Thursday, December 1, 2016

Will real estate tank in 2017?

In many ways, 2016 has been a banner year for U.S. real estate.  Housing prices continued to strengthen in several major metropolitan markets and even reached frothy proportions in at least three major markets.  Below the surface of an otherwise healthy market, however, lies a set of factors that could cause problems for the housing market in 2017.

Like most financial assets, home prices have been stuck in a sideways trend since 2014 and by all appearances weren’t going anywhere anytime soon.  The chart shown here from the Calculated Risk blog shows the CoreLogic Home Price Index from a yearly percentage change standpoint.  The dramatic increase in the tax and regulatory burden courtesy of the outgoing regime contributed to this standstill.  In the last several months it was the uncertainty over the November presidential election which contributed to subdued speculative activity in the financial markets. 


Now that the uncertainty has lifted to a large degree, asset prices are breaking out from their constrictive trading ranges, with many stock market sectors making nominal new highs.  Investors are hopeful that the incoming administration will be more pro-business than the last one.  Even real estate prices have ticked higher on a year-over-year basis, as shown by the above chart. 

With continued strength in real estate prices comes an increase in home equity wealth for homeowners.  According to CoreLogic, home equity wealth has doubled since 2011 to $13 trillion due mainly to the housing market recovery. Moreover, CoreLogic has forecast that a continued five percent rise in home values in the coming year would create an additional $1 trillion in home-equity wealth for homeowners. 

The current supply/demand balance for U.S. residential real estate is still favorable for a rising market.  Existing home sales and new home building permits are on the rise, with existing home sales rising in recent months by positive increments.  The National Association of Realtors recently reported that the supply of homes was a 4.5-month supply at the current level of sales.  This means that supply has decreased 7 percent in the past year.


Up until now the rally in bond yields (and fall in bond prices) hasn’t had much of a discernible impact on mortgage rates.  That may be in the process of changing, however.  The U.S. 30-Year Fixed Mortgage rate rose to 4.03% from last week’s 3.94%.  In doing so it pushed the year-over-year percentage change in the mortgage rate above the “zero” line and into positive territory.  Whenever this has happened in the past it tends to create weakness for the real estate-related stocks in the market.  It can even negatively impact the overall broad market for equities if mortgage rates continue rising over several months.  Rising mortgage rates can also be quite detrimental for the overall real estate sector if they persist long enough. 


It’s also worth pointing out that three-month Libor rates, which are the benchmark cost of short-term borrowing for the international banking system, have nearly tripled in the last 12 months.  As Steen Jakobsen of Saxo Bank has observed, “The Libor rate is one of the few instruments left that still moves freely and is priced by market forces.  It is effectively telling us that the Fed is already two hikes behind the curve.” 


My colleague Robert Campbell, who writes The Campbell Real Estate Timing Letter (www.RealEstateTiming.com) had this to say in his November newsletter: “Current real estate valuations are justified only if rates stay low – and if the Fed does raise rates in December as the financial markets currently expect, housing prices could start adjusting downward.”  This is certainly worth pondering as we head into 2017, especially if the interest rate uptrend continues.  

Real estate has been on a solid footing in the last few years but looks to encounter some turbulence at some point next year. The increase in market interest rates may well pressure the homebuilding sector, especially given the vertiginous levels which bond prices have soared to in recent years.  Any continued weakness in the bond market will only increase the pressure on housing loan demand. 

Tuesday, November 15, 2016

U.S. economy at major long-term pivotal point

As the dust settles from the U.S. presidential election, multitudes of political analysts and news commentators continue to scratch their heads wondering “what went wrong?”  The collective question they’re asking of course is in reference to the candidate who was elected President. 

This is the wrong question to ask, however.  What they should be asking is what led millions of (mostly) middle class voters to rise up against the favored establishment candidate and voice their disapproval with the incumbent party.  As is normally the case with anything relating to politics, the answer is to be found in the realm of economics. 

It’s no secret that the main source of the middle class revolt is that class’s overall lack of strong participation in the economic recovery of the last seven years.  Pundits have tended to put the blame for this squarely on the shoulders of middle class workers.  They never tire of repeating the mantra that the middle class’s skill set is fast becoming obsolete due to the evolution of technology and increased globalization.  This, though, has been true for at least the last three decades, so it hardly qualifies as a prescient insight. 

No, the root of middle class revolt is far more contemporary in origin and is much easier to isolate than the pundits think.  Let’s ask ourselves, in political terms, what is it that the middle class demands more than anything else?  The political philosopher Niccol√≤ Machiavelli provided the answer to this rhetorical question centuries ago: the working class want nothing more than to be left alone by the ruling class.  In other words, they don’t want to be excessively taxed.

Without almost a single exception, any revolution in any country – be it political or military – has begun when the people were over-taxed and their cost of living became too high to support without undue strain.  It isn’t as much a lack of skills which has led to the middle class’s troubles as it is a drastic increase in their cost of living, thanks largely to an extraordinary increase in taxes in recent years.  And the main source of their tax trouble can be pointed to a single source, viz. the Affordable Care Act (a.k.a. Obamacare). 

Regardless of what your opinion might be as to the efficacy of this legislation, the undeniable fact remains that for millions in the middle class it has effectively drained their earnings by inflicting a hefty a penalty on those who don’t wish to purchase health insurance.  It enacts an even stiffer drain on consumers’ earnings by encouraging the young and healthy to purchase costly medical insurance when they don’t really need it. 

As Machiavelli himself wryly observed, history does tend to repeat and most political rulers fail to learn from its precepts.  One would think the Democrats would have learned a valuable lesson about forcing healthcare upon an unwilling populace in 1993, when the Clinton Healthcare Plan (a.k.a. Hillarycare) was first proposed.  It basically amounted to a forced attempt at socialized healthcare in the U.S., and it was staunchly opposed by millions of (mostly) middle class voters.  A vigorous initiative against the plan launched by the Christian Coalition effectively sealed the fate of the Clinton Healthcare Plan, allowing the economy a narrow escape from a substantial tax increase.

A rudimentary lesson of Economics 101 is that unwarranted taxes always hinder productivity to some degree or other, for taxes are a disincentive to produce.  The more taxes government implements to remove money from the pockets of wage earners, the less incentive they have to work hard and make even more money.  Thus the velocity of money decreases, which is the basis behind a sluggish economy (as we’ll see here). 

The Obamacare penalty must certainly rank as one of the biggest tax increases in U.S. history.  One simply cannot tax the American middle class like that and expect to that economic growth will continue unimpeded.  This is a big reason why the Democrats lost big in the latest election: it was the middle class’s repudiation of the Obamacare tax more than perhaps any other factor. 

Although the economy has certainly made significant strides since the depths of the Great Recession, there’s no denying that it hasn’t regained its luster from the heady years prior to the crash.  Economists often lament the lack of money velocity in the U.S., which is depicted in the following graph. 


Velocity is simply a measure of how quickly money is changing hands in the U.S.  The above chart is a snapshot of the annual percentage change in money velocity.  The picture speaks for itself and is a perfect reflection of the residual anxiety still very much present within the middle class economy.  Money simply isn’t changing hands fast enough among typical wage earners and this has kept the economy from what could have been a vigorous expansion. 

The blame for that can be put largely on the biggest tax increase in decades previously mentioned.  As long as the Obamacare tax remains on the shoulders of non-healthcare consumers it will continue to create a drag on the economy and prevent the kind of efflorescence historically associated with the strongest rebounds. 

Beyond the impact that the Obamacare penalty laid upon millions in the middle class, it has also had repercussions for investors and business owners.  The drag created upon business by Obamacare requirements has almost certainly contributed to the lack of forward momentum in the stock market these last two years.  It can be seen most clearly in the NYSE Composite Index (NYA), below, which is the broadest measure of the U.S. equity market. 


The breakout to new highs in several of the major indices, excluding the NYA, may indeed prove to be an anticipatory move in response to expectations that the Trump Administration will relieve business of its excessive tax and regulatory burden.  In order for the breakout to give way to a continued boom, however, this expectation should become reality.   

Now that Republicans control both chambers of Congress they have a chance to redeem themselves from their lack of a concerted effort against the Obamacare vote.  Regardless of whether they support the law remaining intact, to acknowledge the middle class constituents who voted for them they can, and should, send an undeniable message of support.  By eliminating, or at least significantly lowering, the penalty for not buying health insurance they will have given the middle class the best possible gift they can give.  In doing so they will be lifting a huge hindrance to the economy and allow it to truly take off in 2017.   

The 60-year economic cycle of inflation/deflation which bottom a couple of years ago hasn’t had a chance to work its magic on the U.S. economy by lifting the deflationary currents from the last two decades.  The early years of the new 60-year cycle tend to exert a benign inflationary impact by gradually lifting prices without creating the problems associated with too much inflation.  The up-phase of a new 60-year cycle also tends to stimulate consumer spending and investment within the economy due to the gradual increase of benign inflation.  Yet the cycle hasn’t been allowed to do its work thanks to the grievous burden of taxation imposed by Obamacare.  

If this tax is reversed by the incoming Congress, it’s highly likely that we’ll witness a magnificent flowering of the economy in the years that follow.  While the economic recovery since 2009 can be likened to foliar growth in a fruiting plant, the second and most important phase of the recovery must involve flowering.  Only then can the plant bear its fruit.  To date there has been much leafy growth, yet little flowering.  The stimulant required for this flowering is the lifting of the excessive burdens placed upon it by the previous caretakers.  

Thursday, November 10, 2016

What investors can expect from the Trump revolution

They’re calling it the Great Revolution, and rightfully so.  Donald Trump’s earth-shattering victory over Hillary Clinton on Nov. 8 must surely rate as one of the greatest political upsets in U.S. history.  It stretches the mind to recall the last time a true political outsider won the Oval Office.  The prospects of what an independently wealthy and politically unattached President can do for the country are tantalizing to consider. 

Let’s leave the hyperbole and political predictions to others, though, and focus on what little can be discerned in the wake of Trump’s historic win.  There’s a saying we’re all familiar with: “Don’t listen to what they say, follow the money trail.”  That bromide has never been more relevant than it is right now.  With that as our starting principle, let’s examine what the “smart money” thinks about Trump’s presidential victory.  They’re the ones, after all, who determine the financial market’s course and it’s their opinions that will likely prove most accurate. 

In the wake of Mr. Trump’s victory of the U.S. presidency we’re seeing an avalanche of predictions and commentaries from all sides of the political spectrum as to what the President-Elect will do once in office.  His opponents vehemently assert he will drag the country into an economic recession – or worse – with his proposed policies.  His supporters maintain he will restore American greatness and revitalize the nation’s struggling middle class.  Not in ages has there been a more polarized response among both sides of the political divide.

Since no one but Trump himself and perhaps a few insiders can possibly know exactly what his true intentions are, any attempt by outsiders such as me at predicting the coming months would be mere speculation.  That doesn’t mean we’re completely without guidance, however.  The old tried-and-true bromide that every successful investor knows by heart can always provide valuable insights on what likely will be next, viz. “The tape tells all.”

What exactly does “The tape tells all” mean?  It means that while individuals may cast votes on a ballot and share their opinions with pollsters, the only votes that really count are the ones they make with their money.  After all, when one’s hard-earned dollars are at stake you tend to think long and hard before placing your “vote” in the marketplace.  Campaign promises can be broken and good intentions are ephemeral, but investment decisions typically have bigger consequences.  As such, they tend to be made with far greater forethought and longevity than mere spoken words.  With that said, let’s examine what the smart boys and girls who vote with their dollars actually think about the prospects of President-Elect Trump’s upcoming reign.

One assumption that many held about a Trump victory was that the global markets would plunge and the economy would deteriorate.  Already there were some headlines appearing after the election forecasting a “Trump recession.”  The stock market “tape” doesn’t indicate that informed investors are concerned about the prospects of recession under Trump.  In fact, the market crash that many had predicted failed to materialize and instead a vigorous rally greeted Wall Street on Wednesday morning after the election.  The stock market gained 1.43% on Wednesday despite S&P 500 futures being down 5% at one point overnight.  This isn’t the money voting action of a group of insiders concerned about imminent recession or a bear market; it suggests that cooler heads have prevailed against last night’s emotional reaction in the futures market.


One of the best ways of anticipating a president-elect’s policies is to take notice which industry groups are outperforming in the days immediately prior to and following the election.  This technique works especially well if the industries in question have been underperforming for an extended period.  Again, the rationale behind this is that informed investors are better equipped than outsiders to predict a president’s trade and economic policy intentions.  Sudden and dramatic shows of relative strength prior to, and in the wake of, an election are signs that the insiders are buying stocks poised to benefit from those policies. 

A couple of weeks ago we discussed the strong performing defense sector and the implication it held for potential military activity in the coming 1-2 years.  While my assumption for this was predicated on a Clinton victory, a Trump presidency may still hold the prospects for militarism.  Note the stunning performance of the Dow Jones U.S. Defense Index (DJUSDN) on Wednesday in the wake of the election.  Defense stocks were one of the top-performing groups for the day as the Defense Index posted a 6.21% gain.  The smart money apparently sees the potential for military action even in spite of the President Elect’s dovish rhetoric. 


The financial sector has been a star performer since before the election and had another blowout day on Wednesday after the election.  Led by the big institutional financial firms like Goldman Sachs (GS), the bank stocks gained an average of 5% for the day while the broker/dealers were up 6% on average.  Here’s what the PHLX Bank Index (BKX) looks like as of Wednesday.  The index made a new 52-week high as you can see, quite impressive given that the average NYSE stock is still below a 2-year trading range ceiling. 


This is an important consideration since leadership and relative strength in the broker/dealer and banks normally carries bullish implications for the broad market.  It also tells us that, far from being disturbed by the threatening aspects of a Trump presidency, Wall Street (or at least a large faction of the Street) is apparently enthusiastic about the prospects for success under his administration.  Time doesn’t permit a more extensive analysis of the many industry groups and their reactions to Trump’s victory, but we’ll take a closer look at them in the next commentary.  

Wednesday, October 26, 2016

The next big catalyst for stocks/commodities

We’re about to enter that time when financial commentators offer up their best guesses as to what investors can expect in the Near Year.  It always makes for fun reading, but it also never fails to disappoint.  Instead of engaging in that tired exercise in futility, investors would do better to focus on something more productive.  And that would be next year’s most likely catalyst for stock and commodity prices.

Instead of asking the fruitless question, “At what price will the S&P 500 finish in 2017?” wouldn’t it be better to ponder what could possibly stimulate asset prices out of their lethargy?  Granted, this is as much a guessing game as the former question.  But at least applying critical thinking to the catalyst question, investors are almost certain to uncover some hidden opportunities for profit.

Having said that, what could be next year’s biggest catalyst for a meaningful breakout-type move in: the broad equities market, the commodities market, or individual issues within both categories?  Putting the pieces of global events over the last year together and reading between the lines allows us to make at least one educated guess: military conflict.  War is after all one of the biggest catalysts for both stock and commodity prices, and it has the added benefit of boosting the economy, short-term.  Of course war must be paid for down the line, but that’s why “kicking the can” was invented (so that the day of reckoning can be perpetually delayed). 

Terrorist events have historically served both as precursors and pretexts for going to war.  As the following graph shows, terrorism has expanded dramatically in recent years [Source: www.civilserviceindia.com].  The exponential increase in terrorist events will likely be used to justify further military excursions among the Western nations which have become the targets of these events.


Indeed, the rumblings of war have been audible for some time now, and it’s evident that what has kept the U.S. out of another overseas conflict has been the focus on this year’s presidential race.  The current Commander-in-Chief is bound by his promise to end America’s long wars in Iraq and Afghanistan.  The incoming president, however, will be under no such constraint.  If that president just happens to be a certain candidate with the initials H.R.C., it’s also likely that America will have its next war-time president. 

As Micah Zenko argued in his recent Foreign Policy article on Hillary Clinton, the presidential hopeful has a long track record which strongly suggests she is a war hawk.  “Though she has opposed uses of force that she believed were a bad idea,” he wrote, “she has consistently endorsed starting new wars and expanding others.”

While the U.S. has already been at war for 15 years, the intensity of our nation’s war efforts have been dramatically scaled back in recent years.  Under Clinton, it’s easy to foresee a revival of warfare activities in the Mid East region.  While Zenko’s article was supportive of Hillary in the role of chief military commander he also acknowledged that “those who vote for her should know that she will approach such crises with a long track record of being generally supportive of initiating U.S. military interventions and expanding them.”

The U.S. isn’t the only major country which will likely see military action in the intermediate term.  One region which of the world in which military activity may see a notable increase in the foreseeable future is the Far East.  Japan is a case in point.

Earlier this year, Japan’s Prime Minister Shinzo Abe has made a controversial call to revise Article 9 of the nation’s constitution, which declares that “the Japanese people forever renounce war as a sovereign right of the nation and the threat or use of force as means of settling international disputes.”  In view of China’s ongoing military buildup in the South China Sea and other threats, Abe has said the restrictions on Japan’s military “do not fit into the current period.” 

Bert Dohmen of the Wellington Letter observed that an amendment to Article 9 “would lead to a military buildup, which always stimulates the economy,” adding that “Japan could finally get out of its 25 year deflation” if Article is deleted.

In response to increasingly hostile behavior from nearby North Korea, Japan may also accelerate roughly $1 billion of planned upgrades to ballistic missile defense systems, according to Reuters.  This consideration comes shortly after United States Strategic Command systems detected a failed missile launch recently in the northwest North Korean town Kusong.  Japan has been considering the budget request that will determine whether to add a new missile defense layer from either Lockheed Martin Corp or from Aegis Ashore.

Defense firms like Ratheon, Lockheed Martin, Mitsubishi, and Boeing are reportedly on tight production schedules with a backlog of international orders.  Following is a 10-year chart of the Dow Jones U.S. Defense Index (DJUSDN).  As this graph illustrates, defense stocks have significantly outperformed the S&P 500 (SPX) in recent years.  The average stock price for the leading defense companies underscores the immense war-related preparations and activity taking place within the sector. 


All over the world, it seems, nations are arming themselves with the offensive and defensive weapons of war.  The production-for-use theory of economics states that military buildups always eventually lead to the employment of those weapons in actual warfare.  Sooner or later the expansive activity that has been taking place in the defense sector in recent years will be implemented on the battlefields of the world.  When it happens, investors who are prepared for it will not only avoid the deleterious aspects of war, but will also profit from it.

Friday, October 14, 2016

America’s 50-pound ball and chain

America’s economic condition is truly a “tale of two cities.”  Upper middle class and wealthy earners have never been more flush thanks in large part to the record liquidity creation of the last eight years as well as to their financial market exposure.

By contrast, the middle and lower classes have either stagnated or are struggling as perhaps never before, due in part to their under-exposure to the financial market but also to the erosion of their real estate wealth in the last 10 years. 

The turmoil for the middle class began with the implosion of the real estate market in 2006 and accelerating with the events of the two years following.  The deterioration of home values and the loss of employment imperiled the middle class during the crisis years, and while many the middle class have since recovered their overall fortunes have never complete rebounded to pre-2007 levels.

The upper classes meanwhile have shown remarkable recovery.  One such reflection of their ebullience is the following graph which shows the New Economy Index (NEI).  As can be seen here, the NEI has made a series of new all-time highs in 2016 and this is significant.  It shows that consumers – mainly in the upper middle and upper classes – have been quite prolific with their spending.  NEI is a forward-looking measure of the retail economy based on the leading publicly traded retailers, business service, and business transportation providers. 


Notwithstanding the strength of the upper classes, there is at least one major impediment to a full-scale middle class recovery.  A heavy burden is weighing down the middle class, a tax which hangs upon its neck like a 50-pound ball and chain.  The tax in question is the healthcare mandate of the Affordable Healthcare Act (ACA).  Under this grievous yoke, individuals and married couples making middle class incomes must pay anywhere from $700 to over $4,000 per year in taxes (for non-compliance) or for healthcare coverage, even if coverage isn’t desired.  The ACA has forced millions who previously didn’t want or need health insurance (which to them is a liability) into buying it.  If they refuse, they must pay a substantial penalty.

While pundits have argued that the ACA is “working” and has “fixed” the nation’s healthcare crisis, they fail to specify for whom the law “works.”  It has certainly helped lower income individuals who had difficulty gaining access to healthcare previously.  And it definitely doesn’t hurt the rich, for whom the ACA tax burden is barely felt.  Middle class wage earners and small business owners, however, are the ones who must shoulder the burden.

A cursory examination of the middle class economy will reveal that the healthcare taxes of the last 2-3 years have acted as a drag on consumer spending among middle class taxpayers.  It has also inhibited small business hiring to a degree and has even forced some business owners to close shop.

Even for those taxpayers for whom the ACA isn’t a debilitating burden, at the very least it provides a reason to restrain their discretionary spending.  The impetus toward reduced spending is reflected in the exceptionally low monetary velocity, as well as in the diminished fortunes of several old-line retail companies.  This can be seen in the following graph comparing the share prices of three major U.S. retailers: Macy’s (M), Gap (GPS), and Wal-Mart (WMT).


An argument can also be advanced that the directionless stock market of the last two years is at least partly attributable to the reduced participation of retail investors in the middle class.  There is no denying that retail interest in equities has dwindled appreciably since 2013 with a consequent loss of momentum.  Powerful bull markets require heavy active participation from retail investors, otherwise the market turns into a veritable closed feedback loop with institutional interests trading among themselves.  The end result is a stock market that goes nowhere like the NYSE Composite chart shown here.


The first priority of the next Presidential administration in 2017 should be to reform the ACA by lifting the crushing tax burden from the middle class.  Doing so would remove a big obstacle in the path to full economic recovery.  It would also provide the stock market a reason to finally break free from its restraints of the last two years.  Here’s hoping that the next President has teh wisdom to see it and the will to carry it out.

Thursday, October 6, 2016

Will the bull market remain intact in 2017?

The question confronting investors right now is whether the lateral trading range in the major indices represents consolidation of the long-term uptrend, which precedes an eventual upside breakout from the range?  Or does it represent distribution (i.e. selling) which precedes an eventual breakdown of the trend? 

Bulls and bears have assembled evidence to support their respective take on this conundrum, but the most basic and useful evidence suggests the first outcome, namely an eventual upside resolution.  Let’s examine the evidence in support of this conclusion. 

While the bears have correctly observed that in the previous instances when the major indices have bumped up against trading range resistance – or temporarily exceeded it – the market has always had a sharp decline.  It’s also true that during the sideways range-bound market of 2015 there was definite evidence that distribution was taking place among informed investors.   This preceded the July-August collapse last year and the secondary collapse in January-February of this year. 

All through the spring and summer of 2015 the list of stocks making new 52-week lows on the NYSE was growing.  It remained elevated well above 40 – the dividing line between a healthy and unhealthy market – for much of the year.  Anytime there is a stretch of several consecutive days where new lows are above 40 while new lows are shrinking it strongly implies internal selling pressure beneath the surface of the broad market.  This was one indication that distribution was taking place last year while the Dow and S&P were churning in a sideways trend.  Finally, after several months of this internal selling pressure the market broke under the weight of it, as can be seen in the following graph.


After bottoming in February the stock market has only seen a total of nine days where the new 52-week lows numbered 40 or above.  That’s an impressive stretch of internal health and it shows that there has been little or no selling urgency or distribution since then.  The dearth of new lows argues strongly, therefore, in favor of the longer-term bullish trend remaining intact heading into 2017.  

On a short-term basis, however, there has been a definite loss of momentum.  As we’ve reviewed in recent reports the NYSE short-term directional components of our Hi-Lo Momentum (HILMO) index keep deteriorating.  Here’s what the three components look like as of this writing on Wednesday.  The blue line is the short-term directional indicator, the red line is the momentum bias, and the green line is the internal trend.


The downward-slanted trend in the above graph is indicative of a loss of forward momentum on a near-term basis and explains why the major indices have been unable to rally in sustained fashion since peaking in August.  As long as the short-term momentum indicators are declining it will also mean the market is vulnerable to negative news and may at some point experience another pullback. 

Acting as a counterbalance against this short-term downward pressure is the longer-term internal momentum indicator, shown below.  Currently this is the only one of the eight major HILMO components that is rising on a sustained basis.  My interpretation of this graph is that as long as this indicator continues its nearly vertical climb it should act as a deterrent to a serious bear raid.  That has certainly been the case since July-August when the internal cross-currents first became evident.  It’s also why any attempt at short selling among the bears has ultimately backfired due to the strongly rising longer-term momentum current reflected in this indicator. 


So while the loss of short-term internal momentum may negatively impact the near-term trend, it shouldn’t prove fatal to the major uptrend that began in March-April 2009.  

Thursday, September 8, 2016

Will Deutsche Bank collapse the global market?

The past year has seen its fair share of worries.  From the China slowdown to the Brexit, successive waves of overseas fear have rolled onto our shores since 2015, yet none of them were the Tsunamis the bears had predicted. 

The latest foreign fear concerns the possibility for a global credit crisis led by the collapse of a major international bank.  A simplified summary of this scenario goes something like this:  Deutsche Bank is on the brink of bankruptcy and its insolvency could spark a systemic European banking crash.  This in its turn could send shockwaves throughout the global financial system, resulting in widespread economic turmoil on par with the previous worldwide crisis. 

Commentators who favor this outlook tend to illustrate their dire predictions with a graph of Deutsche Bank’s stock performance since last year.  It certainly adds a spark of credence to their argument based solely on the depth of the stock’s plunge. 


One commentator has gone so far as to assert that “if Deutsche Bank goes under it will be Lehmen times five!”  Other observers have expressed a similar concern, albeit in less alarmist terms.  The International Monetary Fund (IMF) labeled Deutsche Bank as the most risky financial institution.  The argument goes that since Deutsche Bank is linked with other publicly traded banks and insurance companies, it has the potential to be the source of another worldwide financial contagion should the bank collapse.

In 2009, Deutsche Bank CEO Josef Ackermann assured investors that it had enough money to survive a crisis.  Three years later, however, some of his colleagues said bank hid €12 billion of operating losses with derivatives.  “The first warnings that Deutsche Bank could declare bankruptcy emerged in 2013 when the bank said it needed additional capital,” according to sputniknews.com.  “In 2013, it attracted $3 billion through issuing shares for its stakeholders.”

In March 2015, a stress test revealed that the bank again needed additional capital.  It was also revealed that the bank manipulated with LIBOR, and in April 2015 it was fined for $2.5 billion.  Subsequently, the ratings agency Standard & Poor’s downgraded Deutsche Bank from A to BBB+, three positions above the junk rating. 

In early June 2016, Deutsche Bank was again involved in a scandal over LIBOR manipulation.  The case involved at least 29 personnel who worked in London, Frankfurt, Tokyo and New York.  Last year, Deutsche Bank reported a net loss of €6.8 billion for the first time since 2008.

Most recently, the bank made headlines last week when its Xetra-Gold exchange traded bond failed to deliver gold upon clients’ request.  This understandably sparked grave concern from many in the financial realm that Deutsche Bank’s back is against the ropes once again.

Could a Deutsche Bank collapse serve as the catalyst for a 2008-type global credit storm?  When analyzing this question one must be very careful from making dogmatic statements since no one (especially an outsider to the international banking industry) can possibly know all the variables involved.  There are, however, some guidelines that can help us understand the position of the broad market vis-√†-vis the effects of an ailing global institution.   These guidelines should allow us to at least handicap the odds of a global financial meltdown.

One important guideline is the underlying strength and internal health of the financial market, notably the U.S. equity market.  In the months prior to the 2008 credit crash the U.S. stock market was exceedingly weak as evidenced by the sustained decline in NYSE internal momentum.  In fact, this is what the longer-term internal momentum indicator for the NYSE broad market looked like just prior to the 2008 collapse.


This internal weakness, combined with growing institutional weakness in almost all major sectors of the economy, meant that the U.S. was highly vulnerable to a financial shock.  When the Lehman Brothers collapse hit the market, the shockwaves were felt immediately and resulted in a domino effect.  In other words, internal weakness makes it far more likely that an exogenous shock to the system will prove devastating, if not fatal.

By contrast, an internally strong internal condition makes it far less likely that an exogenous event, such as the collapse of a giant bank, would derail the U.S. financial system.  Consider the experience of 1998 when the combination of the Asian currency crisis, the LTCM meltdown, and the near-collapse of the commodity market hit the U.S. stock market.  U.S. equities were in a raging bull market at that time and the financial market was internally strong.  The contagion hit our shores in the summer of ’98, and while it did briefly plunge the Dow and S&P into a malaise – within three months the major indices were off to the races again and finished out the year at new all-time highs.  The U.S. essentially shrugged off what would normally have been a catastrophic event due to its internal strength.

I would argue that the U.S. financial market finds itself in a similar situation today.  Instead of chronic weakness, the U.S. market is internally quite strong.  Witness the longer-term NYSE internal momentum indicator below.  As you can see, it’s in stunning contrast to the 2008 scenario shown above.


The late great historian and author Barbara Tuchman said it best when she wrote: “Social systems can survive a good deal of folly when circumstances are historically favorable, or when bungling is cushioned by large resources or absorbed by sheer size as in the United States during its period of expansion….[W]hen there are no more cushions, folly is less affordable.”    

The “cushions” she mentions are in place and are in the form of the rising intermediate-term and longer-term internal momentum previously mentioned.  If a Deutsche Bank collapse happens in the coming months – a mere conjecture to be sure – it would be very unlikely to collapse the U.S. given the prevailing internal strength.