Global QE and the gold price

After months of waiting, the European Central Bank (ECB) finally carried through with its stated promise of unlimited monetary support to its ailing economy.  The ECB announced its own version of quantitative easing (QE) on Thursday, a move which lifted the dark clouds that have recently hung over financial markets.  

In March the ECB will begin purchasing 60 billion euros’ worth of government and corporate bonds through September 2016.  In response to the announcement the equity markets of several major countries rallied while the price of gold and silver also rose. 

Gold also received a boost after the Danish central bank reduced its key interest rate for a second time this week, underscoring the concerted nature of the monetary policy response.  Central banks the world over are finally waking up to the threat of deflation and have responded in lock step this week.  On Wednesday, the Bank of Japan lowered its inflation outlook to 1% from 1.7%, which boosted the yen.  Meanwhile the Bank of England held off on a previously announced intention to increase interest rates, which resulted in a 1.63% rally in the FTSE stock index.   

The great danger facing the global economy in recent months has been the threat of deflation.  The U.S. has been the lone standout as its economy has proven resilient and has been largely immune to deflationary pressures (with the gasoline price being a conspicuous exception).  The great debate raging among economists has been whether and for how much longer the U.S. can hold out against the global economic slowdown.  That question may now be moot thanks to the latest European central bank announcements.  Indeed, equity markets have discounted this and investors are clearly eager to embrace loose money. 

Yet investors haven’t completely cast off their fears as evidenced by Thursday’s rally in the U.S. dollar index to yet another multi-year high.  By contrast, oil, copper and other economically-sensitive commodities were down on Thursday despite the ECB announcement.  Could it be that investors aren’t quite ready to believe the seriousness of central banks’ commitment to monetary stimulus? 

Investors certainly can’t be blamed for being skeptical given how long it took European banks to respond to the deflationary threat. Foot-dragging is a universal policy among central banks, even when faced with a major economic crisis (witness the slowness of the Federal Reserve’s response to the 2007-2008 credit crisis).  When central bankers finally decide to act, however, the policy response tends to be both emphatic and sustained and nearly always has the desired effect of countering deflation. 

Critics maintain that QE “doesn’t work” but there’s no denying the efficacy of the Fed’s QE program in staving off deflationary pressures in the wake of the 2008 credit collapse.  Without it the U.S. almost certainly would have suffered another Great Depression.  Indeed, the one ingredient missing that has prevented a re-inflation of global economies in the wake of 60-year cycle bottom last October has been the austerity (or semi-austerity) policies in many European and Asian countries.  But now that policy makers are finally realizing the folly of such policies, deflation’s days are numbered in the euro zone.  Other countries may soon follow the ECB’s lead, thus fostering the re-inflation of the global economy. 

Now that the promise of coordinated global monetary stimulus may soon become a reality, what are the intermediate-term implications for gold and silver?  The precious metals should continue to benefit from the uncertainty that still surrounds the global economic outlook.  Investors aren’t likely to shake off their fears of deflation overnight and as long as even the slightest apprehension remains, gold is likely to benefit.  But what happens when the promise of global QE becomes an established reality?  At that point there may be an adjustment phase where gold and silver prices enter lateral trading ranges.  In the overall scheme of things, though, gold and silver will likely benefit in the early stages of QE.

The U.S. experience with QE from 2009 through 2014 teaches that the precious metals benefit from the first few years of QE.  The reason is because it usually takes investor psychology a good three years to adjust to the reversal of a major economic or financial market trend.  Gold’s price rallied from late 2008 through the summer of 2011 before entering a bear market.  That’s pretty close to the traditional 3-year period of psychological adjustment. 

If the U.S. QE experience teaches us any lesson it’s that a pan-European and pan-Asian QE should have a similar impact on investor psychology.  The foreign investors who have incessantly worried about the impact of deflation will likely take a while to completely shake off these fears.  It certainly won’t happen overnight.  As long as even the vestige of fear persists, gold can benefit from it. 

Q&A: Moving averages and the A-D line

Question: Why do you use 60-day and 150-day moving average rather than 50-day and 200-day MAs?  And do you have a way of computing the NYSE Advance-Decline (A-D) line sans the bond funds?

Answer: I’ve found the 60-day MA to be more responsive for the major indices than the 50-day MA, which everybody uses.  Also, quite a few individual stocks and industry groups seem to be more responsive to the 60-day MA.  The 150-day MA is a good one to use for evaluating the intermediate-term trend for the S&P 500 and the XAU Gold Silver Index.  Of course the 200-day MA is still useful for the major indices, but right now the S&P is testing the 150-day MA which makes it more important right now.  The 150-day MA also answers to the 30-week MA, which is used by many fund managers and therefore has technical significance.

I’m not sure there is a way of obtaining the NYSE A-D line without bond funds, but then again I’m not sure it would be any more helpful.  My research over the years indicates that the A/D line is quantitative, not qualitative.  In other words, it’s the number of advancing issues over declining issues that matters most, not the types of stocks or funds which are advancing or declining.  

Will the oil crash spell ruin for stocks?

Talk of deflation was overheard on the Street as a few analysts quoted by the news wires mentioned the D-word.  One reason for the recent equity market weakness is the uncertainty among investors as to whether lower oil prices are ultimately beneficial or detrimental for the economy.  In one camp are those who maintain that lower oil prices will boost consumption; on the other side are those who claim that plummeting energy prices can only lead to outright deflation.  Because neither side has a decisive majority right now, equities are caught in the imbalance of opinion which explains much of the recent volatility.

Adding to the uncertainty this week was the latest research note from Goldman Sachs.  Goldman’s chief commodities analyst Jeffrey Currie wrote: “To keep all capital sidelined and curtail investment in shale until the market has re-balanced, we believe prices need to stay lower for longer.”  Goldman made a high-profile call for $40/barrel oil before the bottom has been seen in the crude market.

Both sides of the argument have merit, but history shows that there comes a point at which falling oil prices eventually exert a negative on equities.  The two examples that come to mind are the 2008 oil collapse, which increased downside volatility for the credit crisis.  Before that, the 1998 plunge, which took crude prices below $10/barrel, aggravated the Russian Ruble crisis and LTCM hedge fund collapse of that year and had a decidedly negative spillover impact on stock prices for a while. 

I would also point out that in the Kress cycle forecast for 2015 the 6-year “echo” suggests that the first few weeks of the New Year could be negative for stocks.  The Kress cycle echoes tend to be fairly accurate in warning of broad periods of above-average volatility and of the years which most closely align with 2015 in terms of the key Kress cycles, January was shown to be a particularly vulnerable month for selling pressure. 

Meanwhile commodities continue to take center stage as concerns mount that the weakness in the energy market may spill over into other areas of the financial system and the economy at large.  On Wednesday, Citigroup cut its iron ore and coal forecasts due to supply costs and signaled that the oil price crash is feeding into other commodity markets.  An even bigger sign that that weakness is having an impact on global demand can be seen in the chart for copper futures.  Copper is a widely watched gauge of global economic strength and the following graph suggests diminishing demand.

One of the major culprits for the weakness in oil and other commodities is the austerity policies in Greece and other euro zone countries, which is coming home to roost right now.  While the U.S. Federal Reserve responded to the unmitigated demand for money during the critical years 2009-2012, other countries chose to ignore the need for increased reserves and liquidity and instead initiated an ill-timed tight money policy.  Fast-forward to 2015 and while the U.S. finds itself the envy of the world in terms of its domestic economy, other nations are showing major signs of weakness with some verging on recession. 

The risk is that the commodities bear market continues exerting a negative influence on economies in Europe and Asia with weakness eventually being exported to the U.S.  This is what happened, on a temporary scale at least, in 1998.  While we’re a long way from the danger zone, there are preliminary signs that some of that weakness is already showing up.  The latest U.S. retail sales numbers, for instance, showed a 0.9 percent drop for December in what should by all accounts have been a positive month.  Electronic and clothing retailers were among the nine of the 13 leading categories that showed a decline in sales as Americans chose not to spend the extra money from gasoline price savings. 

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 past year consolidating its gains since 2009 by tracing out a lateral range.  The NEI chart looks decent but could certainly use some improvement.  My interpretation of the NEI pattern is that while consumers have been spending at moderate levels, they haven’t completely “let loose” with those frenetic spending binges that have always characterized strong economies of the past. 

Although joblessness isn’t a major problem like it was in years past – the latest jobs report showed a surge of 321,000 new jobs in November – consumers are apparently concerned enough about keeping their jobs that they haven’t accelerated their spending.  It will be interesting to see how they respond to the continued weakness in the commodities market.

Deflation and the year ahead

Stocks were hit by selling pressure on Monday as the S&P 500 (SPX) declined 1.83% and the Dow 30 shed 1.86%.  The energy sector bore the brunt of the selling with the NYSE Oil Index declining 4.61%.  Crude oil prices also dropped nearly 5% for the day to close at 5 ½-year lows.

Fears that Greece may exit the euro zone are being blamed on the latest broad market decline.  Upcoming elections in Greece have spooked many investors, who feel that the country’s exit from the euro zone would be disastrous.  The most likely reason for the market decline, however, is the fact that investor sentiment has been excessively bullish in the last couple of weeks.  A pullback in the major indices should remove much of the excess optimism and pave the way for a sounder market environment. 

Many investors are also concerned over the potential for a bad year based on the so-called January Barometer.  This indicator is predicated on the belief that as goes the month of January, so goes the entire year.  Some even place emphasis on the first five days of January as having prognosticative value.  Yet the January Barometer was wrong in 2014 – the month of January last year was resoundingly negative, yet the year as a whole was positive.

As discussed in previous commentaries, the year ahead should be a bullish one overall based on the Year Five Phenomenon, notwithstanding the possibility of a volatile January.  This particular market maxim has held true for over 100 years, namely that there has never been a losing year in the fifth year of the decade.  The reason for this is that the 10-year Kress cycle bottoms at the end of the fourth year and the resultant upward pressure from the new-born 10-year cycle is beneficial for equity prices. 

Turning our attention to the crude oil collapse, weakness was once again in the oil price on Monday.  The crude oil price was 3% lower for the day after hitting a 5 ½-year low.  Adding to pressure against crude oil prices has been persistent strength in the U.S. dollar index (see chart below).  Recent dollar strength and oil price weakness has once again stirred up concerns among investors that deflation could be a problem in 2015. 

While I don’t envision deflation being a dominant theme for most of 2015, it could be problematic during the early part of the year.  When the 60-year Kress cycle of inflation/deflation entered its final “hard down” phase in 2008 it created major problems for the U.S. financial sector in 2008-2009.  Yet except for a brief period in 2008 and early 2009, it failed to deliver the anticipated deflationary collapse in essential commodity prices and the corresponding increase in the dollar’s value.  Many investors jumped to the conclusion that the long-term Kress cycle was either broken or else mitigated by the monetary policy actions of the Federal Reserve. 

Bud Kress always used to say that ultimately “Mother Nature and Father Time” would prevail when it came to the financial market.  That is, the natural forces of inflation and deflation will always manifest sooner or later – even when central bankers do their utmost to stifle it.  Viewed from this standpoint, the recent oil price collapse, dollar rally and overseas turbulence can be attributed to the cycle somewhat belatedly having its way despite the efforts of central banks.  Central bankers thought they could completely eliminate the impact of the cycle but it would seem that the cycles are having the last laugh.

On the subject of the oil price collapse, a recent Bloomberg article entitled “Oil below $60 tests U.S. drive for energy independence” provided some background for the ongoing crisis.  Asjylyn Loder, who wrote the article, observed: “The U.S. shale boom that’s brought the country closer to energy self-sufficiency than at any time since the 1980s will be challenged in 2015 as never before.” 

The article also pointed out that some of the largest U.S. shale drillers “have been spending money faster than they make it, borrowing to pay for their expansion.”  It would appear then that the fracking boom which provided a much needed stimulus to the U.S. economy at a time when it was needed most will face its first major obstacle in the coming year.  The oil price collapse and dollar rally has been a boon for consumers – Goldman Sachs analysts have said that cheaper U.S. gasoline will boost economic growth by 0.5 percentage points this year.  Economist Mark Zandi of Moody Analytics estimates that if oil prices stay at $60/barrel it will result in $150 billion in savings on gasoline for consumers. 

However, the oil price collapse will also eventually run headlong against the old market bromide that “low prices cure low prices.”

Is the utility stock boom a bad sign?

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

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

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

A look ahead into 2015

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

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

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

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

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

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

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

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

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

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

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

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

The war cycle: 2015 and beyond

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

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

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

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

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

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

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

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

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

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

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