Wednesday, August 24, 2016

Can stocks survive without stimulus?

A fiery debate rages among investors over the question of central bank stimulus.  The question is whether the stock market needs stimulus in order to advance, and is stimulus only creating a bubble which will burst at some point and lead to depression? 

Regardless of the philosophical rectitude of central bank intervention, there can be no denying its efficacy.  The most fundamental truth of the financial market is that “liquidity, liquidity, liquidity” is the market’s lifeblood.   Financial stimulus contains the seeds of recovery and will cure any bear market in equities, as I’ll attempt to prove in this commentary.  The truth of this assertion can be found in the very wisdom of King Solomon, who in the book of Ecclesiastes wrote that “money answers all things.”  Stocks will always, without exception, respond positively to stimulus – provide there are no countervailing obstacles in the way [e.g. tax increases, margin requirements]. 

Critics of stimulus often point to Japan as an example of how quantitative easing (QE) supposedly failed.  Seventeen years ago the Bank of Japan (BOJ) led all other central banks by more than a decade with its zero-interest-rate policy, when its benchmark rate was lowered to zero for the first time during March 1999.  As Dr. Ed Yardeni recently observed:

“The BOJ lagged behind the ECB by nearly 20 months, introducing its negative-interest-rate policy (NIRP) on January 29 of this year.  The central bank was early with QE when it expanded its reserves balance starting during November 2001 through January 2006.  That was just a warm-up act for the dramatic expansion of these reserves that started in early 2011, and then went vertical since late 2012.”

While Japan’s economic troubles remain, is it fair to assume that the BOJ’s attempts at stimulus were an abysmal failure?  Let’s examine the evidence.

Following is a long-term graph of Japan’s Nikkei stock index.  Japan’s attempts at QE started in late 2001 and ended in 2006.  Given the downside momentum that had been established in the Nikkei heading into 2001 – 11 years worth to be exact – it took some time before the first effects of the stimulus registered in the stock market.  By 2003, however, the Nikkei was on the up-and-up.  Japan’s central bank let their foot off the QE accelerator between 2006 and 2001, though, and this explains why the rally didn’t continue further.  The 2008 credit crisis only added to the Nikkei’s woes.


Then starting in 2011, the BOJ once again commenced QE at an even more furious pace than before.  This led to a much quicker improvement in the Nikkei, which zoomed to its highest level in over a decade.  Undoubtedly, Japan’s second attempt at QE would have been far more successful had not the government implemented an ill-advised tax increase.  This foolish measure heavily undermined the positive impact of QE and put the brakes on the Nikkei rally.  It also put Japan’s economy back into recession for a time.

A lingering problem for the European Union countries since 2008 has been the negative impact of years of misguided austerity policies.  European Central Bank (ECB) President Mario Draghi famously pledged years ago the ECB would do “whatever it takes” to reverse the deflationary undercurrents plaguing the euro zone.  But until this year the ECB failed to live up to that promise.  Late last year Europe’s central bank finally got serious and lowered deposit rates while extending its 80-billion-euro monthly asset purchase program. 

Positive results of the bank’s efforts to date haven’t yet been seen, though there are preliminary indications that many European bourses are establishing intermediate-term bottoms.  Much depends on the ECB’s commitment to QE in the year ahead.  By keeping the proverbial pedal to the floor for an extended length of time, the ECB may yet succeed in reversing the continent’s financial malaise.  However, if the bank makes the mistake Japan made by easing up on QE prematurely, the euro zone can expect to see a resumption of the economic malaise.

By far the biggest success story of QE has been the U.S.  The Fed’s unprecedented stimulus measures in the wake of the 2008 credit crash galvanized an historic rally in the stock market which brought recovery to the major indices in record time.  Since the U.S. essentially has a financial economy, any sustained recovery in financial asset prices must of necessity lift the economy sooner or later.  Thus the improvement in many sectors of the economy since 2009 can be attributed, at least in part, to QE. 

The evidence to date strongly suggests that stimulus played an integral role in fueling the mighty asset price recovery that began over seven years ago.  The Federal Reserve’s interventionary QE program was successful beyond anyone’s wildest guess when measured by the result of the equity and real estate markets.  And while many are quick to condemn QE as having been a failure at resuscitating the economy, the data would argue otherwise. 

But after about six years of easy money, the Fed brought its QE program to a close in late 2014.  After that the stock market as measured by the NYSE Composite Index (NYA), the broadest measure of U.S. equities, entered a prolonged sideways trend, which can largely be attributed to the loss of QE.  The loss of billions of dollars per month of liquidity for stocks was gone and with it the sustained forward momentum that fueled the market’s surge from 2009 to 2014.


Keeping the U.S. market buoyant since then has been a combination of factors.  Continued low interest rates coupled with huge inflows of cash from foreigners seeking a safe haven from the global crisis have been a huge benefit for equities.  The lack of competition from commodities and other assets has also helped.  This influx of foreign “hot” money has amounted to a de facto stimulus for stocks, so in essence the market is still receiving stimulus from afar. 

Stocks need stimulus in order to advance in the absence of a strong economy.  When the economy is strong investors need no prodding to put their excess earnings into equities with hopes of greater profits.  A strong economy also breeds confidence in the present and optimism about the future; it serves as a kind of natural stimulus for the stock market.

Ironically, central bank stimulus can also serve as a deterrent for small investors since they interpret the need for stimulus as confirmation that the economy is weak and needs assistance.  Thus the public sometimes lack the incentive to take risks when QE is in full swing.  It’s the professional investor who is sophisticated enough to read between the lines and buy stocks in a weak economy, provided there is stimulus.  This is the great paradox of a stimulus-driven bull market: only the few participate, yet it eventually benefits the many as the wealth generated from higher stock prices permeates the broad economy. 

The great unknown factor concerning QE is the outer limit of its success.  Just how successful can QE be in stimulating the economy?  A satisfactory answer to this question hasn’t yet been supplied.  Just when it looked like the financial market rebound from the 2009 low was ready to explode into a full-fledged runaway bull, the Fed took its foot off the accelerator.  Eventually the generous liquidity the Fed was supplying ground to a halt and the stock market responded accordingly as its forward momentum slowed exceedingly.  

Central bankers, it seems, have an inveterate fear of inflation.  Most of today’s voting Fed members came of age during the runaway inflation of the 1970s.  The memories of that harrowing experience continue to haunt them, and its influence is reflected in their policies.  The prevailing belief is that too much QE equates to too much inflation.  This is a fallacy.  The U.S. and global economies have been so significantly altered by demographic, social and political shifts in the last two decades that inflation won’t be a major concern for many years to come. 

The Fed could have doubled its asset purchases between 2009 and 2014 without creating any appreciable increase in inflation.  Instead it decided to stop QE before inflation even registered, which was tantamount to pushing a stalled vehicle up a hill only to stop pushing before the summit is reached.  It would have been exciting to see just how successful QE could have been had the Fed decided to gun for prosperity.  Instead, the Fed chickened out and ruined its best chance at delineating once and for all the outer limits of central bank stimulus.

The other objection to a full-throttle QE initiative is the widespread fear of creating another asset bubble similar to the real estate bubble that popped in 2006 and led to the credit crisis.  History and human nature testify that a catastrophic crash of the magnitude of the ’08 credit storm takes at least one entire generation (i.e. circa 20 years) to dissipate.  In other words, it takes the advent of an entirely new generation who didn’t experience the crisis to repeat its mistakes.  At present there is a complete absence of risk-taking behavior among the generation that experienced 2008.  That deep-seated fear of risk won’t disappear anytime soon.  Thus the “bubble that broke the world” isn’t going to happen again for a long, long time. 

The simple answer to the question, “Can stocks survive without stimulus?” is an emphatic “No!”  Stocks always need fresh injections of liquidity to gain ground and surge ahead.  Whether the stimulus takes the form of QE, fiscal policy or surplus savings is a moot point.  But stimulus in all its many forms must be present to propel equity prices ever higher.  And rising stock prices in a financial economy like the U.S. always creates a wealth effect.  Thus in the final analysis, stimulus is to everyone’s benefit.

Wednesday, August 10, 2016

Why the U.S. benefits from global financial crisis

Let’s turn our attention to the global economy.  Last week the Bank of England said it would buy 60 billion pounds of government debt in order to cushion the economy against the impact of the recent Brexit vote.  England and the European Union are emulating the quantitative easing (QE) policies of the U.S. Federal Reserve but so far without any measurable success.

Meanwhile the Bank of Japan (BoJ) has begun a massive stimulus program which may already be having an effect on Japan’s bond yields.  There has also been talk of Japan initiating a “helicopter money” scheme whereby the BoJ would directly finance fiscal spending. 

Indeed, loose money policies in England, China, and Japan are all the talk right now among investors.  The attempts by the ECB, BoJ, and People’s Bank at stimulating their way out of deflation have yet to show appreciable results, but this won’t stop them from trying. 

If nothing else, these desperate attempts at re-inflating their economies are providing support for gold, U.S. Treasuries and corporate bonds.  In many countries the interest rate is negative, which means that bond investors are essentially paying the bond issuer to hold their money. As one observer put it, “Negative interest rates were unheard of a few years ago.  Now they are spreading around the world like cancer.”

The yield on the U.S. 10-year Treasury note is only about 1.60 percent (see chart below), but on a relative basis the U.S. is a veritable high-yield paradise in the eyes of yield-hungry investors.  Along with U.S. Treasury and mortgage bonds, safe haven assets such as gold, silver and even U.S. real estate are in high demand.  Gold especially is a fear-driven asset, and with growing uncertainty surrounding the economic outlook for China, Japan, the EU and other countries, gold should continue to benefit in the coming months. 


Although there has been no formal crash in the European markets, euro zone bank stocks have acted as if a financial crash is underway.  Consider the following graph.


As shown above, the STOXX index of 47 leading European bank stocks shed nearly 40 percent of its value from May 2015 to May 2016.  Bad loans along with negative interest rates have significantly eroded the banks’ profitability as illustrated in this chart. 

Here’s something else to consider: In 2014, IMF chief Christine Lagarde proposed that 10 percent of every saver’s bank account be essentially confiscated as bail-out money, similar to what happened in Cyrus in 2013.  Robert Campbell, in his latest “Campbell Real Estate Timing Letter” (www.RealEstateTiming.com) asks, “If you were a European saver, would you keep your money in a bank savings account knowing that the money could be confiscated if the bank needed capital to keep operating?  Or would you think long and hard about taking your money out of the European banks and investing it in the U.S. – in stocks, bonds, or real estate – where your money is safer?”  

Campbell suggests – and quite correctly, IMO – that U.S. financial markets have benefited from capital flight out of Europe and other countries.  “It might seem paradoxical,” he writes, “but the worse the economic situation gets in Europe, the better it could be for U.S. asset prices.”  The experience of the last several months argue strongly for this conclusion.

Thursday, August 4, 2016

Clif Droke on Financial Sense News Hour

I was recently interviewed by Cris Sheridan of the Financial Sense Network.  The interview can be downloaded at the following link:
In it we discuss the the bull market which began in February and the possible outcomes for the remainder 2016.  Special thanks to Cris and everyone at FSN.

Thursday, July 28, 2016

Is the tape being painted for Hillary?

In the old-school lexicon of Wall Street, the term “painting the tape” referred to the large scale purchase of market-moving stocks by insiders for the purpose of giving the market an appearance of strength.  Painting the tape was practiced by “pools” and large firms who were in the know; it was designed primarily to present a picture of strength when there was an undercurrent of weakness. Painting the tape was also done in some cases to trick amateur traders into buying certain individual stocks by means of manipulating the stock’s trading volume. 

While the technique of “tape painting” has changed since those days, the practice of manipulating the market is still quite common. Indeed, it happens on a daily basis and successful speculation requires the ability to recognize it and deftly sidestep its intended consequences.  That said, now would be an appropriate time to ask the question: “Is the market’s recent internal strength the result of natural demand or of manipulation?”  And if the latter is true, for what purpose is the market being given a false appearance of strength? 

Let me begin by asserting that I don’t believe the broad market’s increasing strength since February is the result of outright deception.  While there may be individual stocks, and perhaps even select industries, which are undergoing active manipulation the fact that the stock market’s recovery is nearly six months old is an argument for legitimate demand-driven buying.  Experience has taught that it’s not possible to artificially strengthen a market for that length of time, especially when the NYSE new high-new low differential is so consistently strong.  There must be broad-based demand, for no clique or coterie could possibly keep the entire market elevated for that length of time without widespread participation.    

Having said that, I’ll acknowledge the possibility that the recent breakout in the large cap indices may have been premature.  While it was accompanied with great fanfare, the breakout to new highs was unaccompanied by some of the other major indices, including the Dow Transports and the NYSE Composite Index (NYA).  The important financial sector stocks, moreover, remain stuck in their lateral trading patterns of the past year and didn’t confirm the breakout, either. 

If the tape is being painted, for what or for whom is the fireworks display being made?  The most obvious culprit would be the upcoming U.S. presidential election.  One possibility is that a large contingent on Wall Street is trying to influence the outcome of the November election.  There’s a well-known historical association which states that I the stock market rallies in the months before the election the incumbent party typically wins.  The idea in fashion among Wall Street pros is that the Democrat nominee’s policies would favor Wall Street.  By contrast, there seems to be no clear consensus among pundits that the Republican nominee would be good for stocks. 

A correlation has also been made between the periods of weakness in the financial market this year and the surges in candidate Trump’s popularity.  Trump has enjoyed his greatest campaign success when stocks have stumbled or remained subdued for long periods.  An extended rally in the major indices, however, has coincided with a drop in his positive polling.  There is, in other words, an inverse correlation between Trump and the prevailing stock market trend. 

Again I must emphasize that this is merely a speculation on my part and cannot be empirically proven as a definite reality.  If the new highs are being engineered for political or economic reasons, however, it will become clear in the months ahead.  We’ll know, for instance, if the new highs are artificially induced if the banking and broker/dealer stocks are unable to make yearly highs in the next few weeks.  Failure of the Dow Transports to confirm the new high in Industrials would be another clue.  In particular traders should keep a close watch on the chart of the NYSE Securities Broker/Dealer Index (XBD) shown below.  The best and strongest extended bull markets have always been confirmed by higher highs in the XBD.


If the tape is indeed being “painted” then we can expect to see continued new highs in the Dow and SPX in the coming months, even if unconfirmed by the other indices and industry groups.  Large cap stocks have been the beneficiaries of the informed buying of recent months and show no signs of being under distribution.  Internal selling pressure within the NYSE broad market is nonexistent right now, which favors the bulls in their attempts at pushing large cap stocks higher before the election.  There may, however, be a reckoning after the election is over.  

In the meantime traders have some fantastic opportunities to take advantage of the favorable internal conditions within several of the market sectors.  As a painter might say, one should never let a good canvas go to waste.

Wednesday, July 27, 2016

The great gold stock rally

This year has been extremely kind to gold and silver mining stock investors.  If you were one of the few participants to have had the courage to buy when no one else was interested, you certainly have enjoyed a profitable ride so far.  Thankfully our subscribers were among those who took the plunge and bought mining stocks when they were cheap.  We’ve been basking in the rewards in the past few months and hope to continue our winning streak in the months to come.

Here’s what our performance has been in like since last year.  The following graph is a weekly tally of all trading recommendations made in the Gold & Silver Stock Report.  This includes all gold/silver ETF and individual mining stock trading recommendations.


As illustrated by this chart, patience is typically rewarded whenever you consistently practice a reliable trading discipline.  Discipline is the key word here, for without it a trader will always succumb to blind emotion and eventually lose money.  That’s why discipline [i.e. sound money management] is so important whenever you’re operating in the financial market.  With GSSR, you always have the advantage of a time-tested discipline at hand and you can always be assured of avoiding the big market declines while benefiting from the big rallies.  This is how a trader or investor comes out a winner in the long-term scheme of things.

Tuesday, July 19, 2016

Is Kyle Bass finally getting his revenge?

One of America’s most prominent hedge fund managers is betting the farm that China’s economic troubles are far from over.  His bet centers around the U.S. dollar and by extension several Asian currencies.  What happens to the dollar from here will determine whether this man’s epic trading positions pays off, and China suffers a major setback, and whether his worst case scenario for the global economic outlook is merely a mirage.  If he’s right, the outcome of his bet will also affect the commodities market and perhaps even the equities market. 

Below is a graph of the PowerShares U.S. Dollar Index Bullish Fund (UUP), an excellent proxy for the U.S. dollar index.  UUP is useful since it allows us to see trading volume patterns, particularly since UUP is a favorite of institutional currency traders.  The graph shows that UUP has been establishing a short-term base of support above its rising 15-day moving average for the first time this year.  The recent breakout attempt above the nearest pivotal chart benchmark at the 25.00 level technically paves the way for a dollar rally, which may in turn create some short-term headwind for equities. 



A decisive breakout above the 25.00 level in UUP would allow the ETF to retrace more of its losses from past months.  Any rally in the dollar from here would also put a bit of a strain on some of the major foreign currencies, which in turn would cause global investors to become more apprehensive.  One reason for bringing up the dollar is the famous bet made by the billionaire hedge fund manager Kyle Bass.  Bass made headlines when he correctly predicted the 2008 credit crash, and he has made another big short trade against China. 

According to the Wall Street Journal, Bass’s Hayman Capital Management sold off the bulk of its investments in stocks, commodities and bonds so it can focus on shorting Asian currencies, including the yuan and the Hong Kong dollar.  “About 85% of Hayman Capital’s portfolio is now invested in trades that are expected to pay off if the yuan and Hong Kong dollar depreciate over the next three years – a bet with billions of dollars on the line, including borrowed money,” according to the WSJ.  “’When you talk about orders of magnitude, this is much larger than the subprime crisis,’ said Mr. Bass, who believes the yuan could fall as much as 40% in that period.”

In an interview on FOX Business Network’s Wall Street Week on Apr. 15, Bass clarified his investment position:

So we have all of our focus on Asia.  We don’t have any money invested in Asia.  What we have is, we’re long the dollar, the U.S. dollar.  And we’re betting against the Chinese currency, i.e.  If we’re right about the banking crisis and we’re right about the fact that they’re going to do everything that it takes to fix themselves, which they will.  They’ll recap their banks.  They’ll reform, everything they can do on the spending side.  They’ll…do everything they have to do….What that means, their currency is going to have a massive devaluation.”

Essentially, Bass is betting that Asian currencies will fall while the U.S. dollar will strengthen.  For much of 2016 his bet didn’t pay off, but things are starting to go a little more in his direction.  What’s more, his investment time frame is long enough to allow him leeway to ride through periods of dollar weakness and Asian currency strength.  Incidentally, here’s what the yuan trend looks like through the lens of the WisdomTree Chinese Yuan Strategy Fund ETF (CYB).


In a July 1 interview on Real Vision, Bass told investors that China’s $3 trillion corporate bond market is “freezing up” amid rising defaults and canceled debt sales.  “We’re starting to see the beginning of the Chinese machine literally break down,” he said. 

China’s corporate bond market contracted by a record amount in May as tepid economic growth and a spate of missed payments spooked investors.  Seventeen publicly-traded Chinese bonds have defaulted so far this year, up from six in 2015, and at least 188 firms have scrapped or delayed debt sales since the end of March, according to Bloomberg.  See graph below.


In the Real Vision interview, Bass reiterated that China’s lending binge in recent years has created “the largest macro imbalance in world history.” He expects bank losses of $3 trillion to trigger a bailout, with the central bank slashing reserve requirements, cutting the deposit rate to zero and expanding its balance sheet – all of which will weigh on the yuan.

Bass doesn’t believe that China will experience Armageddon, however.  “They are going to [recapitalize] the banks, they are going to expand the People’s Bank of China’s balance sheet, they are going to slash the reserve requirement, they are going to drop their deposit rate to zero, they are going to do everything the United States did in our crisis,” he said.

Bass and his hedge fund have had a rough go for the last couple of years.  If the dollar manages to get a rally started in the coming months, however, he would have a measure of revenge against his many critics who contend that China is in much better shape than Bass contends.  A dollar rally may also have the spillover effect of at least temporarily putting a drag on the stock market’s rally. 

As mentioned previously, in 2016 more than ever the global financial outlook depends on the prevailing trend of the U.S. dollar.  Since last year the dollar’s strength has been inextricably tied to global market weakness while dollar weakness has led to stock/commodity market strength.  A breakout in the dollar index below its benchmark chart resistance (highlighted below) would serve as a harbinger of returning U.S. currency strength and potential weakness for commodities and possibly equities.  It would give the China bears like Kyle Bass their moment in the sun. 

Kyle Bass’s “revenge” is no private matter but something that concerns all investors.  For that reason, what happens to the dollar from here will take on added significance.  

Wednesday, July 13, 2016

A real estate mania redux

Among the biggest relative strength leaders in the U.S. broad market right now are the home builders and REITs.  The U.S. real estate sector is heating up and is also beginning to attract “hot money” inflows from foreign investors looking for a profitable safe haven.  Real estate is building a measure of momentum not seen since before the 2008 credit crash.  As such, the question as to whether a renewed property market mania is underway is a timely one and will now be addressed.

The following graph of the Dow Jones Equity REIT Index (DJR) illustrates the growing demand for hot properties.  REITs in particular have been on a rip-and-tear of late as reflected in the chart.  Ultra low interest rates and continued agency bond purchases by central banks have helped bolster real estate and the related equities, among other factors we’ll discuss here


Investors should accordingly expect to hear more enticing stories about the desirability and investment potential of U.S. commercial and residential real estate in the months to come.  One such story appeared in a recent Fortune.com article entitled, “How Brexit Could Make Your House Worth More.”  The author, Chris Matthews, argues that Britain’s decision to leave the EU could mean higher real estate prices for the U.S. 

According to Matthews, as the Brexit vote result sent U.S. Treasury yields tumbling it will also exert a downward pull on 30-year fixed mortgage rates.  This in turn will make U.S. real estate more attractive to investors both foreign and domestic. 

He also quotes KC Sanjay, an economist with Axiometrics, who said, “International investors have been increasing their holdings in the U.S. over the past several years, as they have gained a better understanding of the American apartment market and an appreciation of the sector’s profitability.”  This means, says Matthews, that investors are primed to view the U.S. real estate market as a favorable alternative to the London market.

British property investors have indeed taken a blow in the wake of the Brexit vote.  It was reported earlier this month that three financial firms stopped trading in their respective U.K. commercial property funds on the heels of a “rapid increase” in investors trying to sell their holdings.  The move was cast by the financial press as a “temporary measure” to help avoid another credit event like the one seen in 2008.  It further underscored the exodus out of overseas property holdings and the corresponding increase in U.S. real estate demand.

A further incentive for foreign investors to increase their financial exposure in the U.S. is provided courtesy of U.S. government rules easing the tax burden on foreign real estate investments.  A non-U.S. investor, for instance, can now own up to 10 percent of a REIT before incurring federal taxes.  That percentage is up from 5 percent prior to the new rule being implemented in December 2015.  As is normally the case, federal policy is paving the way for a future asset craze. 
  
In a recent issue of The Campbell Real Estate Timing Letter (www.RealEstateTiming.com), real estate timer extraordinaire Robert M. Campbell points out that U.S. housing prices should continue appreciating based on several fundamental factors.  Campbell notes that the current market is still appreciating at a vigorous inflation beating pace of over 3% per year, and the data suggests real estate has continued upside potential.

He also points out that the momentum behind the CoreLogic Home Price Index increased by 6.7% year-over-year in March 2016.  Momentum increases in this index have historically been followed by additional upside in U.S. housing prices in the months ahead.  Moreover, the U.S. home ownership rate has plummeted to its lowest level since the 1960s as more and more Americans are renting.  When adjusted for population growth, the supply of homes to rent hasn’t been keeping up with demand which means more units will have to be built.  This is but one facet of the strong real estate sector performance this year. 

Most of the increasing demand for property is coming not from the middle class, as was the case in the previous real estate run-up, but from the upper middle class.  The greed of gain and the inveterate tendency for the upper middle and upper classes to ostentatiously display their wealth is translating into a race to build the biggest house.  This in turn is one of the driving forces behind the expansion in the U.S. residential real estate market.  Below is a graph of the Case-Shiller 20-City Composite Home Price Index showing the steady increase in home prices since the 2010-2012 market bottom.


No socioeconomic class is immune from the inexorable pull of runaway greed, and no class ever fully escapes punishment from extreme greed.  As the upper middle class emerged relatively unscathed from the housing bust aftermath, it remains for them to be drawn into the vortex of real estate mania before the next big housing bubble expansion and subsequent collapse occurs.  In the end, they too will endure much the same fate as the U.S. middle class in the years since the last housing bust.