Don’t discount the Kress cycles

One of the biggest mistakes economists are making in their analysis of the recovery is in ignoring the impact of the long-wave deflationary cycle.  Known as the Kress Cycle, this cyclical force will largely determine the future course of the global economy in the coming one year. 

Many, if not most, economists insist that the financial market and economic recovery that has been underway these last 3-4 years will continue into 2014 and beyond.  The reasoning behind this forecast is nothing more than linear extrapolation – the classic recipe behind most economic predictions.  Conventional economists excel at simply observing a trend that has been in place for the last 3-4 years or more – psychologists tell us it takes at least three years for the average person to recognize a trend – and then projecting that trend well into the future.  This extrapolative outlook is based on a number of dangerous assumptions, one of which happens to be that the economy is cyclical, not linear.  Not surprisingly, most economic forecasts are proven wrong by future events.

If there is any truth to the Kress cycles, and my 13 years experience with them tells me there is, then next year will most likely upset the rosy forecasts of most mainstream economists.  Indeed, with storm clouds already gathering on the horizon we can see trouble spots beginning to manifest in key areas of the economy, most notably in the real estate market.  Real estate alone could upend the consensus optimistic outlook for next year.

It’s a tough road ahead for the U.S. economy as it will be forced to slog through the combined forces of the constituents of the 120-year cycle: the 60-year, 40-year, 30-year, et al, cycles.  Each of these cycles is scheduled to bottom around the beginning of the fourth quarter in 2014.  

A news-sensitive stock market

The old saying, “Loose lips sink ships” is prescient when it comes to the financial sector.  The Fed’s ill-advised statements about tightening its monetary policy this spring led to a major spike in Treasury yields, which has all but torpedoed the bubble in income-oriented investments.  The yield spike has also begun to put cracks in the real estate recovery, as witnessed by the 13.4% plunge in new home sales for July reported a few days ago.  Higher mortgage rates are beginning to bite into potential homeowners’ pocketbooks.

The spike in Treasury yields has had the biggest impact on interest sensitive areas of the financial market and the economy as we have seen recently.  As reported by Briefing.com, the weekly MBA Mortgage Index remained in a downtrend with Wednesday’s 2.5% fall marking the fourteenth decline out of the past sixteen readings including last week’s 4.6% slide.

In yet another sign that rising interest rates are taking a toll on the real estate sector, pending home sales on Wednesday were reported to have fallen 1.3% in July, worse than the 0.2% increase forecast by consensus and below last month’s decrease of 0.4%. 

Earlier this week it was the Administration’s warnings to Syria about the potential for a military action that led to an increase in stock market volatility.  The Dow Jones Industrial Average dropped shed 170 points on Tuesday while the Volatility Index (VIX) spiked over 10% in reflection of the increased level of fear and uncertainty on Wall Street.  Granted the VIX is nowhere near as high as it has reached in previous market sell-offs, but the latest spike indicates that a healthy level of fear is returning to the market place. 

What all of this illustrates is that the market is currently sensitive to loose talk by officials.  Such a climate is typical of an environment where the cycles are in the peak phase, as we’ve seen in recent weeks (with three consecutive short-term cycle peaks in August).  In other words, an internally weak market is extremely vulnerable to negative headlines.  This isn’t the case when the market is internally strong, as evidenced by the new 52-week highs and lows.  [Excerpted from the Aug. 28 issue of Momentum Strategies Report]

Fuel prices and the economy

Another weight around the economy’s neck as we head into the potentially troubled waters of 2014 is the high price of fuel.  Oil and gasoline costs are unusually high given where we are in the economic long wave; traditional cycle theory suggest fuel prices should be considerably lower until the deflationary cycle bottoms out late next year or early 2015. 

The latest spike in retail gasoline prices could be seasonal since the summer driving season doesn’t end until next week.  With gasoline prices on the rise again, however, businesses and consumers will be feeling the pinch if the trend continues beyond Labor Day.  The dual factor of rising interest rates and fuel costs are a potentially devastating one-two punch that has the potential to torpedo the economic recovery assuming the trend continues.

Keep in mind that it was the oil and gasoline price spike in the summer of 2008 that served as the proverbial “straw that broke the camel’s back” during the credit storm.  The economic impact of high fuel costs can never be underestimated when the economy is already weakened by the undercurrents of the long-term deflationary cycle.

Sowing the seeds of recession

In the latest economic news, durable goods orders dropped 7.3 percent in July according to the Commerce Department, the steepest drop in nearly a year.  Contributing to the drop were fewer orders for commercial aircraft and weakened demand for computers and electrical equipment among businesses. 

The drop in durable goods orders is a definite sign that the business economy is losing momentum.  Yet the New Economy Index (NEI), which measures the overall state of the retail/consumer economy is still in fine shape.  Why then is there such a disparity between the manufacturing economy and the retail economy? 

Manufacturing typically slows before consumers start reigning in spending on discretionary items.  What we’re witnessing the beginnings of a slowing economy where the manufacturing sector will be the first to experience weakness.  Then a spillover effect will eventually make its way into the everyday economy of consumer spending.  It’s a slow, gradual process akin to a large tanker ship doing a turn at sea: it takes time for the forward momentum to reverse before the shift in direction can be made. 

Big ticket items and luxury goods are still selling mainly because high-end buyers – the driving force behind the current stage of the recovery – are always the last to exit when the Ferris wheel grinds to a halt.  Big spenders are still spending like there’s no tomorrow, which is why the stocks which comprise the NEI are still mostly in a rising trend.  Eventually this trend will reverse, however, when these big money spenders realize the economic picture isn’t as rosy as it was earlier this year.

In reality, the seeds to the next recession were sown when the Federal Reserve first hinted this spring that it would begin “tapering” the $85 billion/month asset purchases at some point later this year or early in 2014.  The taper talk led to a major spike in Treasury yields, which has all but torpedoed the bubble in income-oriented investments.  The yield spike has also begun to put cracks in the real estate recovery, as witnessed by the 13.4% plunge in new home sales for July.  Higher mortgage rates are beginning to bite into potential homeowners’ pocketbooks.

The seeds to the next recession – likely sometime in 2014 when the long-term Kress cycle bottoms – have already been sown by the very regulators who are supposed to keep the economy on an even keel.  The relentless tendency of the central bank to zig when they should be sagging is having a negative impact already on investor expectations, which is where declines in spending and investment patterns always begin.  

War on the horizon

After two years of winding down the U.S. military’s presence in Iraq and Afghanistan, the rumblings of war are being felt in Syria.  Calls for American intervention in Syria’s civil war have been increasing lately, especially after reports indicate that Syria’s government used chemical weapons on civilians.   

According to a Reuters /Ipsos poll, 60 percent of Americans surveyed said they don’t favor the U.S. intervening in Syria, even if it’s confirmed that chemical warfare is being used in that country.  Only 9 percent believe President Obama should act now.

Regardless of what Americans want, it may well be war that they get.  A prescient barometer for gauging the likelihood of military conflicts in the near future suggests war is on the horizon.  The Dow Jones U.S. Defense Index (DJUSDN), a composite measure of defense stocks, has been one of the stock market’s top performers this year.  Defense stocks are conspicuously outperforming the S&P 500 (see graph below), just as they did in 2001 in the months leading up to and following the 9/11 terrorist episode.  During this same period the broad market as measured by the S&P 500 was suffering a bear market. 

In 2001 the defense stocks clearly saw war on the horizon and proved to be an accurate barometer for the launching of Operation Enduring Freedom in Afghanistan in late 2001.  This time around it’s Syria that is the potential catalyst to another military escapade.  Americans have clearly become weary of war, yet with the Federal Reserve’s proposed strictures on monetary policy another war would act as a surrogate financial market and economic stimulus.  This could provide the excuse needed to launch a military initiative in the near future, especially if the bond market continues to sag.

Also worth mentioning is that the 24-year cycle of war, a component of the 120-year Kress cycle series, is due to bottom late next year.  Historically wars have been fought around this critical cycle bottom. 

Investors turn to gold amid currency turmoil

As Wall Street continues worrying about the winding down of the Fed’s QE3 stimulus program, bond yields around the world have been surging and the dollar has been falling.  In the wake of higher yields equity prices have been driven lower.  The upshot of higher yields and a weak dollar has been higher gold prices as investors run to safety.  Weaker earnings reports in the U.S. and increasing violence out of Egypt have also contributed to increasing demand for the yellow metal. 

Since the gold price bottom of late June, the daily correlation between the gold price and the S&P 500 index has inverted once again, i.e. as stock prices have fallen gold prices have risen.  Since gold’s price low of June 27, gold futures rallied 12.34 percent while the S&P 500 Index is up only about 3% as gold returns to favor among investors.

While some of gold’s recent rebound can be attributed to the increased desire for safety in light of Wall Street’s worries about the Fed’s money policy, much of the rally is a result of the unwinding of short positions from the last couple of months.  There are no guarantees when it comes to near term price predictions, but a test of the nearby chart resistance zone at the $1,420-$1,425 area is a distinct possibility in the immediate-term (1-3 week) outlook.  While some analysts are betting on even higher prices if this zone is overcome on the upside (on the assumption that additional short covering will be triggered), I recommend we play it safe and continue to raise stop losses on our conservative long position in the gold ETF in the event that this event fails to materialize.

Fed kicks over the milk pail

On Wednesday the Fed released the minutes from its July 30-31 policy meeting.  Minutes from the meeting showed that most members of the FOMC agreed that a reduction of the stimulus was not yet appropriate.  Only a few thought it was time to “slow somewhat” the pace of the stimulus policy.

Investors continue to fear that the Fed will start to slow its $85 billion monthly asset purchases, with most predicting September as the beginning of the end of the aggressive quantitative easing (QE) program.  This fear was manifested beginning in June as foreign investors sold U.S. Treasuries to the tune of $489 billion in that month alone.  The annualized rate of Treasury notes and bonds sold over the last three months was $271 billion.  In more recent days, Asian currencies have declined as investors fear tighter Fed policy will starve emerging markets of investment funds.

Zero Hedge’s Tyler Durden observed: “Somehow to foreigners, Bernanke’s Taper Tantrum was a more shocking event than the biggest bankruptcy filing in history (one which launched the global central bank scramble to buy up everything that is not nailed down).”  See chart below.

Although Wednesday’s FOMC minutes provided no concrete timetable for the slowing of QE3, the handwriting is clearly on the wall.  Investors, particularly foreign investors, sense the end of the Fed’s easy money policy is near and have acted accordingly by selling stocks and bonds.  U.S. investors have been much slower to react but even they are beginning to sense that QE’s days are numbered. 

The rising Treasury yield since May is not, as some economists affirm, the result of a strengthening economy.  Rather it’s a consequence of the market’s anticipation of the withdrawal of stimulus by the Fed.  To put it in colloquial terms the market senses the Fed will soon “kick over the milk pail” if it hasn’t already.

Consider: during the boom year of 1999 the Federal Reserve under Chairman Greenspan began tightening money and eventually succeeded in precipitating the 2000-2002 “tech wreck” and recession.  Then after a period of loose money in 2002-2003, the Fed started tightening money again in 2004 and continued to do so until the onset of another recession and bear market in late 2007. 

After dousing the flames of the credit crisis in late 2008/early 2009, the Fed under Chairman Bernanke has largely embraced a looser monetary policy in the last four years.  But once again the Fed is telegraphing its intention of ending its easy money policy, just in time for the upcoming deflationary cycle bottom in 2014.  Either the Fed is averse to prosperity as its critics have alleged or else its leaders have the worst sense of timing.  As I mentioned in a previous posting, tight money is properly defined as “reduced expectations of future spending.”  Based on this definition, the Fed has already begun tightening.  

Unfortunately, kicking over the proverbial milk pail is what the Fed excels at and it’s a likely bet that it  will once again undermine what, for the most part, has been a successful recovery effort.  A premature ending to QE3 would all but guarantee a resumption of economic weakness with the potential for deflationary pressures to accelerate next year as the long-term deflationary cycle makes its final descent.  

Will the end of QE bring deflation?

A client writes, “You mentioned in your latest commentary that deflation would rear its ugly head if QE were limited.  Do you think QE is the solution to keeping the stock market inflated and also the economy?  I fear that QE isn’t the solution – maybe for the stock market – but not for Main Street.”

It’s doubtful that the Fed’s quantitative easing (QE) policy can heal the wounds inflicted upon the economy by the 2007-2008 credit crisis.  This may not have even been Bernanke’s intention when QE was initiated back in 2008.  The principle reason for QE was to provide the banking system with needed liquidity and to also satisfy the world’s insatiable demand for money.  In that regard QE was a success. 

QE was mildly helpful in stimulating business activity via the trickle-down effect, though it has far from reinvigorated the economy.  More than anything, QE has help to keep deflation at bay by allowing the financial system to stabilize and recover after the devastation of the credit crash.  The financial sector is the lifeblood of the economy and as long as it has abundant cheap liquidity at its disposal, businesses have no imminent fear of falling profits/prices. 

The coming end of QE changes this equation.  The economy will be forced to reckon with the “hard down” deflationary forces of the 120-year cycle next year without the aid of central bank stimulus.  It would be surprising to say the least if the financial market and the economy can weather this storm without QE’s assistance.

You are correct that QE isn't the answer for Main Street (though it has certainly helped somewhat).  IMO, the Fed should consider letting QE continue until at least the end of 2014 when the cycle bottoms; after all, why stop now when they've kept it going for five years?  The Fed could then let the economy finish the healing process on its own when a new long-term inflationary cycle begins in 2015.

Stock market update

On Friday the S&P 500 was down for the day as a result of a jump in the 10-year Treasury yield index.  In doing so the SPX closed under the widely watched 50-day moving average for the first time since July.  The Dow was substantially below its 50-day MA and has even managed to violate the dominant interim 90-day MA on a 2-day closing basis.

The unhealthy number of new lows has resulted in a downward trend in the hi-lo momentum index (HILMO).  The HILMO indicators, which are based on the new highs-new lows, show us the stock market’s path of least resistance on a short-term, intermediate-term and longer-term basis. 

It goes without saying that HILMO needs to reverse before we get the next buy signal, but before this happens the number of stocks making new 52-week lows must diminish.  In 19 of the last 20 days there have been greater than 40 new 52-week lows on the NYSE.  Keep in mind that anything above 40 is considered to be a sign of internal selling pressure; the higher the number of new lows, the more the selling pressure….

It was equally surprising that Thursday’s AAII investor sentiment poll showed a net bullish reading.  That is, more investors polled by AAII were bullish on the market outlook than were bearish.  Again, this isn’t consistent with a market bottom.  Historically the AAII poll registers a net bearish reading at market bottoms.  This suggests the market decline may have further to run before it reverses course. [Excerpted from the Aug. 16 issue of Momentum Strategies Report.]

Tight money has already begun

Aside from the fact that the 10-Year Treasury Yield Index (TNX) is rising, another reason for the latest equity market sell-off is the uncertainty generated by the Fed’s recent announcement.  

At its latest press conference, Fed Chairman Bernanke indicated the central bank could start winding down its $85 billion/month asset purchase program known as QE3 as soon as next month.  This has understandably caused a certain amount of consternation on Wall Street, especially given the feeling among many traders that QE has been largely responsible for the stock market’s rebound. 

What many investors don’t realize is that the Fed’s monetary stance has already tightened even before the “tapering” begins.  Author Ramesh Ponnuru, in his National Review article entitled “Cause for Depression,” points out that by merely telegraphing its intentions, the Fed creates expectations for future money conditions.  This in turn reverberates through the financial system well ahead of actual changes in Fed money policy.  

“When the Fed creates an impression about future spending levels,” writes Ponnuru, “it affects the spending that people undertake today in anticipation of that future.  So when the Fed suggests that it will pursue a tighter money policy in the future, it is effectively tightening money in the present.  Even when it cuts the federal-funds rate, it may be tightening money if markets had projected a sharper cut.”

Ponnuru went on to define tight money as “reduced expectations of future spending.”  That’s as concise and as practical a definition of tight money as you’ll hear.  His explanation of future expectations for money conditions fully explains what’s happening right now with the bond market and the stock market.

Gold's improving sentiment backdrop

Investor psychology for gold remains negative, and that’s potentially bullish from a contrarian standpoint.  

Sentiment towards gold remains weak as gold backed ETF holdings fell to a new low on August 7, according to Sharps Pixley.  ETF holdings in countries such as Japan and India, by contrast, remained stable even as gold prices plunged this year.  This throws in sharp relief the attitude towards gold among Asian investors.  As some pundits have observed, it could also help shape the future for global gold demand.

Short covering is also coming into play, which is boosting the price of gold near-term.  Net combined non-commercial positions for gold declined 23,518 contracts in the week ending August 6. Net non-commercial gold positions also saw its biggest increase since August 2012 before the commencement of QE3.

Meanwhile the short-term chart pattern for the iShares Gold Trust ETF (IAU) is firming up and looking more constructive by the week.  A decisive breakout above the nearest pivotal high of 13.05 (the July 23 close) would likely stimulate additional short covering.

An XAU turnaround?

The last few days have been good ones for gold but even more so for the gold and silver mining stocks.  The mining sector was helped by a weak U.S. dollar, which fell for five straight days last week. 

Let’s have a look at the gold/silver mining stock group via the XAU index.  With the XAU index I’m not going to evaluate the interim trend by looking at any trend lines or moving averages, which can sometimes cloud the issue.  While I do believe certain moving averages are important, especially for the immediate-term trend, I also believe there’s a danger of attaching too much significance to moving averages.  Traders sometimes fall victim to the trap of attributing almost mystical powers to certain moving averages, and this can be a dangerous error.  When evaluating the main interim trend of the XAU it’s often best to just look at the “naked” chart without any technical adornments such as moving averages.

With that proviso, let’s examine the year-to-date chart of the XAU index.  As you can see, each and every rally attempt so far this year has met with failure; the turnaround attempts as far back as January were reversed into lower lows, which amounted to a continuous downtrend. 

By definition a reversal of the trend requires the market to break this chain of lower highs and lower lows by establishing a final low.  In other words, the market has to succeed in making an initial higher low and higher high, which in turn becomes the first step in a new upward trend.  As we’ve seen already, days like today where the XAU has rallied have normally failed to reverse the downtrend.  But one thing that has already distinguished the XAU’s chart pattern over the last few weeks is that the index is in the process of establishing a higher low. 

If the XAU succeeds in following through in the coming days by pushing above the nearest high of 103 on a closing basis (the July 23 closing high) then we’ll have our first confirmed instance this year of a higher low and a higher high.  In other words, we’ll have the beginnings of a genuine turnaround as opposed to another “dead-cat bounce.”  

How will stocks react to less liquidity?

Much of the 2009-2013 stock market recovery was due to the stimulus provided by the Fed, so it’s only natural that investors wonder if the eventual withdrawal of that stimulus – possibly later this fall – will lead to a retreat in stock prices. 

Interestingly, the market isn’t as panicked this time around as it was in May when it was first suggested that QE3 would soon be winding down.  It’s possible that investors are becoming inured to this suggestion, yet a more likely explanation is that they simply don’t believe it.  After all, they were told this spring that QE3’s days were numbered only to hear the Fed backtrack and change its mind.  My guess is that until they see that a wind down of the stimulus is imminent, investors will remain skeptical.

By the time the tapering finally begins, however, it’s entirely possible the market will have already undergone a prolonged topping process.  Usually before the major indices make a final top the market spends several weeks-to-months topping out internally, that is, a few industry groups begin declining even as the leading industry groups continue advancing.  This process could already be underway as suggested by the dominant intermediate-term internal momentum indicator shown here. 

While most growth-type stocks haven’t topped out yet, the market is showing considerably more internal weakness when viewed from the standpoint of the commodity-related industries, homebuilders and REITs, and of course China ADRs.  [Excerpted from the Aug. 7 issue of MSR]

The Great Non-Rotation

The Investment Company Institute (ICI) estimated weekly net cash outflow from bond mutual funds of $13.5 billion during the week of June 12.  This followed a staggering $10.9 billion outflow the previous week.  So began a steady exodus from bonds and bond funds in June that has continued until now. 

Until recently, bonds were the safe haven du jour among investors who preferred to park cash in low-yielding debt instruments in the wake of the 2008-2009 credit crisis.  Investors never got over their fear of equities, even as stocks outperformed in the years 2009 through 2013 to date.  The dramatic leap in Treasury yields over the last three months changed this attitude, however. 

Since June investors have continued running for the exits in the bond market.  Last month’s bankruptcy of Detroit only added to this impetus and resulted in wholesale dumping of municipal bond funds.  In the last two weeks investors have increasingly unloaded muni-bond funds, so much so that the disturbingly high number of new 52-week lows on the NYSE has been comprised almost entirely of these funds.  Witness Tuesday’s 191 new lows; it marks the first times since June 25 that there were more new lows than new highs.  It’s also the first time since June 25 that there were anywhere near this many new lows.

So with investors running to the exits for bonds, does this mean we’ll finally see the long-awaited rush into equities the experts have been predicting?  Well it hasn’t happened yet as the following chart, courtesy of Dr. Ed Yardeni’s blog (blog.yardeni.com) shows.  

Dr. Yardeni points out that during the two weeks of June 5-12 when bond fund outflows totaled $24.4 billion, equity fund inflows actually had net outflows of $2.0 billion.  Clearly the “Great Rotation” that Wall Street is hoping for isn’t happening.

First it was the euro, then gold and silver, then the emerging markets, then bonds.  One “safe haven” after another has been shot down.  The proverbial “last Indian standing” is the U.S. stock market, yet the average retail investor isn’t exactly making tracks to jump on this bandwagon.  If not stocks, where are investors’ funds going?  For now the movement is into cash as investors remain unconvinced that long-term stability has returned to the financial market.

Consumer spending trend remains up

The latest nonfarm payrolls report released on Aug.2 revealed an addition of 162,000 jobs created, compared to a downwardly revised 188,000 in June.  Economists expected the latest report to show 175,000 jobs created.  The average workweek dropped 34.4 hours from 34.5 and average hourly earnings declined 0.1%.  Aggregate wages fell 0.3%, “which will put substantial downside pressure on retail sales growth,” according to Briefing.com. 

Yet despite the negative economic news, the U.S. retail economic trend according to the New Economy Index (NEI) remains up.  The NEI is a stock price composite of the leading retail, business transportation and employment agency stocks.  It’s currently just below a 6-year high, having long since surpassed its previous all-time high from 2007.  While it’s certainly possible we’re witnessing the beginnings of an economic topping process, it’s still too early to assume the worst.  

Until the uptrend in the NEI is broken, we can assume the economic outlook is still positive despite the bumps beginning to appear on the road.

Gold trades inversely to positive news

A recent commentary by Barclays suggested that the gold price remains sensitive to U.S. macro-economic data and will likely react negatively to any positive news regarding either employment or Fed policy.  It was not surprising, therefore, that gold pulled back today following the latest Fed policy meeting on Jul. 31 in which the central bank said it would continue to purchase $85 billion/month in assets to bolster the financial market.  That was good news for the stock market but not so good for precious metals and PM mining stocks. 

Additional factors weighing on gold prices include a stronger dollar (up 1% on Thursday), stronger U.S. factory data, and the European Central Bank’s pledge to maintain low interest rates.

Economist Ed Yardeni believes the Fed won’t “taper” (i.e. reduce) its asset purchases in September as many Fed watchers had previously expected.  He bases his opinion on the fact that U.S. GDP growth for Q2 came in at a rather anemic 2.9% y/y, the lowest since 2010.  Yardeni suggested this is what will keep the Fed from tapering until next year.

Elsewhere in the news, CFTC managed money combined total positions in gold increased to 70,067 contracts as of July 23 from a recent low of 31,197 contracts a month ago.  It’s noteworthy that combined short contracts declined to 52,429 from a high of 80,147 on July 9. 

Meanwhile, the central banks of Russia, Ukraine, and Kazakhstan added 4.2 tons of gold to their reserves, according to Sharps Pixley.  In China, the first two gold-backed ETFs raised about 1.6 billion Yuan, equivalent to about 6 tons of gold. The recent influx of gold buying hasn’t been able to offset the decline in investment demand this year, however, as Pixley points out.