Technical Talk: Intermediate Trend is Down, Short Term Indicators Overbought, Not Yet Peaked (August 13, 2012)

Monday, August 13th, 2012

by Don Vialoux, timingthemarket.ca

Economic News This Week

July Producer Prices to be released on Tuesday at 8:30 AM EDT is expected to increase 0.2% versus a gain of 0.1% in June. Core PPI is expected to increase 0.2% versus a gain of 0.2% in June.

July Retail Sales to be released on Tuesday at 8:30 AM EDT are expected to increase 0.3% versus a drop of 0.5% in June. Ex autos, July Retail Sales are expected to improve 0.4% versus a decline of 0.4% in June.

The August Empire State Manufacturing Index to be released on Wednesday at 8:30 AM EDT is expected to slip to 7.2 from 7.4 in July.

July Consumer Prices to be released on Wednesday at 8:30 AM EDT are expected to increase 0.2% versus no change in June.

July Industrial Production to be released on Wednesday at 9:15 AM EDT is expected to increase 0.5% versus a gain of 0.4% in June. July Capacity Utilization is expected to increase to 79.2 from 78.9 in June.

July Housing Starts to be released on Thursday at 8:30 AM EDT are expected to slip to 752,000 from 760,000 in June.

August Philadelphia Fed to be released on Thursday at 10:00 AM EDT is expected to improve to -4.0 from -12.9 in July.

August Michigan Consumer Sentiment to be released on Friday at 9:55 AM EDT is expected to slip to 72.2 from 72.3 in July.

July Leading Indicators to be released on Friday at 10:00 AM EDT are expected to increase 0.2% versus a 0.3% decline in June.

Earnings Reports This Week

Equity Trends

The S&P 500 Index added 14.88 points (1.07%) last week. Intermediate trend is down. Support is at 1,266.74 and resistance is at 1,415.22. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking.

Percent of S&P 500 stocks trading above their 50 day moving average increased last week to 80.20% from 74.80%. Percent is intermediate overbought, but has yet to show signs of peaking. Percent has reached a level where an intermediate peak above the 80% level normally leads to at least a short term correction.

Percent of S&P 500 stocks trading above their 200 day moving average increased last week to 70.60% from 63.60%. Percent is intermediate overbought, but has yet to show signs of peaking.

The ratio of S&P 500 stocks in an uptrend to a downtrend (i.e. the Up/Down ratio) increased last week to (273/142=) 1.92 from 1.40. The ratio is intermediate overbought, but has yet to show signs of peaking.

Bullish Percent Index for S&P 500 stocks increased last week to 67.80% from 63.00% and remained above its 15 day moving average. The Index remains intermediate overbought, but has yet to show signs of peaking.

The Up/Down ratio for TSX Composite stocks increased last week to (131/90=) 1.46 from 1.02. The ratio is intermediate overbought but has yet to show signs of peaking.

Bullish Percent Index for TSX Composite stocks increased last week to 55.91% from 51.63% and remained above its 15 day moving average. The Index is intermediate overbought, but has yet to shows signs of peaking.

The TSX Composite Index gained 228.30 points (1.96%) last week. Intermediate trend is down. Support is at 11,209.55 and resistance is at 11,936.16. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains negative.

Percent of TSX stocks trading above their 50 day moving average increased last week to 66.26% from 52.44%. Percent is intermediate overbought, but has yet to show signs of peaking. Peaks near the 70% level normally lead to at least a short term correction by the Index.

Percent of TSX stocks trading above their 200 day moving average increased last week to 40.65% from 35.37%.

The Dow Jones Industrial Average added another 111.78 points (0.85%) last week. Intermediate trend is up. Resistance is at 13,338.66. The Average remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains negative.

Bullish Percent Index for Dow Jones Industrial Average stocks was unchanged last week at 83.33% and remained above its 15 day moving average. The Index remains intermediate overbought.

Bullish Percent Index for NASDAQ Composite stocks increased last week to 52.42% from 49.75% and moved above its 15 day moving average.

The NASDAQ Composite Index gained 52.95 points (1.78%) last week. Intermediate trend changed from down to up on a break above resistance at 2,987.94. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains negative.

The Russell 2000 Index added 13.07 points (1.66%) last week. Intermediate trend is down. Support is at 729.75 and resistance is at 820.44. The Index remains above its 50 and 200 day moving averages and moved last week above its 20 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains negative.

The Dow Jones Transportation Average fell 22.76 points (0.45%) last week. ‘Tis the season! Intermediate trend is down. The Average fell below its 20, 50 and 200 day moving averages last week. Short term momentum indicators are neutral. Strength relative to the S&P 500 Index remains negative.

The Australia All Ordinaries Composite Index added 59.80 points (1.41%) last week. Intermediate trend is down. Support is at 4,033.40 and resistance is at 4,515.00. The Index remains above its 20 and 50 day moving averages and moved above its 200 day moving average last week. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains neutral.

The Nikkei Average jumped 336.33 points (3.93%) last week. Intermediate trend is down. Support is at 8,238.96 and resistance is at 9,136.02. The Average moved above its 20 and 50 day moving averages last week, but remains below its 200 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index is negative, but showing early signs of change.

The Shanghai Composite Index added 36.01 points (1.69%) last week. Intermediate trend is down. Support is forming at 2.100.25 and resistance is at 2,478.38. The Index remains below its 50 and 200 day moving averages, but moved above its 20 day moving average last week. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index is negative, but showing early signs of change.

The London FT Index gained 64.23 points (1.11%), the Frankfurt DAX Index added 99.33 points (1.45%) and the Paris CAC Index improved 82.52 points (2.45%) last week.

The Athens Index gained 20.11 points (3.36%) last week. Intermediate trend is down. Support is at 471.35 and resistance is at 662.49. The Index remains below its 200 day moving average and above its 50 day moving average. Last week it moved above its 20 day moving average. Short term momentum indicators are trending higher. Strength relative to the S&P 500 Index remains slightly negative.

Currencies

The U.S. Dollar Index added 0.17 (0.21%) last week. Intermediate trend is up. Support is at 81.16 and resistance is at 84.10. The Dollar remains above its 200 day moving average and below its 20 and 50 day moving averages. Short term momentum indicators are trending down.

The Euro fell 0.87 (0.70%) last week. Intermediate trend is down. Support is at 120.42. The Euro remains below its 50 and 200 day moving averages and above is 20 day moving average. Short term momentum indicators are trending higher.

The Canadian Dollar added 1.03 cents U.S. (1.03%) last week. Intermediate trend is neutral. Support is at 95.76 and resistance is at 102.05. The Canuck Buck remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking.

The Japanese Yen added 0.45 (0.35%) last week. Intermediate trend is down. Support is at 124.12 and resistance is at 128.77. The Yen remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are trending down.

Commodities

The CRB Index added 1.12 points (0.37%) last week. Intermediate trend turned positive on a break above resistance at 305.04. The Index remains above its 20 and 50 day moving averages and briefly tested its 200 day moving average. Short term momentum indicators are trending higher. Strength relative to the S&P 500 Index is neutral/positive.

Gasoline gained another $0.08 per gallon (2.73%) last week following news of a fire at a California refinery. Gasoline remains above its 20, 50 and 200 day moving averages. Strength relative to the S&P 500 Index remains positive.

Crude oil added $1.97 per barrel (2.16%) last week on growing Middle East tensions and declining inventories. Intermediate trend changed from neutral to up on a break above resistance at $93.25. Crude remains above its 20 and 50 day moving averages and below its 200 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains positive.

Natural Gas fell $0.09 per MBtu (3.12%) last week. Intermediate trend is up. Resistance may be forming at $3.28. Gas remains above its 50 and 200 day moving average and below its 20 day moving average. Short term momentum indicators are trending down. Strength relative to the S&P 500 Index remains positive, but showing early signs of a change.

The S&P Energy Index added 12.38 points (2.34%) last week. The Index is testing resistance at 544.25. The Index remains above its 20, 50 and 200 day moving averages. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains positive. ‘Tis the season!

The Philadelphia Oil Services Index gained 7.13 points (3.22%) last week. The move above a reverse head and shoulders pattern continues. The Index remains above its 20 and 50 day moving averages and moved above its 200 day moving average last week. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains positive. ‘Tis the season!

Gold added $15.30 per ounce (0.95%) last week. Intermediate trend is down. Support is at $1,526.70 and resistance is at $1,642.40. Gold remains below its 200 day moving average and above its 20 and 50 day moving averages. Short term momentum indicators are trending higher. Strength relative to the S&P 500 Index remains neutral/positive. ‘Tis the season!

The AMEX Gold Bug Index gained 22.62 points (5.55%) last week. Intermediate trend is down. Support is at 372.74 and resistance is at 464.76. The Index remains below its 200 day moving average and above its 20 day moving average and moved above its 50 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to gold has turned positive. ‘Tis the season!

Silver gained $0.31 per ounce (1.12%) last week. Intermediate trend is down. Support is at $26.10 and resistance is at $28.44. Silver remains below its 200 day moving averages and above its 20 and 50 day moving averages. Short term momentum indicators are trending higher. Strength relative to gold remains neutral.

Platinum fell $2.90 per ounce (0.21%) last week. Intermediate trend is down. Platinum remains below its 20, 50 and 200 day moving averages. Short term momentum indicators are trending higher. Strength relative to gold remains negative.

Copper added $0.04 cents per lb. (1.19%) last week. Intermediate trend is down. Support is at $3.24 and resistance is at $3.56. Copper remains below its 20, 50 and 200 day moving averages. Short term momentum indicators are bottoming and trending higher. Strength relative to the S&P 500 Index remains negative.

The TSX Global Metals and Mining Index jumped 47.21 points (5.71%) last week. Intermediate trend is down. Support has formed at 781.13. The Index remains below its 200 day moving average and above its 20 day moving average and moved above its 50 day moving average last week. Short term momentum indicators are trending higher. Strength relative to the S&P 500 Index has been negative, but is showing signs of change.

Lumber gained $15.29 (5.35%) last week. On Friday, it broke to a 17 month high. Lumber remains above its 20, 50 and 200 day moving averages. Strength relative to the S&P 500 Index remains positive.

The Grains ETN slipped $0.06 (0.10%) last week. Intermediate trend is up. Resistance has formed at $64.83. The ETN remains above its 20, 50 and 200 day moving averages.

The Agriculture ETF added $0.52 (1.04%) last week. Intermediate uptrend resumed on a break above resistance at $50.54. The ETF remains above its 20, 50 and 200 day moving average. Short term momentum indicators are overbought, but have yet to show signs of peaking. Strength relative to the S&P 500 Index remains neutral/slightly negative.

Interest Rates

The yield on 10 year Treasuries increase 0.072 (4.57%) last week. Intermediate trend changed from down to neutral on a break above resistance at 1.686%. Short term momentum indicators are overbought, but have yet to show signs of peaking.

Conversely, price of the long term Treasury ETF fell another $1.72 (1.35%) last week. It briefly broke support at $123.56.

Other Issues

The VIX Index fell another 0.90 (5.75%) last week. It broke below support at 15.45 last week. The Index remains below its 20, 50 and 200 day moving averages. Short term momentum indicators are oversold, but have yet to show signs of bottoming.

Second quarter earnings reports are winding down. The focus this week is on reports from the retail merchandisers.

Economic reports this week are expected to be neutral/positive for equity markets. The next major economic event to watch is the Jackson Hole Economic Conference hosted by the Fed from August 30^th to September 1^st. Bernanke previously announced Quantitative Easing at the Jackson Hole Conference. Will he announce QE III at this conference?

Macro news is relatively quiet this week. European economic data to be released on Tuesday could attract attention.

Short and intermediate technical indicators currently are overbought, but have yet to show signs of peaking.

North American equity markets have a history of moving flat to lower in mid-August

North American equity markets have a history of moving higher from July to August during a U.S. election year. However, equity markets also normally show at least a shallow correction in September and into early October.

Cash on the sidelines on both sides of the border is substantial and growing. However, political uncertainties (including the Fiscal Cliff) preclude major commitments by investors and corporations.

The Bottom Line

Equity markets on both sides of the border have had a good ride since their lows set on June 4^th. The Dow Jones Industrial Average is up 9.7% and the S&P 500 Index has gained 11.0%. Investing in equity markets has become less attractive. Accumulation of seasonal trades on weakness continues to make sense as long as the seasonal trades are outperforming the market. Sectors in this category include agriculture, energy, leisure & entertainment, software and gold. A cautious bullish stance appears appropriate.

Tom Rogers’ Weekly Elliott Wave Blog

Following is a link:

http://www.tomrogers.net/signpost.htm

Special Free Services available through www.equityclock.com

Equityclock.com is offering free access to a data base showing seasonal studies on individual stocks and sectors. The data base holds seasonality studies on over 1000 big and moderate cap securities and indices.

To login, simply go to http://www.equityclock.com/charts/

Following is an example:

Platinum Futures (PL) Seasonal Chart

ETF News

The latest weekly update on ETFs in Canada to August 10^th is available at

http://www.etfinsight.ca/

Disclaimer: Comments and opinions offered in this report at www.timingthemarket.ca are for information only. They should not be considered as advice to purchase or to sell mentioned securities. Data offered in this report is believed to be accurate, but is not guaranteed.

Don and Jon Vialoux are research analysts for Horizons Investment Management Inc. All of the views expressed herein are the personal views of the authors and are not necessarily the views of Horizons Investment Management Inc., although any of the recommendations found herein may be reflected in positions or transactions in the various client portfolios managed by Horizons Investment Management Inc

Horizons Seasonal Rotation ETF HAC August 10^th 2012

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Declines in Transports, Dr. Copper, and Equity Volumes are Seasonal Weakness (Until October)

Monday, August 13th, 2012

by Don Vialoux, EquityClock.com

Upcoming US Events for Today:

• No Significant Events Scheduled

Upcoming International Events for Today:

1. The Bank of Japan releases the Minutes from its July meeting at 7:50pm EST.

The Markets
Markets in the US ended positive on Friday, despite concerning signs of economic contraction with China posting a disappointingly low trade surplus number for the month of July. Investors were expecting a surplus of $33.0B, up from the $31.7B reported previous, but the actual was a mere $25.2B. A shockingly low increase in exports at only 1.0%, off from the 8.8% analyst expectation, was the predominant factor behind the weak headline number, which is being pinched primarily by slowing demand from Europe. According to Econoday.com, “this was their worst performance for a non-holiday month since November 2009.” The impact of slowing exports from China is being picked up in the Baltic Dry Index (BDI), which tracks the price to ship freight over the world’s oceans. The BDI is once again pushing towards the lows of the year, signaling that economic fundamentals remain severely depressed. This is typically a leading indicator to equity market weakness.

The Baltic Dry Index is not the only shipping gauge that is under pressure. The Dow Transportation Index has been significantly underperforming the market for almost a month, hinting of weak demand for goods. The Dow Transports typically confirm broad market equity moves, leading markets higher when economic fundamentals are strong, and leading the markets lower when fundamentals are weak. The fact that this cyclical industry, Transportation, is not showing the same upside momentum as what the broad market showing is a significant concern. Higher oil prices are also pressuring transportation stocks, a situation which is seasonally typical into September and October.

Turning to the equity markets, last week saw the lowest equity market volumes for a non-Christmas holiday week in years. The S&P 500 ETF (SPY) was shown on Friday with a 4-day volume moving average. The fifth day, Friday, only weakened the average further. The Dow Jones Industrial Average is also showing a similar volume profile to SPY. Now take a look at the NYSE Primary Exchange Index, which showed the lowest 5-day volume average since the 1990’s. Low volume implies low conviction, often a precursor to market declines. Volumes are typically lower than average during the summer months, albeit not as low as present levels, picking up once again in September as traders return to their desks from summer vacation. As a result, September and October are known to be the most volatile months on the calendar as regular trading resumes.

Concerning activity remains evident in the price of Copper, often referred to as “Doctor Copper” due to its ability to predict broad market moves. Copper has maintained a long-term declining path over the past year, underperforming the market in the process. With expectations of further monetary stimulus overriding economic fundamentals, it would be expected that copper would react positively as well, producing positive results and outperforming the market before central bank officials confirm activity, similar to what occurred prior to the last two QE programs. Investors in the cyclical metal are showing signs of skepticism toward the prominent stimulus expectations, perhaps warning that fundamental concerns are still too serious to ignore. Copper seasonally declines between August and October due to economic factors, such as weak manufacturing demand.

Despite a number of warning signals that remain intact, bullish characteristics are prevailing within the price action of equity markets. The S&P 500 continues to maintain a trend of higher-highs and higher-lows following a June low. Significant moving averages (20, 50, and 200-day) are curling positive. Even bond prices are showing signs of coming under pressure, a positive for equity markets. Sell signals for broad market indices have yet to be confirmed, so although risks are increasing, maintaining appropriate allocations to equities appears prudent until technical indicators roll over. Seasonal tendencies for Presidential election years turn negative into September, so equities are within a window where a peak could be realized at any time. Be prepare to react accordingly.

Sentiment on Friday, as gauged by the put-call ratio, ended neutral at 0.99. The ratio broke out of a falling wedge pattern, which could be the precursor to elevated levels of volatility. The VIX has fallen back to levels where the market has been known to correct as complacency reaches extremes. Volatility remains seasonally positive through to October.

S&P 500 Index

Chart Courtesy of StockCharts.com

TSE Composite

Chart Courtesy of StockCharts.com

Horizons Seasonal Rotation ETF (TSX:HAC)

• Closing Market Value: $12.37 (unchanged)
• Closing NAV/Unit: $12.39 (unchanged)

Performance*

* performance calculated on Closing NAV/Unit as provided by custodian

Click Here to learn more about the proprietary, seasonal rotation investment strategy developed by research analysts Don Vialoux, Brooke Thackray, and Jon Vialoux.

Tags: Baltic Dry Index, Baltic Dry Index Bdi, Bank Of Japan, Broad Market, Christmas Holiday, Don Vialoux, Economic Contraction, Economic Fundamentals, ETF, ETFs, Exports From China, Headline Number, Leading Indicator, Lows, Market Equity, Market Weakness, Oil Prices, Predominant Factor, Seasonal Weakness, Significant Events, Trade Surplus, Transportation Index, Transportation Stocks
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Begging for Trouble (Hussman)

Monday, August 13th, 2012

Begging for Trouble

by John P. Hussman, Ph.D., Hussman Funds

With the daily focus on European crisis and the hope of central bank intervention, one of the essential features of the investment climate – at least for long-term investors – is easy to lose in the shuffle. That feature is valuation. It’s an easy concern to overlook, because with corporate profit margins close to 70% above historical norms (largely because of unsustainably large government deficits coupled with low private savings rates – see Too Little to Lock In), Wall Street is quite happy to look at the ratio of prices to near-term earnings estimates and conclude that valuations are satisfactory. But stocks are not a claim on one year of earnings. They are a claim on a very long stream of cash flows that will actually be delivered into the hands of investors. Unfortunately, the conclusion that stocks are appropriately valued rests on the implicit assumption that profit margins will remain elevated into the indefinite future.

We presently estimate a projected 10-year total (nominal) return for the S&P 500 of less than 4.6% annually. Nothing in recent years, much less the past decade, indicates any material change in the relationship between actual market returns and expected market returns as we estimate them using a range of fundamentals including normalized earnings. Indeed, the 5.1% total return of the S&P 500 over the most recent 10-year period has been right on target (see also my July 7, 2002 comment). It’s notable that even without compelling valuations a decade ago, we lifted 70% of our hedges several months later in early 2003, at what turned out to be the start of the next bull market – something to remember for those who misunderstand our two-data sets issue of 2009-early 2010 and assume that we’ll never lift our hedges until the market is deeply undervalued.

I anticipate that a decade from now, the S&P 500 will have achieved a total return that is very weak from a long-term perspective. Remember also that you don’t “lock in” a 10-year return. You ride it out. I continue to expect that investors will have numerous opportunities to accept risk in the coming years in expectation of much better prospective returns than are presently likely.

Of course, with the yield on the 10-year Treasury bond at just 1.6%, one might argue that a prospective 10-year return of nearly 4.6% on stocks is still very good by comparison, and should be enough to prevent any substantial adjustment to lower prices and higher prospective returns. To inform that argument, I’ve added the 10-year Treasury bond yield to our standard chart below. Note that the correlation between 10-year S&P 500 returns and 10-year Treasury bond yields (which reflect both expected and actual 10-year returns, provided no default occurs) is just 0.1. There is virtually no relationship at all, with the exception of the early-1980’s, when the prospective and actual returns were quite high for both as a result of inflation shocks.

While the simultaneous rally in both stocks and bonds from the early 1980’s through the late-1990’s gave the illusion that the 10-year bond yields and forward operating earnings yields had a precise point-for-point relationship, spawning an unfortunate little cottage industry of adherents to the “Fed Model”, this model is based entirely on the relationship between stock yields and bond yields during a specific 16-year period of sustained disinflation, and there is no evidence – or even sound theory – supporting that spurious one-to-one correlation more generally.

Why aren’t the 10-year returns of stocks and bonds (prospective or actual) more closely related? The reason is simple, really. 10-year bonds have an effective duration of only about 7-8 years, depending on the coupon, which means that your ending wealth is nearly completely determined within that horizon. In contrast, stocks are very long-term assets, with an effective “duration” roughly equal to the price/dividend ratio*, which means that changes in valuation dramatically affect the terminal value of your investment even for horizons out to 30-40 years, and sometimes longer when valuations are rich and yields are low.

[*Geek’s note: You can derive this by differentiating the Gordon growth model P = D/(k-g) with respect to k, and calculating the elasticity of price to changes in the gross return: (dP/P)/{dk/(1+k)}].

Consider investors who bought stocks back in 1999 when the price/dividend ratio was 70. Those investors were assured that the value of their investment would be dramatically affected by even very small changes in yields. The S&P 500 has now underperformed Treasury bills for over 13 years – even when recent market advance is included. If the S&P 500 indeed achieves a total return of 4.6% annually over the coming decade, those investors will have achieved a 23-year total return of just 3.2% annually. But even if the S&P 500 achieves a 10% annual return over the next decade, the 23-year total return for those investors would still only work out to 5.6% annually. When investors commit funds at rich valuations, the inevitable return to more normal valuations matters, and it matters for a very long time.

The most controllable determinants of investment returns are the level of valuation at which investors choose to initiate their investment and the level of valuation at which they choose to terminate their investment. Once you choose to initiate your investment at a rich level of valuation, you require a rich terminal valuation at some point in the future – and the good fortune to sell at that point – in order to achieve an acceptable long-term return. At present, rich valuations promise a very challenging decade for stock market investors, regardless of any fleeting short-term relief that monetary policy might provide.

Keep this in mind – when the market is deeply oversold and market internals are demonstrating positive divergences and recruiting favorable breadth, it can be sensible to accept market risk despite uncompelling valuations, as we did in early 2003. But speculating in a richly valued market where internals are showing increasing divergences, and the environment features an exhaustion syndrome and other historically dangerous conditions (see An Angry Army of Aunt Minnies) – is just begging for trouble.

Begging for Trouble

Investors remain so addicted to the temporary high of monetary intervention that they continue to ignore very real downturn in global economic indicators, to an extent that we have not seen since the 2007-2009 recession. This is particularly evident in the deterioration of new orders and order backlogs, which are short-leading indicators of production, which in turn is a short-leading indicator of employment.

Trading volume has been unusually low, while a 14-handle on the CBOE volatility index also suggests unusual complacency.  It’s understandable that people are reluctant to place trades in a weakening economy, yet one where quantitative easing is widely expected. Wall Street is scared to death of being out of the market when the perceived salvation of QE3 is announced, and at the same time is increasingly encouraged by negative economic data in the belief that this will accelerate delivery. In short, investors are practically begging to be shot, mauled by dogs, and diced by a Veg-O-Matic so they can get their next fix of pain-killers.

The chart below shows the average standardized value (mean zero, unit variance) of the overall, new orders, and order backlogs components of numerous regional surveys from the Federal Reserve and the Institute of Supply Management (ISM). We observe the same sustained deterioration in economic data across the world, including Europe and China (where the absolute values are higher, but the standardized values are similarly bad). The overall pattern reflects what Lakshman Achuthan of ECRI often describes as the “three P’s” – pronounced, pervasive, and persistent. Those three P’s help to distinguish signals from noise. Presently, our own noise-reduction methods suggest that a global recession is at hand.

One problem with the widespread faith in QE3 is that quantitative easing has had very weak and temporary effects on real economic activity or employment. Regional Fed governors like Eric Rosengren (Boston), John Williams (San Francisco) and others have increasingly advocated another round of quantitative easing, feeling extreme pressure for the Fed to “do something” about the economy. But as I’ve asked before, suppose that Ben Bernanke announces that he is going to stop spitting watermelon seeds into a can. Should we all become concerned that the Fed is suddenly not doing enough to stimulate the economy? Well, only if you think that spitting watermelon seeds into a can is stimulative.

Unfortunately, the impact of QE has been almost exclusively restricted to marginal changes in interest rates that have little effect on economic activity, and provoking temporary speculative bouts in the financial markets. This ineffectiveness has been predictable, not only because of the very weak relationship between GDP growth and stock market changes (a 1% change in stock market value has historically been associated with just a 0.03-0.05% change in GDP), but also because – drumroll – with trillions of idle reserves already sloshing around in the banking system, QE doesn’t relax any constraint that is actually binding on the economy.

The typical effect of QE-induced speculative runs has been little more than to help the stock market recover the decline that it experienced over the prior 6-month period (see What if the Fed Throws a QE3 and Nobody Comes?). In effect, QE is a policy that has negligible effects on the real economy, and is effective only in suppressing spikes in risk premiums and supporting the stock market after hard declines. We should not be surprised if it turns out to be fairly ineffective in lowering risk premiums when they are already depressed, reducing interest rates that are already near record lows, or supporting stock prices that are already quite elevated. Needless to say, the Fed is virtually certain to initiate another round of QE3. But the fact that it is needless to say this should be of some concern, because it suggests that the intervention is already fully discounted.

The suspended animation of the market here is very reminiscent of the similar suspension that occurred in 2008, as the markets eagerly awaited the near-certain passage of the Troubled Assets Relief Program (TARP). If you recall, within one minute of the passage of that bill by the House of Representatives, the stock market entered a free fall. Buy the rumor, sell the news.

Given the spike in risk premiums across Spanish and Italian debt, it is clear that a round of massive bond purchases by the European Central Bank would come as quite a relief to those debt markets and the European stock market. So massive ECB purchases would almost certainly have greater short-run impact than another round of QE by the Fed. But ECB monetization of distressed European debt is a policy that is still vehemently opposed by stronger European countries, and even what has been done already dabbles at the very edge of German constitutional law.

I continue to expect that the Euro will eventually break apart, and that it would be least disruptive for the stronger countries (Germany, Finland, Holland, etc) to exit first, allowing the remaining countries to print money and depreciate the Euro as they desire. The reason is that existing contracts in Euro could still be honored, without the massive corporate and private defaults that would occur if peripheral countries had to revert back to their previous national currencies and yet have to honor contracts in a dramatically stronger currency.

In my view, it is unwise to dismiss the possibility that the stronger European countries will split off either into their pre-Euro currencies, or into a new common currency with a more restricted membership. That is essentially what the sovereign bond markets foreshadow. Government bonds in Finland, Germany, Holland and several other countries are presently sporting negative interest rates, with German yields reaching record negative levels just last week. As Ray Dalio of Bridgewater recently wrote, “we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.”

For the United States, the main force of policy here should be on measures to ensure that the financial system is as immunized as possible from deterioration in the European banking system. On that front, Reuters reported last week that major banks have been directed to develop plans in the case of a renewed credit crisis.

With regard to the preparation of the U.S. financial system, I remain skeptical, but am somewhat more hopeful than I was a few years ago. Part of the Dodd-Frank act was the creation of an Orderly Liquidation Authority (OLA) to resolve too-big-to fail banks (Systemically Important Financial Institutions or SIFIs). The objective is to preserve large financial firms as going concerns in the event of insolvency, while ensuring that shareholders and creditors bear all the losses and customers and depositors are protected. The mechanics: following receivership, a temporary bridge company would be created, the FDIC would write down the assets to market value, old equity would be written off, and liabilities would be transferred by seniority (senior secured debt first) until the  bridge company had 10% equity. Remaining debt would be exchanged for equity in the new company.

The JP Morgan resolution plan provides a good example of how this would work. Notably, JP Morgan’s illustration suggests that an after-tax loss of $50 billion (just 2.2% of total assets) could be sufficient to take the company to insolvency, driving the company to a negative $16 billion equity position (h/t DailyBail). How could that happen? The example presented by JPM assumes two additional driving changes: a deposit run of 20%, which would be a substantial reduction in deposits, but certainly not unprecedented in other banking crises; and a $150 billion mark-down of asset values by the FDIC upon creation of the bridge company. Now, I’ve been quite critical of the 2009 FASB ruling that removed the need for banks to mark their assets to market, but a difference of $150 billion between the reported value of assets and the value that would be recognized in a reorganization? That would represent about 80% of the equity presently reported by JPM. One hopes that this figure has no relationship to reality.

Market Climate

As of last week, our estimates of prospective return/risk for stocks remained in the most negative 0.6% of historical observations, based on a blend of horizons from 2-weeks to 18-months. Strategic Growth remains fully hedged, with a “staggered strike” position that raises the strike prices of the put side of that hedge closer to market levels, presently representing about 1.6% of assets in time premium looking out toward year-end. Strategic International also remains fully hedged. Strategic Dividend Value is hedged at 50% of assets – it’s most defensive position. In Strategic Total Return, we used the spike in yields last week to very slightly increase the duration of the Fund to about 1.8 years. About 10% of assets remain in precious metals shares, with a few percent in utility shares and foreign currencies.

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