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Today's Market WrapUp 03.10.2009 Mon Tue Wed Thu Fri Barbera Archive The Leaky Bathtub Economy Meets the At the moment, only a fool would argue with the premise that the primary trend for the global economy at this time is ‘contractionary.’ ‘Down -- and down hard’ is the best phrase to describe the current global economic trend. Some would argue that in this context, Deflation is the dominant theme in what we have sometimes characterized as the ‘Leaky Bathtub Economy.” Picture the global economy as the bathtub, where on the one hand we have a huge credit deflation taking place where debt is being extinguished, defaulted upon, and wealth is being destroyed at a record rate. In the analog, loss of wealth and the reduction in credit is the money flowing out the bottom of the bathtub through a gigantic leak. At the same time, we see global damage control being implemented by the governments of the world and the collective central banks. In this case, massive money printing (IOU creation) is attempting to keep the water level from sinking while governments are, at the same time, trying to find a good plumber to stop up the leak.
Given this dynamic, all investors need to remain very hip to the point where “Joe the Plumber” finally arrives. For once the bathtub leak is finally plugged up, history speaks volumes to the idea that the water pouring in to the tub is rarely shut off promptly. In fact, going back through history, we find that most of the time, the water ends up overflowing onto the bathroom floor. For the global economy, a stabilization in the various components leading to a loss of wealth (the stock market, the housing market, the credit markets) implies that at some point, inflation will likely burst back on the scene making a dramatic entrance. For our account, we do not believe that “a turn” back to inflation is likely in 2009. In my view, this is far more likely a 2010 or 2011 event. I have no doubt in my mind that down the road a bit, inflation will return and return with a vengeance. So, given the fact that the trend in motion is to the downside, and like an ocean liner, the global economy is NOT given to fast “U-Turns,” a question becomes what would be some of the leading signals for a turn? Interestingly, while it is all too soon to be at all certain, over the last few days and weeks we have seen what could be the very first, very slight inflationary embers blowing in the wind. Again, at the moment we are inclined to view these as only the most preliminary hints of change and that like sparks, will quickly fizzle before too long. For in every trend, even the most pronounced trends, there are always subtle hints of a false start, call them ‘head fakes’ in the opposing direction. To be sure, these clues are always detected by those who reside as permanent members on the “clutching at straws committee.” Yet as keen observers of the markets, we cannot help ourselves from time to time indulging in a little old fashioned “what if?”. To that end, for today’s article, and for today’s article only, we proudly assume the mantle of Chairmen of the Clutching At Straws Committee looking for signs of the next Great Inflation and in that vein, we henceforth call the meeting to order… We begin with Item One on the Agenda, namely, has anyone noticed the incredible upside persistency in Bond yields, especially the 10 Year? In what can only be seen as a most distressing turn of events to those in the Deflation camp (where we basically still reside), the 10 year Bond yield has stubbornly, very stubbornly, refused to go back down.
From a technical point of view, and here we sound a note of genuine candor, it is important to note that late last year as Bond yields plunged from Point A to Point B, roughly 3.80% in October to 2.00% in December, the move was accompanied by huge downside momentum. It is rare indeed for that kind of downside momentum to represent any kind of final low in almost any market. Where technical analysis would have its voice heard strongly and loudly, last year's Q4 low in Bond yields should by all rights have been no more than perhaps an extreme oversold MOMENTUM low. Momentum lows are precisely that; they are a point where a market crunches down, becomes deeply oversold, and then yields to a RECOVERY BOUNCE in the opposite direction. Once the recovery bounce has run its course the RETEST phase then takes command, with prices revisiting the former low, often creating the appearance on a chart of a “W.” As prices revisit prior levels during the RETEST phase, momentum is always diminished and positive divergences begin to form. This then becomes the foundation for a more sustained reversal. In the case of the 10 Year Bond Yield, the deep oversold lows in December 2008 at 2% could easily be recognized as the Momentum low. To that end, the recovery in yields which then followed in the early phases of 2009 up toward the high at Point C near 3% could also have easily qualified as Recovery Bounce. However, what is fascinating to me at this point, is the lack of a meaningful decline back down to RETEST the prior lows. In Bonds, the 9 day RSI for yields peaked at a fully overbought value of +74.96 on February 9th, and while it is true the yields did BEGIN to dip falling to a low of 2.63% on February 18th, so far, 10 Year Bond yields are nowhere remotely close to retesting their December 2008 panic lows. In fact, as an experienced technician watching markets for nearly 26 years, I would suggest that the absence of a RETEST decline to this point is now strongly begging the question. On a fundamental level, we are all aware that the huge quantities of government spending now pledged and promised, suggest massive auctions dead ahead. Who will be buying these auctions is the question of the day, or perhaps more to the point, did Hillary find support in China on her recent trip? Of course, only time and a close examination of upcoming .TIC reports (detailing the flow of funds by foreigners) will tell the tale. However, in studying the chart of the 10 Year Bond Yields, the price action being sketched out by yields looks most like a sideways consolidation, perhaps an Elliott fourth wave triangle and an RSI 80-40 correction.
To be sure, in Elliott parlance the primary trend is defined by a five wave movement. So far, the advance in Bond yields from the December lows can still be counted as an upward “three” (A-B-C), but any move above 3.00% in a material fashion in the days and weeks ahead would have the undeniable ring of a five wave pattern. At that point, while there is still lots of very strong and historic overhead resistance in the 3.30 to 3.40% range on the 10 Year yield, the overall ‘look’ of the chart would start to take shape as that of a burgeoning uptrend, and one that could begin to morph into a much large primary trend reversal. With markets like the Bonds, which resemble the Titanic in more ways than one, major trend reversals ALWAYS take lots of time. Once trends have been reversed, moves can unfold with striking speed, but the trend change itself is usually a multi-month process. While we know that it is much too soon even at this date to draw any firm conclusions, we have to admit that the fact that yields have NOT moved back down closer to 2% in the last few weeks is beginning to tilt the equation to something other than a traditional deflationary view. In the traditional deflationary view, stocks get killed and bonds do well as interest rates continue to decline. Well, Red Alert everyone! Stocks have been beaten to a bloody pulp and bonds have now failed to rally on said news. This can only mean that something could be potentially in the process of going very wrong in Bondland. In addition to the stickiness which has become evident in Bond yields, an inflationist could also draw some ray of hope from a survey of other markets and some of the inter-market relationships which have prevailed over the last few weeks. Take for example, the price of Crude Oil, which despite a stronger Dollar has actually managed to gain ground even in the face of endless news headlines featuring economic gloom. While prices have not yet broken out above resistance in the $48 to $50 zone, the price action in Crude could almost resemble something of a saucer bottom or, at the very least, a stabilizing base pattern. This in turn, could lead those prone to optimism to conclude that Oil prices may be nearing a more important low and with that, a hint that the global economy could be near a low. And what about those Oil Stocks? Well, our inflationist could look at the chart below, showing the S&P in the top clip, and just below it, the chart of the Amex Oil Index and draw a shred of hope. What would he see? Well, a series of lower lows on the S&P, with the XOI, (guess what?) refusing to move to new lows? That’s right, the new lows on the S&P in November, and now again in March have so far NOT been confirmed by new lows in the XOI. It’s almost enough to make one consider going out and buying a house; concluding that perhaps all the economic gloom of late is overdone.
Of course, if our hopeful inflationist looked even further, there could be other hints of change, with tiny beacons of light evident in the action of overseas markets during the last few weeks. Take China and the Shanghai market, for example. For weeks this market has been in a steady, nascent recovery. A mild, up sloping trend channel. Yet, despite the collapse of European markets to new lows, and the American market to new lows, Shanghai has refused to break.
As China has steadied, the pattern of underlying firmness has become mildly contagious with other markets like Japan’s Nikkei 225, Brazil’s Bovespa, and South Korea’s Kospi refusing to make new lows.
At this rate, the only thing left to send our exuberant inflationist into orbit would be a rally in the Marine Shipping Index. Wouldn’t that be just too much to believe?
Of course, I put forward these thoughts in good part in jest, and in some part with real candor. In watching all these markets, a few conclusions seem reasonable and they are as follows. First off, everything that is in orbit around China, including the Nikkei, Brazil, the Base Metals and Base Metal stocks, Energy, Korea, and the rest of Asia has held up magnificently well during this most recent global equity market decline. This implies that perhaps the markets are engaging in a kind of global arbitrage, trying to pick a recovery winner, and voting along the lines that the recovery will appear first in South East Asia. Since these are high growth economies with huge population’s in need, it is not implausible to conclude that the Chinese government may want to see the emergence of the new consumer based spending model. What’s more, China’s stimulus package is relatively larger than that put forth by other countries (when compared to GDP) and is likely better focused on yielding projects with lasting returns. To this end, we read this Asian relative strength as a signal that this region may be the first to emerge when the overall downturn eventually comes to an end. Second, the US could be facing the early signs of a major funding problem, as the fact that bond yields are not easing in a time period when they otherwise should be would seem to sound a very ominous note. Remember the old saw, that when a market can’t move up on good news, something is very wrong. In the case of the ghouls in the bond market, bad news is good news, and in the last few weeks, we have had nothing but a steady diet of bad news. That bond yields have been unable to rally amidst all this bad news suggests that perhaps something more than ‘clutching at straws’ could be at work. As for the US Stock market, and the larger deflationary theme, odds are still very high that more unpleasantness is ahead, and that the more important turn toward sustained inflation, i.e. ‘the reflation trade,’ will emerge near the very end of 2009, or most likely in 2010. On that score, the odds are high that recent scattered inflation hints notwithstanding, the contractionary economic ocean liner still needs more time to turn, or put another way, the leaky bath tub has in all likelihood not yet been repaired. Frank Barbera Copyright © 2009 All rights reserved. CONTACT
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