Short Takes

Traders often look for relatively easy ways to monitor the battle between “risk-on” and ‘risk-off”. Given that foreign stock indexes have lagged the S&P 500 in recent months and the center of the risk universe sits in Europe, you can make an argument the fate of the EAFE Index will determine the fate for the vast majority of risk assets. A partial list of the MSCI EAFE Index Fund’s (EFA) country weightings is shown below.

Tom DeMark, of Market Studies, LLC, has his own set of proprietary tools to determine and monitor key support levels. Last week, EFA closed below DeMark support levels on its daily, weekly, and monthly charts. The longer EFA remains below these levels, the more concerning it is for all risk assets in the short-to-intermediate term. Conversely, if EFA can recapture the levels shown below, it gives some hope for a risk rally.

On May 13, we described how to estimate possible downside “targets” when a market has a set-up for a head-and-shoulders pattern. A much longer-term, and potentially bearish, head-and-shoulders set-up appears to be forming on the weekly chart of EFA. The green lines show a possible downside target of 33.55, which represents a 27.5% decline from the pink neckline. The pattern becomes much more meaningful from a probabilistic perspective if price violates the pink neckline. For now, the pink line represents a possible area of support.

The weekly chart of the EAFE Index below shows possible levels where buyers may become interested (a.k.a. support). The most important levels relative to the head-and-shoulders pattern shown above are 45.90, 44.91, and 43.27. Each successive break of those levels would increase the probability of the head-and-shoulders pattern taking prices toward 33.55.

It is extremely important not to assume a bearish head-and-shoulders set-up will produce bearish outcomes. The term “set-up” hints at probabilities, not certainties. The S&P 500 Index had a head-and-shoulders set-up in early October 2011. The set-up did not produce bearish outcomes.

This article provides several key EFA levels to watch. With policymakers and central bankers waiting in the wings, it is best to monitor the levels with an open mind. A break of support becomes more meaningful if it can carry into week’s end. The violations of the DeMark support levels shown previously did carry into the end of a week, which means we need to respect that weakness could continue in global markets.

The gravity of the global debt crisis can be seen in the flip-flop game plans from policymakers. The reaction to the 2008 crisis was to try to “spend our way out of this”. That didn’t work, but it did succeed in pushing debt levels even higher. The second approach, championed by Germany’s Angela Merkel, is based on the “cut spending and restore confidence” theory. That isn’t working either.

Now we have come full circle with Tim Geithner and the IMF again calling for “pro-growth” policies. Pro-growth is a politically correct way of saying “spend money we don’t have.” According to the Wall Street Journal (WSJ), the Keynesian approach of the government leading the private sector to the promise land of growth, is now being embraced by the most broke nation of them all – Greece:

Mr. Tsipras, the head of Greece’s left party and an engineer by training, recommends a stimulus package to boost the Greek economy and has called for tearing up the country’s existing austerity-for-loans program. He has suggested scrapping plans to lay off 150,000 public-sector workers by 2015, and repealing recent measures to push down private-sector wages. He favors nationalizing the banking system so as to better direct lending policies, and speaks favorably of Franklin Delano Roosevelt’s Depression-era New Deal program and President Barack Obama’s stimulus package—something Mr. Tsipras said is lacking in Europe.

As we outlined in October 2011, the debt levels of many nations have moved into unsustainable territory. Thus, it is not surprising that policies from both ends of the spectrum have failed. Mr. Tsipras is also engaging in a full-tilt game of political chicken. From the WSJ:

The head of Greece’s radical left party—throwing down a gauntlet that could increase tensions between Greece and its frustrated European creditors—said he sees little chance Europe will cut off funding to the country but that if it does, Athens will stop paying its debts.

The video below looks at the current state of the markets (SPY) as we head into a G-8 weekend. Risk assets are oversold, but remain in prove-it-to-me mode. We will continue to err on the defensive side until the market or policymakers show us something of substance.

Note: This is the same video shown in the previous post.

In an a low interest rate environment, it was not surprising to see real estate investment trusts (REITs) move up in our ETF rankings over the past few months. Monitoring the health of market leaders is one way to monitor the health of the entire market. When market leaders begin to show cracks, it tends to be negative for the general market. Since our latest ETF rankings saw REITs drop five spots, we decided to take a closer look.

From a fundamental perspective, yield-chasing investors have pushed REIT valuations higher. In a May 15 MarketWatch article, Greg Brewer, executive director of research at Value Line, cautioned REIT investors:

The industry Brewer thinks is a trap for investors now is real estate investment trusts, which have been popular because so many people are seeking yield, but which Brewer said have been bid up way too far, making them a bad proposition right now. Equity Residential (EQR), Boston Properties (BXP), AvalonBay (AVB), BRE Properties (BRE)… it’s not that these companies are bad companies – they’re not – but they are pretty fully priced right now, and as an investor, I would be concerned that I am going to get in and I am going to get crushed.

On May 16, the REIT ETF (IYR) opened in positive territory, but experienced selling pressure for the rest of the day. IYR closed near the low of the session. The daily chart below shows the performance of REITs relative to the S&P 500. Point A highlights the intraday reversal that occurred relative to the S&P 500 on May 16. Near point B, MACD shows slowing momentum for REITs relative to the S&P 500. MACD will experience a “bearish cross” if the black line drops below the red line.

With loans difficult to obtain and the diminished appeal of owning a home, apartments have been in high demand. According to an April 27 Bloomberg story:

Real estate investors competing to buy Manhattan apartment buildings have sent prices to record highs as rental demand surges, reducing yields on the properties to the lowest in more than six years. The capitalization rate, a measure of investment return that declines as prices rise, averaged 4.4 percent for Manhattan multifamily buildings in the first three months of this year, the lowest since the third quarter of 2005, according to New York- based data firm Real Capital Analytics Inc.

The current daily chart of IYR below shows bearish divergences between two indicators, MACD and RSI, and price. A bearish divergence occurs when price makes a higher high, and the indicators fail to make a higher high. The divergences can be seen by comparing the slopes of lines A, B, and C. In this chart, MACD has already experienced a bearish cross (black below red below - see red arrow). The Relative strength Index (RSI) has also dropped below 50, which indicates the “bears are in control” (near orange arrow).

With the Fed promising to keep rates low for some time, REITs may continue to be market leaders. However, given the situation in Europe, stretched valuations, and the recent deterioration in the charts, REITS may not be immune to further weakness.

Based on the parallel trendlines below, our current exposure to risk, and some potential support on the DeMark charts, we decided to take no action today as long as the S&P 500 closed above 1,323. The close came in at 1,324.

We still do not like this market in the intermediate-term, but we would like to see how things play out near the blue arrow in the chart above.

Last summer the big question in the markets was whether or not the European Central Bank (ECB) would print large quantities of money in an effort to cap rising bond yields in Europe. Between July 6 and August 8, 2011, the markets were not confident about getting assistance from European policymakers or the ECB. In the end, the ECB flooded the financial system with enormous amounts of printed money, but prior to making that announcement the S&P 500 dropped 17% between July 6 and August 8.

The relevant point for us today is the markets fell sharply during the period of uncertainty. You can argue the uncertainty relative to Europe in 2011 escalated as the S&P 500’s 50-day moving average turned down (see red arrow in chart above), which is an indication of a weakening uptrend. Moving averages are used to filter out shorter-term volatility, allowing us to focus on the bigger picture in terms of trends.

Fast forward to the present day and we find more uncertainty related to outcomes and possible repercussions in Europe. This morning’s Wall Street Journal captures the gravity, and possible short time frames, relative to this stage of the Greek tragedy:

Swedish Finance Minister Anders Borg, whose country is in the EU but not a member of the euro, warned Tuesday while attending a meeting of EU finance ministers in Brussels that Greece may be nearing the end of its time in the euro zone. “We are very close to the end of the road,” Mr. Borg told reporters. “The situation is very serious.”

The markets seem to understand the serious nature of the challenges facing Europe. Last week, the slope of the S&P 500’s 50-day moving average turned down, indicating a shift toward risk aversion. While there is no question the market’s current bias is to the downside, any good news could spark an oversold rally similar to what we saw in June 2011. Like June 2011, an oversold rally may prove to be short-lived.

Markets are always looking ahead. Given Greece most likely will hold new elections in mid-June and that by the end of June, the country must detail and approve fresh measures to close a budget gap of €11.5 billion, the markets are anticipating increasing uncertainty in the weeks ahead.

Between mid-June and the end of June, Greece must form a new government and pass controversial budget measures. All this seems like a tall order from the market’s current perspective as evidenced by the recent break of the Dow’s 22-week moving average (MA). All things being equal, a move below the 22-week MA is a bearish signal.

Another question facing the markets is what happens if Greece fails to make the necessary budget cuts to obtain additional aid. From Scotland’s Daily Record:

If Greece refuses to make cuts, European leaders are likely to withdraw bailout funding agreed in March and an exit from the euro is almost certain. And if that happens, the impact on the UK and other European countries would be devastating.

The S&P 500 has also reacted to the heightened risks in Europe by dipping below the 22-week moving average. The markets are in the process of shifting from “risk-on” to “risk-off”. A move below the 22-week can be short-lived (see early 2010 below), but it should be respected until the market provides some bullish clues.

Another major area of uncertainty is the possibility of an escalating flight by depositors from Greek banks. From today’s Wall Street Journal:

The steady outflow of deposits from Greek banks hasn’t yet turned into a full-blown bank run, and the European Central Bank has nearly limitless capacity to provide banks with additional liquidity. But economists have long warned that a run on banks could develop if the population fears Greece’s departure from the euro is imminent and that their savings would evaporate. A bank run could trigger the euro exit if it reaches a scale that forces Greek authorities to freeze bank accounts and print their own currency to keep the financial system alive.

Like the Dow and S&P 500, tech stocks are in the process of breaching their 22-week moving average. The moves on weekly charts become more meaningful if they carry into the end of the week.

Adding to the concern about a possible full-blown run on Greek banks, is the real possibility that ECB support could disappear if Greece fails to make the necessary budget cuts by the end of June. Both the long and shorter-term trends in the euro reflect the real possibility of membership changes in the EU. The euro has remained below its downward-sloping 200-day moving average (see red arrow below), which is often used to define a bear market. The purple arrow shows the shorter-term moving averages have recently rolled over in a bearish manner. Like stocks, the euro could experience an oversold rally on any good news from Europe, but the long-term trend remains firmly down.

The most significant area of uncertainty relates to the Greece-leaves-the-euro scenario. The Wall Street Journal touched on the topic this morning – note the use of the unfriendly-to-the-markets term ‘collapsing’:

If Greece leaves and investors begin to question the viability of the euro in other vulnerable countries, such as Spain and Italy, Germany and the rest of Europe could be forced to take bold action to keep the currency from collapsing.

As we noted on May 10, gold appears to be questioning the ability of central bankers to ward off deflation. As of Tuesday’s close, gold’s 200-day moving average continued to roll over in a bearish manner. The chart below also shows the shorter-term moving averages (green, red, and blue thin lines) crossing below the 200-day MA, which is also negative relative to trends in the yellow metal.

We outlined in an October 2011 video the magnitude of the problems related to a global economy saddled with too much debt. In today’s world, the markets have become a battleground for deflationary and inflationary forces. The deflationary forces are writedowns and defaults. The inflationary forces come from central bankers desperately trying to keep asset prices artificially boosted in an effort to “buy time”.

You can make an argument that the best way to monitor the inflation/deflation battle is to look at commodity prices. Commodities are used to hedge against the unlimited amounts of paper/electronic money that can be created by the ECB and Fed. Commodities are also in greater demand when the global economy is growing. As shown in the chart below, commodities reacted to the eye-popping injection of cash from the ECB in late 2011. However, the sugar high from the ECB could not carry commodities over the bull/bear demarcation line (the 200-day). The failure of the CRB Index to clear its 200-day moving average in late February was the first clue the deflationary forces had not been extinguished by the ECB’s printing press.

Traders, with much shorter time horizons than investors, create “tradable” oversold bounces. A trader-induced rally could come at anytime, but even that is not guaranteed given the news of the day. The S&P 500 dropped 17% in summer 2011 with little in the way of resistance from traders.

Our risk model, which tracks the health of the markets using numerous sources, has dropped firmly into neutral territory. Until it shows some meaningful improvement (more than an oversold bounce), we will continue to take cues from our defensive coordinator. If the head-and-shoulders pattern turns out to be the market’s guide in the coming days, longer-term investors should pay closer attention if the S&P 500 trades between 1,280 and 1,306.

We reduced risk again today in an incremental fashion. Until the market shows us something, we will continue to err on the side of safety. The chart below is an updated version of one we first showed on May 8. Four trendlines have been violated on a short-term basis.

We will get a DeMark buy setup today on the S&P 500, but the DeMark chart also has resistance between 1,343 and 1,350. A setup could lead to a reversal or a completed buy countdown (meaning more declines could follow).

It is possible the head-and-shoulders pattern we mentioned on May 13 could open the door for a push toward 1,280 to 1,306, but an oversold bounce is also a possibility.

The green arrows show where the blue trendlines recently acted as support. Those levels (below the purple arrow) will now act as possible resistance. A move above 1,360 would improve the odds for a somewhat sustainable bounce. The chart below is as of 1:15 p.m. EDT.

Prior to the open on May 7, we discussed concerns about Greece (GREK) and outlined evidence of slowing momentum in stocks. Since then, the S&P 500 has dropped 31 points. On the morning of May 15, some better than expected data came from Germany with GDP growing 0.5% in the first quarter versus expectations of 0.1%. As shown below, the German DAX Index (EWG) is having trouble holding on to its early morning gains (as of 7:35 a.m. EDT). If the DAX cannot rally on better than expected news, it is not a good sign for risk assets in general.

The serious and fragile nature of the situation in Greece is underscored in the excerpts below from a May 15 Bloomberg article:

“The euro (FXE) breakup story is gathering steam again,” Marchel Alexandrovich, a senior European economist at Jefferies International in London, said in a research note. “If Greece were to ever exit the euro, no amount of reassuring comments will convince investors that other countries won’t soon follow.”

“Greece needs to elect a pro-reform and pro-austerity parliament or I foresee big problems,” Dutch Finance Minister Jan Kees de Jager said. “There is no room to weaken the agreements by reforming less or reducing spending cuts.”

The chart below shows the performance of the VIX or “Fear Index” (VXX) relative to the S&P 500 (SPY). When the ratio is falling the acceptance of risk is stronger than fear or risk aversion. On the left side of the chart, fear began to increase in July 2011. The thin colored lines are moving averages, which are used to smooth out day-to-day volatility, allowing us to focus on trends. All three of the moving averages turned up last July (blue, red, and green lines), indicating escalating concerns by investors. Notice as of Monday’s close, all three moving averages have turned up for the first time since October 2011.

Still focusing on the chart above, fear now has a clearly defined uptrend relative to the S&P 500. The ratio broke the downward-sloping blue trendline (see green arrow) in April 2012. A higher low was made near the blue arrow. The ratio recently made a higher high to complete a change in trend (purple arrow). The right side of the chart above looks similar to the left side. Stocks did not perform well in late July/early August 2011, meaning it is prudent to keep a close eye on risk assets in the present day.

Today’s Wall Street Journal reminds us that even when some form of a resolution comes out of Greece, it is unlikely the markets will stop obsessing about the mountains of debt in Europe:

A Greek exit from the euro zone would exert more pressure on Portugal and Ireland. Portugal and Ireland are already expected to get fresh financial assistance of some form. Guntram Wolff, of Brussels think-tank Bruegel, believes that, should Greece exit the euro, the market will turn its attention to these two vulnerable countries.

The market’s concerns about further deflationary bond writedowns are encapsulated in the waning interest in commodities (DBC). Commodities, often used as an inflation hedge, have made a lower high (below blue arrow in chart below), and have violated a three-year old bullish trendline (red arrow).

On the bullish side of the ledger, the weekly chart of the S&P 500 below is nearing the intersection of parallel trendlines that have acted as both support (green arrows) and resistance (red arrows). In a May 13 video, we highlighted a Tom DeMark (Market Studies, LLC) “buy setup” that may be in place as of Tuesday’s close on the S&P 500 futures. Several individual stocks and sectors have similar, and potentially bullish DeMark setups in place or forming.

The markets may be due for a bounce or multiple-week rally. However, based on the news from Europe and technical deterioration that has taken place, a rally may prove to be nothing more than a selling opportunity. We will keep an open mind, but the market needs to show us something in terms of technical strength - the bias remains down until proven otherwise.

If Greece heads to another round of elections, the anti-austerity movement is expected to strengthen. It appears to be only a matter of time before central bankers have to step in again. The Spanish 10-year is hovering at yield levels not seen since November 2011, before the ECB’s unlimited three-year loan program for banks.

It is possible we are looking at a similar scenario to summer 2010, when stocks weakened considerably between May and July. Things did not turn around until Ben Bernanke strongly hinted at QE2 in his August 2010 Jackson Hole speech.

In a May 13 video, we outlined numerous ways to monitor the markets over the coming weeks.