Tuesday, December 30, 2014

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.

Saturday, December 20, 2014

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. 

Tuesday, December 9, 2014

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.

Tuesday, November 25, 2014

A brand new 120-year cycle

Last month kicked off a new long-term Kress cycle.  The Kress cycle, which answers to the Kondratief wave of inflation/deflation, is responsible for the overall climate of economic and financial market conditions in the U.S.  This long-term cycle also influences the course of central bank monetary policy by creating the conditions which the Federal Reserve must tailor its policy response to.

The final 10-12 percent of the 120-year cycle is characterized by deflation.  For the last 14 years or so the financial system has indeed struggled with periodic episodes of deflation, and these episodes have often taken the form of ripples in the global economy.  The final 12 percent of the 120-year cycle began in 2000, a year of major transition for the U.S. equity market and the economy.  That year witnessed the end of the great 1990s bull market and the start of a period of secular stagnation that has continued until now.

During the 14-year period beginning in 2000 the U.S. suffered two economic recessions and two major bear markets in the stock market.  The most telling influence of the 120-year cycle during this time was the feverish attempt of central bankers and policy makers at countering the deflationary undercurrents created by this cycle.  At times these attempts at countering deflation with monetary policy resulted in temporary pockets of inflation in commodities prices.  Far from helping alleviate deflationary pressure, Fed-created inflation only put more stress on the economy. 

The long-term inflation/deflation cycle is salutary and beneficial to both savers and consumers when it’s allowed to naturally run its course.  When central banks interfere, however, the effects can be catastrophic for both groups.

The successive policy interventions of the Fed between 2000 and 2014 did great harm to the middle class, a much lamented development among politicians and commentators.  Retail food and fuel prices were elevated to unnaturally high levels in the years between 2004 and 2008, and again in 2010-14.  Instead of receiving a much needed respite, consumers paid higher prices for basic necessities during these years while savers were punished by the Fed’s weak dollar policy.

It’s clear that this trend can’t persist for long given that the Fed refused to let the Kress cycle run its course, which would have healed consumers’ finances.  The Fed-sponsored Wall Street bailout came at the expense of Main Street which meant many years of paying unnaturally high prices on the retail level for most Americans.  Thankfully, though, Main Street is finally getting a much needed respite in the form of a strengthening dollar and falling fuel prices.  Food prices should also begin to slowly decline from here. 

Far from being planned by the Fed, this is a natural reaction as the economy enters the post-QE adjustment phase.  Now that the Fed’s money printing program known as QE has ended, interest rates along with the inflation rate will seek their natural levels.  A 2011 report by the Bank of England highlighted the influence of QE on the economic system.  The following chart shows the qualitative impact of QE divided into two phases: the Impact phase and the Adjustment phase. 

The Impact phase is when QE (money creation) has the most effect on lowering interest rates, increasing asset prices and stimulating economic activity.  All of these were features of the years immediately following the 2008 credit crash.  The second phase is known as the Adjustment phase, which is the current phase.  This is the period after QE ends when the inflation rate reverts back to its natural level since it isn’t being actively manipulated by central banks.

To give one example of what could happen during the Adjustment phase, consider the following assessment by Robert Campbell in the November 15 issue of The Campbell Real Estate Timing Letter (www.RealEstateTiming.com).  Campbell is specifically discussing the impact of mortgage rates, a critical component of the U.S. economy:

“Even though mortgage rates had been in a long-term downtrend since 1982, a substantial body of empirical research has found that the Fed’s massive bond buying purchases since 2008 has significantly lowered mortgage rates and long-term Treasury yields.  Hence, without QE mortgage rates could likely be 2.0 to 2.5 percentage points higher than they are today – which means most of the people who made money in real estate in the last 3-4 years would not have done so if housing prices weren’t driven higher by artificially low mortgage rates.”

Campbell suggests with the end of QE, the bull market in housing may also soon end due to the diminished purchasing power of mortgage owners thanks to rising mortgage rates.  Mortgage rates are still in decline, however, and it could be a while longer before the Adjustment phase forces them higher.  Sooner or later, though, the inflationary impact of the new long-term Kress cycle will begin working its magic by pushing interest rates higher across the board. 

Whether or not the U.S. economy is strong enough to handle higher rates is debatable.  A more likely scenario in my view is a period of low inflation which persists for at least the next 1-2 years, thanks in large part to soft overseas economies.  Meanwhile the major engine of global economic growth will continue to be the U.S. since our long-term economic cycle has bottomed while other major industrialized countries are still in the throes of deflation.  Eventually, the U.S.-led recovery will gain enough traction so that QE will become a distant memory.

Friday, November 21, 2014

Investor sentiment in the balance

As several market technicians have pointed out recently, price oscillators and sentiment indicators for the U.S. stock market point to an excessively “overbought” condition, both technically and psychologically.  To take just one instance of how overstretched the market has become, take a look at the following chart which shows the SPX in relation to its 200-day moving average.  The 200-day MA is widely followed by small investors and big money managers alike. 

While most participants prefer seeing the SPX trading above the 200-day MA, whenever the S&P has gotten over-extended from the trend line it has set up a period of (temporary) under performance.  The last such instance of an overstretched SPX occurred in the weeks leading up to the autumn decline.

Another important indicator which highlights the current sentiment profile of individual investors is the American Association of Individual Investors (AAII) bull/bear survey.  The AAII bull/bear ratio last week reached its most pronounced level of investor optimism in years with 60 percent of respondents bullish versus only 19 percent bearish on the stock market’s interim prospects.  With so many bulls and so few bears the question that begs to be asked is: “What will happen when the buyers finally stop buying and there is no new buying power to boost the major averages?” 

It’s easy to see that investors are almost uniformly bullish with hardly any bears to be found, and that’s a condition that normally doesn’t long persist without a market pullback.  Whether the next market “correction” takes the form of a short, sharp decline or a lateral consolidation (i.e. trading range) is open for debate, though.  Internal momentum is still running strong, though, which should prevent a sell-off of the magnitude we saw in late September/early October.  Instead, the market’s next correction phase could be surprisingly shallow or perhaps even take the form of an internal correction where a few high-profile stocks get shot down while the major averages remain buoyant.

The one group of investors (other than the perma-bears) that haven’t bought into this rally is value investors.  They’re licking their chops as they wait for what they think will be a major market decline so they can jump in and scoop up shares at a relative bargain.  They may well be disappointed, however, especially if the next market correction is as shallow as I think it will be. 

By the same token, the bears will be even more disappointed if the big decline they’re expecting either doesn’t materialize or is much less severe than they’re expecting.  This in turn would provide the backdrop for another major short-covering rally. Although the market has been very overbought lately the market’s overbought condition followed close on the heels of a record “oversold” condition.  Normally when the market goes quickly from oversold to overbought it tends to be net bullish for the intermediate-term outlook.

Short-term internal momentum on the NYSE continues to strengthen, which explains why the major indices aren’t pulling back despite stocks being overbought.  Below is the chart showing the NYSE short-term momentum bias indicator, an important gauge of the market’s near-term path of least resistance.  With this indicator rising as consistently as it has in recent weeks it has acted as a prod to the bulls and a thorn in the side of the bears.

The sub-dominant and dominant intermediate-term internal momentum indicators haven’t been as lively, however.  The blue line in the following graph represents the former while the red line represents the latter.

As you can see in the above chart, these two components of the NYSE internal momentum index could use some improvement.  The stock market clearly hasn’t been firing on all cylinders, which explains why the rally hasn’t been quite as vigorous as it was a few weeks ago. 

If nothing else, the next market correction phase should work out some of the internal kinks within the NYSE broad market and allow the internal momentum indicators to get back in synch as the bull market continues.

Tuesday, November 18, 2014

The Dow and the MACD indicator

Question: “Looking at the weekly chart for the Dow, I see some negative divergence between the index and the MACD.  Do you see a cause for concern here?”

Answer: There are a couple of things to remember when looking at the MACD indicator.  One of them is that the MACD is more reliable at bottoms than at tops.  MACD is also not a consistently reliable indicator as a standalone, although it can be used to confirm technical bottom – and occasionally top – signal when used in conjunction with other indicators.

To reiterate, the MACD gives its best signals when it's confirmed by numerous other technical indicators (i.e. weight of evidence).  I’d also point out that while the weekly MACD for the Dow has diverged lowers in recent months, the monthly and daily MACD indicators look okay.  That’s two out of three, so I’m not worried about it.  Plus, the weekly MACD recently gave a positive crossover signal. 

It’s also not uncommon for the MACD indicator to diverge lower against the price line of a stock or major index in an established bull market -- it essentially reflects an “internal correction.”

Tuesday, November 11, 2014

Why the Congressional elections won't change anything

The recent mid-term elections gave Republicans control of both the House and the Senate.  Many economists and investment strategists are cheering the Republican takeover since they believe it will mean positive changes ahead for the U.S. economy.  If history teaches us any lesson, however, they are likely to be disappointed.

The last time Republicans swept mid-term elections in similar fashion was in 1994.  At that time American voters were fed up with a rising tide of liberal policies under a two-term Democratic president and were eager for a change.  Conservative Republicans campaigning under the promise to roll back taxes and onerous regulatory burdens were pushed into Congress by an angry electorate.   The promises that many candidates of this “Conservative Revolution” made to their voters were, however, quickly broken and a business-as-usual attitude was embraced by the incoming congressmen.  They were unwilling to give a Democrat president the credit for any positive legislative changes that might have been created, so they did nothing of note. 

Fast forward to today and the parallels are uncanny: a two-term Democrat president who is viewed by some as ineffectual and a voting public disenchanted with higher taxes and a gridlocked Congress have once again led a conservative revolution on Capitol Hill.  Promises abound among the many incoming freshmen congressmen, but the outcome is likely to be much the same as in 1994.  There simply isn’t enough unanimity among Republicans on key issues to lead to meaningful changes, and the incentive isn’t there to do anything the President might get credit for.  Therefore a do-nothing approach is the most likely outcome.

Investors have no reason to fear this, however, as a do-nothing Congress has been just what the doctor ordered for the corporate outlook and stock market.  With Republicans and Democrats unwilling to compromise, the financial market recovery has persisted these last six years with nary a serious setback along the way.  That’s because when Congress is on the same page and making “progress” it usually results in a higher tax and regulatory burden for businesses and taxpayers.  In other words, we the people get the screws.

I’m convinced the reason why the recovery has continued on for as long as it has – in defiance of the long-term cyclical norm – is partly because Washington politicians have been unable to derail it through a unified legislative agenda.  The constant partisan bickering amongst themselves and with the president has led to a lack of agreement on areas which affect all of us, including taxes, energy policy and small business regulations.  Thankfully, the potential damage to the economy has been minimized due to Congress’ failure to reach agreement in these areas. 

The Congressional cycle, which happens to be bullish for stocks, is also a factor for equities going forward.  Economist Ed Yardeni mentioned this cyclical indicator in a recent blog posting.  His statistical consultant, Jim Marsten, wrote the following:

“Suppose I told you there is a technical indicator that, once the buy signal was given, has an amazing record--with the S&P 500 up three months later 17 times out of 18 since 1942, up six months later 18 times out of 18, and up 12 months later 18 times out of 18. The only condition this technical indicator has to meet is a particular political-calendar date, i.e., mid-term election day, which happens to be tomorrow. Buying on that day is one of the best technical strategies I have ever seen. One has to go back to Depression-era market losses to find two periods when this indicator did not give consistently positive results. The historical odds are almost 100% in your favor. The average percentage changes are also good since 1942: 8.5% for the three-month periods, 15.0% for six months, and 15.6% for 12 months.”

It’s no coincidence that one reason why this indicator works is because election years normally coincide with bottoms in the Kress yearly cycle series.  Next year is also the fifth year of the decade, which historically is one of the most bullish years in the decadal rhythm for equity prices.  The Year Five Indicator hasn’t had a single miss going back over 100 years.  With all the major yearly cycles up next year, and with the Congressional cycle in its peak phase, the odds greatly favor a bullish 2015 for stocks.

Since a gridlocked Congress is the closest we can come to the Jeffersonian ideal of “That government is best which governs least,” it should be viewed as a blessing in disguise.  As investors and taxpayers, we can only hope it continues for at least two more years.

Sunday, November 9, 2014

Why a strong dollar is the ultimate stimulus

Earlier this year commodities prices were fairly buoyant thanks in part to strong demand in Asia.  The strength didn’t last long, however, and by summer weakness was evident in Europe and China.  Global growth slowed considerably in the months leading up to October, when oil plunged below $90/barrel for the first time since 2012.  Apart from weakening global demand and the growth of energy supplies (thanks to fracking), the strengthening U.S. dollar has accelerated this trend.

The strong dollar has resulted in an interesting feedback loop: as the value of the dollar increases a combination of steady U.S. economic growth and corresponding weakness in Europe and China make the dollar attractive to foreign investors.  Since many developing countries are dependent on commodities, dollar strength tends to benefit the U.S. economy at the expense of other countries.  Below is a chart of our favorite dollar proxy, the PowerShares U.S. Dollar ETF (UUP), which shows the extent of the dollar’s impressive rise this year.

One of the key variables of the financial markets from roughly 2001 until 2011 was a persistently weak dollar.  The weak dollar of those years, moreover, tended to be bullish for equity prices.  The reason for this is because the 2001-11 decade encompassed most of the commodity price boom (or bubble, as some would have it).  Many of the stocks which outperformed in 2001-11 were of commodity-related companies such as mining and oil/gas producers and explorers.  The oil stocks were one of the single biggest contributors to the run-up in the S&P 500 of the years prior to the credit crisis, so it made sense that a weak dollar benefited these companies since it boosted export prices and increased the bottom line. 

In recent years, the commodities bubble has deflated and the stock market’s gains have come largely from technology, financial sector, and non-commodity related stocks.  A stronger dollar typically benefits these types of companies, as was the case in the booming corporate economy of the late 1990s.  It appears that the strong dollar/strong stock market dynamic of those years is making a comeback and it couldn’t be happening at a more opportune time.  The middle class in desperate need of a “bailout” and a strong dollar is arguably the best form of stimulus for consumers.  It will also help companies which cater to consumers by increasing profit margins and generating higher sales volumes. 

A dollar bull market, in other words, benefits everyone except for those in the natural resource sector.  While a strengthening dollar may seem at face value to be deflationary, the danger of a rising dollar index is only acute when the long-term economic cycle (the 60-year cycle) is in its “hard down” phase.  As of last month a new long-term up-cycle was born and deflation from here will become less and less of a threat, at least in the U.S.  Indeed, “deflation” in terms of falling commodity prices and consumer prices is actually beneficial to consumers when the 60-year cycle is in its ascending phase.  So we needn’t worry about the long-term impacts of a rising dollar index from here either as investors or as consumers.

Dollar weakness has also had the dual benefit of lowering fuel prices, which in turn is benefiting consumers.  Citigroup analyst Ed Morse estimates that if oil prices stabilize near current levels, the typical U.S. household will receive the equivalent of a $600 annual tax cut.  Another recent Citigroup analysis concluded that oil that’s 20 percent cheaper than the 3-year average price amounts to a $1.1 trillion annual stimulus to the global economy. 

Goldman Sachs estimates that every 10 percent drop in the oil price stimulates 0.15 percent more consumption in the world economy; moreover, it also increases demand for oil consumption by half a million barrels per day.  Clearly then commodity market weakness is more of a blessing than a curse for the consumer-based U.S. economy.

Another factor which is helping the consumer economy heading into 2015 is the drop in mortgage rates.  Below is a graph courtesy of the St. Louis Fed which shows the 30-year conventional mortgage rate going back to the year 2006.    The recent drop in mortgage rates to below 4 percent has spurred a refinance rush.  Demand for refinancing rose 23 percent in the seven days through Oct. 17, according to the Mortgage Bankers Association.  The share of home loan applicants seeking to refinance jumped to 65 percent – the highest since November 13 and up from 59 percent the previous week, according to the MBA.   

According to Businessweek, application volumes in the week ended Oct. 10 doubled from a week earlier at mortgage lender Quicken Loans.  Mark Vitner, senior economist at Wells Fargo Securities, believes the refinancing “boomlet” will provide an added lift for the financial sector in the fourth quarter.  The strength of the refinancing demand can also be seen in two invaluable charts, which happen to have important implications for the overall financial sector.  The first chart example is of the PHLX Housing Index (HGX), which shows a potentially bullish consolidation pattern.

The next chart exhibit shows the progression of the Dow Jones Equity REIT Index (DJR) over the last past few weeks.  The REITs tend to be more immediately sensitive to changes in interest rates and often lead the broader housing sector.  Note that DJR is in a relative strength position versus both the HGX as well as the S&P 500. 

Both DJR and HGX suggest that the housing market, which showed some weakness in the third quarter, will likely benefit from the recent mortgage rate drop as well as last month’s long-term Kress cycle bottom.  Next year could finally be the year that sees prospective middle class homebuyers emboldened enough to finally begin taking the plunge back into the mortgage market once again. 

Some Wall Street analysts question how much longer the bull market in equities can continue if the dollar remains strong.  They would do well to recall the magnificent period between 1997 and 1999, which was the last notable period of dollar strength.  At that time the U.S. economy was white hot, stock prices were on a relentless upward march, energy prices were low and the U.S. was the undisputed leader in attracting foreign capital inflows.  Again I would emphasize the point that as long as the long-term Kress cycles aren’t declining, a strong dollar can only boost America’s economic and financial market prospects.

Unfortunately, due to the reticular nature of the global economy there is no such thing as “everyone’s a winner.”  Gains in the U.S. economy can only come at the expense of foreign countries whose economies are much more highly sensitive to commodity prices than ours.  As the dollar strengthens and energy prices plunge, for instance, oil-dependent nations such as Russia and Venezuela will weaken.  On the other hand, industrialized nations which are highly dependent on exports stand to gain as the dollar strengthens.  History teaches that a persistently strong dollar will eventually undermine several important foreign economies, which will in turn lead to the next global crisis.  (As one historian has remarked, “The world economy progresses only at the expense of crisis.”)

From the standpoint of middle class America, the strong dollar couldn’t be more welcome.  The middle class deserves a break after all the suffering of the last six years, even if it means other countries are suffering at our expense.  Americans, after all, have no reason to feel any allegiance to the global economy and are rightly concerned with their own prospects.  With any luck, the strong dollar will continue into 2015 just as the U.S. enters the “sweet spot” of the decadal rhythm. 

There has never been a losing year for stocks in the Five year of the decade; moreover, there has hardly been a losing year after a Congressional election year.  And with the 60-year cycle having recently bottomed, all the major yearly Kress cycles will be up next year.  Combine this with a domestic economy that is showing signs of wanting to finally break out and 2015 is shaping up to be an across-the-board “good” year for most Americans, the first in quite some time.  

Wednesday, November 5, 2014

Credit and the commodities bubble

Q: “Since 1971 when we became a Fiat currency Total Credit Market Debt rose from $1.7 Trillion to $58 Trillion.  From 2000 to 2008 the Total Credit Market Debt expanded nearly $30 Trillion.  Since 2009 it has only grown about $5 Trillion.  Gold rose from $250 to $1900 and is now back to $1170.  During that period the Dollar Index $USD fell from 120 to 72.  The recent rally has it at $87.  The CCI Index rose from 180 to 680 and today it is back to 482.  My point is that all of this borrowing had a major impact on economic activity around the world leading to a falling dollar and rising commodity prices.  Now as the borrowing has slowed dramatically since we can't afford to pay the interest on existing debt nor add anymore debt, the dollar is rallying.  And as you know commodities are priced in dollars so they are falling as the dollar rallies.  I think it was this massive borrowing binge which is a major reason for the rise and fall of the dollar and commodities. Does my analysis have any merit?”

A:  I tend to agree with your analysis in that the debt bubble of 2000-2007 most definitely contributed to the commodities bull market.  Where I would differ is on the idea that we can't afford to pay the interest on existing debt or add anymore debt.  Consumer debt levels have been pared down considerably since 2008 and can be expanded if consumers get the "itch" once again (which I suspect they will in the coming years).  

Government debt can also expand through deficit spending.  The government, moreover, can always handle the debt load since it is the one issuing the debt in the form of Treasury bonds by printing even more.  Don't forget the demand for Treasuries has been voracious in the last couple of decades.  If investors ever decide to again increase their risk aversion and sell Treasuries, the money would most likely go into equities and other riskier assets which in turn would further along an economic expansion.  This in its turn would increase government tax revenues, hence shrinking the deficit.  For the U.S. to ever get into a position where debt expansion is impossible would require another catastrophic credit crisis (or perhaps a series of them).  It usually pays to never underestimate the extent to which the debt game can be played in a highly complex and ultra-sophisticated financial system such as ours.

Thursday, October 30, 2014

Gold prices in the post-QE world

Lacking a distinctive catalyst, gold prices have languished in recent weeks after a failed turnaround attempt earlier this month.  Gold’s primary form of price propulsion is fear and uncertainty; as long as investors are worried what the future might hold, gold is treated as a financial safe haven and its price tends to appreciate due to increased demand.  When investors aren’t worried, however, gold is typically ignored and risk assets (viz. equities) become the preferred choice.

There was plenty of fear to go around earlier this month: Ebola, the global economy, the U.S. stock market, and a host of other concerns.  Now that those fears have abated the equity market has regained its attraction for investors, especially after the plethora of bargains that were offered after the steep decline in stock prices.  Gold has once again been relegated to the sidelines and awaits the appearance of the next bout of investor fear and panic. 

On Wednesday the U.S. Federal Reserve announced the formal ending of quantitative easing, the long-standing policy of purchasing Treasuries and mortgage-backed securities.  Gold bugs lamented the end of QE, but the gold market long ago discounted its finale.  Actually, QE did gold little favors in the grand scheme of things.  Many commodity investors are under the mistaken notion that QE was inflationary, which manifestly wasn’t the case.  The primary purpose of QE, as economist Scott Grannis has explained, was to satisfy the seemingly insatiable demand for bank reserves and low-risk assets.  As Grannis puts it, “Without QE, there would have been a critical shortage of safe, risk-free assets, and that would have threatened financial stability.” 

Aside from the observation that QE3 didn’t really help the gold price, even if QE had been truly inflationary it’s doubtful it would have given gold much of a boost anyway.  Gold doesn’t actually benefit from inflation unless the inflation is extreme.  As my mentor Samuel Kress observed, gold tends to benefit most during the hyper-inflationary phase of the economic long wave, or 60-year cycle. 

Gold’s biggest booster in the last 14 years came primarily from two things: 1.) the fear and uncertainty of the post-911 world where geo-political turmoil and financial market volatility became regular features, and 2.) the unparalleled demand for commodities from booming Asian economies. 

China in particular was a big reason behind gold’s run to stratospheric highs.  During the boom years for China's spectacular growth in the 1990s and 2000s, the country accumulated huge amounts of foreign exchange reserves.  This led to a significant appreciation of the yuan currency, which as Scott Grannis speculates, was a major reason for higher gold prices.  

“The spectacular growth of the Chinese economy beginning in the mid-1990s created legions of newly prosperous Chinese whose demand for gold pushed gold prices to stratospheric levels,” writes Grannis.  “China's economic boom attracted trillions of foreign investment capital, which China's central bank was forced to purchase in order to avoid a dramatic appreciation of the yuan, and to provide solid collateral backing to the soaring money supply needed to accommodate China's spectacular growth. China's explosive growth and new-found riches were what fueled the rise in gold prices. But in recent years the bloom is off the rose.”

Chinese economic growth has unquestionably slowed in recent years.  China's foreign exchange reserves only increased by 6% in the year ending September 2014, while the yuan is unchanged over the past year.  Meanwhile gold prices are down by one-third from their 2011 peak.  While China’s economy is no longer booming, it’s still growing around 7% a year which is nonetheless impressive.  As Grannis puts it, “China's economy is not collapsing, it's maturing.”  

Don Luskin of Trend Macrolytics also made a worthwhile observation regarding China's foreign exchange reserves: they are closely connected to the rise in the price of gold.  He argues that the outstanding stock of gold grows at about 3 percent per year, but that the demand for gold experienced a dramatic increase in the first decade of the new century as China, India, and other emerging markets experienced enjoyed explosive economic growth.  As the demand for gold increased much faster than supply, it was to be expected that the gold price experienced a dramatic increase.  As one analyst put it, this amounted to a “one-time surge in the demand for the limited supply of gold.”

Grannis further points out that the growth in China's foreign exchange reserves was exponential for many years, but now it's slowed to a trickle.  Capital inflows have slowed, while outflows have increased.  The meteoric demand for gold ended three years ago once China's capital inflows settled down to more manageable levels.  It also coincided with the regulator’s decision to increase margin requirements for gold futures positions. 

Grannis calculates that gold’s long-term average in real terms over the last 100 years in today’s dollars is around $650/oz.  Without the insatiable demand of newly rich Asian buyers, therefore, gold’s price is coming back down to more closely track other commodity prices. 

In other words, the speculative element of gold’s price is being replaced by the value element.  And until gold reaches a price level which satisfies the world’s value investors, it will probably be a while before the next major long-term bull market kicks off. 

Rallies in the gold price between now and then are likely to be short-to-intermediate-term affairs and will largely be determined by investor psychology and technical factors (i.e. “oversold” or “overbought” market conditions).  Sustained demand of the type that fuels sustained longer-term bull markets in gold likely can only occur if either a climate of fear returns (not likely in the foreseeable future) or else inflation rages out of control (again, not likely).  So until the longer-term investment climate changes we’ll have to content ourselves with the periodic buying opportunities gold presents to us, taking profits whenever it reaches an oversold condition and awaiting the next rally. 

Wednesday, October 22, 2014

The inevitability of QE

A swan dive in commodity prices followed by the latest stock market correction has investors talking about the “D word” once again.  References to deflation abound in the news while economists seriously discuss the possibility of a global economic recession.  What, they ask, will it take to arrest the slowdown in the euro zone and China and prevent its coming to U.S. shores?  Why central bank intervention, of course!

One of the dominant themes of 2014 has been the unwinding of the U.S. Federal Reserve’s QE stimulus measure.  After purchasing as much as $85 billion worth of long-term Treasuries and mortgage-backed securities per month in 2013, the Fed was scheduled to end asset purchases this month.  With the revival of deflation fears, however, there has been some talk among Fed members that perhaps it would be wise to delay the end of QE.  Considering that the QE tapering process has clearly had a negative impact on stocks and commodities, as well as the real estate market, the suggestion to extend QE further is being seriously considered.

While there have been many negative headline events this month that have been blamed on the September-October stock market decline – ranging from overseas economic concerns to unrest in Hong Kong and Ukraine to Ebola – the real reason for investors’ worries can be boiled down to one major concern, namely liquidity.  (Remember the old Wall Street mantra: when it comes to the stock market it’s all about “liquidity, liquidity, liquidity”). 

The selling panic started just as the Fed was putting the final touches on phasing out QE.  While economists were convinced the market would be able to stand on its own two feet without the benefit of QE, investors were far less certain.  Adding to the concerns of U.S. investors were recent actions (or inactions) by the heads of Europe’s and China’s central banks which suggested that both regions weren’t committed to pursuing further monetary stimulus.  Those concerns have recently been allayed by statements by central bank chiefs in the last couple of days. 

Last week, James Bullard, head of the St. Louis Fed, said the Federal Reserve should continue with asset purchases and thus extend QE until the U.S. economy shows more strength.  “We can go on pause on the taper at this juncture and wait until we see how the data shakes out into December,” Bullard told Bloomberg Television.  “Delaying the taper is something we could do right now that could buy us a little time.”

Not everyone at the Fed agrees with Bullard, however.  Boston Fed President Eric Rosengren suggested that when the Fed meets for its Oct. 28-29 policy meeting it likely will maintain its original intention of ending QE at that time.  “The [QE3] program was really designed that once we made substantial progress on the unemployment rate and labor markets more generally that that program would end.  If it looks like we're not going to get that kind of progress now and going forward then we’d have to reconsider it, but I would be surprised if in the next two weeks we get enough data to make us change our mind on that,” he told CNBC.

Despite Rosengren’s hawkish comments, other central bank members share Bullard’s dovish tone.  European Central Bank executive member Benoit Coeure said that ECB purchases of asset-backed securities are set to begin within days, while Bank of England Chief Economist Andy Haldane stated that recent economic data “speaks in favor of delaying the BoE’s first rate hike,” according to Briefing.com. 

Bullard also made an even more revealing statement.  “Inflation expectations are dropping in the U.S. and that is something that a central bank cannot abide,” he said.  There you have in a nutshell the entire philosophy of the Fed these last six years.  The actions of central banks, especially the Fed, are governed by the idea that a little inflation is a good thing and that inflation should even be created where it doesn’t exist.  Instead of letting prices take their natural course according to the demands of the free market, the meddlesome Fed is constantly intervening to prevent the natural cycles from doing their job and keeping the economy healthy.  This intervention does more harm than good since it tends to create artificial asset price bubbles followed by their subsequent deflation. 

The trend of retail prices on the consumer level since the credit crash is a case in point.  What should have been a bonanza for consumers with money in savings turned out to be burdensome as retail prices were artificially high from about 2010 and beyond.  Only in recent weeks have consumers finally seen some relief in the form of collapsing fuel and commodity prices.  But of course the Fed won’t allow this break to consumers to carry on for very long since the bank is intent on stoking the fires of inflation.  With any luck, though, consumers may get to enjoy at least a few months of lower retail prices before the next round of QE starts up. 

Wall Street is also keen on seeing the Fed reinstitute some form of QE.  Since money managers have gotten used to the easy stock market gains fueled by the loose money and corporate share buybacks of recent years, they’re understandably in no hurry to see it end.  They’ll no doubt push the Fed to keep its foot on the monetary accelerator in the near term despite calls from the hawks to completely end the stimulus and raise interest rates. 

The important thing for now is that investors are apparently satisfied that central banks are at least showing an awareness of the risks confronting the global economy and won’t be as quick to tighten monetary policy (which would no doubt be bad for stocks).  A recent report suggested that China may replace the current head of the country’s central bank with someone more dovish.  China’s currently tight monetary policy is one reason for its diminished gold and commodities demand.  A loosening of monetary policy strictures would surely set the wheels in motion for higher stock and commodity prices. 

Central bankers may even heed the calls of the doves and loosen monetary policy (which would be bullish for stocks, at least in the interim).  Thus the September-October stock market correction was arrested by nothing more than the reassurance that central banks stand ready to do “whatever it takes” to keep the financial system liquid. 

Global investors still aren’t completely convinced of the Fed’s intention to maintain liquidity at all costs, however.  The distrust of investors both foreign and domestic can be seen in the strength of the U.S. dollar, which has become the safe haven du jour since this past spring.  Indeed, the dollar index (above) has been in a sustained uptrend during the final descent of the long-term deflationary cycle and is stubbornly remaining near its highs.  Only when a concerted central bank monetary stimulus becomes a reality again will the dollar lose its allure.  

Friday, October 10, 2014

Revenge of the Kress Cycle

Throughout most of 2014, economists were convinced that the threat of deflation had been successfully bypassed thanks to Fed intervention.  Indeed, many celebrated economic forecasters have been loudly cheering the mostly solid-looking economic data throughout most of this year.  But as Yogi Berra once said, “It ain’t over ‘til it’s over.”

The Kress 60-year cycle of inflation and deflation, known as the Super Economic Cycle, was scheduled to bottom this October.  The bottom of the cycle may well be in, but the deflationary pressure it has helped create hasn’t bottomed yet.  If the downward spiral of commodity prices generated by the final “hard down” phase of the cycle this summer and fall isn’t reversed soon, we may end up seeing “Revenge of the Kress Cycle” coming to a theater near you. 

Put another way, the incessant meddling and intervention by the U.S. Federal Reserve in recent years may have staved off the deflationary impact of the final years of the 60-year cycle after the credit crash.  But as Mr. Kress himself was wont to say, “The Fed ultimately can’t beat Mother Nature and Father Time.”  The years of artificial suppressing the natural cycle of deflation may have created a cyclical backlash, a counter-wave if you will, that could witness a confluence of falling prices across several major financial markets around the world. 

There have definitely been premonitions of such a deflationary backlash in just the last few weeks.  One of the most conspicuous of proofs that deflationary currents are at play is the drastic decline in petroleum prices.  Consider that gasoline prices have been plunging and are now at their lowest level in almost four years. 

Since oil and gas prices are among the most important variables in determining prices of all sorts of goods, it stands to reason that as oil prices fall it will eventually lower prices on the retail level.  It has long been the observation of top cycle analysts that a failure of the oil price to decline in a meaningful fashion before long-term deflation reaches its nadir would do irreparable damage to the economy once the next long-term inflation cycle kicks off.  If retails prices enter a renewed inflation cycle at a high level, the return of cyclical inflationary pressures down the line will only serve to strain the economy in the form of higher living costs.  Seen from this perspective, the plunge in oil and gas prices is a blessing in disguise. 

Oil isn’t the only major commodity to suffer the ravages of deflation.  Prices for a large basket of commodities have continued to slide in recent months.  The Dow Jones Commodity Index has fallen over 10% year-to-date since commodities peaked in late June.  Most losses to commodity prices have come since then, which corresponds to the final descent of the Kress cycle.  Falling demand and prices for commodities has hurt countries which rely heavily on industrial exports, including China and many European countries. 

Europe’s economic powerhouse Germany, for instance, has been particularly hard hit by the sanctions imposed upon Russia in the wake of the Ukraine crisis.  Manufacturing orders for Germany dropped 5.7% in August, which is the lowest level in over a year.  The country’s industrial production plunged 4.3% in August to the lowest reading since January 2013, according to Ed Yardeni. 

In the wake of these recent developments, economists have modified their forecasts and are predicting deflation in the euro zone as EU monetary policy remains tight.  ECB president Mario Draghi has made attempts at raising prices by hinting at a U.S. Fed-style QE initiative, but so far his plans have been stymied as policy makers in Germany refuse to endorse it.  For now the European Union remains mired in an economic malaise with no stimulus effort on the immediate horizon.

Assuming Mr. Kress’s dictum that “the cycles will always prevail” is true, let’s examine some possible scenarios for the final resolution of the long-term deflationary cycle.  The first possibility is that of a Kress cycle compression.  Simply stated, this scenario would mean that most of the deflationary damage has already been done and that the short-term will only witness some residual damage, followed by gradual recovery in equity prices as well as oil prices. 

The next possibility is that of a Kress cycle inversion.  An “inversion” is a term used by Mr. Kress to describe what happens on rare occasions when a major cycle bottom essentially transforms into a top, leading to an extended decline beyond the time frame of the original cycle.  An example of this was seen in the final stage of the credit crash of late 2008.  While the worst of the damage was seen in the third and fourth quarters of 2008 when the 6-year Kress cycle was bottoming, there was additional spillover damage into the first quarter of 2009 before stock and commodity prices put in their final lows.  The (temporary) failure of the 6-year cycle bottom to reverse the downside momentum in late 2008 was due to a lack of confidence among market participants.  It took reassurance from the Fed and from Washington in the form of massive stimulus before investors felt confident enough to commit to buying once again. 

Currently, investors are perhaps waiting for the U.S. elections next month before making major commitments in the financial market.  Meanwhile, foreign investors aren’t budging until they see the promised stimulus efforts from Europe’s central bankers and policy makers.  If this “wait-and-see” attitude persists it could give credence to another Kress cycle inversion, just as it did in 2008.

The market may also be waiting to see if the Fed reverses course on its stated intention of raising interest rates sometime next year and instead introduces more stimulus measures if the deflationary pressure continues.  Certainly much more in the way of stimulus is expected of Europe’s and Japan’s central banks, and aggressive policy actions from both regions will likely be seen in the coming months. 

Meanwhile there is a growing realization on Wall Street that perhaps the winding down of the Fed’s quantitative easing initiative was premature.  If the Kress cycle inversion scenario is realized and prices continue to slide, the Fed will be confronted with the possibility that emergency stimulus measures are needed to reverse the damage and prevent full-blown deflation. 

If recent market developments have done nothing else, they have proven the celebrations of economists and pundits over the “death of deflation” to be woefully premature.  Before the Fed’s vision of a return to “normal” inflation can be realized, it’s clear that more work lies ahead.

Tuesday, September 30, 2014

NYSE internals need improvement

Looking just below the stock market’s surface we can see that there is still much need of improvement before the next immediate-term buy signal is confirmed.  The NYSE advance-decline (A-D) line is one of the most basic, yet reliable, methods for discerning market breadth.  Despite the new highs in the Dow and the SPX, the A-D line still hasn’t confirmed the breakout in the large cap stocks.  As you can see in the following graph, the A-D line is lagging appreciably and should ideally reverse its downward slope before we get the next all-clear signal.

Another sign that there are volatile currents directly beneath the surface of the market is seen in the fact that the number of new 52-week lows has been excessive in the last couple of weeks.  Considering that a major longer-term series of Kress cycles are bottoming right now, perhaps we’ll see that number diminish in October.  If this happens it would in fact be a strong indication that the cycle has bottomed and that the market’s internal condition is improving.  For now, though, the fact that there are well above 40 new highs each day is a warning signal that the market isn’t as strong as it should be internally.

Before we can turn bullish we need to see improvement in the following areas: 1.) NYSE new 52-week highs and lows; 2.) NYSE internal momentum (HILMO); and 3.) the NYSE advance-decline (A-D) line. 

Tuesday, September 16, 2014

Can gold finally recover?

Gold recently fell to its lowest level in seven-and-a-half months as the dollar rose to a 14-month high.  Easing tensions in Ukraine and the Middle East also acted as a drag on gold and silver prices.  Investors have been asking the obvious question as to whether gold can recover from here and if a bottom of at least short-term duration is imminent?

Dollar strength has been especially hard on the precious metals of late.  Commodity prices in general have been beaten up in recent weeks by the surging U.S. dollar index, as sagging gold and silver prices attest. 

Both the U.S. dollar and commodity prices in general are largely determined by the relative strength of the U.S. economy.  With the economic recovery now in its fifth year, investors (especially foreign ones) are increasingly attracted to the U.S. as a safe haven.  Economic weakness in the euro zone has galvanized a flow of “hot” foreign money to the U.S. dollar, further bolstering the dollar while at the same time depressing commodity prices.

Along with a strong dollar, another reason for the recent weakness in the gold ETFs has been a curious plunge in the level of short interest.  For instance, the iShares Gold Trust (IAU) was the target of a large decline in short interest during the month of August despite a weak price trend. 

As of August 15th, IAU short interest totaled 1.19 million shares, which represents a decline of 48 percent from the July 31 total of 2.29 million shares, according to Stock Ratings Network.com.  Based on an average trading volume of 2.19 million shares, the days-to-cover ratio is currently 0.6 days.

Meanwhile ETF holdings for gold have continued to shrink with preliminary data for August revealing an outflow of 11 tons and flows in September have started the month off on a negative note at nine tons.

Earlier we examined the Market Vectors Russia ETF (RSX) for signs of a technical breakdown in Russia’s stock market.  A plunge in the RSX below the low from early August would suggest turmoil ahead for Russia on the Ukraine front, which in turn would be a major catalyst for gold bulls to charge.  Lately, however, RSX has remained well above the August bottom as the cease-fire talk between Ukraine and Russia has gained momentum.  As you can see in the following chart, RSX is now well above its August low of 23.00 and has bought itself at least a temporary reprieve.  In turn, gold and silver have suffered as the safe haven trade unwinds.

More than perhaps any other factor, gold has been at the mercy of the macro environment, as Barclays recently observed.  News from around the world hasn’t done the gold price any favors lately as the yellow metal continues to search for a much-needed fear catalyst. 

The December gold futures price has under-extended from the 30-day moving average by nearly 4 percent as of last week.  This is significant since a long-term research history of gold shows that whenever price extends by approximately 4 percent +/- above or below the 30-day MA, a technical reversal usually follows shortly thereafter.  Gold is technically oversold on a short-term basis and is therefore vulnerable to a relief rally in the upcoming days.  The extent and magnitude of the next relief rally, however, will depend in large measure on either a large short interest (which apparently doesn’t exist right now) or else buying interest among institutions and hedge funds looking for bargains.