THE YIELD CURVE IS LYING TO YOU

By Lance Roberts

You are being lied to. There is currently more than sufficient evidence that indicates that we are either in, or about to be in, a recession. The last time I made that statement was in December of 2007. In December of 2008 the National Bureau of Economic Research stated that we were correct. I don’t make statements like that lightly and, honestly, I hope I am wrong as this is a horrible time for the economy to relapse.

However, the reason that I bring this up is that there have been numerous analysts and economists stating that the economy cannot be going into recession due to the spread between various sets of interest rates. (For the purpose of this report we will focus on the spread between the 1-year Treasury bond and the 10-year Treasury note.) Historically speaking they would be correct and I will explain why.

The steepness of the yield curve has been an excellent indicator of a possible future recession for several reasons. First, the spread is heavily influenced by current monetary policy which has a significant influence on real activity over the next several quarters. When there is a rise in the shorter rate this tends to flatten the yield curve as well as to slow real growth in the near term. This relationship, however, is only one part of the explanation for the yield curve’s usefulness as a forecasting tool. The steepness of the curve also reflects the expectations of future inflation. Because economic growth is affected by the level and trend of both interest rates and inflation it is not surprising that the spread has historically been a good predictor of future recessions.

This time it could be wrong.

The issues with the spread between interest rates today are twofold. First, the U.S., via the Federal Reserve, has embarked upon an unprecedented series of policies to deliberately suppress the yield curve. Through outright purchases of treasuries through Permanent Open Market Operations (POMO) and Quantitative Easing (debt monetization) programs have been implemented to specifically target areas of the interest rate curve. Even the recent announcement of “Operation Twist” is specifically designed to flatten the yield curve to “help promote the demand for credit”. Therefore, since abnormal and artificial influences are being applied to the bond market to manipulate interest rates it removes the usefulness of the yield curve as a forward indicator of recessions.

Secondly, and most importantly, the economy is currently not operating under a normal economic environment. As we have discussed in recent missives the U.S., for the first time since the “Great Depression”, is undergoing a balance sheet recession. During the “Great Depression” beginning in 1929, the Total Credit Market Debt as a percentage of GDP rose substantially before eventually collapsing. We saw this phenomenon begin again in the 1980′s as total debt began to expand dramatically until the Total Credit Market Debt hit 380% of GDP in early 2009. We are now experiencing the deleveraging of those credit excesses which creates economic drag as money is diverted from savings and consumption to the repayment of debt.

Japan has been struggling with the same reality since the bursting of their real-estate/credit bubble and subsequent balance sheet recession. The government of Japan has implemented many of the same policies that Ben Bernanke has been foisting upon the US economy but to no avail. As a result Japan has been mired in a stagnating/declining economic growth environment for the last two decades with frequently recurring recessionary downturns.

The yield spread between Japanese bonds, much like we expect to happen here in the U.S., has remained positive due to government interventions since the beginning of their economic malaise some two decades ago. As far as a recessionary indicator goes – the yield spread has failed miserably.

Japan has been struggling with the same declining employment to population ratio, stagnating wages, an overburdened pension system and weak economic growth enviroment that currently faces the U.S. today. If that is the case then the economic future that has been laid out before us is not a bright one. The coming deleveraging of debt which will result in a needed cleansing of the excesses from the system will result in continued weakness in economic growth as consumers and businesses remain on the defensive. This defensive posture leads to deterioration in the demand for credit, stagnation of wages and lack of productive investment.

If the recent history of Japan is any reflection of the path that we have been set upon then we will likely enter a recession by the beginning of 2012. Of course, it will confound, confuse and surprise the mainstream analysts and media as the yield curve will most likely remain positive. As I stated before, I sincerely hope I am wrong, and that everything turns out for the best. Deep down I am an enternal optomist and believe in the innovation, ingenuity and passion that has made this country great. However, “hope” and “optimism” are not investment strategies by which we can successfully navigate the finanical markets today or in the future.

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1946 ANALOG HOLDS KEY FOR CURRENT MARKET

by Tom McClellan

I love price pattern analogs, because I love just about anything that can tell me in advance what is going to happen to stock prices. If the current price behavior is similar to that of another period in history, then sometimes it can give us insights about what lies ahead.

Subscribers to our Daily Edition and our twice monthly McClellan Market Report newsletter have enjoyed getting to see this week’s chart on a regular basis. It compares the ugly decline of the summer of 2011 to a very similar decline in the summer of 1946.

We first took a look at this comparison back in August 2011 because of a common factor in each period: there was no divergence in the A-D Line. Most of the time when there is a price decline as big as we have just seen, the A-D Line gives us warning of liquidity problems by making a divergent lower high as prices make a higher high. We did not get that A-D Line signal in the summer of 2011, although other divergences did tell us (and thus our subscribers) that there was trouble brewing.

1946 similarly did not have an A-D Line divergence, and so that made it worth taking a look at as a comparison model. When lining up the price patterns in a single chart, the correlation of price movements then and now became obvious.

1946 also shares other similarities with the current time frame. The U.S. was in the midst of dismantling the stimulative effects of a war-time economy, and unemployment shot up in a big way. There were also concerns about rebuilding post-war Europe, and whether or not loans would be repaid like the Lend-Lease Program. Now we have an economy with high unemployment, and the expiration of stimulative efforts like TARP and QE1 & 2. There was great labor union unrest in 1946, which led to the 1947 passage of restrictions on union activity in the Taft-Hartley Act, which passed over President Truman’s veto. 2011 saw a big push back against unions in states like Wisconsin and New Jersey.

Zooming in closer, we can see that even the manner in which each of the steep declines unfolded was very similar. There was a rapid one-day drop, a slight hesitation, and then the final plunge in both cases.

Rather than continuing the decline after the steep plunge, the 1946 market saw a long series of retests, with the DJIA seemingly bouncing along against a price floor for several months. The last of those came on Nov. 22, 1946, and with the price pattern alignment shown in these charts, that equates to a bottom due Oct. 21, 2011.

One point to understand about using price pattern analogs is that eventually the correlation breaks up and stops working. Often that point will arrive at the moment when one is most counting on the correlation to continue working. So one should never give these pattern analogs complete trust, no matter how good they look. But for the moment, the 1946 pattern does seem to be telling us the correct answers about how the current market’s corrective period will play out.

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PUTTING THE RISK IN PERSPECTIVE

By Surly Trader

There are very few widely available data points for most investors to track corporate credit spreads. The corporate credit spread is the difference between the interest rate that a company has to pay and the US Government has to pay on their treasury bonds to borrow money. A company that issues debt at a spread of 250 bps over the 10 year treasury will have to pay 2.5% plus the current yield on the 10 year treasury. The credit spread represents the perceived riskiness of the company, its probability of default and ability to pay its debts.

In 2008, the credit risk of corporations blew out to record levels. If we just look at A rated and BBB rated US corporations, the tail event of 2008 stands out starkly:

Credit spreads have widened, but not past expected levels of fear

The markets of 2008 showed us what happens when the financial markets freeze up. Loans and bonds are the lifeblood of the economy and when no one is willing to lend or will only lend at extremely high levels of interest rates then we question the solvency of such companies as General Electric. To date in 2011, the credit markets have not frozen. In fact, with the 10 year treasury at 1.75%, even with a 250 bps spread, companies are able to borrow money at very attractive levels of interest. Even at a spread of 300 bps a company will pay less than 5% pretax on that debt. Why can they borrow at such low rates? Because corporate balance sheets are in terrific shape.

What really stands out is the CMBS market. CMBS (Commercial Mortgage Backed Securities) represents pooled commercial loan assets. In 2008, this market absolutely imploded. Instead of gapping out from 60 bps to 600 bps, this market gapped out to nearly 1600 bps or 16% over treasuries. If we look at the current risk flare we see a 350 spread that actually seems stable at this level:

CMBS spreads lack their past flare

What is different about this market? Mostly it has just absorbed the losses. Commercial real estate has already fallen in price and appear to have bottomed out and might be at fair value. Therefore the loss expectations today are nowhere near what they were in 2007/2008:

Commercial Property Prices bottomed and recovering?

This same argument applies to the residential real estate market and the impact on bank balance sheets.

Are things rosy? No. Are things as bad as 2008? Not right now. If we do enter into a recession it seems improbable that we could see the depths of this last crisis.

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The Week Ahead: Is the Majority Wrong?

by Tom Aspray

Bearish sentiment and economic troubles continue to take their toll on the markets, but certain sectors look good and a buying opportunity may be right around the corner, writes MoneyShow.com senior editor Tom Aspray.

Even though global stock markets were able to stabilize on Friday, the sharp declines last week added to the overwhelming negative sentiment in the markets.

The technical formations prior to last week suggested that stocks were vulnerable to decline, and the short-term outlook turned more negative Tuesday.

Of course, the magnitude of the decline was a surprise to all, and Thursday’s sell-off was similar to the panic selling that occurred in early August. This gave the investment firms and major banks some vindication, as they have been racing each other for weeks to cut their forecasts for the economy and lower their year-end targets for the S&P 500.

Even the Federal Reserve joined in, as their new plan to lower long-term rates was accompanied by the comment that there are “significant downside risks to the economic outlook, including strains in global financial markets,” something that undoubtedly spooked an already skittish market.

Though I think the Fed’s concern is valid, the general consensus of economists makes me more skeptical. Many believe that if we are not already in another recession, we will be soon. If this turns out to be the case, it would be the first recession that was predicted by most as it was occurring.

These predictions comprise the majority of market sentiment, even though last week’s housing data was better than expected; existing home sales jumped 7.7% in August. Nevertheless, a survey of 100 economists painted a bleak picture of housing, as they expected prices to drop 2.5% this year, and then only rise 1.1% through 2015.

In my experience in the market, the majority is rarely right. When you have a consensus view—especially one that persists for some time—I always look at the technical evidence to see whether it supports this consensus.

For example, my volume analysis on gold turned positive in 2006, but sentiment toward gold was often mixed. In the fall of 2009, however, public sentiment on gold was overwhelmingly positive, right before gold topped out on December 1.

This began a months-long decline. The correction was severe enough to turn enough of the bulls negative on gold, which created another good buying opportunity.

Therefore, while the short-term outlook for the global equity markets is decidedly negative (as I detail later), I think by year’s end the stock market may surprise many of the current bears.

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Of course, the problems with the US economy and our leadership are just magnified overseas. Many are suggesting that the Eurozone will eventually break up, as their leaders fail to comprehend the severity of their debt problems.

The focus remains primarily on Greece, but the contagion fear is still hurting the markets. The economic news last week was also grim, as the Eurozone purchasing managers’ index dropped in September for the first time in two years. Rating agencies downgraded many Italian and Greek banks, which did not help. (I would love to see someone start rating the rating agencies.)

Late last week, the G-20 announced that it would take “all necessary action” to shore up the banks and financial markets. I think they will eventually figure out the necessary actions and move accordingly.

Unlike the US stock market, the German Dax Composite has continued to decline after the sharp drop in late July. The Dax was sharply lower early last Friday, but closed higher, and could have formed a very-short-term bottom.

Things weren’t that much better in Asia, as selling was heavy. News that China’s factory activity declined in September reversed some of the positive sentiment that had been building for their economy.

The Hong Kong Hang Seng Index had a rough week, down 7.9%, and as the chart shows, the long term 50% Fibonacci support was broken. The 61.8% support stands at 16,544, which is 7.5% below Friday’s close.

The market is likely to get a good test from the economic data this week. On Tuesday, we get new-home sales figures, the S&P Case-Shiller Housing Price Index, and the latest readings on consumer confidence.

Wednesday will bring the latest numbers on durable-goods orders, followed Thursday by the final reading on second-quarter GDP, jobless claims, and pending home sales.

On Friday, we get the numbers on personal income and consumer sentiment, which is likely to be watched closely by Wall Street.

WHAT TO WATCH

The sharp drop last week pushed many of the market indicators to levels where a sharp rebound is likely. The odds would have been even greater if stocks had been sharply lower again on Friday.

Some charts show potential double bottom formations, and while the volume action does support this view, the evidence is not strong enough to act. Given the overhanging political and economic problems, a new trading range is more likely.

I still think the current decline will be an opportunity to establish long stock positions in some of the sectors that I like, but we need to see a decrease in downside momentum first. Technology and cash-rich, high-dividend stocks are my favorites, followed by the retail sector, as I do not think Christmas shoppers will stay away.

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S&P 500

The Spyder Trust (SPY) is holding above the August lows as it is testing the daily Starc- bands. Last Thursday’s gap lower opening took out the prior lows at $114.05.
 

If the August lows are broken, then the 127.2% Fibonacci target from the flag formation is at $106.50, while the width of the flag gives downside targets in the $104 to $105 area.

First resistance stands at the gap in the $114.21 to $116.27 area, with stronger levels at $118.50. The daily trend line resistance is at $121.50.
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The S&P 500 A/D line is so far holding above both the recent lows and those that were made in August (line d). This is an encouraging sign, but a move through the downtrend (line 3) is needed to confirm a bottom.

Dow Industrials

The Spyder Diamonds Trust (DIA) came very close to the 38.2% support of $105.46 last week, as DIA gapped though the lower boundary of the flag formation (line f) on Thursday.

There is resistance now at $107.95 to $110.69, with a key level to follow at $114 to $115.25.

The Dow Industrials A/D is diverging from prices (line h), but needs a move through the resistance (line g) to confirm the divergence. A convincing break of this support will indicate a further decline.

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Nasdaq-100

The PowerShares QQQ Trust (QQQ) also gapped lower Thursday, then closed back above the uptrend (line b) on Friday, which is positive.

It would take a close below the September 6 lows at $51.91 to signal a test of the August lows.

The Nasdaq-100 A/D line overcame its downtrend (line c) last week, which suggests the A/D line could be bottoming. The A/D line shows a slight uptrend (line d) which could be broken on a further decline. A move in the A/D line above last week’s high would be positive.

There is resistance now at the gap in the $54.46 to $55.37 area.

In a recent article, I took a close look at not only the PowerShares QQQ Trust (QQQ), but also the Select Sector SPDR Technology (XLK), Semiconductor HOLDRs Trust (SMH), and Apple (AAPL).

Sector Focus

All of the major sectors were hit hard last week, and three—energy, materials, and industrials—look the weakest.

The Select Sector SPDR Utilities (XLU) is holding first support in the $32.70 to $33 area, and a drop back to the $32 to $32.40 area should be a buying opportunity.

The Select Sector SPDR Consumer Staples (XLP) and Select Sector SPDR Health Care (XLH) are also holding well above their highs, but the short-term momentum is still negative.

Oil

November crude plummeted as expected last week. The support at $85 and the $83.20 level both gave way, with crude hitting a low of $77.55 on Friday.

This could be a final washout, but it will take some time for the market to recover from a $13-plus drop.

There is initial resistance at $82, with stronger levels in the $84 to $85 area

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Panic Sellers Are Often Sorry

by Tom Aspray

Widespread recent selling in equities and gold looks to be a panic reaction by the masses, as opposed to a calculated response to real market data.

The over 5% decline in the Dow Industrials in the past two days has turned investors’ focus back on the downside, which is different from the positive spin that prevailed just a week ago.

From a technical standpoint, I have been making the case that the rebound from the August lows was a typical flag formation. The Nasdaq Composite has been the strongest since the August lows, but the negative signals from the McClellan Oscillator as of Tuesday’s close indicated even the Nasdaq had likely topped out.

Those who sold at the August 9 lows have had almost two months to watch the market stage a typical 50% rebound. If anyone sold yesterday because stops were hit or as a result of a previously developed plan, that is fine, but Thursday’s drop suggested many were just hitting the sell button in a panic reaction.

The bearish sentiment of individual investors jumped sharply this week, as 48% are now bearish with just 25% bullish. These numbers are as of Wednesday, so they should become more bearish by next week.

Gold was also hit hard Thursday and could be vulnerable to more panic selling before the current correction is over. By looking at the charts, we can get a better idea of what may occur so that you can develop a plan based on data, not emotion.

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Chart Analysis: The daily chart of the Spyder Trust (SPY) shows that it gapped below support on Thursday, line b, completing the flag formation. SPY is now just above the August lows at $110.27, which are likely to be tested over the next week.

• The 127.2% Fibonacci target from the flag formation is at $106.50, while the width of the flag gives downside targets in the $104-$105 area
• The NYSE Advance/Decline (A/D) line broke support, line d, with Wednesday’s close, setting the stage for Thursday’s plunge. The last rally had taken it just barely above its weighted moving average (WMA)
• The A/D line needs to move above its downtrend (line c) to turn positive
• The A/D line shows a band of major support between the March 2011 lows and the November 2010 highs
• Volume had been declining as the flag developed, but broke its downtrend on Thursday’s drop. It is still well below the levels seen in August, so the volume should be watched closely

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The Nasdaq Composite was much stronger than the S&P on the rally, but the PowerShares QQQ Trust (QQQ), which tracks the tech-heavy Nasdaq 100 Index, was even stronger, as it surpassed the 61.8% retracement resistance.

• Thursday’s drop gapped through support at line b, completing the flag formation
• The close was at the daily Starc- band with next support at 2330-2385. The 127.2% target from the flag formation (lines a and b) is in the 2250 area
• As noted Wednesday, the negative divergence in the McClellan Oscillator, line c, indicated the rally was over. It is back to -150 and could fall to the -250 or -300 level before the decline is over
• A rebound over the next week or so is likely to fail near the zero line
• Resistance now stands at the gap in the 2500-2550 area

The SPDR Gold Trust (GLD) dropped 2.6% Thursday on volume of 32 million shares and is down another 2% in early-Friday trading. This will take GLD close to the weekly Starc- band at $163. Over the past month, the closeness to the weekly and monthly Starc+ bands had indicated that risk on the long side was high.

• The break below support at $174.45 last week and the break of the daily uptrend (not shown) this week set the stage for the sharp drop
• The minor 38.2% support is in the $163.40 area with the more important 50% support at $156.70. This is very close to the weekly uptrend, line e
• The major 38.2% support from the 2008 lows and the long-term uptrend (line f) are in the $140 area
• As noted previously, the weekly on-balance volume (OBV) did form a negative divergence at the recent highs (see circle) and is now testing its weighted moving average. A similar divergence in late 2010 led to an eight-week correction
• The daily OBV (not shown) formed a divergence at the highs and is well below its weighted moving average
• There is resistance now at $172.20-$177.40

What It Means: If you look at SPY, a test of the August lows would be a 2% drop from Thursday’s close, while a drop to the 127.2% target at $106.50 would be another 5.6% decline. Of course, I expect that the tech sector will hold above its lows.

If you are still holding weak stocks, decide over the weekend how much more pain you can take and then stick to that plan.

Stops under the August lows for stocks or ETFs are risky, as marginal lows could stop you out before prices reverse. I do expect that prices will be 8%-10% higher in the next two weeks. Further weakness should be an opportunity to buy those cash-heavy, high-dividend stocks that others are dumping.

As for gold, a few weeks ago, it looked like gold could fall instead of rally if stocks dropped, and I recommended hedging long gold positions at that time.

The SPDR Gold Trust (GLD) is likely to reach the first downside target in the $163-$165 area over the next week. A drop to the $153-$155 area is possible before the correction is over, but the long-term volume analysis is still positive, so core holdings should be held.

How to Profit: For those who hedged their long gold positions, I would suggest covering half if GLD drops below $165, as there may be an opportunity to put the hedge back on at higher levels.

On Wednesday, I recommended that traders buy the ProShares Short S&P 500 ETF (SH) at $43.36 or better. Unfortunately, the low was at $43.41, just missing the buy level. The fund closed Thursday at $46.28…ouch! Cancel that order at this time.

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Gold Wave 4 Correction Continues

By: David_Banister

I got a bit of hate e-mail over the last few weeks from the Gold Bugs who thought I didn’t know what I was talking about when I forecasted a multi-month consolidation and correction in Gold was imminent. I’ve written ad nauseum about crowd behavioral patterns as they related to both stock markets and precious metals. It should not come as a surprise that Gold is continuing to drop after a 34 Fibonacci month rally from $681 to $1910 per ounce. That rally came in five clear Elliott Waves and ended with a parabolic race to the top. I consistently warned my subscribers and readers of my articles about not being caught holding the bag and to take defensive measures.

My most recent update was to simply try to figure out whether the continuing correction in Gold would take the form of an ABC pattern or an ABCDE Triangle Pattern. It is becoming more clear that the official pattern is ABC. In English it means that the first leg down from 1910 to 1702 was the “A” Wave, the rally back up to 1920 was the “B” wave. The C wave is continuing underway and one of my longstanding targets is $1643, which is a Fibonacci fractal relationship to the prior lows and highs, and also conveniently fills in a “Gap” in the Gold chart in the 1650’s.

During these 4th wave consolidation periods, it reduces sentiment back down to normal levels and lets the economics of the move in Gold catch up with the price action that was extended. The first area to watch is the re-test of $1702 spot pricing for a C wave low, but the evidence is for a further drop to $1643 before I would get too interested in trying to game Gold to the upside.

Here is the chart I sent out 9 days ago with Gold at $1837 forecasting a possible C wave continuing lower

I’ve stayed away from either shorting Gold or going long gold while I watch and confirm the 4th wave pattern. It’s simply the smart way to go knowing that upside will be difficult to obtain and downside risks are high. It does now appear that I am eliminating the Triangle pattern and sticking with the ABC Correction with the C wave still working its way lower. If $1702 breaks, then you should expect to see 1620-1643 as next pivot low ranges.

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