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.