I’ve been talking about a dead cat bounce for a few weeks now while also touching on sector rotation last week. Right now, technical levels are very important because investors and portfolio managers are clearly uncertain in determining future outcomes here in the U.S. and globally and thus tend to rely more heavily on technical indicators and price levels to judge investment strategy. For that reason, failure to breakout of these technical levels or worse, whipsaw, will be detrimental to this current rally. Let’s peel back some layers of the market onion as the technical behavior of this market will guide the technical bounce. Mrs. Gump’s wise advice to affirm her son, Forrest, was that “stupid is as stupid does”. The technical bounce will continue as long as the technical indicators and price levels support such a move.
For example, today the ISM manufacturing number was better than expected, but delving into the meat of the survey, it was clear that this was not a good report in terms of employment and production. While new orders ticked up, ever so slightly, it was still a contraction reading below 50. Strength was found in inventories, a dubious increase that isn’t clear whether shelves are being stocked based on higher demand expectations in the future or current lack thereof. Ok, so that was a fundamental reason why the market should correct, but why did the S&P 500 correct down to the August 15th high and hold there all the way until closing below it by 4 points just before the close?
If anything, this rally is a technical rally rather than a fundamentally driven one. You might say that Jackson Hole and the FOMC minutes over the past week have been a catalyst, but the market was holding 1120 days before either of those events. There hasn’t been any substantial news out of Europe that would indicate problems are fixed. The waterfall correction, rally, and the retest of 1120 were the main catalysts to a dead cat bounce. As the rally has been technically driven and resistance levels have been breached, we’ll continue to look towards technical indicators to identify the strength of this rally and what’s holding it back.
With the market up seven of the last eight trading days, one would think that a break was needed. Nothing goes straight up and nothing goes straight down. In fact, looking at a daily chart of the percentage of stocks in the S&P 500 above their respective 10-day moving average, oscillation is the norm.
So the market is overbought on such a great string of gains in the S&P 500 with 95% of the S&P 500 trading above 10-day moving averages. Bear rallies happen quickly and sharply as shorts “run for the hills”. “Value” was picked up cheap by investors who focus on the micro (company) picture when they saw stocks like Apple and Google down 13% and 21% respectively because the “E” in “P/E” hasn’t changed yet. Analysts haven’t guided down earnings based on the slowing global macro picture yet. That’s the next step and the low price to earnings ratios won’t look so attractive any more as “E” follows “P” down.
Technical Price Levels
But let’s go ahead and dissect this rally and then look at some potential catalysts ahead. Starting off with the S&P 500, we created a double bottom at 1120. The bottom was confirmed when the index broke out above 1208, the top in the mid-August rally, on Monday. Since then, despite the move quickly to 1230, I’ve sensed some hesitancy in the bulls to stretch this rally much further. Interestingly enough, the week in economic indicators have caused the S&P 500 to retest the 1208 breakout (yesterday we touched 1209 intraday), but the S&P 500 closed below that level today. By breaking below 1208 today to close at 1204.42, it signals a false breakout or whipsaw event. Such an event is a fairly bearish. While I sense a hesitancy in bulls to carry stocks higher, we’ve had a pretty poor week in economic indicators with the Chicago PMI lower, multiple Eurozone PMI surveys lower, the ISM manufacturing index lower, and lower ADP employment. Despite all of that, the market is up on the week! Obviously, we need to peel some more here.
Let’s look at the Dow Jones Industrial Average and the Dow Jones Transport duo. Thus far, the Dow sell signal came when both indices broke below the June low in tandem, which also corresponded with dual breaks below the 200-moving average. 11555 is a significant technical level the market is respecting for the industrial average. It marks the March low, and the mid-August rally high. We scooted above it Wednesday but fell below it again today. Likewise on the transport index, the mid-August rally closed at 4684. Would you guess we closed at 4683.96 on Tuesday and played peek-a-boo above that level yesterday before closing below at 4666. Today, the Transport Index fell to 4599, still below a needed breakout above 4684.
“Risk Off” Trade Needs to Break
The flip side of the “risk on” trade in equities and commodities is the “risk off” trade in gold, Treasuries, and the volatility index. Treasuries have been holding up well, easing their overbought condition through a “sideways” running correction. For the rally in equities to have “legs”, we really need the public in Treasuries to stop being so defensive. Because that isn’t happening, it’s drawing a lot of distrust in the rally. I could draw out either a bullish pennant or a bearish head & shoulder formation on TLT, but I think the best statement is to say that it’s going sideways. If you’re following trends, such conditions tell you to do nothing until a breakout.
The volatility index (VIX) or “fear index” has remained “elevated”. It has corrected from a high of 48, but hasn’t “spiked down” as it has in past bull market corrections. The VIX will need to drop below 30 and head towards 20 for equities to climb much higher.
While I argued that gold’s parabolic move was unsustainable two weeks ago, it has held up from a normal waterfall correction that typically follows after such a move. Gold is being supported on potentially more accommodation from the Fed and renewed fears in Europe; however, the chart still looks damaged. I like gold equities (not silver) that are breaking out after year-long consolidations. Caution is still advised as fears have not turned towards deflation yet. Fear of deflation (or contraction in credit) is the eventual outcome when sentiment turns towards recession from “slow growth” down the road. Gold corrected 11% from the overseas high of 17. If gold really is correcting, the next move will be down to break this rally. If gold has more near-term upside potential, then it will break above 45. Seems the bears are making their stand at that price. Since Jackson Hole last Friday, gold hasn’t budged in either direction.
We need the “risk off” trade to break for a rally in the stock market to continue; as such gold, the VIX, and Treasuries need to correct. The risk off trade is neither breaking down nor is it breaking out to higher highs. We’re in a very uneasy location for both the bears and the bulls. Uncertainty is definitely showing between equities and the risk off trade.
Other Factors
Other factors I’m watching that I think have some long-term implications are oil, China, and Europe. If you view a chart on oil, it has correctly predicted weakness in the growth story long before the market rolled over. Likewise, I’m watching to see if oil breaks out above the -91 range on economic strength. It could rise based on the hurricane season that has arrived, but I think that’s a short-term play. Rising oil in correspondence with improving economic conditions would add much to the “slow growth” economic story; a lack thereof hints at more economic, industrial, and commodity weakness ahead.
Another factor I explained is China. China raised reserve requirements last Friday and the Shanghai index has lagged the world markets in the rebound. Recall that a lot of the global growth story has stemmed from China’s double-digit growth rate and demand on natural resources over the past 10 years or so. A significant technical level in the Shanghai is 2600. We broke below that and haven’t been able to rally back above it this summer. A break back above 2600 would give more credibility to the “slow growth” story and not the global recession one. The bottom of the existing trend channel on the Shanghai is somewhere near 2100, or 18% lower.
It’s important to understand that weakness in the economy because of Japan supply disruptions and high cost inflation triggered a temporary lull in the economic breeze powering the main sail, but the credit crisis in Europe has broken the rudder. The Federal Reserve is trying to repair the rudder, but participants aren’t sure if they have the right tools to fix a structural European problem. They don’t. So we need to continue to watch how European markets are trading as well as watch the headlines.
There’s a team of inspectors in Greece again to evaluate how their austerity measures are being executed. Likewise, there’s been some concern that Italy isn’t measuring up to the austerity plans it had approved in turn to get ECB bond backing. The IMF just issued a report that shows they’re concerned over European Bank balance sheets form their holdings of troubled Eurozone sovereign debt. “IMF and eurozone clash over estimates”. Greece is fending off rumors they’ve hired a prominent legal firm to discuss the prospect of leaving the EU. The Germans have moved to vote on enhancing the powers of EFSF (some are talking about having the EFSF guarantee bank bond sales) on September 29th, but are asking that the German parliament have a veto power over any new bailout decisions. The Eurozone problems don’t appear as dire as they did weeks ago, but they’re certainly not resolved.
Conclusion
The stock market has bounced. Investors are expecting QE 2.5 or 3.0 from the Federal Reserve, but I think it’s quite clear that accommodative monetary policy won’t shore up Greece’s, Italy’s, Spain’s, France’s, Ireland’s, China’s, or the U.S.’s economic issues, which are large sums of debt, unbalanced budgets, and/or higher cost inflation. Many economists have argued that both austerity measures and money printing have done more harm than good. The main issue is that debt levels are too high and what Keynesian strategies worked in the past (governments borrow and spend to relieve private industry contraction) will no longer work as creditors say “no more”, demand more interest, and thus increase government budget expenses. It may be possible that the can has been kicked down the road for far too long, and this is just the developed economy’s come upends. If China can control its inflation, a turnaround there could rally commodity prices and production to turn around the global economy as China relies less and less on the U.S. to grow.
