Short Takes

Sentiment, especially when it reaches extremes, can be a good contrary indicator. A new record high in bullish sentiment qualifies as an extreme. According to Steel Market Update:

Steel Market Update (SMU) Steel Buyers Sentiment Index rose +9 points since the middle of December and is now at +41 the highest level recorded since the index began in November 2008. The previous high for our Index was +40 which was recorded the first week of April 2011. One year ago SMU Steel Buyers Sentiment Index was 16 points lower at +25.

The last record was made in early April 2011. How did the steel ETF (SLX) and S&P 500 (SPY) fare in the next six months? SLX was down 48% and SPY lost 15%. Extreme bullish steel sentiment aligns with our January 10 comments relative to possibly cutting back on our long positions (IJR) and considering the short side of the market.

On December 13, we noted a bearish head-and-shoulders pattern in silver and stated:

If SLV fails to retake the neckline, a decline toward 26.40 could be in the cards.

Here are the “BEFORE” and “AFTER” charts for SLV:

As our video outlined in detail on December 18, 2011, global debt levels in numerous countries have crossed over the sustainable/unsustainable line of demarcation. “Solutions” to large debt burdens tend to take two forms:

1. Deflationary / bearish for risk: Debt defaults and writedowns occur.
2. Inflationary / bullish for risk: Money printing and central bank intervention increases inflation expectations (think QE2 in late August 2010).

An excellent way to track the market’s perception of intermediate-term inflation/deflation expectations is to monitor the silver:gold ratio. How can these charts help us with stocks, commodities, and precious metals? Silver tends to be in greater demand when (a) the economy is expected to grow, and (b) when inflation expectations are high. According to the Silver Institute:

Silver has a number of unique properties including its strength, malleability and ductility, its electrical and thermal conductivity, its sensitivity to and high reflectance of light and the ability to endure extreme temperature ranges. Silver’s unique properties restrict its substitution in most applications.

When silver is weak it is logical to question (a) the expectations for future economic growth, and (b) if investors are concerned about future inflation. If inflation is not a concern, then deflation fears are most likely increasing.

The chart below shows the silver:gold ratio making a new low in August of 2008 (left of blue arrows), which represented a deflationary signal. The S&P 500, shown at the bottom, followed the silver:gold ratio lower (see orange arrows). The shift from bearish/deflationary expectations to inflationary/bullish expectations typically takes some time, especially under bear market conditions. The silver:gold ratio bottomed in October 2008 or five months before the stock market, which means until the silver:gold ratio can at least stabilize, stocks and risk assets may continue to struggle in 2012.



What is the silver:gold ratio telling us about probable outcomes over the coming weeks and months? The ratio made a new low on Monday, which points to more problems in Europe and a difficult first quarter in 2012.



As we noted yesterday, the ECB’s back-door bazooka and a record number of shorts in the euro, could spark a short-term rally in risk. The S&P 500’s 50-day moving average sits at 1,230; shorter-term resistance is shown below.

If you own stocks, you want gold and economically-sensitive silver to perform well. Weakness in precious metals is reflective of diminished concerns about future inflation and increasing concerns about deflation. The Fed, via money-printing exercises such as quantitative easing (QE), is attempting to “inflate away” the large debt burdens plaguing governments around the globe. The Fed is also trying to hold off deflationary forces, which can morph into a negative economic feedback loop of falling asset prices. If gold and silver cannot muster a sustainable rally soon, it will tilt the economy and markets toward bearish/deflationary outcomes over the coming weeks and months.

Chart patterns in technical analysis are a way of monitoring human behavior. The patterns tend to produce fairly predictable results, but sometimes humans stray from the pattern. In recent months, potentially bearish patterns have surfaced for both gold and silver, which could be an ominous signal for stocks. The action in precious metals aligns with the concerning setups in the currency markets outlined on December 12.

As shown below, gold has traced out a head-and-shoulders topping pattern. The blue line is neckline of the pattern. A break of the neckline tends to foreshadow further downside. However, it is not uncommon for price to retest the neckline, which means the gold ETF (GLD) could move back toward the 161.50 to 164.00 range while staying within the confines of the potentially bearish set-up. A sustainable move above the neckline would greatly reduce the odds of the pattern holding true to form. If the pattern remains in place, GLD could logically fall toward 146.00 in the coming weeks, which would represent an additional loss of 7.8%.

In addition to the head-and-shoulders pattern appearing on the chart of the silver ETF (SLV), gold’s cousin has traced out a series of lower highs (orange arrows) and lower lows (blue arrows). The lower highs and lower lows define a bearish downtrend. A retest of the upward sloping blue neckline could bring SLV back toward the neighborhood of 30.64 to 31.05. If SLV fails to retake the neckline, a decline toward 26.40 could be in the cards. A move to 26.40 would add 11.46% to the losses incurred in SLV since the late April peak.

We have been concerned about gold and silver for some time. We stopped out of SLV near 36.00 way back on May 10. SLV has dropped roughly 17% since May 10. We exited GLD on August 24 near 170.00. GLD has dropped roughly 7% since August 24.

The Fed and global central bankers remain bullish wild cards for precious metals and stocks. The Fed seems to be taking a wait-and-see approach on the next round of QE. If risk assets take another leg down, gold and silver could provide early clues relative to the market’s expectations for more QE. As long as gold and silver remain weak, it is bearish for both risk assets and expectations for QE. Until conditions improve, we will continue to favor conservative assets, such as cash and the U.S. dollar (UUP). Given the generic statement for the Fed on Tuesday, we also have a small exposure to shorts (SH).

See this update

It is almost midnight - too late to draw any firm conclusions, but a press release from the CME group regarding the transfer of MF Global’s accounts may result in an abnormally large number of margin calls in the futures market on Monday, November 7, 2011. It is common to liquidate positions in order to meet a margin call. It could be a volatile day in the futures markets on Monday with a lot of “forced” sales.

Here is some of the CME’s release, followed by some additional info from Bloomberg:

CHICAGO, November 4, 2011 – Today, CME Group continued to successfully transfer additional MF Global U.S. customer positions and CME Clearing-held collateral to other qualified clearing firms. The remaining customer segregated positions are expected to be transferred by the end of the day, completing the total transfer of customer positions at CME Group exchanges in approximately 15,000 MF Global accounts and approximately $1.45 billion in associated clearing collateral, as approved by the Trustee and bankruptcy court. Receiving commodity brokers for these transfers are responsible for notifying customers as to the new commodity broker for their accounts.

From Bloomberg:

CME Group Inc., the world’s largest futures exchange and the regulator for New York-based MF Global’s customer accounts, said on Nov. 4 it was in the process of transferring about 15,000 positions as of Nov. 4, the company said. Under a court order in the bankruptcy case, no funds or collateral not backing futures positions can be transferred to another futures broker.

MF Global, the holding company for the broker-dealer run by ex-Goldman Sachs Group Inc. co-chairman Jon Corzine, filed for bankruptcy protection on Oct. 31 after making bets on European sovereign debt. Its broker-dealer unit, MF Global Inc., faces liquidation. The firm listed debt of $39.7 billion and assets of $41 billion in Chapter 11 papers filed in U.S. Bankruptcy Court in Manhattan.

Saying an asset class may be “hammered” may seem like a colorful way to express an opinion, but the table below shows stocks and commodities were indeed hammered during a sharp U.S. dollar rally that occurred in the period August 2008 - November 2008. In the early stages of the last bear market, inflation-friendly assets, such as commodities (DBC) and emerging market stocks (EEM) held up relatively well as investors believed (a) the economy would avoid a recession, and/or (b) central bankers could create positive inflation via their printing presses. As the scope of the problems in the global financial system came to light, the markets shifted to a strong deflationary bias in the summer of 2008 as the U.S. Dollar Index spiked higher. The table below shows asset class/sector performance after the dollar flashed a deflationary signal in 2008.

The video below provides commentary on the table above, as well as ways to monitor the odds of continued strength in the dollar and weakness in stocks and commodities. The video explains inflationary and deflationary signals to look for in the Australian dollar (FXA) and agricultural commodities (DBA). Recent data on short positions leaves the door open to renewed selling pressure from hedge funds wanting to make bearish bets. The video is best viewed in full screen mode (use button lower right on video player).

The charts below compare the look of the U.S. Dollar Index in August 2008 to the present day. From a fundamental perspective, how could the dollar possibly see a sharp rally? Unlike stocks, currency movements are all relative to other currencies. Roughly 60% of the movement in the U.S dollar is relative to the value of the euro. This week Moody’s is expected to downgrade several French banks, which may be the next nudge for the euro to move lower and the dollar to move higher.

The negative correlation between the dollar and euro is easy to see in the charts below. Notice the euro broke out of a trading range in a bearish manner late last week as the markets began to sense the strong possibility of a default in Greece. If you are planning on the Fed killing the current dollar rally with ‘Operation Twist’, you may want to review these comments.

Bloomberg noted the term ‘bank run’ may be returning to a financial channel near you:

Nobel-prize winning economist Robert Mundell, whose research contributed to creation of the euro, said a Greek default would trigger a run on banks of “monstrous proportions.”

“This risk means that issues in Greece and the euro area are an international problem,” Mundell told reporters in Budapest today.

Th European Central Bank and the Federal Reserve should introduce a “very large” swap facility, in the range of $1 trillion, to tackle any potential dollar shortage, Mundell said.

As detailed in the video above, our bias this week will be to favor assets in green in the ETF performance table at the top of this article. If the euro takes another leg lower, the ‘big three’ ETFs may prove to be SH (S&P 500 short), UUP (U.S. Dollar), and TLT (Treasuries). We currently own all three and may add to our positions if the euro weakens and the S&P 500 closes below 1,146. As we noted on September 6, a logical case can be made for stocks to drop 49% from recent levels; nothing has changed yet to alter the bearish case. As always, we remain open to better than expected outcomes, but the bearish signals continue to pile up.

Updated as of 8:00 a.m. Thursday

After Wednesday’s close, the Chicago Mercantile Exchange announced that they were raising the margin requirement for gold by 27%. This means the collateral they need to hold from traders buying on margin (borrowed money) jumped by 27% in a day. This is basically an attempt to break the back of gold. Central bankers do not like to see gold rising in a rapid fashion since it draws attention to their inflation-inducing and currency-debasing printing presses. Is it just a coincidence that the margin requirement was raised two days before Chairman Bernanke’s Jackson Hole remarks? It’s difficult to say “commodity prices have come down” when the chart of gold is rising in a vertical manner.

Since significant gains can evaporate quickly in markets heavily dependent on printed money, we booked our profits in gold (GLD) on Wednesday. We also sold our remaining stake in silver (SLV). While it may not feel that way given the last two days, gold is still up significantly off the summer 2010 lows.

Gold and silver may both go on to make new highs, but their current risk-reward profile is much less attractive following gold’s recent vertical ascent. We are very open to re-entering gold when a more attractive risk-reward profile is in place. While it has also been hit hard in the last two trading days, silver was still a better place to be than stocks over the last three weeks.

Given the Fed wants to avoid deflation, especially in the form of falling asset prices, the two-day sell-off in gold and silver does not give a lot of confidence in the market’s expectation for inflationary/bullish outcomes following the Fed’s Jackson Hole speech this Friday. Silver was the biggest winner after last year’s inflation-inducing QE2 remarks from Jackson Hole. As noted on August 18, traders do not seem to be expecting a repeat performance of the 2010 post-Jackson Hole market.

The chart below shows the current gold/silver ratio (GLD/SLV). Silver tends to outperform gold during economic expansions and periods of positive inflation. Gold tends to outperform silver when fears of economic weakness and/or deflation move to the forefront. Notice the gold/silver ratio moved back above its 200-day moving average on Wednesday - the ratio is also close to a bullish crossover, as the 50-day approaches the 200-day (see chart below). These are deflationary, and possibly bearish, developments for asset prices. Given the change in margin requirements for gold, we do not want to read too much into any short-term analysis in the precious metals market, but the balance between downside risk and upside potential remains a little uncomfortable.

In the context of the last bear market, the move above the 200-day moving average that is shown above may not be a good sign for stocks, gold, or silver over the next few months (see next four charts).

In 2008, gold did recover and make a higher high, which is obviously possible in the coming weeks.

We are open to revisiting stocks if, and only if, we see something more than a snap-back rally. Our August 25 post identified another in a long series of concerning bearish developments for stocks. Volume on both the NYSE and NASDAQ was lower on Wednesday vs. Tuesday, indicating the big players were not participating as enthusiastically as individuals. Stock market breadth was positive, but far from great (not really aligned with the gains on Wednesday). It would not be surprising to see hedge funds short this rally in the coming days, especially if the S&P 500 gets back to the 1,200 to 1,260 range, which would not be out of character for a countertrend rally in a bear market.

Given what we know today, the current rally in stocks may be nothing more than a standard bear market bounce. If the Fed disappoints on Friday and stocks can hold their own, it may mean the economy is in better shape than what the markets have priced in (a bullish sign). Regardless of what is said at Jackson Hole, the market’s reaction will help us. The bias remains to the downside, but the bulls have made some short-term progress in the form of stabilization. We need more information before deciding if we like the long or short side of these markets. We have a neutral stance with cash and a relatively small allocation to bonds (TLT).

The battle between the U.S. dollar and the euro is based on the “lesser of the evils”, which underscores the current long-term attractiveness of gold (GLD) and silver (SLV). The dollar remains stalled in the middle of the range defined by the blue trend channel below.

With governments around the globe being forced to rein in spending, even more pressure will be placed on central bankers to provide accommodative policies (print money). According to the Wall Street Journal (Aug 3):

There is growing fear in markets, as well as in some G-7 governments and the International Monetary Fund, that the debt crisis may spin further out of control. If it engulfs two of the euro zone’s largest economies, Italy and Spain, it threatens to push the global economy back into a recession, many economists warn.

Back in the United States, the market will be looking for additional clues as to the economy’s staying power in Friday’s labor report. Last quarter’s economic growth and the first quarter’s tepid figure of 0.4% increases the odds that we could slip back into a recession.

Bloomberg reported on August 3:

Federal Reserve staff economist Jeremy Nalewaik in April published a paper, “Predicting Recessions Using Stall Speeds,” that identified 1 percent growth or less in the economy “as a moderately useful warning sign that the economy is in danger of falling into a recession.” The economy grew at annual rates of just 0.4 percent in the first quarter and 1.3 percent in the second. Nalewaik hasn’t announced what the indicator is saying now about the likelihood of a recession.

While it is too early to make a call either way, the transition from a bull to a bear market is never easy. However, as the bearish signs begin to line up over time, it does get easier to make decisions to raise cash and reduce risk. The global stock markets are on the lower end of a range that, if broken, could significantly increase the need to reduce risk. If things continue to deteriorate, we will continue to migrate toward a portfolio of cash, gold (GLD), silver (SLV), and very conservative fixed income instruments. There is a fine line between making prudent defensive moves and irrational moves induced by a sense of panic. If the bull market is coming to an end, we have a plan in place to transition our portfolios. If this morning’s weakness persists, we are prepared to raise more cash.

Monday night’s nationally-televised addresses by party leaders did little to clear the air in the debt-ceiling debate. Once some form of resolution is born (good, bad, or indifferent), the early reaction, especially in terms of market leadership, will be important. If commodities can regain some traction, it would be a bullish signal for the economy and markets.

The weekly chart of the CRB Index, a basket of commodities, is the poster child for an indecisive market. The index sits right in the middle of the trend channel. A break higher would probably be followed by a move toward the upper end of the channel (near point B). A break lower by the CRB Index might be followed by a move toward the lower bound of the channel (see B2 for a similar move).

Near point A, the orange arrows show the recent bearish bias has not been cleared in terms of the Relative Strength Index (RSI). Healthy and stronger markets tend to see RSI stay above, not below, the orange horizontal line. Near point C, the Williams %R indicator has been unable thus far to clear the midpoint hurdle of -50, which shows an understandable lack of conviction from market participants.

Commodities (DBC), gold (GLD), silver (SLV), and bonds (TLT) will all provide clues about the tone of the post-debt-saga market that is just around the corner. The first three days of trading after some clarity in Washington will help determine which of the two major scenarios is like to play out:

1. The market can stand on its own, based on fundamentals, and stocks move higher.
2. The fundamentals cannot support stocks; stocks drop and then the Fed begins more chatter about stimulus.

As we discussed on July 13, gold and silver have been looking better relative to stocks. On July 25 we showed the bond market, like commodities, is giving some mixed signals, but bonds are holding up well given recent debt-related events in the United States and Europe.

We are fence-sitting in the commodity markets at the present time. We own both gold and silver. Gold is the better choice if the post-debt-saga market takes on a bearish tone. Holding silver will most likely be more advantageous under more favorable conditions for risk assets.

While gold (GLD) and silver (SLV) could experience a quick/sharp pullback in the coming days, the intermediate-term picture still looks good. As mentioned earlier in the day (see post below), we did pick up some silver and gold. We also cut back on our market exposure in some accounts.

STUDY and SCREENING PROCESS from this morning’s post.