The February jobs reports came in strong and as the stock market celebrates its eighth year of this Bull market, the post-election rally is showing signs of running out of steam. This recent jump in asset prices was predicated on fiscal stimulus, reduced taxes and corporate earnings growth.
Fiscal stimulus is useful when unemployment rates are high, and with good a monthly jobs reports, there may be less interest from Washington to pass such a bill. While corporate earnings have risen, they have not grown as fast as analysts projected and remain well below their 2014 highs. As far as lowering taxes, well that will depend on how much the debt ceiling can be raised.
Next week, one day after the Fed is expected to raise interest rates, President Trump meets with Congress to deal with the debt ceiling. If nothing is done the government is projected to run out of money sometime in June – an event that is not factored into stock prices today.
The big driver of stock prices has been sentiment and optimism with polls showing both at either cycle or multi-decade high levels. Back in 2011 the survey data was very optimistic against weak economic data, and it would turn out the survey data was wrong. Going back even further to the Reagan era, sentiment data was very high when the tax cuts were passed. Today we see the opposite; hope that tax cuts will be passed.
Yet the hard economic data tells a completely different story. The Atlanta Fed GDPNow model projects first quarter GDP to come in at a mere 1.2%, which indicates that GDP growth is continuing to decelerate from its 2014 peak. The Atlanta Fed Wage Growth Tracker shows that wage growth peaked in October 2016 and has contracted back to June 2015 levels! Even the NFIB small business survey showed that small businesses are less likely to raise wages then they were three months ago. History tells us that when GDP growth is contracting, wage growth is stagnant or contacting, inflation is rising and that we are in the late stages of an economic cycle, that a recession is looming.
It seems logical that Wall Street would celebrate a strong jobs reports with another strong move up in stock prices, but they didn’t. Wages are not growing very quickly and labor costs are rising, which put a crimp on corporate profits. Along with wage growth contracting, the M2 Money Stock is contracting, meaning consumers are chasing fewer dollars as inflation in rents, energy and medical rise. With bank credit contracting, limiting consumers’ access to loans, this forces people back into the workforce to make ends meet.
Despite that retail investors have poured 80 billion into US equity funds since the election and nearly 8% of that came in last week. It reminds me of Bob Farrell’s Rule #5 of investing: The public buys most at the top and the least at the bottom.
This is baffling because based on cyclically adjusted price-to-earnings ratio this is the third most expensive market in history and quickly closing in on being the second most expensive market in history. The S&P 500 is trading at 21.5x’s trailing earnings which is high; only the dot com bubble traded higher at 24x’s earnings. The Dow Jones Industrial Average is at an all-time high based on its price-to-sales ratio. Wall Street says not to worry because earnings are going to grow, but if they don’t grow soon, it puts stock prices in jeopardy for a major sell off.
This is at a time when corporations are heavily leveraged or indebted. The gross leverage ratio for U.S. investment-grade companies or the corporation’s liabilities less cash, is at 2.4 times. This matches the prior peak set in March 2002 and is at the highest level since 1992. This might not be an issue if corporations have cash on hand to ride through an economic downturn, but the amount of cash on hand is near the lowest level set in 2009, just after the last recession. If there is a prolonged downturn in the economy, corporations will be forced to issue shares of stock to make payments on their debt. Historically this has the effect of quickly driving stock prices down.
I have been on record stating I didn’t think the Fed will raise interest rates this year, but by the time you read next week’s update, there’s a near 100% chance the Fed will have raised interest rates. My view stemmed from the fact that the hard economic data was too weak to justify it, especially as the M2 Money Supply, wage growth and as bank lending contracts. Not to mention that global, government, corporate and personal debt levels are near or exceeding record highs.
Raising interest rates at this point just puts the economy closer to a recession, but the Fed projects the expansion will run four more years. They are also close to their mandate of full employment and inflation is trending towards their 2% target, so they feel compelled to raise rates while opportunity presents itself. I don’t have a PhD in Economics, so what do I know?
Since 1950 there have been thirteen rate-hike cycles. Ten of them came late in the economic cycle, as one should expect, and all ten of them led to a recession. Three of them came earlier in the economic cycle and led to a “soft landing.” Given we are in the third longest expansionary cycle in the history of the United States, I think the probabilities favor that hiking interest rates will trigger a recession.
How the debt ceiling led to a temporarily spike in stocks and yields.
There’s been a great deal of speculation on why interest rates rose after the election, with most of the credit going to Trumponomics. Investors bought into the notion that President Trump’s policies would lead to higher inflation which caused them to sell bonds to buy stocks. This was amplified by Wall Street, who used futures contracts to short the 10-year Treasury bond, which quickly drove yields up from 1.5% to 2.6%. Then for the past 5 weeks yields have hovered around the 2.5% range. One might think with Trump in office that this trend in rising rates would continue, but it has appeared to stall. This recent move in yields has more to do with the debt ceiling coming back into law at $20.1 trillion than anything else.
In 2015 the debt ceiling limit was suspended under the Obama administration with the plan for it to be reinstated on March 16, 2017. It was planned that the next President would deal with this problem.
Starting in November the US Treasury began drawing money out of its deposits held at the Fed in anticipation of the debt ceiling coming back into law. Think of the Fed as the US Treasury’s bank account. Currently the national debt is around $19.6 trillion and our government spends about 3.9 billion per day. Without the ability to issue new debt over the ceiling, the US Treasury pulled $200 billion out of their bank account in anticipation of needing to fund the expenses of the government until the debt ceiling issue is resolved.
There’s two things that happen when the US Treasury draws down its bank account:
- It causes interest rates to go up.
- It has the inadvertent effect of putting money into the economy by boosting bank reserves; this time it was about $200 billion that got injected into the economy after the election.
When money is injected into an economy it causes asset prices, or stock prices, to rise. When a large amount of money is injected over a short period it can cause a significant boost in asset prices.
Since the US Treasury needed money and it had no ability to raise money, this “withdrawal” caused interest rates and stock prices to go up after the election. It makes you wonder if Hillary had won if we would be talking about Clintonomics and celebrating the market reaching new highs. My guess is we would. Sometimes timing is everything, and in this case, it was perfect timing for President Trump.
What will happen when the debt ceiling is raised?
On March 16 President Trump will open negotiations with Congress to raise the debt ceiling. Current projections show there is enough money to last until sometime in June before our government runs out of money.
The first issue we will face is a potential government shutdown if an agreement cannot be reached in time, which the stock market has not priced in as a potential outcome. The size of the increase will also determine if fiscal stimulus or tax cuts will become a reality; both of which the stock market has fully priced in that will happen. If the debt ceiling is not raised enough to cover all of that, it could trigger the beginning of a Bear market as Wall Street’s dreams are crushed.
Regardless of how high the ceiling is raised, once it is, the US Treasury can start raising cash by selling bonds. The excess cash will likely go back on deposit with the Fed. As money goes back on deposit with the Fed it will cause interest rates to fall, meaning the yield on the 10-year Treasury should fall back to its long-term average of 1.4-1.6%.
It will also have the effect of pulling liquidity out of the market – remember the US Treasury injected 200 billion into bank reserves in anticipation of needing the money, which has the same effect as injecting money into the economy. The opposite effect will happen when the US Treasury pulls that money out of its member banks to put it back on deposit with the Fed. That reverse effect will have a negative effect on stock prices at a point when the retail investor has gone “all in.”
Let’s discuss the big elephant in the room: the 10-year Treasury yield. For five weeks yields were on a slow descending pattern which is bearish for yields. As I may have mentioned when going over the charts, there will be a point on the weekly time scale where yields fall enough to bump into the upward moving 21-day moving average (the average of the past 21 weeks of price). This is a critical moving average because yields will not fall until it starts to rotate down. It won’t rotate down until there’s one last upward spike which happened this week.
Looking back at historical trends in yields, before they rotate down there is usually a second “test” of the recent high. About half the time this second test exceeds the prior high, which we must prepare for. Another factor is there is a record amount of short interest in 10-year Treasuries, which is pushing yields up. When those futures contracts are sold, it will drive yields down quickly.
Despite a big headline jobs report, the yield on 10-year Treasuries failed to break over the prior high set back in December. Yields are starting to fall, which could be the beginning of the longer-term trend down.
This backup in yields has created other opportunities.
I believe another Leaman Brothers financial crisis is not too far off. Given the overall week global economy and high debt levels, a financial crisis is sparked when money supply falls. In November, I noted that global money supply had fallen to a rather low level that is synonymous with where financial crisis occur. Hard assets and commodity producers (miners) perform very well during those events. Not to mention hard assets are setting up for a major bull market run.
I predicted gold futures should drop back to $1,180-1,190 and then revised that prediction to $1,208. The recent low on gold futures is $1,199. I also predicted that the Gold ETF (GLD) would drop to $114, it fell to $114.20 Thursday night. I predicted Gold Miners ETF (GDX) would fall to $22-22.5 and it is now in the low $21’s.
Opportunity is knocking. The next wave up in metals and miners will lead to a test of their longer-term declining trend, which if broken, will trigger a bull market rally in those sectors. The upside potential of the test is huge, the upside potential after a break out is substantial.
With both asset classes moving down into or below my target buy zone, I am just waiting for prices to settle to indicate the next leg up, which will likely coincide with interest rates falling. There’s a couple ways to identify a bottom: a low volume day will signal that there are no more sellers, a high-volume day and corresponding price move up will signal the big players have moved in, or a gap up move will signal a trend change.
It’s completely normal for prices to fall until there are no more sellers; the same trend we see in Treasuries. Once all the sellers have been shaken out of the tree, then the buyers will step with the confidence that the downside risk is minimal. This is what I am looking for, asset classes that are low that create significant upside potential and even bigger opportunities should a crisis occur.
If yields have peaked, then I should see confirmation that metals and miners have bottomed, which will trigger my signal to buy.