Ever since the dramatic sell off that occurred in the markets in the last quarter of 2008, one of the indicators I’ve been watching like a hawk is the exchange rate between the Euro and the Yen. I use it as a gauge for deleveraging and the character of risk averseness in the markets. The breakdown of the seven year trend in the cross rate between the Euro and the Yen in early September was a major warning sign that significant deleveraging was underway. Within a matter of two months the Euro gave back six years of ground it gained relative to the Yen, and the stabilization in the markets in October and November of last year was associated with the sell off in the Euro relative to the Yen abating. Since that time the cross rate between the two currencies has fluctuated between roughly 1.16 and 1.30, with rallies in the cross rate associated with market rallies and declines in the cross rate associated with market sell offs.
Figure 1
Source: StockCharts.com
What I have been watching for as a sign that the markets were heading higher or lower is a resolution to the upside or downside in the Euro/Yen cross rate, and yesterday brought that resolution, unfortunately, with a break to the downside. Not only did the Euro fall to new lows relative to the Yen, but so too did a swath of other global currencies as highlighted in the figure below in two separate panels, which means a test of the November lows is likely in the weeks ahead.
Figure 2. Yen Cross Rates Normalized to 100 as of 10/01/08
Source: Bloomberg
What also points to further weakness ahead is that the market may be oversold in the short term, but many longer term indicators remain far from oversold conditions which indicates the markets have room to fall. The NYSE Summation Index is rolling over and signifies a market top and the S&P 500 Bullish Percent Index is far from oversold territory. Moreover, the percent of NYSE stocks above their 50 day moving averages is in neutral territory and has further to go before the indicator enters oversold territory.
Figure 3
Source: StockCharts.com
Figure 4
Source: StockCharts.com
Figure 5
Source: StockCharts.com
There are other areas that are showing signs of stress that the markets will be hard pressed to ignore. Credit default swap spreads on sovereign debt issues have risen to new highs as countries battle the current economic crisis, with Italy showing the greatest deterioration with their US dollar-denominated five year swaps rising to nearly 200 basis points. A rise in sovereign debt protection partly explains the weakness in global currencies relative to the Yen, with Japan sporting the lowest spreads at 50 basis points.
Figure 6 – Sovereign Debt CDS Spreads (USD-Denominated)
Source: Bloomberg
Another troubling sign is that yields on the lowest quality of the corporate debt spectrum continue to rise. Yields on “B-rated” corporate debt have risen to north of 16% with “BB-rated” debt yields not far off their highs of 12.5%, and yields are rising for “BBB-rated” corporate debt. The greatest ease in the bond market has been in the highest quality “AAA-rated” debt issues as yields have fallen to their lowest levels since May of 2005, and “AA-rated” issues falling to their lowest levels since early 2007. Until yields come down on the lower end of the corporate bond spectrum many businesses will be hard pressed to stay profitable while being forced to pay interest rates north of 10%. Moreover, the spread on “B-rated” corporate debt to 10-yr US Treasuries remains at its highest level in decades, with a bottom in the markets likely to remain absent until the spread comes down as it did in early 2003 when it broke to a new low when it fell below 5%. The current spread is coming in at 13.68%, nearly double the highest spread seen in the last bear market.
Figure 7 - AAA-Rated to B-Rated U.S. Corporate Bond Yields
Source: Bloomberg
Figure 8 - S&P 500 and B-Rated/10-Yr UST Spread
Source: Bloomberg
One of the leading indicators for the markets has been and continues to be the financial sector. The financial sector peaked in the first half of 2007 and has been in a bearish decline ever since. What appears to be the sector’s script is to break to new lows followed by a rebound that fails to break through to the upside of the prior lows, with the sector then continuing lower. The financial sector ETF (XLF) broke to new lows yesterday, falling to .07 after taking out the .67 November low. For the markets to have a fighting chance the financials need to rally above their November lows, while failing to do so would indicate that the markets will likely retest their November lows and possibly break through them if the financials continue to fall further.
Figure 9
Source: StockCharts.com
What has me concerned and gives me little faith in a sustained advance in the financial sector is continued bleeding from losses in the sector’s loan portfolios. The 60d+ default rate in residential real estate continues to climb across various loan types, with subprime mortgages reaching a default rate of nearly 32% and still climbing, Alt-A loans accelerating northwards in the last year to over 17%, and even prime mortgages accelerating upwards as the approach a nearly 10% default rate. While weakness in residential real estate is not news, marked weakness developing in stronger loan categories is not a welcoming trend.
Figure 10 - Residential Real Estate 60d+ Default Rates
Source: Bloomberg
To add insult to injury, with widespread weakness in the economy other types of loan categories are playing catch up with the deterioration seen in residential real estate. Commercial real estate is taking a turn for the worse with bankruptcy announcements becoming the daily norm, leading to further store closings and empty malls. The nearest shopping mall to my home in San Diego has more and more empty stores as Linens & Things, Mervyn’s, and now Circuit City have declared bankruptcy.
On top of weakness in commercial real estate is a rising trend in credit card delinquencies. Delinquency rates are rising across the board with Target leading the way with an 8.55% delinquency rate followed by Bank of America with a 6.56% delinquency rate. While American Express possessed the lowest delinquency rate for the last two years, the company has since seen a large acceleration in the past quarter. This development is most likely due to their market segment as they cater to wealthier individuals who witnessed their stock portfolios plummet in the last three months.
Figure 11 - Credit Card Delinquency Rates
Source: Bloomberg
This commentary was written in the early morning hours of the day and since then the markets experienced a strong advance after testing yesterday’s lows. The Euro/Yen cross rate moved above its lower trading range and the financial ETF (XLF) moved above its November lows.
Figure 12
Source: Bloomberg
Figure 13
Source: Bloomberg
The burden of proof remains on the bulls as the S&P 500 has several overheard resistance points such as 850, the 50 day moving average (~ 874), and resistance at roughly 920. A break above each of those targets would be bullish, particularly if accompanied by a sell off in the Yen relative to global currencies. However, an advance up to those areas will likely put the markets in short-term overbought territory and it will be interesting to see how the S&P 500 holds up. If it can stay in overbought territory and continue to advance the burden of proof then shifts towards the bears.
From a technical standpoint using the Tom DeMark Combo (TD Combo), the S&P 500 has moved to a bullish posture as the S&P 500 completed an hourly buy setup for the TD Combo in early morning trading as well as a completed daily buy setup as today likely marked an exhaustion point in selling in the short term.
Figure 14 - S&P 500 Hourly TD Combo Chart
Source: Bloomberg
Figure 15 - S&P 500 Daily TD Combo Chart
Source: Bloomberg
However, the trend is clearly down as the weekly TD Combo is only on count 2 of 9 for a buy setup, meaning we are far from the bottom of the 9th inning in terms of selling exhaustion. Of interest in the weekly chart below is that the weekly TD Combo has failed to produce a weekly sell setup as the S&P 500 has not exhausted itself to the upside, indicating a weak market that can not sustain an advance that lasts longer than several months. This is in stark contrast to the S&P 500 in 2003 that witnessed two weekly and five daily sell setups as the markets advanced off the March 2003 lows in a sustained advance to the upside.
Figure 16 - S&P 500 Weekly TD Combo Chart
Source: Bloomberg
Figure 17 - S&P 500 Weekly TD Combo Chart of 2003
Source: Bloomberg
The prior twelve months are quite different than the picture seen in 2003 as there has been two weekly and four daily completed buy setups that have resulted from exhaustion to the downside, indicating a weak market. What will likely prove to be a safer entry point for new capital would be to see a weekly buy setup coupled with a lower low in mutual fund redemptions, indicating that the desire to sell has been exhausted, a similar setup to what was seen in 2002/2003.
Figure 18
Source: Standard & Poor's/ Investment Company Institute
What would also likely accompany a similar setup would be positive developments in the various risk management indicators highlighted in my commentary two weeks ago (Priority #1: Risk Management). Until then it is probably wise for new capital to remain on the sidelines until the bulls can prove otherwise.
