A somewhat-in-depth update of what I see going on in the markets this last week, and what we may be looking forward to in the week (and further) ahead..... sent via email (sorry, no fancy formatting on this one!)
This week we saw a quite-extreme level of internal technical damage done to all three of the major indices. Both the S&P and the Nasdaq finished the week outside of their channels. Whether this is a further "push-down" of the bottom of the channel or the start of a break below support is an open question for now.
The DOW, having blown beyond its wedge, albeit without conviction, pulled back inside. In a more ominous note, the 10 Yr Bond made a thrust above the 4.80% level, settling at 4.86. This is significant because in each serious decline in the market since the Fed got done raising interest rates the 10 year has preceded the pullback by about a month, with the triggering level being 4.80%.
Finally, all three indices are either signaling that one should exit long positions or are very close to it (in the case of the DOW). I use three primary indicators for this purpose - Stochastics (fast 10 points divergent from slow), MACD and a third indicator which is an amalgamation of three different technical indicators with its foundation being the Wilders ADX.
Now let's add a few more things to the mixture just to pour gasoline on a smoldering fire, as if we really needed to do that. First up is what appears to be a serious attempt by the US Congress to blow up the trade situation with China. Incensed with the Chinese government's refusal to move more quickly on "adjusting" their currency, Congress is now threatening tariff legislation, likely with a veto-proof majority, as it is coming from BOTH the Democrat and Republican sides. This is terribly ill-advised, because the root of the problem with our currency lies not with China but rather with our own Fed, which has been growing the money supply at a double-digit rate with a less-than-one-percent GDP growth rate - that's a real inflation rate of somewhere around 12%, and its entirely home-grown. This has been done in a raw attempt to keep the party going rather than take our medicine in the form of a recession, in a blatant continuation of the farce that Greenspan started after 9/11 by cutting Fed Funds to what was, at the time, an effective negative interest rate.
And oh, by the way, if you want to know what M3 (growth in money supply) is you have to reconstitute it yourself (which is not terribly difficult) - The Fed stopped publishing it a while ago. Gee, I wonder why?
The unfortunate reality is that you can't make someone WANT to buy your debt, and the likely result of all the saber-rattling will be a pullback by governments from participating in our US Treasury Auctions. The bond market smells this possibility, which is why we've seen the 10 tick up as strongly as it has - people are selling bonds in anticipation, and this raises REAL interest rates - whether the Fed likes it or not. As I've noted before this is going to hit LIBOR, which will in turn hit every credit card and other debt rate in the nation. It has already hit mortgage interest rates and the GSEs (Freddie and Fannie) have said they expect mortgage rates to continue to rise through the end of the year.
Then we have China's equities markets, which are in a totally unsustainable parabolic ascent. This bubble WILL go "boom" - it is simply a matter of when - not if. China has a terribly nasty problem on their hands, in that people are mortgaging their houses to speculate in the markets and, lacking a coherent credit market there is no such thing as a short sale or margin account. The problem here is that there is no way to express "bearish" sentiment as a counterbalance, as we have here - so when the buying dries up and prices fall there is no way to profit from it! This is going to hurt a huge number of people over there, and has a high probability of resulting in civil unrest. China can ill afford that with the Olympics coming next year. As a result they are faced with having to pop this bubble in the near future or risk it blowing up NEXT year. My bet, given that their officials don't have to stand for election, is that they will choose to pop it up now rather than later. The last time they played with the equities market in any sort of real fashion it gave us our "February cold." This time around may be more like the Asian Bird Flu.
We have a new bill working its way through Congress to penalize "gouging" on energy prices. But just what IS "gouging"? The bill doesn't say. So now we have a bill criminalizing conduct that isn't defined! If this passes it will serve to do one and only one thing - constrain supplies in a serious way - as its only purpose is to be able to prosecute anyone in the fuel business whenever certain people would like to. Would YOU sell gasoline if you thought you might find yourself on the wrong end of a criminal complaint due to market forces, or would you simply put bags over your nozzles and say "sorry, no Gas"?
We also have an insane credit market. But it is STARTING to show some signs of reason - there have been deals in the last couple of weeks that have run into trouble with "covenant lite" transaction flow, with the buyers of debt packages demanding more protection. To a large degree the last year of market appreciation has been driven by what amounts to "nearly free"(compared against treasuries) financing on debt that is barely - or not even - investment grade. WHEN (not if!) this unwinds - and it will - there will major dislocations in the credit markets. The Subprime mess and damage it did is just the beginning on that account; when the general corporate debt market starts to correct back towards normal risk premiums you will see a virtual implosion of the "easy money" games. April, for example, was extraordinary in that there were NO recorded corporate bond defaults! The ever-spiraling demand for more return has led to a wild disregard for risk, and recognition of this will come home to roost - eventually. We are simply arguing over WHEN, not IF, someone is left holding a big deal that blows up in their face. The cracks in this dam are becoming wider by the day, and they're leaking. An article in the last couple of days speculated that perhaps Merrill Lynch might be left holding some of the bag, and thus may be a good short (!)
Finally, there are all sorts of other technical indicators that say we're in serious trouble. Cycle analysis and Elliott Wave theory are two of the more prominent, but by no means the only ones on the list. I tend to discount most of these, but you have to have admiration for a pattern that appears to be nearly textbook in its presentation. As an example, look at the 1999/2000 blowoff in the S&P, then overlay it with the recent rise. There was a correction about 2/3rds of the way in, then a parabolic ascent to the finish, and we know what came next. Are we repeating history? Cycle analysis says yes, Elliott Wave Theory says yes, market internals say yes and the bond market says yes. Care to ride that roller-coaster in your account once the clacking stops and the screaming starts?
My expectation is that we've got one last gasp upward, but BE NIMBLE IF YOU ARE ON THE LONG SIDE! Taking profits here - building cash - is certainly not a bad idea. Remember, PROFITS ARE NOT YOURS UNTIL THEY ARE REDUCED TO CASH - paper profits held in a security are not profits at all, but POTENTIAL profits.
I still believe it is not (yet) time to "short with both hands", but that day is almost certainly approaching. We will likely leave May behind us without getting there, but coming into June we start to see the headlights of "confessional season" beginning to blink on, and they may be white-hot this time around. We already know what the spring "selling season" looks like in real estate. Should the discomfort that retailers experienced in the first quarter continue onward into the second quarter earnings reports, and if the LEIs do not improve, it is highly likely that a credit dislocation will emerge within the next month and set up the "perfect storm."
IF THIS OCCURS IT WILL ALMOST CERTAINLY COME WITH LITTLE OR NO WARNING.
Before I went on my little vacation I tightened up my stops on my longs, cashed in a short on CFC that I had taken the week prior (at a nice profit; I still hold long-term PUTs; that was half my vacation right there), took out a straddle on SPY and another on the Qs. I expect volatility to become quite severe in the next couple of weeks, and the entry points looked damn juicy on Thursday, with what I expect to be a rebound upward (at which point I can cash the CALL side) and then a collapse (at which point I can cash the PUT side!) If we get a truncated move up and a collapse I still make plenty, and of course if the parabolic ascent isn't quite out of steam I make good money that way too. With my expectations that volatility will be high and premiums very attractive on these positions Thursday it was just too good of a shot to pass up. I also took a quick play on a takeover possibility with Micron Friday (CALLs) and bought PUTs on FORD - the latter trade looked particularly good as the ITM puts were trading with only a couple of pennies of premium. I expect a pullback to the $8 range in the next couple of weeks on Ford, which will be a nice quick double. Its not often you get a short play via PUTs without paying for premium with most of the front month left, and the chart suggests that its headed back to $8.Micron may be a bust, but if it is I'm sure not going to be alone on that speculative play - there were an unbelievable number of contracts traded on it Friday.
When I am able to get back to monitoring the markets on a daily basis I will likely short CFC again, especially if it moves back up materially over $40. This is a stock I believe will trade for $20 before the end of the year, and the options premiums are getting EXPENSIVE. Being that its easy to borrow, there's no reason not to just short it directly.
I also believe we're due to see some disruption in the chip makers before this is all said and done. Intel and AMD are locked in a brutal price war, and there are signs of overcapacity in the other chip vendors as well. I'm inclined to short Novellus and perhaps Applied Materials, and will be looking at those positions in the next week or so.
In short the setup hasn't changed a bit. I continue to watch my "Canary", which is a numerical model combining the technical indicators I've outlined above along with a couple of other markers. So far its still alive, but I'm becoming more and more concerned that when it dies there will be only a day - or perhaps NO - warning, in that instead of a deterioration that builds to a rollover, we may instead have a blowup in the credit markets propagate almost immediately to equities, or a "surprise" in the Chinese market that nails us good the next morning.
Good luck in the coming week...... I'll be checking in from time to time during the week, and back to normal this coming weekend.....
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