Tuesday, July 6, 2010

Dr. Copper teeters over the abyss

The market action last week was dominated by concerns of a double-dip. Indeed, the week began with John Hussman warning of a double-dip recession and ended with John Mauldin's hand wringing over the NFP release.

Dr. Copper, one of the most economically sensitive of commodities, is curiously showing weakness but hasn’t fallen apart. This is an indication to me that it may be a little early to over-react to recessionary fears.

By contrast, the SPX has shown a greater degree of weakness than copper. While the red metal is in a downtrend, it hasn’t even tested major support levels. By comparison, equities sliced through support like a hot knife through butter.

In fact, the entire commodity complex is showing the same pattern as copper – weakness but no freefall.

Apocalypse not yet
Does that mean all is well?

Not quite. Take a look at the copper to SPX ratio. While the ratio is indicating a near-term positive relative performance by copper, the ratio is displaying a rounding inverted saucer top pattern which is indicative of a long term decline.

These conditions are consistent with the readings of my Inflation-Deflation Timer model, which remains in neutral but perched at the edge of a deflation reading, which would be indicative of a 2008-style panic. The Inflation-Deflation Timer model is a trend following model, which can be late in calling economic trends.

These conditions are also consistent with John Hussman’s earlier essay outlining the tripwires of a double-dip recession. The only sign that remained to call for a full blown double-dip recession was the ISM Index at or below 54. The latest release of the index came in at 56.2, declining fast but not quite at 54 yet. Hussman did note, however, that the ECRI Weekly Leading Indicator, which has been in freefall, is highly correlated with ISM with a lead time of 13 weeks - and that's why he made the double-dip recession call.

Overall, I am tilting towards the views of Barry Ritholz, who wrote that "We do not rule out a double dip or a recession in 2012 — we simply do not have sufficient evidence to draw that conclusion."

Right now, my inner investor is extremely cautious and defensive in light of the risks of a hard landing. On the other hand, my inner trader tells me that a waterfall decline is not an immediate threat, but to be prepared for a short and sharp relief rally to lighten long positions and/or to initiate short positions.

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