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Volume 2, Issue 5

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THE CREDIT FREEZE IS THAWING. HOWEVER, US EQUITY MARKETS AND FINANCIALS HAVE YET TO SHOW THE STRENGTH NECESSARY TO END THE BASEBUILDING PROCESS.

There has been a noticeable improvement in credit markets during recent weeks. This is where the problems first appeared last year. In previous updates, charts, and comments have shown that the interest rate spread that banks charge each other over and above Treasury Bills has declined from record highs of 4.3% on October to 0.94% now. This is now back to normal! As the flight to safety intensified late last year, the yield on one month US Treasury Bills dropped below zero. In December, the yield increased slightly to 0.08% but it rose as high as 0.20% today. The rate is also getting closer to what would be considered normal in light of current Fed Funds rates. Another indication of credit conditions is the interest rate spread between US corporate bonds and US 10-year Treasury Bonds as seen in the chart below. This spread increased from 1.75% to 3.5% last March when Bear Stearns collapsed. It then spiked to peak at 6.22% on Dec. 19, 2008, which was one month after the Nov. 21 equity lows. In spite of all the gloomy economic reports, the demand for corporate bonds is now the highest in three months. You can verify this by looking at the chart below. The spread is now down more than three quarters of one percent to 5.42%. This spread peaked at 4% in Nov. 2002, which was also one month after the stock market lows were reached.

While many equity bear markets occur because stock prices moved too high and became overvalued, this bear market was caused by real estate prices moving too high because credit was too easy. The losses from this easy credit eventually hurt stock prices and then the economy. Now that credit conditions have clearly improved, equity markets should also improve. Equity markets had a major advance from the Nov. 21 lows into early January, but US markets have lost much of those gains. For the month of January, the SP 500 was down 8.6% while the TSX was down 3.2%. The US financial stocks were the culprits as the Banding Index (BKX) declined 35%. The long-term oscillators for the US financials are in the extremely oversold level now. It is difficult to determine if the move since November is a short-term rise within a longer term decline that started over 15 months ago (for US markets), or just a continuation of a base-building phase before a major advance. The long-term oscillators for the US markets have turned lower, but the same indicators for the TSX and the Canadian financials have not. As of today’s close, the TSX is still 12.8% above the Nov. 21 lows and the SP 500 is 11.3% higher. Better credit conditions should be positive for equities but market action in the days ahead should provide more clarification about what the shorter-term future holds.

The media has talked about the January effect. In the past, equity markets have often moved up for the year when markets moved higher in January and down when markets moved lower in January. However, the markets were higher in January 2001 when 2001 was a down year and had a very strong year in 2003 when the markets were lower in January 2003. I believe that the best way to determine future trends is to use the tools shown here which show where the money is flowing, instead of where experts think the money should be flowing.

Bonds – Government bonds continued to move lower for the third week after a sell recommendation on Jan. 12.

Commodities – In March, July and October of last year, gold peaked when the financials bottomed. The rise in gold is showing signs of a pause. That might help financials. Oil is trying to stay positive.

Currencies - The US$ and yen are strong while the CAD$ and euro are weak. Most assets seem to be at an inflection point so paying close attention to the markets is important now.

 

The long-term oscillators for US market averages have turned lower before reaching the overbought level. This could change next week but for the time being it indicates weakness for US markets.

 

The black line on the lower right is very close to the lowest level reached since 2004. While the US financials could still move lower, this indicates that they should be close to turning around and moving higher. This sector has major implications for equities, commodities and currencies.

 

The strength in gold, materials, and the relative strength in Canadian bank stocks vs. US banks have enabled the long-term oscillator to stay positive for the TSX. What happens in the US will have an impact on global markets.

 

The Canadian banks are some of the best and strongest in the world. Even though they have been dragged down by steep losses incurred by their US counterparts, the oscillator is still able to stay positive for now.

 

The oscillators for US and Canadian government bonds peaked on Jan. 12 as prices peaked and yields were close to the lows. Inflation-adjusted bonds have reached the highest yields in three months! This is very positive since it suggests that investors starting to become more concerned about inflation than deflation. Weakness in government bond prices is another sign that the flight to quality is winding down.

 

It is hard to see, but the long-term oscillator for gold is peaking. This could merely suggest a pause after the recent rally or something more serious. Since gold has peaked when financials have bottomed, it will be interesting to see how they both react in the days ahead. Could this signal a low for US bank stocks?

 

Oil seems to be in a base-building phase along with many other assets. From September to December, US Treasury securities, the US$ and the yen all moved up as everything else declined. Now, US Treasury securities are not rising anymore. This is another sign that the flight to quality trade is breaking down.

 

This is an indicator for shipping rates. A level of 1,500 was normal until 2003. After a huge blow-off to 11,759 in May 2008, it dropped to 663 in December and is now at 1,070, an increase of 61% from the low. This shows that goods are starting to move again and that letters of credit are easier to get.

 

The euro is weak and bouncing off the lows as equities weaken.

 

The CAD$ is still weak and base-building, waiting for markets to resolve this base-building stage.

 

After a strong rally, the euro has given up a good portion of the gains. It is a tug of war between the US$, yen and Treasury Bills against everything else. Market action in the days ahead should help us to determine which side might win.