Monday, February 3, 2014

Some of the Fundamental Issues Facing World Markets

It's time to address the elephant in the room.

I generally watch charts first and fundamentals second, for the simple reason that fundamentals give me a biased view of the charts.  That may sound a bit strange to some folks, so let me explain further by way of analogy:  I think of fundamentals as the foundation which underpins the collective "market."  Looking at the foundation of a house gives us a general idea of how many square feet it might be -- but the foundation won't tell us anything about whether the bathroom floor inside that house is made of linoleum or Travertine tile.  And it won't tell us how many people live in the house, or whether those people even like the house in which they live.

In other words:  The fundamentals set the backdrop for the market in broad strokes, but the charts contain the specifics.

Fundamentals drive social mood to a degree, and I've found that if I focus on them too much, I start to become subject to current mass sentiment -- and the problem is, the market is all about doing the opposite of what sentiment thinks it should do.  We can throw out adages in abundance to illustrate this point:  "Buy when there's blood in the streets";  "Sell on the sound of trumpets"; "Bull markets climb the wall of worry";  "Bear markets slide down the slope of hope"; etc.

So to some degree, I try to compartmentalize the "real" world (fundamentals), and keep it separate from the fantasy world of hopes, dreams, and fears that is the market.

And the fact is, what constitutes the "real world" as I see it is only my opinion anyway.  While there is most certainly an objective reality, none of us are truly capable of seeing it clearly -- we all see some vestige of ourselves when we look at the world, because we are forced to interpret the world through the lens of our own minds.  Our minds are, in essence, the brokers of reality, and due to a host of human traits which relate to our emotional needs and insecurities, our minds frequently avoid giving us a full disclosure of reality.  To some degree, we all cast our own shadows onto the world beyond.  (For more thoughts on this subject, please see:  Trader Psychology and Why the Stock Market is Always Right)

Anyway, to draw a totally arbitrary example, I might look at, say, a massive quantitative easing program and say to myself, "Self, something this huge is bound to have huge unintended consequences somewhere down the road.  Like ripples spreading across a pond, this is going to impact the global economy and cause issues we cannot control, or even foresee."  But the next guy, especially if he's a Primary Dealer for the Federal Reserve, might look at QE and say, "Hey cool, free money!"

His reality differs from mine -- but true, objective reality is likely to lie somewhere in-between.   

As a finite person in an infinite universe, I recognize my opinions of reality can never claim the corner on objective truth -- so I try to listen to the charts first, because charts are less subjective than my interpretations of reality.  As an example, back in late 2012, the news headlines still talked of fear and dark days ahead, while the charts told the story of a rally to new highs (and by the beginning of 2013, the charts told the story of a massive rally).  The same thing happened in reverse more recently: the charts told the story of pending trouble, while the media was still touting the message that stocks were headed to "infinity and beyond."

This has been my consistent experience of many years of charting: charts are forward-looking, while the media typically only reports that which has already happened.  Since the immediate past is what impacts current sentiment, giving the charts more weight is one way we can avoid becoming part of the herd.

So, with all that said, I feel it's time to talk about some of the fundamental issues which could become the catalyst for trouble -- especially since the charts continue to warn that trouble may be lurking.  The issue currently grabbing the headlines lately is "the emerging market crisis."  "Emerging" is a reference to the markets of less-developed countries; this is a term we use in the West to refer to countries who don't enjoy the sophisticated conveniences we do, such as:

1.  The Super Bowl, wherein we humbly crown a team from our country as "World Champion."
2.  A massive, ludicrously-powerful central bank.
3.  Ben Bernanke (currently available).

The "crisis" these unfortunate countries are experiencing comes about from, of all things, our very own ludicrously-powerful central bank (let's have a big Las Vegas welcome for: the Federal Reserve!).  In a nutshell, this is one of those unintended consequences people are always yammering about: When the Fed was pumping $85 billion a month into the primary dealer's pockets, that money found its way into anything and everything -- especially with Fed interest rates effectively at zero, investors looked for places they could put that money to work to earn a higher return. 

Enter the carry trade.  If you're not familiar with that term, quite simply, a carry trade is when investors borrow (or short) a currency which has a low interest rate, such as the Japanese yen or U.S. dollar, and then use that money to buy currency (or invest in assets) from a different country where they can get a higher rate of return.

Enter the aforementioned emerging markets.

So, for example, I might borrow money in yen at 0%, then invest that money in an emerging market where I can get 5%.  Seems like a no-brainer, right?  More free money!  Not necessarily.

Trouble starts when sentiment begins shifting.  As the threat of QE taper becomes reality, investors have been reassessing their risk exposure:  After all, if the good ol' U.S. of A. is going to raise interest rates, why stay invested in a higher-risk emerging market? 

Nobody wants to be the last one standing when the music stops, so in some emerging markets investors have been rushing the exits -- and this is causing currencies such as the South African rand, the Turkish lira, the Argentinian peso, and the Indian rupee to plummet.  This has a contagion effect, so the currencies of less-troubled nations, such as South Korea and Mexico, tend to suffer as well.

This is not the first emerging market crisis the world has ever seen, nor is it likely to be the last.  Historically-speaking, things have been relatively mild so far.  However, this is the worst "emerging market crisis" we've seen in the past five years -- and we must acknowledge that these things always have to start somewhere.  The financial crisis of 2008 didn't start off as the end of the world.  Don't get me wrong, I'm not trying to be alarmist here, I'm simply pointing out that problems generally start off small -- then from there, they either get better or they get worse.  How bad things will actually get, and to what degree this may or may not impact the U.S., is currently the subject of significant debate among people who know more about it than I do. 

So to bring everything full circle from the opening paragraph:  My personal suspicion (since the day QE was announced) is that as QE winds down, there will be plenty of other unintended consequences.  However, since I can't anticipate most of those -- and since I certainly can't time exactly when they'll occur -- I'll stick to the charts for the specifics.

Since we've been talking about the emerging market crisis and the carry trade, let's start off with the US dollar/Japanese yen chart.  This charts shows usd/jpy is sitting on a zone which appears to be key support, having formed an apparent head and shoulders topping pattern.  From an Elliott Wave perspective, the highest probability wave count appears to be a bearish nest of first and second waves -- but as of yet, there's been no serious technical damage to this chart and it could still be viewed as a simple back-test of support.  The noted support zone is critical, and if this market sustains trade beneath that neckline, classic technical analysis would target a trip to 97.800-98.100.   The first step for bulls to begin a recovery would be a sustained breakout over the upper boundary of the blue trend channel.

Next up are the financials, via the Philadelphia Bank Index (BKX).  My first inclination when I look at this chart is to think we rally over the near term -- but I've outlined a number of signals on the chart to allow for a "let the market dictate" approach.

Finally, the S&P 500 (SPX) chart.  This is another chart where I prefer to let the market dictate its next intention.  As I mentioned in a recent update, the market has been behaving like it's in a crash wave, so while I'd "like" to see a rally here, I also feel this is potentially a dangerous market right now.  I'm always in favor of trades where one can get a low-risk entry -- but I would highly recommend staying extremely nimble and honoring one's stops with the market in its current position.

In conclusion, so far all the market has done is briefly arrest its decline.  There's been nothing significant to indicate bulls have regained control.  Trade safe.

Follow me on Twitter while I try to figure out exactly how to make practical use of Twitter:

Reprinted by permission; Copyright 2014 Minyanville Media, Inc.



  1. Johnnie Flukie ReddingFebruary 3, 2014 at 7:34 AM

    Pretz, you nailed it again.

  2. Ben Bernanke took a job with the Brookings Institute, so he's no longer available.