This is a Relief Rally?

For anyone hoping that a weekend off would help break the string of selling and bring a new rally this week, today’s action was exactly what you were looking for.  Well, maybe not.  While the S&P 500 did manage to finish higher, a 0.13 point advance is far from convincing.  On top of that, volume registered a miniscule 2.6 billion shares.  Not exactly the stuff that bull markets are made of.  In fairness, though the equities did trade lower rather sharply at the open, so the fact that prices recovered enough to post a positive print is at least something to give the bulls hope.  (I won’t even bother mentioning the fact that the market was poised to finish lower with about 30 minutes to go.)  Not much hope, but hope none the less.  Here’s how today’s trading action affected the charts.

As you can see, momentum is firmly in the bear camp.  1,060 is now a real risk on the downside and needs to be maintained to give the bulls a fighting chance.  It is worth noting, however, that down days on the S&P 500 have been met with greater volume readings than those seen during rallies over the past couple of weeks.  While both readings are pretty anemic, this further reinforces the negative sentiment that has been building in this market.

The longer term chart further supports the bears' case.  Note the dramatic drop in volume since May.  As I've said before, I'm looking for equities to head lower later on this year.  However, as I still maintain a few small positions that could benefit from a equity move higher, I want to see the 1,060 level hold.  Otherwise, I'll have to simply back away.

I still find the divergence between corporate bond prices and equity prices fascinating.  The fact that investors feel confident enough in corporations' financial prospects to bid up their debt while shunning the equity is surprising.  Perhaps this is a collective move by investors up the capital structure?  Hard to know for sure, but it's something I continue to monitor very closely.

Crude simply can't find a bid.  As you can see, its been down 7 of the past 8 trading sessions.  This after busting though the $80/barrel level fairly handily.  Concerns about deflation are certainly weighing on the market, but I'm surprised that the global political environment hasn't kept the market more firmly bid.  I continue to hold on to my USO position and don't see any reason to pull it as yet, especially since I'm using it as a geopolitical hedge for my portfolio.  On a brighter note, though, crude was able to maintain its near term trend line today, which was a positive development.  While holding above the $72 is most critical to maintaining the bull's case, this was an encouraging development in an otherwise sour market environment.

Simply put, investors are once again focusing on deflation and its prospects for infecting the U.S. economy.  Nowhere is this concern more obvious that in the Treasury market.  Yields once again fell across the curve, with the 30 year bond the big winner on the day.  Its yield declined a whopping 14.61 basis points to 3.7169% while the 10 year note saw its yield drop to 2.5733%.  These are truly huge moves.  To be sure, the Fed’s announcement of its intention to purchase longer dated Treasury securities (2 to 10 year maturities) is driving a descent amount of this buying.  But, more than anything, it’s the Fed’s economic outlook that seems to have investors spooked (even though the Fed telegraphed this outlook in the run up to its interest rate decision).  Concerns about a double dip recession and a Japanese-like decade of little or no economic expansion are once again rampant in the market.  Quite a change from a few weeks ago. 

For my part, I do view deflation as a threat, but not one whose effects are not yet evident or imminent.  Inflation data still shows that the domestic price level, on a year over year basis, is rising.  In fact, last week’s CPI report showed that the general price level has risen 1.1% since last year.  Stripping out volatile food and energy prices, inflation registered a 0.90% increase over 2009.  While certainly not highly inflationary readings, the fact remains that inflation is still present in our economy.  The concern, of course, is that this trend does not continue.  Given the slowdown that we are likely to see in the second half of this year and the first quarter of 2011, deflation is certainly a possibility and definitely a headwind for a rally in equity and commodity markets.  That said, the scale of the moves seen in the Treasury market over the past couple of trading sessions gives me the sense that investors are getting a little too cautious a little too soon.  When any asset has to be owned by every investor out there, that’s when I prefer to run to for the door.  Some may argue that the recent rally is simply a reflection of investors being underweight Treasuries and, therefore, they are now reallocating their portfolios accordingly.  This is certainly a possibility, but given the amount of supply that has come online over the past 18 to 24 months, I find it hard to believe that at least a portion of most portfolios isn’t at least somewhat exposed to the Treasury market.  As such, I would prefer to remain in cash rather than Treasuries at this point as a way to hedge against deflation.  This may give up some of the potential profit if this rally continues, but I’d sleep better knowing that a buyer’s strike or additional supply wouldn’t hit my position’s value.  If today’s action has shown nothing else, it’s that the sleepy old Treasury market can move just as fast as its equity or commodity counterparts.

Gold may have been the beneficiary of today’s elevated deflation concerns as well.  As I mentioned last week, gold has been showing signs of resiliency of late and, today, it took a big step towards getting back on the winning past.  As you can see from the chart below, gold was able to break above the near term resistance level of $1,220/oz. and finish the day at $1,225.  With momentum indicators like the RSI and MACD sitting at levels that are supportive of a move higher, gold is no perched to make a run at its previous high around $1,265.  That said, gold has been up 12 of its last 14 sessions, so a pullback of some sort should be expected.  Also, any swift move up to the $1,260 level would likely put momentum indicators well into overbought signals, which would certainly hamper the drive to a new high.  I say this not to undermine any potential rally that may be coming, but rather to point out that this market has come a long way in a relatively short time and, therefore, may need a pause before trying to break out.

Things are starting to look pretty dire for the equity bulls.  With a challenging economic environment slated for the back half of the year, things seem likely worsen before they improve.  I'll continue to hold out hope for a quick pop by the end of the month, but I'm ready to head for the sidelines when/if this market breaks down.  With PPI, Capacity Utilization, and Industrial Production numbers out tomorrow, I suspect that investors will look to any under performance as a reason to continue the selling.  But with volumes as low as they are, anything can truly happen.  Perhaps that's why I'm looking forward to moving to sidelines for a while.  Until tomorrow.....