With the passage of Hurricane Sandy and all the devastation in its path there's going to be a lot of rebuilding and replacement. Is that going to be good for the economy?
Hurricane Sandy's damage is record-breaking. Our hearts and prayers go to all those who were in the path of the storm and suffered any losses. Many of us have family and friends who are without power and have some difficult days ahead. It makes worrying about what the stock market is doing pale by comparison. But worry we do and as a country we have to wonder how this will affect us, just as we worried about the aftereffects of Hurricane Katrina.
Today was the last day of the month and the end of the fiscal year for many funds. Obviously there wasn't much time to prepare final positioning for end-of-month since there was no trading Monday and Tuesday. It made today somewhat of a throw-away day since it's hard to judge the importance of today's moves in the longer-term.
What was bearish about today, or at least this morning, was the fact that the market gapped up and immediately sold off from there, again. This is a repeating pattern that started last week -- work the futures higher, gap the market up and then use the early liquidity push (with traders scrambling to deal with the gap up) to sell inventory. It's a distribution pattern that we're seeing and the two big selling days and the selling of rallies since October 18th speaks of large funds handing off inventory to the retail crowd who are hoping to catch any further gains into the end of the year.
Further stock market gains into the end of the year could be a problem if it's to be based on corporate earnings. For the first time since the financial crisis in 2008 profit growth is expected to turn negative. Many analysts have been hoping we're hearing the worst of the corporate earnings and that Q4 would be better. But we've been getting a lot more warnings that earnings are not expected to improve. Matthiew Arsenau, a National Bank Financial (NBF) economist, says the negativity of corporate guidance is nothing short of "stunning." NBF put together a chart, below, that shows the ratio of negative to positive preannouncements and it has spiked to an all-time high for Q4. Those who have been hoping for a better Q4 are going to find this data very disappointing.
Ratio of Negative to Positive Preannouncements, chart courtesy NBF
The spike in the ratio in Q4 could come down a little as more companies report earnings and what they see for Q4 but other than financials the remaining companies have not been encouraging with their outlook. The expectation that Q3 would be a negative blip, followed by a recovery in Q4, is not supported by this chart. The Q4 spike comes off a climbing ratio since 2010 and is now well above the peak in Q1 2001.
But now that Sandy has passed I'm already hearing about the positive effect it will have on our economy and GDP. This is a fallacy and deserves a discussion. While it might help as a short-term blip for some companies the overall net effect is negative for our economy. There will be a massive cleanup effort, lots of new construction along the coast and many many home repairs. This will put lots of people to work in the construction industry and that industry could certainly use the help.
There are also going to be a lot of new cars needed. Salt water flooding is very damaging since it's so corrosive. Electrical connections will corrode and cars will break down quickly (be careful over the next year if you're in the market for a used car -- be sure you know the history of the car (pay to buy a report) and don't buy any car that's been flooded). I saw pictures of huge parking lots full of rental cars, busses, taxi cabs and of course the thousands of personal cars that were moved like toys by the tidal surge along the coast. Some of it was a little reminiscent of Japan's tsunami when you look at the devastation along the New Jersey shore.
Replacing all those cars is going to give the auto companies a boost and this morning their stocks gapped up in anticipation of the surge in new orders for cars, trucks and busses. General Motors (GM) gapped up and ran higher, tagging its October 18th high, and closed at 25.50 (+2.22, +9.5%). Ford (F) gapped up and made a new high for its move up from August, punching through its 200-dma that it had broken down through on its gap down on April 30th. In fact it's getting close to that breakdown level at 11.42 and would close that gap at 11.60. It closed at 11.13 (+0.85, +8.2%). I suspect there was a fair amount of short covering in these stocks so follow through will be the key.
The home builders also got bought but they did not hold up as well (they mirrored the broader indexes). Home Depot (HD) gapped up to 62.89 from Friday's 60.03 (+4.8%) and Lowe's (LOW) gapped up to 32.74 from Friday's 31.35 (+4.6%) but then sold off some and HD closed +1.34 (+2.2%) and LOW closed +1.02 (+3.25%).
All of the rebuilding efforts will be very helpful to several industries, similar to the aftereffects of hurricane Katrina in 2005. Most see the rebuilding effort as good for the country because of the construction and rebuilding in the recovery phase. This boosts GDP and that gets people feeling more positive about the economy and the brighter outlook is generally positive for the stock market. There's just one problem with this theory -- the destruction is far more damaging to the economy than what the recovery phase can compensate for. It's called the broken window fallacy (not to be confused with the broken window theory relating to crime) or glazier's fallacy and it was first discussed by Frederic Bastiat in 1850. In his essay (That Which is Seen and That Which is Unseen) he discussed why destruction, and the money spent to recover from the destruction, is actually not helpful to the economy.
Bastiat discussed the idea that opportunity costs, as well as the law of unintended consequences, can affect the economy in unforeseen ways and are ignored when thinking about the positive aspects of the recovery phase. He used a parable of a shop keeper and his son and the effect of the son breaking one of the shop's windows. The consensus of the people in the town was that it was actually a good thing that happened because it provided work for the town glazier, who would otherwise have no work if not for the broken window.
As Bastiat explained, the money received by the glazier for his work is a good thing but what is unseen is the fact that the shopkeeper was not able to spend the money on something else that might have been more productive for his business. Perhaps he would have spent the money on material to produce something that he could then mark up and sell to one of his customers. Or he might have invested it in a piece of equipment that would expand his business and serve the needs of more townspeople than just the glazier.
To further Bastiat's point, he pointed out that if the glazier had hired the boy to break the window, paying him $1 in order to get a $10 repair job, the glazier would be accused of stealing because everyone knows you don't purposely break something as a way to get the added work benefit. So why is it beneficial when Mother Nature breaks the window instead of the little boy? The net result is exactly the same. Bastiat's argument was to point out that a small group (the glazier in the parable) might benefit from the damage but all groups (society as a whole) will suffer the consequences.
Taken to an extreme, this fallacy is carried over into war making. Everyone recognizes that war is destructive. And yet most credit WWII for dragging the global economies out of its depression. Nothing could be further from the truth and in fact the war extended the global depression -- all the rebuilding costs were to get things back to the way they were and one can only imagine the huge benefit from all that money that was spent had it been spent on investments for the future. The U.S. (one group) might have benefitted but society as a whole (the world) suffered greatly. Auto industries might benefit over the next several months from orders for replacement vehicles but the country as a whole will suffer the consequences.
Government spending (except for things like new infrastructure projects, basic research and other projects that are long-term investments in our future) can also be thrown into the category of wasteful spending that increases GDP. But it's taking money out of private hands that would have used the money for productive investments and gives it to other people to do things that might not be productive to society. History is full of examples of government spending following disasters and most people never see a penny of it.
Most of the government's spending for these kinds of disasters goes to government contractors, real estate developers and other groups that are closely connected to the government. The government doesn't make money to spend on these projects; they take it away from the productive parts of our society and give it away to parts that typically do not benefit the greater society. The broken window fallacy is as true for government spending following a disaster as it was for the little shopkeeper replacing his broken window. GDP might go up because of the spending but in fact there is no net benefit to the country. There is only loss. The blow to the economy is negative no matter how much rebuilding comes out of it. It slows everything down as money is poured into putting everything back to the way it was -- no net benefit for the enormous amount of money that will be spent.
By the way, this whole argument goes back to Keynesian vs. Austrian economics and I believe when all is said and done in several more years the Keynesians, which includes the likes of Paul Krugman, Bernanke and most economists in the U.S., will be proven wrong in their theories. Unfortunately for us as a nation we'll have to suffer through their learning experience. One of the reasons modern day Keynesians will fail, I believe, is because they've bastardized the theories that Keynes developed. Keynes has strong warnings against what the governments and central banks are now trying to do.
With that we'll move to the charts, which obviously haven't changed a whole lot from this weekend's update. Other than the tech indexes, which were more negative than the others (thanks in part to AAPL), the market closed more or less flat from Friday. As I looked over the charts and watched the RUT outperform to the upside, thanks mostly to an afternoon rally, I wondered if it was just an end-of-month push or the start of something more. If we have another rally leg in front of us (not just a bounce to correct the decline from October 18th) I think there's a good chance the RUT will lead the way. So I want to start with a weekly chart review of the RUT.
The September 14th high for the RUT fits well for the top of a corrective price structure for the bounce off the October 2011 low, which in turn completes a 3-wave price structure off the March 2009 low. But one other interpretation supports the idea for a rally into year-end, shown with the dashed red line on the weekly chart below. A 5-wave move up from October 2011, to complete a rising wedge pattern, is a viable alternate pattern and with the RUT holding its uptrend line from October it has to be kept on the charts as something to watch for. If the RUT breaks much below 800 it's going to start looking more bearish but at this moment the bulls cannot be counted out.
Russell-2000, RUT, Weekly chart
My QCharts hasn't corrected the missing two trading days this week, which screws up trend lines (think of today's candle right next to Friday's candle in order to get a good idea where it is in relation to the trend line). Friday's low at 807.91 is an important level for the bulls to hold since a break below 807 should lead to a move down to the next support level near 790 and it would likely lead to lower prices in November, as depicted with the bold red price path.
Russell-2000, RUT, Daily chart
Key Levels for RUT:
- bullish above 843
- bearish below 806
Looking at the SPX weekly chart with the same idea, another rally leg could take it to the 1500 area. A break below 1370 would be more bearish.
S&P 500, SPX, Weekly chart
SPX spent today bouncing between its uptrend line from October 2011 (support) and the bottom of its previous down-channel from September (resistance) and closed in between. The daily candle is a long-legged doji and indicates indecision. Between 1400 and 1420 is a potential chop zone so stay clear of it. Follow a break above or below that range but stay aware of the possibility for a quick break and then reversal.
S&P 500, SPX, Daily chart
Key Levels for SPX:
- bullish above 1464
- bearish below 1400
The missing two days of trading is most apparent on the 60-min chart below but the picture is the same. It's possible we're seeing a sideways triangle forming from last week, which would fit as a 4th wave within the move down from October 5th. The only requirement of the 4th wave is that it must not overlap the 1st wave, which is the October 12th low at 1425.53 so if it continues to chop sideways below 1425 we'll probably see another leg down as depicted. A drop to its 200-dma, currently near 1378, would be the expected move into next week and then a larger bounce into mid-month before rolling over again. But as shown with the red dashed line, it's possible we'll see a quick rally to the 1430 area early next week (into the election is a cycle turn date) and then strong selling to follow.
S&P 500, SPX, 60-min chart
When I thought about the possibility for a rally into the elections and then a strong selloff I wondered what that could mean about the election results. Then I listened to an update by Archie Crawford yesterday and he's not predicting good things from November 6th. As most of you may know, he used astrological signals for his predictions, something I don't have a clue about so I report, you decide. It's something about Mercury in retrograde and it points to a market crash. If I got it right he said the last time we had this setup during an election was 2000, which was the battle between Bush 43 and Gore, which went to the Supreme Court in the battle over FL. Crawford is predicting the same outcome between Obama and Romney. That had me thinking fiscal cliff looming and not knowing who the president will be. The market hates uncertainty and that would be about as uncertain as we could get. Something to think about with your positions as we head for elections next week.
The DOW tested its uptrend line from October 2012 at today's low and at the day's high, closing in between (like SPX). How did it do both with a range of 137 points today? The low tested the uptrend line using the arithmetic price scale and the high tested the line using the log price scale, which is shown below. The high was also a test of the bottom of its down-channel from September. It needs to break today's range but still be careful about a break and then reversal.
Dow Industrials, INDU, Daily chart
Key Levels for DOW:
- bullish above 13,600
- bearish below 12,970
Support-turned-resistance near 2660 and the 200-dma at 2656 proved too much for the bulls today and NDX closed back below both. The pattern looks weak and lower prices are expected -- the bottom of its down-channel from September is currently near 2600.
Nasdaq-100, NDX, Daily chart
Key Levels for NDX:
- bullish above 2775
- bearish below 2636
Last Thursday the 30-year yield (TYX) tagged its downtrend line from June 2011 through the September 2012 high and has since fallen back down. On Friday it gapped down and closed back below its 200-dma, a convincing slap following the test of the downtrend line. Today it broke its uptrend line from July and its 50-dma at 2.876%. Without a quick recovery the drop will look bearish, which would be confirmed if it breaks below its October 12th low at 2.80%. If the pattern of the bounce from July is to turn bullish it has to do it from here. Otherwise the pattern is a choppy correction of the previous decline and will be followed by another leg lower into the end of the year, which is the way I've been leaning for months. The buying in the bonds, which drops bond yields, would likely be bearish for stocks so it's an important inflection point here.
30-year Yield, TYX, Daily chart
The past 5 trading days, including today, have seen the BIX find support at or near the lower end of its 157-159 support zone. The past 4 trading days, including today, have seen rallies stopped at the top of the range. The sideways consolidation on top of support looks like a bearish continuation pattern and a breakdown should see the BIX drop to its 200-dma at 153.77. Follow the money whichever way the banks go from here.
S&P Banks index, BIX, Daily chart
The TRAN continues to chop up and down in 3-wave moves. There's no direction to it and while it fights resistance it's not breaking down. Just waiting for something to happen with this one...
Transportation Index, TRAN, Daily chart
The dollar pulled back to the 20-dma at 79.81 and bounced back up, finishing with a hammer on potential support. Back above last week's high at 80.42 would be bullish, potentially for a strong run higher, but I can see at least another pullback before heading higher. A drop below 79 would negate the bullish pattern.
U.S. Dollar contract, DX, Daily chart
Gold is getting a little higher bounce that I expected to see and the 20- and 50-dma's, which cross near 1737 on Thursday, could be tough resistance if tested. A drop through 1680 would confirm the bearish price pattern, with a bearish heads up below 1700.
Gold continuous contract, GC, Daily chart
Oil's consolidation since last Wednesday should lead to another leg down. Only a rally above 89 would have me backing away from the short side on oil. And a decline in oil backs up the idea that the global economy is slowing down. If those two ideas diverge I'd be careful trading oil but right now the two ideas fit together.
Oil continuous contract, CL, Daily chart
Thursday will be a busy day for economic reports, some of which were rescheduled from Tuesday or today, such as the ADP employment report. Other employment reports, ISM, construction spending, consumer confidence and auto/truck sales could move the market. We could get some speculation about future auto/truck sales from a Sandy boost. Friday will be the big day with the nonfarm payrolls report.
Economic reports and Summary
I had expected Wednesday to be essentially a throw-away day because it was end-of-month and I had no idea how much influence (if any) that would have on the market. It was the only day this week to finalize the books for end-of-quarter for many funds. Was that why the RUT got a boost above all others this afternoon? We'll need Thursday and Friday to see if the market picks a direction after today's doji kind of day.
We've got new-month money the next two days and then a run-up into the elections next week. Once the positive influence from the first two days of the month is over we could be heading for some uncertainty next week. If the polls continue to run very close, and if Archie Crawford is correct, we're going to have a too-close-to-call race, which could extend after the election. The market is not going to like that if it happens.
The short-term pattern supports the idea we're going to get another leg down for the decline from the October highs. But unless the market is standing on the edge of a cliff and about to do a beautiful swan dive I'd watch for bullish divergences at a new low and look for a bounce next week. The bounce in that case (following a new low) would be a very good setup for the bears. But if we get the opposite with a higher bounce in the next couple of days it could be followed by a rollover shortly after the elections. The pattern in that case suggests a strong selloff to follow.
All we can do is let price lead the way from here and get out of the trading range it's been in for the past week. Then we can evaluate the move to see if we should be looking for a reversal.
Good luck with the remainder of the week and I'll be back with for one more weekend wrap this weekend, which hopefully will provide some further clues as to what we can watch for next week. And then a week from today I'll be able to sum up what the picture looks like post-election (and see if Archie Crawford was right). Trade safe in the meantime.
Keene H. Little, CMT
In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying