Non-Confirmations Still Persist

The S&P 500 has recently made a new high, in short the rebound from the mid October low has not failed at a lower high. Therefore, the clock has so to speak been reset. However, as our updated comparison chart between SPX and the major euro-land indexes shows, there is now a third divergence in place between them, and this one is even more glaring than the first two. Keep in mind that there such divergences have not always been meaningful in the past. However, when global markets are drifting apart, it is a sign that the global economy is no longer well-synchronized. Given that the Fed’s “QE inf.” is in relative pause mode (we hesitate to say it has ended), the situation is certainly worth keeping an eye on.

A third divergence between the SPX and the major continental European stock markets is now in place – click to enlarge.

ECB Meeting and Central Bank Coordination

There will be an ECB meeting this week, and possibly the central bank plans another surprise announcement, although we actually doubt that at this point. While the rate of change of euro-land CPI has continued to decline, the BuBa is implacably opposed to “QE” involving government bonds, and with three different liquidity pumping measures already in place, there is surely a case to be made for the ECB to wait for their “success” before embarking on even crazier schemes.

We only mention this because it seems highly likely that the recent Fed, ECB and BoJ actions were subject to coordination. Let us not forget, these people regularly meet (in secret) at the BIS. It is not a secret that these meetings are taking place on a regular basis – secret are only the details and what is discussed there. Let us just say that everything that has recently happened in terms of central bank decisions smacks of a coordinated effort. Even the jawboning seemed to be coordinated at times.

As noted in this recent report at Der Spiegel, “deep divisions have emerged at the ECB” over putative plans to expand QE into the sovereign bond arena. The usual pablum about the alleged “dangers of deflation” is mentioned of course, but as the article also points out, the “success” of QE is actually impossible to gauge, since no-one can possibly know what would have happened without it.

The technical differences between Fed QE and BoJ QE are of course not touched upon, but it seems to us that they are rather important. It is a lot easier to restart bubble activities in the economy when QE not only crates bank reserves, but also creates deposit money directly, as is the case in the US. How relevant the BoJ’s success in boosting asset prices will be to economic activity in Japan remains to be seen, but past experience indicates that it usually appears to work up until the time when monetary pumping is abandoned again.

Note here that we don’t believe that economic activity is per se a useful measure of economic progress. After all, aggregate economic statistics always look good during boom times, and yet, they tend to mask a lot of capital consumption. In aggregated statistics, malinvestment of capital cannot be differentiated from wise capital investment. We do however know with certainty that monetary pumping distorts relative prices and that unless the entire business community decides not to play along, capital malinvestment inevitably ensues.

As an aside to this, even if all businessmen were fully aware of Austrian capital and business cycle theory and were to agree with its conclusions, a majority of them would likely still decide to come out and play, in the belief that they will make hay while the sun is shining and will be able to jump off the train in time. Many institutional investors find themselves in an exactly similar position. A number of surveys have shown that many fund managers are indeed well aware that asset bubbles induced by monetary pumping are bound to end in tears – and yet, they are playing along, presumably not least because not doing so would represent a career risk for many.

Junk Bonds Diverge As Well

High yield credit also continues to diverge slightly from the stock market. To be sure, this divergence is small enough that it could be easily erased, but for the moment it persists:

JNK, SPX and the JNK-IEF ratio (we are using IEF instead of TLT, as this provides us with a more accurate proxy of credit spreads. The maturity profile of IEF’s holdings is closer to that of JNK’s holdings). A number of divergences between JNK and SPX have emerged as well recently - click to enlarge.

Conclusion:

With the major US stock indexes at new highs, the coast seems superficially clear for the market, but there is certainly a significant element of uncertainty left. There have also been instances in the past when marginal new highs turned out to be traps (the most prominent fairly recent occurrence was the October 2007 peak), so as such, they are not sufficient to sound the all clear. Given the ongoing divergences with European markets and high yield bond spreads, caution continues to be advisable.

The recent explosive move higher in the Nikkei (as we recently discussed, Japanese stocks had been heavily shorted, which undoubtedly played a role in the ferocity of the advance) on the other hand is a “confirming” move, but we suspect that the Japanese stock market has some potential for marching to its own drummer, at least over the medium to longer term.

As a final remark, although we plan to discuss market sentiment in more detail on another occasion, the Rydex bull-bear asset ratio has just closed at a new all-time high again. While it has only slightly exceeded its previous highs, this is worth noting because the market started at least a short term pullback every time a new high in the ratio above the 18 level has been reached this year (this means more than 18 times more Rydex assets are currently in bull and sector funds than in bear funds).

Charts by: StockCharts