The Bottom Line

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The perfect storm of resistance last week in the Nasdaq Composite Index (as well as other major technical levels for the other Indices) was the setup for the next down leg in the market. The FOMC meeting yesterday failed to provide investors the extra stimulus they were looking for. Commodity and financial equity investors were the most negatively affected by the Fed’s tool of choice, “operational twist” because the interest rate spread would narrow for the financials and no additional monetary stimulus would be added (inflation expectations got hosed). On top of that, we get two whoppers from the newswires today in a lower Chinese PMI, and the “EU looks to speed up recapitalization of 16 banks”. Wait a second here. Didn’t we just hear from many credit agencies in addition to the banks themselves (PNB Paribas et al.) that they had plenty of capital/U.S. dollars?

The bottom line is that the economy has been weakening since April. The market took a 19% nose dive in August from the May high of 1370 down to 1101 on August 9th for the S&P 500. So how much of the future weakness in the economy or a Greek default has already been discounted in the markets? The bottom line is that nobody knows. The news doesn’t make the markets. The markets make the news. Put another way, the market's reaction to the news is what clarifies how important it is. So what’s most important—and the bottom line isis whether the August technical levels hold. If the August lows are breached on news that Obama is taxing the rich, Greece is rioting, Arabs are promoting regional instability, or China is slowing down, it’s not the news that’s important; what’s important is whether the lows are breached and on volume. If they are, market participants are saying, “I don’t trust current valuations and I will not buy until they are cheaper!”

Red Flags Abound

I was only able to comment on the Nasdaq last week due to time constraints. My thoughts have also been heavily sitting on the price of crude, copper, and the U.S. dollar. Jim Puplava was right when he said that the price of crude is the new Fed Funds Rate. Essentially, if crude continues to decline, it means that the economy is still weakening. But there will come a time that crude gets cheap enough that profit margins widen on transportation and in plastics just as credit gets cheap enough with a low Fed Funds Rate to stimulate demand for credit. Oil is a leading inflationary indicator because moving people or goods take oil. Economic activity takes oil. Oil bottomed on December 22nd 2008 at $31.41. The equity market bottomed two and a half months later, and a few months later economic indicators began to rise.

oil 2008 to now

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While the stock market has consolidated since the waterfall correction between July and August, oil too consolidated by rising from a low near $75 to a higher near $90. No break in the declining trend for oil meant no break in the declining trend for the stock market. Despite oil’s rise to $90, it couldn’t break the declining trend, MACD stayed in negative territory, and the 50-day moving average continued to resist the advance. Today, the consolidation channel was broken (blue lines below) and a downward leg has begun. The next support area that demand will likely set in will be between $70 and $75 where oil bottomed during the summer of 2010. That would represent a 100% retracement of the QE 2.0 move in oil.

light crude oil spot price 22 sep 2011

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Copper is another economic indicator I follow. If the price of copper is falling, then one must assume that economic activity is falling. Copper bottomed on December 24th, 2008 nearly 2 and a half months before equities bottomed, and many months before economic indicators bottomed. Looking at this year, copper peaked three months in advance of equities on February 14, 2011. Equities peaked in May and economic indicators flashed recession signals in August (leading economic indicators peaked in March).

copper now low

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Today, copper was slammed by contracting purchasing manager index readings today for Europe and China. In addition, commodities got slammed by the FOMC tool of choice (operational twist) which did not add any additional money supply as well as a rising U.S. dollar on global economic contraction and falling interest rates (Brazil). All-in-all, copper’s chart looks horrendous with a major breakdown and top formation that has completed. The next support level will be $3 dollar copper. We’re already halfway there due to volatility today after the breakdown.

copper breakdown 22 sep 2011

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Another red flag is found in the U.S. dollar. Gold and the dollar have decoupled recently and, even more important, the dollar has broken out above a flat 200-day moving average. That’s a long-term buy signal folks. The fact that gold isn’t following the dollar, means that gold is losing its safe haven status (short-term) and concerns are shifting towards disinflation and fears of deflation as was the case in the second half of 2008. July 2008, commodities corrected including gold. GLD fell from $100 to $70 (30%) in a few months. It’s imperative for gold that it holds above the August 25th low. A double top has formed and will complete if that low is violated. If we break the near term decline, then the probability will grow that gold is merely consolidating; however, the current relative strength relationship between the U.S. dollar and gold is not supporting that thesis.

dividing the uup fund

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us dollar declining trend 22 sep 2011

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So the dollar’s breaking out to begin a new long-term bullish trend. The last time it did that was from December 2009 to June 2010. While the daily chart is flashing a long-term buy signal as of last week, the weekly chart still shows major resistance at 79. Many technical analysts were pointing out the breakdown in the weekly chart many months ago in the dollar, as did I, but I pointed out the extreme demand zone that couldn’t be brushed away near the 2008 lows. We’ve based near those lose since May when Greece became a hotspot again. The September rally is now testing the breakdown in the U.S. dollar (red circles)

triple bottom for usd 22 sep 2011

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Conclusion

Despite the equity market indices holding the August lows today, commodities are rolling over instead of firming which is not the condition the market needs in order to find a long-term bottom. Tomorrow’s trading will be volatile. The question on every investor’s mind is, “will the August lows hold”. That’s the bottom line as far as equities are concerned. Everybody sees that level, just as everybody saw the March and May lows as a level to watch. What happened when those levels gave way in August this year? A waterfall correction occurred as stop loss orders were triggered. Program trading platforms kicked in sell orders that had been pending for weeks. Clients called their brokers to liquidate in fear. Obviously, the same could happen this time.

We might get a short-term bounce if the August lows hold as they did today, but the breakdown in copper and oil and the breakout in the U.S. dollar are signaling long-term problems. The probability that the market will head lower has increased dramatically and technical analysis warned of major resistance conditions on last week’s advance. Individual investors should err on the side of caution using a small gross exposure to the market. Precious metal investors and gold bugs beware of 2008 conditions in which commodities performed inversely to the dollar on disinflationary fears. Do not let a secular bull market in precious metals cloud your view of the volatility in commodities.

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About Ryan Puplava CMT

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