Thursday, January 28, 2010

December Durable Goods Missed by a Mile, Market Angst Reasserts Itself

As I said yesterday, long-time readers know that I am keenly sensitive to lows set in the equity markets on
consumer confidence reports. In short, if the SP500 is above a significant Consumer Confidence report low
(some Consumer Confidence (CC) lows are more important than others, and this week’s CC low was quite
important as it came just prior to the confluence of several significant events following it), investor
confidence is greater than consumer confidence. If the SP500 is below a consumer confidence low, then
investor confidence is worse than consumer confidence. That in a nutshell explains why it is imperative
stock market traders pay close attention to the Jan 26 CC low was set at 1081-1086. Most important is 1086
pit session low (not the 1081 electronic low) which dovetails much better with the December low anchored
at 1085.

As it stands now, with one trading day left in the month of January 2010, we are not only below 1085-1086,
but we closed below 1086. All trading below the Jan 26 consumer crisis low at 1086 is a market signal that
investors are in the throes of a crisis of confidence. A close below 1086 tomorrow will provide an outside
down month, and in candlespeak, this would be a bearish engulfing signal. This is a signal that will be well
broadcast to the public, particularly because it is the first month of the New Year, and the popular saying
“as goes January, so goes the year.”

I do not want my clients being overly sucked into this mentality or bias, as outside down months are not
good bearish signals for the SP500, they usually ends up being “bear traps.” Since 1982, there have
been 23 outside down months. Only three outside down months of Oct 1983, July 1990, and Dec 2002 were
valid bearish signals that led to significant follow through. And in the two of the three instances that this
signal was valid were the months leading up to the two wars with Iraq, Desert Storm and Shock and Awe.
There is no imminent war in 2010. The obvious point I am making is don’t make a big to do about this
signal, the stock market was supposed to crest anyways on Jan 11 the day after the NFP report, and it was
supposed to double top on the Jan 15 retail sales report. And that is that.

That said, what remains important is all trade below the Jan 26 Consumer Confidence low at 1085-1086. It
signals that investor confidence is swooning below consumer confidence. This signal can signal never be
taken lightly by market bulls. Some market observers, including myself have pointed to the market cross
downs below the 2009 year high at 1126-1128 and the 2009 year close at 1111 as being crucial cross-downs
from bull to bear. Yes, these were critical cross-downs, but that is what happened last week. With the
market now trading below 1086 the market is too extended from the 2009 year high and close to be of much
relevance to us short term. These higher levels should temporarily fade into the backdrop of our collective
consciousnesses only to be conjured back into our memories when we find the crisis in investor confidence
seems to have reached some sort of climactic bottom.

Traders must track and monitor investor confidence as closely as possible. Consumer confidence reports are
a great tool for measuring the pulse of investor confidence and their animal spirits. When the stock market
plunges below a significant consumer confidence level, such as the Jan 26 consumer confidence low at 1086
this is huge tell that investors have to digest a really big problem or overhang in the market. These market
signals may not necessarily be tradable but neither are they to be ignored. For the time being, passing below
1086 is a bit like crossing the Rubicon. How do investors cross back above it near term?

Using 1086 as a benchmark line in the sand for the balance of the day (ahead of the Bernanke confirmation
vote) and month, let us take a look at the 30 minute chart below. This chart shows us several key possible
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level at 1076, 1086, 1092.50 and 1098-1100 which traders might look to trade around. The bearish
momentum on the intraday charts using the moving averages is sloping into this morning’s shelf high at
1092.50 and 1099, just below the Consumer Confidence high at 1100. The market has been trading on both
sides of 1086 all week, so clearly that has not been a safe trading level or pivot. While it has not been a
tradable pivot, it needs to remain on the forefront of traders minds to gauge investor confidence. Ask
yourself this: how is it that the investor confidence plunged below the consumer confidence low fell below
1086 this morning? The primary culprit, though certainly not the only culprit, is the disappointing December
Durable Goods report which missed by a mile. The disappointing Durable Goods report whipsawed market
bulls. And those that thought that most of the investor angst (including myself) might have passed after the
market safely cleared the Geithner hearings, FOMC statement, and Obama State of the Union address on
Wednesday were wrong. The market angst hadn’t passed at all, and the disappointing Durable Goods made
that plainly evident. This disappointing Durable Goods report indirectly could have led some investors to
question whether it was appropriate for the Fed to announce the winding down of certain emergency lending
facilities in the first half to 2010 (March 8, March 31, and June 30) in yesterday’s FOMC statement One
could surmise market participants are questioning the wisdom of that particular Fed decision this morning.

For the balance of the session, bears will certainly want to keep kicking the stock market into the gutter, but
they are best suited to watching the bearish momentum (in red) sloping through 1092 and 1098-1100 levels

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(as I write this), and not the 1086 consumer confidence low. Only a breach of the Consumer Confidence
high at 1100 will put the stock market bear on hold and into neutral.

What both the bulls and the bears have to pay attention to for the balance of the session how the market
behaves going into the 3.20 pm EST Senate Cloture vote to re-nominate Bernanke and how it behaves after
the vote. (The consensus expectation was that Bernanke would get the renomination nod and vote of
confidence from the Senate this afternoon, hence the mid-session rally into that vote). A vote of confidence
from the Senate would presumably be a positive signal for the market. Viewed as a positive signal, one
might have expected Bernanke’s confirmation would have the potential to more than offset to the bearish
Durable Goods signal this morning. But, you would have been wrong. In hindsight we find that the market
treated Bernanke’s reappointment rather anti-climactically. The market failure to rally after Bernanke’s
confirmation was yet another short term bearish indication which traders can not take lightly. (The market
rally into the Bernanke vote stopped at 1088.75 just above the 1086 level and was rejected when it ran into
short term bearish momentum after which it just sold off again. You can see the rejection of 1086-1089 zone
on the updated 30 minute chart at the end of this report).

Beyond Bernanke’s confirmation, what else might be a potential offset to today’s disappointing Durable
Goods report? Why, tomorrow’s adv-GDP which is expected to be rather glowing. So, I put a query into
Moody’s Economy.com this morning. Specifically, I wanted to know if the Dec Durable Goods report
would cause them to lower their 4.1% estimate for tomorrows Q4 2009 adv-GDP report. They answered:

John,
If anything, today's report suggests upside risk to our forecast of a 4.1% gain. The two
items in the report that are used to estimate GDP, core capital goods shipments, which are
nondefense capital goods excluding aircraft, and inventories, both pointed in the direction
of strong growth. Core capital goods shipments rose for a fourth straight month in
December, lifting the Q4 annualized gain to 8.5%, pointing to a solid rise in real capital
equipment spending. Durable goods inventories fell 0.2% following a similar reading in
November and the average reading of -0.3% in Q4 is dramatically less than the 2.3% per
month decline during the third quarter, reinforcing the case for a larger contribution to GDP
growth form inventories in Q4.

Also, keep in mind that the miss owes entirely to a surprise drop in aircraft orders. Boeing
orders leapt from 9 in November to 59 in December, resulting in 119% increase in not
seasonally adjusted aircraft orders in December. But the seasonally adjusted number fell
11%. This is only the second year that the Census has incorporated such a large factor (we
had thought that last year's adjustment was a one-time event, based on our research and
conversation with "in the know" people, but obviously that turned out not to be the case).
Also, keep in mind that aircraft shipments rose 9% and that total durable goods shipments
rose 2.9%, the most since July; shipments matter more for Q4 growth while orders are
more pertinent for activity in Q1.

Put simply, tomorrows Q4 adv-GDP report does have potential to offset today’s disappointing and
volatile Durable Goods report (and anti-climactic reappointment of Ben Bernanke – note). As
bearish as things have been this past week, it is worth pointing out that to keep pressure on the
stock market, the bears are going to need more fuel on the fire. Tomorrow’s adv-GDP report is not
likely to provide the bears with much fuel. This could whipsaw the stock market back to the upside
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on the last trading day of the month, yet another reason to key off the pit session consumer
confidence low at 1086. Though Bernanke did get the renomination nod from the Senate with a 70-
30 cloture vote, Bernanke and the Fed did come out looking much worse than Geithner did at
yesterday’s AIG/Geithner hearings. As pointed out by Naked Capitalism’s Yves Smith:

“No matter which way you look at it, the picture that is emerging of the Federal Reserve,
as revealed by the ongoing probes into its AIG bailout, is singularly unflattering. AIG
Scandal: Fed as Chump or Fed as Crony?

Through the Geithner hearings it was alleged that Ben Bernanke also overrode his own board’s
recommendation to let AIG fail rather than bail it out. Asks Graham Fisher’s Josh Rosner:

In today’s House Oversight Committee meeting both Secretary Geithner and Secretary
Paulson repeatedly stated “we had to bail out AIG, we had no choice”. If, in fact, Federal
Reserve Board Staff recommended against the bailout. Was it so clear they really “had to”?
Bernanke Vote: Cloture Votes and Cheap Ploys

Now, it is equally possible that even a Bernanke nomination and a glowing Q4 GDP number are insufficient
to turn the market back north after having crossed down below the 2009 year high at 1128, the 2009 year
close at 1111, and below the Jan CC low at 1086 as the market carves out its initial 2010 trading range. For
that purpose, it is essential to look at the bigger pictures, and so we need to turn our attention to the larger
time frames. I begin with the 300 minute e-mini chart:

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The 300 minute chart shows a short-covering price correlation between Wednesday Jan 28 2010 and
Wednesday Oct 28 2009. The short covering rally into Oct 29 and Jan 28 led to lower lows. If the price
correlations and short coverings play out, there may still be one more whipsaw to the upside (that fails to
take out today’s highs) which then leads to a washout low of sorts either Sunday evening or early next week.
More generally, the price correlation models on the 300 minute chart above point to the e-mini’s remaining
pointed down into Sunday evening or Monday morning targeting 1065-1066. The 1065-1066 price level is
just below the critical Nov 27 Dubai World Crisis low at 1067 on the continuation chart. But 1065-1066 is
not below the 1062 Dubai World low on the March 2010 contract.

Such a model suggests there might be a false auction below the Nov 27 continuation low at 1067 on the
continuation contract. One caveat that favors the bulls short term ahead of Friday’s Q4 GDP report is that
the Nov 27 bull gap window on the March SP500 e-mini contract remains open at 1072..25 It is that bull
gap window which must close in order for the SP500 to take out the Nov 27 Dubai low at 1067 on the
continuation chart and test the Nov 27 Dubai World low at 1062 on the March 2010 contract on Sunday
night or Monday morning.

However, even the 300 minute chart might prove myopic, and too minuet. As stated above, all trading
below the Consumer Confidence low at 1086 indicates investor confidence is in the midst of a crisis. It
would be a grave mistake to discount or dismiss the significance the loss of investor confidence at this point
if nothing steps in to shore it up in the near term. For this reason, while under 1086 it is imperative to ask
how far might investor confidence swoon in 2010? I present the daily chart below for your consideration:

With the swoon in investor confidence since the Jan 19 high, this might well be the first crisis of confidence
since June 2009. How big a scale will this newly emerging crisis of confidence plunge if nothing surfaces to
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stabilize the financial markets? Or, if Bernanke’s reappointment and Q4GDP fail to shore up investor
confidence?

The daily chart shows there is a possibility that investor confidence can shore up in the first week of
February, as happened in the first week of Sept, October, and November 2009 when the stock market found
a floor under the ISM or ISM non-services reports. The Feb 1 ISM and Feb 3 non-ISM reports could put
another floor under the stock market ahead of next Friday’s Feb 5 NFP report. However, you will want to
note I have mapped out a bearish price and time correlation that extends this crisis of investor confidence
into mid February. This bearish correlation map takes the June swoon beginning on June 11 2009 and
correlates it to the swoon that began on Jan 19 2010. This price and time correlation model suggests a
plunge to 1036 or worse is possible. I mention worse because at present, the swoon off the Jan 19 high is
every bit as strong as or stronger than the decline off the June 11 high.

Note that this is the 7th trading day off the Jan 19 high and that the market found a short term floor on the 8th
trading day following the Jun 11 high. This suggests that some of the heat on the market this week could
stall out between the 7th and 9th trading days. This allows for the stock market to catch a bounce into next
Fridays NFP report and then still weaken to new move lows by mid-February.

None of these scenarios, it bears mentioning, are written in stone. But it is imperative that traders and
investors stay in close touch with what will or won’t be sufficient to shore up investor confidence. If any
short term market recovery is lacking in power, whatever low is carved out in the short term will constitute a
very weak bottom. On the other hand, any market recovery with significant buying power behind it is apt to
be sustainable and to push the market off to new highs. This would be consistent with the 20 other outside
down months since 1982 that led to a road to nowhere on the downside!

However, investor confidence has become unstable in the past week and a half and that can not be easily
dismissed without a clear market signal. That said, bears can not just assume, based on either recency or
other cognitive biases that investor confidence will remain unstable in the near term. All traders must be
keenly alert to market signals that either keep investor confidence unstable or act to shore it up. In the
backdrop of every trading decision you make, please keep a prospective and keen eye on what events will
either shore up or destabilize investor confidence. I will help prospectively guide you as best I can through
this newsletter and additional email support.

In a discussion I had with one client this morning, we spoke of the second derivate trade of 2009 (the delta
or rate of change in the economic data) being a two-edged sword. In 2009, the economic data was becoming
“less bad.” Economists called these less bad economic reports “green shoots” and the market rallied
prospectively that things were becoming “less bad,” as if things were actually changing for the better.

In the first half of 2010, the second derivative will on balance show things getting better as the full force of
Obama’s fiscal stimulus kicks in. But the second derivative, that is, the rate of change is expected to show
things getting better at a slower rate. As the slower rate eventually caps out as fiscal stimulus dries up,
market participants will not be appreciative of the economic data getting “less better.” As green shoots
pushed the market higher in 2009, as these green shoots begin to wilt in 2010, the economy will begin to
sputter and stall, thus destabilizing investor confidence and pushing market participants to exert additional
downward pressures on the stock market. Eventually, if the private sector does not fill in the void left by the
fiscal stimulus which will be diminishing in 2010, (which the private sector absolutely can not do without a
catalyst that could match the housing boom of 2003-2007) “fingers of instability” will inevitably begin to
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accumulate into the economy. This will exert a destabilizing force on the financial markets. As and when
that occurs, the downward pressures exerted on the market will begin to push the stock market over the
edge.

The Feds are removing the emergency lending facilities in 1H 2010. This can be viewed as a sign that the
Fed has confidence the financial system has stabilized. On balance, this would seem to suggest the financial
markets and by extension the stock market could remain more or less stable into the second half of 2010.
But by the time FY 2010 ends in September just before the mid-terms election, how is the private sector
going to carry the economy in 2011 and 2012? The private sector, namely the capital markets and shadow
banking system remains largely insolvent. There is still a huge mis-match between the big banks assets and
liabilities that must be funded.

The funding gap between assets and liabilities has to close by 2013 when the Big Banks will have to put
their toxic assets back onto their balance sheets by 2013 as required by the FASB and Basel Committee. The
big gamble the Fed, Treasury and Big Banks are making is that these toxic assets will be worth more in
2013 than they are now. They are also gambling that the Big Banks can successfully recap themselves by
taking advantage of trading and leveraging up the yield curve at zero cost and zero risk. While no one
doubts the Big Banks will be vigorously recapping themselves with the yield curve, less certain is what
becomes of those toxic assets over the next two to three years. There is a good chance those toxic assets will
be performing as poorly as or worse than they are today.

So, 2008-09 was a huge financial crisis, one whose magnitude was of epic proportion, similar to that
earthquake destroying Haiti a few weeks ago. Haiti was rocked into oblivion by the structural shifts in the
tectonic plates underneath it. That shift in the tectonic plates below Haiti caused an aftershock and another
earthquake just a week later. Aftershocks describe the tendency for one earthquake to beget another. The
financial earthquake that took place in 2008-09 resulted from a structural crack embedded in the fault lines
of our capital markets. Nothing is or has been done to shore up the crack in the fault lines of our capital
markets to date, if anything, the cracks in financial fault lines have been preserved as it was. As a
consequence we can expect another financial earthquake to rock our financial markets in 2011-12 as the
banks strive to close their funding gap, that mis-match between their assets and liabilities. Depending on
how well they are able to accomplish the goal of funding that gap, and their ability to restore the safety and
soundness to the financial system and capital markets by 2013 will determine the extent of the damage that
is incurred by the next financial quake.

Between now and the funding of that gap in 2013, you can rest assured that the capital markets will remain
fully dysfunctional, characterized by big banks hoarding their reserves. To the extent that the Big Banks
must both hoard and herd their reserves ahead of 2013, you can rest assured the private sector will be unable
to fill the void in 2011-2012 left by Obama’s fiscal stimulus running out in FY 2010. As and when that
happens, the power laws exerted by the accumulating “fingers of instability” will inevitably and eventually
exert yet another destructive force in the financial markets. The magnitude of that destructive force is as yet
unknown. But, on one thing you can count on, hell is coming to breakfast in 2011-2012. Some believe hell
is coming sooner, but in my view, we need time for more “fingers of instability” to accumulate into our
capital markets and economy.

As I finish this report up that I began more than three hours ago, the Senate Cloture vote which passed 70-
30 in favor of Bernanke’s confirmation did nothing to reassure investors. Subsequently, the market sold off
end of day to close at 1079.25, a hair above Wednesday’s FOMC announcement low at 1078.50. Not even a
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favorable cloture vote for Bernanke’s reconfirmation gave the market any cheer intraday. The only net
positive is that the 1079 close was above Wednesday’s FOMC low.

However, not even the glowing tech earnings reports after the market close have proved to offer investors
much comfort. Nothing as yet is helping to restore their animal spirits which took flight on Thursday Jan 19.
Remember that while the market is trading below the 1086 consumer confidence low and Bernanke
renomination high at 1088.75, investor’s animal spirits have vanished.

While we now have some ideas as to how low investor confidence will cause the stock market to swoon in
the near term, nothing is written in stone that says it can’t go much farther than what I have mapped out
above. When it comes to stock market tops and bottoms, I generally “know it when I see it.” Thus far, I can
assure you I don’t see it. Overnight, the inside bar low at 1076 and 1086 ought to be decent guideposts for
traders. Below 1086 the market is aggressively bearish and below 1076, new lows should be expected.
Above 1086, and a challenge of 1098-1100 or higher can not be ruled out.

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