Markets

SNB Removes Currency Peg

This morning, the Swiss National Bank (SNB) removed its policy of setting a minimum exchange rate against the Euro (EURCHF) of 1.20.  This decision is the reversal of the decision it made in September 2011, when, in response to a rapidly appreciating Swiss Franc, the SNB chose to set and maintain the aforementioned minimum exchange rate. It defended its actions in a further statement following the announcement this morning:

The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation.

As for why the SNB felt that now was the right time to make the move, it said the following:

Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.

Indeed, when the policy was implemented in September of 2011, the EUR/USD traded at roughly 1.40. In the hours before the announcement, it had been trading between 1.17 and 1.18. The SNB had been buying Euros all the way down from EUR/USD 1.40, to defend the EUR/CHF peg at 1.20, and with the prospect of the ECB announcing QE next week, odds are it would have had to escalate its Euro purchases even further as it faced the prospect of a further declining Euro. To date, the SNB purchases of Euros in defense of the peg were extraordinary in comparison to the size of its balance sheet – a fact which was not widely mentioned, but to a few astute commentators this presented a potential ticking time bomb.

Balance-of-percentage-GDP

Apparently the SNB saw the writing on the wall and feared it would have to expand its balance sheet to an even more dangerous degree to continue buying continually depreciating Euros. In essence, it has decided that continuing to print good Swiss Francs and throwing them after bad Euros was a bad idea, and it’s time to cut its losses.

Despite a return to relative sanity, the SNB has come under fire from some elements of the investment and business community. From Reuters:

Swatch Group Chief Executive Nick Hayek called the Swiss National Bank’s decision to discontinue the minimum exchange rate on the Swiss franc a “tsunami” for the Alpine country and its economy.

“Words fail me! Jordan is not only the name of the SNB president, but also of a river and today’s SNB action is a tsunami; for the export industry and for tourism, and finally for the entire country,” Hayek said in an emailed statement on Thursday.

more…

“Absolutely shocking … For companies with international operations – translated earnings are going to be lower and if companies make products in Switzerland it is going to hurt margin. It is a terrible day for corporate Switzerland,” Kepler Cheuvreux analyst Jon Cox said.

Beyond that, much has been said about the ‘loss of credibility’ the SNB has brought upon itself by not telegraphing its move, and making it a complete and total surprise. Dennis Gartman, speaking on CNBC earlier, called it the ‘worst decision made by a central bank’ in his 40 years of time in the markets.

This consternation stems from two ideas. The first is that the SNB originally acted in 2011 to prevent a strong CHF-induced ‘deflationary spiral.’ This feeds into the bog standard deflation-phobia that permeates the economic understanding in the developed world. The story is that a strong currency hampers exports, and reduces economic growth.

I have responded to that claim a few times on this blog, most recently when discussing Abenomics in Japan, a policy which is founded on that same basic idea. The bottom line is that currency depreciation makes it easier for exporters to sell goods overseas, swelling their coffers. This is merely a short term effect, however, as the rise in input costs tends to reduce any advantages provided by the weakened currency. As non-exporters, and any other entity of the currency loses out via reduced purchasing power, the end result is that any currency devaluation scheme does nothing more than transfer wealth from the holders of currency to the exporters. It is noticeable that the early voices of dissent at this move have been such large multinational exporters and financial institutions. It is important to understand that their concerns are largely based on a removal of the policy driven subsidies that they once enjoyed, rather than a true deterioration in the prospects of the Swiss economy.

Those fortunes will be determined by one thing – the ability of Swiss producers to manufacture high quality products. This has not changed with the SNB announcement, and has always been true. What the SNB announcement, and the appreciating Franc does is to force Swiss producers to maintain their competitiveness through continued efficiency, rather than ‘coasting’ as an artificially cheap Franc artificially boosted their sales.

The horror stories put forth by mainstream economists and large exporters simply do not jive with the historical record. If the EURCHF going from 1.20 to parity is to cause the Swiss economy to implode, why didn’t an even more precipitous move – the 2007 to 2011 move from 1.67 to parity – already destroy the Swiss economy? Furthermore, the Swiss Franc has been on a terminal ascent since the 1970s, yet Swiss companies have been able to thrive. This is because they have been consistently producing high quality goods and services, and doing so in an efficient manner. The experience of the Swiss economy over the last number of decades gives the lie to the idea that weak currencies are the key to economic growth, such that a central bank is wise when it engages in a policy to weaken its currency.

The other idea which has driven disappointment in the SNB is related to the ‘deflation is bad so currency strength must be prevented’ argument. It is the fundamental belief that central banks have everything under control, are able to manipulate markets flawlessly, and are steady hands that can guide the ship through the turbulent waters of uncertainty. The actions of the SNB should render this view, which is pretty much ubiquitous throughout mainstream academia, Wall Street and the government, to be foolhardy, but I doubt it will have that effect.

Ultimately, the SNB engaged in price fixing, holding the CHF at an artificially low level against the Euro for nearly 3.5 years. Price fixing in any capacity does nothing but create imbalances. In this case, these imbalances were exposed when, after the peg was dropped the EURCHF fell nearly 40% in less than 30 minutes. The speed of this move has been another talking point in this saga, with large multinationals, financial institutions, and hedge funds all potentially caught out in a negative manner. Undoubtedly such a rapid, unpredictable move resulted in some bloodshed. The blood is on the SNBs hands, not for removing the peg, but for having it in the first place. Absent the peg, today’s move would have happened over 3.5 years, rather than 3.5 minutes.

Do those in opposition of today’s decision think that the SNB could have kept the peg on indefinitely? The economic realities determined that the Swiss Franc was to be bid higher. Central bankers are powerless to alter real economic conditions. The only thing they have at their disposal is the ability to postpone the effects of those economic realities via a printing press. This is what the SNB did, and as a result of their continuous printing, they ignited a real estate bubble. Defending the peg against what was to be a further onslaught driven by European QE would have only meant a further buildup of inflationary pressures, and a further squandering of capital in an unsustainable, depreciating Franc-driven mania. The SNB was right to end its peg, because in doing so it corrected the mistake it made when it put the peg on in the first place.

Today a central bank essentially admitted it can’t control real economic conditions, and that it can’t hold the hand of market participants while it walks on water to the Promise Land. That this is considered to be a ‘loss of credibility’ by the vast majority of commentators and economic participants tells you all you need to know about the state of economic thought and the reverence central bankers have attained in the 21st century. The bottom line is that the SNB learned a dear lesson today, which I doubt will be acknowledged by it, or any other central bank. Whatever moves the SNB was so afraid of back in 2011 happened anyway, except today, these moves happened in minutes as opposed to months or years, creating the very instability they thought the peg was preserving. Furthermore, they have given birth to a housing bubble, which too will lead to instability where they thought stability was assured. It is the same lesson which central bankers across the developed world refuse to learn, which is that economic problems can’t be solved via intervention in markets.

 

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Market Views 23 December 2014

As I write this, the S&P 500 futures (ES) are flirting with fresh all time highs. Santa has been kind to Wall Street this year. The following is an hourly chart of the December action in ES.

1223es1h

The while oval represents the two hours during which the Federal Open Market Committee released it’s latest economic outlook, along with the press conference of chairwoman Janet Yellen to explain it all to reporters. The biggest story from it all, was a semantics change from the FOMC. With reference to the process of raising rates, the next step on the march to monetary policy normalization, the FOMC pledged it would exert ‘patience’ in carrying out the process, rather than merely keeping rates at zero for a ‘considerable time.’ While Yellen asserted that the change of language meant nothing in terms of a change in action, the markets took off from there. Whether these new attempts at all time highs can be upheld remains to be seen.

One thing about the month so far that has been evident is the difficulty in being a bear at this time. Despite the fact that pre-Yellen, ES had sold off 100 points from the highs of the month, there were sharp rallies of 27, 33, 25 and 50 points which meant that it was extremely difficult to actually make money on the short side. That sort of volatility may actually embolden the bearish case going forward, but for now it seems as though the bears will have to retreat until further notice. A two year view of ES:

1223es2y'

Up 33% in 2013, and another 13% in 2014 with 8 days left in the year, with no signs of stopping. So what is the bearish case? That requires the consideration of two factors: time frame, and the adherence to reality. Quite frankly, over the long run I don’t think a bearish case exists for the US stock market, at least in nominal terms. This is because FOMC is fully committed to preventing asset prices from ever falling, and will print infinite dollars to do so if that’s what it takes. The issue is that monetary policy induced perpetual rises in stock prices tend to be divorced from economic reality. See: Argentine and Venezuelan stock market appreciation vs economic realities in those countries.

The creation of more currency does not drive real economic growth, but it can increase stock prices, which ostensibly reflect greater economic growth prospects, creating a discrepancy between real economic prosepcts and the supposed barometer of such. Thus it is possible to have a situation where on one hand, there are shortages of toilet paper, as the stock market makes new all time highs, as it was in Venezuela earlier this year. Or closer to home, last year, the US market making a fresh all time high on the day Detroit, once a symbol of American industrial might, filed for bankruptcy.

What these sort of discrepancies mean is that the bullish case has been, and can continue to be right for the wrong reasons. As being on the right side of the trade is all that really matters in the long term, it’s really hard to argue with the idea that one should just blindly buy and forget about it.

None of this precludes a shorter term attempt by the market to ‘revert to the mean.’ In fact, in order for the long term ultrabullishness to play out, this sort of short term ‘correction’ is necessary, as policy makers won’t flood the market with even more currency unless there is a threat of sustained asset price declines. Thus, the bearish case is really a case of a brief temporary adjustment to economic realities before policymakers step in to resume the voyage to Fantasyland. As I’ve been discussing over the last week, the most likely catalyst for such a short term correction is the oil situation. A long term chart of oil, spanning 20 years:

1223cl20y

 

Based on the rise from $10.65 low in 1999, the current price in the mid 50s still seems ridiculously high. That is until you consider that for the majority of the last 10 years, oil was trading over $50. Most commentators have pegged $40 as the ultimate resting place, which is roughly where it bottomed in 2009 after the crash from the $147 all time high of 2008. Based on chart analysis, specifically the Elliott Wave principle of a three wave correction, I believe that $20-30, rather than $40 will be the ultimate place oil bottoms.

That is, the price action from $147 until now is all part of a longer term correction, after which price will resume higher eventually, ultimately taking out the $147 high nominally. From $147 to $35 in 2008-2009 was the first leg. The second leg was up, from $35 in 2009 until June 2014 (chart below), and the third leg from June 2014 to its ultimate bottom, perhaps in the $20-30 range, which coincides with the last major low before oil prices really took off for the stratosphere in late 2001.

1223cl5y

This is consistent with my views above, namely that in the longer term we are going to be in for severe price appreciation, however this will take place after a deflationary event induces the Federal Reserve to go even more ‘all in’ than it already has. Oil seems to be the first domino in that deflationary chain.

Technically speaking, the triangle formation that took about 4 years to form broke in August, as shown in the above chart. On that break, I drew in the support lines pictured. The manner in which price scythed through these levels suggests there is a real force behind this move. In the immediate term, this move lower could be overdone. The penultimate green candle represents last weeks action, and if the low from last week isn’t broken this week, it will portend a slight respite in the decline. Perhaps a move back to $65-80. But the trend is clearly down, and it will take some doing to arrest the decline. Particularly as Yellen and Co. do not see any real threats from the falling oil price at this time, which suggests they will do nothing to arrest it.

The next immediate place to look after the oil domino falls is the Junk Bond space, as a lot of the financing for oil related projects came through junk bonds. The following is the JNK etf action for the last two years:

1223jnk3y

 

Despite the market as a whole being up over 10%, junk has diverged, to this point down a little over 3% for the year. Something to keep an eye on in 2015.

As for other areas, US dollar strength continues apace:

1223dollar2yr

The above is the US Dollar Index ($DXY), over the last two years. I mentioned in October that my target for  $DXY was 92.5, which seems to be on the cards. This coincides with multi year support on various dollar related currencies, including EUR/USD, GBP/USD, AUD/USD, USD/CHF, USD/JPY, and NZD/USD. With all the sentiment biased in favor of a strong dollar, it wouldn’t be surprising to see at the very least a correction in dollar bullishness, if not a major reversal.

 

More On the Oil Price Developments

The consensus view on the recent plunge in oil prices is that it is a net positive. The logic involved is that the falling price represents a transfer of wealth from oil producers to oil consumers, and as there are far more of the latter, the boost to consumer spending will outweigh any difficulty faced by oil producers.

This logic would be sound if it was simply a case of increasing production satisfying consistent demand. The following chart suggests that is not the case:

supply_vs_demand.0

While supply has risen over the last 5 plus years, the extent to which it has risen has been exaggerated a bit in relation to the explanations for the oil plunge. The supply rise has been relatively consistent, and even with the recent boom in US shale oil, the additions to the global supply from that boom have not been so dramatic as to send the global supply kiting through the roof. The main issue has been the lack of demand for oil at the levels that prevailed for most of the last 5 years, between $70-110/barrel. In the face of the recent flattening of demand (which OPEC expects to further decline in 2015), combined with the unchanged supply situation, a price drop is to be expected.

The next issue to resolve is the reason for the declining demand. As Irving Fisher wrote in his 1913 article The Monetary Side of the Cost of Living Problem, analysis of the supply and demand conditions relating to the good itself is only half of the picture. The monetary condition is equally as important for determining the whole story. From that standpoint, we turn to the Fed. The following is a chart displaying the year over year change in the Fed balance sheet compared with the price of oil.

fredgraph

The heavy pre 2010 year over year changes in the Fed balance sheet reflect the magnitude of the original Quantitative Easing program. The subsequent iterations of QE had less of an impact on the growth of balance sheet in relative terms, each time ‘only’ increasing the Fed Balance sheet roughly 40% year over year. This has been accompanied by price action in oil which has basically oscillated in a $40 range. I’ve mentioned multiple times that for QE to achieve the goal of constant price increases, each increase of the balance sheet has to be larger than the last, in relative terms. Since the original QE increased the balance sheet by 100%, subsequent increases of the balance sheet have to be in excess of 100%. Failure to do this will result in downward pressure on prices as the relative flow that is responsible for boosting prices starts to deteriorate. As I wrote in ‘Underpants Gnome Economics’:

Not only does active tightening place downward pressure on prices, but inaction by the Fed also leads to lower prices. Once prices have been pushed higher via accommodative policy, their continued rise depends on continued demand, which can only express itself when there are increased dollars in circulation. A relatively stable money supply does not suffice, and compared to an expanding supply, this stance is actually tighter, even though the absolute level of money in circulation may be very high. This is especially true in the face of an increased supply of goods and services.

Despite engaging in unprecedented easing of monetary policy in absolute terms, the fact that the Fed has been relatively tight (especially with the tapering of QE3 beginning in September 2013) means that deflationary pressures are certain to reassert themselves.

A few have been speculating in recent weeks that oil may be the first place in which this deflationary pressure appears. I joined them the other day in examining the implications of an oil collapse. Since then, the line of reasoning I presented (that the oil decline might reveal a layer of bad debt and pose a threat to the financial system) has been buttressed by a number of news articles with gloomy implications. From Bloomberg this morning:

In a stunning analysis this week, Goldman Sachs found almost $1 trillion in investments in future oil projects at risk. They looked at 400 of the world’s largest new oil and gas fields — excluding U.S. shale — and found projects representing $930 billion of future investment that are no longer profitable with Brent crude at $70.

….

The Goldman tally takes the long view of project finance as it plays out over the next decade or more. But the initial impact of low prices may be swift. Next year alone, oil and gas companies will make final investment decisions on 800 projects worth $500 billion, said Lars Eirik Nicolaisen, a partner at Oslo-based Rystad Energy. If the price of oil averages $70 in 2015, he wrote in an email, $150 billion will be pulled from oil and gas exploration around the world.

An oil price of $65 dollars a barrel next year would trigger the biggest drop in project finance in decades, according to a Sanford C. Bernstein analysis last week.

Unprofitability at a lower price means a reduction in outlays for future production. This means a decline in employment and utilization of capital, as this BBC article mentions:

“It’s almost impossible to make money at these oil prices”, Mr Allan, who is a director of Premier Oil in addition to chairing Brindex, told the BBC. “It’s a huge crisis.”

“This has happened before, and the industry adapts, but the adaptation is one of slashing people, slashing projects and reducing costs wherever possible, and that’s painful for our staff, painful for companies and painful for the country.

“It’s close to collapse. In terms of new investments – there will be none, everyone is retreating, people are being laid off at most companies this week and in the coming weeks. Budgets for 2015 are being cut by everyone.”

Mr Allan said many of the job cuts across the industry would not have been publicly announced. Oil workers are often employed as contractors, which are easier for employers to cut.

His remarks echo comments made by the veteran oil man and government adviser Sir Ian Wood, who last week predicted a wave of job losses in the North Sea over the next 18 months.

The US-based oil giant ConocoPhillips is cutting 230 out of 1,650 jobs in the UK.

This month it announced a 20% reduction in its worldwide capital expenditure budget, in response to falling oil prices.

Other big oil firms are expected to make similar cuts to their drilling and exploration budgets. Research from the investment bank Goldman Sachs predicted that they would need to cut capital expenditure by 30% to restore their profitability at current prices.

Service providers to the industry have also been hit. Texas-based oilfield services company Schlumberger cut back its UK-based fleet of geological survey ships in December, taking an $800m loss and cutting an unspecified number of jobs.

On Wednesday Aberdeen-based Wood Group announced a pay freeze for staff, and cut rates for its contractors.

Apache, one of the North Sea’s biggest producers, has followed suit and will impose a 10 percent reduction on its contractors’ wages from January 1st.

Capital Expenditure reduction. Employment reduction. Wage freezes/reductions. All of these have knock on effects in the shape of reductions in spending in other areas, not to mention the pressure that bad loans puts on the financial sector. The oil decline is a classic debt deflation in the making, which is a totally different prospect to the positive ‘it’s like a tax cut’ interpretation which is the consensus view at the moment.

Despite the potential bleak situation, the solution is to actually embrace the oil declines, because the falling price is the cure. The real problem was the proliferation of credit and debt issuance which roughly tripled the oil price rise from the 2009 depths to its stasis in the $70-110 range, enabling an expansion of investment, capital formation, and an increase in production costs. These unsustainable developments have now been revealed, as the inability for the economy as a whole to sustain high oil prices has led to a drop in demand, and thus the price. The drop in price now renders a lot of the credit undertaken in the past dubious in nature. Inevitable credit contraction and liquidation will follow, perhaps culminating in a reduction in oil supply. However, the end result is a situation in which stability returns. Costs of production will fall along with the price, to a point where investment projects can be undertaken profitably again, leading to the resumption of hiring and production. This is how markets work to correct imbalances.

Unfortunately, central bankers do not like the way markets work, so they will attempt to intervene. As it stands now, the Federal Reserve seems unperturbed by the move in oil prices, based on Janet Yellen’s press conference yesterday. If and when the issues I’ve mentioned rear their heads, the interpretation of any troubling situation will be that it is the low price which is the problem. The erroneous view that price moves cause changes in economic fortunes, rather than merely being effects of those changes, will lead the FOMC to resume easing, in ever greater amounts, to bail out anyone who may have been harmed by the pitfalls of a contraction of bad debt. The end result of this intervention will likely be a propping up of prices at elevated levels, the exact phenomenon which enabled an unsustainable edifice of oil development funded by leveraged financial institutions to be constructed in the first place. Let’s not get too far ahead of ourselves though, these developments are a few steps down the road, but it’s a road we’ve travelled on multiple times in the last 15 years. It’s hard not to be concerned.

On the Implications of a Plunging Oil Price

As I write this, the price of Crude Oil is down roughly 50% from its 2014 peak of $107.60, made exactly 6 months ago in June. It is currently the biggest single issue in the financial world, with economists and pundits debating the consequences of every tick lower. There are a few major themes being discussed – the possible reversal of fortune for countries such as Russia, Venezuela, and to a lesser extent Canada and the much talked about US oil boom. There is also some optimism that a lower oil price will lead to lower energy costs which in turn will boost the spending power of the average consumer, which in turn will increase spending and economic growth. These issues, while significant, ultimately pale in comparison to the larger issue of underlying monetary conditions, potentially burst bubbles, and contagion. The true impact of the rapid decline in oil will not be known for another few months or even longer, as the inner workings do take time to play out, but the implications aren’t great. (more…)

Market Views 1 November 2014

The trading landscape has been nothing short of incredible over the last month, particularly the last 20 trading days. The S&P 500 has gone from 10% correction to new all time highs in the blink of an eye. When I last wrote, on 9 October, the market was in the midst of falling, but had been rescued by a bullish interpretation of the Federal Reserve minutes released the day before. I had speculated that the massive rally was a fake rally, and that the market would eventually go lower, to about 1900. The market went there, and beyond, in short order, breaking 1900 on the futures and going all the way as low as 1813. Even though I had been looking for such a move to occur, I had thought it would be more protracted, taking until the end of the year to play out.

The ferocity of the move was surprising, and more importantly, it created a condition in which momentum indicators were screaming oversold. Thus the stage for the violent rally which took place over the second half of the month. The ease with which 1900 on the futures was overtaken from the downside was a first clue that the bears were not so strong. Then 1920-30 and 1970-80 fell, which meant that a test of the all time high of 2014 was on the cards. That was breached yesterday, confirming that indeed the bull market that has been in place for upwards of 5 years is still on.

The Federal Reserve confirmed on Wednesday that it will allow the QE program to end, finishing the last round of ‘tapering.’ I remain of the view that this development is a negative for the market going forward. This doesn’t preclude prices from rising higher – in the 9 October post I posted the following chart of the S&P 500 when the last rounds of QE ended:

fedes

The white circles represent the days that the previous QE programs ended. In each case, the market went higher immediately following the ending of QE, by roughly 5% and 3% respectively. What followed that in each case was a ~20% correction.

The reason for this is that QE is a relative tightening of monetary policy. Consider the following diagaram:

continue

From right to left are the various actions the Federal Reserve could take to affect the economy, from loose to tight policy. On this continuum, QE was the at the easiest end of the scale. In ending QE, the Federal Reserve has now shifted to the next step, titled ‘lowering short term rates via gov’t bond purchases.’ Given rates are already at 0, this shift is effectively Neutral Policy. However, it is less easy than QE, so it does represent a relative tightening.

Many commentators do not recognize this, and only believe that  we enter the realm of relative tightening when we go one step further on the continuum, to the rate normalization phase, the last occurrence of which took place in 2004-2006. In that sense, they understand that the rate normalization period could have a negative impact on prices, as the explicit withdrawal of money from the system means there is less money coming into bid up prices.

However, the same impact is had when, as you go from QE to no QE, there is relatively less money coming in than before. Said differently, if you start with a base of 100, and add 50, then 25, then 10, then 5, then 0, each addition will have a less impact on the total figure than the prior round. When starting with 100, adding 50 was a boost of 50%. Adding 25 to the increased figure of 150 represents only a boost of 16%, and so forth down the line. This, in essence is what has happened with the tapering process. Its ultimate effect will not take place immediately, but it is inevitable that without the increased impact of QE, prices will fall significantly.

At the end of the day, this is the ‘fundamental’ that matters the most, trumping most traditional data points such as earnings. That is the reality of a market that lives and dies on the whims of central bankers.

In that vein, the early hours of Halloween, the BOJ came out with an announcement that they would increase their QE program. On a larger level, this presents an interesting situation in which the Federal Reserve is ending QE (for the time being), while the BOJ and ECB are moving in the opposite direction on the policy continuum. The yen took a massive plunge, as shown in the following USDJPY charts, the first showing the action over hte last year, and the second showing the action over the last 10.

usdjpy111

usdjpy111week

The longer term chart suggests that 123 is on the cards, which is still miles away from its current levels at over 112. With the BOJ hell bent on destroying the value of the yen, shorting it against all pairs seems to be the no brainer trade of the next few months. Tread carefully of course. Until next time.

Market Views 9 October 2014

The trend is your friend, until it ends…

The entrance of fall has seemingly brought with it a shift in the financial landscape. Mario Draghi looks ready to bring QE to Europe. Bill Gross has left PIMCO. The low volatility of summer has been replaced by a more volatile early fall, and the resulting price declines have sparked a bit of a concern. This concern is healthy, given the lengthy run up in asset prices over the last 5.5 years, and especially the last 2 years. No one rings a bell at the top, which is why it is important to be on the lookout for the early, technical signs.

S&P 500 Futures

The following is a chart of the S&P 500 futures since summer of 2011. (as with all charts, click for a larger view)

esweekly

This timeframe encompasses the lows from 2011, just after the US government debt downgrade fiasco, until now. As you can see, it’s been a one way street. 3 years and over 80% appreciation later, and the trend is seriously being threatened for the first time, as seen in the action in the upper right of the chart. The following is a closer look at that more recent action:

eswithlines3

What we have here is a daily chart going back over roughly the last 12 months of trading, with some horizontal price levels which I believe are important. Prices have been fliriting with breaking the red terndline over the last few days, and yesterday in particular was interesting. The release of the FOMC minutes from the last meeting in late September sparked a violent afternoon rally. As impressive as that was, it has yet to break the lower moving momentum which has been in place since the September 22 high at 2014. The following chart provides a closer look over the last few weeks of action:

es4h

Yesterday’s rally is a relief rally until proven otherwise. That proof would be a break of the 1970-1980 area to the upside. Until then, the sellers are in charge of this market, with how much lower they can drive things a mystery. Referring to the prior chart, the yellow horizontal lines are ‘lines in the sand’ where opportunities will present themselves. Assuming the 1970 area holds on the upside and the market is driven lower, 1900 is the first such level, and a move there would almost certainly be supported. On a very short term basis, the market would be plenty oversold, having come down from 2014. Panic would probably ensue for a few hours, especially if it happens in one day or two. But it would be a good place to bottom pick for a move back towards 1980 again.

It would however, also represent a clear break of the red trend line. It remains to be seen whether this break would be the beginning of a full on bear market, as in fall 2007 or merely a big correction, as in 2010 and in 2011. In either case, a relief rally following a break of the red trendline isn’t out of order. Below 1900 is a bit more interesting, but we’ll cross that bridge if we come to it.

Russell 2000, Social Media, Homebuilders

While the S&P 500 has only begun looking sketchy over the last month or two, other equity markets and certain sectors have been struggling for much longer. The Russell 2000 chart looks much worse than the S&P 500, which paints a darker picture from an economy point of view, given that the Russell 2000 is full of smaller cap, more domestic companies which are US facing, versus the multinationals that populate the S&P500:

rut5yr

The Russell 2000 has definitively broken it’s 3 year trendline and is definitively making a series of lower highs and lower lows. The following is a closer view.

rutcloser

On a strictly technical basis, the double top at 1219 serves as sort of a head, with the two touches of the yellow line at 1180 either side of the double top serving as shoulders. If this pattern plays out, it’s resting place would be between the 940-960 area which I’ve also drawn.

The fundamental story for the price rises in stocks since 2011 has been the bouncing back of the housing market, as well as the advances made by technology companies, particularly social media related companies. These two sectors have basically led the market up. The following two charts are two ETFs, the S&P Homebuilders ETF (XHB), and a Social Media ETF (SOCL). Home builders

social media

Both charts show the action over the last two years, and both have seemingly run its course.

The divergence between the Russell, Homebuilders, social media and the S&P is interesting to note, with the former three being down 5.7%, 10.6% and 9.06% for the year respectively, while the latter is still up 6.5% for the year. In what could be one of those historical markers people discuss for years to come, the largest IPO of all time, Alibaba, came to market on, what is at this point, the high print of the market. This sort of divergence and individual sector weakness does not mean the larger indices will go lower tomorrow, it merely means that the pieces are starting to align themselves. Unless the market finds a new leader, or the Fed stops tapering, and reverses course, the S&P 500 will ultimately go lower.

US Dollar Strength

The other major story line in recent weeks has been the strength of the US dollar. To maintain some perspective on the recent moves, here is the view of the dollar index over the last 20 years:

dxindex

The dollar is strong relative to the lows in early 2008, which had been flirted with in 2011. Having failed to make new lows, the dollar has been steadily increasing since and looks primed to reach the 92.5 level highlighted on the chart. Given this is still miles away from the highs at 120 and above from the early part of the century, it isn’t quite accurate to label the dollar as ‘strong,’ particularly when this strength is predicated on the weakness of other currencies it is compared to.

The rise in the dollar has been explained as a reaction to the tapering of QE by the Federal Reserve, a process that is scheduled to end within the month. This will mark the third time the Federal Reserve has ended QE programs, the prior two coming in 2010 and 2011. The following chart is of the S&P 500, over a time frame encompassing the ends of both QE programs.

fedes

The two white circles are the days when the QE programs officially ended. What followed both times was a slight price increase and then a sharp declines of roughly 20% each time. Fundamentally this makes sense, as in order for prices to keep rising continually, more monetary injections are also needed. Ending QE ends the impetus for price rises. The same thing is slated to happen now, which perhaps more than anything else explains the bumpy nature of prices over the last few weeks.

All that said, the S&P 500 is less than 3% from all time highs, with yesterday’s action being the best day of the entire year. While signs are emerging that the bull market is struggling, the facts are the facts. The most one can say as a longer term holder of stocks (which I’m not, I trade short term only), is that now is not the time to initiate new positions, but to monitor your portfolio and taking note of stocks which are under performing. Reassess at 1900, and doubly reassess when the Fed ends QE.