Fear Abating??

The past few days have seen a significant abatement in fear across global markets. - Fear had seemed pervasive across many markets over the past couple of weeks, which merely seemed a further installment of the various episodes of recent months. - The week before last week saw a capitulation in sentiment from the retail individual investor, last week it was the turn of newsletter writers to capitulate. The most recent survey by Investor's Intelligence saw a marked drop in those who see the market as a) bullish or b) within a correction, with those defecting moving to the bearish camp. Last week's reading was:

Bullish ................... 29.4 (-3.9%)
Within a Correction... 32.9 (-2.6%)

Bearish ..................37.7 (+6.5%)
   

This is the first time that the Bullish Camp has been below 30% since MARCH 2009. The chart below shows the SP500 versus the Investors Intelligence Newsletter survey since the early 1990s

Another indicator of recent fear has been the Japanese 10 Year Government Bonds, the yield on these bonds has dropped precipitously over the past few months, from an already low 1.4% to around 0.9%. (Yep, fear has been so strong that investors have been willing to accept yields below 1 per cent for the next 10 years on an instrument issued by a country with a Debt to GDP ratio of close to 200%.  - ( yep TWO HUNDRED PER CENT) - Just for the record the Greek debt to GDP ratio is around 130% (about 2/3rds of Japan's). -- [ I know that is not how markets look at this, but one day a very clever and articulate investor/trader with big bags of bucks, will look at it like that, and suddenly realise WTF,,, he (or she) will rush to get out of Japanese bonds, as well as US and all other bonds.... followed by one or two more, then before you know it everyone is rushing for the exits, and baaaammmm, up go Japanese Bond Yields, then US yields then Euro Yields, and suddenly we are staring a bond market crash right in the face. - Of course it may not happen,, but I believe at some point in the future it probably will happen ,,,,not immediately, but possibly in the next few years.. When that happens, I would not want to be invested in anything that is not at least shiny and hard.]    --  Anyway I digress, the past couple of days have seen a sharp correction higher in JGB yields, currently they stand at 1.12%, from last week's low of 0.90%, this may be reflective of the recent fear starting to abate. This can be seen in the chart below, which also highlights the under performance of US equities at the same time as Japanese yields declined.

The next chart shows fear in relation to the European Sovereign Debt crisis. The top window in this chart is the SP500 Index, the second window is the Spanish v German 10 year yield, I use this as a proxy for all the PIIGS, the third window is the VIX index, and the bottom window is the EURUSD FX. This shows how during late April though May, the PIIGS crisis really exploded, leading to a flight from the EURO and risk, and a sharp pick up in volatility. I have highlighted 3 episodes of Fear during the past 6 months, it is noticeable how each episode, has seen lower peaks in fear as measured by the Spain v German 10 year yield spread, and the VIX index, and the higher level of the EURUSD.

This easing of fear in relation to the above, if it were to continue, could add a favourable backdrop to US equity markets going forward, and this is something which is certainly worth keeping an eye on for now.

Equities Topping Patterns - Everywhere

My post yesterday highlighted the risk of a short-term bounce, everything was setting up for a 'key-day reversal'. Well the bounce as it happened was very very short-term, the indices made it to the neckline of the Head & Shoulders pattern which broke last week before falling away. Though the S+P futures, did manage to complete a weak 'key-day reversal', this was not confirmed on the S+P500 index itself. Looking ahead some of the conditions still exist for this bounce to re-occur, however I think the odds have become remote for now. Looking at the bigger picture, though recent days' price action has show indecision, refering back to some of my earlier posts, I feel we may head lower soon, and possibly much lower.

Beyond that, I have decided to see how the bigger picture looks across a wide variety of markets. One of the maim tenet's of Charles Dow's original 'Dow Theory' was that of confirmation. Dow believed that a directional move or trend in the Dow Industrials Index could not occur unless the Railway's average (The Dow Transports Index) was moving in the same direction. If they diverged, then this called in to question the sustainability of the trending move. - The world has moved on since then, there are far more markets, covering specific sectors, or different size of market capitalisation. To that end I have looked as charts across a broad spectrum of indices, these can be seen below. All charts have a similar topping formation and each one has recently broken to the downside. To me this is strong confirming evidence, which adds weight to the major topping pattern, the Head & Shoulders, which should portend significant lower levels in the weeks and months ahead.
Beyond the US markets, it is also worth looking at global markets. The following charts show a selection of major G7 markets. What is clear here is once again we have similar topping patterns, though the German DAX offered a variant of the Head & Shoulders and has not yet made a new low for the recent phase (nor have a number of other markets within the EURO bloc).

The next set of charts move beyond the US and G7 countries and look at a variety of markets symbolic of Asia, South America and Commodity countries. Once again the major topping pattern is evident in all three charts. The Hong Kong markets has produced another variant of the Head & Shoulders pattern, this is probably because of the strong Chinese influence, - Chinese stocks indices seem to march to a very different beat. - As was the case with the German market, these have yet to make new lows for the recent move, however they all appear to have a strong downward bias.

'The End is NOT Nigh'

No charts today, just some musings and thoughts........

Over the past few weeks we have seen may markets take a serious turn for the worse, global bonds yields have dived (except in Europe's PIIGS countries where they have either risen or soared), and most non-precious metal commodities prices have dropped sharply. - As I read though the weekend press and various on-line news articles it is clear the optimism of late 2009/early 2010 is rapidly abating and I start to see articles referring to where has it gone wrong, what mistakes were made, what could be have been done or what should be done. My feeling is that whatever they did (or do), whether it is the austerity route, or continued fiscal expansion, there is very little that the authorities really could do,, any more than any government could do to protect its coastal region from a Tsunami wave racing towards it..... I wish I could be more positive or more upbeat ( I am a natural optimist - glass half full type person, and have never been a perma-bear) but my reading of the situation does not allow room for optimism right now. -- To continue the tsunami metaphor, we face a huge deleveraging tsunami; consumers, households, governments, municipalities, corporations, all are deleveraging in what I believe is the downside of the long-wave business cycle, with equity markets probably poised for much deeper losses. [The long-wave business cycle is a controversial theoretical concept, originally proposed by Russian economist Nikolai Kondratiev. The existence of the Long-wave cycle has been argued, and debated by economists for many years. The truth is it will take many decades or even centuries before its existence can be truly proved or disproved, in the meantime its existence remains conceptual at best.]

-- I think I'll stop here before I jump out the window, in fact first I'll try and balance things out.....

I am a strong believer in Human Nature, in Democracy, in Capitalism, Free Enterprise and Free Markets, even though all have many imperfections (which is why we need rules and regulations, sometimes we need protecting from ourselves). I think the Central Banks have largely acted in a responsible manner the past couple of years, (even though their total and utter irresponsible behaviour in the recent past has been a major contributing factor in exasperating an already bad situation. - Al Greenspan gets my vote for world's worst ever Central Banker.) - The major world economies are generally in better shape to withstand the next few years than at any time in the past (though I could also post a million caveats). We have strong democratic institutions, political and non-political, open media, a strong humanitarian streak and living standards far better than anything we ever had. -- I keep hearing talk of how the fear is that the west is heading into Japan style deflation. If we are heading for deflation I hope it is the Japanese style. Since the early 1990s Japan has had an abysmal growth record, and has periodically suffered bouts of deflation, though nothing of a serious nature (so far). However Japan's unemployment rate has never yet exceeded 6% and it remains one of the worlds leading economies. I visited Japan a few years ago and for a country supposedly mired in recession it had an incredible vibrancy and its people certainly did not appear downbeat. The fact that equity markets were at levels less than 20% of their highs a decade and a half previous was of little concern. - I am no fool either, I know that underneath the surface there are problems, that its standard of living had not advanced for years, that it has built up a huge government deficit which has since got far worse and has to be dealt with, that it has a serious demographic problem, etc, etc. I also understand how Japanese society is very different from the major Western societies. But it would probably be best if we could ride out the next 10 or so years in a similar fashion to the way Japan has so far riden out their so called 'lost decade'.

I have also read articles that the next global depression (if that is what we are facing) will likely end in global conflict. -- The supposed rationale for this is that the last global depression ended in global conflict. -- That was co-incidence, that is all... --There were many many reasons leading to WWII, I am not going to enter that debate here, though I will add that yes economic hardship was one contributing factor to the rise of the Nazis, but that can not be attributed to the Global Depression. Also to counter this idea, what about the global depression of the 1870s and 80s, did that end in global conflict,,, NO... - Furthermore, conflict either local, regional, or global has been and remains a continuing process ---- Since I have been alive the British forces have been involved or engaged in conlflicts on one scale or another almost continuously, be it Northern Ireland, the Falkland Islands, Kosova, Iraq or Afghanistan or the Cold war (which is much better than a real war). Much the same can be said for the US and to a lesser extent many other countries. A world without war or conflict would be wonderful, however it is probably but a pipe dream. - I do accept that depressions make the world a less stable place, but also wars do not happen because of depressions.

I am not optimistic, but neither do I think 'The end is nigh'. We face a a tough decade or so, statistically we face a 'reversion to the mean' and eveything that goes with that. However, in the long run it is part of a natural process and cycle; Spring, Summer, Fall and Winter, but eventually spring will come again......

Is the US yield curve losing its ability to forecast recessions?

One of the most reliable leading indicators of US economic activity over many years has been the difference in the price of the yield curve between 2 year and 10 year yields. The basic premise being that when the yield curve difference is close to or below zero (or flat), that economic activity is likely to contract, and that to a lesser extent, a steep or steepening yield curve is associated with economic expansion. - The charts below show US economic growth as measured by annual GDP (Top chart), the US 2 year 10 year yield curve (Middle chart) and level of Fed Funds (Bottom chart) from the mid 1970s. During this period, and indeed for many previous years , the 2 year 10 year yield curve has been an extremely reliable indicator and probably has a better record of predicting recessions than many seasoned economists. However, I am questioning whether its ability to predict changes in economic activity may be seriously impaired in the current low interest rate environment.

- It is important to consider what causes the shift in the value of the curve. - 2 year yields are far more responsive to changes in short-term rates than 10 year yields, thus when the Fed cuts rates the 2 year yield will drop far more sharply than the 10 year yield, and vice versa. The 10 year yield on the other hand will price to a far greater extent a normalisation of rates going forward, and hence will remain closer to historical levels. Thus an extended period of low rates is likely to lead to increased distortion in the yield curve, by keeping the level of 2 year yields lower for longer than 10 year yields, which stay closer to historical norms for longer. Hence in an extended period of abnormally low rates, this can give a false impression of economic strength, when in actual fact it may be a symptom of more prolonged economic weakness.I will use the example of the Japanese yield curve to reflect this. I have posted charts below showing the Japanese 2 year 10 year yield curve versus Japanese growth and the BOJ target rate. (I have a limited history available with regard to Japan, hence I can only revert to 1990 with these charts). In the early 1990s, when Japanese rates were generally at a higher level, a yield curve inversion signalled a period of oncoming economic weakness. However, since 1995 the BOJ target rate has never exceeded 0.5%, during this time Japan has entered 3 defined recessions, however the 2 year 10 year yield curve has not even come close to zero. Furthermore, the 2009 recession, by far the deepest of the past 20 years, registered a very moderate dip in the yield curve. It is also worth pointing out that the sharp drop in the Japanese 2 year 10 year curve in 1998 and 2003 was co-incidental rather than leading with regard to growth. - Unfortunately I do not have enough data points of Japanese yield curves and growth to know whether this is normal or not, however the US yield curve drop in value on the above charts, had always been a leading indicator, and in Japan the yield curve inversion in 1991 was a leading indicator.
I am not comparing the US economy to the Japanese economy, I am however pointing out that a prolonged period of low rates can reduce the ability of the 2 year 10 year curve to predict future economic activity. Last night the Fed continued to stress that it is likely to keep rates on hold for an extended period, and many other commentators see low rates for a very long time. With many people still watching and indeed citing the level of the US 2 year 10 year yield curve as a proof of economic strength, it may be worth re-evaluating this metric.

I would also like to point out that a steep or positive yield curve makes funding a large deficit far easier, no one has as interest in buying Long-Term paper with little of no carry.

Austerity measures the Vogue in Europe + Japan 10 Year Yield Analysis

Today's main event in the UK, is the new government's first budget, and one that they hope will re-assure markets with regard to the credibility of the UK's finances. However, I think its significance may be that it will be further confirmation of the reversal of the expansionary Fiscal policies of Western governments of recent years, particularly in the wake of the financial crisis and recession of 2007/8. European Governments have started already, in the case of the PIIGS they have been or are being forced into tough austerity measures, whilst the core Euro governments argued strongly at the recent G20 that deficit reduction is now priority Number 1, and Germany just recently announced a budget aimed at drastically reducing its own deficits. Across to the Far-East and just over a week ago the new Japanese prime-minister Kan Naoto spoke of a new 'Third-way' in Japanese economic policy, whereby deficit reduction measures will become a key leg of government policy. Elsewhere, in emerging markets economies, fear of inflation may be leading to stronger anti-inflationary measures, some commentators cite this as one of the reasons for the weekend's Chinese move of allowing its currency to strengthen against the US dollar. - The US continues to stand by its more expansionary fiscal policy of recent years, however the drive for tighter fiscal policies from Europe and Japan, alongside continued deleveraging efforts by consumers, increases the risk that deflationary forces may continue to exert pressure on asset valuations.

I will post one chart today, it follows yesterday's analysis on the US 10 year yield, whereby I stated that I believe the balance of risks favour lower yields, although as usual things are not that straight forward and we remain close to key pivotal levels which could lead to a reversal in yields. Today I am posting a chart showing weekly 10 year Japan government yields over the past decade (See below). Like the US 10 year yield, this sits very close to a major pivotal line, and today it has moved to within a whisker of this level (The close last night was 1.195%, the lowest close since 1.17% in Jan 2009). Also like the US yield chart, significant price patterns are exerting downward pressure on yields, price action over the past couple of years has led to the formation of a Bearish 'Descending Triangle', additionally price action since 2003 has evolved possibly as a multi-year Head & Shoulders type formation. - Since 2003, the support zone of 1.17-1.20 (my line in the sand), has held as support on numerous occasions, and is likely to be a difficult hurdle to overcome, furthermore rating agencies are watching Japan closely which may provide further support. - However, should this line suffer a clear and sustained breach, I believe that it would suggest stronger deflationary pressures ahead for Japan, though this time, it might not be Japan alone facing the threat of deflation.One final set of charts, unrelated to the above. It is the SP index in 3 charts. Top Chart is 1980s through to present day on a Log Scale. Middle chart is SP Index Mar 2009 daily. Lower chart is 5 minutes for past couple of weeks. Are there similar patterns forming across the 3 different time scales?? ,,,or perhaps I am just curve-fitting (Always a danger)? If the S&P bounces to around 1120ish, then falls through support around 1105/06, it may suggest something in this, though the likelihood is strong that I have curve-fitted...........