1) BIX relative to SPX – looks suspiciously like the S&P500 financials are setting up to outperform the broader index. The trend break in the RSI is one prerequisite that has been checked recently:

Trying to reason how this might work requires a bit of imagination – US financials benefit from the flight of capital from Europe and China into the USD perhaps? The flipside is that materials and exporters take a hit by this same rise in the USD. Alternatively, the Fed is playing a game of cat’n'mouse and will in fact unleash QE3 in January (as consensus would have us believe).  In any event, it doesn’t mean that the market as a whole is about to head higher does it…

2) Market breadth – which leads us to a quick look at recent trends in market breadth. Following is a chart of market breadth capturing those hectic days of late 2008 and early 2009:

Note that during the selloff into the March 2009 lows, breadth began to signal value investors were entering the market as early as December.  First, the NYSI created a small divergence into a new low. Next, the NYSI broke its relative downtrend as the market rallied out of this low. Finally, as the market plunged into the capitulation selling, the NYSI flashed that a valuation floor had been found.

Now to a glimpse at how the NYSI is behaving today – the recent low gave us a small divergence – which has duly been followed by a relatively healthy rally. The question from here is how breadth will respond should we get the deeper selloff that seems so near to hand.

One of the more remarkable features of the first phase of the crisis was that banks were permitted to roll their problem assets. Through the magic of mark-to-market accounting, the system was able to buy time and often times induce enough investors to stump up for tranche 1 of the recapitalisation. But it was always a finger-in-the-dyke solution.

The European sovereign debt crisis has called time. While markets have long ignored the flagrant abuse of the Maastrict Treaty at al, something broke over the last two months and the herd is now running scared.

The key problem is that the leverage in our banking system is based on collaterallised lending. This global pool of collateral has been bid up by decades of credit expansion. At some point the suspension of disbelief that this virtuous cycle requires becomes impossible to sustain. Total leverage relative to cashflows – rather than collateral – is too high. At this point, the banks find themselves in a prisoners dilemma.

And so we arrive at today, where the European banks have broken ranks and have begun a firesale of assets. While quick exits often prove profitable for the buyers, history is pockmarked with examples where the resultant lower asset prices have a disturbing ripple effects on markets.

It is this uncertainty that investors of all shades and hues have to contend with. While the bear market rally from March 2009 failed on declining volumes, there is a strong liklihood that the current selloff will be joined by volume selling as the flight from all but the very safest collateral goes mainstream.

From a valuation perspective, it is likely that this widespread weakness is throwing up opportunities to accumulate specific stocks. But until we start to see market breadth strengthen into weakness, the odds remain with the bears for the broader indices. Watch for government intervention in some form or another as the most likely catalyst for a rebound when the time comes.

Exhibit 1 – The downdraft has been accompanied by high volumes. It could be argued that this is capitulation by the weaker hands, but for mine we haven’t traded low enough to attract ‘value investors’ (witness Jeremy Grantham’s latest tome – S&P 950). Rather the volume selling suggests that this selloff is different relative to last year’s correction.

Note too, that momentum is still reeling from the severity of the fall. Given the damage done to confidence and level of uncertainty in the market, it is likely that we will at least revisit the recent lows. Watch to see how the MACD responds should this eventuate.

Exhibit 2 – An old favourite, the McClellan Oscillator that measures market breadth has completely broken down. Again, we’d expect to see a divergence in this indicator when investors are starting to accumulate on market weakness:

At the risk of repeating myself, the playbook we’re following is one where we take our lead from government stimulus. Negative real interest rates are not sufficient in a deleveraging market. That is why QE3 in whatever disguise is more likely than not and also why Japan, the UK and any other sovereign state with their hand still on the monetary tiller will follow suit. In the absence of fresh stimulus we’ll wait for signs that the market has exhausted it’s selling impetus before leaping into the void.

Last time we looked at this chart (1st June here), equities were about to dip lower. Now with the European mess behind us, equities have all but recovered that lost ground. It’s just that this has been achieved with fewer and fewer stocks pushing higher relative to their more pessimistic siblings. Declining market breadth suggests a lack of conviction in the most recent recovery.

So will the inevitable resolution of the US debt ceiling debates clear the way for broader participation – and maybe even new highs in the S&P500 index? Perhaps – though maybe the markets have overestimated the ability for politicians to amicably resolve the issue. In any event, without a meaningful break higher in market breadth, we’ll be waiting for the return of the government stimulus machine before adding meaningfully to long positions.

You’d think that weakness in the China growth engine would be reflected in commodities prices – but the charts would suggest otherwise.  Consider that bellweather of commodity demand – copper:

Apologies for the somewhat crowded chart, but it’s interesting from a few perspectives – starting from the top:

1) The copper price has rolled off its highs but has materially lagged the selloff in Chinese equities. As we have discussed previously (most recently here and background here), the Shanghai Composite has been led down by the resources and financials sectors. Eyeballing the relative price movements suggests that equities tend to lead the copper price – particularly at turning points.

2) The copper price has been diverging from equities since the start of March. With domestic tightening leading to unwinding of copper inventories in China and difficulties in its property development sector, it’d be reasonable to expect copper to follow the equities markets lead rather than the reverse.

3) I’ve included the RSI for copper to illustrate that the price could fall someways before becoming oversold by this measure. Notably, the MACD looks to be crossing over again – suggesting that momentum is turning against coppers price.

Finally, and in some ways following on from yesterday’s post about the impact of the investor class on commodities prices, consider the following chart that maps US equities against the copper price.  For mine, the correlation says a lot about US monetary policy, its impact on investors, and the resultant movement in the copper price.

So you’ll understand my intent when I say “it’s different this time”. No really, it is. Consider the following chart of the VIX and credit spreads (as measured by the AAA to Baa spread on US corporate bonds):

To explain – we are going to compare the end of QE1 in March 2010 with the current environment. The numbered inflection points provide the backdrop;

(1) The VIX made a low of 15.73 on 20 April 2010 (all prices are at the daily close) – while the S&P500 made its high on 23Apr10.

(2) The VIX high of 45.79 was recorded on 20 May 2010 – the S&P500 made a low on 2 July 2010.

(3) The VIX registered a low of 14.62 on 28 April 2011 – the S&P500 reached its high on 29 Apr 2011.

This all seems pretty consistent – the VIX leads the S&P500 by a day or thirty. So what if we haven’t actually finished with QE2 yet? We all know what happened next – seems reasonable that the exits would be rushed a little sooner this time.

Then what to make of the CBOE put/call ratio? It’s been trending higher since Christmas which is hardly consistent with previous instances of extreme bullishness before the fall.

If anything, volumes suggest that it’s contracting demand for calls that has been dragging the ratio higher. While this indicator is a bit of a blunt tool, as it says nothing about the shape of the volatility smile nor the nature of options being exchanged, it does clearly indicate that volume is on the wane.  This is a trend reflected in NYSE volume incidentally.

In any event, while the VIX may be an imperfect measure, it does have form in anticipating turning points. This is the reason why we keep an eye on the following charts:

Note the same inflection points as noted earlier.  At (1), the S&P500 as implied by the VIX, failed to confirm the actual indexes high, and the actual index promptly sank 200 points. And (2), following the low in the VIX in May, the implied S&P index marked out a long positive divergence against the actual index – which ultimately followed it higher.

So we get to the more curious current events. Not only did the S&P500 as implied by the VIX make a new high on 19 May 2011 well after the high in the actual, the implied has failed to make any new low on the downside with the most recent weakness.

Now maybe this divergence is simply indicating that this measure is broken. It’s a reasonable argument – that QE has distorted option market activity by encouraging the selling of ATM risk while buying the wings. Maybe. But it never hurts to have an open mind…

At least, we can’t argue with the statement ‘it’s different this time’.

To my way of thinking, weakening breadth is a reflection of progressively more companies bumping up against valuation constraints (that is, individual share prices are becoming stretched relative to expected earnings).

If we look inside which sectors are leading the US markets higher, it becomes apparent that those companies that benefit from a weaker US$ are outperforming – energy and commodities stand out. Still we can’t argue with the performance of the market as a whole:

This got me thinking once again about the transmission mechanism for QE. The Fed has been keen to emphasize the ‘portfolio balance channel’ (see here for how the POMO works). But as we have argued before there is another aspect to promoting ‘financial conditions supportive of recovery’ – the decline in the USD (for a summary of the argument see here). In that context, contrast the gyrations in the US$ with those in breadth:

When the US$ is rising, breadth tends to fall and vice versa. Perhaps there are two forces are at work here:

1) Earnings of at least some US companies are materially effected by changes in the US$.

2) The attractiveness of US assets to international (non-US denominated) investors will vary with changes in the US$

So what has this got to do with China? I’m glad you asked. Please consider how breadth on the NYSE is tracking relative to the Shanghai Composite index:

All smoke and mirrors perhaps, but the swings and roundabouts in the Chinese index do seem to have a strange bed-fellow in the breadth of the US equity markets. Is this an outpouring of the same US$ effect that we noted above. Seems reasonable – given that 1) China runs a peg against the US$ and 2) China is an export driven economy.  But equally, the US$ effect may have found expression in the same commodity trade that has taken the world by storm – this would be consistent with the anecdotal evidence out of the commodities markets there.

As always it is not a simple matter to get some hard facts on the relative sector performance in China (check out the Shanghai Stock Exchange website here). But that won’t stop us – I guess it is remiss of me not to have sought this out before…

Comparing the recent price action of the VIX to that of the S&P500 suggests that option traders have not anticipated the recent price weakness in the equity index. The markets complacency can also be gauged by the CBOE Put/Call ratio that looks suspiciously like it has recently bottomed driven by buying of calls:

This implies that we can expect volatility to be bid up in the near term – probably accompanied by more downside for the equities markets. In any event, we’ll watch how the VIX responds as it has a reasonable track record in anticipating support when it comes.

For a discussion of what the VIX derived forecast is etc… click here and here.

Volatility has now officially joined the QE trade – as near term vol has been sold aggressively (as noted at Merrill Over Matter):

Very few things in the markets are absolute certainties. But that hasn’t stopped the Fed from trying. What was initially $300bn in Treasury purchases over the next 12 months (on the back of MBS repayments) has quickly become $1.3 trillion. Multiply this by a factor of ‘x’ to take account of the market front-running the Fed, and we have one hell of a wave to wash through risk markets.

I can’t help thinking that man wasn’t meant to play God. Isn’t this what got Dr Frankenstein into all that trouble?