Weekly Economic Update 03-31-2017

Let’s Check the Scorecard

  • Third longest expansionary cycle in history.
  • Weakest GDP growth of any expansionary cycle in history.
  • The second longest Bull market for stocks in history.
  • Record high stocks prices.
  • Third highest stock market based on cyclically adjusted Price-to-Earnings ratio.
  • Third highest stock market based on Market Cap-to-GDP ratio, or more affectionally known as the “Warren Buffett” indicator.
  • Record high global debt.
  • Record high government debt.
  • Near or record high corporate debt.
  • Record high consumer debt.
  • Record high student loan debt.
  • Record high auto debt.
  • Restaurant sales have been declining for 9 months, a consistent indicator of a recession.
  • Consumer Confidence at the level in 16 years (going back to the peak before the crash), a peak predicts a recession within 9 months on average.
  • GDP Growth peaked in 2014 and has been declining.
  • GDP Growth in 2016 was 1.6%, tied for the worst year since the great recession.
  • The Atlanta Fed GDPNow model predicts first quarter 2017 GDP will be 0.9%, which the Fed says is transitory.
  • The Federal Open Market Committee (FOMC) is raising interest rates, which out of the last 13 times, three triggered a soft landing and ten triggered a recession. A terrible track record!
  • Margin debt, or the amount of money borrowed to purchase stocks, is at a record high.
  • Household exposure to stocks is at high levels as they look to the stock market to solve their debt and retirement issues. The public buys most at the top and the least at the bottom.
  • Federal personal income tax receipts are down 8.7% from a year ago, indicating households are making less money.
  • The rate of money supply growth is contracting; money supply needs to grow for the economy to expand.
  • Commercial and industrial lending is contracting, which leads to a recession when it happens late in the business cycle.
  • Consumer delinquency rates are accelerating, especially in the sub-prime automobile sector.
  • Retailers are projected to close over 2,000 stores in 2017.
  • Average hourly earnings for employees is starting to contract and have not been keeping up with inflation. It is the weakest wage growth of any expansionary cycle.
  • Real disposable income, which helps drive discretionary spending, has been contracting since 2015.
  • Change in Nonfarm payrolls peaked in early 2015 and is contracting.
  • Domestic auto production has been contracting since 2015 and is in recession territory.
  • Unsold new car inventories are at or near record high levels, despite incentives.
  • Credit card balances are at the same level they were before the 2008 recession.
  • The soft economic data is pointing to a boom, while the hard economic data has been contracting for the last 9 months.
  • Since 1910, every President that follows a two-term President has experienced a recession in the first 12 months of their term.

The Fed will tell you these points are transitory and will go away soon. What I can tell you is that these are the same things that occurred at the peak of the business cycle and stock market in 2000 and 2007.

Even though most people believe the stock market is overvalued, they are still buying with every penny they can find. People are overly optimistic at a point in time they shouldn’t be. After all, the Fed says business cycles don’t die of old age, even though history suggests otherwise.

Some people think that buying dividend stocks is okay, even at high historical valuations. Those people would be better off buying an annuity for income or waiting to buy when stocks are half price. People forget that companies can and do lower dividends when profits fall.

It’s not much different than those who bought a rental property at the peak of the real estate market in 2008. While they are collecting rent, the value of their property plummeted and they probably had to reduce their rent in the years that followed. Had they waited until the bottom of the crash to buy, they would have an appreciating asset and be cash flow positive on their rent.
Buying low and selling high is a novel idea that few follow.

What Will Push Stocks Higher
Stocks go up for the same reason as any other asset, the next buyer is willing to pay a higher price than the previous buyer.

If you’re buying stocks today, who’s buying after you and why are they willing to buy them at such a high price?

Corporations have been buying their stocks back, but that has significantly slowed down recently. This is the same mistake they made in early 2007.

Institutional managers, or the smart money, bought in a long time ago.

Retail investors bought in at record levels after the election in November, even though stocks have been going up since 2009.
When you hear that the public buys most at the top and the least at the bottom, there’s a reason why: Once the public buys in, there’s nobody left to follow them!

What Drove the Market Up, Will Probably Drive them Down
Why did the markets go up after the election? Optimism. People are optimistic that the economy will get better. Tax cuts, health care repeal, fiscal stimulus, and deregulation have been cited as reasons things will get better. And the survey data has confirmed that with consumer confidence spiking to the highest level in 16 years.

Consumer confidence always peaks late in the business cycle, because consumers are hopeful that things will get better. Yet nobody has bothered to ask the question, what if things don’t get better soon enough? After all, the hard economic data continues to show that the economy is getting worse, not better.

If things don’t get better soon, and they usually don’t at this stage in the cycle, be ready for consumer confidence to fall in the months to come. When it does, unless something else triggers it sooner, stocks will go down just as quickly as they went up. Remember, optimism isn’t a strong foundation to invest long-term on.

Why Interest Rates are Headed Down and Deflation is Coming Back
The yield on the 10-year Treasury can be expressed by a simple formula. Add the nominal GDP to the rate of inflation and you get the yield, expressed as a percentage. This formula works because investors prefer to earn a yield above the prevailing rate of inflation.

The best way to see the nominal GDP is to look at the Atlanta Fed GDPNow projections, as they are the most accurate projection of GDP growth available. As of today, the GDPNow model predicts first quarter GDP growth will be 0.9%. On a side note, that’s very low!

The inflation rate is equal to the Consumer Price Index (CPI) which is about 1.7%.

If you add 0.9% and 1.7% the yield on the 10-year Treasury should be around 2.6%. The yield has been at 2.6%, but it’s currently around 2.4%. If inflation is expected to rise and the Fed is raising interest rates to combat rising inflation, then yields should be rising, not falling. So, what does the market know that we don’t?

The largest contributor to the CPI is the price of oil. On a year-over-year (YoY) basis, the price of oil has declined rapidly. By charting the YoY change in oil against the CPI, which I did for you in the chart pack, it’s easy to see that the CPI index is going to head down soon. When it does, it’s going to be a shock to the Fed who is expecting rising inflation and everyone who is shorting Treasuries.

If the CPI follows the trend in oil prices, that means that the CPI should be near 1.0%. If you add 0.9% (GDP) and 1.0% (CPI) the yield on the 10-year Treasury should be around 1.9-2.0%. That’s very bullish for bond prices. Long-time followers of my research know I have predicted the next major move for bond yields would be to the 1.9% range!

If yields break below 2.3%, where there’s a gap in prices, they will quickly fall to 2.0% and most likely fall further as there will be a massive short squeeze in bonds. There’s a heavy amount of shorting of Treasuries from both institutional managers and more recently the public. Being short means an investor is betting that prices will fall. If prices start to rise, the investor has a big problem. They can either exit their contracts quickly to avoid a loss, which other investors will be doing as well, or they can go long. In the futures market, this means buying long contracts and for the average investor, this means buying Treasury bonds. When many investors that are short suddenly go long, yields will fall even faster as they are “squeezed” out of their short positions.

As yields and inflation fall, it suddenly leaves the Fed in an uncomfortable position of having raised interest rates in a deflationary environment. A tight money supply in an economy of falling prices is not a good thing!

The variable in this equation is the price of oil, and if oil prices continue to fall, then it will only push inflation and yields down further. While I’m not an expert on oil or what drives the oil market, I’ll leave you with this thought: there’s a record amount of supply, a record amount of speculative long positions (futures contracts) and a weak global economy. If oil prices fall it’s possible there will be a “long squeeze,” which would force those speculators to start shorting oil. If that happens, oil prices will likely fall further than expected.

Client Update:
Quick update this week… on Thursday the allocation fell below a key trendline, after a solid performance the week before. This was mainly due to what I perceived as a brief dollar rally in response to the UK triggering Article 50 to leave the European Union. One might think defensive assets would do well on that news, but they didn’t.

The allocation broke the trendline mid-day, but literally, in the last minute of trading, it pushed back over the trendline, only to drop below 3 seconds before market close. Either way, the rule going forward is simple: if the allocation (in this case the miners) fail a key trend line at market close, then the allocation will be sold the next day unless the allocation shows a clear sign of closing above the key trendline.

After a slow start, this morning, gold and the miners took off strongly as the dollar started breaking below key trendlines. In the final minutes, there was selling, leaving me without confirmation that downward trend has been halted. It appears that it has, but it’s too soon to call. Since the allocation closed above the trendline, I am on pause.

If the allocation fails to hold the trendline Monday, it will be obvious that momentum is negative and the positions will have to be sold. If it holds, then I can evaluate bringing some of the remaining cash in. Perhaps in smaller amounts.

For the moment, the allocation is slightly negative since purchase, but compared to the broad equity market, it is outperforming. Plus 50% of the allocation remains in cash ready to move in. Compared to the broad market, the longer-term upside potential of our allocation is favorable.

More details in the video.

Summary: The allocation remains on hold until the upward trend has resumed. Failure to hold key trendlines will mean these positions will need to be sold until the downward move completes.