Beware of the Retail Sales Hat Trick
Retail sales had back-to-back monthly declines in February and March. This may not seem like a big deal, but when retail sales have three months of consecutive declines, it implies that we are at, in or almost out of a recession. Historically there have been 17 times retail sales have had three consecutive monthly declines, 16 of them occurred just before, in the middle or at the end of a recession. To put this in context, with consumer confidence at very high levels, it makes me wonder why the consumer is not spending at equally high levels if they are so optimistic!
Retailer Borrows to Pay Interest on Loans It Can’t Pay
You probably did not see this in the headline news last night, but Neiman Marcus is taking out a loan because they cannot make the interest payments on their existing loans. After hearing this news, many might be grateful they do not own Neiman Marcus debt. Except they probably do. Their debt is classified as junk bonds, which is likely a component of two popular junk bond ETFs that the public has been pouring money into to hedge against rising interest rates.
When Neiman Markus files for bankruptcy (a bold prediction on my part) down the road, I doubt those bonds will hold much value. Image the impact that will have on investors when they truly understand the value of junk bonds when the economy is in the depths of a recession. Something to think about!
What Really Drives Real Interest Rates Higher
I am not referring to the type of rates the Fed hikes, but real interest rates like the 10-year Treasury yield that affects everything from mortgage rates to business loans. For interest rates to go up there are three things that need to happen: inflationary pressure, wage growth, and economic growth. Inflationary pressure is a function of borrowing costs and inputs. If I want to build a new home and borrowing costs and materials are higher than they were the year prior, then that is inflationary pressure.
In the short term borrowing costs and materials have moved higher, but as I have mentioned in prior updates I believe that is transitory and that both are headed down. As far as wage growth goes, the data shows that wage growth has been flat and has recently started to decline. Economic growth has been declining since late 2014 when the GDP growth rate peaked and is estimated to be 0.5% for the first quarter, based on the Atlanta Fed GDPNow model. When you factor weak wage growth and weak economic growth with a short-term blip of inflation, it is easy to see that real interest rates are likely to head back down.
Forget Indexing, Just Buy the Top 10
If you ask most people if an index fund is diversified, they will probably answer yes. Most probably think that if you invested $500 into an S&P 500 index fund that they would end up buying $1 in each of the 500 companies. But that is not how it works. Index funds are market-cap weighted, meaning more money is allocated to the larger companies in the index. The S&P 500 allocates almost 20% of itself to 10 of the companies, which represents a mere 2% of the overall index. The top 25 companies take over 33% of the money coming in while only representing 5% of the total index.
More than half of the recent gain in the S&P 500 can be attributed to the top 10 companies in the index. It is as simple as following the money! Inadvertently investors will come to find themselves over weighted in a small number of companies. Apple, the largest company in the S&P 500, finds itself in 150 other Exchange Traded Funds ranging from growth funds, value funds, global funds, dividend funds and even a millennial fund. Because Apple is in so many ETFs, it is entirely possible for an investor to be less diversified than they think.
Being over weight in one company does not matter too much when the market is going up. In the video portion of each update, I review the percentage of stocks in the S&P 500 trading over their 50-day moving average. If a stock is trading below its 50-day moving average that is a bearish indicator that suggests prices should further fall. If you look at the S&P 500 today, about half of the index is trading below its 50-day moving average, or 250 companies, which should suggest the market should be falling. Since a small number of companies comprise a large portion of the index, they can effectively hold the index up while other companies in it fall.
This will matter when the market goes down because the short sellers will be able to focus on a small number of companies to drive the index down. As investors seek to sell their holdings as the market drops, they will quickly find that everyone owns large positions in the same companies. When everyone is selling the same thing, prices tend to fall faster as liquidity in the market for buyers dries up.
If you do not believe me, on October 19, 1987, also known as Black Monday, liquidity dried up and the markets dropped over 22% in one day as investors rushed to sell. Or as I like to view it, that was a fantastic buying opportunity!
On Wednesday I made the call to exit all the mining positions across all portfolio models at market close. The prior Friday GDX (our control position) touched a key trend channel that I was looking for it to break over before making the next major move up. At the same time, Gold was testing its secular six-year downtrend channel. Unfortunately, both failed, otherwise it would have been the beginning of a major move up. When a security fails to break a trend line it usually makes a short-term move back before a second attempt is made. Things only become a problem when the second attempt fails.
The real underlying issue is that gold typically moves inverse to the US dollar. When the dollar is falling, gold is rising. On Wednesday that correlation broke; the dollar fell and so did gold. While I believe this was a temporary disconnect, the fact it broke its correlation is a warning sign that prices of gold (and miners) may fall further.
On Wednesday GDX (along with the other positions) broke down through two previously identified trend channels and two key moving averages. I have established rules that if a position fails to hold a key level or moving average that it will be sold to minimize downside risk. In absence of being able to effectively use ‘Stop Losses’ due to the size of our positions (not wanting to trigger a volume spike and take an even larger loss), the proper move was to enter a ‘Sell at Close’ order.
After several attempts to close over the lowest of the two key trend lines on Thursday, in the final two minutes of trading, it closed below the trend line. Volume was also low which in this case indicates a lack of buyers. I expect this downward move should complete in approximately 7-8 trading days, which if it does, should provide an even lower point to buy back in.
I’ll go over more of this in the video.
The long-term view hasn’t changed. If you believe, as I do, that the next recession will bring an even bigger financial crisis compared to 2007/08, then the investments you want are U.S. Treasuries, physical metals and commodity producers (the miners).
If you believe the Fed has turned the economy around through successive QE’s and money printing then you should be buying equities because the next big bull market is about to start.