Tuesday, December 13, 2016

Why collapse isn’t on the menu

The word “collapse” instantly conjures primal feelings of both fear and excitement whenever we hear it.  We fear it because it evokes our collective belief that collapse is fatal and final, yet it excites our imagination to the possibility, however, remote, that perhaps we’ll be among the lucky few to survive and even prosper from it. 

Whether in reference to a financial market crash or the collapse of government, the very idea has given birth to a plethora of writings on the subject.  Indeed, some of the top selling books in the financial literature category in recent years have had collapse as the subject matter, for writers instinctively know they can always count on a visceral reaction from their readers whenever they write of it.

Laying aside the fear it evokes, the study of collapse is a fascinating and rewarding endeavor.  Historians have long known what financial writers have only recently discovered, viz. that writing about collapse is a lucrative industry.  Consider the hundreds of books dedicated to the decline and fall of the Roman Empire, or to any number of past civilizations (Aztec, Egyptian, Babylonian, etc.).  One of the great preoccupations of writers of this genre is the guessing game of what exactly causes a society, or an economy, to collapse.  There is invariably no consensus among historians as to how, or even when exactly, it happens. 

Consider the famous example of ancient Rome.  What was it that actually precipitated the decline and fall of this mighty empire?  While there have been hundreds of reasons offered by specialists as to the cause(s), the most commonly assigned factors can be generally summarized as follows: 1.) Immigration and assimilation of foreigners (i.e. barbarians), 2.) Failure to continue expanding the frontiers via military conquest, 3.) Loss of personal discipline and liberty; 4.) Corruption on both the administrative and personal levels. 

Even if we accept any, or all, of these reasons as being legitimate, it still doesn’t answer the perennial question of what led the Romans to decide on making such a fateful decision.  In other words, what was the ultimate reason for the decline and fall?

Financial writers are plagued by the same lack of agreement as to what causes markets to collapse.  The reasons they offer range from the prosaic to the profound.  Most commonly they assume that a market collapse is the result of asset prices being “too high” or unsustainably expensive relative to valuation.  What many don’t realize is that demand for any given asset can extend well beyond the boundaries of normal valuation for years, or even decades, at a time.  We need look no further than the Treasury bond market to see an example of this. 

It has become fashionable among collapse historians to assume that collapse often occurs without warning out of a clear blue sky as it were.  Nothing could be further from the truth.  Collapses are invariably preceded by long periods of internal weakness, whether it’s the financial market or any other social system.  This explains why strong societies, much like strong markets, can withstand any number of external shocks without toppling.  It’s only when weakness is entrenched that one can expect external pressure to cause serious damage to a structure. 

An example of this is the stock market plunge of late 2015/early 2016.  In the months leading up to it there was a sustained period of internal weakness and technical erosion in the NYSE broad market.  The number of stocks making new 52-week lows was well over 40, and often in the triple digits, which was a clear sign of distribution taking place in some key industry groups.  This weakness was evident in the NYSE Hi-Lo Momentum (HILMO) indicators, which depicted a downward path of least resistance for stocks.  The following graph is a snapshot of what the HILMO indicators looked like in the weeks just prior to the January 2016 market plunge.

This is also what stock market internal momentum looked like prior to the 2008 credit crash.  In fact, it’s what precedes every major collapse and it’s also a good representation of the internal weakness which takes place before markets, societies and empires collapse.  Look below the surface and you’ll always see the internal decay which paves the way for the coming destruction.  A healthy and thriving system, by contrast, is simply not conducive for a collapse to occur.

When we view the internal structure of the current NYSE stock market through the lens of the HILMO indicator, what do we see?  A market ripe for collapse?  Far from it, we see overall signs of technical health – even if the market isn’t firing on all cylinders.  Below are all six major components of HILMO.  The orange line is the longer-term momentum indicator, which is one of the most important one for discerning whether or not the market has been undergoing major distribution (i.e. internal selling).  It has been rising for several months now and is the polar opposite of what it looked like heading into 2016.

It would appear then that a collapse isn’t on the menu right now, at least not in the intermediate term outlook.  If it happens at all it will require a significant reversal of the market’s longer-term internal momentum currents, which in turn would likely take several months.  The weight of evidence suggests that the doom-and-gloomers who are predicting collapse are much too early and should save their apocalyptic warnings for a more propitious time.

Wednesday, December 7, 2016

The great middle class revolt gets bigger

With the U.S. presidential election now behind us, many investors feel they can finally breathe easy again after a nail-biting period of uncertainty since last year.  The rally in the major equity market indices since Nov. 9 has been in large part a relief rally of sorts and has been broad-based.  The sell-off in bonds has also been an indication of this collective relief. 

Despite the powerful stock market rally, not everyone is relieved about the election’s outcome.  There is some evidence that a large segment of the U.S. population is still feeling uneasy about the incoming president.  I’m referring specifically to the upper-middle class, which by some measures hasn’t expressed any enthusiasm in the way of increased spending patterns since the election.  Indeed, many in this socio-economic group have expressed an unwillingness to make major purchases until they see evidence that President-elect Trump’s policies are beneficial for the economy. 

The upper-middle class is roughly defined as those individuals that earn from around US$85,000 to $150,000 per year. Based on one measure of upper-middle class retail spending, they’ve noticeably curtailed their discretionary spending for at least the last two years.  Middle class spending also remains below its 2014 peak. 

Here’s a theoretical question: If it were possible to invest in either the middle class or the upper-middle class as if both were individual stocks or ETFs, which would you choose?  Logic would dictate the latter group since we are assured by economists that the upper-middle class has actually grown in recent years while the middle class has allegedly shrunk.  Moreover, upper-middle class members typically earn on average at least twice as much as the middle class average income.   So given a choice between the two, which do you think has performed better in the last couple of years?

The answer will no doubt surprise many of you; it’s the middle class.  Here’s what a middle class “ETF” would look like:

This theoretical class index is comprised of several companies which cater mainly to the middle class, including WalMart, Dollar General, McDonalds, Ford, and JC Penny.  Notice in the above chart that while most of the middle class-oriented stocks peaked in 2014, many of these stocks have actually held their own and have been trending more or less sideways since last year.  Some of them have even shown an upward bias since this year.

Now for the upper-middle class “ETF.”  Here’s the chart: 

As you can see, the upper-middle class hasn’t exactly felt ebullient since their discretionary spending peaked in 2014.  This index is comprised of stocks which cater mainly to members of the upper-middle, including Target, Starbucks, BMW, Whole Foods, Apple, and Chipotle Mexican Grill.  Evidently, the upper-middle class has felt less than enthusiastic in the last two years as the overall trajectory of most publicly traded companies who serve this sector has been, surprisingly, downward trending. 

This is not to imply that the fortunes of the upper-middle have been declining; economic statistics suggest the opposite.  Yet a distinction must be made when performing this type of analysis between having money and the willingness to spend it.  Clearly the upper-middle class has been, by and large, less willing to spend than in the years prior to 2015. 

It would be tempting to lump the trends shown in the above charts together and label them collectively as a great “middle class revolt.”  Undoubtedly that could be said about the way the middle class feels, for they made their grievances known in the recent election.  As I’ve demonstrated many times in the past, nothing is more devastating to the mass psyche than a prolonged sideways trend in the equities market.  The directionless stock market trend visible in the NYSE Composite Index (NYA) since 2014 is a case in point.  I believe that this, more than perhaps any other factor, has engendered the spirit of revolt among the middle class.

Human nature is so constituted that if progress isn’t evident over a certain period of time, people become restless.  The longer that people feel they aren’t progressing, the more restless they become.  This explains why, almost without exception, every political or military revolution in industrialized countries occurs after a prolonged trading range in that country’s equity market.  In the case of the U.S. middle class, it’s not that this class is actually getting poorer; rather, they only feel they’re not progressing.  The above middle class “ETF” chart only serves to underscore that belief. 

I would also make one more observation about both the above mentioned “ETFs.”  The middle class and upper-middle class charts suggest that investors in both classes have been underperforming the major averages.  Perhaps this is another factor behind the widespread notion that the middle class is “shrinking.”  While their collective earnings have either stayed the same or increased in recent years, their potential earnings (via the investment markets) have declined.  This can only feed into the growing sense of disillusionment that many within the middle class are feeling.  What comes as a surprise, however, is that the same might also be said of the upper-middle class. 

The next few months will be extremely interesting from the standpoint of middle class investor sentiment.  Should the middle class index fail to break out from its 2+ year trading range soon, the middle class may show further signs of discontent next year – especially if President Trump fails to deliver on his promises to the middle class.  

Moreover, a failure of the upper-middle class index to significantly reverse its downward trend fairly soon could potentially cause problems with the broader economy given their outsized impact on consumer spending. Needless to say, the next few months will be very informative on a number of levels.

Thursday, December 1, 2016

Will real estate tank in 2017?

In many ways, 2016 has been a banner year for U.S. real estate.  Housing prices continued to strengthen in several major metropolitan markets and even reached frothy proportions in at least three major markets.  Below the surface of an otherwise healthy market, however, lies a set of factors that could cause problems for the housing market in 2017.

Like most financial assets, home prices have been stuck in a sideways trend since 2014 and by all appearances weren’t going anywhere anytime soon.  The chart shown here from the Calculated Risk blog shows the CoreLogic Home Price Index from a yearly percentage change standpoint.  The dramatic increase in the tax and regulatory burden courtesy of the outgoing regime contributed to this standstill.  In the last several months it was the uncertainty over the November presidential election which contributed to subdued speculative activity in the financial markets. 

Now that the uncertainty has lifted to a large degree, asset prices are breaking out from their constrictive trading ranges, with many stock market sectors making nominal new highs.  Investors are hopeful that the incoming administration will be more pro-business than the last one.  Even real estate prices have ticked higher on a year-over-year basis, as shown by the above chart. 

With continued strength in real estate prices comes an increase in home equity wealth for homeowners.  According to CoreLogic, home equity wealth has doubled since 2011 to $13 trillion due mainly to the housing market recovery. Moreover, CoreLogic has forecast that a continued five percent rise in home values in the coming year would create an additional $1 trillion in home-equity wealth for homeowners. 

The current supply/demand balance for U.S. residential real estate is still favorable for a rising market.  Existing home sales and new home building permits are on the rise, with existing home sales rising in recent months by positive increments.  The National Association of Realtors recently reported that the supply of homes was a 4.5-month supply at the current level of sales.  This means that supply has decreased 7 percent in the past year.

Up until now the rally in bond yields (and fall in bond prices) hasn’t had much of a discernible impact on mortgage rates.  That may be in the process of changing, however.  The U.S. 30-Year Fixed Mortgage rate rose to 4.03% from last week’s 3.94%.  In doing so it pushed the year-over-year percentage change in the mortgage rate above the “zero” line and into positive territory.  Whenever this has happened in the past it tends to create weakness for the real estate-related stocks in the market.  It can even negatively impact the overall broad market for equities if mortgage rates continue rising over several months.  Rising mortgage rates can also be quite detrimental for the overall real estate sector if they persist long enough. 

It’s also worth pointing out that three-month Libor rates, which are the benchmark cost of short-term borrowing for the international banking system, have nearly tripled in the last 12 months.  As Steen Jakobsen of Saxo Bank has observed, “The Libor rate is one of the few instruments left that still moves freely and is priced by market forces.  It is effectively telling us that the Fed is already two hikes behind the curve.” 

My colleague Robert Campbell, who writes The Campbell Real Estate Timing Letter (www.RealEstateTiming.com) had this to say in his November newsletter: “Current real estate valuations are justified only if rates stay low – and if the Fed does raise rates in December as the financial markets currently expect, housing prices could start adjusting downward.”  This is certainly worth pondering as we head into 2017, especially if the interest rate uptrend continues.  

Real estate has been on a solid footing in the last few years but looks to encounter some turbulence at some point next year. The increase in market interest rates may well pressure the homebuilding sector, especially given the vertiginous levels which bond prices have soared to in recent years.  Any continued weakness in the bond market will only increase the pressure on housing loan demand.