With stock markets moving straight up you might think that GDP growth was north of 6% per year, inflation was running over 4% a year and that the economy was burning red hot like it was in the late 1990’s. Yet today we have the third longest expansionary cycle in history, GDP growth at 1.6% for 2016 (tied for the lowest level this cycle!), inflation at less than 2% per year, record levels of debt, stagnant wages, a contracting money supply and aging demographics. Even first quarter GDP projections are weak; the Atlanta Fed GDPNow has first quarter GDP at a mere 1.8%!
It’s hard to think that the stock market is fast approaching the second highest level in history based on cyclically-adjusted price-to-earnings ratio and with a forward price-to-earnings ratio on the S&P 500 is at the highest level since May 2002. It leaves me wondering what returns investors hope to realize by buying at these levels.
The Investors Intelligence polls shows investors are very bullish right now with the survey showing the bull camp at the highest level since January 1987! When investors get overly bullish and complacent the market tends to move the opposite direction.
The real issue is debt. GDP growth of an advanced economy that has non-financial debt over 250% (as percentage of GDP) can barely generate growth over 1% per year. The United States’ non-financial debt just hit 248%, suggesting the sub-2% growth rate is here to stay, with more downside risk than upside. Yet consumers and businesses remain optimistic!
The National Federation for Independent Business’ Small Business survey showed optimism at a cycle high, yet uncertainty at a record high. Consumer Confidence is at the highest level since July 2001, which if you remember, in July 2001 we were in the middle of a recession. Makes you wonder if consumers are optimistic because the feel things can’t get much worse or because they see the economy turning around in their favor.
Employment expectations, for people hoping to find work in the next six months, has jumped to a cycle high. Normally this happens at the end of recession not at the end of an expansionary cycle. This suggests that consumers are hoping things can’t get much worse as they are desperate to find meaningful work.
The good news is coming out of the manufacturing sector with the ISM PMI moving to a two-year high. Orders are up, but the employment part of the survey is in negative territory. To put this in context, the last time we saw an ISM PMI rising like this, annualized GDP growth was around 5%, not sub-2% like we are seeing today.
Consumers have spent the last few months, but mostly on automobiles due to record high incentives. In January, real spending dropped 0.3% on an inflation adjusted basis. The worst decline since early 2014! In addition, disposable income dropped 0.2% in January, leaving consumers feeling pinched with a 0.4% increase in consumer prices. Despite being optimistic surveys are showing that consumers are planning to cut their spending going forward, which will make the trend in the manufacturing surveys hard to sustain.
Meanwhile the Fed is making strong hints that they will raise interest rates in March. They feel this may be a small window of opportunity given the recent surge in optimism and asset prices. Inflation continues to rise in rents, medical and energy, all of which take money away from discretionary spending. Absent of wage growth, rising interest rates will lead to a recession. The Fed has a flawless track record of triggering recessions by raising rates at the end of an expansionary cycle when trying to combat inflation.
And to think I remember a time when the Fed raising interest rates would cause Treasury yields and equities to fall.
Market volume tells us where the next downturn in stocks will take prices. Since 2009 the broad market has been making new highs on decreasing volume, which can be seen on a monthly price chart.
When markets correct, they tend to move back to the point where there was a large amount of volume. It is at these points where investors are unwilling to sell; it tends to create a floor in prices. Looking at the charts for the S&P 500, Dow Jones Industrial Average and Nasdaq-100, the last major volume moves indicate that prices will likely fall 50% during the next recession. This validates my research on long-term moving averages or momentum that suggested a 50% drop is likely in the cards when the next bear market comes.
Client Update: Looking for opportunities in a weakening and heavily indebted global economies lead to investments in physical metals, commodity producers (miners of the physical metals) and US Treasuries – all of which historically do well during recession. The biggest opportunity being with the miners. I have been looking for a pullback in mining stocks over the last month to hopefully buy in at a point that minimizes downside risk.
Sometimes the markets give you what you want.
About six weeks ago or thereabouts I said that gold mining stocks needed to pull back to confirm the bullish trend line which would put the price of GDX around $21.50-$22.xx and on Friday prices touched $21.53. At the time it seemed like a bold call since prices continued to move up past $25, but after the peak in early February, prices have fallen around 14% to my target buy zone.
Just because prices have fallen into the buy zone doesn’t mean an automatic buy is triggered. When prices of a security are falling it’s prudent to wait for them to stop falling before buying. The reason being is that my data does suggest prices could fall further while maintaining the long term bullish trend, even though I don’t think it’s very likely.
Ideally at this point I’d like to see a large volume move in the miners, which would indicate the big money is putting a halt to declining prices. Even if that doesn’t happen, just seeing prices firm for a few days or a couple weeks would be good because I can look back to December to see prices supported by high volume at this same point on the trend line.
The other move that usually happens is that gold should fall in a similar manner. It’s important to note that metals follow the miners, meaning prices of metals trail the movement of miners. What normally happens is that miners will start moving up after the metal makes a corresponding down move. For the moment, I’ll take a big volume move and prices firming as confirmation, even if gold doesn’t make a similar move down.
The good news is the upside potential is intact. A larger pullback on GDX gives them ample room to make a run at the major support level at $25.5x. If prices move up and break above that price point it will indicate a continuation of the bull market trend in miners and metals. It will also be at that point that momentum takes over and prices will quickly move higher.
Beyond that miners usually hold price for a week or two as the metal moves down. I will be watching both closely along with the volume to trigger the buy.
As I also mentioned several weeks ago, a move down in metals and miners would likely cause a move up in Treasury yields which would correspond with a move down in Treasury bond prices.
Treasury yields have been declining since mid-December and setting lower highs, which is an indication of a bearish trend for yields. Drawing a trend line from the high to the next two lower highs indicates the next high should touch but not break around 2.52%. On Thursday yields moved up near that level, but didn’t break. That is a very positive sign.
While that move up in yields did bring bond prices down it didn’t break the trend. If the trend is strongly broken, then I will need to reevaluate those positions.
The other challenge in the Treasury market is that speculation in the futures market on the 10-year Treasury yield going higher (meaning traders are short Treasury bonds) is at the highest point in 5 years. This means that yields are being artificially held high and that if the speculators are forced off their positions, yields will quickly fall.
The main reason to own Treasuries is that they perform very well during a recession, which as we know is triggered by the Fed raising interest rates to combat wage-less inflation growth late in the economic cycle.
Worth noting: Jeffrey Gundlach (bond guru), chief executive of DoubleLine Capital, said on Friday he expects the yield on the benchmark 10-year U.S. Treasury note to drop below 2.25 percent as global investors seek safety.