After the Fed announcement on November 3rd, uncertainty left the market and investors jumped into equities with both feet. Since then, stocks have corrected in the face of the April highs, a logical point of reference for supply to enter into the market. Trendlines have been broken and a trading range or correction is in the cards.
Shots Across the Bow
I’ve seen a few warnings surface that cause me some short to intermediate-term concern in commodities. As I mentioned last week on Tuesday, the first was an increase in margin on silver contracts from $5,000 a contract to $6,500 by CME Group—the world's leading and most diverse derivatives marketplace across the CME, CBOT, NYMEX and COMEX. This helps to squeeze profits on speculators who don't have any emotional attachment to silver. As their profits are squeezed, they sell and it becomes a self-feeding event.
The second issue that surfaced last week deals with China. Bloomberg reported imports of copper fell 26% in September (Copper Imports by China Drop…), just as China's production increased. Inventories in Shanghai warehouses increased 21% in September despite the drop in imports. Additionally, news released on Thursday indicates that China's inflation rate is on the rise. The CPI rose 4.4%, well above the 3.5% rise in September largely due to a spike in food prices. It's expected that the Chinese central bank will raise rates three more times before the end of 2011, in addition to raising the reserve ratio requirements, allowing a 5% appreciation in the Yuan, and stepping up capital controls. The mantra: “Watch China for demand and Brazil for supply” continues to hold.
Source: Trading Economics
A third issue that surfaced over the weekend was a rumor that Ireland would need financial aid. It all started when Angela Merkel, the current Chancellor of Germany, demanded for measures that would force bondholders to share the cost of future bailouts on October 29th. Irish bonds have sold off ever since. Merkel states, “We can’t constantly explain to our voters that taxpayers have to be on the hook for certain risks, rather than those who make a lot of money taking those risks.” The Irish are trying to borrow as much as they can from the ECB without having to tap the financial markets, with borrowings up 7.3% in October to 130 billion euros. That’s more than Greece’s total of 92.4 billion euros as of October. It’s not that Ireland is so important to Europe’s regional GDP, but it’s a credit contagion that threatens to destabilize the region as credit default swaps rise on the PIIGS (Portugal, Italy, Ireland, Greece, and Spain), yet again.
News about the margin requirement and China's inflation rate has sent nervous speculators packing out of the reflation trade in the past week. Credit default swaps in Europe and a falling euro are also supporting the correction in commodities. So far the correction looks orderly. The U.S. dollar has rallied, and broken near-term resistance above its 50-day moving average as of today. The last time it made such a move was in December 2009, which kicked off a 6-month rally in the U.S. dollar, and a 30% correction in the Market Vectors Gold Miners ETF (GDX) from December to the February low. Similar events preceded such a move in the U.S. dollar back then, such as strong U.S. economic data and a rise in Greece credit default swaps.
Proving the reflation trade isn’t the only thing that is highly (inversely) correlated to the U.S. dollar, the U.S. stock market has begun a short-term correction that has broken trend. Where we go from here is anybody’s best guess. What’s clear, the bears have taken the reigns from the bulls in three trading days (Nov. 9th, 12th, and 16th) to break the two-month, accelerated QE trend that started on September 1.
I emphasize accelerated, because we haven’t had a counter trend correction of which to form a trend channel since the trend began. Put another way, look at a Point and Figure chart of the S&P 500. The last x-column was uninterrupted, from 1050 to 1220. It wasn’t until today that a 3 box reversal (o-column) has formed.
Emphasizing that an important top has formed, the percentage of stocks above their 50-day moving average, within the S&P 500, has dropped from overbought levels (above 80%) to form a sell signal as of November 12th. Below is a chart of the last few times that has happened (May and January correction to name a couple).
Besides what’s going on in commodities, the U.S. dollar, and Europe’s credit default swaps, municipal bonds are getting whacked! Here’s a performance chart using Nuveen and BlackRock municipal bond ETFs. Just look at the recent wealth destruction this month.
Looking at bonds, commodities, and equities over the past week, there’s been nowhere to hide but in cash. Are we looking at another January and May correction due to credit risk? So far it looks likely. If the reflation trade is being shelved, that means the safety trade may be back on the table. If that’s the case, we should see both gold (bullion and NOT stocks) and the U.S. dollar rise as it did multiple times under similar circumstances over the past two years. Don’t be too quick to buy the dip if you agree with this philosophy. There are a lot of speculators in gold right now that will likely get spooked out of the commodity on a commodity selloff. Remember, gold sold off for 3 months before bottoming in November 2008 and again for two months before bottoming in February 2010 under similar circumstances.
