- Stocks ended 2013 strongly but started 2014 weakly, dropping on the first trading day. However, one day trends do not determine the year's direction. - The 10-year Treasury yield rose above 3% for the first time since 2011 but higher rates have not negatively impacted stocks so far. - Gold rebounded sharply against the normal pattern of declining with higher rates, which may indicate anticipation of future inflation. - Chinese and emerging market stocks declined on weak economic data, raising concerns about the health of the global recovery.

1. Stocks ended 2013 with a roar and entered 2014 with a whimper as we witnessed a pretty
severe sell off on the first trading day of the year. Market historians are already foretelling
gloom and doom for the stock market in 2014 based on the one day.
As it turns out, in twenty of the past twenty six years, according to the WSJ Market Data
Group, the Dow Jones Industrial Average has moved the same direction for the year that it
moved on the first day. This trend has occurred every year, in fact, since 2005. The
correlation is weaker for the S&P 500. That index has moved in the same direction as the
first trading day in fourteen of the past twenty six years.
Regardless of correlations, it's hard to make a viable case that much changed from the
close of business on 12/31 and when the markets opened up on 1/2. Given the thin
trading volume (most professional traders won't be back until Monday), the most likely
reason for the sell-off was some delayed tax loss selling on the first trading day of the
year.
In any case, stocks took a beating on Thursday only to trade flat on Friday. The S&P 500
finished the holiday shortened week down 0.54% while small cap stocks as represented in
the Russell 2000 finished the week down 0.43%.
Here's a daily chart of the S&P 500:
(click on chart for larger image)
I had predicted that the S&P 500 would finish 2013 at 1860 and we got close but I was
inevitably wrong. The S&P ended the year with a strong rally into the close of business on
Tuesday, 12/31 where it traded as high as 1849.44 intra-day and closed at 1848.36 for the

2. year. So, I came up a little under 12 points short of my prediction. I had misjudged the
weakness we saw in early December which was the primary reason for my shortfall.
Treasuries finished the year piercing a milestone in interest rates. The Ten Year Treasury
yield popped its head above the 3% level on Tuesday only to fall back, closing on Friday
at 2.99%. The Ten Year yield hadn't traded that high since July, 2011 right before the
threat of Euro zone implosion sent yields to historic lows.
We're on the cusp of the interest rate that many market prognosticators warned would be
the death knell of the stock market. So far, equities are taking the higher rates in stride.
Here's a weekly chart of the Ten Year Treasury yield:
(click on chart for larger image)
Interest rates are clearly moving higher which will have eventual implications for the US
Dollar and stocks. However, I don't see higher rates having any significant impact on the
economy and stocks in the short term. I'll be expanding on this more below.
In the face of the Ten Year breaching the 3% level, gold defied the traditional inter market
relationship between higher interest rates and lower gold prices and staged quite a
comeback this week. The buying commenced on Tuesday with what could not be
technically classified as a key reversal day but had all the earmarks of one, gapping
higher on Thursday with significant follow through on Friday. Here's a daily chart of the
SPDR Gold Trust Shares ETF (GLD):

3. (click on chart for larger image)
While it did broach an important downtrend line with the move this week it is still too early
to call this a positive change in the yellow metal's direction after the worst year it has had
in thirty years.
Regular readers of my commentary know that I have placed much significance to gold's
price movements in 2013, not just as a predictor of inflation, but more importantly as a
deflationary indicator. And as such, I cannot dismiss the price action this week. Many
attributed the gains to increased Chinese buying before their Lunar New Year, which,
beside the Chinese fixation with gold is something they traditionally do. Some attributed
the pop in precious metals to capital flows out of stocks to beaten up asset classes.
However, I think Michael Gayed hit the nail on the head this week when he commented
on CNBC that gold may be anticipating inflationary pressures. Ordinarily, low interest
rates encourage gold buying when gross interest rates minus inflation turn into negative
real interest rates. This had been the prevailing phenomena of the past four years but had
seemingly changed in 2013 when interest rates started rising in May. But with the
anticipation of inflationary pressures mounting we may well be in a negative real interest
rate environment once again.
Admittedly, the thesis outlined above could be labeled as a "cart before the horse"
argument because there is no apparent inflation on the horizon. Vast swaths of the global
economy are still in a disinflationary or deflationary environment. But proponents argue
under the thesis that the market, which is the sum total of all the knowledge, wisdom, fear
and greed of all its participants, anticipates future events in its price action.
Well, if meaningful inflation is on the horizon the Velocity of Money is certainly not letting
on that there is. Below are the latest readings as of 12/20/2013. The first chart shows the
velocity of M2 since the Fed started tracking it in 1958. The second chart focuses on just
the past five years:

4. (click on chart for larger image)
(click on chart for larger image)
The most we can say as we focus on the second chart is that the trajectory of the decline
is waning.
We will see whether gold's rally this past week was simply a counter trend rally in an
ongoing bear market for the precious metal or whether the gold market is being prescient
regarding inflation in the global economy.
Industrial commodities have stirred a bit in the past month but we are still not seeing the
upward momentum in these metals that would suggest that the global economy is
regaining its footing. I'm going to post two charts which tell two different stories. The first
is a weekly chart of the iPath Dow Jones-AIG Aluminum Total Return Sub Index (JJU)
with a weekly chart of Alcoa (AA) superimposed upon it:

5. (click on chart for larger image)
Alcoa, which is the world’s leading producer of primary and fabricated aluminum, as well
as the world’s largest miner of bauxite and refiner of alumina, has been in rally mode since
September while the metal itself has been languishing. An argument can be made that
the low price of aluminum has made Alcoa more profitable. But then why wouldn't the
stock have been doing well for the past five years while the metal continued in its own
price deflation? The chart clearly shows that the company's fortunes have been closely
correlated to the price of the metal. CEO Klaus Kleinfeld is universally recognized as a
top notch executive who has done everything in his power to make the company as
profitable as it has been since the great commodity deflation started. So, is the price of
the stock anticipating higher prices for aluminum or is the market getting ahead of itself?
Here's the second chart. The price of steel is highly correlated with Chinese economic
activity. The chart below is a weekly chart of the Market Vectors Steel ETF (SLX) and I've
added in the bottom panel a price relative comparison of SLX with the Shanghai
Composite:

6. (click on chart for larger image)
Steel has been in an uptrend since mid-2013 while the price of the metal is clearly
outperforming Chinese stocks. So, is the price of the metal predicting stronger Chinese
economic growth? If so, how many more months do we have to wait to see the Chinese
economy catch up?
Traditionally, I'd take the position that the price of the commodity predicts where the stock
and the pace of economic activity goes. Simple supply/demand dictates the price of the
commodity reflecting, in the case of steel and aluminum, greater demand due to greater
economic activity. However, in the examples above, that logic is inverted. Until I start to
see some meaningful movement in industrial commodities it is difficult for me to get
excited about the progress of global economic growth.
In my last commentary on 12/20 I identified a temporary liquidity issue in China which the
PBoC (People's Bank of China) finally addressed comprehensively right around
Christmas. In the past two weeks we have received some disappointing economic data
from the world's second largest exporting economy (we're still the first) that has sent their
stock market reeling. The latest was a disappointing Services PMI (Purchasing Manager's
Index) on the heels of an equally weak manufacturing PMI. Here's a weekly chart of the
Shanghai Composite:

7. (click on chart for larger image)
We've clearly broken down under an uptrend line that had formed over the prior six
months and the momentum indicators in the top panels are bearish. More and more
pundits are warning that China has problems that are not going away but getting worse.
George Soros was the latest to sound the alarm this week over the internal contradiction
in China's growth engine.
At the same time, Emerging Markets have been battered over the past two months as
seen in the chart below of the iShares MSCI Emerging Markets ETF (EEM). It looks as
though the volume spike we had on Thursday and Friday (see lower panel) is a
"capitulation spike" and mirrors the volume spike we had in late June when the effects of
"taper talk" had decimated the emerging market currencies and their stock market:

8. (click on chart for larger image)
Does this mean EM is ready for a bounce? I'm still wary of EM. They are still trapped
under the specter of a liquidity squeeze as our central bank starts to unwind the historic
monetary stimulus implemented during the dark days of the GFC (Great Financial Crisis).
Analysis
When I made my prediction that the S&P 500 would reach the 1860 level by the New Year
I also said we would have to reassess the situation at that time. Certainly, the first two
trading days of 2014 which I've highlighted above has given me much to think about. But
with light trading volume and many professional traders not back from the holidays it
would be premature to make decisions based on some of the anomalies we have seen
this week.
Regardless of theses, there is no rational way to explain gold's drastic about face this
week while events in China and capitulation selling in Emerging Markets give me cause
for concern. The selloff in the US stock market on Thursday was also unsettling though
tax loss selling accompanied by light volume was the most likely culprit.
As we peer into the future, what can we deduce regarding the direction of financial
markets? While NOTHING is guaranteed here's a few predictions I feel fairly comfortable
making:
1. The US Dollar will strengthen in 2014. Assuming the Fed continues to taper its asset
buying program this year the Dollar will appreciate against the other major foreign
currencies. Currency strength under normal economic conditions is usually positive for
that country's equity markets. The test will be whether we are truly back to "normal
economic" conditions. I think we are getting there.
2. Interest rates will trend higher as the Fed takes its foot off the liquidity pedal. This will
manifest itself mostly in the "belly" of the yield curve (five to seven year maturities) and
there will be some pressure on longer term interest rates as well although I believe rising
long term rates will be muted to some extent. So I don't see significantly higher mortgage
rates.
3. China and the Emerging Markets (EM) are huge question marks in 2014. To the extent
that China can resolve the excesses in its shadow banking system and that EM can
overcome the effects of the liquidity drain of Fed tapering will speak volumes on the
strength of the "global recovery".
4. Gold will tell us much about the shape of the global recovery in 2014. Any positive
traction in the yellow metal will be predictive of inflationary forces building in the global
economy. As stated in many commentaries before, inflation is a necessary consequence
of economic growth and prosperity in a fiat currency system. The fact that inflation has

9. been so low speaks to the tepid nature of global economic growth. Gold's recent bounce
off the $1,200.00 level set up a "double bottom" on the chart (see below) and if we can get
momentum above 60 on the RSI (top panel) it will validate the strength of this move:
(click on chart for larger image)
There are several "moving parts" that will decide where gold will go in 2014. However,
assuming my prediction for a muted rise in interest rates in 2014 is correct, then US Dollar
strength will be somewhat muted and gold should be a valuable indicator as to the
strength of the global economy. Whether you are a "gold bug" or not, you should be
welcoming higher gold prices in 2014 because it will be telling you (outside of any
exogenous shocks on the planet) that the global recovery is for real.
That's it for now. I'm looking forward to next week when all participants will be back so I
can try to make sense of the first two trading days of the year.
I hope everyone has a prosperous 2014!