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Or, cutting through the bull in this bull market

SUMMARY

  1. Risk assets: global equities, higher yielding currencies, commodities and commodity based currencies, follow global equities, especially the US stock markets.
  2. Global equities are overbought and vulnerable to a pullback. Why? See below.
  3. The likely catalyst for this will be the US Non-farms payroll report due out 13:30 GMT, 08:30 EDT.
  4. Thus commodities and most currencies are also vulnerable to pullback. This too is a profit opportunity.
  5. There are many ways different kinds of traders or even investors can exploit the market movements this report is likely to create. One can use currencies, commodities, stock indexes, or even ETFs based on the movements of these, as well as picking individual stocks. Likely scenarios and possible responses discussed below.
  6. While it is possible that the report could move risk assets up or down, we suspect that trader's should be most prepared for markets to move down, even if the report is positive, and even if it prompts an initial move up.

Global Stocks Generally Set the Overall Direction for Other Risk Assets Like Forex and Commodities

These assets may well not move in perfect synchronization, but they usually do move in the same direction with at most minor time lags. Note the illustration below (click to enlarge). The charts on the left are for the Nikkei, Dax, and S&P. The Charts on the right are for Crude Oil, the AUD/JPY, AND AUD/USD. The sample is quite representative of how commodities and forex follow the direction of stocks, or alternatively, how stocks best reflect the overall risk appetite of global markets.

Rally Without A Cause: Global Stocks Are Overbought and Vulnerable to Pullback, And Risk Assets Follow Stocks

Risk Assets have been reliably following stocks, especially the direction of US stocks. The past 2 weeks have seen world stock indexes rally from multi-month lows back to near or at new 2009 highs, as markets appear to be anticipating enough recovery in the coming year to justify stock prices that are now about 60% of their all time highs, last seen in the summer of 2007. Just some of the reasons this optimism is unjustified include:

Rally Without A Cause

Per P/E ratios, stocks are extremely overvalued

As of late July 28, with 53% of companies having reported second quarter earnings, the S&P 500's price to earnings ratio (i.e. stock price relative to actual earnings) is 723. Meaning for every dollar you spend on a stock, you're getting 1/723rd of a dollar of the company's actual reported earnings. The historical average is 14, and bear markets typically bottom out when p/e ratios are around 10-12. Even in times of great prosperity this would not be sustainable, and we are clearly not in prosperous times, but undergoing continued, though perhaps slowing, contraction.

Hope: 1, Reality: 0.

Decreasing Slope of Economic Decline Does Not Equal Expansion, Or Even A Bottoming.

Every significant measure of economic health is still in decline: earnings, GDP, employment, consumer spending, various PMIs (purchasing manager sentiment indexes) etc. Many are dropping at slower rate. The markets have interpreted this to imply bottoming and growth coming soon. However, one does not necessarily follow from the other. Rates of decline can increase again, or cease without ensuing growth.

Hope: 2, Reality: 0.

The Relative Meaninglessness of Stocks Beating Earnings

While most of the most well-known, prominent firms reported beating analyst estimates, this was usually a case of bad results beating even lower estimates. The vast majority of firms, especially those in cyclical or financial sectors, reported declining revenues and earnings. Declines of 30% or more were common, and this was on the back of prior declines of similar or worse magnitude.

Yet the markets rose because even this relatively meaningless kind of "beating earnings" was seen as a positive sign, since often the decline was less than in Q1. Again, slower decline does not necessarily mean growth, especially considering the ongoing weakness (and very conceivable worsening) in the pillars of any real recovery: the financial sector and consumer spending.

Blissfully Optimistic Hope: 3, Reality: 0. (Add soundtrack: "I'm Just a Cockeyed Optimist," From Rodgers & Hammerstein's Broadway Classic, "South Pacific.")

The Critical Financial Sector is Still in Trouble

For the financial sector, whose fortunes have been the source of every major market move since the current crisis began with their self-inflicted sub-prime crisis to the recent surprise profits in March 2009 that began the current rally; the situation is just as bad, or worse. Not ONE of the major banks that "beat estimates" did so through profits from ongoing operations that would be likely to produce similar results.

Goldman Sachs (NYSE:GS) did it with highly risky trading profits that by nature may "vary" from quarter to quarter (unless they've found a legal way to cheat). The others like JPMorgan-Chase (NYSE:JPM), Bank of America (NYSE:BAC), did it with one-time gains from asset sales. Citigroup would have shown a loss without the sale of Smith Barney to Morgan Stanley. All warned of "increasing credit risk" i.e. growing defaults on their residential, commercial, and credit card loans.

Euphoric Hope: 4, Reality: 0 (complete with opening guitar riff of Jimmy Hendrix's version of "All Along the Watchtower," "Auld Lang Syne" or other music with similar altered state connotations

US Consumer Spending – 70% of US GDP, is Still in Decline

With about 70% of US GDP from consumer spending, there will be no recovery with a recovery in spending. That flight, passengers, will be delayed. On Tuesday, the US Commerce Dept reported that wages and salaries declined by a record 4.7%. Personal income (includes all income sources, both passive and active) declined by 1.3%, its largest slide in four years. Paradoxically, personal spending rose by 0.4%, but was driven mostly by the inflationary pressures of rising gasoline prices. When accounting for inflation the spending figure sinks to -0.1%. To some extent the harsh reality of spending has been masked by government stimulus which creates the possibility for continued declines in the future.

Wild Eyed Hope: 5, Reality: 0. (Switch soundtrack to the Beatles "Lucy in the Sky With Diamonds," – Loud)

Employment, The Foundation of Consumer Spending, is Worsening

The biggest driver of spending, employment, is still dropping so badly that Fed Chairman Ben Bernanke resisted pressure from US government debt holders (aka the rest of the planet) to give any deadline for an end to USD-devaluing stimulus programs. Yes, the US really needs the Chinese and others to keep buying US debt, but he needs improved employment even more. China and the rest of the planet can be depended on to be patient. After all, to whom do they sell? Also, the planet holds a lot of US dollars that they don't want to see become worthless. The capital of "to big to fail" is not Wall Street—it's Washington. The rest of the planet will wait. And hope. And pray. Mankind may not be united in brotherhood, but all will pray together for the US dollar. Amen, brother.

Wednesday's monthly ADP Non-Farm Employment Change was -371, worse than both the prior -463K and the forecasted -351K. This has proven to be an increasingly reliable indicator of the government's version of the same data that comes out 2 days later. The ADP result is ominous. That President Obama felt the need to remind us a few days ahead of this announcement that he won't rest until employment was more disturbing than reassuring. Wednesday's ISM Non-Manufacturing PMI (Purchasing Manager's Index) was also a bummer, coming in at 46.4 vs. a prior 47.0 and an expected 48.1. Note, most US jobs are NOT in manufacturing.

Given the ADP and Non-Manufacturing PMI results, we are left with the impression that conditions definitely are not improving. The job market will continue to be the main problem that will keep consumers weary and our economy in the recessionary state. The report also noted that the personal savings rate fell to 4.6% from 6.2%. Obviously, the deficit in income has given the individual less money to save.

Equally worrying is that as of the last NFP report, average hourly wages were stagnant and average hours per week were falling. In other words, even those with jobs are making less.

More disturbing is that while unemployment is growing, even if at times by a lesser rate, continuing claims have started to fall. Logically, the only way that can happen is if the long term unemployed exhaust their unemployment benefits.

Delusionary Hope 6: Reality: 0 (Turn up the volume on that soundtrack, images of lava lamps, please).

The July Rally Was a Low Volume Rally, Lacks Credibility

Healthy rallies should show growing volume. Low volume rallies tend to reverse more often. The 20 day simple moving average for volume on the S&P has been dropping mid-May and stayed flat for July, raising question about how long the current rally can last (click to enlarge).

Note the Declining 20-Day Moving Average for Volume Since Mid May for the S&P.

As Graham Summers writes in Five Reasons the Market Could Crash This Fall, high frequency trading programs (HFTPs) account for 70% of current market volume. That is could stop in the event of a serious sell off, leaving the already tepid market volume at feather-light volumes seen on the day before Xmas when most serious traders are already off or leaving early. Even with HFTPs, market volume has contracted the most since 1989. He sagely reminds us:

For those of you who aren’t history buffs, the S&P 500’s performance in 1989 offers some clues as what to expect this coming fall. In 1989, the S&P 500 staged a huge rally in March, followed by an even stronger rally in July. Throughout this time, volume dried up to a small trickle.

What followed wasn’t pretty.

There's an understatement. It was the crash of '89.

He notes that whenever stocks shoot higher on low volume and miserable fundamentals – the current rally's conditions exactly—the risk of a severe breakdown is high.

Manic Delusionary Hope: 7, Reality: 0. Markets appear to have lost ability to perceive reality, living in own world of delusionary fantasy. Recommend immediate commitment to professional care for the patient's own safety. Call the fire department and good psychiatrist, the markets may attempt to leap and fly from fatal heights.

Even A Good NFP Report Could Also Spark A Profit-Taking Selloff

Even if there is substantially good news from Friday's non-farm payrolls data, one could argue that the rally is so advanced that expectations for recovery in the coming year are already priced in, so even a good NFP reading could prompt profit taking if it's seen as a mere postscript for an already written story of coming expansion. Traders may decide the news of the bottoming is in, and thus so are the likely gains for the near term.

Given the above ADP non farms payroll and ISM non-manufacturing PMI, both of which fell below not only expectations but prior month's results, the probability of an encouraging government report on non-farm payrolls is receding—fast.

Manic Delusionary Hope Certified Insane: 8, Reality, 0. "Markets, this is the fire department. Come down from that ledge or jump into the nets below. You cannot fly or otherwise resist gravity."

Conclusion: How to Profit

Here are some ideas worth considering:

If the NFP results disappoint:

The greater likelihood is for markets to pull back, though once again, we ARE dealing with a somewhat delusional patient. Once one sees markets beginning to pull back, ideas to consider include:

  • Forex traders: Long the USD, JPY. Given the extreme amount of USD shorts against the AUD, NZD, CAD, selling the AUDUSD, or going long the USDJPY or USDCAD might work well.
  • Commodity Traders: Crude oil has been among the most volatile commodities, and often makes short term moves that exaggerate those of the S&P or other indexes. Gold too can move hard. So either of these could be shorted.
  • Stock index traders: short any index
  • Stock traders: Short stock index ETFs, or long assorted Ultrashort ETFs like Proshares SDS (for the S&P 500) SDK ( 2x shorts financials), or bearish USD ETFs like the UDN.

If the NFP beats expectations:

Though there may be some additional gains in stocks and other risk assets, we suspect the greater likelihood is for profit taking, since the news on the recovery would be confirmed, and traders may well decide to take profits and await the next market moving news. Ideas would be same as above.

Long investors should be sure to update their wish lists and with entry points.

DISCLOSURE & DISCLAIMER: The author may have positions in above mentioned instruments.

Source: Profiting from Friday's U.S. Non-Farm Payroll Report