We know the stock market has been disconnected from reality for quite some time. Some key commodities may now be signaling that disconnect might not last much longer, starting with today's selloff.
I'm filling in for Linda this evening, who apologizes for her absence this week.
The big news this weekend and today is what's happening in gold. In last Wednesday's update I discussed the bitcoin crash, which was a small indication that people are starting to become less comfortable with risk. It was a small leak in the dike and taken on its own it meant nothing -- just as Greece meant nothing (too small an economy to worry about) and just as the Cyprus bank robbery meant nothing (just an offshore banking center). What they indicate and portend is a shift in sentiment and only in hindsight will people put the pieces together to see how they were all linked. Our job as traders is to try to get in front of those changes (to protect our positions and/or trade with them).
Today's decline was blamed in part by some further signs of global economic weakening. China's GDP dropped from +9.9% in Q4 2011 to +7.7% in Q1 2012. We'd kill for a +7.7% GDP in this country but for China it's another sign of slowing. And that's after China massaged the number, which means it's probably even slower than that. What growth they are experiencing is coming primarily from their over-inflated property sector and monetary policy. In any case, the number came in less than most economists expected to see. The net result for the stock market today was the worst single-day selloff since August 2011. If this wasn't a wake-up call to complacent bulls then I'm not sure what it's going to take. But I'm sure the dipsters will stay active for some time.
Not helping the sentiment picture this morning was the Empire Manufacturing index, reported before the bell, which showed a decline to 3.1 for April, dropping from 9.2 in March and below expectations for 5.0. I don't think the report had much of an impact on the market -- the futures were already down in overnight trading but it certainly didn't help. One has to wonder how many signals the market needs before it believes a coming recession (we're very likely already in one) overpowers the Fed's ability to prop the market up any further.
The first indication of a sentiment shift can be seen in what has happened to the metals and other economically sensitive commodities the past two days (unless you count last week's bitcoin crash as the shot across the bow of the USS Bullship). The ones who got hurt Friday were the gold and silver bulls -- the metals have been in full breakdown mode on Friday, which continued even more today and gold has a 2-day loss of about $213 to $1347 (-14%) while silver dropped almost $5 to $22.70 (-18%). That's a crash in anybody's book.
I'll cover the chart of the metals and oil a little later but it's important to understand how these commodities are confirming a slowdown in the global economy. The drop in gold and silver (both of which topped in 2011) have been telling us inflation is not the problem but in fact deflation is the greater concern. The Fed is losing the battle and once the stock market realizes this fact and loses faith in the Fed's abilities there will be nothing more to prop up the stock market.
The stock market has been propped up on faith that the Fed will not fail in its efforts to prevent the economy from spinning out of control and down the drain. What they've done is make the problem worse by covering up the sins of the past (excess credit, banks out of control with highly leveraged risks and no accountability or responsibility, etc.). Hiding cracks in the walls by papering over them does nothing to fix the cracks. The walls are still crumbling and by not fixing the underlying problems they've only gotten worse. Anyone who has put off fixing a car or house knows that the eventual fix is likely to be more expensive. Getting rid of termites can be expensive but replacing major support beams will be an order of magnitude more expensive. Pay me now or pay me a lot more later but the Fed has been under the misguided belief that they can yell "Boo!" at the termites and make them go away.
Fundamentals have not mattered to the market for a long time and it's the faith in the Fed that has kept things propped up (the extra free money has certainly helped but it's mostly been due to bullish sentiment). If fundamentals suddenly become important again because the Fed appears to be losing control, the correction that might have taken a year could happen in a month. Talk about disruption! The weekly chart below shows SPX vs. copper since the end of 2008 and you can see the disconnect that has been widening since the early 2011 peaks. We've been on this divergence for two years because of the Fed's efforts to convince the market that fundamentals don't matter. I've said for a while now (too long and as usual the market has remained irrational far longer than I thought possible) that it will all matter when it matters and people will suddenly wonder why it matters now and not before. Sentiment is a funny thing.
SPX vs. Copper, Weekly chart
I could show you a slew of charts with a similar disconnect between the stock market and the commodity index, Transports and most other foreign markets. Many will say that's because the U.S. is the best of the bad places to invest but it doesn't make us invulnerable to the same selling pressure that will be seen globally. Being the best of the bad is not a good reason to be invested in the stock market. Cash is king and will become more so as the year progresses. Take some of that cash and play the short side. Just be careful because bear markets are a lot more volatile.
Making the market especially vulnerable at the moment is the amount of margin that traders have used. Cash in trading accounts is near an all-time low, which means credit used to buy stock is near an all-time high. The chart below shows the NYSE margin debt and it's well above the high seen at the 2000 stock market high and almost back up to the high seen at 2007 peak. The data is updated at the end of each month so it would be interesting to see how much more margin increased as the rally progressed into last week's high.
NYSE Margin Debt (in $B), chart courtesy hussmanfunds.com
When selling starts and margin calls go out it only exacerbates the selling. It may be part of what we're seeing in the gold and silver markets. And now margin requirements are going up -- Interactive Brokers announced they're raising day margin requirements to 100%, the same as their overnight rate. This will only create more margin calls and may have been part of the reason for strong selling seen today in the gold and silver markets. When traders are maxed out in their use of margin any selling is going to create margin calls on their positions. Even Bank of America analyst Mary Ann Bartels wrote a note a few weeks ago to her clients suggesting caution, noting that this margin-call indicator flashed a sell signal not seen since April 2010. That was just before the May 2010 flash crash.
OK, let's jump into tonight's charts to see what the picture looks like after a little selloff from last week's highs. It's only one day and the weekly candle could change drastically but the bulls do not want to see this kind of candle at the end of the week -- a tweezer top at resistance would have SELL written all over it. The throw-over above the top of its rising wedge(s) followed by a drop back inside the wedge(s) also creates a sell signal. A drop below 1539 would be stronger confirmation that we've likely seen the high. Back above 1610 would be very bullish.
S&P 500, SPX, Weekly chart
It's only a 1-day close below its uptrend line from December-February, currently near its 20-dma and trend line across the highs from May-September 2012 (1563-1565) and a quick recovery on Tuesday (turnaround Tuesday?) would create a potential save for the bulls. In addition to the short-term pattern, shown further below on the 60-min chart, a decline below 1539 would also be a break of its 50-dma and another reason to feel bearish. The bulls can save this but they can't waste any time doing so.
S&P 500, SPX, Daily chart
Key Levels for SPX:
- bullish above 1595
- bearish below 1540
As sharp as the decline is from last week's high, it's only a 3-wave pullback so far. A rally back above 1589 from here would leave it that way and would be a bullish move. But at the moment I think there's a higher probability for a bounce/consolidation on Tuesday and then another leg down on Wednesday, which would complete a 5-wave move down from last week and confirm a trend change to the downside. The 5-wave move would be followed by a larger bounce (saving opex week) that would set up an even better shorting opportunity for next week. Notice too that a larger bounce later this week would create the right shoulder of a H&S topping pattern. It's speculation for now but something to watch for.
S&P 500, SPX, 60-min chart
The DOW held up relatively well the past two days, closing flat on Friday and down "only" -1.8% today. The daily chart shows it has dropped to its uptrend line from December-February and its 20-dma, near 14598 on Tuesday. It will have price-level support near 14550 and its longer-term uptrend line from October 2011 near 14530. So it would be more bearish below 14500 but remains potentially bullish above it.
Dow Industrials, INDU, Daily chart
Key Levels for DOW:
- bullish above 14,865
- bearish below 14,550
NDX tried last week to climb above resistance at 2862-2867 but the best it could do was almost 2864 on Thursday. An afternoon rally looked like it might be saved but today's selling pummeled those who bought into that belief. It closed marginally below its 20-dma but hasn't made it down to stronger support at its uptrend line from November-February and its 50-dma, at 2783 and 2790, respectively. The wave count looks complete and unless the bulls can drive NDX above 2870 I think it's a time to short the bounces.
Nasdaq-100, NDX, Daily chart
Key Levels for NDX:
- bullish above 2870
- bearish below 2744
At last Thursday's high the RUT back tested its broken uptrend line from December-February, which was also a test of its March highs. Friday left an inconclusive candle but it was a drop away from the trend line, leaving a bearish kiss goodbye. Monday's decline left little doubt about last week's bearish setup. It broke below an uptrend line from November through the April 5th low, currently near 923, so watch to see if it holds as resistance if back tested. A drop below 908, where the decline from March 28th has two equal legs down, is more bearish. Holding below 908 would likely mean a move down to 881 can be expected, which is where the 2nd leg down would be 162% of the 1st leg and it would be a 38% retracement of the November-March rally. I think it will drop much lower but it would be support until proven otherwise. But first we could see at least a consolidation of today's decline before heading lower again.
Russell-2000, RUT, Daily chart
Key Levels for RUT:
- bullish above 950
- bearish below 908
Last Thursday's bearish setup on the TRAN is a great example to use for demonstrating the back test and kiss goodbye. Thursday's high was a perfect test of its broken uptrend line from November-December (you had to use the log price scale to see it), which was followed by a small decline. Friday left some doubt as to whether it would work but the short play was still holding. Monday's decline made the kiss goodbye very clear. Today's close well below the 50-dma is the first break since the TRAN climbed above it in November.
Transportation Index, TRAN, Daily chart
While the U.S. dollar got a little bounce today it can hardly be blamed for the selloff in the commodities today. Until I see something to change my mind I think the dollar will be dead money for a while.
U.S. Dollar contract, DX, Daily chart
In Wednesday's update on gold and silver I showed the weekly chart of gold to point out the likelihood for at least a test of support at 1524 and an expectation for support to break. However I wasn't sure it would break right away or after a bounce off support. I was wondering if the large net-long position held by commercial traders would create the bounce or if instead it would create a strong breakdown (from them covering their long positions).
Friday's and Monday's declines answered that question with an exclamation point -- about $180 below support as of today and as you can see, the two weekly candles (today's is obviously only 1 day for this week) made the break emphatic. The bearish wave count called for a sharp break to the downside, one reason why I thought commercial traders getting caught on the wrong side might create the whoosh to the downside that the wave count called for. With today's decline gold is now below its 200-dma, near 1436, which hasn't even been tested since it was left behind in January 2002.
Gold continuous contract, GC, Weekly chart
To review the bearish wave count, the decline from October 2012 was a series of 1st and 2nd waves into the March bounce, leaving a very bearish setup last week for an unwinding of a few 3rd waves. The sharp decline Friday and Monday is the meat of the 3rd of the 3rd of the 3rd wave down and that leaves the pattern needing to stair-step lower to finish the multiple 4th and 5th waves to complete the count. As depicted on the above chart, which is just a guess at this time but something that would be typical, we could see gold down around 1150 by August/September. In the move down from September 2011 the 2nd leg down (from October 2012) would be 162% of the 1st leg at 1151 (at 1398.30 it was equal), which coincides with the 62% retracement of the rally from October 2008, at 1155.
Considering the weekly closing prices are the most important, a look at a weekly line chart for gold, below, shows an even more bearish pattern. The break of support near 1570 last Wednesday was the bearish heads up but until Friday's decline there was still the opportunity for recovery before the week finished. Friday's close was also a breakdown below its down-channel from September 2012 and back below its broken downtrend line from September 2011. There's no other way to look at this other than as very bearish for the tarnished metal (and gold doesn't tarnish). On this closing prices chart, the 162% downside projection is about 100 points higher, near 1263, than the one above (based on closing prices instead of intraday extremes). This coincides with the 38% retracement of the rally from 1999 (1264). We've got some Fib levels to keep an eye on -- 1302-1303, 1263-1264 and then 1151-1155.
Gold continuous contract, GC, Weekly closing prices (line chart)
There's a lot speculation as to what's going on in the gold market. Most analysts, and the commercial traders, have been bullish on the metal for all the right fundamental reasons -- the central bank policies are inflationary and gold makes a good hedge for when fiat currencies are dragged through the mud, stomped on and flushed down the drain. But as I've been saying for quite a while now, I think these folks are correct but early. We've got some deflationary times to get through and the slowing in the velocity of money supply has been a clear indication that debt destruction and cash hoarding (including by the banks) have been adding to the deflationary pressures. Once people realize the Fed has lost this battle (they were never winning it) there will be hell to pay in the stock market as well.
Some of the speculation for the selloff in gold is that Cyprus and other European banks are selling gold to meet cash demands. Or maybe it's the Chinese selling gold and part of their commodity stockpile in an effort to free up cash. There's some speculation that the Chinese may be freeing up cash as a way to counter the effects of Japanese inflation imported into China (the Yen crash spikes the price of commodities in terms of Yen). There could be a large hedge fund (or two or three), including Paulson's, that are in trouble and selling their gold holdings. It's interesting to see how large the GLD ETF is -- 2nd only to SPY, as the table below shows. As can be seen, it's quite a bit larger than even the QQQ. Gold has become of the largest holdings by many mutual funds.
15 Largest ETFs
On Friday it had looked like silver might hold support near 26, which is price-level support from previous lows since September 2011 and its broken downtrend line from May 2011. Today it crashed through that support as well as a price projection at 23.97 for two equal legs down from February 2012. That opens the door to a move down to about 17 but more likely back down to the 12-15 area sometime this year where it would hit its longer-term uptrend line from 2003-2008.
Silver continuous contract, SI, Weekly chart
Oil has dropped 7.16 in the past 3 days to 87.39 (-7.6%) and today emphatically broke support at its uptrend line from June 2012, currently near 91. This followed the back test last Wednesday of its broken uptrend line from March 4th and its broken 50-dma, leaving a nasty looking bearish kiss goodbye (it was a fantastic trade setup to short oil, the same as the TRAN setup). It then dropped to its uptrend line from June 2012 on Friday, which is the bottom of a small sideways triangle shown on the weekly chart below (inside a larger sideways triangle).
Oil continuous contract, CL, Weekly chart
Keeping an eye on the big picture, the larger sideways triangle playing out since the high in May 2011, which fits as a bullish continuation pattern, could see oil trapped in a sideways consolidation for the rest of the year. The bottom of the triangle is currently near 80 and other than a brief throw-under to grab stops, that level will need to be defended by the bulls if and when we see oil get there.
Adding to the brief discussion above, about what might be causing all this selling in commodities and the metals, some have speculated that Japan's recent QE announcement, blowing away anything any other country is doing at the moment, is creating a problem with banks holding JGBs (Japanese Government Bonds). The thought here is that the banks are being forced to reduce holdings because of the added volatility, which is causing them problems with their risk profiles. Instead of selling their JGB holdings they're opting to sell other assets to raise their cash levels to compensate for the added risk from JGB volatility. Selling large amounts of gold could therefore be coming from Japanese banks and what some are wondering is what happens when they need to sell other assets, such as stock holdings.
The point I'm making about all this speculation is that one relatively small occurrence somewhere can have huge ramifications somewhere else. The entire financial system is a house of cards that is leveraged to the max. One small breakdown somewhere obscure can be the first domino that starts an unstoppable collapse. Is this the start of it? I have no clue but I do know the system is vulnerable and people looking for reasons for why gold is selling off may be missing the bigger picture. Selling gold, or silver, or oil or copper may have nothing to do with the commodity itself but instead is simply one asset to sell when their bigger portfolio is in trouble or needs to be reduced in order to reduce overall risk. Multiply that by thousands of banks and thousands of funds and it's not hard to imagine the outcome. When everyone is filled to the brim with assets, using all available margin, it's a tinder box looking for a match.
Tomorrow's economic reports include CPI numbers, which are expected to show some decline (CPI) or hold steady (core CPI). I wonder if the government will take money away from seniors' social security if CPI goes negative for a while...I digress. Housing starts and building permits will show us some more data on housing (I'll cover the home construction index on Wednesday but it's also breaking down) and then we'll get industrial production and capacity utilization. If everything is pointing south for the economy it could prompt more selling but I think the market is ready for some consolidation.
Economic reports and Summary
The market has been showing signs of cracking and today's selloff (starting with Friday's in the metals) could be a sign of deepening cracks and a few more leaks in the Fed's dike. Bernanke has proven himself to be all thumbs when it comes to the market so we'll see if he has enough of them to plug the leaks. Maybe double down and go for $170B in QE each month.
Monday's decline broke some important support levels but follow through for the bears will be key. They've been chased off the field so many times it's hard to believe they might be onto something here. If we get a choppy bounce/consolidation on Tuesday (bear flag), look for lower. But keep in mind that one more leg down following a small bounce will leave the market set up for a large bounce to correct the decline from last week. Continue to play this market short term while we wait for clarity from the longer-term pattern.
Good luck and I'll be back with you on Wednesday to see how the rest of the opex week is setting up.
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