Let me recap on my overall position. I am long commodities for a parabolic finale into a secular peak in 2013, with my biggest exposure in precious metals. I am long stock indices, largely opened in Q2 2012, looking for a cyclical bull top in the current window stretching into 2013. I have recently added long certain stock indices looking for a longer term hold, where I believe secular bear value has been reached, namely China, Russia, Japan and Austria. And lastly, I am short treasuries, with less exposure than stocks and commodities, also looking longer term for a new secular treasuries bear market.

The recent draw down in equities has reduced my open profits – but judge me on my trades once they are closed. A cyclical stocks top is a process, with common characteristics. Large sideways volatility with alternate up down moves as the market gradually rolls over in a period of months, and a double top or higher high where we see negative divergences in internals, such as breadth. As the topping process unfolds, we should see more and more issues at new lows as participation thins, and we should see defensives outperforming cyclicals. Right now, we continue to see cyclicals outperforming defensives despite the falls, we have not seen the trademark congregation of new lows leading into this, and if this is a top, we have yet to see the push back up the highs, accompanied by the telltale weakening internals. I have not blindly held on to long equity positions, but am awaiting the coming together of topping indicators to sell out. Patience, as always, is the key.

If a topping process in equities has not begun, then we should need to see improvement in global macro and leading indicator data to support bull continuation following this correction. If a broad commodities acceleration is to take place, then even more reason to need improvement in such data. In another twist, we now see signs that data may indeed be improving again.

Here are the latest Conference Board leading indicator releases:

UK +0.2 (same +0.2 previous month)

Japan -0.4 (up from -0.5 previous month)

Spain +0.3 (up from -0.1 previous month)

Korea +1.2 (up from -0.6 previous month)

So improvement across the board again, and a big leap in Korea in particular.

Next is a chart showing the drop in industrial output globally that has been recently taken place (aggregated for the G7 and leading emerging 7 nations). However, the leading indicator here shows an upturn ahead. This leading indicator is global real narrow money expansion and precedes economic activity by around 6 months. Global real narrow money supply has been growing since a bottom in April/May, so industrial production should now start to increase again.

China’s recent improvement in economic data could therefore be part of a wider pick up in growth globally ahead.

For the US, there continues to be mixed data, but the overall picture is represented here by ISI’s diffusion index, which subtracts the bad data from the good, and it can be seen this is currently positive and rising, not the picture of an economy rolling over.

Source: Advisoranalyst / Factset / ISI

The Economic Surprise Index for the US also maintains a positive picture:

Source: Advisoranalyst / Factset / ISI

Overlaying this economic surprise index on US stock market performance reveals a current disconnect – either economic data should now rapidly start to disappoint or stocks should reverse upwards – or some combination of the two.

So let’s see, but maybe tipping into global recession is premature. It could be that the mid year series of rate cuts, renewed QE and other stimulus measures needed time to have an impact. By solar-secular history, a growthflationary finale should be the theme into next year’s solar peak. A cyclical stocks bull top should also be accompanied by rising bond yields, which would be more likely under growthflationary conditions. The relationship between 5 and 10 year inflation expectations and real CPI reveals that inflation should pick up as we enter 2013. If global deflation is setting in then that would be difficult to achieve.

Lastly, here is the updated Hang Seng chart for interest (click for full size). It recently broke out of its long term triangle and is now backtesting the breakout. Will it hold and push on? Failure here would be particularly bearish, as a return into the triangle would suggest a fake out had occurred, with the possibility of a subsequent breakdown the other way.

A pick up in China looks likely into year end, both in the stock market and economy.

On the weekly and daily views, the Shanghai Composite looks to be basing for an up-move.

Source both: Cobra / Stockcharts

It is doing so on a p/e valuation of just 7.8, which is historic extreme cheapness.

Meanwhile, the Hang Seng broke out of its long term triangle and has advanced away from the breakout, which further bodes well for Chinese equities.

China PMI has pushed back up recently, which as a leading indicator suggests an upturn in the economy ahead, even if only short lived rather than enduring.

Source: Ed Yardeni

And the Chinese National Bureau Of Statistics leading indicator suggests an uptick in GDP growth is likely.

I maintain that strength in China is important to fulfill a secular commodities finale next year, due to China’s role as the world’s largest aggregate commodity demand source. Now let’s see whether this improvement in China is mere counter trend respite and stabilisation or a move that gathers momentum, but given the Chinese central bank pumped the equivalent of $50bn into the economy on Sep 25 and another $42bn on Oct 9, there is the potential for a period of reasonable strength.

My multi-month world trip with my wife (who is Austrian – nationality rather than economic school of thought) and 2 kids (who are 6 and 10) begins on Tuesday, starting with a week in Singapore, adopted home of Jim Rogers. He has said that a smart man would have moved to London at the start of the 1800s, to New York at the start of the 1900s and to Asia in the early 2000s, anticipating Asia to be the economic power of this century. He believes today’s Asian work ethic is the same as the USA used to have. I hope to get a feel for that myself. After Singapore we travel by land into Malaysia, and from there into Thailand. We intend to visit quite a few countries around the world, so if I am coming to your neck of the woods, and you have a few tips on what to do, what to see, where to eat or where to stay, let me know. John (at) solarcycles (dot) net. I will keep you updated of our route. My posting times will change, due to the time difference. Also I may not be able to achieve the same depth or frequency. But over this important time (when it is ever not?) I will absolutely still be sharing my thoughts and actions, and looking for your continued input.

OK, to the markets. This week’s data looks like this. US earnings are now overall slightly negative year on year but slightly above pre-season expectations (which was for worse). US economic was data overall mixed, but Economic Surprises are still strong (now standing at +51.7). Conference Board global leading indicator data has generally disappointed for this month. Australia -0.8 (last month zero), Eurozone -0.4 (last month +0.5), China +0.3 (last month +0.7). That data is a warning flag because the global improvement seen in September over August may be being reversed. Eurozone PMI came in lower than expectations and sets the scene for a negative GDP reading.

Source: SoberLook / Markit

Technically pro-risk has been pulling back en masse, but without obvious recipients, as treasury bonds, corporate bonds and gold have not advanced. I’m not quite sure what to make of that development, but we will find out soon. As per my last post, I believe that the next move will be a counter rally in pro-risk and there is some evidence that we may be reaching the kind of bearishness that may initiate a snapback:

Source: Sentimentrader

After this coming Monday’s full moon the pressure should change to positive, coinciding with positive seasonality into and around the US election. Again, as per my last post, I will be looking for an up move with negative divergences (in economic data and technicals) for evidence a cyclical equities topping has begun (and to sell into the up move), or for positive developments to accompany the up move and to suggest that the sell-off we have seen was rather a post QE announcement normal pullback based on unimpressive earnings. Tom Demark believes the Nasdaq has made its price peak already and the counter rally due will therefore fall short, whereas he believes the SP500 will make a marginal new high, before both then retreat 12-17%.

The Hang Seng has held up relatively well during this last 2 weeks and has maintained its long term triangle breakout. Treasury yields have also performed bullishly. Gold sentiment has pulled back sufficiently to enable a renewed move higher, and the 1700 level that it has currently reached represents a 38 fib retracement of the recent up move.

Source: Sentimentrader

Below is my recent prediction for stocks and commodities into 2013. Now if stocks top out lower than 1600 on the SP500 and have begun their topping process already then that is still consistent with historic mirrors (only the peak price level would change), as long as commodities now go on to outperform and make their blow off secular top. The rise in treasury yields despite the pull back in pro-risk is a positive for this scenario because by history yields need to rise as money flows out of safe havens into pro-risk, and if equities are stalling then commodities should be the recipient. The current threat to this scenario is the renewed weakness in global data (leading / concurrent). I maintain there needs to be sufficient health in the global economy into 2013 to enable a broad secular commodities blow-off top. Gold could potentially go its own way – operating as a hard currency and safety asset – but right now it isn’t showing any outperformance. And one last thought – if a renewed global turndown did gather pace right ahead, then might the Fed step in once again, this time with one of its as-yet-unused unorthodox policy tools, which could then inspire a mania into hard assets if desperation was perceived? It may not work again but could provide a tipping point into hard assets.

Well, that’s just speculation. We will see how things develop. Any cyclical stocks top should be a drawn out rounded affair so there is no rush to action. And the leading commodity in this secular commodities bull, gold, is in a bullish technical position, having broken upwards out of its 11 month consolidation. Collectively, when stocks and commodities make their next up trend move – whether that be counter or renewed trend – more evidence will come to light.

Regarding US stocks, if we cross reference the closest percentage correlated periods from history in terms of chart action to date together with presidential election seasonality (i.e. periods into the US  election like now) as well as previous secular stocks bears / secular commodities bulls periods then the closest mirrors from history are shown below:

Source: MRCI

Both have chart correlation percentages over 80%, both 1944 and 1972 were US election years and both fell within secular stocks bear / secular commodities bull periods, and the combined prediction would be for an up move next into and around the US elections, which is consistent with expectations further up the page. No guarantees of course – just a guide.

Lastly today, price to book ratio.

Price to book ratio (p/b) is an alternative valuation measure for stocks to price/earnings. A p/b ratio of 1 is the theoretical liquidation value of a company or stock index, i.e. assets minus liabilities. Buying a stock at a p/b sub 1 is either getting a bargain or there is something wrong with the company. Shown below is the p/b ratio for US and Europe indices since 1975 to current. The best time to buy a porfolio of the two would have been 1981/2 when they both dipped under p/b 1.

Source: Seeking Alpha / MSCI

The cheapest stock indices valuations globally that have ever been witnessed were in Thailand at the time of the Asian Financial crisis (late 1990s) and Greece in the Euro debt crisis of current times. Greece hit a price/earnings valuation of sub 2 at its lowest whilst the Thai SET reached a p/e of 3.

Here is the Thai SET long term p/e valuation chart, showing a double dip to around 3 in that crisis period. The Thai SET is currently 4 times higher now than then, so buying Thai stocks when the p/e was 3 would have been a good investment.

We can also see the p/b ratio hit its lowest around then also, to around 0.6, which again would have been a great entry point, with markets overly discounting bad scenarios.

A snapshot of global stock indices p/b valuations in 2011 looked like this. Greece was the cheapest on a p/b of 0.76. The great majority of other countries, ranging from G10 to developing nations ranged from a p/b of over 1 to sub 3, with a few rogue outsiders more expensive than p/b 3.

There is no question in my mind that the Greek stock index will return handsomely in the long term for those brave enough to have ventured in at its lows this year and last (it has currently doubled off its lows). The risk is that it tanks again, once or more, before rallying in earnest, subject to developments in Europe and the wider world. Now that is has doubled, its valuation by p/e or p/b is no longer cheap but mid-range globally. But, like the Thai SET in the late 1990s, the point is to buy in at a p/b some way below 1 and be patient.

So, it is interesting to see Japanese stocks at a p/b ratio of just 0.77.

 Source: Vectorgrader

Whilst price/earnings valuations haven’t dropped so extreme low (13.7 Nikkei, 10.9 Topix currently), the price/book ratio reveals a much more compelling undervaluation, suggesting the liquidation of all Japanese companies in the Nikkei would actually return almost 25% more cash than it costs to buy them currently.

Since the 1989 Nikkei peak, the index has gradually been making what appears to be a rounded bottom. Recall the 19 year cycle showing up in the Dow Jones stock index spectrogram? Well, from the Nikkei peak to the nominal low to date was 19 years. Just speculation that it may have relevance here, but if the rounded bottom continues its trajectory then that nominal low of Oct 2008 should hold.

Underlying source: Ed Yardeni

In support of that price bottom holding, the price to book ratio of 0.77 is historically extreme. It is in the same zone as the Thai SET at the worst of the Asian financial crisis and as Greece in the Euro debt crisis accuteness. It is also little higher than that reached at the Nikkei’s nominal Oct 2008 bottom.

So are the Japanese stock indices a great buy and hold opportunity here?

To answer that we have to consider its debt and deflation problem that has plagued it throughout its decline since 1989. It has the highest debt to GDP ratio in the world. However, unlike other indebted countries most of this debt is held domestically, by the Japanese people. This makes Japan less likely to be a default candidate, particularly given the Japanese culture. However, it has to keep rates low to service the debt and pursues inflationary policies which would help shrink the debt. Until now though it has failed to re-ignite inflation despite its policies. It is heading for one of two outcomes: debt default – which I believe is unlikely (at least in this decade) – or inflation finally takes hold and yen-weakening becomes the trend. Given the yen has been in a 30 year bull market since the early 1980s making for extreme relative historic valuation to other currencies, and real estate prices have dropped to 36% below long term averages in terms of both versus rent and versus income, and equities have reached extreme historic p/b cheapness valuation, I believe there is a strong possibility that money now starts to pour into the inflationary assets or equities and real estate (over months and years).

So what about the p/e valuations not having reached sub 10? Well, that is a thorn in the side of the undervaluation story, however, Japanese p/es average higher historically than other countries. Nikkei and Topix p/es are actually lower now than they were at the bottom of the 1970s secular bear.  On p/e alone I would not be a buyer but it is the p/b valuation that really shows the current value on offer. If further casts doubt on a deep stocks bear ahead – at least in that part of the world, with also Chinese equities on a p/e of just 7.9 paying dividend yields of 3.8.

In terms of Japanese equities I believe it is more likely they can further their rounded bottom. The historic extreme undervaluation for real estate and historic extreme overvaluation for the Yen is also supportive of a wider risk/safety inflation/deflation asset reversal. I maintain we are in the transition years from global secular stocks bear to global secular stocks bull and K-winter to K-spring, and that this is also supportive.

My average Nikkei long position is 8481 (current price 8913). I have added to that this morning with a view to a longer term hold based on the above.

Edit: One more chart to add that I missed off: Japanese equities now yielding more than Japanese bonds, adding to their relative attractiveness.

Source: Daily Wealth

 

This is how some of the key stock indices currently stand. The FTSE 100 is trying to break out of a long term triangle.

On the nearer term view, however, it has been turned away at declining resistance. The question is whether this is a fifth failure since the cyclical bull began in 2009, or whether it is consolidating before it finally breaks through.

The Hang Seng, meanwhile, has now broken out of its similar long term triangle, and it is breaking out on a p/e of 11, which is historically relatively cheap. Unless it is pulled back in this week then that break would be validated.

On the nearer term view, it can be seen that it is now up against another resistance level: the March 2012 highs. So if it is to be pulled back into that long term triangle range, then here is a level to be repelled at. Two things to keep an eye on therefore.

The German Dax is also into a zone of importance. Below is the horizontal support of the March 2012 highs which it appears to have successfully backtested, whilst above is the cyclical bull high-to-date resistance (from 2011) around 7500. It additionally has the support of a rising channel to potentially take the index up to that resistance level. A break of either support would turn things more bearish.

Meanwhile, the Nasdaq in the US is in a different place. Unlike the indices above, the Nasdaq reached far above its 2011 highs already, early in 2012. It since then rose above those 2012 highs (in March) to higher highs (in September) but has failed to hold above. The chart below shows that this could be meaningful.

The near term action since September has produced a little series of lower highs and lower lows, which suggests a new bearish trend. On the flip side, the index is nearing oversold, approaching RSI 30.

Clearly the Nasdaq has some way to fall before dropping out of the bottom of its cyclical bull channel and officially into a new bear market, but we should not need to wait for that to be able to judge whether the cyclical bull has topped out. One topping signal would be a major distribution day near the top, and we saw that on Friday. Another would be that cyclical stocks such as Techs break down first and money roates into defensive stocks. Techs are the weakest sector currently. US earnings are now overall flat year-on-year, which actually beats expectations (which were for shrinkage), but tech stock reports particularly have disappointed.

So the question is, are we seeing the first part of a topping process, with techs leading us down first, or are we just seeing some current weakness particular to tech stocks and their poor earnings (overall US earnings are so far flat, which actually beats expectations), with some knock on effect from the Nasdaq index onto other indices? With different indices around the world in different positions, it’s not clear, but there are some other common characteristics to cyclical stocks bull tops, so let’s review:

1. A topping process, normally months, with reversals of reversals of reversals in a range

This chart shows the last two cyclical bull market tops highlighted. Both topping processes lasted around a year, and within the boxed ranges there are both double tops and double bottoms, reflecting the reversals of reversals in a range criteria. If we are seeing a top on the SP500 currently, then we should see this play out into next year, with some sideways volatility to make a topping process. That should allow the 200MA to catch up and then the market can slice through it to begin a new cyclical bear. Could the topping process have begun in March this year at the lower peak? If so, we should still see more up/down oscillation as the market gradually rolls over.

Source: Ed Yardeni

2. Evidence of overbought and overbullish extremes (such as RSI and sentiment surveys)

I’ve done some checks on this and the evidence isn’t very compelling that this actually correlates with a cyclical bull top, namely because of the sideways ranging. These indicators can flash at the start of a topping process, as an up move rolls over into ranging, but thereafter don’t hold persistently.

3. Breadth divergence (such as new highs / new lows and advance-declines)

Cobra’s chart here shows how at the 2007 cyclical bull top for the SP500 price made a higher high whilst advance-declines made a negative divergence. This shows narrower participation compared to a healthy rally which is based on broad participation.

Source: Cobra / Stockcharts

Chris Puplava’s chart here shows that in the run up to the previous cyclical bull top of 2000 shares hitting new lows in the NYSE (SP500 and Dow) exceeded those hitting new highs, which again is a signal of a narrowing rally.

Source: Chris Puplava

This is how things stand today. NYSE (SP500 and Dow) advance-declines are still in an uptrend. For topping evidence, we would want to see a pullback in stocks and this ratio, followed by a new high or double top in stocks where the ratio negatively diverges.

Source: Stockcharts

And this chart is a cominbation of Nasdaq new highs – new lows and NYSE new highs – new lows. Again, we don’t see divergence yet, so would want the same as above – pullback then push up with negative divergence.

 

Source: Humble Student / Stockcharts

4. Cyclical sectors topping out before the index top and money flow into defensives

Leading into a cyclical bull top, money normally rotates out of cyclical sectors such as technology, consumer discretionary and materials into defensives such as healthcare, utilities and consumer staples. This is because the economy is turning down or forecast to turn down and these sensitive sectors therefore become less attractive. Below we can see that into the 2007 top, two cyclical sectors topped out several months before, whilst one remained strong, but the two were sufficient a clue for a top.

Source: Chris Puplava

Fast forward to today and this is how things stand. SP500 cyclicals have overall been in an uptrend since August and do not show that negative divergence.

Source: Stockcharts

Comparing three defensive sectors to three cyclical sectors below, we don’t yet see defensives outperforming and cyclicals falling away.

XLV Healthcare, XLU Utilities, XLP Consumer Staples

XLY Consumer Discretionary, XLF Financials, XLB Materials

Source: Stockcharts

However, the biggest faller has been tech, and that is a cyclical sector. So, as things stand, I would want to see a couple of other cyclical sectors join tech in underperformance relative to the wider indices, to add weight to a top.

5. Major distribution days near the highs

We got one on Friday so that’s a warning flag.

And in the wider environment:

4. Yield curve flat or negative

5. Tightening of rates through rising yields

6. Excessive inflation

7.  Rolling over of leading indicators and recession model alerts

The below chart captures 4. and 5.

Source: Scott Grannis

Cyclical stocks bulls have historically ended with inflationary and speculative froth, money pouring out of safety and pushing up yields, inflationary pressure and natural tightening tipping us over into recession, and indicators of forthcoming recesssion in evidence before the speculation tops. Is this time different due to Fed intervention in the bond market? I don’t believe it affects the overall mechanism, but perhaps means yields will peak lower than otherwise. I still foresee this excessive speculation and inflation playing out, as per my previous Forecast 2013 posts. Thus far we see a little inflationary froth through grain prices, but little else excessive.

Regarding leading indicators rolling over, a glance at the US ECRI WLI shows an indicator performing quite differently to the last two cyclical bull tops (leading into the grey banded recessions). What we would need to see is this indicator start to roll over and break into the negative. This coming Friday’s WLI reading is forecast to slip to 5.82, so there is a potential seedling for a trend change. But we would need to see a few weeks of increasingly lower readings to be consistent with previous tops.

Source: Dshort

The Citigroup economic surprises index for the US is also in a strong uptrend, and its correlation with the SP500 is shown. Again, it would need to reverse trend for a few weeks and break into the negative to be consistent with previous tops. More often than not, this indicator leads a trend chane ahead of stocks topping or bottoming.

Source: Ed Yardeni

 Turning to the global picture, Conference Board leading indicator latest readings for Germany and Australia this week both came in negative and worse than last month. This is in contrast to the recent general improvement since August in global leading indicators. Once again, we should see a trend change in global indicators back to the negative over several weeks, to be consistent with previous equities tops, i.e. leading indicators should roll over before the definitive top in stocks.

So let me sum up. There are several potential cyclical stocks bull topping signs: techs underperforming, the Nasdaq breaking technically and a major distribution day near the highs. However, this could as yet be a ‘theme’ to US earnings season, namely disappointing tech stocks sell off, infecting other indices, in seasonally weak mid-October, before the cyclical bull continues. To differentiate between the two we should see more bull topping indicators aligning, if this is to be a top, and the whole process should last a while yet. Following the current down move we should see another up move, and perhaps repeat that down-up oscillation one or more times again lasting into the end of this year. In support of this, Tom Demark’s latest forecast is for the SP500 to make a move up again to peak out at 1478-1485 in the next 10-12 trading days and for that to be the high for this year. That would fit with Presidential seasonality being strong into and around the US election.

Should we get that move up, then we should expect to see some negative divergences if this is indeed a topping process, such as narrower participation or economic indicators weakening or underperformance of cyclicals. Should that occur then I will use that strength to sell out of some or all of my stock indices positions.

It is curious to see the Hang Seng breaking out and the Shanghai attempting to bottom whilst the Nasdaq is potentially peaking. How might that resolve? Well, my overall message is that a market top should take some months yet to fully form, so there is no rush for everything to align. Solar and secular history suggests equities should top first and then commodities should make their blow off top. It is therefore appropriate that we see some strength or at least stabilisation in China, as a key demand source for commodities. US indices are also amongst the most expensive by p/e whilst China is in single digits. It would therefore fit if the US indices were to roll over first.

A gradual topping process over a few months (rather than a swift decline) should also enable sufficient speculative froth to produce the inflationary finale whereby commodities make a secular final parabolic and bond yields escalate.

So, I sit on my positions for now. I await a renewed up move in pro-risk after this coming weekend’s full moon and into the US elections, targetting Tom Demark’s range. There I will look for further evidence of a topping process to judge whether to sell out of equities.