posted on 18 October 2016
by Investing Daily, Investing Daily
-- this post authored by Joe Duarte
The financial markets are supposed to be forward looking-constructs. That’s why I always worry when price charts, as they are doing now, start to mirror current events instead of anticipating future outcomes.
As the old saying goes, “Bull markets climb a wall of worry", and there are certainly plenty of worries around at present. But, it seems as if the word ‘worry’ isn’t descriptive enough of how some investors may feel about possible events, if a host of unpredictable outcomes continue along their current paths. Think about it; Aside from a sluggish global economy and rising geopolitical tensions, the amount of leverage in the markets is significant. For example, just two banks, J.P. Morgan (NYSE: JPM) and Deutsche Bank (NYSE: DB), hold $100 trillion worth of derivatives.
And that figure does not include the derivatives that are sitting on huge trading books at Goldman Sachs, Morgan Stanley, Banque Paribas, Warren Buffet-related entities, large insurance companies, hedge funds and any other financial institution that is a member of the global big money clique, which is all connected via the derivative umbilical cord. So while this week’s charts are worthwhile, I want to explore this dynamic briefly before delving into the technical indicators in order to provide adequate analytical background to the visuals. I am focusing on this particular set of circumstances because of the historical precedent regarding what happens to banks that can’t pay off on derivative bets that go against them, and how such a liquidity crisis can set off the proverbial selling frenzy which leads to crashes and bear markets.
I’d like to briefly focus on JPM and DB, two key cogs in the Wall Street led global derivatives casino. Remember that both made bad bets on subprime mortgages that went wrong in 2008. From there things diverged, with the former having fared much better than the latter. As far as anyone can tell, JPM is well capitalized while DB is not. That means that DB is the most likely to fail of the two if it faces a serious margin call on its derivative cache. The major reason for their divergence, aside from really bad judgment on the part of DB’s past management team, is that JPM was bailed out by the U.S. taxpayers via the TARP initiative, and its balance sheet is at least presentable. DB, for good reasons, became the poster child for the subprime mortgage crisis and has been abandoned by everyone, especially the German government (Deutsche Bank is headquartered in Frankfurt, Germany). So while JPM may be able to withstand some adversity, Deutsche Bank - which essentially is the current Lehman Brothers - has nowhere to run if things get dicey.
Now, let’s review how markets can unravel under the right conditions. The 2008 subprime crash fully unfolded when the U.S. Treasury decided that it would be a good thing to let Lehman Brothers fold. Lehman was a centrally-placed trading bank in the derivatives market, as is Deutsche Bank. What that means is Lehman was a counter-party to a big chunk of derivatives, and the government deemed that its bets were so bad that a bailout might have been dangerous to the financial system and the government would never be paid back for a loan. It may be helpful to think of the financial system as a galaxy and of Lehman at that time as a black hole on steroids in the middle of the galaxy which was so out of control that - in the eyes of the U.S. government - it threatened to suck the whole galaxy into oblivion.
Thus, what the German government has quietly done to Deutsche Bank is only slightly different - at least in principle - than what the Treasury did to Lehman, but it is plausibly based on the same line of analysis. The only real difference is that the Treasury abandoned Lehman in the midst of the early stages of the 2008 crisis while the German government has abandoned Deutsche Bank before the crisis, if there is to be one. To put it bluntly, it is entirely plausible that Deutsche Bank has been abandoned by the German government because its derivatives cache may be so toxic that it can’t be bailed out for fear that it could bankrupt the government and do irreparable damage to the already feeble European Union. And if that is true, then in the current environment it’s good to be cautious.
Running out of Gas
A picture is said to “speak 1000 words," and to my eyes and ears the current chart of the S&P 500 (SPX) has the look of a wounded bird. Indeed, it seems as if there is now some growing synchrony between the fundamental backdrop of a tired economy, rising worry about the election, and a generally poor geopolitical climate. More important, and perhaps least evident on Main Street is the lack of willingness to raise interest rates by the global central banks, even if they were to do it just to lower them again in a few months as the global economy tanks, if that’s what ends up happening.
Figure 1 - S&P 500 shows topping pattern
The first takeaway is that the S&P is not just going nowhere, but it hasn’t even been able to get back to where it was in August or September. And although it’s not always a reliable observation, the index seems to have developed the proverbial “head and shoulders" pattern with the left shoulder extending from July to August, the head from August to September, and right shoulder forming since then. Head and shoulder formations are often meaningless, but in this case who knows? In a market in which nothing that has ever worked before as a predictor has worked, this particular head and shoulder pattern could be meaningful.
Even more meaningful are the tightening Bollinger Bands (green lines above and below prices), which signal that the market is setting up for a big move. Adding to the negative vibe, note that On Balance Volume (OBV, upper panel) and the Money Flow Index (MFI, lower most panel) are what I would describe as lackluster, or nearly lifeless. That means that very little money with any conviction is coming into the market, i.e., there is poor liquidity in this market. And rounding out the indicator review, the MACD and MACD histogram show a flattening of momentum, confirming the negative tone seen in OBV and MFI.
Broad Market Shows Weakness
The lack of conviction from buyers is not limited to the S&P 500. In this section I will highlight the poor positioning of the broad market based on the activity of the New York Stock Exchange Advance Decline line (NYAD) and three major indexes; the New York Stock Exchange Composite (NYA), the Nasdaq Composite ($COMPQ), and the Russell 2000 (RUT).
Figure 2 - NYAD compared to NYSE, Nasdaq Composite, and Russell 2000 indexes
The NYSE advance-decline line, which is the difference between rising and falling stocks on a daily basis on the NYSE, topped out in late September and is in a short-term down trend. The NYSE Composite and the Russell 2000 index of small stocks are showing nearly identical chart patterns, while the Nasdaq Composite is essentially flat.
Those investors who derive some comfort from the lack of an evident top in the Nasdaq Composite may want to rethink their view after reviewing the third chart for this week, which compares the Nasdaq Advance Decline line (NAAD) to the Nasdaq Composite.
Figure 3 - Nasdaq Advance Decline Line diverges from Nasdaq Composite
The top panel is the Nasdaq Advance Decline line (NAAD), which seems to have topped out in late September even though the Nasdaq Composite Index (lower panel) has been moving sideways. This is known as a technical divergence, and suggests that the index is providing a false picture of what’s going on inside the total Nasdaq Composite index. The reason for the divergence is that large-cap stocks such as Alphabet (GOOGL), Facebook (FB), Netflix (NFLX), Amazon (AMZN) and Apple (AAPL), which are heavily weighted in the index, are propping things up while smaller and lesser-known names are not faring as well.
It is always possible that central banks and high frequency algorithm traders may push the market higher for a longer period of time. That’s just a fact of life these days. Yet, history shows that major market events often occur when the technical and fundamental pictures travel closely together as they currently seem to be. Specifically, the stock market is showing signs of vulnerability during a time when high leverage and poor liquidity combined with a sluggish economy and an increasingly volatile geopolitical backdrop are raising uncertainty. As a result, it is plausible to consider that global banking system risks are on the rise. And then there is the U.S. presidential election. Oh my!
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