Watch Oil, The Dollar Index, And Bonds For Clues.

Watch oil, the dollar index, and bonds for clues.

In our last article we discussed the importance of oil and its first critical support level.  Crude broke its first support level (130 level basis nearby crude in chart 1) to signal an intermediate-term top that may prove to be a pre-recession top in this commodity.  Crude oil is now approaching its second critical support level between 120-123.5 basis nearby futures.  How crude responds at this important support zone will determine whether the decline from 147 is the start of a significant or less significant correction - and whether the economy and stocks will be able to derive much sustainable benefit from that correction.  Our models suggest that oil will need to decline under 120 and stay there for some time for the downside pressure economically from higher oil prices to ease up.   We see more macro economic support for a deeper recession starting to develop that will have more global reach than it has thus far, and this could negatively impact oil - but let's let the markets tell the tale.

 
Chart 1:  Crude broke 1st support zone to make intermediate high and 2nd critical support zone approaching.  Crtsy Bloomberg

We also discussed the dollar and trades against it if it broke down in some detail in our last column.  We still suggest watching for those trades to materialize - but they still need a clear close by the dollar index under 71.80 to trigger them.  So far the dollar has failed to oblige.  The dollar has benefited from lower oil prices and the fact that European economies are increasingly looking weak too.  If oil prices don't break down, a dollar decline under 71.80 would likely still trigger a final leg down in the buck.  But if oil prices break down or if foreign economies begin to clearly play catch-up to US economic weakness, the undervalued dollar could put in a long-term bottom.  The dollar index would need to close strongly over 74.50 (quite a long way off right now) to signal such a bottom technically - but here too, let's let the markets tell the tale.

 
Chart 2:  Dollar refuses to close under critical 71.80 support so far - is a dollar bottom underway?  Courtesy Bloomberg

One of the biggest problems for the US economy and market is that the Fed rate cuts since last August were pretty much muted completely by market forces - they essentially back-fired.  As the Fed cut rates sharply the dollar fell more substantially than during prior rate cutting periods.  This led oil prices higher and interest rates shot up as inflationary fears increased.  While Fed Funds rates fell, most interest rates for corporations and individuals did not.  Thus the economy didn't really get much benefit from easing.  Instead of creating an RTC-style fund to bailout sub-prime loans, and underwrite housing, the Fed has chosen targeted measures that do not seem to be stabilizing housing (the underlying asset that must be stabilized before write-offs can stop and downward economic pressures can stop from spreading).  It is difficult to imagine real estate stabilizing until mortgage rates decline - and mortgage rates can't decline until bonds rally and bond investors stop focusing on inflation concerns.  That may require more economic weakness and some help from lower oil prices first.  In the meantime the economic damage spreads.
 
Chart 3:  Mortgage rates have risen since credit crisis started - they must fall for housing to stabilize.  Crtsy Bloomberg

 
Chart 4:  Bonds must rally and rates drop for mortgage rates to have a chance of falling.  Courtesy Bloomberg
 
Chart 5:  Further substantial payroll declines could begin to undermine consumption.  Courtesy Bloomberg

 
Chart 6:  Consumption growth hasn't broken down yet, but if it does, the recession could broaden.  Courtesy Bloomberg
As economic weakness spreads the potential downside risks are exacerbated.  Two related keys to watch are payrolls and consumption growth.  Chart 5 shows that so far payroll declines have not reached normal recession levels associated with the recessions of '73-'75, '80-'81, '90, or '01-'02 yet.  However the longer we sit with no effective stimulus because the Fed's hands are tied and because authorities refuse to underwrite the housing and sub-prime markets that are the weak link dragging everything else lower, the more likely it becomes that payrolls will begin to contract to normal recession levels.  And with the consumer more debt-laden and heavily impacted by housing declines (because it borrowed on housing appreciation to consume in prior years) than ever before, payroll declines could be the final straw that leads to substantial consumption retrenchment.  With 70% of the US economy tied to consumption, a substantial consumption retrenchment could turn this financial crisis into a deep and real recession that would have larger global impact ahead than it has thus far.  So payroll declines and clear negative consumption growth are milestones to watch that would signal deeper economic and market pain ahead.

 
Chart 7:  Meanwhile foreclosures are going through the roof adding supply to housing for sale.  Courtesy Bloomberg

 
Chart 8:  Housing prices falling further, feeding into more needed write-offs and loan cutbacks.  Crtsy Bloomberg

 
Chart 9:  While inventories of housing up for sale continue to soar, meaning future price cuts needed.  Crtsy Bloomberg
Banks are having to cut-back on loans and increase lending standards substantially, which is starting to feed into other areas of the economy as the recession broadens.  Despite accounting mechanisms that allowed some banks to report less negative earnings than the market expected in the past week, the fuel towards requiring greater write-offs is growing because housing prices continue to fall.  Chart 8 shows the Chase-Shiller housing price composite falling 15% over the last year, with the decline accelerating.  Chart 7 shows foreclosures going through the roof, and Chart 9 shows the inventory of unsold homes is now over 11 months worth, nearly twice the normal amount of homes on the market.  It will be hard for housing to stabilize while inventories of homes for sale are rising and foreclosures are skyrocketing.  And it will be hard for banks to sustainably report better numbers when housing prices, which underlie mortgages, are continuing to drop sharply.  Moreover if the problem isn't soon reversed, it will start to feed into payroll declines and consumption declines that will then become the mechanism for a far broader based recession developing. 

 
Chart 10:  S&P unlikely to be able to rally sustainably until housing stabilizes.  Courtesy Bloomberg

And of course it will be hard for the overall stock market to do much more than undergo sharp but unsustainable bear market rallies that lead to lower lows over time, as long as the economy is weakening and recession forces are broadening.  The rule changes on short-sales led to a very sharp short-covering rally in financials and airlines in particular.  But short-sellers are not responsible for the decline in financials, the deterioration in their underlying assets is.  Short-covering rallies are likely to give way to ultimate renewed declines even in financials unless the underlying decline in real estate values and mortgage values is addressed more directly, or unless the Fed gets more leeway to ease via much lower oil prices.  It may even be that the bear rally is already over at the 38% retracement level as financials hit resistance levels.

It is worth noting that pension funds and speculators in oil are not responsible for high oil prices either.  The cash market for oil is where real prices are rising and pensions and speculators are not impacting the cash price - they're not buying and hoarding oil.  The real problem in oil is a supply-demand imbalance.  EM's are growing rapidly and demand is soaring.  Meanwhile 75% of all proven reserves are controlled by governments, and governments are not responding to higher oil prices as the free market would, by increasing exploration and production investments in the reserves they control.  So the typical supply response to higher oil prices isn't developing.  Supply is thus actually potentially set to DECLINE ahead while demand will rise absent a global recession.  It will take 5-10 years of lag for investments in new exploration and alternative fuels to take hold - so if we have a global recession as the global economy re-accelerates out of it, we're likely to face renewed oil crises down the road.

Investors are encouraged to mostly stand aside from this dangerous market environment.  Short-sellers are being targeted but the fundamentals behind a sustainable economic rebound are absent.  Wait for clear breadth and volume on the upside before trying to play the next bear market rally that may be catchable ala March-May.  Watch the dollar, oil, bonds, payrolls, consumption, and market internals for clues as to when this downward spiral will end.  If it ends soon and before too much more downside action in stocks, a global recession can still be avoided.  If it does not, and the recession grows into a consumption decline then there will be more rounds of write-offs from consumer debt and more broad-based earnings declines that will feed into a deep and more global recession than we've witnessed in many decades.

The market is in its most dangerous negative phase.  The Fed remains stuck in a box where it cannot raise rates because that would kill banks that are already on the ropes, but it cannot lower rates because inflation is flaring from higher oil and food prices.   Until either oil and food prices correct sharply or the economy and stocks soften significantly further, the Fed cannot ease broadly.

Our long/short strategy since our last update took profits on LVS shorts as our lowered trailing stops were hit - that's why we use trailing stops - to lock in profits.  The strategy is now 100% in T-bills awaiting new trades.  Since our last update we got close calls on the buy side from GHM and FSL, and on the short-side from NVLS, and MNT.  No valid signals, though, which is good because this market is treacherous!  Check out www.midasresourcegroup.com for daily listings of Top EPS/RS New Highs and Bottom EPS/RS New Lows to make sure you catch all these.  As the chart at the bottom of the page illustrates, we do not have top RS/EPS new highs or bottom RS/EPS new lows in a clearly dominant position (40 over the other for 5 or more days in a row) to signal a good environment for either long-side or short-side dominated activity. This is often the most dangerous and tricky phase of a bear market.

For those not familiar with our long/short strategies, we suggest you
review my book "The Hedge Fund Edge," my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call "upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. In the U.S. market, continue to only buy or short stocks in leading or lagging industries according to our group and sub-group new high and low lists. We continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).   We keep capital in T-bill cash while waiting for more trades.

The chart below shows that neither Top RS new highs (available on www.midasresourcegroup.com) or Bottom EPS/RS New Lows are over 40, let alone greater than their opposite series by 40 or more.  Heavy cash and alternative asset class defense should be utilized!