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Weekly Wrap-up: Footprints in the Sand

The following article was originally posted at The Agile Trader on Sunday, February 12, 2006.

Dear Speculators,

This week I want to look specifically at some of the footprints in the sand that we see as liquidity dries up in a variety of markets.

First of all, as far as the 4-Year Cycle on the SPX goes, we are entering the phase of the cycle that can be hardest on the bullish case.

On this chart we see the SPX in the top pane (log scale) and the 9-month Rate of Change on the SPX in the bottom pane. The 4-Yr Cycle lows are marked with blue dashed vertical lines. And the 4-Yr lows that showed notable troughs on the 9-month Rate of Change(ROC) line are highlighted in green. Nine of the past 11 4-Yr lows have seen significant ROC troughs.

Now look at the pink dashed vertical lines. Those are placed 26 months subsequent to each 4-Yr Cycle Low. When the market continues to make new highs subsequent to (to the right of) the pink verticals, then the ensuing 4-Yr Cycle low tends to be relatively benign. And such is the case subsequent to the most recent pink line (Dec. '04).

The 2 periods that we see as the closest analogs to the current 4-Yr. Cycle are shown here:

The SPX has now completed trading-day # 842 since its October 2002 low. The tops in 1966 and 1994 came on trading days #847 and #839, respectively. So we are currently inside the envelope for the formation of an SPX top created by these two prior cycles.

And what will determine just how relatively benign or malignant the (likely) imminent retrenchment is? In our view it will depend on the extent and duration of the inversion of the Yield Curve.

With the 10-Yr Treasury currently yielding 4.58% and the Effective Fed Funds rate at 4.52%, the difference is just 4.58%-4.52%= 0.06%.

With the correlation between the 2 series at a very strong +0.83 over the past 2 ½ years, and with the Curve now "upside down" for durations from 6 months to 30 years...

...the extent to which the market's Price/Earnings Ratio will contract or expand during this calendar year will likely significantly be determined by just how upside-down the Curve goes and for how long.

Interestingly, since October 28 the strong positive correlation between the Yield Curve and the PE has gone negative (-0.69). PE has expanded (albeit modestly) while the 10-Yr - FF spread has continued to flatten. In other words, over the past 3 months the market has been anticipating either that the Curve will not go very far upside down for very long or else that (as Greenspan has said), this time it won't matter (much). Or, put yet another way, the PE expansion has begun to anticipate that the 10-Yr - FF spread will reverse itself well in advance of such a reversal.

That kind of forward discounting is standard practice for the stock market, but that doesn't mean that it's always correct, or that the first "shimmy" toward PE expansion will spell "sustainable rally."

As you can see, the red line often leads the blue line (PE leads Yield Curve) at the troughs as well as at the peaks. But these reversal points are generally processes that take some time and not sharp reversals.

Now, 1994 was an exception. Why? It's one of the rare times when the Yield Curve did not go much below the ZERO line. And that allowed for a well piloted soft landing for the economy as well as for a benign dip into the SPX's 4-Yr low (visible on the first chart presented above).

So, will the Bernanke Fed engineer a soft landing as did the Greenspan Fed in '94-'95 and push the Yield Curve right-side up from near the ZERO line, provoking a retrenchment on the SPX of less than 10%? Or will we see the Fed Funds Rate in the neighborhood of 1% higher than the 10-Yr Yield as we did in 1966, facilitating an SPX decline of more than 20%?

The answer doesn't lie just with the Fed. It also lies with foreign central banks which have become significant drivers of US interest rates in their efforts to competitively devalue their currencies. So, unfortunately the shape/orientation of the Curve may now hinge as much on, e.g., Chinese and OPEC dollar-recycling tactics as it does on Fed policy.

Irrespective of cause, the inversion of the Yield Curve is likely to set off big-money selling at various points between now and October. And we may already be seeing the effects of the inversion in both the Oil and Gold markets, among other commodities.

Crude Oil for March delivery is now trading at $61.66, down from recent highs near $69. Is that the last gasp of a liquidity-driven fast-money bubble? We'll know more when the triangle breaks...depending on which way it goes. A break below $60 could provoke a test of the early June gap up, down into the low $50s. If Crude breaks above $70, then another parabolic top could be in order, perhaps up toward $85.

Meanwhile, Gold may have "parabola'd out."

If the December top in the $530s breaks to the downside then a test of $500 will likely follow, with a dip perhaps as low as $480. On the other hand, if $570 is breached again to the upside, then a trip to $600 could well follow.

Why study these commodities? Because so much hot money has been pouring itself into them. And if those charts do any serious breaking to the downside, it will be a pretty good indication that money will be moving into "self-preservation" mode, when Hedge Fund Managers and Institutional Money Runners will be trying to save their jobs, defending their gains and staving off disasters rather than seeking profits. And in such an environment a whole variety of markets could become essentially defensive, including the Equities markets.

(Note: squeezing money out of commodities will likely induce short-term pain in stock indices, but it would be a kind of creative destruction that would bare the foundation for a sounder structure to be built.)

As well as these commodities markets we'll be watching the Dow Transportation Average, which has lately continued to display positive Relative Strength.

If liquidity is being squeezed out of the markets, slowing economic growth, then the Transports would likely begin to perform less well (or even more poorly).

Likewise we'll be eyeing the semiconductor stocks.

In the negative scenario we're discussing for the period between now and October, an underperforming SOX would be important confirmation. Is this chart Double Topping in the 560 area? Too soon to say. But the chart looks choppy since the new year began, and we'll be keen to see how this one plays out.

We'll be looking at the Morgan Stanley Cyclical Index (CYC) and the Amex Securities Broker/Dealer Index (XBD) among others in our Morning Call in the days and weeks ahead, looking for clues as to whether, how badly, and/or when the broader indices are likely to break down.

Auto-trade subscribers to The Agile Trader Index Futures Service took net profits of 23% and 25% off the table last week while subscribers to The Agile Trader realized gains of 1.5% and 2.1% on their QQQQ and SPY positions.

Have a great week!

Best regards and good trading!

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