S&P 500 may hit 1,000 before it makes a new high

Deflation is in the air. It’s gutting the prices of raw materials, emerging markets, junk bonds and starting to catch up to equities.

It’s going to get ugly

The journey up was fast and fortuitous, without the structural economic improvements that should accompany such a prolific bull market.  And more importantly, with enormous leverage and speculation driving prices.

The mini-panic on August 24, 2015 showed us that the market is capable of wild swings, and likely enormous drops.  In 2008 we saw the stock market lose more than a quarter of its value in days.  This sort of action is not only likely, but I expect it.

Why 1,000? 

This level puts the index back to major area of psychological support and also seems to complete what may be a head and shoulders pattern forming on the S&P 500 back to the base of the left shoulder.

1,000 is a level where the market was before the latter incarnations of QE wildly distorted prices higher. I believe that the beneficial effects of QE were overestimated and that the detrimental effects underestimated.

The gross distortion of prices has destroyed many price signal indicators.Adding to that the lack of interest bearing savings account has forced savers to speculate, hoping for a gain.

spx

Buyback backtrack?

The stock market’s valuation has largely benefited from corporate buybacks.  Now corporations possess an enormous amount of debt.

Additionally, corporations tend to get cold feet as the market is volatile or when prices decline quarter over quarter.  That means less buybacks should occur as fear overtakes greed.

Have some cash set aside

Right now my own inclination is to make a wish list of stocks to own and an idea of what prices make sense to buy them.  Then wait for prices to come to me.

Rather than chasing prices or settling for buying something that may be overvalued I think it makes sense to set cash aside and buy in at lower prices.  In all likelihood they are coming soon.

Trend support broken on S&P 500 index

Stocks are selling off — and fast.  But what exactly is a price trend and what do they look like?  Trends are defined as a series of higher highs and higher lows for an uptrend and a series of lower lows and lower highs for a downtrend. Uptrends are the result of more buying than selling for a given period of time while the inverse is true of downtrends.  An uptrend is essentially a chart where the price starts on the lower left and ends on the upper right.

After the S&P 500 consolidated for about a year it has decidedly turned much lower — and quickly.  With the worst three point day rout in the Dow since its inception behind us now, what is going to happen next?

First, I think it’s important to note that while I believe the trend remains down, there is likely some sort of bounce that will come soon.  Think of it as a moderating bounce.  One where we see some positive price action to push things off the extreme lows and encourage some buying.  After all, across just about every measure on the short to intermediate term, stocks are oversold.

damagedWe’re overdue for a bounce, but what follows may be a trounce.

That being said, it’s most likely that such a wave of buying will be short lived and followed by additional, deeper selling.  The reason I believe that this is the case is that the main catalysts that have driven the market higher, as discussed in my previous article, are largely drying up.  While at the same time, the global picture seems to be much more grim.

Crude head fake means lower prices ahead likely

Crude oil has had quite a slide since July of 2014.  Recently it appeared as though prices may be stabilizing, but recent price action may suggest that what seemed to be a double bottom may actually have lead to a head fake rally rather than a durable price support level.

crude oil pricing

US crude oil spot price chart from the last 6 months.

With a firm rejection at the 50 day moving average, and the bollinger bands widening, it seems that on a technical basis crude is poised to take out its lows.  Is a $30 even $20 in the cards?  Possibly.  Crude traded as low as the mid $30s back in early 2009.  We could see similar price action in a capitulation event or a slow grind down.  There is not enough conviction for a significant price breakout without increased demand or a geopolitical event threatening oil production.

 

Higher stock market volatility may be persistent in 2015

A recurring theme in the bull market rally since 2012 has been minimal volatility.  The days of enormous whipsaws in price were seemingly behind us until late 2014.  The mood of the market has decidedly changed as of late.  What used to be a complacent, calm and somewhat orderly march in to parabolic territory has degenerated in to a much more unpredictable series of widening trading ranges.

Watch for a potential trend change

As volatility increases, there is the potential that fear will overwhelm greed and the bulls will become more concerned about securing profits than taking risk.  Margin levels are off the chart and short positioning is still historically low, so downside momentum may hasten quickly if it is perceived that an interim top is forming.

Volatility index (VIX)

If such a change occurs, it is likely that we will see a long overdue correction occur in the broader equity and lower tier credit markets.  It also may prompt an exit from the crowded long dollar trade if the risks are perceived to be domestic.  2015 holds plenty of promise for interesting global and financial market developments.  Stay close to the news feed and price ticker.

Caution! Market crash could be imminent

With growing uncertainty surrounding the European debt crisis, and the contagion spreading to much larger sovereigns, such as Italy, we now see risk aversion back on the table.  US markets are down over 3%, the headlines seem to be getting progressively worse and many fear that the situation could deteriorate much further — giving up much of the gains achieved in October.

Growing concern as market whipsaws

This kind of volatility, both up and down, is historically an indicator of very large market moves.  With the bias largely negative, it seems that a market crash could be coming if no resolution is found for the EU debt implosion.  Alternatively, should a large scale bailout ($2T+) occur, we could see a significant rally, especially within precious metals spot prices and miners.

For investors and traders, this type of price action is stressful.  Seeing fluctuations of multiple percentage points in indices and nearly 10% in stocks can cause forced position liquidation because of stop loss orders being triggered.  For traders, who generally capitalize on multi-day moves rather than moves within a single day, this type of action can cause significant losses should one be caught on the wrong side of the market action.  High frequency trading machines may capture gains, but are not providing liquidity or improving market efficiency, especially during periods of intense market moves.  Instead, evidence seems to be growing that the machine-based traders are making the market less stable and more prone to large price swings.

World view deteriorates

Global markets plunged as well, with Italy down over 9%, Poland down nearly 9%, Germany down over 7% and other European markets leading weakness as stock prices bleed, especially within the financial sector.  The lackadaisical response out of the EU, ECB and IMF leadership seems to be draining confidence and sparking fear in the markets.

US banks have hundreds of billions of dollars worth of exposure to European sovereign debt, banks and other related instruments.  Many have written credit default swaps, a form of insurance that has no capital reserve (see AIG implosion circa 2008) against European debt, exposing them to significant risks should the EU situation worsen.

Broken bonds from backwards economies

Many Western countries now face the prospect of sovereign debt problems, as their economies continue to slow, while investors fear that they will not be able to pay back the debt.  The United States is no exception, as its official debt reaches 100% of GDP, and by some estimates, their total outstanding unfunded liabilities have reached $75 trillion.

Japan has a 200% debt-to-GDP ratio, which is only made possible by the fact that most of their debt is held by Japanese banks and pensioners, but the situation there is deteriorating with growing political and economic instability.  Even China is no exception, as their economy is slowing down and the yield curve on Chinese debt has inverted for the first time — causing serious concern for those that felt China would lead the world out of recession.

The coming crisis

What happens next is not clear, but what is evident is that the world is changing.  Slowing economic growth, the bursting of the largest credit bubble in history, significant deterioration in debt-driven consumption and resource depletion all leads to a potential crisis.  All of the new debt that has been created to attempt to stem the last debt crisis has only exacerbated the underlying structural economic problems we are facing.  Papering over large amounts of fraud within the financial system and ignoring the peril of main street has divided the Western world.  Growing civil unrest and lack of available employment, especially for the young, has created the potential for large scale disruptions (think of the “Occupy” movement, but on a global scale with a significant percentage of the population participating).

I feel that unless we start seeing accountability within the financial sector and governments of the world, prosecution of the enormous fraud, transparency within the political and electoral process and erosion of corporate personhood in so far as money is considered free speech, as well as more regulation of over the counter derivatives, we will look back at the 2008 crisis and think of it as a relatively calm and orderly time within the financial markets compared to what could happen next.

S&P 500 uptrend intact for now

The S&P 500’s uptrend remains intact in a defined channel that found support today, during the stock market sell-off, at the 20 day moving average. The chart below shows the trend channel as well as the moving averages.

S&P 500 chart

Uptrend channel intact

There are some technical issues at play here, however, that we cannot discount. First and foremost, as I mentioned in the previous post there is a double top pattern in the S&P 500 that is playing out and causing a decent amount of fear. Combine that with Chinese inflation worries that toppled the Shanghai index down over 5% last night and we find the markets climbing a wall of worries in to the weekend. Most commodities took extreme hits today, with sugar, silver, palladium, gold, cotton and various grains falling off their highs. Oddly enough the dollar was weak while all this selling in commodities and equities was taking place, which is contrary to what we’ve seen in the past months.

Seasonally this time of year tends to be rather positive for equities. The holiday season usually gives earnings and employment a boost and consumer sentiment usually picks up — except for what we witnessed in 2008 of course. Next week should shed more light on the technicals and fundamentals of these markets. As we see trading begin in Asia it will be interesting to see if the appetite for precious metals is once again renewed as it was after the silver sell off on Tuesday after the CFTC raised margin requirements by 20% (from 5% to 6%).

Is the rally topping out or just starting?

We’ve seen a significant gain since the bottom in March of 2009, up about 80% since those 666 S&P 500 lows.  Now the market is facing significant resistance, even after the massive $600 billion QE2 plan to inject more liquidity.  The resistance comes both in the US dollar beginning to find trend line support and the S&P 500 showing potential resistance at what could become a double top formation.

First let’s have a look at the long term dollar chart:

US dollar long term chart

It’s clear that the US dollar, despite a large drop in recent months, is beginning to find support at the trend line formed from previous lows. If this trend holds it could bolster the ailing US currency and provide room for not only a short term reversal, but some significant appreciation on the back of Europe’s woes and a correction in the commodity currencies. On the other side, the dollar is seeing significant headwinds towards sustainable appreciation because of the unsustainable forward looking debt load of the US government combined with the massive stimulus and easing programs.

Now let’s have a look at the S&P 500 chart:

We see the potential for a double top formation in the index around 1220. If this level can not be broken to the upside then we have some serious downside potential to contend with in the US stock market. The rally of around 15% over the last two months indicates that many are confident in putting their money in to equities, rather than bonds, and with that a lot of speculative stocks have seen impressive gains. But another side of this rally is that it has largely been supported by extremely loose monetary policy, a “Bernanke put,” is what many are calling it, meaning that there’s no reason to buy protection (or put options) on your investments because the Fed will be there to prop up the market.

This is an inflection point. It has the potential to decide the direction of where many different markets, including currencies, commodities, equities and bonds, will be trading for the next several months ahead. Should the dollar fail its trend line support and the S&P break to the upside of the resistance around 1220 we’ll see a massive rally in other currencies, commodities and equities. If instead we see the dollar hold firm and appreciate against other currencies, reinforcing the trend line support and the S&P breaks down at the aforementioned resistance level then we could see a daunting correction in other currencies, equities and commodities.

All we can do now is watch, wait and act accordingly…

Market bounces on extreme oversold condition

On Friday the US stock market enjoyed a bounce because of an extremely oversold technical market condition.  These market conditions often happen when there are extreme emotions in the market.  It may seem obvious, but excessive greed leads to overbought conditions and fear leads to oversold conditions, such as the one we recently experienced.

NYSE index

The above chart of the NYSE index (a broad US stock-based composite) depicts the rally and the recent selling.

This chart illustrates levels that are considered overbought or oversold on the NYSE McClellan Oscillator.

The condition, illustrated by the red arrow in the chart, has not been fully worked out so there is still room for more buying.  On a technical basis, oversold conditions typically occur after waves of selling that knock an asset out of balance with supply and demand creating a void that must be filled.  They are measured by various technical indicators.  I prefer the NYSE McClellan Oscillator.

As you can see in the above charts when there is an oversold or overbought condition that reaches an extreme, it is typically corrected and often with violent reverberations throughout the markets.

Downtrend to continue?

Even as the oversold condition resets, it is unlikely that we have seen the last of the selling.  Global market conditions are worsening.  Sovereign debt defaults, EU stability and China’s perceived slowdown are at the forefront of concerns by market participants.

Typically there is a large bounce that resets the oversold condition to neutral or even overbought and then the downward volatility will continue, assuming that the market is going to continue to keep its eye on the powerful headwinds a global recovery faces.

Fundamentals failing

So far the rally since March of 2009 has priced in what economists call a “V-shaped recovery”.  That is to say, a powerful drop and an equally powerful recovery.  In order for this theory to play out there must be improving macroeconomic fundamentals, but instead the exact opposite is occurring as the fundamentals deteriorate.

US Government debt and GDP percentage of debt graphic

This chart shows US government debt is climbing fast and already at multiples of our GDP.

Western government debt is soaring much faster than any GDP growth.  The GDP growth projections are just as unrealistic as the expectation that a debt crisis can be solved with more debt. 

A pronounced fear is building up that this surge in global stock prices we’ve seen for the last year may have been nothing more than a mirage without a basis in reality.  It’s likely that massive tax increases and spending cuts across many governments are going to be inevitable. Such actions will crush the economies of those countries and create more problems for the global economy.

Alternative measure of unemployment     Americans not finding enough work

Unemployment continues to stay at high levels.  In the US unemployment as measured by the Department of Labor U6 survey is at 17%, meaning over 1/6 people cannot find enough work, if any.  U3, a more conservative measure is close to 10%. 

These levels of unemployment are devastating to everyone trying to support themselves financially. Another effect is that it creates a vacuum of sustainable durable or discretionary spending now and in the future hurting businesses everywhere.

The coming correction

At some point there is going to be an even more significant correction than what we’ve seen so far.  One that brings asset prices back in to parity with fundamentals.

While zero percent interest rates and government bailouts may have buoyed the markets, they have not improved the economy.  Some would say these actions actually damaged the economy because the failing companies were not allowed to dissolve.

As the flight to safety occurs we may see an appreciation in US Treasuries, US Dollars and perhaps even gold.  The Japanese Yen will probably also appreciate, damaging the nation’s ability to be competitive with its export prices.

US Government probes JP Morgan silver trades

Federal agents are probing JPMorgan Chase’s silver trading activity in order to determine if the bank used derivatives to artificially lower the price of the precious metal.

Part of a larger problem

It is estimated that JPMorgan holds up to 40% of the world’s silver short.  If this is true it is certainly indicative of price manipulation as JPMorgan doesn’t possess 40% of the physical silver.

Derivatives played a large role in the market collapse that began in 2006 that was largely blamed on subprime loans.  Because these mortgage backed securities, credit default swaps and other instruments weren’t on exchanges there would be a very wide difference between the bid and ask (or the spread), especially during market volatility.

This could lead to huge price swings in the instruments, making holders uncertain what the true value really was.

Light must be shed

When reflecting on this opaque market’s role in recent events it’s clear that something must be done.  We need more transparency with derivatives.

They should be traded on open exchanges where they can be settled every trading day.

Shorting silver

The reason silver (and to a large extent gold) have been shorted is to artificially depress the prices of precious metals vs. the prices of stocks and bonds, helping to hide the true effects of inflation.

In fact, using these derivatives to add liquidity to their balance sheet by shorting silver, it’s likely that JPMorgan would use that cash to invest in stocks and US Treasury bonds.

Bribing Washington

Wall Street sends $500 million to Washington every year, using lobbyists to shape the opinion of lawmakers.  There is also a shameful revolving door between government and the private sector that often hinders regulators from employing their full might.

Consequences of manipulation

The DOJ and CFTC are looking at both civil and criminal charges as the investigation continues.  They are examining trading tickets and other information.  I expect the probe may expand to other assets, too.

It is possible that the firm will be fined, but I’d be very surprised if anyone goes to jail.

It’s time for a new and improved uptick rule

Since the SEC eliminated the uptick rule on July 6th, 2007 there has been a marked increase in volatility.  Of course other factors significantly contributed, but in all likelihood with the uptick rule in place, selling would have been more controlled and orderly.

Another Black Thursday

After the most recent Black Thursday on May 6th the market dipped almost 1,000 points because of what the exchanges claim were computer errors (and probably the bid disappearing because market makers were running scared), it’s time to look at reinstating the uptick rule.

Black Thursday resulted in many investors losing money, including retirements and pensions. Whether it was a computer event, human error or some combination of both the fact remains that a rule to prevent short selling without first an uptick in prices would have curbed losses.

History of the rule

The uptick rule was originally enacted in 1938 as a response to concentrated short selling.  It forbid short selling a stock unless there was first a positive tick in prices.

Short sellers today claim that the rule was largely symbolic and only affected a few exchanges.  They’re right, it was not broad enough and regulation did not keep up with the way markets changed.

A better rule needed

The new uptick rule should affect all US stock, options, forex and futures exchanges to ban short selling except on an uptick in prices.  This would, in effect, buffer investors and exchanges from the cataclysmic stock market losses that we saw on Black Thursday.

Another benefit is it would force the computerized programs to, by law, have protection mechanisms built in to prevent endless selling.

Regulators must regulate

Now that the carnage that’s only possible without more balance in the market has been witnessed, it’s time for regulators, like the SEC and CFTC, to stand up and enforce existing regulations more stringently and insist on new regulations, such as a new and improved uptick rule.