Vikram Saxena's  Instablog

 The financial markets continued to trade in a choppy manner today. As I had anticipated, the price action on Friday, with the SPX opening at a new high but closing below prior highs (Trader Vic’s 2B pattern), resulted in more selling today. Equity markets gapped down open and were under negative pressure most of the day. However, the volume in the sell-off was low and the markets did not lose any key technical levels. Later in the day, the markets had a wild swing up with SPX erasing all its losses and going positive before selling off into the close. After the zig-zag action, the equities finished closed to unchanged but with a negative bias.

Reassessing Risk

The market is still digesting the implication of Friday’s jobs report. In spite of comments by the government that the recession is far from over, the market is pricing in a greater possibility of an end to the monetary easing policy of the Fed. The yield curve continues to flatten with many traders taking off the curve-steepening trade which has worked very well. The rise in short term rates is forcing a re-evaluation of many assumption underlying the current equity rally, which is primarily a result of excess liquidity in the system (cash on the sidelines, with low borrowing costs).

In my view this flattening is a pure technical reaction as traders exit the curve steepening trades (long short term, short long term treasuries), and does not reflect any sustainable shift in expectations. Regardless of how the non-farm payroll numbers are spun, the economy is still far away from a strong recovery, and higher long term yields are going to put an even greater pressure in keeping growth down.

As anticipated, the dollar continued to strengthen. However after reaching an early morning peak, it weakened through the day, with the Euro finishing almost 1c higher from its lows against the dollar.

Oil is showing remarkable resilience in spite of the strong dollar. Oil was supported by a bullish call by Morgan Stanley, following on the bullish statements by Goldman Sachs last week. Both GS and MS are major participants in the physical delivery oil market, and such calls which help sustain the speculative bias, are helping to strengthen their bottom-lines.

Market Outlook: Choppy Action Will Likely Continue

Late day spikes where the broad market rips up 1-2% in a matter of minutes are becoming very common. Many of these spikes are triggered by short-covering when the market gets over some key technical levels. This shows that though the bearish sentiment has not gone, it lacks conviction. The bears rush to cover at the slightest hint of a rally.

Some bears will take heart from the fact that the market sold off into the close after the spike. Though the inability of the market to hold higher price levels is not strongly bullish, what is the key here is the ability of the market to hold key support levels on the downside. In spite of the sell-off today at the open (and the close), the trend continues to remain bullish. The market did not violate any key technical levels and the sell-off was at a low volume.

I expect the market to continue to display the sideways choppy action as the gains of last week are consolidated and some participants reduce their risk exposure. We are likely to see more intra-day swings, and a retest of the 200 Day Moving average. However, unless the key technical levels of 903 and 880 on the SPX are violated, the trend remains up.

The financial markets had a roller coaster ride today after the surprisingly lower loss in payrolls reported by the non-farm payrolls report. Equity futures shot up almost 1.5%, well above their 2009 highs, while treasuries were sold hard. After an initial sell-off, possibly related to automatic trading linked to equity futures, the dollar rallied with the Dollar Index Futures (DX) finishing 1.68% higher above the key psychological 80 level.

The rise in dollar was a result of perceived strength of the US economy. However as soon as the dollar started rising, equities started to sell-off. The selling took the ES (S&P Futures) from a high of 957.50 down to a low of 933.25. After some more ups and downs, the equity markets finished almost flat with a slight negative bias. Unlike last week there were no fireworks into the close, with the market staying in a narrow range in the final hour, a rare occurrence. Interest rates moved up across the curve, with the biggest changes in the shorter duration (1 to 2 years) leading to a less steep yield curve from the historic highs reached earlier this week.

Commodities performed reasonably well given the backdrop of the rising dollar today. Traders are now pricing in inflation and economic growth and not just a weak dollar in their analysis. Oil hit the $70 mark in early trading before pulling back to close with a slight loss.

A Closer Look at Economic Data

The surprise drop in the number of jobs lost, had a few dark clouds hovering over it. The hours worked dropped to a level which would have corresponded to another 350K jobs lost. The unemployment rate (U3) rose to a record high of 9.4% as more workers, especially recent graduates from schools and colleges joined the workforce. A measure of true employment which accounts for all under-employed workers, U6, reached a high of 16.4%; this rate was at 9.4%, a year ago.

The retail sales data earlier this week was weak as expected. What also surprised on the negative side was the much sharper than expected drop in Consumer Credit of 15.7B compared to the consensus of -7B.

Corporate Earnings and the Bottoming Economy

There is no doubt that the free-fall in economic activity has been controlled and the economy has likely reached the bottom or close to a bottom. However, what the new normal will be like is not clear.

 In spite of hectic activity in the distressed homes market, organic sales of non-distressed properties are very week. The rise in long term interest rates is likely to hinder this market even further. Home prices may not free-fall too much further, but the activity in the non-distressed sector is likely to remain depressed for a significant time to come. Home sales trigger a lot of consumer spending and that component of consumer spending is going to be missing from the economy, apart from depressed construction activity.

Consumer spending will continue to remain constrained due to higher unemployment, lower credit availability and a greater propensity to save. This is likely to limit the upside to the profitability of companies which are dependent on US consumers. Though earnings estimates are likely to go up as analyst’ optimism catches up with green-shoots, the ability of companies to continue growing their earnings is going to be limited for quite some time to come.

Lack of Conviction Shows up in a Trigger Happy Market

The price action today showed how the equity markets lack conviction. The shock of the headline number of the NFP report sent the futures soaring, only for them to come down to earth as the rest of the report was digested. Such choppy volatile action is an indication of an uncertain market where participants lack conviction.

However, demand for equities will continue to be high purely from technical reasons. There are a lot of fund managers who are underinvested in equities and with the end of the quarter approaching in a few weeks, not many can afford to remain in cash as equity indices continue to outperform cash.

It is very likely that the market may continue to go higher but there risk of a major disappointment will grow as time passes, and the green shoots do not grow into strong trees. Art Cashin, the director of floor operations for UBS and a CNBC commentator said that another 1000 up move in the Dow will send him to the bomb-shelters.

Market Outlook

I expect the dollar to strengthen further next week as the anti-dollar trade unwinds. Unless the correlation between the dollar and equity prices reduces, equities are likely to be under pressure. On a technical basis, the SPX’ price action today corresponded to Trader Vic’s 2B Rule, which would also suggest that a pullback is likely. How long the pullback will last before the bulls rush is a different question all together. Treasuries are likely to be under pressure as more supply comes to the market and the perception of an improving economy increases risk appetite. 

The market continues to be in a very strong bullish trend. With Rusell2000 and the Nasdaq making new highs, it is very likely that the S&P500 will also make a new yearly high tomorrow. The SPX may have been waiting for the Non-Farm Payroll numbers to get out of the way before it charges ahead. Unless there a major negative surprise, I do not expect the bullish bias to change.