How to Engineer a Rally

The first in a two-part series…

I write almost every day about how CL and USDJPY-driven algorithms are being used to drive stocks higher.  It used to be almost solely USDJPY, via the yen carry trade.  But, as the yen got too cheap and started producing real live inflation in Japan, central banks needed to keep the “we must have more inflation/easing!” meme alive.

They simultaneously crashed oil, which took inflation down a notch or two and largely offset the impact of the sinking yen (rising USDJPY.)2016-04-01 CL v USDJPY daily 1011This was great for stocks.  SPX, already up 85% on USDJPY’s levitation from 75 to 105, rallied another 7% through some very difficult overhead resistance.  But, clearly the effect was waning.  When USDJPY topped out, stocks did too.2016-04-01 USDJPY v SPX 1034The other problem was that crashing oil had nasty side effects.  It bankrupted oil companies, threatened banks, and hit oil producing states and countries hard.  With O&G making up 15% of the SPX, lower oil prices were hurting more than they were helping.

When CL plunged through a long-term channel dating back to 1998 earlier this year, stocks plunged too, dipping below the Aug 2015 and even Oct 2014 lows.  It was time to engineer a rebound.2016-04-01 CL v ES D 0943 On Feb 11, we called a bottom on CL and USDJPY based on very clear chart patterns [see: USDJPY Finally Relents.]  Over the next five weeks, oil futures spiked an astounding 63%.  SPX (which also bottomed on Feb 11) spiked 13.4% and, two days ago, nailed our upside target identified on Feb 22.  It capped off the single biggest quarterly rebound ever for the Dow.

CL’s rebound wasn’t straightforward.  It initially launched into the sharply rising purple channel seen below, also constructing a rising wedge (in yellow.)  This took CL as far as heavy resistance at 39, where multiple channel lines and Fib levels spanked it back down.  2016-04-01 CL v ES 60 0943When the rising wedge also broke down, SPX reversed below the recently reacquired 2000 level in a heartbeat.

But, with the rally in danger of falling apart, CL suddenly gapped dramatically higher, breaking out of the rising purple channel and past all that overhead resistance to new highs.  It’s highlighted in the above chart in blue.

By the time CL reached its peak on Mar 18, SPX had spurted up another 50 points to 2050.  At that point, the party might have been over — especially after CL fell back below the purple channel top.   But, USDJPY had other plans.

Unlike CL and SPX, USDJPY spiked only 3.5% after bottoming out on Feb 11.   It made sense, as Japan imports all its oil.  With CL up 63%, the BoJ needed the yen to maintain at least some buying power.

On Mar 18, with CL topping out and stocks thinking about joining in, USDJPY began a third spike higher — this one 2.8%.  The BoJ didn’t really want USDJPY to make new highs (purchasing power, remember?)  But, it was enough to drive stocks up to new highs.  It was essentially a downsized repeat of the July 2014 big event.2016-04-01 USDJPY v ES 60 0913But, it didn’t have legs.  By then, it was apparent that USDJPY was going to bounce back and forth within the falling red channel shown above.  When USDJPY reversed before even reaching the top of the red channel, it required some fancy footwork for CL.

Tumbling fast in a falling channel that began on Mar 18, CL suddenly spiked higher — seemingly breaking out of the channel and suggesting an alternative to the large, purple channel it had broken out of a few days before.  The new, rising red channel was even more impressive than the purple one.  Surely, CL was headed for new highs.

2016-04-01 CL v ES engineeringAs we anticipated, the breakout was a phony as a $20 Rolex.  But, it didn’t fall back to earth until after SPX had been driven up past critical resistance [see: Why Today Was Critical.]  Of course, having fallen for it once, investors wouldn’t be stupid enough to fall for it a second time, right?

Actually, they fell for it a second and a third time: yesterday and, most recently, early this morning.  Yellen’s dovish diatribe earlier this week linked the need to go slower in raising rates with weak economic performance both here and abroad.  This morning’s positive economic data, coupled with bearish news for oil out of Saudi Arabia, sent oil (and thus equity futures) tumbling.

USDJPY made a valiant effort to limit the damage to ES’ SMA10 around 8:30, but the selling pressure was too strong.  It took CL bouncing off key technical support and another, stronger push higher by USDJPY to turn the ship around.

2016-04-01 USDJPY v ES 5 0913By 1:00 this afternoon, the morning’s losses had been completely erased and SPX was making new highs again.  USDJPY made a half-fast effort to engineer a backtest along the way, but to no avail.  Once the momentum ignition has occurred, it’s tough to switch it off.

USDJPY and CL are, at this very moment, plumbing new lows, even as SPX melts up.  Why?   TPTB don’t really want more expensive oil and a less valuable yen.  They simply want the higher stock prices that go along with them.  They want all the taste without the calories.

Actually, it’s more like all that Coors Lite you drank in college.  Sure, it tasted like camel piss.  But, damned if it didn’t make you funnier, better looking and a great dancer all at the same time!

Unfortunately, these currency and commodity manipulations also come with a hangover.  Higher oil prices are a wickedly regressive tax, impacting the poor and middle class the most.  And, as discussed above, a weaker yen imposes higher fuel (and food) costs on heavily burdened Japanese consumers (the ECB’s actions deserve a column all their own.)

We can only hope the damage stops there, rather than reaching the cirrhosis of the liver stage where extreme valuations produce even more extreme corrections and crashes.

If you’ve made it this far, you understand more about the “markets” than 99% of all investors — including many professionals with billions at their disposal.  It’s no surprise that many who were well-schooled in the Capital Asset Pricing Model and fundamental analysis can make no sense whatsoever of the last seven years.

None of the many models, equations nor principles I learned in earning undergraduate degrees in math and economics, an MBA in finance, or my CFA designation can explain the kind of close we had today — nor why its ilk has become commonplace.

2016-04-01 SPX 5 1300“Buy the dip” has gone from a humorous catch phrase to a (supposedly) legitimate investment strategy — the fundamental, underlying philosophy of which is to forget everything you learned before 2009.

In the next installment of this two-part series, we’ll discuss how to successfully invest in such a heavily manipulated environment.

Stay tuned.

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How to Engineer a Rally — 2 Comments

  1. Maybe we understand the “market” more than 99% of investors now. Yet 99.99% of investors can’t write what you just wrote. It is an unique and superb piece.

    And I understand fundamental may not matter. However, big banks have exposure to oil, not to mention the massive layoff in the oil industry which has other side effects.

    Would TPTB allow oil to crash further along with the hits on big banks? It is hard to imagine TPTB would allow that.

    • Thanks for the kind words, Tommy. No, I think oil probably reached the limits of TPTB’s comfort level in February. Supposedly, the big banks have laid off all their O&G credit risk. But, I’m unclear as to (1) whether that’s actually true, and (2) what contingent liabilities remain. I’ve been trying to find some good info along these lines.

      Bottom line, central planners are walking a tightrope. And, oil patch casualties are definitely a consideration. But, the more important ones are stock “market” performance and TBTF bank prosperity.