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Two Significant
Shifts Put The Stock Rally In Doubt:
- Central
bank action seems less likely in the short-run.
- A key
risk-on ratio looks similar to past stock market peaks.
Unless Ben Bernanke can spark some
renewed interest in risk assets, selling pressure could continue. Below we
outline our concerns and what we will be watching in the days ahead.
Central Banks Could Disappoint
Prior to looking at a troubling chart
for stock investors, it is important to understand what spooked the markets
in recent days. The head of the European Central Bank, Mario Draghi, is not among the central bankers gathered in
Jackson Hole this week. Mr. Draghi's absence has
raised questions about the ECB's plans
to intervene in the European bond market. On top of that, Dennis
Lockhart, the Atlanta Fed president, threw some cold water on the
QE3-is-coming-soon theory. Thursday morning, Lockhart told CNBC:
"If we were
to see deterioration from this point, let's say a persistence of job growth
numbers that were well below 100,000 per month, or see signs of disinflation
that could signal the onset of deflation, then there wouldn't be much of a
question about policy."
On August
28, we pointed out some caution flags on the chart of the S&P 500
(SPY) relative to intermediate-term Treasuries (IEF). While the chart that
follows looks complex, it is based on the simple concepts of support and
resistance. When the ratio is rising, stocks are in favor relative to bonds
(see chart below). When the ratio is falling, bonds are strong relative to
stocks. An updated version of the chart as of Thursday's close is presented
here; the stock/bond ratio is at the top with the S&P 500 below it.
- Points
A1 and A2 (see chart) show the twin peaks made by the S&P 500 last
spring. Points B1 and B2, which occurred simultaneously with the stock
market's peaks, show where the stock/bond ratio (SPY/IEF) was rejected
by the downward sloping blue trendlines
(acting as resistance for risk).
- Points
C and E show where the stock/bond ratio is running into similar resistance
in the present day. The red arrow to the left of B2 shows an important
support break for "risk" relative to "risk-off" (see
gap to left of arrow). The break of support for risk in April
occurred on the same day the S&P 500 peaked at point A1.
- Point
E shows a similar break of risk-on support that occurred on August 30
(this week). The two red arrows show similar support breaks for risk
relative to risk-off. The horizontal line F could act as support for
risk in the days ahead, meaning we must keep an open mind about where
stocks go from here.
- The
blue arrow shows the S&P 500 flirting with a break of support near
1,400 (bottom of chart). If stocks remain weak, point D shows an area
near 1,388 where buyers may become interested again.
 
Back on the QE3 front, CNBC was told after the close
Thursday by Charles Plosser, President of the
Philadelphia Federal Reserve:
"My current
assessment of the both the economy and effectiveness of QE is that I don't
think it really meets the cost-benefit analysis."
Shorter and Shorter
Rallies?
If you follow our work, you know we
have been buyers of risk since early July. We have also made the case for
higher highs in stocks, but not without some caveats. After the close on
Thursday, we revisited some "shorter-duration"
concerns that have prompted us to book some profits over the past two
weeks. We have taken profits in oil stocks (OIH), oil (USO), Germany (EWG),
and small caps (IWO). How could the market peak so soon after seeing bullish
set-ups in stocks,
oil,
and precious
metals? The time between buy signals and sell signals may still be in a
pattern of shorter and shorter durations (see green lines below). If so, we
have to be open to the possibility of legitimate sell signals occurring soon
after seeing buy signals.
Weak Close Before
Jackson Hole
Thursday's close was weak. The chart
below shows a bullish breakout in the stock/bond ratio (see blue arrow).
Unfortunately for the bulls, the risk-on breakout failed (see red arrow).
Risk-on momentum on the 30-minute chart was also turned back by the bears in
the final half hour of trading (orange arrows).
An Emerging Markets Short?
Heading into Friday, we have a
substantial cash position. If the SPY/IEF risk-on/risk-off ratio continues to
break support, we will most likely hedge our long positions rather than
entering additional sell orders. While emerging markets (EEM) were extremely
oversold at the close on Thursday, if EEM closes below 38.85 on Friday, we
may consider taking the bearish side of the trade via EUM (or similar
vehicle). For those scoring at home, the 00:15 mark of an August 29 video
shows key bull/bear demarcation levels you can monitor in small caps (IWM).
If the small cap rally falters, it would be a red flag for all stocks,
commodities, and precious metals. Should small caps continue to show
impressive relative strength, it would increase the odds of risk assets
pushing higher. Bullish or bearish, IWM can help us
monitor risk.
Are We Calling A Top?
Absolutely not, but we have seen
enough to make some fairly significant changes to our client portfolios. We
do not care if the market goes up or down. Our objective is to maintain a
prudent exposure to growth assets. The only way to do that in this
centrally-planned financial world is to maintain a posture of maximum
flexibility, which requires an open-mind. On one hand, if Uncle Ben delivers
at Jackson Hole and the S&P 500 clears resistance at 1,415, we are happy
to redeploy our cash in a bullish manner. On the other hand, if buy signals
start to look like sell signals, who are we to argue?
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