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$HYG – High Yield Corporate Bond ETF

Let’s cut to the chase: Europe is still a mess and the LTRO sugar buzz has faded, now it is time to get down to real business. We all know that the eurozone needs to become more fiscally integrated while implementing sweeping structural reforms throughout much of the periphery. However, bank runs have begun and people are rapidly losing confidence; therefore, Draghi must take bold action NOW not in six months when the genie is out of the bottle. Here is what must be done:

• ECB guarantees of up to 250,000 euros on all euro bank accounts within the euro area
• Large bank recapitalisations aided by ECB financing to the sovereign treasuries
• Large scale ECB purchases of sovereign debt in an indication that the ECB is serious this time and will not back down in easing stress in financial markets
• Begin a credit easing operation with purchases of mortgage/credit instruments to help take some strain off banks’ balance sheets

I fear that the ECB won’t do any of the above and that it will remain badly behind the curve as it holds interest rates at 1% while much of the EZ is mired in a deflationary downward spiral. There was a lot of hope when Mr. Draghi took the helm at the ECB, the LTROs were creative but clearly weren’t enough – bank runs are the oldest manifestation of economic crisis and the people’s loss of confidence in their financial system. Surely the ECB can’t sit by idly and watch this play out.

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The $SPX/$RUT ratio bottomed on February 3rd as the “high beta trade” reached peak momentum which it has been unable to regain since:

Now that we have the obvious gap fill on the SPX out of the way and most major equity indices have corrected 7+% off their highs it might be time to think about a market bottom. However, the relentless afternoon sell-offs which we have experienced recently paint a picture of market participants still trying to leave equities in numbers:

Most significant market bottoms which I have witnessed came about after early weakness gave way to substantial (high volume) afternoon strength which accelerated into the close – we have yet to see any signs of such activity. To make matters slightly worse than they already are, the head & shoulders top on the $IWM fully confirmed today with a close more than 1% below the neckline (http://www.robertsinn.com/2012/05/15/is-it-really-a-head-shoulders-top/).

RGR Weekly

RGR Daily

It is no secret that the combination of a parabolic ascent and significant volume expansion often means the end of the run is near – remember silver ($SLV) in April 2011?

Distribution patterns are not only characterized by high volume, they are also volatile and wide ranging which can be seen at both tops in RGR and SLV.

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Europe is clearly the paramount concern for markets, however, China and Europe go hand in hand given that Europe’s slowdown has weighed greatly on China’s export economy. Izabella Kaminska over at the FT has an excellent piece up this morning explaining the potential for a significant dollar shortage in China due to the worsening trade situation. But what about all those dollar reserves that China has accumulated over the years you ask?

“As it stands, China sits on a huge pile of Treasuries it can’t openly liquidate for fear of sending the wrong signal to the Treasury market, as well as fear of moving the underlying. But at the same time it is finding it ever harder to absorb dollars from the system, because fewer surplus greenbacks are making their way into China via trade.” Kaminska

The PBOC RRR reduction over the weekend turned out to be a dud as the market sees Chinese banks as capital constrained and generally unwilling to lend. It seems that China’s leaders will have to get more creative over the coming months in order to avoid the much feared “hard landing” scenario – make no mistake that they will pull out the stops in order to keep the economy afloat with a transition of power scheduled for the end of the year.

Click on over to read the rest of Izabella’s story: “Why China’s RMB Exodus IS the Story”

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$GLD/$SLV Daily:

Gold/Silver Weekly:

Silver is reaching short term extreme oversold territory; therefore, I expect some mean reversion in the gold/silver ratio. However, a breakout above 60 would send a powerful signal of risk aversion.

The fact is that this formation does not meet any of Edwards & Magee’s (E&M) volume profile rules for a “proper” H&S formation:

Left shoulder: “A strong rally, climaxing a more or less extensive advance, on which trading volume becomes very heavy, followed by a minor recession on which volume runs considerably less than it did during the days of rise and at the top. This is the “left shoulder.”

“Note that each and every item cited in A,B,C, and D is essential to a valid Head-and-Shoulders Top formation. The lack of any one of them casts in doubt the forecasting value of the pattern.” (Edwards & Magee)

The IWM H&S has the lowest volume at the left shoulder and the right shoulder has roughly the same volume as the head which contradicts E&M’s assertion that the right shoulder should be “A third rally, but this time on decidedly less volume than accompanied the formation of either the left shoulder or the head….”

Despite the fact that the formation is almost perfectly symmetrical and quite pleasing to the eye, the volume profile does not meet E&M’s criteria – they go on to write:

“First, the matter of volume. It is always to be watched as a vital part of the total picture. The chart of trading activity makes a pattern just as does the chart of price ranges. The two go together and each must conform to the requirements of the case.”

It must be noted that these ideas and words were formulated in 1940 – needless to say the market environment was much different in 1940 than it is today. A great deal has been written regarding volume in the current market environment and the fact that it has rarely conformed to any of the historical technical analysis principles regarding market volume profiles. The E&M rules for a H&S top make a lot of sense:

• The public/dumb money rush to buy into an overextended rally creating a volume surge at the left shoulder
• The smart money distributes their shares throughout the left shoulder and head of the formation
• the third shallower rally occurs on low volume demonstrating lack of conviction which forms the right shoulder
• Buyers who bought in during the topping formation are trapped once the neckline breaks causing capitulation selling which triggers sell stops at lower and lower levels

It makes perfect sense doesn’t it? Almost too perfect. The February – August 2011 H&S top in the S&P 500 ($SPY $SPX) was a textbook example of a modern day H&S that fit all of E&M’s criteria. However, I’m afraid this was a rare exception in the current market environment in which chart patterns are increasingly tricky and more often than not do not match E&M’s full set of criteria for a valid pattern.

One final point, E&M also made a point to emphasize that the neckline break is only confirmed once price has fallen below the neckline by an “amount approximately equivalent to 3% of a the stock’s market price.” Given that 3% is quite a large margin on a major equity index, I personally use a break of the neckline by 1% or more on a daily closing basis as offering confirmation of a neckline break; therefore, yesterday’s marginal close below the 78 level on IWM did NOT confirm the H&S top….YET.

$CRB/$GLD/$GDX/30-year US Treasury Yield ($TLT)

2008 pre-Lehman:

Now:

The $CRB is set to close below the 292-293 support level for the first time since October 2010 which was just before QE2 was formally launched – there is a strong whiff of deflation in the air…..

I have found that during times when quality ideas and analysis are most valuable they are often the hardest to come by. For whatever reason people feel that 8:30am on a Monday morning with equity futures down 1%+ is a good time to crack tired jokes and share biased and ill-informed opinions. This is where the power of StockTwits and formulating lists of high quality sources on Twitter come into play – most of my follows keep their jokes to Twitter and use StockTwits to offer value-added insights into real time market action.

Now don’t get me wrong, I like to joke around on Twitter as much as anyone I just believe that there is a time and a place for everything. Another downside to allowing too much noise intake is that it clouds the mind – remember Mandelbrot’s excellent concept of “slowing down the tape”:

“Imagine for a moment that you could take the tape-the New York Stock Exchange’s ticker, or the Reuters record of currency quotes-and play it fast or slow, like a videocassette tape. Run it slowly when prices are flying; there is so much action packed into the tape that you can only see it all by liberal use of the “pause” and “review” buttons. Speed it up during the boring parts, when there is little new information to digest. This is, it turns out, exactly how to analyze a financial market-and exactly how my current and best mathematical simulations of the market work.” The Misbehavior of Markets -Mandelbrot

How can we slow down the tape and formulate cogent thoughts when we are being deluged with biased opinion and unbridled speculation? Filter your follows down to lists or a tight high quality “home stream” on Stocktwits and remember that if you aspire to be a high quality social media source it is best to avoid committing the following sins:

• Pompous and disingenuous self promotion: Don’t retweet every compliment you receive and cut out the BS hindsight and/or late trade tweets because people can see right through it and it adds to the overall noise level
• Limit the jokes and sarcasm to slower times of the market day or leave it until after 4pm – some of the best follows sprinkle in humor throughout the day but they don’t incessantly blast the same tired joke topics
• If you’re a blogger don’t tweet your blog posts more than twice – 3 or 4 tweets of the same post comes off as desperately seeking attention and page views
• Don’t ask for RTs or ask people to follow you – this generally comes off as rather pathetic
• We all have opinions and biases, just remember that high quality trusted sources try to remain as objective as possible
• Volatile and uncertain market environments offer ample opportunity for the best social media sources to rise above the crowd – offer value and followers will find you

This combination of negative news flow and a deteriorating, albeit resilient, equity market environment leaves market participants with a difficult and at times confusing situation across markets – does one buy equities that are “on sale” after the recent pullback? Or is it better to stay away given the numerous bearish divergences and warning signs present throughout the various key charts?

Let’s review some charts and then I will offer my thoughts on the current situation across markets:

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SPX Weekly

S&P 500 futures daily ($ES_F)

Dow Transports ($IYT $TRAN)

$XLF Weekly

$JPM Weekly

EUR/USD Daily

US Dollar Index Daily ($DX_F $UUP)

And perhaps the most important chart out there right now – the CRB Index:

While the technical market picture offers a strong signal of caution, if performing well in financial markets were as easy as buying charts that looked great and selling charts that looked ugly we could all retire to a 150-foot yacht in the Caymans. I am a strong believer in technical analysis, however, I also believe in incorporating fundamental analysis while placing the technical picture in the context of the fundamental macro-market backdrop. After all, without context a picture can be quite misleading.

Given the significant number of downside surprises in the last two weeks I believe the fact that the major equity indices ($IWM $SPY) held major support levels is at least as significant as the bearish divergences and breakdowns which occurred in several major markets last week ($EURUSD, $GLD, $UUP, etc.). Moreover, given the increasingly bearish/cautious sentiment it is almost certainly too late to bet on an aggressive move lower in the near term.

This weekend’s news flow from China & Europe is in stark contrast to the dour series of downside surprises markets have been treated to over the last few weeks – the People’s Bank of China lowered bank reserve requirements and Europe is showing strong indications of shunning austerity and turning toward a more growth oriented focus (“German voters reject austerity”, “Austerity pushing European Union toward economic ruin”, “Growth Needed More Than Austerity”).

With the PBOC firmly set on a policy easing course and European leaders finally coming to the realization that they need to turn away from their current disastrous course before it is too late, I can make a convincingly bullish case for equities and increasing risk exposure across the board. However, the market’s interpretation of the weekend’s news over the next 48-72 hours will be hugely important – if the positive news is sold and rallies fail then the gap fill back to SPX 1325 will be an optimistic downside target and the probability of a move down to the 1290s will greatly increase. Meanwhile, if the SPX can quickly regain the 1370 level shorts will be forced to quickly cover and sold-out former bulls will scurry to jump back into the market.

 Best Ideas:

• Crude oil ($CL_F $USO) June bull put spreads
• Long mega-cap integrated oil names $CVX $XOM in front of major long term support
• Bear call spreads and/or put spreads on $TLT
• Long select energy names $PXD $UPL
• Long coal and miners for an oversold bounce following China RRR cut ($GDX $KOL)
• Sell $AUDUSD on rallies