FINANCIAL REVIEW

Sprinting Up a Mountain

Sinclair Noe — November 14, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 18 = 17634
SPX + 0.49 = 2039.82
NAS + 8 = 4688
10 YR YLD – .02 = 2.32%
OIL + 1.74 = 75.95
GOLD + 26.40 = 1189.30
SILV + .64 = 16.41

The recent rally in the S&P 500 has been really, really strong. Today marked the 41st record high close for the S&P. In mid-September, the index dropped, and that continued until October 16th. On October 17th we told you about a bullish reversal pattern, and since then the S&P 500 has gained about 160 points. The S&P 500 has traded above its 5 day moving average for 21 consecutive sessions; this is unusual; it means the rally has been extremely strong and nearly non-stop; there were a couple of days where the index paused, but never really went down. The past 21 days resulted in a 12% gain; that’s like a runner sprinting up a mountain. The market is now extremely overbought. Typically, when the market is overbought, you might anticipate a pullback. We haven’t seen it yet, but we can anticipate and wait for the market to show us.

There are plenty of reasons to think the stock market will continue higher. First reason is that it is in an uptrend right now; a trend in place is more likely to continue than it is to reverse. Another reason is that there is a seasonal tendency for stocks to do well heading into the end of the year. And a lot of institutional investors are looking forward to a positive year and bonuses that come with a profitable year. The stock market in 2014 has not been a smooth ride.

We started the yearly wobbly, with a 5% dip in late January; that scared off some weak hands. Stocks rallied into the summer, and the S&P 500 hit 2000, then we got another 5% pullback; again, scaring off some weak hands. Followed by another rally into September, and then a quick and sharp drop of about 9%, which really did scare many of the institutional investors. Of course this was about the time the Fed was finishing QE3, and many investors were on the short side of the bond market. This was also when the Eurozone started to wobble, with Euro stocks down and Euro bonds down. The result was a flight to safety in the form of US Treasuries at the exact time that many investors were short government bonds. So September was a double whammy.

Now, the institutional players have to make up for their mistakes. Those managers are lagging the S&P 500′s positive 2014 performance, and hedge funds sitting on losses all have to figure out how to make money by New Year’s. Their bonuses and jobs depend on it. The path of least resistance is for stocks to go up. The US economy is showing signs of strength, and there is a seasonal tendency, and the trend is up.

But there are a few concerns. The first problem patch could be exposed this weekend in Australia with the G-20 meeting. Russia has sent troops and equipment back into Ukraine; there might be fighting and the future of Ukraine is in the balance. Putin is flexing Russian military muscle by sending bombers on patrol in international airspace near the US; and Russian fighters and bombers have been moving into European airspace with increasing regularity. There are reports that a convoy of Russian warships had arrived earlier this week in international waters north of Brisbane Australia, the site of the G-20 meetings.

And the reversion to Cold War animosity is not one sided. The sanctions against Russia are hurting the Russian economy. The Saudis are dumping oil and that puts pressure on Russian oil production and that is the biggest driver of their economy.

That move is also risky for the US. Five years ago at the beginning of the US shale oil revolution, drillers started to load up on debt to fund their operations and acquire new acreage to open up for exploration. In 2010, energy and materials companies made up just 18% of the US high-yield index, which tracks sub-investment grade borrowers, but today they account for 29% of the measure after drilling firms spent the past five years borrowing heavily to underwrite the operations. Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20% to $60 per barrel, it could result in up to a 30% default rate among B and CCC rated high-yield US borrowers in the industry.

And at least part of the problems in Ukraine can be traced back to US involvement in overturning the old government in Kiev. The other effect it’s having is to drive the Russians and the Asians together. This past week, President Obama signed a non-binding pollution deal with China, but before that, Putin signed a $400 billion deal to deliver gas to China. Putin is shifting Russia’s export focus and economic alliances towards Asia, particularly China. This has been underway informally for a while but clearly became a higher priority after Europe, at US behest, imposed economic sanctions on Russia over Ukraine.

The G-20 meetings are notorious for inaction, but something is about to happen in Ukraine and it will probably be quite consequential, especially in Europe. Today, Europe’s stats agency reported the 18 country Eurozone economy grew 0.2% in the third quarter, narrowly averting a triple dip recession – very narrowly. The big drags were the Eurozone’s largest economies, as a slowdown in Germany, a weak recovery in France and a triple-dip recession in Italy weighed on the region. It’s no longer a story about the periphery; the core is now weakening.

Treasury Secretary Jack Lew delivered a speech this week critical of Europe’s handling of the economic downturn, saying: “Resolute action by national authorities and other European bodies is needed to reduce the risk that the region could fall into a deeper slump.”

If you think Secretary Lew’s comments harsh, you’ll want to read unedited transcripts just published by the Financial Times from former Secretary Timothy Geithner’s memoirs. Geithner claims Europe’s leaders did indeed attempt to smash Greece back into the Stone Age out of vindictive rage; conspired to withhold debt support for Italy unless the elected leader was forced out; and mismanaged the EMU crisis for three years with a level of stupidity that makes you want to weep. When Geithner comes off as the sanest guy in the room, you know it’s bad.

And while Euro leaders can’t seem to find the gas pedal for the economy, a Russian invasion in Ukraine would certainly slam the brakes on Eurozone growth. This indicates that Euro leaders at the G-20 might make a push to avoid confrontation, and step away from Russian sanctions.

Closer to home, next week President Obama is expected to announce a broad overhaul of the nation’s immigration enforcement system that will protect up to five million unauthorized immigrants from the threat of deportation and provide many of them with work permits. That action, in and of itself, would not have a profound effect on the stock market, but late yesterday, House Speaker John Boehner said that if Obama went forward on his own, House Republicans would “fight the president tooth and nail” and he refused to rule out a government shutdown, despite saying that was not his goal. Republicans believe their best option to block the president’s immigration actions is an upcoming spending bill, which must pass by Dec. 11 in order to fund the government through the next year.

Meanwhile, the House of Representatives today approved the Keystone XL pipeline, which probably won’t find support in the Senate, and even if it does, the measure faces a presidential veto.

In economic news: the University of Michigan/Thomson Reuters consumer-sentiment index increased to 89.4, the highest level since July 2007; from a final October reading of 86.9. The two major reasons why consumers feel better: lower gas prices and a slightly strong labor market. Consumer sentiment may provide clues to consumer spending, as we head into the holiday season.

Prices paid for imported goods fell 1.3% in October. This report goes back to lower oil prices. Excluding fuel, import prices dipped 0.2% last month. The price of U.S.-made goods exported to other nations, meanwhile, declined by 1% last month.

Retailers in the United States reported strong sales in October, up 0.3%. Sales have been higher but for a 1.5% drop in receipts at gasoline retailers. But it looks like consumers are spending whatever they might be saving at the gas pump.

Separately, the Commerce Department reported today that businesses in the United States added to their stockpiles at a faster rate in September. Business inventories rose 0.3 percent in September, after a 0.1 percent rise in August. When companies add goods to their stockpiles, it typically reflects optimism about future demand.

Next week’s economic calendar includes a couple of real estate reports on homebuilder’s expectations, plus housing starts; and on Thursday the National Association of Realtors reports on existing home sales. The Fed will report on October industrial production Monday. We’ll also look for the regional Philly and New York manufacturing surveys.

On Wednesday, we’ll see the minutes from the last Federal Reserve FOMC meeting, where they ended QE3. I don’t expect we’ll find anything we haven’t seen before, but you never know.