Could the unthinkable happen in 2016?

The most important question investors should be asking at this point isn’t whether the secular bull market which began in 2009 is over, but whether continued equity market weakness in 2016 will lead to the unthinkable, namely an economic recession.  A recession in 2016 has been deemed virtually impossible by most mainstream economists, so much so that all discussion of this possibility has evaporated.  And while most U.S. economic data categories are still admittedly strong, the persistent weakness under the surface of the equity market over the last several months demands that the topic be reexamined.   

One of the tenants of Charles Dow’s conception of the stock market is that the market’s primary trend is a precursor of U.S. business conditions in the aggregate.  Dow maintained that a steady decline of the major indices typically precedes trouble in the business economy by at least 6-9 months.  And while there are a few instances when the economy was able to withstand a bear market without entering recession, such cases are the exception instead of the rule. 

The stock market’s problems can be traced primarily to weakness in commodities, particularly crude oil.  Commodity weakness has been a result of diminished industrial demand in Asia and Europe as the leading industrial countries are still suffering the effects of the misguided tight money and austerity policies pursued by central banks and foreign governments in recent years.  As predicted, those austerity chickens have come home to roost and they aren’t in any hurry to leave the chicken house.  If our own experience in 2008 is any guide, it will likely take the better part of 2016 for the stimulus measures enacted by the People’s Bank and the ECB to have any measurable impact, and that’s assuming both entities remain committed to an aggressively loose money policy.

So the bigger question is whether the U.S. economy has enough forward momentum to withstand the impact of the global slowdown.  The effects of this slowdown are clearly being felt by equity investors, and that should be a warning sign to economists that a consumer spending slowdown is a real possibility in 2016.  Most economists consistently downplay Dow’s theory that the stock market is a leading indicator, however, so any slowdown in business this year will likely take most of them by surprise.  Moreover, most economic statistics that most economists rely on for making forecasts are lagging indicators.  This means these numbers won’t reveal a weakening domestic economy until it’s too late to take preventive measures. 

The key “statistic” for measuring the condition of the U.S. consumer should be the stock prices of the leading consumer retail, consumer discretionary and business service and transportation stocks.  Examples would include FedEx (FDX), United Parcel Service (UPS), Amazon (AMZN), WalMart (WMT), and Starbucks (SBUX).  These and other stocks are included in the New Economy Index (NEI), which I devised in 2007 to measure the underlying strength or weakness in the U.S. consumer economy.  Here’s what the NEI looks like as of Jan. 8.

Remarkably, NEI has managed to stay above its intermediate-term uptrend line for months on end despite the continual erosion in the global economy.  This can be attributed to the increasing willingness of consumers to make discretionary purchases, as well as their blithe unconcern at the possible domestic impact of the global slowdown.  NEI is finally showing signs of weakening, however, and may be on the verge of finally breaking its intermediate-term uptrend.  If this happens it will be the first indication in several years that the U.S. consumer is beginning to lose confidence.  I should mention that the only consumer confidence that really counts is whether the consumer is actually spending money, not the opinions he expresses to some pollster on the state of the economy.  

Behind the weakness is a drop in the dollar value of commodity prices, which reflects the deflationary undercurrent still present in several European and Asian nations.  While deflation is no longer a major threat to the U.S., the residual effects of the weak global economy are beginning to erode corporate profits.  This is one reason for the internal weakness in the NYSE broad market in the last few months.  A critical precursor to an improvement in the equity market then will be a reversal of the overseas economic weakness. 

To that end, the European Central Bank (ECB) announced a year ago its first round of quantitative easing (QE) with monthly purchases of EUR 60 billion worth of public bonds.  The European QE is expected to last until September 2016, with any extension dependent on the exigencies of the euro zone economy.  The goal of this stimulus measure on the part off the ECB is to reverse the deflationary trend and hopefully replace it with some inflation. 

In the March 2015 issue of Business Credit, economists for the euro zone economics team Euler Hermes S.A. forecast a “positive but limited impact” for Europe’s QE of 0.5 percentage points of GDP growth and 0.3 percentage points on inflation through July 2016.  That forecast, which many economists shared, looks to have been a tad optimistic in light of recent developments.  Although the ECB stepped up its stimulus program in December, the latest data show consumer prices have remained unchanged at an annual 0.2 percent, below consensus expectations. 

Euler Hermes rightly observed that the ECB lags far behind the U.S. Federal Reserve and the Bank of England when it comes to rapidly responding to deflationary threats.  The Euler Hermes team also pointed out that the “transmission mechanism of QE is less clear in the euro zone because the private sector is less intertwined with financial markets than the United States or the United Kingdom.”  Moreover, non-financial corporations in Europe tend to finance between only 10-20 percent of their debt in the market.  Euro zone households have less equity market holdings, preferring savings deposits or bonds; real estate holdings also have less impact on consumption than in the U.S.  With these fundamental differences between the euro zone and the U.S., it’s easy to see that the success of Europe’s QE program faces many obstacles.

The biggest hope or success of euro zone QE is, as Euler Hermes observed, the “policy signaling effect” which would theoretically help to increase business confidence and therefore raise inflation expectations and loan demand. Unfortunately, however, the ECB was late “coming to the QE party” which will make it more difficult to reverse the effects of deflation.  In Euler Hermes’ words, “If the ECB was a credible deflation-fighter, it would not need to print humongous amounts of money; the mere announcement of a credible target would trigger a virtuous circle leading to that target.”

Perhaps the old saying “better late than never” applies to the ECB’s attempts at staving off deflation.  But given the central bank’s poor track record, investors shouldn’t get their hopes up too high that success will be met anytime soon.

So if European QE won’t be a major factor in reversing the global economic malaise in 2016, what could possibly bring about an improvement?  Confidence is the keystone of a thriving economy, as any economist will testify.  When consumers, investors and business owners are confident in the strength and stability of business conditions they express this confidence by spending money, either to consume or to invest and expand business.  The lack of confidence in the long-term strength of the recovery is what has held back U.S. economic growth in recent years.  Every time it looked as if the economy was ready to take off it was hindered from doing so by some foreign threat or another.  In 2015, uncertainty over the global outlook led to cost-cutting and a complete lack of capital expenditures among S&P 500 companies.  Revenue growth and net income were also down for the year due to the strong dollar and hard-hit oil sector.  Thus confidence in the long-term outlook has been sorely lacking.

Without confidence, the next best thing is outright fear.  The type of profound fear that was common in the years immediately after the credit crisis hasn’t been seen since the recovery gained traction in 2013 and beyond.  While confidence is far preferable to fear, at least fear can generate the kind of action needed to stimulate the economy – much as was the case with the Fed’s QE program after the crisis.  So without a return of confidence in 2016, perhaps it will come down to how much fear is needed to generate concerted and aggressive action by governments and central banks in the coming months.

The U.S. Congress abdicated much of its authority to the Fed in the wake of the credit crisis; Congress must reassert its authority in the nation’s fiscal affairs, however.  Businesses and investors would find renewed confidence in the economic outlook if taxes were lowered and regulatory burdens were lifted.  The current administration has done much damage to the economy by way of increasing both, which has added to the uncertainty among investors and has hindered capital investment.  

Of the two major factors – confidence and fear – it would appear the safer bet that fear, rather than confidence, will be the dominant force behind efforts at reversing the damage caused by the global economic slowdown in 2016.

Santa Claus rally or the start of something bigger?

Stocks are trying to live up to the expectations for a year-end “Santa Claus” rally.  Most of the market’s improving internal condition is due to the latest strength in the energy sector, with the NYSE Oil Index (XOI) rallying some 6% from its recent lows.

Although recent trading volume has been far lighter than normal, the NYSE advance/decline ratio for Dec. 23 was an exceptional 13:1 in favor of upside volume.  That completely reversed the 1:11 downside volume day on Dec. 11.  It also was the first time since Oct. 5 that the up/down volume ratio has been so high in favor of advancing volume.  While the Dec. 23 big volume ratio may have been a holiday-related aberration, if it’s followed by a 9:1 up/down volume ratio in the next few days it will qualify as a major volume reversal signal which would mean at least a temporary reprieve from the selling pressure of the last few months.

The key to the holiday rally has been short covering in the two biggest problem areas for the stock market: energy stocks and China ADRs.  The 6%+ rally in the XOI mentioned above was mainly the result of a rally in the crude oil price.  As you can see in the following graph, crude oil still hasn’t closed the two days higher above the 15-day moving average required to confirm an immediate-term bottom, but it’s testing this important trend line. 

A reversal of the oil price decline, even temporarily, would undoubtedly give the equity market a relief from the selling pressure that has plagued it for months.  Most of the stocks showing up on the NYSE new 52-week lows list have been energy sector stocks.  An oil price rally would result in spillover strength in oil/gas stocks, which in turn would almost certainly put the new 52-week lows below 40 on a daily basis.  Remember that we need to see a few consecutive days of less than 40 new lows to confirm that internal selling pressure has lifted.  For the last three days there have been fewer than 40 new lows – the lowest 3-day number since the first three days of November, which was the last time there were less than 40 new lows.

Here’s what the reversal of new lows in the last couple of days has done to the important NYSE short-term directional indicator.  As you can see, both the short-term directional (blue line) and momentum bias (red line) indicators are trying to reverse the decline of the past weeks.  A confirmed reversal of both indicators would mean that the stock market’s near-term path of least resistance has turned up in favor of the bulls.

Below is the dominant intermediate-term component of the NYSE Hi-Lo Momentum Index (HILMO).  This particular indicator is important for determining the market’s intermediate-term bias.  Note that after several weeks of declining, this indicator is also trying to reverse. 

While it’s still too early to get excited in light of the historical tendency for the market to rally in late December (the so-called “Santa Claus rally”), if the internal momentum indicators show continued and substantial improvement after January 1, the odds will finally tilt in favor of the bulls eventually regaining control of the intermediate-term trend.

Speaking of intermediate-term trend, our interim trend indicator has turned from bearish to neutral and is on the cusp of potentially reversing.  If at least four of the six major indices (Dow, SPX, NDX, NYA, MID, RUT) finish the week above the 60-day moving average, the trend indicator will tilt bullish.  It wouldn’t mean that the stock market’s troubles are completely over, only that a temporary reprieve has been granted for early 2016.  The next few days will at least tell us what we can probably expect for January.

Below is the SPDR Barclays High Yield Index (JNK) has been a major leading indicator for the stock market for 2015.  The decline to multi-year lows in high-yield bond prices was largely a consequence of the stress in the oil and gas industry, courtesy of plunging oil prices.  Note that JNK is testing its 15-day MA (below). 

The fate of high yield “junk” bonds also ultimately depends on the resolution of the oil/gas stock bear market.  High yield corporate energy bonds have been in a tailspin since the shale oil “fracking” bust began, and this has put dramatic pressure on the debt of oil/gas exploration companies.  This debt-related stress is captured in the downward trajectory of the SPDR Barclays High Yield Bond ETF (JNK) shown above.  As you can see, JNK hasn’t been able to close above its 15-day MA since October and, as such, remains firmly in the grip of the bears.  However, if JNK confirms an immediate-term bottom in the next few days it would provide another indication that near-term selling pressure for the stock market has lifted.  

Returning to the broad market outlook, a New Year’s rally largely depends on continued improvement in the internal condition of the NYSE.  The most important indicator of NYSE broad market health is of course the new 52-week highs and lows.  When traders and fund managers return from the holidays next week, we’ll have a much better idea of what the market’s near-term direction is likely to be since this will tell us whether the recent contraction in new 52-week lows is a holiday-related aberration or the start of internal recovery.  

Reversing the damage of global austerity

A significant undercurrent of internal weakness is plaguing the NYSE broad market.  This weakness is primarily visible in the dangerously high numbers of stocks making new 52-week lows.  Lately that number has exceeded 300 on a daily basis, though it has been above 40 for the last few months in a sign that the market’s health is less than optimal.  The best way of showing this internal weakness is in the following exhibit which graphs the cumulative new 52-week highs and lows on the NYSE. 

As you can see here, the new highs-new lows are in a sustained downward trend which suggests vulnerability to selling pressure in the stock market.  A reversal of this downward trend is required to put the market back on a healthy track.

As potentially dangerous as this internal weakness is for the broad market in the near term, I still don’t think it will prove fatal to the secular (long-term) bull market that began in 2009.  This opinion is based on a qualitative analysis of the new NYSE 52-week lows: most of them are in the energy and natural resource sectors.  The blame for the weakness in this area is mainly due to plunging prices for oil and other commodities.  This in turn has put strain on firms who produce or market these commodities with spillover impact to other areas of the broad market.

The residual influence of weak energy prices has also spilled over into the bond market.  Below is the chart of the SPDR Barclays High Yield Bond ETF (JNK), which I use as a proxy for junk bond prices.  Most of the weakness reflected in the junk bond market originates in the high-yield debt of energy companies. 

The weakness in the high-yield bond market is also spilling over into higher yielding corporate debt, as the Dow Jones Corporate Bond Index also reflects.  See chart below.

I’m reminded of the 1997-98 experience which witnessed a similar scenario.  In those days the U.S. stock market was in the midst of a powerful bull market, yet there was a negative undercurrent from the so-called “Asian contagion,” i.e. the foreign currency crisis as well as soft commodity prices.  Oil prices had plunged to $10/barrel while gasoline at the pump was just under $1/gallon.  This proved to be a bonanza for U.S. consumers but put tremendous strain on countries that heavily depended on energy exports, such as Russia.  The result was an increasing number of U.S. listed natural resource stocks which put strain on the broad market.  The end result was a quick-but-nasty mini-bear market in the summer of 1998.  

When finally the commodity market weakness was finally resolved in the fall of ’98, the U.S. stock market entered the final year of the glorious 1990s bull market.  In early 2000, the bull was over and a new bear market began.

What I’m suggesting is that we’re probably witnessing something at least remotely similar.  Most key industry groups which comprise the NYSE broad market are still in decent shape.  It’s primarily the commodity-heavy industries which are showing most of the weakness.  If the bear market in commodities can be “washed out” by early 2016, it’s possible the secular bull trend for equities can continue at least one more year. 

The other major reason behind the recent broad market weakness is a case of the chills thanks to the global market weakness.  Europe is one such area of global weakness.  The ECB recently cut its deposit rate by the minimum amount expected, which did little to encourage investors that the central bank is serious about bolstering continent’s economy and financial system.  One is reminded of how the U.S. central bank responded to the growing credit crisis threat in December 2007.  At that juncture investors were on edge and looked for guidance from the Fed.  Instead of aggressively attacking the problem, however, Fed Chairman Bernanke announced a tepid quarter percent rate cut in December ’07 which disappointed investors and which eventually catalyzed a plunge in equity prices.

Investors had hoped based on comments ECB President Draghi made in previous speeches that the ECB would increase its version of QE in order to help stimulate the euro zone financial markets, in turn helping the economy.  Yet the ECB responded in the tepid fashion we’ve all grown accustomed to seeing in recent years.  This is no way to calm the market and it’s not surprising stocks, bonds and commodities have responded the way they have lately.

Looking back at a commentary I wrote on Dec. 8, 2011 I was surprised to find how little things have changed since then.  I wrote, “If Mr. Draghi believes the euro zone won’t eventually be torn apart by the debt crisis he is sadly mistaken and would appear to be severely underestimating the severity of the problem confronting him.  And if he believes that ‘budget discipline’ (read austerity) is the key to successfully dealing with the debt crisis at this stage he is further mistaken.  The time for budget discipline is long since passed; now is the time for aggressive action.  One can only hope that the central bankers of Europe have learned something from our own credit crisis in 2007-2008, namely the importance of preemptive monetary policy action.  Failure to take action right now, when Mr. Draghi still has the option, will result in remorse down the road.”

China didn’t help matters by slamming on the brakes of its real estate market boom.  China’s leaders enacted their own version of tight money by increasing strictures on equity and real estate investors.  Japan’s government meanwhile proverbially shot its economic recovery in the foot by increasing taxes, essentially undermining a successful QE measure. 

When will the world’s central banks get their acts together and re-synchronize monetary policy for maximum global impact?  Your guess is as good as mine, but there are signs that at least the ECB, and possibly the People’s Bank, are slowly waking up to the mistakes of recent years.  How quickly they act upon this realization is a matter of speculation, though.  Hopefully the New Year will witness a renewed resolve on the part of both banks to reverse the damaging austerity and tight money policies which have caused so much grief.

In the meantime, the only safe remedy for global market instability is continued patience and prudence in one’s investing discipline.  The equity market will work through the commodity market and global economic weakness and will, I believe, resume its bullish trend at some point next year.  Until the NYSE new 52-week high-low index tells us that the broad market internal weakness has been completely reversed, however, investors should maintain a healthy skepticism for what may appear, at first glance, to be buying opportunities in the stock market.  Only when the internal condition of the broad market decisively improves will the odds favor embracing risk.

The cycle of debt release

To many investors cycles are the holy grail of the financial market.  Many investors have devoted years to the study of them.  Some have even claimed to have found the ideal cycles for consistently predicting price movements.  What no one can seem to agree upon is exactly which cycles are most accurate for anticipating market moves.  But what all studies of the cycles share in common is an unshakable conviction that cycles hold the answers for what is coming in the future.

If there’s one thing I’ve learned over two decades of studying cycles it’s that there is no holy grail when it comes to historical market rhythms.  Even if there is a “one-size-fits-all” cycle the true believers in cycles tend to forget that in the short term, factors such as trader psychology and news reactions can exert an outsized influence on markets and can temporarily whipsaw a cycle.  The influence of central bank intervention and government policy initiatives can also override, or at least mitigate, the influence of cycles for prolonged periods.

As with any technical discipline, however, there’s always the temptation to strictly adhere to the cycles in a rigid manner.  Alas, this is where many students of the cycles go astray.  By fixing one’s focus on the cycles to the exclusion of other forms of market analysis and liquidity studies, cycle traders are often disappointed when their cycles fail to produce an expected turning point in the market.  This failure can be explained by the influence of, for instance, Fed intervention which can produce cycle “inversions” or else reduce the impact of the cycle altogether.  Extremes in investor sentiment can also produce temporary countercyclical shocks to the market which frustrate the cycle trader.

A general rule when it comes to cycles is that the longer the period (i.e. time), the more reliable they tend to be.  Probably the most famous of these long-term cycles is the Kondratieff Wave, which tends to average 60 years in length.  The K-Wave as it’s called is the dominant cycle of inflation and deflation in the economy.  While it does influence stock prices, its major impact is on commodity prices which in turn influence the overall state of the economy. 

The 60-year cycle was to have bottomed around the year 2014, although the residual effects of a cycle this long can last beyond that time.  This is the most likely explanation for the continued deflationary undercurrent in the global economy.  Its effects are being felt most acutely in China and to some extent in Europe.  A visual aid which shows the effects of this cycle-driven deflationary trend is the Reuters/Jefferies Commodity Research Bureau Index (CRB), below.  As you can see, commodity prices have fallen to multi-year lows in the face of a drop in global industrial demand.  The effects of the 60-year cycle are clearly manifest in this chart.

Another longer-term cycle which tends to reliably repeat is the 20-year crisis cycle, otherwise known as the “Sheep Shearing Cycle.”  This rhythm manifests itself in the market plunges at roughly 20 year intervals.  (It’s not to be confused with the 20-year Kress cycle.)

The crashes of 2007-08 and 1987 are examples of this rhythm, as are the 1929 crash and the 1907 panic.  Major crashes tend to occur at roughly 20 year intervals, especially if there is widespread market participation among the public.  The explanation for this cycle is that a generation runs approximately 20 years and it takes about that long for the old generation to forget the pain associated with the previous crash.  By that time, of course, a new generation will have come along which doesn’t remember the last crash or depression and are therefore more risk averse.  Thus the entire cycle of boom and bust repeats itself as the next generation repeats the mistakes of its elders. 

Another reliable rhythm which manifests in both the financial market and the economy is the 7-year cycle known as the “Year of Release.”  This cycle was first ordained in the Old Testament book of Deuteronomy as a relief for indebted Israelites.  The law reads: “At the end of every seven years thou shalt make a release.  And this is the manner of the release: Every creditor that lendeth ought [anything] until his neighbor shall release it; he shall not exact it of his neighbor, or of his brother; because it is called the Lord’s release.” [Deut. 15:1-2]

Although the year of release is no longer formally observed, this ancient precept is unconsciously embedded in the financial dealings of Western nations.  The debt release cycle can be seen in the recurring price “corrections” of commodity prices, and to a lesser extent equities, at roughly seven-year intervals.  This cycle can be seen manifesting in the credit crash of 2008, the tech wreck of the 2000-01, the mini-bear market of 1994, the stock market crash of 1987, the inflationary/commodity peak of 1980, and the broad market plunge of 1973-74.

The most recent 7-year debt release cycle was scheduled to make its appearance around 2015; and indeed the cycle’s effects are still being felt.  Depending on how many price imbalances there are within the broader economy, the influence of the 7-year cycle can spill over into the following year, as was the case in 1973-74 and 2000-01.  The primary course of the latest 7-year debt release cycle is in the commodities market, with repercussions in the overall state of the global economy.  It would not be surprising if the residual impact of this cycle is felt in 2016.

The purpose of the 7-year release cycle is to wash away the negative effects of debt and other forms of financial enslavement from the economy.  This would also include artificially high prices, which was clearly a problem in recent years in the energy market.  That oil and gasoline prices have come down so sharply in the last year is indeed a godsend for consumers.  It’s also beginning to have the beneficial effect of increasing oil demand. 

One area in desperate need of correction is retail food prices.  Prices to U.S. consumers at grocery outlets are, in some food categories, at or near all-time highs despite falling diesel and agricultural commodity futures prices.  Before the course of the debt release cycle has completely run its course, it’s necessary that the financially enslaved among us experience a release from the heavy burden of high prices in this area.

A final point to be addressed is the impact of the 7-year debt release cycle on stock prices.  Since the 7-year debt cycle isn’t expressly aimed at equities, its impact on this area isn’t always sharply delineated.  The main effect of this cycle is on commodities, as previously mentioned.  It can be argued, though, that the 7-year cycle’s impact was felt in the stock market this year in the lagging nature of the NYSE Composite Index (NYA), which is arguably the best representation of the broad U.S. stock market.  The cycle’s effect is also reflected in the abnormally large number of new NYSE 52-week lows since earlier this year. 

Much of this broad market weakness is attributable to the weakness of commodity prices, especially in the energy and mining sectors.  Of course it can be argued that this is a spillover effect of the longer-term deflationary cycle previously mentioned.  In any event, the impacts of this cycle are still discernible in the internal condition of the NYSE broad market: new 52-week lows remain abnormally high as of this writing. 

In previous commentaries I’ve suggested that next year would likely witness a bottom in the commodity prices that have lately plagued the global economy.  The standard deviation of the 60-year cycle as well as the 7-year debt release cycle support this notion.  By the time both cycles have completely run their course, the oppressiveness of high prices in the economy should attenuate enough to provide some relief for the debtors who need it most.  Thus the Year of Release will have once again worked its magic.

Has deflation been defeated?

The last 15 years have been among the most turbulent on record.  Since the year 2000, America has experienced two recessions (including a near depression), two stock market crashes, numerous selling panics, two terrorist attacks, and one of the slowest economic recoveries on record.

Just when it appears there might be some light at the end of the tunnel and the consumer is getting his confidence back, the threat of global deflation has appeared and has given them reason to remain cautious.    This time around the threat of deflation is coming from overseas, specifically from China.

Thankfully, the near brushes with deflation in the last 15 years have all been averted so far due to the aggressive monetary policy responses of the U.S. central bank.  Every time deflation reared its ugly head, the Fed was right there to ensure prices didn’t stay low for long.  In doing so, however, the Fed has short-circuited the natural process by which the economy is periodically cleansed of economic excess. 

The natural cycle of deflation also brings an important adjustment in the cost of living for everyone, especially the savers among us.  Those who sacrifice spending in the immediate term are typically rewarded for their thrift by the long-term economic cycle.  This time, though, the long-term deflation cycle wasn’t allowed to completely run its course.  The net result was that savers were essentially punished for their thrift while debtors were exonerated.  It means that the natural economic order was turned on its head by central bankers.

This begs a number of important questions: 1.) Does this mean the cycle inflation and deflation known as the K-wave has been defeated by the Fed?  2.) Or will the natural order eventually reassert its primacy over central bank manipulation?  3.) Has the Fed run out of ammunition for mitigating future economic downturns?

Samuel “Bud” Kress, for whom the long-term Kress cycles are named, taught that when it comes to attempts by government to circumvent the long-term cycles, “Mother Nature and Father Time” always prevail in the end.  If Bud were alive today I have no doubt he would maintain the Fed’s impotence in ultimately destroying the long-term economic cycle of inflation/deflation.  The effects of the long-term economic cycle, he always asserted, must win out.

The long-term cycle of inflation/deflation identified by Kress has a period of 60 years and is roughly analogous to the more widely known Kondratieff Wave (K-wave).  According to Kress’ numerical system, the cycle was to have bottomed in late 2014.  The period between 2000 and 2014 encompassed the deflationary portion of his cycle, and it was during this time that the U.S. economy experienced most of the aforementioned turbulence.  During this time frame the closest the U.S. came to the deflationary depression predicted by Kress was in 2007-2008.  The Fed stepped in, however, and unleashed record amounts of liquidity in a furious attempt at reversing the deflationary spiral.  Its efforts proved successful as depression was averted and prices recovered in the years that followed.

Yet the threat of deflation is ever present and remains a constant bugbear of central bankers, especially in Asia and Europe.  The U.S. Fed may have succeeded in forestalling deflation, but the austerity programs pursued by other countries in 2009-2015 are coming back to haunt them.  The interrelated global economy so passionately defended by many has revealed its ugly underside.  Deflation, it turns out, can be spread abroad even to countries that aren’t directly experiencing it at home. 

A classic symptom of the deflationary pressure many countries are experiencing is the steep decline in commodity prices.  The Reuters/Jefferies Commodity Research Bureau Index (CRB) is the benchmark price index for the broad commodities market.  As the following graph illustrates, the CRB is at its lowest level since the 2008 credit crisis.  This depressed level reflects the lack of industrial demand owing to the global economic slowdown.

When monetary policy fails, the classic political response to deflationary pressure of this magnitude is to start a war.  War is inflationary and always succeeds in boosting commodity prices and industrial production to above normal levels.  The military adventures of the U.S. between 2002 and 2011 contributed to an historic boom in commodity prices and likely forestalled the early onset of deflation after the 30-year cycle peaked in late 1999.

There is also a 24-year cycle component of the Kress system which typically harbingers war.  The last few times this cycle bottomed it was followed by a major military conflagration involving the major Western countries.  The most recent 24-year cycle bottomed in late 2014.  It will be interesting to see if any nations pursue this course of action in the years immediately ahead, especially in light of recent developments.  Of interest, the Dow Jones U.S. Defense Index (DJUSDN) suggests that perhaps preparations to that effect are in the making.

In answer to the question of whether the Fed has succeeded in destroying the long-term deflation cycle, the evidence points to the negative.  While there’s no denying the mitigating influence that six years of QE had on U.S. equities, the billions of dollars created by the Fed failed to produce any discernible inflation in the broad economy.  The fact that interest rates and commodity prices remain near historic lows illustrates this failure.

Essentially, there are two possible outcomes to the global economic slowdown: 1.) Either natural market forces will be allowed to run their course, or 2.) Governments will intervene with a vigorous monetary policy and/or military response.  The latter option is the most likely outcome based on history.  Although the central banks of China and Europe have already introduced stimulative monetary policies, these policies have so far failed at reversing the deflationary undercurrents still present in the global economy.  A much more aggressive stimulus effort will be required to achieve the effects desired by central bankers and bureaucrats.  It’s questionable whether they have the political will to do this, however.

By far the quickest route to reversing low commodity prices is the warfare route.  War lifts prices much faster than even the most aggressive QE could ever do.  As undesirable as it is, war unfortunately remains the most likely choice for governments desperate to boost their economies at any cost.

The short answer to the question, “Has deflation been defeated?” is “No,” at least not yet.  It will either be allowed to finish its course, which is a salutary and beneficial outcome for consumers.  Or it will be prematurely circumvented by policy makers, as it was in the U.S., to the detriment of the many and the benefit of the few.  History suggests the latter course will be the one most likely chosen.

Clif Droke in Trader's World Magazine

Traders World, the leading magazine on Gann, Elliott Wave and technical analysis, has published an article by yours truly on the topic of moving averages.  In it I explain the basics of some of my trading techniques involving harmonic moving averages based on Kress cycle time frames. Traders World issue #61 is now in circulation and you can view the article (on page 113) free by visiting the following link:

http://www.tradersworld.com/issue61/#/0

The bear indicator never lies

In the September 10 column entitled, “The bear makes a welcome return”, we discussed the return of the infamous bear image on the front cover of several news magazines and newspapers.  The most conspicuous example of the bear could be seen on the front cover of Businessweek magazine, shown below.

From a contrarian’s perspective, this was a most welcome return for it strongly suggested that the bottom would soon be in for the stock market after the August decline.  As I observed, “From a contrarian standpoint it doesn’t get any more emphatic than this.”  Since then the major indices have rallied off their lows with some even making token new highs (e.g. the NASDAQ 100).  I’ve never heard of a manifestation of the bear cover indicator failing to mark a decisive market bottom, and this time proved no exception.

Now that the Dow Industrials and the S&P 500 index have rallied back to the February-July resistance zones, should we expect a resumption of the selling pressure that plagued the market this summer?  Or should we rather expect a period of consolidation (i.e. backing and filling) and eventually a breakout to new highs?  As always, the answer to that question will be answered by the market itself but the current weight of evidence does provide us a meaningful clue as to the most likely outcome.

Before we look at the evidence, it’s worth making an observation about the previous sell-off.  What happened to the stock market over the three days between August 20-24 qualified as a classic selling panic, as opposed to a fundamentally-driven crash or credit episode.  This distinction is important, for if true it will make the difference between entering a bear market in 2016 and continuing with the bull market that began over six years ago. 

A market panic is catalyzed by an adverse and extreme reaction to a news event.  In the August sell-off it was the currency devaluation in China that panicked investors into selling.  One thing that history consistently has shown is that true selling panics are usually retraced in short order once the fear subsides, i.e. usually within a couple of months.  The less time it takes for the major indices to recover their losses, the less likely the selling was fundamentally driven.  Hence, a true selling panic isn’t typically the precursor of an imminent bear market.

It’s also worth noting that the market’s present internal condition is virtually in complete contrast to what it was earlier this summer heading into the August panic.  Prior to the summer swoon, the market’s extremely weak breadth could be seen on a daily basis for weeks on end.  From June onward the number of NYSE stocks making new 52-week lows each day was extremely elevated and showed that the market wasn’t internally healthy.  Moreover, this showed up in the NYSE internal momentum indicators (which are based on the new 52-week highs and lows).  Most of those indicators were in decline as I mentioned earlier this summer.

Since the August bottom, the situation has reversed.  The number of new 52-week lows has been drying up since September and have numbered less than 40 for most days since Oct. 5.  The NYSE internal momentum indicators are now mostly in a rising pattern as opposed to the declining pattern before the August crash.  Below is a chart showing the six major component of the Hi-Lo Momentum (HILMO) index.  Only the longer-term component (orange line) is still in decline; the others are either rising or bottoming, in the case of the dominant interim indicator (blue line at bottom). 

These indicators are very important because they show the stock market’s near-term path of least resistance.  There is at least one fly still in the ointment, namely the longer-term internal momentum indicator which is still declining, as already mentioned.  But all the other indicators – short-term and intermediate-term – are rising.  This implies that the bulls currently have the advantage and that the heavy internal selling pressure which characterized the stock market this spring and summer is not an issue right now.  This doesn’t preclude another (potentially sharp) pullback between now and year’s end, but the market’s main uptrend should remain intact.

Also worth mentioning is that the New Economy Index (NEI), our in-house measure of how strong or weak U.S. retail spending is, hit a new all-time high last Friday, Oct. 30.  Although business owners remain worried over growth prospects, mainly because of overseas woes, consumers don’t seem the least bit concerned.  They just keep spending as the NEI chart suggests (below).  What’s more, we’re about to enter the critical holiday season when retail sales typically hit their highest levels. 

After a major decline in the stock market it always pays to monitor the sectors and industry groups for signs of relative strength.  When, for example, the Dow Jones Industrial Average makes a series of lower lows during the final stage of a decline and certain individual stocks make higher lows, that’s a tip-off that informed buying is likely taking place.  When the market turns up again and these individual stocks continue leading the market, that confirms it.  At the bottom of the August panic, the industry groups which showed the greatest resilience to the decline were water, defense, and broadline retail stocks along with toy companies. 

Among Dow Jones industries currently showing exceptional relative strength are: Broadline Retailers (DJUSRB), Business Training and Employment (DJUSBE), Consumer Finance (DJUSSF), Defense (DJUSDN), Leisure Goods (DJUSLE), Restaurants and Bars (DJUSRU), Software (DJUSSW), Toys (DJUSTY), and Water (DJUSWU).  This group of industry leaders is very much in keeping with the bullish consumer spending patterns we’ve seen reflected in the New Economy Index lately.

There are, however, some industries that are conspicuous laggards which are close to their yearly lows.  If these industry groups don’t improve soon it could pose a problem at some point in 2016.  Not surprisingly, most of them are commodity and industry related and were heavily impacted by this year’s global economic slowdown.  They aren’t likely to a pose a problem for the balance of 2015, however, especially if they remain within their 2-month holding patterns.  They include: Aluminum (DJUSAL), Coal (DJUSCL), Healthcare Providers (DJUSHP), Mortgage Finance (DJUSMF), Pipelines (DJUSPL), Steel (DJUSST), Railroads (DJUSRR), and Recreational Products (DJUSRP).

If commodities can establish a bottom in the next couple of months, particularly crude oil, then the global economic woes of 2015 are far less likely to be of concern to the U.S. in 2016.  Moreover, if the stimulus measures of the ECB and China continue the global economic slide will likely be halted next year.