by 25%, so a drop to $70 from current levels in earnings could take the S&P down below 1,000 points on a 12 times multiple. Cash levels in money market funds are extremely low, financial stress is starting to rise, volatility is at very complacent levels and credit spreads are very narrow relative to fundamentals, so I expect a risk off scenario in due time.

• Positioning: I've positioned myself towards the secular commodity bull market and especially in Silver (SLV, PSLV, SIVR) for awhile now. I have recently just accumulated more, because I believe central banks will continue to print money and devalue currencies whenever the economy gets worse. Furthermore, investors were heavily exposed to US Dollar and the sentiment on Silver is also extremely negative, so from a contrarian point it makes a lot of sense. On the other side of my book, I have recent opened a short on Junk Bonds (HYG, JNK), as I believe credit spreads will spike into the future, similar to the VIX. I have also shorted various US stock sectors, including Technology (XLK) and Dow Transportation (IYT), former because the sector is much loved by the global fund managers and the latter because I believe economically sensitive stocks will suffer during a recession. Finally, I have recently hedged Silver longs and plan to do more if the triangle breaks below $26 support. If the triangle breaks on the upside, I will take my hedges off and most likely buy more.

• Watch-list: A major short in due time will be US Treasury long bonds (TLT), as they are extremely overbought and in a mist of a huge bubble mania. Other than that, not too much is on my watch list right now.

What I Am Watching