Is the utility stock boom a bad sign?

I was asked by a subscriber about all the new 52-week highs among the utility stocks, specifically whether it was a bad sign for the broad market outlook.  Here's my answer:

Utilities tend to trade in line with Treasury prices.  As such, they can be considered almost a quasi-bond.  Leadership in the Dow Jones Utility Average (DJUA) is normally a good confirming/leading signal for the broad market.  The only exception to this rule I can think of was in the weeks immediately preceding the 2008 credit crisis when the DJUA gave a misleading signal -- a new high while the S&P 500 made a lower high.  Aside from this exception, in most cases when the DJUA shows leadership the rest of the market usually follows.  

I would also add that the intense demand for utilities among investors right now is a reflection of the demand for relative safety in an environment where many investors don't feel comfortable with the situation developing in Europe and Asia.  As such, you could almost call the utility bull market a safe haven play.  I'd much rather see utilities on the new highs list than a more speculative asset class since the latter would indicate a potential bubble forming.  I see no danger of that right now.

A look ahead into 2015

With 2014 winding down, now would be a convenient time to discuss the prospects for the financial market and economy in 2015. 

Year 2014 was in some respects a tumultuous year; from the slowdown in Europe and China to the collapse in oil and ag commodity prices, the deflationary undercurrents of the 60-year cycle was apparent this year.  The long-awaited bottom of the 120-year cycle of deflation was finally made in October, and aside from some residual weakness still evident, the cycle bottom was a successful one. 

With the lifting of the deflationary cycle, year 2015 promises to be a much stronger one than last year.  The birth of a new long-term cycle will mean slow, steady re-introduction of inflation into the economy.  More to the point, the next few years should witness gradual re-inflation.  The runaway inflation that some analysts are wary of is still many years away.  By the same token, the recent fears of many economists of a deflationary collapse are misguided.  Deflation will gradually cease to be a persistent problem in 2015 and beyond as commodity prices should stabilize next year and consumer finances should continue to see improvement.

Year 2015 is also of course a “Five Year” which is the most reliably bullish year of any given decade.  Going back to the previous 120-year cycle bottom of 1894, there has never been a bear market in the Five Year.   One reason for this is because the 10-year cycle – a component of the 120-year long-term cycle – always bottoms at the end of the Four Year.  The 10-year cycle is the primary long-term directional cycle within any given decade.  Thus with a fresh new 10-year cycle underway in 2015 the odds favor a good year ahead for equities. 

Fortunately for stock investors, most major indices are in a good position heading into 2015.  The major indices are above their key longer-term trend lines, namely the 30-week and 60-week moving averages.  Stocks have built up a good head of steam and are therefore primed to enjoy an overall bullish year ahead thanks to the release of upward pressure from the newly formed long-term Kress cycles. 

One of the factors which kept many retail traders from participating in the stock market in 2014 was the lack of a clear directional bias in small cap stocks.  The 1-year graph of the Russell 2000 Small Cap Index (RUT) below perfectly illustrates the frustration that small investors experienced this year.

A truism of investor psychology is that prolonged sideways movement in equity prices does more to discourage small investors than anything else.  Indeed, a lateral trading range does more to discourage investors from investing than a major market collapse has ever done. 

Will the small investor return to the stock market in 2015?  This is very much an open-ended question and one that defies an easy answer.  It can be stated with some degree of confidence, however, that the lateral trading range in the small cap stocks will likely be resolves in 2015.  This will do much to attract some sideline money in the year ahead, though whether the anticipated breakout in the small caps is enough to shake the average retail investor from his reticence is debatable. 

My guess is that small investors will remain out of action in 2015.  Many are still stinging from the 2008 market collapse and are too gun shy to invest in equities.  Others view the heights achieved by stocks in the last few years as untenably high and therefore vulnerable to a major decline.  Their collective reluctance to return to the stock market will, however, limit their options for growing their capital in the year ahead.  Instead, many will elect to remain in low-yielding bonds and other underperforming assets.

Another big concern for investors heading into 2015 is the state of the U.S. economy.  Much has been made over the improvement in consumer confidence this year, yet consumer spending hasn’t been as powerful as the confidence levels would suggest.  A better reflection of what the average consumer is doing with his money is visible in the New Economy Index (NEI).  NEI is a basket average of several stocks within the consumer retail and business sectors.  For years it has provided an accurate real-time picture of the overall state of the U.S. retail economy.  Here’s what the NEI looks like right now.

NEI reached an all-time high last January and has spent the bulk of 2014 consolidating in a lateral range.  The NEI chart looks good but not great, and there’s definitely room for improvement.  My interpretation of the NEI pattern is that consumers are still spending at above-average levels but haven’t completely “let loose” with those ever-increasing spending binges that characterize strong economies. 

Although joblessness isn’t a major problem like it was in years past, consumers are apparently concerned enough about keeping their jobs that they haven’t accelerated their spending.  That may change as we head further into 2015, especially if the financial market outlook shows continued improvement. 

The war cycle: 2015 and beyond

This year witnessed the bottom of one of several components of the 120-year cycle of inflation and deflation.  The cycle to which I’m referring is the 24-year cycle.  Of particular relevance is that this cycle answers to the cycle of war.

Since 1894 when the previous 120-year Grand Super Cycle bottomed and a new one began, there have been four military conflagrations at each subsequent bottom of the 24-year cycle.  Most of these wars have been major in scope.  The first such instance of war occurred in the years leading up to 1918, which saw the first 24-year cycle bottom of the current 120-year cycle.  The 24-year cycle that bottomed that year saw the ending to the First World War.  Remembering that the final “hard down” phase of the 24-year cycle approximates to almost two-and-a-half years, this represented roughly the second half of that major war, a war that involved the United States.

The next 24-year cycle bottom occurred in 1942.  This year represented the United States’ entry into the Second World War against Japan and the Axis Powers.  Both the 1918 and the 1942 cycle bottom years proved vicious in terms of military conflicts on the global scale.

Following the 1942 bottom, the next 24-year cycle bottom occurred in 1966.  This was a particularly harsh year in the Vietnam War in terms of the United States’ involvement.  Following the 1965 National Liberation Front attack on two American military installations, President Lyndon Johnson ordered the continuous bombing of North Vietnam.

The year 1990 saw the most recent 24-year cycle bottom in the current 120-year Grand Super Cycle.  This year saw the start of the first Persian Gulf War involving the United States and its allies against Iraq.  This period also saw a rather conspicuous jump in the price of crude oil as it related to the war and its anticipated supply disruptions. 

The waning years of the 120-year cycle witnessed a winding down of the militarism which typified the years 2002-2010.  A two-front war in Iraq and Afghanistan, which dragged on for some eight years, was waged in part to revive an economy rendered sluggish by the “tech wreck” and recession of 2001-2. 

Although much was made over China’s industrial demand during those years, without the billions in war spending between 2002 and 2010 the boom in commodities prices would almost certainly have been less pronounced.  Not coincidentally, the decline in commodities prices began with the winding down of both wars.

War has long been used as a panacea to fight the ravages of inflation as well as deflation.  Viewed from this context, war is as much a policy response to economic malaise as it is a political response to a threatening foreign power.  Most recently, Russia’s president, Vladimir Putin, has shown aggression against Ukraine.  Some observers, including Mohamed El-Erian, view Putin’s militant threatening as a distraction effort designed at taking his people’s attention away from the increasingly weak state of the Russian economy.  Since Russia’s economic prospects are closely aligned with the oil market, continued weakness in the oil price will only give the country more incentive to find ways of reversing its woes.  In the short term, a military response may be Russia’s only recourse. 

The last six years have seen economic policy governed almost exclusively by the Federal Reserve.  The executive and legislative branches of the U.S. government have done amazingly little and were content to cede their authority to the Fed.  The pendulum swings both ways, though, and the Rule of Alternation suggests that the years immediately ahead will witness a greater authoritative response from government.  Now that the Fed’s QE program has ended, look for Washington to craft its own policy response to the threat of a global economic slowdown.

One such response would be of a military nature.  The dramatic plunge in oil and copper prices is a troubling sign that global industrial demand for these key commodities is contracting.  What’s more, both commodities are considered by many economists to be barometers for the global economy.  Indeed, the stunning drop in the prices of many commodities is reminiscent of the prelude to the 1998 global mini-crisis which threatened to plunge the developed world into outright deflation.  A policy response from the Fed in late ’98 was sufficient to restore investors’ confidence, however, and the malaise was quickly reversed.  With interest rates currently hovering near long-term lows in many countries, a monetary policy response today would carry decidedly less weight than it did then.  The only alternative might be a military response.

The initiation of a fresh war campaign in the coming years would provide an emphatic cure for persistently low commodity prices as war spending always leads to higher prices.  It would also fix the reduced industrial output of many countries whose economies heavily depends no industry.  History shows that war is often the last resort of desperate governments whose economies are wracked by diminished demand.  Even the rumor of war can have a short-term impact in boosting prices.  Don’t be surprised then if war rhetoric finds its way back into the headlines in 2015.