The Real Deal?

For months I have been mentioning seeing signs that inflation is perking up. This is seen directly in the prices of commodities as they are coming back to life after severe multi-year downtrend. Taking a look at wheat as an example, it’s easy to see its price peaked back in 2012 and has fallen almost 60%, bottoming in late 2016. Since then it has been consolidating sideways, eventually breaking above the red long-term trendline mid last year.

The 2-year (so far) sideways consolidation has formed a fairly symmetrical inverse head and shoulders reversal pattern with price now sitting above a rising 200-day moving average and just under the pattern’s neckline. If in the next few weeks/months price were to confirm the pattern by breaking above the neckline on increased volume, its upside target is near the 730 level (indicated T1 above), a 35%+ increase from where it sits today.  

In spite of a relatively ideal reversal investment set up that has developed on wheat, I still wonder whether this is the real deal. Even though this provides a remarkable 7:1 reward to risk ratio because so many commodities have provided false breakouts over the past few years I have become somewhat jaded to their signals.

Bullish Demand Tailwind

Stock prices work like most other free market items, the greater the supply, the lower the price. On the flip side, the greater the demand, the higher the price. Corporate stock buy-backs have historically provided a tailwind for higher stock prices as companies retire shares (thereby increasing demand while reducing supply) but have been decreasing for the past 3 years. 

It looks like 2018 may reverse that decline. If the above repurchase forecast turns out to be true, it should provide a bullish backdrop for equity prices this year. While it may or may not be enough to push prices higher, it will surely provide a floor likely keeping a lid on the size of any decline.

At a Crossroad

Looking at the daily chart of 20-year US treasury bonds TLT below, you can see after forming a double top, they have fallen more than 8% and closed right on the 116 support zone. With the large head and shoulders topping pattern in the background and price below a falling 200 day moving average, long term bonds look like a horrible place to be invested right now. This is especially true if price cannot stay above the pattern’s (green horizontal) neckline as it portends to another 8% or more decline.

As we have learned, looking at a longer term time frame helps identify the direction of the  trend and helps to keep us focused on the bigger picture. The 5-year weekly chart below looks familiar, doesn’t it? The huge head and shoulders topping pattern stands out like a sore thumb. It should be obvious but if not, notice how the daily chart above is just a close up of the right shoulder in the weekly chart below.  Yup, another example of a pattern within a pattern (see Monday’s post “Nesting”).

It goes without saying that if bonds break their current levels being pushed down by rising rates, we can likely put a fork in the 35+ year bond bull market. If this should occur, it could have an ominous impact for all investment markets. I have been warning about this potential for years, its impact to investor’s portfolios (most investors don’t know what a bond bear market is or how to deal with it) and just as importantly the huge potential negative impact to pension funds here in the US and across the globe. It’s time to be concerned, very concerned if this scenario unfolds and reaches its downside pattern target. The bullish alternative scenario would be If support holds right here and the pattern fails. Only time will tell but because of the impact bond holdings have on overall portfolio returns, its easy to see why we are at a crossroad.

Nesting

When looking for investment opportunities, some of the most interesting setups can only be found when looking across multiple time frames and is why I find it a critical step. If something looks interesting short term but is in a long term downtrend, it is likely that opportunity will only be a winner if managed as a short term trade.  But when something develops in a short term view and is in alignment with the longer term, it not only increases the probability of success but also the expectation of large gains. These are borne out when a short term pattern is nested inside a much larger pattern.  A good example is what is occurring right now with Jazz Pharma, JAZZ.

The daily chart below shows price is ready to breakout above the neckline of this almost 10 month inverse head and shoulders pattern. Notice how price has held above the 200 day moving average, when its support was tested twice in April and May. When combined with the fact that RSI momentum is rising and is within the bullish zone, the weight of the evidence says a break above the blue horizontal neckline provides a compelling upside target in the 191 area above, some 19% higher.  This looks like a great set up.

When looking at the same investment on a weekly time frame something very interesting stands out as you can see below. Nesting. The inverse head and shoulders pattern that I showed above (blue) is actually the right shoulder of the same but much bigger inverse head and shoulders (green) pattern. Notice how the blue (daily time frame) target just so happens to be at the prior 2015 high. This is not unusual. That is where resistance exists. Those that purchased at or near that level in the past and are still holding will provide a huge amount of share supply which will likely either slow or stop a quick move above that level. They are currently underwater and as such, the normal desire to “break even” will induce many to sell, even though now seems like a time to accumulate.

The upside target for the larger (green) pattern has an even more attractive target near 225, doubling the smaller pattern’s return. When nesting occurs like it has here, it sets up the possibility not only for greater returns for the opportunity but also extending its holding period, a benefit for those wanting to be less active. 

Uncharted Territory

Almost every prior stock market crash was caused, or at least exacerbated, by market illiquidity.

As you can see in the chart below, the FED’s recent activity of unwinding their balance sheet by selling a small fraction of their QE accumulated holdings coincided with the most recent 12% stock market consolidation (not the sole reason for the correction mind you).  It is important stock investors understand the correlation between the FED removing liquidity and lower stock prices. When you combine this balance sheet activity with a simultaneous push higher in interest rates we are entering into uncharted territory knowing just how the market will react.  

Regardless, the current consolidation in the SP500 has a clearly defined upper and lower boundary, 2670 & 2530 respectively, making it a much easier task to manage whatever happens.  Above I add exposure, below I decrease.