Wednesday, February 18, 2015

The fear factor meets the Year Five Phenomenon

Despite continued front-page fears over Greece’s threatened exit from the euro and the military encroachments of the terrorist group known as ISIS, investors apparently aren’t sufficiently worried enough to sell equities.  If anything, adage about the “wall of worry” has been the driving force behind recent equity market gains as the front-page fears have been largely ignored.

Investors were skittish entering 2015, so much so that billions were poured into safe haven assets including U.S. Treasuries and precious metals.  The soaring U.S. dollar (below) was as much a sign of the flight to safety as it was a symptom of U.S. economic strength. 

Since the start of February, however, there has been a conspicuous change in investors’ perceptions of the foreseeable future.  To begin with, the sudden reversal of investor fear can be seen in the chart of the iShares 20+ Year Treasury Bond ETF (TLT), a proxy for the U.S. bond market.  Treasury prices haven’t fallen this sharply since the May-September 2013 period, which also marked a period of increasing confidence in the future outlook for U.S. consumers and investors.  During that period, Treasuries and other safety assets underperformed vis-à-vis risk assets such as stocks.

Another indication that investors have cast off their worries (at least for now) is the dramatic plunge in the Dow Jones Utility Average (DJUA).  The utilities have given back all their gains from the last two months and are experiencing their worst performance since 2013.  Utility stocks normally follow the direction of bond prices, so it’s not surprising to see the DJUA’s recent weakness given the recent sell-off in Treasuries.  The relatively higher yields that utility stocks typically command along with their safety-oriented reputation make them attractive to investors seeking safety.  The utilities benefited from the increased investor pessimism of the late 2014/early 2015 period.  Now the safe haven utility stocks are suffering along with gold from the unwinding of the “fear trade.” 

Concomitant with the subsiding of investor fear is the breakout to a record high in the New Economy Index (NEI).  NEI is comprised by averaging the stock prices of the most economically sensitive companies within the consumer retail and business sectors, including Amazon (AMZN), Fed-Ex (FDX), and Wal-Mart (WMT).  After spending most of 2014 in a lateral trading range, NEI broke out above the 1-year trading range ceiling earlier this month and followed it up with another high last week.  The implication behind the breakout in the NEI is that consumers and business owners are increasing their spending levels as we head further into 2015, a sign of increasing consumer confidence. 

The true state of the U.S. economy has been the subject of heated debate lately.  Going strictly by the accounts offered by many respected economists, including Ed Yardeni and Scott Grannis, spending levels on both the consumer and business levels are quite healthy.  Government statistics bear this out, as do various consumer confidence polls.  Yet some analysts insist that the government’s numbers are “cooked” and do not accurately reflect the underlying state of the economy. 

According to an Associated Press article, while the official unemployment rate has fallen to 5.6 percent, average hourly wages have declined.  It was also reported last month that a record 92,898,000 Americans are not currently in the workforce.  One news service even reported that there are still over 46 million Americans who are food stamp recipients.  As one analyst concluded, “It is quite obvious that the official numbers by the government are often very deceptive.” 

So who is right – the mainstream analysts who contend that the U.S. economy is on the mend or the naysayers who claim the economy remains stuck in neutral (or worse)?  The source of the confusion can be traced to misguided attempts at generalizing the enormous and multifaceted U.S. economy.  The economy is much like the weather in that any attempt at creating a compressed generalization is bound to cover a multitude of important details.  The economy, much like the weather, covers a broad geographic area can only produce a very sloppy “average” picture while ignoring the scores of micro-climates within that picture.  What is commonly called the “economy” is simply a snapshot of the United States based on averaging the data within various sectors. 

Conventional economic analysis also tends to lump the various socio-economic strata – namely lower, lower-middle, middle, upper-middle and upper classes – into a single broad category.  Presently the U.S. upper-middle and upper classes are in a much more prosperous condition than are the lower-to-middle classes.  Because the higher income groups account for so much of the big ticket purchases it tends to gloss over the fact that the middle and lower income strata have lagged.  This is one reason for the differing accounts behind the U.S. recovery.

It’s often overlooked that at its core the U.S. economy is essentially a financial economy.  The financial sector accounts, directly or indirectly, for a huge percentage of total economic activity.  This is why central bank policy is paramount to the overall state of economic activity in America.  Quantitative easing (QE) directly benefits the financial market by inflating stock prices, which in turn benefits the financial sector (the economy’s major component).  As long as the financial sector is growing, it’s only a matter of time before the rest of the economy follows suit. 

There’s no denying the strength in the New Economy Index (NEI) previously discussed.  An expanding NEI is tangible proof that consumers are spending at increasing levels while businesses which cater directly to consumers are also seeing increased sales.  This will eventually filter into the broader economic statistics used by economists.  NEI is essentially a real-time reflection of consumer spending levels.

In the wake of the 1930s Great Depression, Freeman Tilden made this timely observation:

“In a great state in prosperity, things are never as good as they seem; on the other hand, in adversity they are never as bad as they seem.  This is why contemporary prediction is nearly always wrong.  Long after a tottering state should have fallen it is propped by the patient, law-abiding, submerged, industrious and thrifty middle class, and by the mere habit of existing.  The heart continues resolutely to beat.”

Sometimes the lag between a financial market turnaround and a general recovery in consumer finances can be quite long, as was the case in the 1930s and 1970s.  Given that the U.S. suffered its worst financial catastrophe since the Great Depression in 2008, it’s to be expected that a broad-based economic recovery has been very slow in arriving.  As long as the financial sector remains healthy and monetary liquidity remains loose, the beleaguered middle class will eventually see improvement in its economic prospects.  Despite proclamations to the contrary from pundits, the U.S. middle class will emerge from the Great Recession in a stronger state.

Tuesday, February 10, 2015

The end of the 1-year sideways trend

Investors are starting to feel numb by the lack of action in the broad market.  Since December, the Dow and SPX have settled into sideways trading ranges.  The NYSE Composite (NYA) has been range-bound since last summer while the Russell 2000 (RUT) has been stuck in a lateral ranges for the past year.  While trading ranges don’t necessarily result in the loss of capital, its effect on the minds of market participants tend to be significant.  Trading ranges are frustrating.  When trading ranges become established over a period of months the effects upon investor and mass psychology can even be devastating. 

Consider that some of the most devastating social, political and military revolutions in history have occurred during prolonged periods of stagnation in both the economy and the equity market of the countries concerned.  Human nature is dynamic and demands continual movement – whether in the form of progress or even regress.  A long period of stagnation where neither progress nor regress is seen has a profound impact on the human psyche in the aggregate and can lead to psychosis if the stagnation continues for very long. 

There is also the effect of the trading range to consider upon the mind of the individual.  The celebrated stock trader Jessie Livermore is a case in point.  After making a fortune selling short the stock market prior to the 1929 crash, he found himself at the mercy of the dull market conditions of the late ‘30s and early ‘40s and was unable to make his accustomed living from the market.  He ended his life by blowing his brains out in a hotel coat closet in 1940. 

Trading ranges also tend to be characterized by increased volatility.  It’s easy to be fooled by the periods of increasing market volatility during the times when stocks are visiting the lower end of the trading range.  Many (falsely) assume that the volatility spikes mean that the market is primed for a bear market.  But periodic volatility spikes are part and parcel of any drawn out sideways movement in the major indices and nothing can be inferred by the temporary rallies in the Volatility Index.

It’s certainly understandable that investors, particularly small-cap investors, are feeling frustrated right now.  After all, they’ve had to sit through more than a year of seeing their portfolios going virtually nowhere, if the Russell 2000 chart is any indication.  It’s no wonder that active participation among retail traders has dwindled in the last several months.

Trading ranges serve a distinctive purpose, however, and they tend to be beneficial for the longer-term health of the stock market.  Sideways trading ranges can either represent distribution (i.e. informed selling) or else accumulation (buying).  More often than not, they represent a period of consolidation for a bull market that has over-exerted itself and needs rest.  Lateral trading ranges typically serve as an intermission before the next phase of the bull market.  As a rule, the longer the duration of the range, the more powerful the subsequent rally tends to be.

A good example of a trading range year which gave way to a solid breakout performance for stocks occurred 10 years ago.  Below is a chart of the Dow 30 index.  Note the overall lateral trading pattern for much of that year.

Here is how the Dow resolved that range in 2006.

This is not to say that stocks will spend most of 2015 in a sideways trading range.  As we talked about in the 2015 forecast edition, there are several likely inflection points this year for tradable trends – possibly lasting 2-3 months at a time.  Another point worth mentioning: unlike in 2005, the longer-term yearly cycles are up, not down.

This brings us to the ultimate question: when will the current trading range period for the stock market finally end?  That question is very much an open one for which the market hasn’t yet provided an answer.  However, the indicators suggest that a breakout attempt above the trading range ceiling will likely be made in this quarter.  Moreover, the odds strongly favor of an upside resolution to the lateral trading range by mid-year by virtue of this being: a.) an up year in the alternate 2-year cycle; b.) a Year Five Phenomenon year; and c.) a year when the Kress yearly cycles all kick in to the upside.

Thursday, February 5, 2015

Long-term relationship between gold, oil challenged

Wall Street breathed a sigh of relief this week after a case of the jitters the last couple of weeks.  Fears over a deflationary plunge in the euro zone had sparked an increased demand for safe haven assets, including gold and silver.  The decline to multi-year lows in the crude oil market as recently as a few days ago also fed into investors’ desire for safety.  In the last couple of days, however, those fears have at least momentarily abated as the oil price has rallied while Treasury prices and the U.S. dollar have declined.  Consequently, gold and silver safe haven demand has declined in recent days.

Gold prices were down more than 1% on Tuesday on news that Greece’s government had dropped calls for a write-off of its foreign debt.  This was one of the main factors behind Wall Street’s case of the jitters in the last two weeks.  Equity prices rallied sharply Tuesday while U.S. Treasury bonds had their worst 1-day showing in over a month, with the 10-year Note down over 2%. 

The U.S. dollar ETF (UUP) meanwhile closed decisively under its 15-day moving average for the first time this year (below).  This constitutes a serious challenge to the immediate-term (1-3 week) uptrend; whether the dollar bears are up to the task of forcing the dollar’s value lower from here remains to be seen in the all-important follow-through sessions.

Whether or not Tuesday’s turnaround was the start of renewed “risk-on” approach among investors remains to be seen.  An upside follow-through in equities in the next couple of sessions would almost certainly weigh on gold’s safe haven demand.  A failure to maintain support above the dominant short-term trend line for gold (see paragraph below) would also bode ill for the yellow metal’s prospects in February.  A continuing concern I have for the metal is the failure of gold’s relative strength line to keep pace with the gains of the actual gold price in January (see chart below).  Ideally, gold’s relative strength line should be confirming any strength in the precious metal’s price to let us know gold is in strong hands.

It’s significant that gold was down this week at the same time that U.S. Treasuries were sharply lower.  In the past, rising bond prices (and falling yields) were bearish for gold and silver since a bullish bond market was viewed as a sign that investors were becoming risk-averse by chasing the speculative rally in bonds.  In recent months, however – and with international bond yields approaching zero in some cases – lower yields and higher bond prices have galvanized investor interest in the precious metals.  This is due to, among other things, the lack of income opportunities from Treasury instruments along with the concomitant fear of deflation. 

In a note to clients on Tuesday, BoA/Merrill asserted that a “decoupling” was taking place between gold and its century-old relationship between oil and is now being driven by movements in interest rates and currencies.  BoA/ML analyst Michael Widmer said, “We think that a unique combination of factors is again making gold attractive in investor portfolios: negative nominal interest rates, a closing volatility gap to other asset classes, and improving weekly returns.”  This is certainly a point worth considering, although it’s still much too early to state with any certainty that the long-term positive correlation between gold, oil and interest rates is officially over.  The coming months will likely reveal whether this burgeoning relationship is merely a temporary intermediate-term transitional phase or the start of a new long-term inverse relationship among gold, oil and bond prices.

After rising more than 8% in January for its best monthly performance in three years, gold prices are still above the short-term (30-day) moving average but below the immediate-term 15-day MA.  The 30-day MA is also where the silver price found support after its sharp decline last week, as the following graph illustrates.  The 30-day MA is significant since it has proven to be a pivotal guide line for gold, and especially silver, prices in the last two years.  Whenever the silver price has decisively broken under its 30-day MA a sharp decline has usually followed.  It’s imperative that silver maintain support above the 30-day trend line in the critical days ahead.

On the ETF front, fresh inflows were reported into gold funds on Monday, with holdings of the SPDR Gold Shares ETF (GLD) climbing to their highest since October at 24.65 million ounces.  I don’t consider this news significant to the short-term outlook, however, as inflows can go both ways depending on the volatile psychology of fund managers.