Thinking Inside the Box

“My name’s Alan and I bought a giraffe! Oh, my life is perfect!”

—The Hangover Part III

Repeat…We are now officially in blow-off territory as momentum takes the driver’s seat.

Key takeaway: It is time to simplify. Let’s focus on the two main market drivers, momentum (price and earnings) and the Fed’s rate cutting schedule. Perceptions about these two factors are going to be shaped by important data this week. We will learn a great deal from the market’s response to big tech earnings Tuesday through Thursday. Market tone is critical given the high bar from Taiwan Semiconductor and Tesla’s 20% jump after earnings. There have been only three other similar daily price jumps since Tesla went public over 14 years ago. Secondly, the final major economic number before the November 7 Fed Funds rate decision is the employment data released Friday morning. Momentum and the Fed are two dimensions, forming a square, or box, containing the following equity market potential paths: ?

Assuming last week’s low near 5765 in the S&P 500 holds, then the target is 5-7% higher. If last week’s low is broken, then the probability strongly increases for a drop below October’s 5674 low. Price moving below 5674 in the S&P 500 is a signal for everyone across all trading horizons to adopt an extremely defensive posture.

We Hold These Truths to Be Self-Evident Dept: The market is expecting rising margins through next year helping drive valuation to a level that has always proven to be unsustainable. The problem with any market top is it is easy to be confused by the bullish outlook dismissing the likelihood of any negative news darkening the outlook. We are entering into a very bullish period for stocks and a lot of uncertainty is going to be lifted after the election, which leaves open the possibility of a stretch beyond 6100 in the S&P 500. That is why prices have not backed off in general.

However, there are cracks forming that I have seen at other major tops, and that is why I will not hesitate if that key price support is broken in a sustained manner.

Facts:

1. Rising rates are being ignored by stocks (see Fixed Income section).

2. There is a 50% chance of a Democratic win and onerous deficit spending with higher taxes and regulation vs. a 50% chance of a GOP win and tariffs (read: consumption taxes) that will depress spending among those with little savings, leading to a recession if fully enacted.

3. A strong potential for another Fed policy error.

4. The earnings and employment data as well as the election are all significant binomial events, analogous to a biotech stock before a Phase 3 trial result.

Being boxed in by events that will have a large impact positively or negatively creates enough uncertainty on its own. Anxiety is high even before considering China’s faltering stimulus or recent Taiwan posture, North Korean troops training in Russia, potential Iranian retaliation, or follow up Israeli action, etc. Objectively ,the positive trend despite those four facts listed above means the market tone is bullish as we enter that strongly positive yearend seasonal.

One market rule to remember this week in particular, because it holds market-changing information between Tuesday October 29 and Friday November 1, before the election:

If the market begins to move sharply in either direction before a major event such as the November 5 election, it reveals investors’ long-term intentions.

Global liquidity dominance over valuation

The chart below ?aggregates M2 across the major central banks: U.S., China, Europe, Japan and the U.K. (apologies to the Bank of Canada).

Over the last four months, this measure has increased at an 18% annual rate, approaching the peak 20% annual rate seen in 2008 and 2021. Because this series is priced in dollars, the recent dollar strength will dampen this measure, but Japan and China have been increasing their respective central bank balance sheets, driving the upsurge.

The chart above has helped make the Leading Economic Indicator (LEI) series irrelevant for the last 18 months. Currently, the six-month diffusion index is below 50, meaning more LEI components are contracting than expanding, and the LEI index’s rate of change is below its -4.4% contraction threshold. That combination triggers a recession warning (shown below in red), normally with alarming alacrity. Due to fiscal policy support and rising global liquidity, the recession has not occurred as it normally does when an LEI warning arises.

P.S. Small caps need the Leading Economic Indicator series to rise. Strong periods of small cap outperformance come on sharp reversals in LEI, and I use this chart as an input in timing a rotation to small caps. Mike Wilson at Morgan Stanley is looking for an increase in the number of upgrades to push small cap earnings revision breadth into positive territory. That is on my list too, but I believe the market senses beforehand when the balance will start to flip positively.

It is this seeming defeat of the business cycle plus the following chart showing margins floating to the moon that has created bulletproof euphoria seen at market tops.

Next year is expected to see 13.5% net margins, led higher by mega cap tech. What’s not to like? The fact that it is already embedded in current valuations, that is what’s not to like.

There is a rule about the dangers of sky-high stock valuations coupled with stunning margins…

…Live by the Jiang, Die by the Jiang

The beauty of linking various markets through history is you appreciate how another market or another time in the same market leaves a footprint. Here are recent inflows and outflows into Chinese equities.

The outflows last week (light blue line) have been the worst since Q2 2015, the last time there was a similar blow off top, but I would direct your attention to the upward spike that just occurred, not only on a noisy one-week basis, but using the smoothed one-month indicator, the inflows just dwarfed anything in the last decade (dark blue line).

Euphoria, Panic, Repeat.

But the size of this rinse cycle gets me concerned about the size of outflows that we may see in the U.S. if we break my key support level.

One Quick Spin on Econ Lane

Because the economic and earnings data this week will obliterate any data before it, I have been light so far on the economic analysis. However, there is one chart I would like to present: Existing Homes Sales: Month’s Supply is showing inventories are back to pre-pandemic levels (note the red horizontal line).

I am looking at housing and autos to see if employment worries are winning out over big ticket purchases. However, for now with financing costs rising, it is hard to get a clear signal to determine if anxiety over job prospects is also keeping potential home buyers on the sidelines.

Sorry, once I get started—two more charts come to mind. Yes, I sometimes do this on the fly…

One chart is a 20-year chart on the Federal Total Public Debt:

And in the “as above, so below” theme, here is the U.S total credit card debt balance over the same 20-year period.

This is Keynesian in two dimensions (again, another box) because it makes sense that when the two highlighted areas fall as the consumer retreats, the federal government should step up their deficit spending. Keynesian economics was in full display during the Global Financial Crisis (GFC) and the COVID crisis as illustrated by the kinks up in the Total Federal Public Debt chart in 2008 and 2020.

Everyone talks about how the Federal Debt should shrink when the economy is good, and of course the continued rise of late has been discussed. Often. But the second dimension of Keynesianism I want to discuss is his line about changing his mind as the facts change.

Part of the acceleration in the total credit card debt balance has come from the rise in credit card financing rates, which were 14.5% in 2020 and are now over 20%. As unpaid credit balances rise exponentially, consumers cut back their spending on credit. Their balances will rise 2% month-on-month even if they don’t spend another penny, thanks to exorbitant A.P.R.s. That logic must filter up to Washington.

The facts have changed, and treasury rates are higher, but Congress is not changing their mind or actions. They need to maneuver with constraints, perhaps respecting the idea of staying in the box. ??

Japan elections: another source of volatility

Prime Minister Ishiba had walked back many of the reforms he had promised when he first became PM a few weeks ago. Additionally, the LDP did not distance themselves enough from party members who were involved in the financial scandal that became the main issue of concern for its voters. Therefore, it is not surprising that the LDP/Komeito coalition has 209 votes, 24 short of having a majority, and far short of the 279 seats they held. The Constitutional Democratic Party (DCP) has 143 seats, gaining 45.

What is interesting is the last two times that the LDP fell out of the majority was in 1993, when the property bubble had burst, and 2009, when the electorate felt the party did not extend themselves enough to help Japanese citizens during the Global Financial Crisis.

Now, however, the economic data suggests that Japan’s lost decades are over, and the economy is rebounding. It makes me wonder whether there is extreme economic uncertainty being felt by consumers now, who brought that to the ballot box. It could not approach the fear after the 1993 real estate bubble or the uncertainty of the GFC, but this is a seismic event for Japanese politics, so it has me wondering if there are also some economic overtones. Stay tuned.

Markets:

Equity Market: Just Marry One Chart This Week

Weekly Trend: Bullish

240-Minute Emini chart says it all

The intraday Emini chart including Globex going back to the August 5 low has some interesting characteristics:

• First, the channel is formed by three fast market selloffs and reversals (see the spike down action at the lows highlighted by the three arrows).
• Second, there is a 5-wave up structure, which leads to the potential of the rally being complete.
• Third, the bear case has 3 stages—first, a break below the lower channel support at 5835 in the December futures contract, followed by a break of last week’s 5800 low, and then the major 5725 support (see red rectangle in the chart above).

From last week’s chart I listed that a move below 5845 in the cash S&P index would target 5765. Price spent three minutes below 5765, going to 5762.50 and reversing hard. Therefore, a break below that level will bring in selling this week. Otherwise the trend remains higher.

The futures equivalent of is 5800 highlighted in the chart above—which means a break of the up channel at 5835 in the futures chart supports the bearish case but does not confirm it.

A trend reversal comes on a break of 5800 in December futures. A sign the entire rally off the October 2022 low is over would be a sustained break below 5725 in December futures—that equates to the major 5674 cash support. Keep the futures level in mind in post-EPS action and after nonfarm payrolls.

QQQ revisit: couldn’t break to new highs even with Tesla blowout earnings

The QQQ weekly chart had another candle formation that occurs at highs, although it is important to note that this candlestick can appear in the middle of a rally, so the conditional is important to remember. However, last week when I discussed this chart, I said selling intensifies below the weekly support line, which is 485. That is a critical pivot level for this week.

Once again, the weekly bar could not close above the 497.75 upside target. Any breakout above the July 503.50 high is a new all-time high, and any notion of selling must be ignored above there. Sell below 485.

NYSE Composite: Beware of a move outside the box

To confirm a break of the 5674 S&P 500 cash level, I am looking at the three-week consolidation (note rectangle/box that never traded back below the high of the rally off the August 5 low).

The index is now trading back inside the box. This 19,300 level in the NYSE Composite chart is the equivalent of the key 5674 SPX support. However,

• Market prices are formed because buyers and sellers come together at an auction and agree on value at that point in time.
• The longer a security (or index) trades at a particular level, the greater its significance.
• The fact that price traded in a tight range seen as fair value between September 19 and October 11 carries weight.

Therefore, a break below 19,300 would mean buyers no longer accept 19,300 as value, a meaningful regime change. A break of this level carries even more weight than the break of the more widely watched S&P 500 Index’s 5674 support.

Fixed Income: Payrolls loom large: weekly levels 3.99% support and 4.325% resistance

Weekly Trend: Bearish

Weekly trend model continues bearish: The Weekly Ten-Year Note yield chart below shows another upward week on a blue bar to 4.25% (trend model projects higher yields). I have added an Ichimoku cloud to show the resistance at 4.325%. A move above the cloud brings in Japanese selling/limits Japanese buying:

Stay short bonds but we now have 5 waves up in yields targeting 4.275%, so I cannot rule out a good pullback before or after Friday’s payrolls. The first sign of a retracement move is pushing below 4.16%. For the longer-term bond selloff to continue straight away, yields need to stay above 3.99% to close the week.

Follow the 2-year during payrolls: The 2-year Treasury yield is sitting at a key resistance level, as illustrated by this weekly chart going back to 2017.

A reversal on Friday above 4.08% would be a preliminary sign that fixed income traders are questioning the FOMC’s rate cutting resolve.

Why is this important?

The following monthly chart of the 2-year in red and blue yield bars with the Fed Funds rate in a dark line. I have used this chart for years to show how the 2-year leads Fed Funds, and many people are now using this chart.

What is important are my proprietary buy signals (blue triangles highlighted with dates) that occurred before significant market tops (see labeled dates), and one is triggering this month. It represents a reset of rate and/or growth expectations. This is a major red flag. It is a monthly signal, so it does not mean a market selloff is happening tomorrow, but it does mean that the ground has shifted, making a selloff possible.

Crude Oil: The worst did not occur, for now

Weekly Trend: Bearish

This weekly chart shows the downtrend, but the trendline I drew in early September has not been challenged. Big-picture support is $65 and I will be looking at tone closely overnight into Monday if there is relief selling on Iran’s oilfields not being attacked.

I noted last week that “$69.50 is the first sign of a reversal within this bearish environment” and all closes last week were above that key level. It continues to be an important level, except now it is support.

A break below $65 support is quite negative, but I had said that Iran going offline was not a huge supply hit and should not cause major price swings (unless the Straits of Hormuz was involved), so any relief kneejerk selling maybe limited. This is all predicated on no further escalation.

.

Best,

Peter Corey

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