Today's Market Observation  06.16.2009  Mon  Tue  Wed  Thu  Fri  Barbera Archive

Problematic Outcomes

by Frank Barbera, CMT | june 16, 2009

Over the last 10 weeks there can be no question that the capital market ‘herd’ has come storming back into the arena for speculation, on the prowl for signs of global recovery and reflation. The idea underpinning the advance has been to surf the coattails of the market gods, -- the global central banks -- which have been creating liquidity as never before. Yet, the event in itself has been a total exercise in wishful thinking as any analysis that penetrates even a little bit below the surface reveals that virtually all of the ‘economic bounce’ seen to date is tied to government spending. Ex-government spending, the green shoots do no exist, and the data is still flat lining. What’s more, on a structural basis, there is no primary economic driver that is large enough or buoyant enough to fuel a global recovery. Yes, we know that China and India are high growth economies, but in both cases they are still hugely export dependent and thus will still be dependent on US and European final demand, demand which is not likely to come back for some time. With so many corners of the capitalist world crippled with high levels of debt and industries shedding jobs, it seems that any true recovery is still months down the line. In my view the event just witnessed is a page from early 1950’s market technician, Ed Quinn’s ‘Action-Reaction’ charts. One extreme begets another with the current rally’s false optimism belied by huge cracks in the foundation. It is the polar opposite of last year’s nightmare ‘Armageddon trade,’ which left virtually all investment managers out on the ledge.

As I see it the “reflation” trade is running into its first correction. Key elements to watch for in the coming days will be how far the Dollar is able to rally, and how far down bond yields are able to go. My guess at this juncture is that the Dollar rally will be labored running into resistance near 83.00, and that Bond yields will pull back to levels between 3.30% and 3.45%. The more important aspect of the counter trend move may be the ‘hang time’ involved, which would work out well if both bonds and the Dollar rallied for a period of 4 to 6 weeks. That would take a lot of “the edge” off overheated stock markets (around the world) and other markets like Currencies, Base Metals and Energy, which have already had huge, uninterrupted moves. Among currency markets, one of our favorite gauges is the trend of the Aussie Dollar which responds very well to any growing signs of reflation, but wilts like a flower on a 100 degree day at the first sign of deflation. For the Aussie Dollar the .785 level is a key support zone, and with prices presently historically extended, this needs to be watched closely in the days ahead as an indicator/sign of potentially changing near-term market psychology.

Above: Aussie Dollar with 50% retracement and 20, 50 day averages. The recent lows at
.785 are now important initial support and a move below that level would be bearish.

Above: GST Base Metals starting to break down, this could be an early indication of an onsetting correction.

In the case of Base Metals, we pointed to this sector as a key leader to watch several weeks ago. Since then the index has moved steadily higher but on sequentially less upside momentum. The break down on Monday with a lackluster day on Tuesday seems to be suggesting that Base Metals could retrace 40 to 50% of the entire March thru June advance. In addition to metals, Energy also looks ripe for a major decline as the price of Crude Oil is in the area of major price resistance having retraced 50% of the prior total percentage decline. On the chart below I have scaled Crude Oil on a log scale, with the retracements computed on a logarithmic basis. Where Fibonacci retracements are concerned this is far and away the better approach, ignoring ‘point’ moves and instead focusing on percentage moves. For Crude, the 50% retracement zone is at hand and that is usually a major resistance point. In addition to the 50% retracement zone the weekly chart of Crude is now coming off a set of fully overbought values above +70, the highest readings seen since the peak in July last year.

Above: Crude Oil with 50% Retracement

Above: Crude Oil with 9 week RSI

In addition to major league overbought values on the weekly chart, Crude is now in a position where bearish divergences are showing up on both the daily and hourly chart. As can be seen using the chart of USO, an OIL ETF (and admittedly only a fair proxy for Oil), we see that prices are in the process of retesting the recent highs at Point B (6/11/09 $40.00) with a well defined trendline coming in as support at $38. Notice also that hourly MACD is very likely to ‘fail’ and record a much lower peak in the hours directly ahead. This would amount to a major bearish divergence and is likely indicating a market that is getting ready to launch a major downside correction. In my view if USO breaks below $38, it is very likely to correct further to the downside, perhaps into the low $30s over the weeks ahead.

For the Crude Oil market, a downside correction could unfold in rather dramatic fashion during the second half of June and the early portion of July. While time-cycles often have a large degree of slippage, there has been a fairly consistent 5 year time cycle in Crude, which has also broken down well into a series of 2.5year cycles.

Above: Crude Oil with 2.5 Year and 5 year Time Cycles – early July marks the next cycle low.

Over the next few weeks heading into the early July time period, Crude Oil should experience a
pull back that would mark the nesting of a 2.5 year cycle low. While I believe that the balance of the next few years will witness much higher Oil prices, it is not impossible that Oil prices could revisit the prior lows seen late last year over the course of the next 15 to 20 months as recessionary conditions continue to linger. For Crude Oil, the next nesting of the five year cycle is not due until July/August 2011 with a number of long dated stock market cycles also due to bottom in the same time frame. Dovetailing these with the Presidential Election cycle, wherein the year from 2011 to 2012 is a pre-election year, that mid-2011 time frame marking the third year of the election cycle (usually the strongest) could end up producing superior returns and the next substantial (multi-year) cyclical bull.

While it is a digression and speculation on my part, I believe that the current rally in equities is still part of a large bear market rally, which is likely to take a pause for the next few weeks and then resume to the upside later this year. Such a bear market rally could either peak out later this year or as late as April 2010, but would in either case be followed up by a second major leg down. That second leg down, a second cyclical bear if you will, could then bottom out in the early to middle portion of 2011 setting up a major cyclical low and giving rise to a powerful new bull phase in the second half of 2011 and beyond. It is also highly likely that the return of a strong cyclical bull phase from 2011 forward would be accompanied by a pronounced increase in the overall economic inflation rate and as a result, gains in the equity markets may end up having to be evaluated on an ‘inflation-adjusted’ basis.

Getting back to the near term market outlook I also want to throw a spotlight on the Bank Index, which over the last few weeks was unable to make new highs in tandem with the major stock market averages. This is a bearish divergence and harkens back to the kind of action we saw in the financials before some of the major problems began in 2007 and 2008. Relative strength weakness is often a very big ‘tell,’ and right now the BKX, the Philly Bank Index resides just above very important support at $35.70. With the 50 day average also in this same neighborhood ($35.94), any close below $35.70 in the days ahead would be bearish not only for the Bank Index, but would be a bearish development for the market as a whole. For the Bank Index a pull back to the low $30 area would be fairly routine and could be a sign of money getting defensive ahead of the release of Bank earnings reports due out in early July.

Above: the Philly Bank Index with the 50 day, 100 day and 200 day moving averages.

Finally, in keeping with some of the other caution signs presented in this week's update (toppy Crude, Base Metals, Aussie Dollar, Bank Stocks) I note that the Ratio of Consumer Discretionary to Consumer Staples also seems ready to turn down. Again, this is another straw in the wind suggesting some mean reversion dead ahead, and potentially another whiff of deflation on the horizon. I like to track the Relative Strength Ratio of Discretionary to Staples using the two ETF’s, XLP which tracks Consumer Staples and XLY, which tracks Consumer Discretionary. The Ratio of XLY to XLP is now just about to break below the rising 50 day average. Over the last few years when the Ratio has been above the 50 day average, the overall trend for the stock market has been positive or at least neutral. Conversely, when the Ratio has dipped below the 50 day average bad things have followed. I show this in the final chart which expresses the Ratio as an oscillator, wherein readings above zero are healthy and readings below zero are negative; hinting at some additional ‘problematic outcomes’, the indicator likely went negative at the close today.

Above: Top Clip-Consumer Discretionary; Middle-Consumer Staples; Lower–Ratio of Consumer Discretionary to Staples. Notice that Staples held up well near the all time high well into the bear market, while Discretionary items were deep into a bear market in 2007. On the come back, Discretionary led, moving above the Jan 09 high, while Staples lagged, recording a peak below the January high.

Above: Relative Strength Ratio of Consumer Discretionary to Consumer Staples, hugging (about to break below(?) the 50 day average).

Above: The XLY to XLP R/S Ratio as an oscillator. Positive readings are indicative of a more stable market climate, negative readings, a climate to be more defensive. It is just going negative now.

That’s all for now,

Frank Barbera
The Gold Stock Technician

Copyright © 2009 All rights reserved.

contact information

Frank Barbera
The Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
Email | Observation Archive | Other FS Editorials | FSN News Team