Why gold and silver hate easy money

Ben Bernanke recently provided some clarity to the confusion surrounding the Fed’s QE stimulus program.  He indicated that the near-zero Fed Funds rate will likely remain at that level long after ending asset purchases under quantitative easing (QE).  This satisfied Wall Street and provided much relief, allowing a mini-rally to transpire in equities but providing additional selling pressure for gold and silver. 

Thus the inverse relationship between gold and the stock market continues to hinge on the assurance of easy money courtesy of the central bank.  While many precious metals analysts continue to insist that gold will benefit from QE, the evidence is quite clear that the opposite is the case.  Stocks are the clear beneficiaries of loose money and investors have exited the safe havens of recent years, namely gold and Treasuries, in favor of equities this year.  Until the massive liquidity provided by the Fed is in any way reduced, gold and silver will likely continue to have a tough go of it.

As Fed watchers have pointed out, both Janet Yellen, the Fed governor nominee, and Fed member Charles Evans have no plans to reduce the stimulus.  “Current low inflation numbers and diminished credit demand suggest a moderate recovery,” as one economist pointed out.  The economic recovery theme is ironically the biggest obstacle facing the yellow metal at present.  Fear and uncertainty are the two catalysts which gold feeds upon, and indeed these two widespread investor emotions kept gold in a strong uptrend until the summer of 2011. 

As I noted in a previous commentary, however, an economic slowdown in Asia and/or Europe would have profound consequences for the global economy and would be a definite stimulus for a return to gold among safe haven investors, and a return of economic volatility in 2014 would therefore almost certainly harbinger a revival of interest in gold as a safe haven investment.

According to the CFTC, combined net gold positions by money managers were down by some 37 percent for the week ending Nov. 12, led by a 104 percent increase in short positions.  While gold futures fell 24 percent this year, the MSCI developed world equity markets index rose close to 24 percent.  Sharps Pixley points out that the worldwide gold-backed ETF holdings tracked by Bloomberg have continued to fall, declining 0.5 million troy ounces in November and 24.6 million troy ounces year-to-date.  “So far, various sources support that most of the gold liquidated from the ETFs have been re-melted into gold bars and sent to China,” writes Sharps Pixley.

December gold underperformed this week following the “death cross” technical signal that has been widely discussed by analysts.  Gold broke below the technical significant $1,268 level on a closing basis and is now in the hands of the sellers in the immediate term.  Chart measurements suggest a low between the $1,180-$1,200 levels can’t be ruled out before the latest decline bottoms out in the short term.  Keep in mind that gold’s technical path of least resistance is down as long as it remains below the declining 15-day moving average.

Meanwhile silver continued its recent slide by closing at $19.90 on Thursday.  Further additional downside is possible to the $18.00-$18.50 area where the lower boundary of a wedge pattern intersects in the weekly chart.  Silver’s immediate-term trend is also down below the declining 15-day moving average, a tool which has done an admirable job of capturing most of the immediate-term trend in recent months.

Goldman Sachs released a research report this week revising its 2014 forecast for gold.  The investment bank said the yellow metal could drop as much as 15 percent next year due to the increased downward pressure facing commodities because of accelerating U.S. economic growth.  Of the major financial institutions, Goldman is one of the few that has the correct understanding of the relationship between gold and the economy/monetary situation, IMO.  Let’s also not forget that Goldman Sachs, which often moves the market based on the sheer weight attached to its forecasts by investors.

U.S. retail sales still bullish

This week is shortened by the U.S. Thanksgiving holiday which will likely contribute to diminished trading volume as the week progresses.  Price movement is also likely to be relatively narrow and confined to recent highs and lows, although a push to a nominal new high in the Dow and S&P indices can’t be ruled out.  

The real action is likely to begin next week after the holiday when traders return to focus their full attention on the retail sales outlook for December.  The results of this year’s “Black Friday” week ending Nov. 30 will set the tone for next week….

Speaking of retail sales, here’s what our New Economy Index (NEI) looks like as of Friday, Nov. 22.  This index is a composite of the leading consumer retail and business service stocks – such as Amazon and FedEx – and is an accurate real-time reflection of the U.S. retail economy. 

As you can see, the NEI is at an all-time high as of last week which means the retail economy is still expanding.  NEI hasn’t given an economic “sell” signal since early 2010 and obviously won’t give another sell any time in the next few weeks.  Extrapolating the trend of this indicator suggests that the critical holiday shopping season will be a good one for retailers.  [Excerpted from the Nov. 25 issue of Momentum Strategies Report]

Why gold and silver are having a tough time

Ben Bernanke provided some clarity to the recent confusion surrounding the Fed’s QE stimulus program.  He indicated on Tuesday that the near-zero Fed Funds rate will likely remain at that level long after ending asset purchases under quantitative easing (QE).  This satisfied Wall Street and provided much relief, allowing a mini-rally to transpire in equities but providing additional selling pressure for gold and silver. 

Thus the inverse relationship between gold and the stock market continues to hinge on the assurance of easy money courtesy of the central bank.  While many precious metals analysts continue to insist that gold will benefit from QE, the evidence is quite clear that the opposite is in fact the case.  Stocks are the clear beneficiaries of loose money and investors have exited the safe havens of recent years, namely gold and Treasuries, in favor of equities this year.  Until the massive liquidity provided by the Fed is in any way reduced, gold and silver will likely continue to have a tough go of it.

On the supply/demand front, the latest report from the World Gold Council revealed that consumer demand for gold in jewelry, bar and coin form increased 26% in the first three quarters of 2013 compared to last year.  Consumer demand, however, was more than offset by ETF divestment along with clampdown on gold by India’s government.  Barclays meanwhile pointed out that the market surplus for gold is at its widest since 2005 due to decreased demand.   

According to Numismatic News, a new record was reached Nov. 12 for sales of silver American Eagles.  The U.S. Mint said total purchases had reached 40,175,000.  This surpassed the previous record high set in calendar year 2011 when 39,868,500 were sold.

“Silver Eagle demand is now snapping up four times the number of coins that were sold by the Mint in 2007, before the economic crisis upended the financial world,” according to Numismatic News.  “Sales in 2007 were 9,887,000 pieces, which was still below the 1987 production record of 11,442,335 pieces.”

By comparison, in 2008, sales doubled to 19,583,500 as panic fueled demand for hard assets.  In 2009, when the stock market was bottoming out, silver Eagle buyers stocked up on 28,766,500 coins, roughly 50 percent higher than the prior year, according to Numismatic News.

Let’s try and put the latest silver coin numbers in perspective.  Investors were correct to snap up silver bullion coins during the bottoming phase of the credit crash between October 2008 and March 2009.  From a monthly closing low of $8.40 in October 2008, the silver futures price rose to a high of almost $50 in April 2011 before peaking.  From there the price of silver has been in a downward trend for the last two-and-a-half years.  Essentially, the buyers were right during the first two-and-a-half-year rally but have been wrong to keep buying silver coins in the last two-and-a-half-year decline. 

With the silver market in a confirmed downtrend, the path of least resistance is down and the market is more sensitized to bad news than to good news.  That means that any negative news developments for silver – which also includes bullish news for the stock market – will likely be used by sellers as a catalyst to keep the silver downtrend intact.  In other words, lower silver prices are a higher probability for now.  Until the pattern of declining tops and bottoms is decisively broken, we have to assume the silver bear market remains intact.  Until the bear market in silver has a confirmed ending, why purchase large amounts of physical silver when the price could end up going lower?  Trying to time the bottom is a tempting preoccupation with individual investors, but in most cases it ends up being a costly mistake. 

If silver is poised to begin a new bull market in 2014 the market will surely give us ample time to make new long commitments without leaving us behind.  There is, after all, a lot of ground to cover before a new upward trend can be established and there’s also a lot of overhead supply to be dealt with before a new bull market commences.  

Another factor to consider is that if silver does end up making a lower low in the coming weeks, there’s always a chance that many of these silver Eagle purchases will be dumped onto the market in the form of panic selling, thereby resulting in even more selling/supply pressure.  Bottom line: let’s wait for the market to signal its intent before jumping on the silver bullion bandwagon.  

The “melt-up” scenario for 2014

Market mavens have increasingly turned their talk to a possible “melt-up” scenario in the stock market.  The big fear entering 2014 is that another runaway freight train-type stock market, like the one preceding the 2008 crash, is gathering momentum.  The latest comment by incoming Fed president Janet Yellen only added to that speculation.

Yellen stated last week that, based on current valuations, stocks aren’t “in territory that suggest bubble-like conditions.”  Her lack of concern is one reason for thinking that the equities could be on the verge of a melt-up.  Economist Ed Yardeni has made the case for this potential scenario playing out, especially if Yellen turns out to be more dovish than Bernanke as he expects. 

There are two principle drivers behind the melt-up scenario: the first is the so-called “reach for yield” among investors that Yellen herself alluded to in her latest remarks and which has resulted in a veritable bubble for corporate and emerging market debt issuance.  The second is the unprecedented monetary policy of the Fed in its frenzied efforts to beat deflation and lower unemployment. 

Emerging market debt suffered a temporary setback in the wake of the “tapering” talk and debt ceiling limit debate earlier this summer.  Since then, however, emerging market bonds have rebounded and there is a growing conviction among savvy investors that this sector is precariously close to being over-inflated.  It’s not there yet, but it appears to be headed in that direction and that’s one of the potential catalysts to an early 2014 melt-up scenario.

Corporate bond issues have risen to a record $6.1 trillion as of the second quarter of 2013, according to Federal Reserve statistics.  This translates to an increase of $625 billion year over year.  Moreover, as Yardeni points out, corporations are likely using some of their bond sale proceeds to repurchase shares of their companies, which artificially inflates earnings per share.  “That’s a bubble-like development if stock prices are getting a significant lift from debt-financed share buybacks rather than actual earnings growth,” Yardeni wrote.

But short sellers beware: we’re not there yet.  The bubble vigilantes are out in full force which suggests a full-fledged financial market bubble hasn’t fully developed.  On the front cover of the latest issue of Barron’s, the editors ask the question of whether or not equities are in a bubble.  Their answer: “Yes, in some tech names and new issues” and “No, in most other shares.”  The Barron’s cover very much underscores the heightened sensitivity to developing bubbles, which in turn keeps investor sentiment from becoming too ebullient before the final melt-up stage of the bull market.

Assuming the market does start melting up in the coming weeks and months, the final outcome is easy enough to predict: a market crash.  The fact that the 120-year cycle is in its final “hard down” phase next year would only add impetus to the crash following a breath-taking rally to new highs.  Accordingly, investors should prepare for this possible scenario in 2014.

The bull market no one believes in

Despite a string of new all-time highs, many investors are sitting out what has been one of the most impressive stock market rallies in years.  A “buyer’s strike” has materialized this year in which value-oriented investors have deemed the market to be too expensive.  Their collective response: taking no action while the bull market passes them by.   

Highlighting the shrinking participation rate among value investors, an article appearing in last week’s issue of Businessweek explained the mentality behind the buyer’s strike.  Value investors look for stocks considered to be cheap relative to a company’s earnings prospects, cash flow or assets.  The last time value managers sat on their hands during an impressive market rally was in 2007 prior to the credit crash.  A contrarian might quickly draw parallels between now and then, but really there is little comparison to be made.  In 2007 the rate of public participation in stocks was quite high versus a relatively low direct participation rate today. 

Value managers look for bear market or young bull markets to put their money to work but tend to eschew committing large sums of capital in maturing bull markets.  The problem with this strategy is that a maturing bull market can remain mature for a long time before eventually giving way to the next bear market.  The likelihood is high that these sidelined investors will be tempted back into a rising market before this bull has ended.

Piper Jaffrey’s Craig Johnson believes the S&P 500 will reach his conservative upside target of 1,850 before the end of the year.  He points out that equities are currently the only game in town now that bonds look dicey and gold is going nowhere.  He told Yahoo’s Breakout that the bullish case for stocks is based on a slow-growth economy and lack of investment alternatives.  He also pointed out that almost no one believes in the sustainability of this bull market.  That’s reason enough, from a contrarian’s perspective, to expect further gains before the bull has reached full maturity. 

Johnson’s very reasonable upside target of S&P 1,850 should be reached by the end of the year.  This is very much a trending market and it’s clear that the major indices, including the SPX, are respecting the trend channels.  Investor sentiment remains optimistic, yet it’s not at frenzied levels normally associated with an imminent reversal. 

As for this being a trend-traders market, many investors who pride themselves on being the “smart money” tend to sneer at trend trading.  What they don’t realize is that trading methodologies are cyclic in their effectiveness.  Trend trading wasn’t a particularly effective tool during the early stages of the bull market in 2009-2011.  Yet it has worked wonderfully for the better part of the last two years.  Moreover, it isn’t being overly utilized by individual traders which is a good sign for its continuity (at least until the crowd embraces it).

It’s also clear that the S&P 500 Index is respecting the parameters of a long-term parallel trend channel.  The upper trend channel boundary happens to coincide closely with the 1,850 level mentioned by Piper Jaffrey’s Johnson.  A failure to at least test the upper channel boundary before the next major correction gets underway would be surprising given the levels of skepticism out there.  It remains, for all intents and purposes, the bull market no one believes in.

Fed official admits failure

Apologies are becoming increasingly common these days.  From the ubiquitous “Twitter apologies” of celebrities to the mea culpas of scandalized politicians, the public has become used to hearing them on a daily basis.  It came as a surprise, however, when a former Federal Reserve official apologized for the part he played in the ultra-loose monetary policy known as QE.

“Confessions of a Quantitative Easer,” the Wall Street Journal published the public apology by former Fed official Andrew Huszar.  The gist of the piece can be summarized in Huszar’s words: “We went on a bond-buying spree that was supposed to help Main Street.  Instead, it was a feast for Wall Street.” 

Huszar claims responsibility for executing the bond-buying experiment known as quantitative easing.  Despite his prior knowledge that the Fed’s independence from Wall Street was eroding, an observation that caused him to walk away from a previous Fed job, Huszar heeded a call to return in order to oversee the Fed’s mortgage purchases.  He described it as a “dream job.” 

After the first round of QE ended in early 2010, Huszar summarized the final results in these words: “While there had been only trivial relief for Main Street, the U.S. central bank's bond purchases had been an absolute coup for Wall Street. The banks hadn't just benefited from the lower cost of making loans. They'd also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed's QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.”

He freely admits that the Fed should have stopped QE after the first round, acknowledging that the “flash crash” in May 2010 prompted the Fed to continue with its QE experiment.  The relationship between Wall Street and the central bank was becoming more and more entrenched and it was simply too late to turn back, according to Huszar.  This is when he decided to return to the private sector, claiming he had been “demoralized” by the failure of QE to lift the economy.

Nearly four years later the large financial market intervention in world history has cost $4 trillion and still hasn’t resulted in the predicted boost for Main Street.  Wall Street by contrast continues to enjoy the liquidity bonanza, with stocks consistently making new highs on a monthly basis.  Pimco’s CEO Mohammed El Erian suggests that for its efforts the Fed may have received a return of only 0.25% of GDP in return for the $4 trillion spent.  Commenting on this, Huszar concedes that “QE isn’t really working.” 

Huszar concluding statement is candid: “As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy.”

Now compare Huszar’s frank admission with the latest words from Janet Yellen, the heir-apparent to chair the Federal Reserve next year.  On Wednesday she stated that the Fed still has “more work to do” to stimulate the economy.  That of course was all Wall Street needed to hear in order to boost participant’s morale and push stock prices higher.  The S&P 500 Index (SPX) ended the session by closing at a new all-time high.

“I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy,” said Yellen.  These remarks led traders to believe that the Fed would continue its ultra-loose monetary policy well into 2014, which is extremely desirable to Wall Street.  This underscores that the Fed is committed to pursuing a continued aggressively loose monetary policy indefinitely.  Traders need not fear any attempts at “tapering” QE, either next month or in the next few months.  It will take considerably more “evidence” before the Fed is ready to scale back its asset purchases next year.

The bigger issue in Huszar’s confession is the failed relationship between the stock market and the economy.  Prior to the credit crisis it was widely assumed that the connection between equity market strength and domestic economic performance was relatively tight.  That relationship is now being questioned after the last five years of continued stimulus with little results for Main Street despite Wall Street’s record performance.  This isn’t to say the relationship is forever broken, only that the lesson from the Great Depression years is being repeated, viz. when the deflationary long-term cycles are down, stocks and the economy typically move at difference paces.

When inflation strikes back

Is there such thing as too little inflation?  To listen to some economists the answer is an emphatic “no!”  Fed chief Ben Bernanke certainly doesn’t believe in the concept of low inflation.  Neither does ECB president Mari Draghi.  But the question must be asked: with so much official opposition to low inflation, how will America’s middle class ever fully recover from its current malaise?

Economists were shocked last week when Europe’s inflation fell to a “dangerously low” annual rate of 0.7 percent.  It’s commonly assumed that when the rate is that low, companies, households, and even governments have a difficult time reducing debt.  What economists fail to consider, though, is that low inflation is beneficial to the working class because it lowers the cost of living, which can outweigh the cost of servicing debt.  Since food, fuel and housing costs make up the bulk of the middle class budget a lower inflation level will only help the struggling middle class and can even serve to stimulate consumption.

One of the major flaws in the Fed’s inflationist response to the credit crisis is that retail prices for many goods were never allowed to fall.  Consequently, the unnaturally high price levels that were established between 2004 and 2008 were never “corrected.”  This means that when the next long-term inflationary cycle begins in late 2014 consumers will likely be forced to contend with even higher prices in the years ahead.  There is a reason why a 60-year boom/bust cycle exists: it’s nature’s way of cleansing the economy of imbalances and excessively high (or excessively low) prices.  When central banks refuse to let the natural cycle take its course it only creates long-term imbalances which in turn can result in major social, political and economic conflagrations. 

In the U.S. it was recently announced by the Labor Department that consumer prices for September rose by only 1.2 percent year-over-year.  This came short of the Fed’s arbitrary 2 percent inflation target, giving the Fed yet another reason to consider its ill-advised stimulus measures.  While a case could be made for the Fed’s intervention in the immediate wake of the 2008 credit crash, its continued stimulus over the last five years has paved the way for future inflation – and significant trouble for the U.S. middle class. 

According to The New York Times, inflation is “not rising fast enough” for Washington’s liking.  The article by Binyamin Appelbaum stated economists are nearly unanimous in asserting that “a little inflation is particularly valuable when the economy is weak.”  That’s not the testimony of history or even the recent past.  Just ask Japan: for the better part of 20 years the country experienced extremely low inflation and periods of deflation, yet consumers were content with the low cost of living that enabled them to get by when the economy was slack.  Moreover, inflation is an indirect form of taxation since it erodes the savings and purchasing power of consumers and thereby chokes off economic growth.

 

Apparently, Ben Bernanke’s successor Janet Yellen is another believer that a controlled amount of inflation is a good thing.  Like Bernanke, she’s being encouraged by policymakers to continue the Fed’s policy of artificial inflation for the sake of juicing the economy.  The fallacy behind this policy is that by keeping the Fed funds rate at or near zero and providing copious amounts of liquidity, demand can be stimulated.  Far from being the case, creating artificial inflation by money printing will do nothing to increase spending on a broad scale, as the chart showing monetary velocity suggests.  Instead, the evidence strongly suggests that the Fed’s QE program has only succeeded in increasing the demand for money itself, that is, money that is kept in safe havens and not spent directly into the economy.

There’s an old saying that has become trite through its frequent repetition: “Be careful what you wish for, you just might get it.”  This bromide rings true, however, when applied to the current Federal Reserve policy.  By obsessing over the lack of inflation in the U.S. economy these past five years, the Fed will very likely be surprised by the vigorous growth of inflation in the years following 2014 after the commencement of a new economic Super Cycle.  The trillions that were created by the world’s central banks to fight deflation will then become tinder for the fires of inflation that will sooner or later be kindled.

Gold

The price of gold fell sharply on Tuesday, declining 1.23% in a day of active trading.  The downside move was blamed on investor speculation that the Fed would begin tapering its QE monetary policy as soon as December.  Such speculation has been rife in recent weeks and has consistently been “whipsawed” by the Fed.  It’s akin to short-term “noise” and should be ignored as such.  What can’t be ignored, however, is the action of the gold price.

Historical evidence suggests that perhaps the single best indicator for tracking the gold price in a bear market is the 30-week (150-day) moving average.  The dominant direction of gold tends to follow the slope of this psychologically important trend line during the course of a bear market.  This has certainly been the case so far this year, as the following graph shows.

Gold has now returned to its previous closing low from mid-October of $1,268.  This is the all-important “moment of truth” for the metal.  A close below this benchmark level would pave the way for additional technical selling since many algorithm and technical traders will view this as a “double bottom failure.”  A self-fulfilling prophetic decline could then ensue as momentum traders seize the initiative to push gold even lower.  It would likely be a short-lived affair but could be a nasty spill if $1,268 is decisively broken.

Are investors too bullish on stocks?

Just how far has the bullish sentiment of independent investors recovered since the 2009 bottom?  Pretty far indeed. 

Below is a chart showing the cumulative AAII investor sentiment going back to 2006.  As you can see, the typical small investor had a mostly bearish outlook on stocks from late 2007 through the end of 2009.  The small traders then turned slowly bullish on equities in 2010 and have been increasingly more enthusiastic about stocks ever since.  As of last week, this indicator made a new multi-year high which shows you just how much investor sentiment has rebounded.  This has caused many to wonder if investors have become too bullish on stocks.

Yet for all this, the public at large is still missing from this remarkable rebound.  It’s mostly high-net-worth investors that are the driving force behind this bull market.  The general public has exposure mainly in the form of 401Ks, but gone are the days of day trading and direct investment.  The average retail investor (i.e. the general public) never quite regained the same appetite for equities he had in the years prior to the credit crash.  Yet high-net-worth investors are as bullish as they have been in years.  So is the typical Wall Street pro.  But is this enough to put a top on the market (from a contrarian standpoint)?  

Consider that in the years since the 2009 bottom there have been at least three notable corrections: the “flash crash” in May 2010, the 2011 mini-bear market, and the April-June 2012 correction while the master weekly Kress cycle was bottoming.  Each of these setbacks occurred on low public participation.  It’s clear that the stock market has largely become a rich man’s playground since the credit crash and Wall Street is basically just playing against itself, not the public at large.  So the answer to that question is yes, stocks can “correct” substantially even without widespread public participation. 

The next question that comes to mind is, “But doesn’t history show that major bull markets don’t end until the public has maximum exposure to stocks?”  This is a true observation, so there is some question as to whether the recovery that began in 2009 will continue, albeit with fits and starts, after the 60-year cycle bottoms in 2014 and until the public finally embraces the bull.  Quite simply, this is a matter of speculation and unfortunately technical analysis, with its short-term focus, offers no conclusive answers.  But the odds are still in favor of 2014 witnessing another broad market correction – the first in over a year.  

So while the general public remains ambivalent toward equities, the current participants – which include large speculators and institutional investors – are as bullish on stocks as they’ve been all year.  The CNNMoney Fear & Greed Index is currently at 71, its highest reading since the September peak.  The AAII bull-bear ratio is currently at a level which in the past has suggested too much optimism and has heralded market pullbacks (see chart below).

Consider also the current state of investor sentiment as reflected in Citigroup’s Panic/Euphoria Model.  The indicator is currently reflecting a state of “euphoria,” as defined by Citigroup’s admittedly loose methodology.  The indicator is not without merit however: it correctly predicted the previous pullbacks of February, May-June and August. 

It must be emphasized that none of the above mentioned sentiment indicators can pinpoint a market top with any precision.  Rather, they should be viewed as “heads up” indicators to prepare us for a potential market juncture in the near future. 

Can the Fed prevent a crash in 2014?

Two questions that I’m commonly asked are: “Do you still expect the market to correct next year, even with all this liquidity?”  And, “Can the Fed mute the effects of the cycles bottoming in October 2014?” 

The first question can only be answered provisionally.  If the stock market melts up heading into 2014, the odds of a crash will increase dramatically at some point before the Kress cycle bottoms toward the end of the year.  The market has certainly shown signs that investor optimism is increasing on Wall Street, even if small retail traders haven’t quite yet joined in on the exuberance. 

There are already a growing number of indications that investor optimism is reaching climactic levels among the pros, a trend that will likely only grow heading into 2014.  Should this continue it’s something that could exacerbate a market correction next year.  As an example, Yahoo Finance recently published an article entitled, “The Next 10% Correction Could Be 5 Years Away” by Jon Markman of Markman Capital Insight LLC, an advisory service in Seattle.  Markman wrote:

“There has been a lot of concern that stocks have gone too far lately without a 10% correction. The fear is that, if the market goes on too long without losing at least a tenth of its value off a high, any pullbacks to come in the future will be a lot more dramatic.

“The analysts over at Bespoke Investment Group took a look at that question this week and came up with an interesting study. They observed that the S&P 500 has now rallied 59% over a period of 515 trading days since Oct. 3, 2011, without logging a 10% decline from a high. And while it is certainly unusual, it is by no means unprecedented, or even close to the longest such streak.”

The above graph, created by Bespoke, shows all past rallies without a 10% correction since the index was created in 1928.  The current streak of 515 days is well above average, but the article emphasized that there have been two periods over the past 25 years that were more than twice as long: the first was from March 2003 to October 2007 (the length of the previous bull market).  The S&P 500 went 1,153 trading days without experiencing a 10% correction, according to Bespoke.  The longest streak on record was from October 1990 through October 1997, a total of 1,767 trading days.

“The current streak would have to extend all the way out to Oct. 1, 2018 — five years from now — to match that record,” Markman observed.  He concluded that “as long as a low-growth environment also features low inflation and an accommodative monetary policy, the price/earnings multiples of successful companies can rise a lot higher than most people think.”

Articles like this one are commonly seen near major highs in the major indices.  As such, they can be viewed from a contrarian perspective which suggests this rally is living on borrowed time. 

As far as the Fed, I think it's safe to say it has already provided enough liquidity to prevent a 2008-type "super crash" scenario in 2014.  This will eventually backfire, however, once the 120-year cycle bottoms next year and a new inflation cycle begins.  In other words, inflation will likely be the next problem in the years following 2014, as we’ll discuss in the paragraphs that follow.

30-Year Cycle

As the final months of the long-term deflationary winter wind down, our thoughts keep turning to the coming spring of a new 30-year inflationary cycle.  This cycle is set to begin after the late September/early October 2014 period based on the methodology of the Kress cycles. 

For a picture of what will likely happen in the U.S. in the coming years, look no further than Japan.  The income gap is widening and the difference between the haves and the have-nots has never been more conspicuous.  The monetary policy of Japan’s Prime Minister, Shinzo Abe, are the driving force between this gap.

Deflation was a blessing in disguise for consumers in Japan, but the blessing of deflation is now being replaced by the curse of inflation.  Deflation was especially beneficial for the country’s aging population for some 20 years as low consumer prices helped the elderly and underemployed get by during times when the economy was sluggish.  With the advent of Abenomics, however, Japan is finally starting to see signs of inflation after more than 20 years of falling prices. 

Consumer prices increased 0.8 percent in August compared to a year ago, the fastest pace since November 2008 according to Bloomberg Businessweek.  Economists expect that Japan’s inflation could rise 2.8 percent in 2014 due to a sales tax increase.  Barclays correctly predicted Japan’s inflation rate would rise earlier this year (see graph below from the International Business Times).  That rate is only expected to increase in the coming years.

Bloomberg also points out that land prices in Japan’s three largest cities – Tokyo, Osaka, and Nagoya – rose for the first time in five years.  Mizuho Securities real estate analyst Takashi Ishizawa believes land prices will continue to rise in the larger cities, where rents will also expected to increase.

To help households cope with the growing problem of inflation, Prime Minister Abe is encouraging companies to raise wages.  The problem is that wages aren’t cooperating: they fell 0.6 percent in August from a year ago, keeping a 15-month downward trend intact.  This is another point of contention for the U.S., for the coming long-wave inflationary cycle could be much more malicious than the previous one that ended around 1980.  At that time wages were rising along with prices and interest rates, which made it easier for consumers to absorb the price increases.  The coming inflationary cycle could witness a continuation of the stagnant-to-falling wage trend as prices and rates rise.  This would be positively catastrophic for America’s middle class. 

As I pointed out in the previous commentary, Japan was the first major nation to feel the effects of the long-term deflationary cycle and is also first to emerge from the long-wave deflationary winter.  What is now happening to Japan is instructive, for it will also happen to the U.S. once the cycle has bottomed next year.

The growing income disparity in Japan is being exaggerated by Abe’s ultra-loose monetary policy and has already become evident.  While the country’s upper-middle class wage earners are enjoying its benefits through the proceeds of their stock investments, lower-income earners are struggling to make ends meet.  Prices are rising and with it the cost of living, which is squeezing workers at the margins. 

To put Japan’s economic picture into perspective, the average income of the country’s richest 10 percent is 4.5 times higher than the lowest 10 percent, according to the United Nations’ 2007-2008 Human Development Report.  By contrast, the gap between the richest in the U.S. is 15.9 times higher than the poorest and 13.8 in the U.K.  This gap is expected to widen in the coming years once the new long-term inflationary cycle kicks into full gear.

Banks and governments never seem to learn from history that refusing to let the cycles take their natural course can only create greater problems down the road.  Unfortunately, America seems doomed to learn this lesson the hard way.

Two major scenarios for the 60-year cycle bottom

With less than a year to go before the bottom of the 60-year Super Cycle many investors are wondering how the coming months will play out.  There are at least two major possibilities that need to be discussed: the soft landing and the hard landing. 

The effects long-term 60-year cycle, which answers to the economic long wave (K-Wave) can be seen in the fact that commodity prices and inflation are unusually low given the extraordinarily high levels of central bank and government stimulus in recent years.  Despite $85 billion in monthly asset purchases by the Federal Reserve alone, the oil price – one of the most sensitive inflation indicators – has actually been declining in the last couple of months. 

Its effects can also be seen in the fact that the job market remains an issue for central banks.  The labor participation rate has dropped steadily in recent years as many unemployed have given up seeking work.  And as we looked at in my previous commentary, money velocity has been steadily declining despite record amounts of liquidity being created by the Fed.  All these indicators are symptomatic of a major deflationary undercurrent.  The Fed is well aware of this structural problem and this is why it has steadfastly maintained a continuous flow of liquidity, for without this life-giving stimulus deflation would surely have its way altogether.

The long-term deflationary cycle has both a malevolent and a benevolent aspect.  The negative attributes of this cycle are well chronicled and have been witnessed in recent years.  The most obvious manifestation of this deflationary cycle was seen in the throes of the credit crisis of 2007-2009.  The painfully slow nature of the job market recovery since then is a lingering reminder that deflation’s work is not yet done. 

Yet deflation can also be quite beneficial for consumers if allowed to take its course.  In Japan deflation was a huge benefit to the country’s aging population for some 20 years as low consumer prices helped the elderly and underemployed get by during times when the economy was sluggish.  With the advent of Abenomics, Japan is finally starting to see signs of inflation after more than 20 years of falling prices.  Just as Japan was the first major nation to feel the effects of the long-term deflationary cycle, it’s also first to emerge from the long-wave deflationary winter.  What is now happening to Japan is instructive, for it will also happen to the U.S. once the cycle has bottomed next year.

Stock prices have greatly benefited from the Fed’s asset purchases and low interest rate policy.  They’ve also benefited from the low commodity prices of the last couple of years, as can be seen in the CRB commodity index shown below, since profit margins are higher when input costs are lower.  There’s a possibility the stock market can dodge the proverbial bullet next year as the long-term cycle makes its final descent, thereby resulting in a mild bottom.  If this happens, however, the danger to the economy will be acute in the years immediately following 2014. 

By refusing to let prices fall continuously since 2008, the Fed’s intervention has artificially boosted retail prices to an extent that the next inflationary long-term cycle that begins in late 2014/early 2015 could easily create runaway inflation.  That is, prices and interest rates could go through the roof once the new cycle kicks into high gear.  This is where Japan’s experience will be most instructive. 

Another thing to watch for as we enter the final months of the cycle is China.  Note that China’s stock market, as reflected in the Shanghai Composite Index (below), has been in a downward trend since 2009.  China’s economy has also been showing signs of weakness at various times in the past two years.  A truism of the 60-year cycle is that the bottom must manifest somewhere.  If it doesn’t produce severe effects in the U.S. next year, it will surely do significant damage to another area of the globe.  The most likely candidate is China. 

With China’s government significantly curtailing real estate growth over the past year, the risk of an economic crisis will increase with the added pressures of the deflationary cycle bottom in 2014.  China is another problem area to watch as we enter the final months of the cycle.

Negative divergences in the broker/dealer stocks

The NYSE Securities Broker/Dealer Index (XBD) is currently reflecting one of the most prominent divergences of any major index.  You’ll remember from our previous discussions in this report that XBD has long been an important leading/confirming indicator for the broad market.  What happens to the XBD usually ends up happening to the S&P.

Although the path of the XBD index itself has been higher in recent months, several technical indicators for the index have gone the opposite direction.  Take for instance the MACD indicator shown in the following chart.  It has clearly established a downward-sloping path since at least June, with each peak lower than the previous one. 

I normally don’t use the Relative Strength Indicator (RSI), but a subscriber has brought to my attention an equally negative divergence in the RSI indicator for the Broker/Dealer Index (see chart below).    He writes, “What an ominous looking RSI non-confirmation of the $XBD, which usually leads.  Makes me un-zip my bull costume right now and be ready to rip it off.  Not yet, but stuff like this is chilling!”

In a bear market rally these divergences would be absolutely fatal.  In a liquidity-fueled bull market like the one of 2013, however, individual stocks and even entire sectors can ignore such divergences for long periods.  It’s possible that XBD will ignore the negative divergences that are now visible in its technical indicators.  But with an upcoming interim weekly cycle peak the market, along with the broker/dealer stocks, will become more vulnerable to external shocks, bad news, etc.   After the cycle peaks…it could make for volatile trading later in November.  [Excerpted from the Nov. 1 issue of Momentum Strategies Report available at http://www.clifdroke.com/subscribe_msr.mgi]