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.

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.

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.