Bond blowoff and market stress

I don’t have the time for a lengthy expose today, but last weeks long analysis on the bond market is still relevant today. There I mentioned that the bonds are getting quite frothy and that yields could still undershoot a bit in a ending diagonal. We have indeed undercut and made new all-time lows, which has led to massive sentiment spikes in the bond markets.

30y yield ending diagonal wave

30y yield ending diagonal wave

In this chart you can see the underthrow in yields. The move is looking quite tired and I would at least expect a reversal back above the TL, from which a much larger reversal could develop.

classic bond contract

classic bond contract

Bond contracts have overshot to the upside, while wave volume is diminishing. The steepening angle of ascend is looking a lot like a blow off top in the making. However, the decline in the Euro and the extreme low yield in German Bunds must make the treasuries look pretty attractive to European investors still. The markets seem to have priced in a sovereign debt purchase by the ECB. Watch out for an unwind if the ECB disappoints.

Bond Market Sentiment

Bond Market Sentiment

Here is a chart I found in my twitter stream. Unfortunately I forgot the contributor, please let me know so I can give attribution.

We can see that bond sentiment is quite extreme already.

Defensive vs cyclical sectors

Defensive vs cyclical sectors

Defensive sectors are out-performing at quite a steep angle. I would expect a pause soon, which could give the broader market some breathing room.

E-Mini

E-Mini S&P500

E-mini futures look ready for a short term reversal to the upside. Overall the picture isn’t great though and the bounce might be short lived, unless we take out the early January lower high.

XLE weekly chart

XLE weekly chart

XLE has seen quite a bit of distribution recently (volume on weekly chart). Breaking the long term trend is structurally bearish, but a bounce back should be expected.

XLE daily chart

XLE daily chart

The declining wave volume on the daily chart leads me to believe that a bounce will not take long to develop.

Bail Bonds? – TA update for 01/10/2015

The US bond market appears once more at a critical juncture. This week I will look at bond price action, spreads and some ratio charts to see what we can glean from the data. This will also have implications on the stock market.

Bond price action

Lets examine price action first. Below is a daily chart of the traditional bond contract (ZB) with an elliott wave count applied. Although this is the most liquid and most widely analyzed of contracts, it is not the best in terms of price action due to the definition (15-25 years), which results in a sliding of the cheapest to deliver contract and a steep jump in duration when we roll to June contract.

It is beyond the scope of this article to explain, but we will look at other contracts below as well.

ZB daily chart

ZB daily chart

On the relatively short duration we are looking here, the distortions aren’t as radical. Furthermore, I am using prices that are adjusted for roll. I can clearly count 5 waves up of the lows in 2013. However, even though the wave count is complete and even displays a nice fibonacci relationship within it, we are still not seeing the ultimate confirmation of a reversal. The overlap within the structure looks like an ending diagonal.

UB daily chart

UB daily chart

Looking at the UB chart (Ultra Bond = 25-30y), we can see the same structure (please excuse the mis-placed 1 near the top). If it wasn’t for the bullish candle on Friday, I would consider it complete, but this final wave can always extend further.

ZN daily chart

ZN daily chart

The 10 year contract (ZN) still hasn’t made a new high, which is the primary reason to be cautious on the 30 year contract 5 wave structure. However, this looks like it represents a significant flattening of the yield curve, which isn’t a good omen for the stock markets. Lets examine the yield curve next.

Yield spreads

30y - 10y spread

30y – 10y spread

The 30y – 10y spread has seen a significant correction. The falling wedge broke down, which is quite bearish for the spread. Furthermore, the topping formation, the support from the 2008 low in the spread and the long term spread channel all meet at about 0.3%-0.35%, which means that the spread between 10y and 30y yields might see this range eventually.

30y - 5y spread

30y – 5y spread

When we examine the 30y – 5y spread however, we can see that we have already reached the equivalent target. Obviously we see some kind of disconnect between short term yields (suszeptible to expectations of tightening) and long term yields (driven by market fundamentals).

Meeting the target in the 30-5 spread could bring about a retracement of the spreads. This could easily be accomplished by a sell-off in the longer duration bonds, so lets look at the yields themselves.

Yields

Yields have been on a 30 year long slide, and despite the many calls for a sharp reversal, we haven’t seen it yet. The 10 year yield sits below 2%, which many economists feel is extremely cheap and only can go up.

To put this in perspective however, the German Bund (10y) yield is currently 0.5% and the JGB (Japanese Bond) yield is currently 0.28%. So we should keep an open mind about the extremes.

30y yields, weekly chart

30y yields, weekly chart – bullish triple bottom or bearish descending triangle

The 30 year yield looks to these eyes like a descending triangle, which has bearish implications. However, the projected target is very low and the energy indicators seem to indicate that this current down move is nearing an exhaustion period.

The opposite theory (bullish triple bottom) is also supported by the pattern in the 10y yields (not shown) that could resemble an inverted head and shoulders pattern (also bullish).

30y yields, monthly chart

30y yields, monthly chart

The stock market (and in extension most tradable markets) is a tool to transfer money from the many to the few. This means we should also consider the greatest pain outcome. I thus believe that the greatest pain will be caused by a new low that is quickly reversed to set up a spring in yields.

This is consistent with the exhaustion in energy (see fractal energy indicator on chart) and with my overall expectation.

Carry trade in bonds

One of the most fascinating ideas and the root cause for the sometimes bullish positioning of many bond traders is the carry trade. Bonds pay interest and with the cheap borrowing rates of today, it has been a windfall for banks (and in extension bond traders) to borrow cheaply on a short term basis and invest that money in longer duration instruments while pocketing the difference.

As individual traders we can easily participate by buying and holding bond futures contracts, which have the borrowing built-in (through cheap futures margin).

Since the yields are currently near their lows again in the 30y contract, we can generate a good visual representation of the carry trade. Using the continuous bond contract and adjusting for roll, we can compare the difference in price between the two instances in time, which will exactly equate to the profit from the carry trade (in other words, how much we made investing in 3% instrument while borrowing at 0.25%).

Ultra Bond carry trade visualization

Ultrabond carry trade visualization

I am using the Ultrabond contract due to the oddities with the traditional contract I mentioned above (which would result in overly optimistic results).

In the nearly 2.5 years since the 2012 low in yields, we would have made $5.5k per Ultrabond contract. Not too shabby, considering we bought the exact low in yields. However, the drawdown that we had to sustain was about $37.6k/contract.

Therein lies the danger in the carry trade at the current low yield. Even though we might still go lower and bonds might still not be done rising, a sharp reversal in yields will again result in a significant drawdown. And even though the carry trade will over time make up for that again, the carry trade can only compensate for a very modest rise in yields.

The risk/reward in the bond trade doesn’t look nearly as compelling this year as it did at the beginning of last year, even if the Fed will not tighten. Even though I do not personally believe in a quick reversal of the 30 year bond bubble (but rather a process), I would prefer to wait for a better entry than this.

Some ratio charts

SPY vs TLT

SPY vs TLT

Looking at the ratio between SPY (proxy for S&P500) and TLT (proxy for the traditional bond contract), we have broken the uptrend in 2014, which is a clear warning sign for the market in general. We can also see that for 2014 bonds did in fact outperform the stock market and that doesn’t even include the total return for both, which will tilt the scale even further in favor of bonds.

SPY vs EDV

SPY vs EDV

When we compare SPY to EDV (proxy for the ultra bond), we can see a similar pattern, except that we already fell through support. Patternwise the outperformance of the bond funds looks corrective, which could be a wave 4 correction. This would work well with the expectation of a rise in yields in the intermediate term. In the short term however, we could see still a final hurrah in the bonds and an undershoot of these patterns.

Rate sensitive markets

XLU vs SPY

XLU vs SPY

Utilities have broken their under-performance trend. We are making higher highs and higher lows. Utilities are a defensive market play, so this divergence might be a bit troublesome for the markets. We should keep an eye on it.

It also means that Utilities traders are still not expecting an impending tightening cycle.

VNQ vs SPY

VNQ vs SPY

REITs are on a tear. We are very stretched to the upside, but REIT traders also seem quite content about low rates for longer.

Conclusion

Bonds are quite expensive. The risk reward ratio of a long term position in bonds is not given, but this could change quickly should bonds sell off. Meanwhile we can still see an overshooting in bonds (undershooting in yields).

Immediate rewards

In last weeks review, I speculated that 1970 (ES futures) / 1980 (SPX) could arrest the decline. As we got closer, I sent out an alert (http://stks.co/c1N54) and a bullish chart on the day before the reversal (http://stks.co/p1A9X).

Despite my bullish message, I was completely surprised to see that we made a new high within only 3 days. Clearly these markets behave abnormal, conditioning investors to expect impossible recoveries. The last two cases clearly exceeded the norm here.

ES future daily chart

ES future daily chart

The bullish message is still intact, and the seasonal tailwinds could keep this rally going a little longer, but we can see that we are now struggling a bit and may thus need to pull back a little bit first.

ES future hourly chart

ES future hourly chart

The hourly chart shows that we peaked the previous high twice and failed twice. Each high exceeding the previous high, possibly running stops of early bears, before reversing. Although expect a pull-back that should exceed 2050 (to set up another bear trap and take out stops?) before advancing further, the markets are seemingly getting less stable. I would still expect the SPX to make a dash for 2100 though.

Crude futures

Crude futures

Crude futures have broken the down trend (http://stks.co/p1BEf), but curiously stopped at what could become a triangle wave 4 consolidation before we get a final leg down.

Bond futures

Bond futures

Bonds also saw a quick reversal, but the lack of volume and the pattern makes me suspicious. I bought some after ES had retraced nearly to the highs and may lock in my profit.

This will be all for today, since I am taking the weekend off to spend with my family.

Oil sentiment

Here is a quick look at Sentiment in the Oil sector.

Oil futures 12/14

Oil futures 12/14

Oil is starting down again, probably based on the remarks out of UAE about $40 oil. I think this is overblown. In fact, sentiment in Oil suggests that we have already seen the washout move and that we may begin stabilizing sooner than I thought, maybe in line with my high target of $55 from this weekend post.

The DTL still hasn’t been broken, so lets look at sentiment.

Brent Oil Overconfidence Index

Brent Oil Overconfidence Index

Here are three charts from Sentix. The overconfidence index suggests that traders are already positioned one-sided and that we could soon see a short squeeze (overconfidence at or below -7 and at or above 7 is extreme territory).

Oil time differential index

Oil time differential index

The time differential index shows that the longer term bias is far more constructive than the short term worries, which is also supportive of a potential reversal.

Oil Strategic Bias

Oil Strategic Bias

The strategic bias in Oil shows a nice positive divergence into the lows, showing that traders are starting to see this decline as an opportunity. Institutional investors are leading private investors in this indicator.

XLE vs SPY

XLE vs SPY

The underperformance of the energy sector is looking exhaustive here too, although there is little in terms of support for the relative chart.

Oil sector vs Oil commodity

Oil sector vs Oil commodity

The Oil sector (XLE) relative chart to the commodity (USO) looks exhaustive as well, suggesting that a reversal in Oil might eventually outperform the reversal in the energy sector. On the other hand, this also shows that the equities have held up well in the face of the oil decline, as this will indeed present a good opportunity for patient investors.

Groundhog Santa

As I have expected since late November, we finally got a minor pullback. The financial media is already going crazy over the contagion from cheap oil price, flashing correlation chart and putting some fear into people. This is also evident from the increase in hedging activity and the outsized move of the VIX last week.

Let’s keep a cool head and look at some things. Earlier this week I mentioned a target for Treasuries (http://stks.co/g1Pnk) and a pullback target for index futures (http://stks.co/j1Po3). Both were slightly exceeded on Friday. The way we closed seems to suggest that we have room to extend further. Here is the evidence:

Sasonal Chart

Sasonal Chart

The seasonal chart does suggest a weakness in the second week of December, just as we have seen last week. In fact, even the peaks and troughs of the seasonal chart lined up with the moves last week by sheer coincidence (these charts are just giving seasonal trends, not daily moves).

ESH5 E-mini chart

ESH5 E-mini chart

Looking at the daily Futures charts, we see that we have punched through and closed below the first support level. Unless we reverse quickly, the 32.8% retracement level is starting to look like a more likely target, since it also lines up with the peak from July. That level comes into play at 1970 for the ESH5 contract (around 1980 for S&P 500).

Indicators chart

Indicators chart

The indicator chart also seems to miss the final washout spike. Its position is comparable with an earlier stage during the October drop. The spike in $trin is  most likely due to the extreme moves in the Energy sector, where we have seen panic selling already, while we saw strength elsewhere. I will analyze this sector in a separate post tomorrow if I find time.

Treasury move

Treasury move

The classic bond contract has already exceeded my upside target for wave B by 10 ticks and if it keeps moving with this strength, we may be on wave 5 already, which would be a bad omen for the stock market (I doubt it). The stong wave volume (bottom) also shows that this up-move in wave B contained more buying than the sharp down move of wave A. However, this does not consider everyone who sold into strength on the bond flash dash (yield flash crash).

Oil weekly

Oil weekly

As I mentioned last week, oil still has a potential $50 target, where the 78.6% retracement of the up move, the January 2007 low and the 61.8% down extension meet. Previously this was also my target for the measured move out of the triangle, but after re-examination, that is now closer to $55 on my chart, where w also have the 50% down extension, making $55 another potential level for reversal, although a weaker one.

Oil short term chart

Oil short term chart

As I mentioned on Stocktwits (http://stks.co/g1PkO) until the steep downtrend line of the current move (see chart above) breaks, it is still too early to think about entering long positions in Oil.

British Patroleum stock analysis

BP technical analysis

BP technical analysis

A user on stocktwits asked me to comment on BP, so I decided to create this simple multiple time-frame analysis.

The conclusion: BP is as cheap as it was 1998 and if it can break its steep short term downtrend, it looks like we may get some positive action soon. However with my recent oil analysis, you should be aware of the risks and the potential for fake-outs and significant price undershoots.

The case for European Big Oil

Wild sentiment swings in broad markets can present fantastic opportunities to patient investors. The reflexive liquidation in the Oil market may present such an opportunity today.

I have just posted an analysis of crude oil and decided to take a quick look at potential long term plays to take advantage of the extremely sharp down move. Please be mindful of the linked analysis, since the move in Oil might not be over yet.

Nonetheless, now is the time to look at potential buying targets in the sentiment washout. I am focusing only on large oil companies that engage in conventional oil production, since they are most likely the long term benefactors of a potential consolidation in the oil market.

The analysis below is extremely simplified. I am not paying any particular attention to any of the underlying fundamentals, the production cost of each company, the debt structure and their investments in unconventional recovery. Do your homework!

However, when I reviewed a few companies and overlayed the oil price one thing struck me as extremely valuable.

Comparing the oil price today to times in the past when the oil price was the same, the American big Oil companies have significantly higher price, whereas the Europeans do not.

One obvious contributor to this huge discrepancy could be share buybacks and the accordingly higher EPS. Again, you should analyze the profit margins for each of the players separately, but even factoring all that in, the Europeans just seem cheaper to me.

The Europeans

BP weekly chart

British Patroleum weekly chart

Price of BP (British) is about the same it was when Oil was this cheap before. The massive overhang from the Gulf disaster isn’t factored in.

Total weekly chart

Total weekly chart

Total (French) looks similar. Also looks fairly priced when only compared to crude oil.

Royal Dutch Shell weekly chart

Royal Dutch Shell weekly chart

Shell also looks ok although not cheap. In fact, none of them look particularly cheap considering where oil stands.

The Americans

Exxon weekly chart

Exxon weekly chart

Exxon looks much different from the Europeans.

Conoco Phillips weekly chart

Conoco Phillips weekly chart

Same for Conoco Phillips

Chevron weekly chart

Chevron weekly chart

Chevron also does not look cheap when compared to Oil.

Make of this what you want. I don’t normally analyze stocks and when I do I look for other things.