I have become increasingly concerned about the markets and the economy, largely because of the poor behavior of economically sensitive commodity prices. If the current commodity weakness were to persist, then conditions may be setting up for a repeat of the Great Bear of 2008.In a subsequent post, I set out some goals for the bulls to achieve in order to stave off a “deflation” signal on my Inflation-Deflation Timer model which would signal the kind of waterfall decline that the markets saw in 2008. I pointed to copper prices and the relative price behavior of the Morgan Stanley Cyclical Index (CYC) against the market.
In the last week, the bulls did manage to rally the markets and achieve a stalemate with the bears, which is a victory of sorts. Take a look at the price of Dr. Copper, which rallied up through the downtrend line but ended the week lower. This may be a signal of underlying strength and a sideways pattern rather than a continuation of the downtrend. Nevertheless, a “dark cross” is imminent in copper prices indicating the development of an intermediate term downtrend.
A similar picture was seen in the relative chart of CYC vs. SPX. CYC rallied through the downtrend line but weakened again which points to a possible sideways consolidation pattern.
The good news
There are signs of good news. David Leonhart at Economix reports that private hours worked are rising in the US, which indicates that the economy is rebounding:
Jeff Matthews wrote that corporate management is reporting signs of nascent economic strength, both in the US and Europe. Such bottom-up reports from the ground are always useful antidotes to the top-down analysis from 50,000 feet.
There is good news in China. China’s economy is slowing but may be headed for a soft landing. Jeremy Grantham was quoted as China may avoid a housing bubble. The vestiges of a command economy still remain in China and her policies seem to veer between flooring the accelerator and stomping on the brakes. It appears that the authorities have decided that they have stomped on the brakes too much and it’s time to step on the gas pedal again. The Shanghai Composite appears to be finding a floor at current levels and there are signs that China’s plunge protection team is going into action ahead of the Agricultural Bank's ginormous new stock issuance.
In addition, the People’s Bank of China announced on the weekend that they are preparing for “currency flexibility”, which is code for an easing or elimination of the RMB to USD peg. Such a move would serve to ease trade tensions ahead of the G20 meeting.
Eye of the storm
Where are we now? Todd Harrison believes that we are currently in the eye of the storm and I agree with that assessment:
We've been pushing risk further out on the time continuum for such a long time that it's become an accepted -- dare I say normalized -- pattern that interconnects the world through a tangled web of derivatives.
While the recent price action has been docile, I believe we're in the eye of the storm, a relative calm between the first phase of the financial crisis and the cumulative comeuppance that'll flush -- and perhaps reset -- the system.
Harrison went on to view any downturn with a sense of optimism, because of the possibility of renewal:
I view the Great Depression as the framework for optimism. Most of society worked, great discoveries were made and formidable franchises were established.
Indeed, if the greatest opportunities are bred from the most formidable obstacles, we're about to enter a most auspicious era.
Unfortunately, I don’t share his optimistic view as I believe that the extrapolation of the American experience in the Great Depression to today has survivorship bias problems (see my comment here about what happens in the really long run). What if America today is not the America of the 1920s or 1930s, but the Britain, France or Germany of the same period? Those were the great developed market economies of the time too.
I do agree, though, with Harrison’s assessment that we are in the “eye of the storm”. We could very well be moving into Act II of the financial crisis, as postulate by George Soros as we move through the eye of the hurricane to the other side.
A time for caution
Despite the rally in risky assets last week, it's a stalemate and it would be premature to conclude that the bulls have the upper hand. The markets remain on a knife edge as the technical picture remains mixed. The above charts of copper and CYC to SPX show rallies through the downtrend but weakness back below the trend line. Could this be a headfake? Indeed, some Dow Theorists believe that the bull may be near death. The copper/gold ratio is also pointing to further stock market weakness.
Mish wrote that the Philly Fed survey, which came out last week, shows signs of weakness and the growth risks remain tilted to the downside. The ECRI Leading Indicator released on Friday continued to weaken from its negative reading the previous week. As well, the Baltic Dry Index is turning down again, indicating slowing global trade.
Despite my reservations about the downside risks, I am not panicking and I continue to maintain the discipline of adherence to the asset allocation based on the results of the Inflation-Deflation Timer model. Trader's Narrative's weekly summary sentiment surveys show that readings are not at extreme levels and give little insight to near-term market direction.
Regardless of the current model reading, the global economy and markets remain in a fragile state. The Inflation-Deflation Timer model is a trend following model and is not designed to spot tops or bottoms, but trends. Should the economy and markets turn south, there will plenty of time to capitalize on the trend.
I can only trade what I see and the current picture is neutral.