Technical problems prevent us from posting the usual PDF this morning, so the report is in this post only.

The Precise Take – Was the poor 2 Year auction yesterday a head fake?  Asian-led weakness overnight.

As we updated yesterday:

Gold materially down from resistance and 30 yr/10 yr holding support today give a bearish tilt to the market’s direction this week and are forecasting successful Treasury auctions.  Also, the EuroYen forex cross, as a barometer of risk, has also materially corrected today in a bearish engulfing candlestick pattern. 

Accordingly, the most likely scenario this week that we envision is a down day today, up day tomorrow into the close because of POMO, retest of highs either by end of tomorrow or early Thursday, then heading down again into Friday close, with the markets attempting to find support and continue the rally sometime next week.  If we can reach new highs by early Thursday, then we could easily see another short covering rally into the 1008 target zone by Friday close; however, this is the less likely scenario.

 Though this was at 10:44 am, before the 2 Year auction, we see no reason to alter our forecast as overnight trading in Asia has led the ES lower.  Also, as we wrote yesterday:

[Wednesday] and Thursday of this week are back to back days in which the Federal Reserve Bank of New York (FRNY) will be conducting permanent open market operations (POMO), which will flood large banks with leveragable liquidity at about 11:00 am on each of those days, and which has an end of day tape-painting effect.  … [Wednesday] we would also expect most gains to be into the close.  And, though there have been only 6 prior back to back POMO days (all since May), the bullish edge appears to disappear on the second POMO day, which would be this Thursday.  Accordingly, swing longs may want to close out positions by tomorrow (Wed) as opposed to waiting for the close on Thursday.

The end of day paint-taping on POMO days has been remarkably consistent, so our primary scenario will be in jeopardy if, by 3:30 pm, the ES is above yesterday’s point of control and long term point of control in the 973.00 to 973.25 area.  Above, and the ES will likely be able to push through critical 980 resistance by close and will hav the 1008 target in sights.  Below, and we will likely only retest highs and head down into Friday.  The next point of control is at 948.75, so that seems a reasonable target.

The 5 Year auction is at 1:00 pm today, with 10:30 am (petroleum) and 2:00 pm (Fed Beige Book) as other report release times to monitor.  Though many would say that forecasting the results of a Treasury auction is a mugs game, as we suggested in the lead of today’s report, leading indicators are pointing to successful auctions for the 5 Year today and 7 Year tomorrow.  If we are wrong, we expect to see 1008 soon.

As we write, Durable Goods at 8:30 am was below expectations.  The critical area today is 973.00 to 977.75, which includes the points of control mentioned above as well as the daily pivot/gap area.  We’re bearish below and bullish above, willing to fade long only at the daily S2′s at 959.00 to 960.50.  Fading short in the bullish area today is too risky for us so we won’t fight a bullish trend above 977.75.

Thanks for all the responses to Sunday’s post on M2 Volatility and the potential consequences to the markets over the next three years.  A few follow up points based on reader questions:

Q.  Are you advocating shorts instead of longs now? 

A.  No, we are not advocating any positions based on this phenomenon.  #1, Heightened M2 Volatility is not a precise timing signal, only an indication of a probable eventual decline and probable increased volatility in the next three months.  #2, We monitor the markets on a daily basis and will alert if and when we see a top forming.  If equities posted their top yesterday, one day after our report, that would simply be a coincidence.

Q.  Then why issue such a dire warning?

A.  We feel the greatest damage will be done to inexperienced traders and passive investors who only exit the market after experiencing significant losses.  This, in turn, can damage market functionality as money heads elsewhere for a protracted period of time. 

Q.  What is your advice to experienced traders?

A.  We simply recommend giving more weight to distribution days.  Tighter stops may not be feasible because of expected greater-than-normal volatility.  So, selection criteria (for stock pickers) is critical.  For day traders, don’t get caught on the wrong side of the market because we expect ranges to widen.

Q.  Do you see any similarities to the 2001-2002 bear market?

A.  Yes, and unfortunately, it looks much worse now.  The July 20 01 low in M2 Volatility (yellow in the chart below) was a higher low than the previous year, and the higher high in M2 Volatility in the week ending September 21 01 (which coincided with the spike low in the S&P 500) was the end of the broadening wedge in M2 Volatility that began in 1995.  The next year, the three month period following the July 19 02 low in M2 Volatility (which still had a high 12 month range), coincided with the low of the bear market in the week of October 11 02, and M2 Volatility from then on contracted into until about mid-2006.  By mid-2007, it was apparent that M2 Volatility was again increasing, and we had the high in the three month period following July 20 07 (after a steep drop into mid-August 07).   Presently, M2 Volatility is still broadening, making new record highs and new lows.  Though the study by itself did not imply causation, if you believe (as we do) that M2 Volatility causes crashes and is not merely correlated with them, the effect of record M2 Volatility on markets should be greater this year than in any other going back to inception of weekly M2 data in 1981.

10:44 am EDT:  ES is testing yesterday’s lows after a worse than expected Consumer Confidence report.  We’re willing to short between 975 and 977, but if the ES cannot get back above 973.25 soon, we could easily head down to the next support area of 962.75 to 965.25, at which we would fade long with tight stops.  We’re not outright bullish until the ES can again get above 980, which we think is unlikely today.  Watch price action around the 1:00 pm Treasury auctions because a disaster (unlikely) would be enough to turn equities bullish.

Gold materially down from resistance and 30 yr/10 yr holding support today give a bearish tilt to the market’s direction this week and are forecasting successful Treasury auctions.  Also, the EuroYen forex cross, as a barometer of risk, has also materially corrected today in a bearish engulfing candlestick pattern. 

Accordingly, the most likely scenario this week that we envision is a down day today, up day tomorrow into the close because of POMO, retest of highs either by end of tomorrow or early Thursday, then heading down again into Friday close, with the markets attempting to find support and continue the rally sometime next week.  If we can reach new highs by early Thursday, then we could easily see another short covering rally into the 1008 target zone by Friday close; however, this is the less likely scenario.

Another thing we’ll be watching today is the shaded light gray box under the current price.  The dotted green line (std dev 1 of VWAP anchored from July 13 09) has contained the ES pretty well since the start of this mini rally and a material breach would likely signal that a correction will finally get underway.

The Precise Take – Slight weakness into significant Treasury auction day

The short term and TIPS Treasury auctions went well as expected yesterday, with the first test of the real demand for medium term Treasuries today at 1:00 pm with the 52 Week and 2 Year auctions.  We’re still looking for leadership clues with gold trying to break through 61.8% resistance or reverse to the downside off this level, and similarly a break in 10 year notes and 30 year bonds of support or a reversal to the upside, with none of the three moving materially since yesterday.

Tomorrow and Thursday of this week are back to back days in which the Federal Reserve Bank of New York (FRNY) will be conducting permanent open market operations (POMO)*, which will flood large banks with leveragable liquidity at about 11:00 am on each of those days, and which has an end of day tape-painting effect.  See page two for time profile graphs of what can statistically be expected for today, tomorrow and Thursday.  There is a tendency on a Pre POMO day, such as today, to front run the expected liquidity injection into the close (3:30 pm to 4:15 pm).  Tomorrow, we would also expect most gains to be into the close.  And, though there have been only 6 prior back to back POMO days (all since May), the bullish edge appears to disappear on the second POMO day, which would be this Thursday.  Accordingly, swing longs may want to close out positions by tomorrow (Wed) as opposed to waiting for the close on Thursday.

Today is a moderately full news day with the times to watch as 9:00 am, 10:00 am and 1:00 pm.  With premarket action in the ES getting down to daily S1 (day-session-only) and below yesterday’s highest value area point of control, we have a bearish bias.  Longs will need to get above the daily pivot/gap area of 976.25 to 980.00 to regain…

Continue reading here.

10:58 am EDT:  …Accordingly, we are only looking for shorts unless and until the ES gets back above the daily pivot and point of control at 973.00.  We’re also willing to fade long in the 963-965 area with a tight stop as it looks like we won’t have a large directional down day.  Below 962.00, however, selling could accelerate, so we’ll again only look for shorts below there down to 949, which is very unlikely to be reached.

Be careful around the 11:30 am and 1:00 pm EDT Treasury auctions.  Should be no surprises, but a surprise would move all the markets forcefully.

We said in the morning report we would be watching gold, 30 year bonds and 10 year note futures.  Though each has pierced the critical support or resistance area, they have each reversed into neutral territory, so we have no signal from them yet.

Update:  11:00 am corrected to 11:30 am above

The Precise Take – New highs overnight into critical week of Treasury auctions

This week, the massive Treasury auctions take center stage and, as we reported last week, will likely determine the rally’s life.  Excellent demand for Treasuries, as we had last month, will likely kick off a correction, while tepid demand will likely provide the inflationary fuel to set new highs.  A mediocre showing allows other factors to determine.  Also closely watched and anticipated is the first edition of Q2 09 GDP this Friday at 8:30 am.  Today, we have the 3 and 6 Month auctions at 11:30 am and 20 Year TIPS at 1:00 pm.  Because the former are short in duration, we do not anticipate week demand and are instead looking ahead to the 52 Week and 2 Year auction tomorrow at 1:00 pm, with the 5 Year on Wednesday and 7 Year on Thursday.  As to the TIPS auction today, we also do not expect demand problems because they are inflation linked and demand has been historically strong.  Of course, any upset will be seen as a bellwether for the upcoming auctions.

We regained our short term bullish posture on the breakout of the 957.50 high last week and will remain bullish, even at overbought levels, until price action or market leaders tell us differently.  However, we are increasingly sensitive to corrections and will pay special attention today and tomorrow to gold, 30 year bond and 10 year note futures, which are each at levels from which they will likely reverse sharply or break through strongly to test old highs or lows.  Gold has been testing the 61.8% resistance from its early June highs and broke through slightly overnight, but has since retreated.  A strong push through is bullish for equities as it is indicative of inflation expectations.  The 30 year is at its 61.8% support from June lows and the 10 year at 50%.  A break down is also bullish for equities and a reversal is bearish.  The success or failure of the auctions this week could be broadcast in these instruments first, and we will update accordingly (register for free notifications and updates here).

As if it were not tricky enough this week, the Federal Reserve Bank of New York (FRNY) will be conducting permanent open market operations (POMO)* back to back, Wednesday and Thursday, which will flood large banks with leveragable liquidity at about 11:00 am on each of those days, which has an end of day tape-painting effect.

After testing daily R1 overnight (high of 984.00), the ES is heading below Friday’s settlement of 977.75.  We don’t become bearish intraday until 972.25 is broken, but are willing to fade long key support at…

Continue reading here.

In response to our previous post and chart on this topic, several people asked for a statistical analysis to accompany the graph.  Hopefully we’ve enhanced the explanation and can issue a proper warning, which, after thorough historical analysis, seems all the more warranted.  We will be developing and expanding on this post in the weeks to come, but submit the following background and preliminary findings:

Background and Summary Findings:

• M2 is the broadest form of money supply currently reported by the Federal Reserve and we have found that large changes in it (what we call M2 Volatility) coincide with stock market volatility and significant price corrections in a critical part of the year–the third week of July to the third week of October.
• M0, the monetary base, though more commonly touted by economists, does not appear to be a good predictor of stock market volatility or of potential stock market corrections (data to be presented in the future).
• Specifically, we use M2 non-seasonally adjusted (NSA) because we have found that the very seasonality (volatility) that the Federal Reserve attempts to remove from the data is what is most correlative with stock market volatility and corrections.*  The Fed publishes M2 NSA along side M2 SA for all to see, so there is no conspiracy–they are simply a bit short-sighted in stressing M2 SA.
• As M0 and seasonally adjusted data are the norm, we believe this analysis is important because it addresses a potential hazard to stock market prices heretofore not widely addressed*.
• Based on an analysis of M2 Volatility in the three month period commencing the end of the third (approximate) week of July and into the third week of October for the past 28 years, we believe that this year, 2009, (1) there is a significant chance of a large (average ~17%) eventual correction as measured from the close of July 17 09, (2) there is a significant chance of increased volatility as measured in percent price range over the period (average ~20%), and (3) that, based on M2 Volatility, equities are in a more precarious position than last year at this time, which experienced a 33.38% loss in the corresponding three month period.

Explanation of graph:

• At the top of the above graph, in the first subgraph is the S&P 500 cash index going back to late 1981 with M2 plotted in cyan, with its 13 week (one calendar quarter) moving average. Weekly data for M2 goes back to January 1981, though monthly data (not usable for our purposes because of low resolution) goes back to 1959.
• The yellow indicator in the second subgraph (M2 Volatility) is the percent change of M2 from its value 13 weeks prior.  The yellow trendlines were hand drawn and show secular trends in the broadening and  contracting of M2 Volatility. Note the percent change is not annualized.
• In the third subgraph are the 12 month (bright red) and 6 month (dark red) ranges of basis point (bp) swings (divided by 100 for presentation purposes) in 13 Week % Change M2.  Basically, they represent the 6 and 12 month range of M2 Volatility.
• In the bottom subgraph is the 10 year US T-Note yield minus the 13 week US T-Bill yield (the 10 Yr – 13 Wk spread), which is one of the simplest representations of bank lending profitability.  The greater the spread, the more profitable it is for banks to borrow on the short cheap end and lend at the more expensive long end.

A closeup of the above graph of the last five years only is here:

Preliminary observations:

• It is immediately apparent that M2 13 Week % Change (M2 Volatility) has been broadening since mid-2006 with higher highs and lower lows.
• As of last week’s M2 figure (reported July 23 09 at 4:30 pm), the 12 month spread (bright red / third down) reached its highest level (674 bp / 6.74 percentage points) going back to 1981.
• There is an approximately quarterly periodicity to extremes in M2 Volatility (yellow).  This lends credence to the theory that money supply tends to exert its influence in three month increments.

Looking further at the quarterly periodicity of M2 Volatility (yellow), most years tend to display the same temporal pattern of peaks and troughs as the previous years.  Eventually, however, the pattern breaks, the relative importance of which will be researched in the future.  In general, the spikes tend to occur in the last week of December/first week of January, the third week of April and the third week of July, with April usually up and July usually down.  There is a notable absence of any regular high or low in M2 Volatility in October, as might be expected at this quarterly mark.

The periodic spike up in the third week of April appears to be particularly important because if M2 contracts too much over the summer into the third week of July, there is a tendency to have a correction in the S&P 500 going into the third week of October. Because we are now closing the third week of July and because most major market corrections are underway into the third week of October**, we will be looking at this three month period exclusively in this report.

Data:  The above graph is 1981 to present, as before, but marked with vertical lines to show the third week of July spike low (red) and the third week of October (gray).  Data from the graph was exported to a spreadsheet for further analysis and to identify key thresholds.   

Analysis:  In the 28 year sample, at the beginning of the three month period commencing at the end of the (usually) third week of July, a (1) 13 Week % Change in M2 (M2 Volatility) (4th column) less than 0.2% along with (2) a 12 month M2 Volatility basis point (bp) spread (6th column) of 320 or more , has coincided nine times with declines of 9% or more measured from the close of the weekly bar at the beginning of the period to the low set in the following 13 weeks, with the average decline being -16.69% [stdev 10.39%, n=10] versus an average decline for other years of -4.12% [stdev 3.79%, n=18].

Two failures were 1) a false positive when the three month period in 2006 met these parameters but had no low that was lower than the close of the beginning week, and 2) a false negative when for the -15.72% decline in 1981, which had a beginning 13 week M2 Volatility of 1.08% (materially greater than 0.2%), but did fit the second criterion, having a max 12 month bp spread of 358.

For the three month periods that did not fit the two criteria, there were average gains of 7.07% [stdev 6.61%, n=18] versus average gains of 4.76% [stdev 4.79%, n=10] for those that did.

The 12 month bp spread of M2 Volatility set for the week ending July 17 09 is an all time high and the beginning M2 Volatility was -1.04%, the second lowest after the July 21 2000 -1.44% reading.  The one saving grace of this period is perhaps the 10 year-13 week Treasury spread of 3.49%.  The largest loss during the three month period with a Treasury spread greater than 3.00% was -8.74% in 1982 (which also had a 24.89% gain), with an average loss of -4.69% [stdev 3.08%, n=6] and average gain of 9.48% [stdev 10.98%, n=6].

When the beginning 12 month bp spread in M2 Volatility was greater than or equal to 320, the average percent range of the S&P 500, or what could be characterized as price volatility, from high to low in the three month period (range / price at beginning of period) was 19.25% [stdev 10.05%, n=13] as opposed to 11.05% [8.13%, n=15] for other years.

Conclusions: Two caveats with respect to the data are: (1) the sample size is small and the average gains/losses are often with the standard deviations, and (2) the boundaries chosen in the two parameters to coincide with 9 of the worst declines are a bit arbitrary, so measurements at about the boundary areas could probably go either way.  What is clear is that we are in no way close to the boundaries for the current three month period in 2009.  And, while the data presented here do not imply causation by themselves, they do confirm correlation of M2 Volatility with stock market prices. 

What we might expect is not only a large eventual correction (ranging in the 9.33% to 33.38% [avg:  16.69%] experienced in previous years), but also a wide price range over the next three months into the third week of October (avg: 19.25%) .  So, while prices can certainly climb higher, there is great danger that all but the most nimble traders or long term investors (with no stops) can be eventually shaken out.  Much of the retail money that left the equities markets last year was permanent, and a second year of thrashing poses an even greater threat to the long term health of the markets.

Further, we noted the possible saving grace that Treasury spreads are high now, which can induce banks to lend and support equity prices.  However, the Fed’s new ability granted by Congress to pay interest on excess reserves held by banks at the Fed can easily erase this potential benefit, and further studies on actual lending activity are warranted.

______________________________________________________

* Thanks to Robert Wenzel, editor of EconomicPolicyJournal for suggesting the use of M2 non-seasonally adjusted as opposed to seasonally adjusted, and for noting the similarity of contracting money supply in 2009 versus 2008, which was the impetus for this study.

** Robert Wenzel points out this is because, “it is the period of great consumer intensity away from savings and toward consumption. New school clothes, winter clothes and preparation for Thanksgiving and Christmas. From mid-August to December, October is at the vortex of a shift toward consumer buying, away from savings–which includes stock liquidation.”

NQ Bank and XLF financial ETF off horizontal resistance and KBW off 200 day moving average (which also stopped it on Jul 15 and 16).