Planet Yelnick

Dollar Firming After G20 Failure Signals Market Reversal

G20 was a dud. The US went to the G20 to try to avoid a competitive devaluation of currencies yet redress trade imbalances, and got pushback from the Germans, among about everyone else, for hypocrisy, given how QE2 will act as a large currency devaluation regardless of jawboning about trade imbalances. When we faced a mercantilist threat from Japan in the '80, the US was able to coordinate a halving of the Dollar's value with cooperation from Germany among other trading partners. Not this time. 

While the initial reaction was that this meant a continuation of the trend since late August - Dollar down, everything else priced in Dollars up - a series of reversals began late Monday. The Dollar appears to have caught a bottom. I posted on the same theme a week ago, but the break of the Dollar at that time looked like a short squeeze, and after a sharp spike, fell back into the trading range since late Sept. That marked it as a False Break, which under Fractal Finance puts us into a wait-and-see mode for the next move.

Some pundits such as the STU expected the Dollar Index to continue down, retesting and even breaking its recent low (76.14), but a funny thing happened on the way to the retest: the G20 failure. The Dollar Index bottomed above the recent low, and has now run fairly well up above 78, approaching the 78.36 level of that short squeeze false break. If it breaks above, the STU believes it pretty well confirms the Dollar has bottomed. 

It may be a bit premature to jump to that conclusion, given the uncertainty surrounding both the mid-terms and the Nov3 Fed QE2 pronouncement. David Petch does an in depth technical analysis of the USD, and in contrast with the STU thinks we have a fake out rally for several weeks and then continue down. His chart shows his wave count and the recent trading rnage of the Dollar Index around 77:

To add a third pundit, Neely expects a several-week Dollar rally and Euro weakness, but not a change in the Dismal Dollar trend. And to add a fourth, here is a longer-term Dollar chart as of last week, which this commentator took as bullish:

My take: along with the pundits, the forex market is now confused as to the Fed's intentions, following the failure to get any coordinated approach out of G20. Goldman first speculated that QE would be $2T, and more recently said $4T for the Fed to accomplish its purpose. They also say it is unlikely the Fed would announce even a $2T program. Instead, what has been pre-announced is $100B to start and then play it by ear. 

Besides the Dollar, however, we have other reversals, starting with a (momentary?) end of the slide in bond yields. This has impacted the possible Dollar bottom; or is correlated to it. A few weeks ago the differential between rates in Euroland and the US were favorable to the Euro, but the gap is closing. The market may be expecting the ECB to monetize in order to prevent a slowdown, or perhaps has priced in any expected ECB rate increase. In either case, the Euro rise against the Dollar has reversed for the moment. 

Perhaps US bond rates have bottomed. Bill Gross of PIMCO made a splash today repeating his theme that the 30 year bond market is over and trash-talking QE as a ponzi scheme that won't work. Bespoke notes how the Long Bond broke support in the last two days, contradicting the argument among bond traders that the bond trade can't lose! because either the economy strengthens, and the Fed keeps rates low; or the economy weakens, and the rates stay low. 

PIMCOs argument is based on QE causing inflation. Not clear it will, as I explored in my prior post; and as noted above, Goldman thinks at least $4T would be required to spur a 2% inflation. Yet an indicator of future inflation gave a stunning signal this week: the inflation-protected TIPS bonds went to a negative interest rate for the first time:

At first glance paying a negative rate may strike you as dumb, but TIPS are instruments which gain in principal depending on the CPI (see table). They can make up for a negative interest with an increase in principal. The spread between the TIPS and the Treasury of same length is the inflationary expectation. Currently the negative rate of -0.55% means the bond market is expecting 2% inflation - spot on the stated intent of the Fed. 

The five-year TIPS had briefly gone negative in August, and has been trending around zero since mid-September, but this dip to 55 bp under raises an interesting risk for investors: if the economy remains weak and inflation does not re-emerge, you will end up paying the government to hold its bond. Given how uncertain are both QE2 and its impact on inflation, this seems like a poor bet. 

PragCap makes an even bolder argument: that QE is DOA already, even before it has been launched. The 10-yr Treasury has only moved 34 bp since the QE2 was first rumored back in early August. Since Bernanke's Jackson Hole speech at the end of August, rates haven't moved! 

The implication is really nasty: QE2 would inflate commodities, meaning the inputs to production, but not cause inflation in prices, the output. Instead of restarting production, it will force it into margin compression. We also saw this in the Great Depression. Rather than helping get us out of the mess, it will push us in even deeper. 

If QE2 Flops, Will Stocks Dive?

There is a general belief that the pre-announcement of QE2 in late August drove the September-to-Remember rally. The market is in a sloppy, overlapping wave action seems to be somewhat headed higher pending the mid-terms on Nov2 and the expected QE2 announcement on Nov3. This indicates it is churning ahead of those events. It is beginning to take the shape of a converging wedge or ending diagonal, although it is not following the rules, according to the STU. Perhaps it gets to 1220 or thereabouts in a final thrust, but it is behaving as if it will hold up into those dates. If so, we may have a double setup for buy-on-rumor, sell-on-news.

I have already discussed how a Repub victory would likely lead to gridlock, and gridlock may not portend well for stocks. Mad Hedge Fund Trader goes further and characterizes gridlock as a market myth. When the Repubs embraced supply-side economics (aka voodoo economics) in 1980, gridlock with a Demo Congress/Repub President created a dynamic of increasing spending, eschewing the balanced budget, as shown in this chart. Milton Friedman had argued that large deficits would constrain spending increases, and Congress proved him wrong. Bush 42 began to reverse the deficits, and this continued under Clinton, especially after the Repubs took the House in 1994; deficits decreased and we got the fabled balanced budget. Possibly, then, gridlock with an austerity Congress will constrain spending, but after 1994 we had a President willing to triangulate to the center, whereas Obama seems determined to hang onto his reforms.  

Similarly, the Fed's actual QE2 announcement is fraught with risk for stocks. There still is a debate inside the Fed as to how large and committed QE2 should be. At one end Krugman urges as much as $10T; and the other is the feeble talk of a mere $100B. If a large slug of QE2 is priced in, the actual announcemnet may disappoint.

Let's go a step deeper. Krugman's call for $10T QE is not as dangerous as it sounds. The hyper-inflationists hyper-ventilate that this is simply printing money! Yikes!

They need to get a grip. It may very well be that even Krugman's QE would have little effect. John Hussman, coming from a very different perspective, essentially agrees. He starts with the impact of being in a liquidity trap, captured in this chart:

Cutting through the fairly dense econo-speak that surround the concept of a "liquidity trap", what this means is at zero interest rates, a short-term bond is the same as cash. Get a bond that pays no or little interest; why not just get a batch of currency? So when the Fed engages in QE by buying bonds, it is not so much printing money as simply swapping a bond that would have issued anyway for currency. 

Hussman's analysis is interesting in that it challenges the deeply held belief that increasing money is what causes inflation. He shows that as the currency base increases, velocity decreases, offsetting the inflationary impact of more money. Mish does a good summary of the analysis. The implication is that monetary manipulations have less impact than economists take for granted. This explains why QE had little effect to save Japan from its two lost decades. As Hussman summarizes:

Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short term interest rates. Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity. ...

Quantitative easing promises to have little effect except to provoke commodity hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5-10 year total returns below 5% annually). The Fed is not helping the economy - it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

Hussman is now in agreement with Krugman on the impact of QE. Credit Writedowns does a good job of comparing the two arguments:

Krugman says that the result of this equivalence between short-rates and cash means that the Fed’s QE is really just a duration change by the Treasury.  In quantitative easing, as contemplated in this next round, the Fed will be buying long-dated Treasuries. Given the preceding analysis, it’s as if the Treasury started issuing a huge slug of short-term debt and retired a bunch of long-term debt, making short-duration bills relatively more plentiful than ten-year or five-year Treasury bonds. I really didn’t think about it this way until I put the Hussman piece together with my November article.  But Krugman’s characterization of this is true. 

Hussman goes one step further, however. He has a view of what would create inflation, or the dreaded hyperinflation:

One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data, and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970′s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers).

My take: the Fed has now created an Expectations Trap: if they fail to deliver the high expectations of QE2, stocks will fall. If they do deliver and it has little impact, stocks will fall. For traders the arbitrage is between the Nov3 announcement and the discounting of future ineffectiveness of QE. 

Bullish Golden Cross to Follow Yesterday's False Break

In Fractal Finance, when a break comes out of a trading range, then reverses back in quickly (relative to the length of the range), it is a False Break. Yesterday the Dollar continued an upwards break, but today fell back into last week's congestion zone. The S&P did the same in reverse. Under wave theory, what looked like the start of five-wave impulses in both indexes turned into three wave zigzag (sharp) corrections, as you can see from this chart by Principal Analysis:

The S&P had done a triple top in the e-mini futures but only a double top in the cash index, so a third retest is underway. If we break above the trading range, under Fractal Finance this is very bullish.

Another bullish indicator is the Golden Cross, which now is inevitable:

According to Traders Narrative, the Dow had the Golden Cross on Oct 1, and the Naz is also about there. We had a Death Cross back in June, and it proved to be of little importance. In general I do not give much credence to these crosses, but they are interesting to the extent they create momentum among traders who do follow them. 

The bears are running out of things to hang on to. It is close to the kickoff of the seasonal strong period (Nov-May) when bears should go into hibernation. The bears can point to the S&P triple top, and to the reversal today not retracing all of the break yesterday. This bearish wave count is best put in this chart from the site which sounds like a Euro luxury car, gi61et:

Here is a chart of same not-quite-all-the-way retrace in the Dollar Index (courtesy Contrarian Advisor): 

For those of you who like to fade Prechter, tonight's STU became short-term bullish, or perhaps more precisely, short-term on the sidelines. They read the false breaks in both the Dollar Index and the Dow/S&P as corrective waves, and therefore expect a final wave to come to retest or even break recent levels (below 76.14 in the DX). It would take another reversal back up above the 78.36 high in the Dollar Index to change this. Yet they remain agog at the bullish extremes in stocks - levels above both the April high and the Oct 2007 high.  Some sort of stock correction is overdue, although it appears it will wait for the Dollar to bottom. 

Those sentiment extremes came a couple of weeks before the actual top. This would suggest any clarity will await both the Nov2 mid-term election results and the Nov3 expected launch of QE2. The Repub's taking back the House seems in the bag, with around 55 seats likely to switch. Another 44 seats are contested ("99 seats on the wall" was the quip by Politico.) If the 44 split evenly, the power reversal will be historic. The Senate seems too close to call, with a gain to 49 seats likely but getting to 51 seats (necessary for control) problematic. As a consequence, uncertainty as to the future political climate remains an issue. The launch of QE2 is pretty well assumed, but the scale and timing are uncertain, and may be influenced by the Q3 GDP report on Oct29.

Neely expects an imminent strong up move in stocks to complete wave 3 of the final five-wave C. Target would be 1200. After that comes the overdue correction, but not an end to the upwards trend. The interesting site TradeYourWayOut has a bullish view which points to a top in March 2011, but first they expect the overdue correction:

Dollar Reversal May Unwind The Presumptions Behind the September to Remember Rally

The Dollar has continued the break up since Friday. The reversal has been strong and has all the earmarks of a short squeeze. As I noted a few days ago, the net short position was quite large. This chart from Credit Suisse shows how deep the Dollar bearishness got:

The break up has formed a nice 1-2-3 pattern, which under ewave suggests it has more to run in wave 3 and beyond. It has also bifurcated out of the recent trading range, which under Fractal Finance means we have a trend change, unless it reverses quickly back down. The STU yesterday was written by Peter Kendall, who has a different style than Steve Hochberg who normally writes it, and as it has for several issues, it started with the Dollar. The bounce since Friday traced an initial five-wave pattern and corrected yesterday in three waves. The strong move today confirms the change of trend up. You can see the bifurcation above the recent trading range, and the turning up of key sentiment indicators, in this chart from EWTrends:

If this Dollar Reversal continues, the most immediate impact should be on commodities and gold. Oil and gold fell today. Treasury yields have reversed up in the last few days, despite the overhang of QE2.

The most interesting move today came from China, where the PBOC raised rates for the first time since 2007.  China continues to be concerned over inflation and other signs in internal overheating. Growth in Europe and Japan has been turning down, and China may follow. The global economic recovery may be topping.

Optimism still rules in stocks. Carl Futia sees a short-term consolidation before a continuation of the uptrend, targeting 1300 by April 2011. Goldman Sachs has provided their guidance, with targets of 1200 by YE and 1275 within a year:

What is noteworthy is Goldman sees continued earnings growth but fading PE, and hence less of a rise in the S&P even as earnings get back to 2007 levels. Carl's key chart also shows a triple top in the e-mini followed by a bifurcation below the recent trading range, which under Fractal Finance indicates a top, not a consolidation:

The case for bullishness rests largely in fundamentals: QE being good for stocks, and continued earnings growth. If the Dollar Reversal continues, score one for technical analysis, since the overhang of QE would not have caused fundamentalists to expect the bounce. So what about stocks?

One of the better technical indicators at a top is to watch the leaders fade against the trend. While Google popped well after their earnings, Apple, IBM and Amazon all showed weakness. Apple in particular may have been priced to perfection, and yet the reason for the drop after hours yesterday seems spurious: while revenues and earnings blew away expectations, iPad sales were lower. Being in the Silicon Valley community, it is clear that iPad missed due to supply not demand. Apple is selling every iPad they can build. Hardily the cause for pessimism. Perhaps Apple will be back on trend in a few days, but if it and the other tech leaders lag despite good fundamentals, it signals a reversal brewing.

Nowhere is this clearer than with bank stocks. They led the rise off March 2009, and were a huge percent of both earnings growth across the whole S&P and market volume. Facing all kinds of pressure due to foreclosuregate, including threats of buyers of their toxic junk wishing to put it back, financial stocks may be in for a tumble. And indeed, Shanky noted over the weekend (and I also received charts from readers via email) that the banking stocks were noticable laggards:

The bears are being cautious, but some are growling. PrincipalAnalysis thinks a big drop is next, and gives levels that would change his view: SP1177 and Dow 11068. The drop looks like a reverse of the Dollar break up, being a wave 1 down, a wave 2 correction,and now we appear to be in 3 down. The levels to watch are the wave 2 highs, which should not be broken if a big drop is right ahead:

Dollar Spike on Friday May Be the Bottom

Once a trend makes it to a major newsweekly, it is usually over. By the time the mainstream media spots a trend, it has already been fully baked into the market and is about to reverse. Historically the newsweekly is Time, although it is hardily the trendsetter it used to be. This week's issue of The Economist has Currency Wars on the cover. Does this signal the end of the free-fall in the Dollar?

I have been noting that 76 in the Dollar Index is a key level, representing the confluence of two trendlines: the down-sloping trendline of the dramatic fall this past two months, and the up-sloping trendline off the prior two bottoms. 

The Dollar Index (DX) fell to 76.14 on Friday, and then bounced to 77.13, a large move. This Sunday evening it has gone above 77.20, then stepped back a bit. When the machines come on in Europe, we may find out where the Dollar is really headed, but this sort of V-shaped bounce is what we should expect at the bottom after such a sharp fall. 

If the Dollar does bottom, it could be expected to run up towards DX100 by 2012, a strong move that would reflect expectations of deflation coming from debt destruction. Possibly the foreclosuregate scandal will lead to mortgage write-downs that spawn the debt-deflation spiral we have so far avoided. Consensus expectations remain that the Fed can prevent deflation, especially with the injection of QE. In the short run, expectations of QE may be so baked in that any slippage of resolve may by itself reverse the Buck. In the longer run, however, it cannot be presumed that QE will prevent deflation. Massive injections of liquidity since 2000 have failed to reflate, as measured by CPI or the GDP deflator. Velocity of money continues to decline. 

The argument that the Fed cannot prevent deflation is one of Prechter's core assertions going back over 10 years. I first blogged about it in 2003. You can read his argument in this excerpt from his book, Conquer the Crash. He has been way ahead of the curve on this issue. His short term update service (STU) has been focusing more on the Dollar lately than stocks, with this observation Friday:

The U.S. Dollar rally appears to be starting. The stock rally is overbought and overbelieved. The conditions are in place that makes a stock market decline a high probability. 

In the larger picture, however, the Dollar may still be doomed, which means it has farther to fall in the Dollar Index. Joe Russo provides a Big Picture view of the Dollar, using the next chart as a backdrop to several scenarios going forward. 

The chart shows the bottom (listed as green C) at the end of the Carter years, followed by the Volcker Rally into 1985 (green D), when the Plaza Accord coordinated a rapid 50% drop in the Dollar. Under Robert Rubin during the Clinton years (blue A), the Dollar strengthened until the dot-com bubble top (blue B). Since then the massive injection of liquidity by Greenspan and Bernanke has driven the Dollar down to historically low levels (red A). 

Russo views this falling wedge pattern as "no better pattern from which our financial masters of illusion could better engineer the most orderly and flexible destruction of currency." He proposes three scenarios:

1. bounce off 76, continuing a cyclical bull into 2012 (red B in the chart)
2. continued slide to 70.70, testing the recent low (red A), before the rally
3. "total destruction" of the Dollar by 2017 if we break 70.70

Whew! We found a technician more bearish than Prechter! I think what Russo is overlooking is that the US is not acting in a vacuum, and has much less leverage now then it had in 1986 (Plaza Accord) or 1971 (going off gold), let alone after the wreckage of WWII (Bretton Woods). Already economic indications are showing an effect of the possibility of QE2 driving the rapid drop in the Dollar: the Eurozone is slowing, and Japan is on the verge of recession. The developed countries therefore have an incentive to stop the Dollar slide. In effect, the US needs to coordinate debasing the buck along with the Euro, the Pound and the Yen; by debasing them together the emerging market currencies (particularly the Chinese) will be forced to rise. 

We shall see how this plays out in fairly short order, as G20 is soon to meet. My bet is the Dollar rises into those meetings and continues up into the next election. 

Gridlock May Not Be Good as Double Dip Still Looms

There is a high expectation that the Repubs take at least one house of Congress, blocking any further expansion of the Obama agenda, and leading to gridlock for the next two years. There is a general view that gridlock is good for stocks, so a post today that looked at the data caught my eye. PragCap reported on a Fidelity analysis that shows NO positive correlation between mid-term gridlock and stocks:

Large-cap stock returns during post-midterm election years have been about the same, whether or not the outcome resulted in gridlock or harmony (i.e. one party controls both houses of Congress and the White House). Small-cap stocks, meanwhile, outperformed in years of political harmony compared to gridlock.

PragCap goes on to comment that gridlock may be bad for the economy in the circumstances we are in. The next chart shows how the stimulus at least buoyed GDP during the past 18 months, and (as I have commented) once past Peak Stimulus the shrinking stimulus is actually a drag on GDP growth that makes a coming double-dip more likely (the black line is the drag from less stimulus plus less inventory rebuilding):

There is hope that the private sector can more than overcome the drag, and expectations have been that the Q3 GDP report (which is released right before the mid-term elections) would be at least flat to Q2.

In August, however, the trade deficit widened, and it acts as an additional drag on GDP growth: the change in exports less imports is a major component of GDP growth, and a wider trade deficit means it could come in more negative relative to the prior quarter. There had been an import surge in Q2 which was largely based on slightly higher oil prices plus restocking for holiday sales, so expectations were for this component to decrease between Q2 and Q3, which would have pushed Q3 GDP growth up on this component.

Now, the NYT reports that Macroeconomic Advisors has reduced Q3 GDP expectations to 1.2%, a decline from Q2's 1.6%. Calculated Risk had expected a 2% Q3, but calculates that the trade deficit will end up about the same as Q2, meaning it will not improve GDP growth, and now estimates 1.5% GDP in Q3. 

Ironically, a poor GDP report boosts the odds of QE2, which should boost stocks until they run up enough to account for the purported benefits of QE. If gridlock results in less fiscal stimulus and less effort to fix serious structural problems (unemployment, exports, bank lending), the normal rise in stocks between the mid-terms and the next election may be less than expected. 

Strike 3 For 3DTV

I have been beating up on 3DTV, and now surveys strongly support my position. NewTeeVee reports that surveys of consumer interest show only 15% interest in 3D at home, with 63% not seeing the need. In contrast, the interest in online (Internet) TV is 51% higher.

The third strike against 3DTV (after lack of content and those darned glasses) is the GoogleTV announcement, with Android-powered online TVs and blu-ray players been launched by Sony.

This launch is huge since the TV now joins tablets and smartphones as the next connected device, which I see as the foundation for the next tech boom. The price increment for an online TV is fairly small, and I expect it to largely disappear as Internet becomes a requirement in future TVs and blu-ray players. 

While online is gaining strong interest, estimates for 3DTV shipments are decreasing from earlier optimism in spite of chirpy optimism normally seen in market research firms trying to sell reports to manufacturers. (A key to understanding these reports is that the "higher numbers win", meaning the ones trying to promote the market will buy reports with higher numbers, so when the chirpy researchers drop forecasts the market is really weak and they are scrambling to regain credibility rather than sell reports.)  

The biggest differentiator of online TV vs 3DTV is: it's the content, stupid. For many viewers, it is a simple as getting Netflix online, which looks like an online subscription movie service with much broader selection than HBO or Showtime. There is also keen interest to add new channels (especially special interest and international) as well as to watch social videos from YouTube and other sources. Sports viewing gets enhanced as well with additional viewing angles and commentary, and it is possible to watch NFL games online despite the blackout on local TV.

There is still much to be worked out. Sony bet their strategy on 3G back at CES, and now seems poised to make a new bet on online TV. They need to fix a few things, like this overly complicated remote. TV is a leanback experience ...

Dollar is Finding a Bottom

In the last two days the Dollar appears to be forming a bottom. You can see in the attached chart how its rapid decline has paused, and it even spiked above the upper trendline of its descent. Overnight it has fallen back inside, and it still may get to DX76 before bouncing. Currently it is right above DX77.

EWTrends adds to this a discussion of the circled technical indicators, which appear to have reversed. 

Sentiment is more bearish than at any time in history (at least since the Dollar was finally severed from gold in 1971).

The downward momentum stalled late last week when the Euro hit $1.40. The AUD is hovering around 98c and flirting with parity, hitting 99.2c so far.  

The most crisp analysis comes from Credit Suisse, which predicts a 100% chance of a rally from here based on net speculative positions. They believe QE2 has been fully priced into the USD "and then some." 

The Dollar Runs Into the Triffin Dilemma

Ever since the Fed pre-announced QE2 (and QE Lite) at the end of August, the Dollar has fallen sharply, and other asset classes (stocks, bonds, commodities) have risen in Dollar terms. There is nothing in the economic fundamentals that should drive those assets to rise, as economic news in the US is ambiguous at best if not worsening. Indeed, the continuing 'recoveryless recovery' is the prime reason for the Fed to consider QE2. 

The Fed is running into the endgame of the Triffin Dilemma, an eventual day of reckoning of the reserve currency that was noted in 1960 and reiterated in 2008: the nation that runs the reserve currency gets a seemingly free benefit of being able to consume more than it produces since it gets to (indeed has to) run budget deficits along with trade deficits to create enough global currency liquidity; but inevitably the value of the reserve currency falls as foreign accounts hold more Dollar claims than the US GDP can support. 

The good news for the Fed is that a near-term bottom for the Dollar may be in reach. The Dollar is rapidly approaching a support level in the Dollar Index represnted by the lower trendline off the two recent bottoms (chart from PragCap):

The Dollar Dive is also running in a channel, which is expected with a zigzag style correction, and the lower trendline of that channel hits the rising trendline of the first chart at the same area, DX76:

You might wonder how the Dollar could bottom when QE2 has not even been launched. Why wouldn't it continue to dive as the Fed proceeds to execute on QE2? Markets may have already anticipated the impact of QE2 and reacted. Goldman Sachs believes QE2 is largely priced in, estimating that $1T of QE is priced into bonds (see chart) and stock traders have taken positions expecting $500B of QE:

Goldman may be too conservative with respect to stocks - the Wilshire5000 has already gained $1.3T of market value since QE2 was announced. This continues a trend since 2000, where the drop in the Dollar (from 120 to under 80 in the Dollar Index) has kept stocks afloat in nominal terms even as they have plummeted in real terms.  This chart from The Big Picture shows the S&P in gold (blue line) vs the S&P in Dollars (red line). One looks good, the other is bad.

Econbrowser agrees with Goldman with respect to bonds, then raises the question of why commodities have risen when inflation expectations (as reflected by lower long term bond rates) are absent? This may be one of those cases where economists are still fighting the last war (the '70s) and not looking at the current fight (the credit bubble), where commodities are up in Dollar terms because the Dollar is down, not because of a rise in inflationary expectations. We saw this in 2008, with oil running parabolic well after stocks had turned down and deflationary fears ran rampant. 

Bullish optimists point out that if the market has already priced in QE, maybe the Fed can skip it altogether? The mere "Bernanke Put" to prevent deflation at all costs may be enough.

This brings us back to the Triffin Dilemma. I have discussed previously how the apparent free lunch of endless budget & trade deficits, which enable the welfare state as well as cheap goods from China, has a terrible cost, but one that only becomes apparent after years of living high. That cost is the eventual erosion of the currency. 

The Triffin Dilemma can be managed by increasing interest rates at about the same rate of foreign clams, which should maintain the foreign exchange value of the Dollar, but that option seems unavailable to the Fed which is trying to restart commercial lending against deflationary headwinds with ZIRP (the Zero Interest Rate Policy). Or, the Fed can try to manage the decline of the currency via inflation at a pace somewhat in balance with the increase in foreign claims (in effect debasing the currency as fast as foreign claims increase, keeping real debt even), but it is having a devil of time trying to reflate. 

In 1933 the US could reflate by going off gold, and had the benefit of doing so after a huge debt-deflation spiral that rid the wold of excessive Dollar indebtedness. This time we went off gold 39 years ago, and cannot pull that trick again; and have kicked the can down the road on deleveraging at scale, and thus have been unable to restart lending, which is how money is "printed" in the fiat currency regime. 

I see bloggers opining that since QE1 failed, so will QE2. The comparison is inapt as QE1 sprung from a different purpose, to essentially back the failing interbank lending markets, as I describe in the post Peak Debt. The Fed has been calmly trying to explain this and apparently falling on the deaf ears of noisy bloggers. Still, there is a big lesson to be learned. During QE1, commercial credit fell, which in effect sterilized the impact of higher reserves. 

John Mauldin has a good discussion of why QE2 may fail. One issue is that the banking system has not been fixed, and so QE2 may not spur any increase in lending; if anything, with the foreclosure mess brewing, more rapid debt deleveraging seems to be ahead. That is deflationary, and the size of potential debt destruction dwarfs the scale of QE2. Also, QE2 has already spurred competitive devaluations from countries such as Japan, and if a general Currency War erupts, as predicted by the head of Brazil, we might see most major currencies race for the bottom, and ironically the Dollar might rise based on falling less fast! At the moment, however, there is no general debasement of currencies. 

IPO Pipeline Building But Quality is Falling

As we go into the final stretch this year, the IPO pipeline is building, but their valuations are sinking. TechCrunch reports 67 deals entered the pipeline since July, and so far this year the first nine months were up over the same period in 2009. IPOs were up to 32 in Q3 from 20 in Q3 a year earlier, but the size was down, with one over $500M. The WSJ gives more data on the pipeline, looking at 49 venture-backed IPO candidates:

• 9 of them are retreads, taking their second shot at going out, which the Journal notes is but "a small fraction of the group that previously cancelled their IPOs." 
• Only 11 of them are above $100M revenue
• Only 16 were profitable in 2009
• Only 1 well-known social media winner is going out - Demand Media

This is not a very compelling distribution, and it is also a bit skewed by two outliers (see charts). It appears we will have to wait for the balance of social media winners (Facebook, Twitter, Zynga, LikedIn) to spark a revival of IPOs. 

Intrade Markets Make the Mid-Term Anything But Dull For Investors

One of the most interesting phenoms of the Internet Era is the remarkable predictive value of synthetic trading markets like Intrade. My son did a study of the predictors of a movie's success used by Hollywood, and found the synthetic trading market among Hollywood insiders was more predictive than the studio heads and all their models. These markets are of course widely used for predicting elections, and you can scan Intrade to see how your favorite candidates are doing.

Yesterday Joe Biden at a fundraiser quipped "You're the dullest audience I have ever spoken to." Normally a midterm election is fairly dull. A study shows that of the 27 midterms since 1900, the party in power only changed 7 times, and the change occurred in both houses of Congress only 4 times. The stock market appeared to be a non-factor.  War is a bigger factor, with the change occurring only once in wartime (2006). 

This one is anything but dull, and raises the core question for investors: does the switch in power have any predictive value for stocks in the next two years?  Normally the two years into re-election are good for stocks:

Most investors remember how after the switch in 1994, the market took off in one of the greatest bulls runs in history. Based on the seven change midterms, one can say the market should be up: in the four where both houses switched, the market was up 3 times; and in the three when one house switched, the market was up one year later in two of those years, and up two years later in another two (but not the same two). Now, the market tends to be up; it is flat or up 80% of the time. When no change occurred in the midterms, the market was normative, up 80% of the time. Hence, these historical comparisons have too little statistical predictive value.  

More important is the reason for the likely switch: a strong desire to cut spending and end the bailout culture. This suggests the new Congress will change course from the past decade of easy credit and large deficits. The more dramatic the change of economic policy, the more unpredictable the markets will be. And it seems increasingly likely that a major change will occur. For a while the Intrade markets have shown the House likely to switch:

Today the Intrade prediction of Biden's party holding onto the Senate went below 50%: 

Tech Startup Valuations Continue to Rise

More indications of a coming tech boom are showing up. Not so long ago, the angel or seed round would value a company at around $1-2M. With the rise of the SuperAngels and the Cambrian Explosion of interest in consumer Internet deals, seed round values have crept up to $3-4M, levels normally seen with traditional Series A rounds.

Now observers are noticing that they are jumping over the $4M line as well. Two recent deals received around $1M each at values above that $4M line. I know of a number of other financings above that line, but what is striking about these two deals is that they are getting done by newer entrants to this game:

• Hipmunk raised in a "hyper-competitive" round where a cluster of angels drove the values up; previously we had seen this sort of auction coming from traditional VCs after the seed round
• The Pulse iPad app (shown above) raised an angel round from four traditional VCs (Redpoint, Mayfield, Greycroft and Lightspeed), who followed the SuperAngel convention of an uncapped convertible note

Both may be one-off situations, particularly the gang of four VC stepping down to the angel level. Sometimes these types of investments make sense due to relationships and are not the start of a new trend. Nonetheless, it is clear the rapid rise of SuperAngels is disrupting the traditional VC business. 

Bullish Breadth Extreme

The market has settled over the trading range and seems to have Sp1174 in its sights. In a Fractal Finance view, by closing above the trading range (1130-1150) and staying above, the odds are favoring a continued bullish break up. The 1174 level is an important one, since it represents the 'fourth of the prior third' (the big bounce right after the flash crash went all the way back to 1174). Tonight's STU notes how this is the most common retracement level. This level is also the 78% retrace if we count from the July low (it is 1181 if we count from the May25 low). The 78% retrace is the last line of defense for the bears. Above the 1174-81 levels, and it is difficult to maintain a bearish posture under wave theory. 

There are several caution flags for the bulls. The Nasdaq is diverging, as the recent tech leaders took fairly big plunges today. Nice chart from EWP:

Sentiment readings are not supporting the rally, such as the 5-day S&P A/D ratio (discussed in the STU). Perhaps the most interesting breadth reading comes from Traders Narrative, which noted yesterday how the number of S&P stocks above their 50 DMA is nearing the levels of prior tops. This metric began to pop up across the blog sites today. EvilSpeculator has tracked this indicator, and discussed it on Sunday, concluding "we have not been this overbought in years."  Here is the chart:

Now, in a thrust up sentiment levels can remain extreme for a while, so hitting such levels is not suggesting a quick reversal. It does suggest, however, that when the reversal comes, it will be sharp and unmistakable. 

The focus is now to the unemployment report on Friday. The STU notes an interesting win-win argument floating around:

• if unemployment is lower, it suggests a recovery, and is bullish
• if unemployment is worse, it suggests the Fed will be more aggressive with QE2

When fundamentalists win both sides of the argument, contrarians get ready to fade their position. Put more prosaically, if the market anticipates the win-win, it will rise on the rumor. So sell on the news. 

Final item is to watch the USD. It continues to sink in the Dollar Index, down to 77.3 today and closing under 77.5, with only 4% bulls. The Euro is approaching $1.40 with only 3% bears. The STU notes that the 'fourth of the prior third' level is $1.403. The next stopping point for the DX may be the lower trendline from the lows in March 2008 (Bear Stearns!) and November 2009, which is around DX76 (yesterday's chart courtesy Contrarian Advisor):

 

3DTV Without Glasses Adds a New Dimension to Future TV (But Don't Hold Your Breath)

I reposted yesterday I post I had done after CES because of the announcements this week of 3D TVs without the need for glasses. Those units are not ready for prime time, and I think the announcements run the risk of the classic Osborne Computer mistake of the 1980s: Osborne was the leader in portable PCs (before laptops), but they were not compatible with the IBM PC during the period when the PC began to gain an architectural lock software. Osborne rushed to announce their next model would be PC compatible, and customers held off purchasing the current model. The company went bankrupt.

The Osborne mistake is now enshrined in business schools as what not to do. So why did some of the big Japanese TV makers jump the shark on 3DTV?

Start with the dreadfully poor outlook for 3DTVs. In my CES post last January, I found the push for 3DTV premature for three reasons:

• too little content - HDTV could leverage movies while broadcast caught up
• too sketchy an experience - the look was not that compelling
• too burdensome to use glasses

Shortly after CES, the early results suggested that 3DTV would be a bust. It was thought to be a gimmick, an expensive feature seeking a market, not a need driven by consumers. Samsung had to add warning labels to their 3DTV sets, that drinking and 3D don't mix. I am not sure this is a real problem or over-anxious lawyering, but some people do report headaches or dizziness while wearing those 3D glasses.

About the same time, the big push by movie studios into 3D seemed to be missing expectations. After Avatar and Alice in Wonderland, the new releases were disappointments. Hollywood is in the doldrums and the studios have been pushing 3D as a way to increase ticket prices and hold theatrical revenues up even as ticket sales droop. Nonetheless, Hollywood is persisting, and recently it was announced that the highly-anticipated Hobbit movies will be in 3D. 

As with color and HD, it is believed that sports will drive 3D demand on TV. Some leagues like baseball and hockey are already streaming 3D broadcasts. (This may cause some bandwidth challenges, as 3D will have to coexist with normal HD.) ESPN launched a 3D channel just in time for the World Cup.

All well and good, and yet there has been no rush to 3DTV. It is coming too quickly after major upgrades to HDTVs, and is way behind in compelling content. And of course has those darned glasses. 

Big news then that this week several makers including Toshiba announced a 3DTV without glasses. When I was at CES I asked when this would be out commercially, and heard promises of "five to seven years." Naked-eye approaches have been known for a while, and are being developed across the TV makers. Here is a video by Toshiba showcasing their new naked 3DTVs:

The Toshiba models have modest sized screens, and need to handle nine viewing angles, which today requires lower resolution images - they are less than HD sets in 3D mode. They have very narrow viewing angles, and you have to get really close to see the effect. The Toshiba models are designed for niche markets, and may not even sell there.

In a nutshell, we are still a years away from commercial HD-quality naked-eye 3DTV sets.

My take: the Japanese often do this, to one-up each other, with less of an eye to the impact on consumers than they should. They launch inside their own echo chamber. The visibility to the consumer of a better 3DTV in the future may suppress 3DTV sales in the present, but the Japanese are probably betting these announcements will be little noticed. Instead, inside their echo chamber, they can use the promise of naked eye 3D to overcome the real problem: the dearth of 3D content for TV. The promise of these sets "soon" should sustain the development of more 3D content for TV.

3 Things to Know About 3DTV

Everywhere you looked at CES this year was filled with the promise of 3D. Sony made a huge commitment to 3D, betting the company it seems. Nine months later, it appears they will lose the bet. 3DTV is not ready for primetime. 

The experience is sketchy

The glasses are a big obstacle. What if you have only two or three at home, and you want a gang to see a football game? Much of the content at CES was repurposed 2D. It looked simply awful. I saw a demo by JVC touted as the first 4K HD experience. It was terrible, with blurs and artifacts. I saw Avatar at IMAX 3D before the show, and even there it took 30 mins into the movie for the mind to calm down and engage with the 3D experience. People with minor eye problems will probably get headaches. The TV experience required real 3D content and new polarized glasses with internal fast switching, and even that was not enough. I agree with this review of Samsung's demo:

Samsung’s glasses-ridden, 50-inch 3D LED LCD HDTV display did not impress us to the least bit. If you can imagine wavy and blurry vertical 3D lines popping at you and inflicting instant nausea and headaches, then you will understand the effect of the display. It was simply too harsh on the eyes and the image changed 3D perspective as the viewer walked left and right. Overall, the image was not natural but was rather cartoonish and definitely not ready for commercial use. 

The content is not here

I saw at least four demos (I lost count). They repeated much of the same content - an Avatar trailer, a Monsters vs Aliens trailer, a Brazilian soccer game, some ancient Kyoto buildings, and some underseas stuff. I had seen Coraline at home in 3D (using the old fashioned red/green glasses) and it was fine. We have had a few other cartoons - Polar Express, Up, Monsters vs Aliens. Hardly enough to fill a Sunday evening, let alone a 24/7 channel. 

Discovery Network announced such a channel, and DirecTv announced they would showcase 3D content, but I see it as a land grab. Early on in HD the inimitable Mark Cuban launched HDNet and grabbed a very valauble cable slot. Discovery need not have that many viewers to create a lot of value, if the 3D content eventually comes. So their announcement does not mean scads of new content.  

When HD launched, there was a lot of content: movies. In contrast there is very little 3D content. It will take years to build. Repurposed 2D movies do not look great. There is a lot of interest in trying this, especially for blockbusters like Lord of the Rings and Star Wars, but it is questionable how good the experience will be. Hollywood is enamored with 3D since they can charge higher ticket prices, and undoubtedly (for a while) higher DVD prices, so we will see some more 3D movies, but it will take a while to fill the library enough for a decent set of 3D channels.

ESPN announced a 3D feed for sporting events. This is more interesting, as football drove color TV and HD. We shall have to see what it looks like, and how much they can afford to broadcast. 

The fix is not that far away

There is a way to get 3D on TV without the funky glasses: use a type of fast phase shift to create the illusion of 3D depth by changing viewing angles. It works with a narrow viewing field today. One way to accomplish this is to shift the angle of backlighting quickly. You can see an example of this effect in the flashing picture, courtesy Jim Gasperini. 

In my conversations I found that it needs 9 fast-shifted views to encompass the broad field of viewing of a typical family room or bar. I suppose this can be thought of as a center view and then four slightly distorted views on each side. The distorted views do the same sort of thing that 'panorama' mode does to stretch 4:3 content across a 16:9 screen. The 9 views allows the off-angle viewing to maintain proper proportions in the center. 

I was told this is 5-7 years away. Apparently the speed needs to increase from (today) 240 fps to over 1080 fps (9 x 120). Or something like that. 

The HDTV industry had been peddling LED as the next big thing. These LED backlit LCD sets are remarkably brighter and thinner, and allow LCD to rival Plasma in much the same way a more efficient speaker sounds better (louder just sounds better; brighter just looks better). Apparently the TV makers got impatient in a bad market; or maybe Sony's big move to bet on 3D pushed the rest of them to join the party. 

I think they will soon have a bad hangover. The rush to start a new buying cycle with 3D is premature. Too many issues come up with the glasses. What do you do when they break? Keep buying more? Are you going to casually sit there in the family room wearing goofy glasses and staring at the Toob rather than socializing? Nah. You will throw the glasses in the gadget bin and go back to normal viewing. 

A Chartfest at the Turn

We are right at the Oct5 turn window. As the market continues longer in its trading range, the odds of a top increase. We are closing on the point where the rise from the beginning of September to now becomes slower than the rise off the July 2 bottom. Let me run through a series of charts with a discussion of whether we are in a topping period which is about to end.

Bullish Arguments

The market today opened down and ran to the 1131 level, testing a bottom hit a week ago. Both the Dow and the S&P broke below last week's bottom, intraday. The bounce off it comforts the bulls by closing above a serious support level, but looking a week further back shows we are close to bifurcating below a two-week trading range. The prior test of 1132 bounced immediately in a V, but this one is stuttering along the bottom of the trading range. See chart courtesy Contrarian Advisor:

  

Carl Futia draws trendlines around this range in the e-mini and predicts a drop to the lower trendline (es1127) followed by a bullish bifurcation up. 

SlopeofHope has a fascinating guestpost showing a potential fractal pattern with the runup to the 2007 top, where we plateaued for a while before bifurcating up:

In a Fractal FInance view, the market is an order-seeking mechanism which runs in a thrust when it finds order, then pauses in a plateau as it seeks the next level. After the Fed's late August meeting where QE2 was made more likely, the market thrust up over three weeks then paused at 1148 on Sep22 and has sat in a trading range between 1150 and 1132 for the two weeks since, with one false break below to 1123 and another above to 1157. We have hit the upper range four times, and failed to break through on the fourth try. In a chaos theory sense, energy is now leaving the system.

Bearish Indicators

The SlopeofHope post notes that volume is not confirming the rally, and is more indicative of a distribution pattern than accumulation. Others have noted how the MACD is rolling over, a bearish sign:

The bearish consensus view, which you can read at sites such as EWTrends, is a break of 1123 will confirm the change of trend. If you look at this closeup of market action, you can see a potential bifurcation down forming. From a Fractal Finance point of view, it only needs to thrust below 1132 and stay there for a few days to confirm the change of trend:

The most telling technical indications come from the divergences across the major indexes. MarketThoughts takes on the 'pause before the next top' argument by looking at how the Nasdaq has already broken below the trading range: 

The STU tonight goes farther, and points out that the Nasdaq 100, which includes the most important Naz stocks, has closed at its lowest level in two weeks. Could be that the tech stocks, which have helped lead the September to Remember charge, are now signaling the October Surprise. 

The most important bearish indicator is in the Currency Wars: the Euro has now hit a level which the STU highlights as a "beautiful picture" of relationships for a top in the Euro. At an overnight $1.38, it has retraced 61% in both time and price from the April low of $1.19, and is right at the fourth-of-the-prior-third level (of the extended first wave down off the $1.51 high in 2009), a common turn point. With only 3% Euro bears, sentiment favors a turn. The change in the Euro's fortunes will of course reverse the Dollar's slide in the Dollar index, where sentiment is also decidedly ready for a turn, with only 5% bulls. 

Neely also favors a turn down in stocks. Neely sees us in a bullish wave up, but in need of a deep corrective wave. He has been counting the whole move off the Feb5 low as an ABC corrective pattern, with the A wave to the April highs, the B wave to the end of August, and the September to Remember Rally as wave 1 of the C wave. Time and price suggest a reversal here and a deep drop of at least 50-62% of the rise, but not to new lows and not below the lows at the end of August (1040). He speculates that wave C may take the form of a Terminal, which in orthodox wave theory means an Ending Diagonal - a five-wave pattern that breaks as an ascending triangle. 
 

The 1937 Analogy is at the Top

The WSJ ran an update to its July piece on the 1937 analogy. The chart shows we would be at the secondary top before the big drop if the analogy holds:

The 1937 has been the most robust of all these historical analogies, and was pushed by EWI as far back as March 2009 when they noticed that the end of the big drop in 2008 and beginning of the Hope Rally was a fractal with a similar bounce in 1937. 

Like all analogies, they are curiosities unless backed by similar causal factors.  Pattern recognition without causation is not predictive. The original WSJ piece, which I discuss in 1937 all Over Again, pointed to a number of similarities, including the potential double-dip. Those similarities still obtain, and the new piece adds two more:

• Smoot-Hawley redux, the bubbling rise of protectionism, especially due to the brewing Currency Wars; supporting this fear is a lead story in today's WSJ, Americans Sour on Free Trade
• Taxes, the coming expiration of the Bush tax cuts that political maneuvering has left alive, which the piece estimates will reduce GDP in 2011 by -2.3%

IPOs in the Fourth Quarter

While the IPO market in 2010 has not turned out as hoped, there is some promise looking forward. A handful of IPOs have performed well. Jinko Solar (JKS) is particularly interesting, rising 3x in four months. JKS is a Chinese solar provider and is taking advantage of cheaper Chinese costs to sell vigorously into the US and Europe. It came out at a relatively modest value, and still seems relatively unknown.

You can fund some other promising IPOs from this year with a bit of research. The clunkers this year are getting more coverage than a suite of winners. You can get a flavor of expected Q4 IPOs here. 

Venture-backed IPOs have done better at 8% returns than IPOs overall (1%), but a big caution flag is over the lower quality of the 42 venture-backed IPO hopefuls in the pipeline: "71% generated less than $100 million in sales over the last 12 months and 57% have yet to turn a profit on a trailing 12-month basis." Some high profile IPOs like Tesla are still holding up. Coming up is Brightsource, a solar-thermal provider, which recently got approval for its facility in the Mojave Desert.