Weekly Economic Update 05-19-2017

Core Inflation Rolls Over
I’ve talked about how the Consumer Price Index (CPI) is likely to fall because the biggest components, rents, oil and medical, were likely to see a year-over-year decline in prices. Oil has been falling since last year, but now rents and medical costs are starting to fall as well. CPI has gone from 2.3% back in Jan all the way down to 1.9% in April. If you look back at prior market cycles this is the lowest peak that inflation has seen in any economic uptrend. If this hold, which I believe it will, then it’s safe to say the secular bull market in bonds isn’t dead yet.

Banks are Going Bust
In 2016, a mere five banks failed, which is the smallest number of bank failures since 2007. This year five banks have already failed, all larger in size than the banks that failed last year. This shouldn’t come as a surprise.

In long business cycles banks are forced to lend to less creditworthy people to maintain profit margins. When those people fall behind on their payment and return to the bank to refinance, they run into a problem – they can’t qualify. As the Fed raises rates it increases borrowing costs which means the banks can’t refinance as many of these marginal borrowers as they’d like to. When those marginal borrowers start to default, so goes the bank. As I’ve said before, increasing bank failures create a financial crisis.

Why the Market Tanked on Wednesday
The market makes the news. Occasionally it’s the other way around, but most of the time the media tries to explain why stocks went up or down. Sometimes it is intuitive, such as a good economic report and sometimes it is Wall Street telling the media what to say.

The explanation for Wednesday’s drop had to do with Trump. I don’t buy it. I didn’t see anything new, not that I was paying close attention. By the end of the day I think it was spun into mounting concerns. Maybe it was, but here’s what really happened.
Before the market opened on Wednesday someone sold two 200+ million batches worth of S&P 500 futures. Did they do this because of Trump or did they do this because they felt the market had peaked? I’m guessing the later. This big sale caused the market to open down. In the first hour of trading the market did stabilize the move down. Lately any move down, no matter how small, has brought in buyers. Today there weren’t many buyers. When markets peak out they peak because buyers run out of money to buy. Plain and simple.

As the day progressed selling started to increase when it was clear there weren’t many buyers. As selling increased volatility increased, which led to a huge one-day spike in the VIX (volatility index) of +46%! As I mentioned when the market starts to move down those who are short volatility are going to get hammered. They did. As volatility rose (and those shorts got crushed) it drove the market down. It triggered a chain reaction of investors selling and getting stopped out (from their stop losses) on their short volatility and broad market trades. Once that starts it’s hard to stop it, until the markets reached their normal closing time for the day.

We already know there were two exhaustion gaps on both the S&P 500 and Dow Jones Industrial Average. The first exhaustion gap that happened in March got filled about 2 weeks later. The second one had not been filled, until today. This is about as big of a bearish signal the market can give. In case you missed it, two weeks ago I noted a report about what happens to the broad market after two exhaustion gaps. To summarize: a bear market is coming soon.

Household Debt Breaks 2008 Record
I’m not sure what more I need to say, but households are now more in debt than they were in 2008 – by 50 billion dollars. Interest rates are higher. Wages growth is contracting. Banks are tightening lending standards. The Fed is tightening the money supply. Any guesses on how this ends??

China Controls US Treasury Yields
A big reason yields jumped after the election is because China started selling their foreign currency reserves to defend the weakening Yuan (their currency). As large holders of US Treasuries, they sold them to raise cash to defend their currency. And it worked, but as a result, yields jumped. Investors who were fearing a Trump reflation trade dumped their positions only to see yields stall out twice at 2.6%. Since then yields have dropped.

The main reason is because China has stabilized their currency, curbed outflows and is now rebuilding their foreign currency reserves by buying US Treasuries. As of last week, hedge funds have joined the bandwagon by taking the largest speculative long position on Treasuries since 2007. What this means is a ceiling has been put into place on yields and they are most likely headed down. It just adds further evidence that the bond bull market is isn’t dead yet. It may be in the final stages, but it’s not over.

May Survey Data Weakens
I mentioned that once all the excitement wore off and reality set back in that we’d see it in the survey data. The main reason for that is surveys also include optimism, but when optimism fades into reality, so does that data. The Empire State manufacturing survey went from +5.2 to -1.0, which is the lowest reading since October. That doesn’t look good going forward. Increasing negative readings late in the business cycle are recessionary.

As a counterpoint, the Philadelphia manufacturing survey was positive.

Client Update

After I released last week’s video I got some distributing news on gold. Hedge funds have backed off their long positions at the fastest rate since 2008. This is good news to know because the hedge funds, or smart money, can move the markets around. Recently they went short on silver and that drove both gold and silver down quickly – that move forced us to sell. Any time information comes out that is contrary to your view it’s important to investigate to understand the narrative and understand the risks of your positions, either long or short.

The narrative for the hedge funds is rather simple. The Fed is largely expected to raise rates again in June and rising [short term] interest rates is bearish for gold. It appears they are backing off their positions in anticipation of this hike. Going back to 2008 when they last made such a move, gold prices (and miners) dropped a lot. Knowing this suggests that a move into gold right now may be premature.

My narrative is simple too. I assume people have learned from their mistakes in 2000 and 2008, and will make wiser investing decisions this time around as the global economy slowly heads into a recession. Then again, I must remind myself that people make the same mistakes over and over; history often repeats itself. Looking back in 2008, gold (and the miners) fell in line with the stock market. It wasn’t until late 2008 that gold (and the miners) took off and outperform the broad market. This is due to the public’s faith in the central banks. That same faith is showing up in the surveys and in the stock market today. Based on that alone it suggests I should be targeting a lower entry point.

I also know that gold usually moves inversely with yields. If the hedge funds are now long US Treasuries, that indicates interest rates should fall and gold should rise. The same holds true with the US Dollar, gold usually moves inversely of the dollar – which is falling as I indicated it would. All that points to gold as a smart move. Except when you come to the realization that correlations aren’t always 100%. There are times when those correlations break, even if for a short period. This may be one of those times.
For the moment, this indicates that gold should fall and create a lower entry point. If it repeats what happened in 2008, then gold is in for a big downward move when stocks go down.

From a momentum perspective gold and miners are in a dead zone unless one bought and held since early 2016. That means we can’t buy in until prices break the short-term momentum top, which if it does, will present a strong buy signal. In the meantime, I get a feeling prices are headed back down and that this is a “bull trap” move to the upside.

From a classical charting perspective, we get an entirely different perspective. I had the opportunity to be a part of a small group of people who got to see how one of the best classical chartists in the world trades. Based on his work, the miners are exhibiting a descending triangle pattern. If this holds true, then prices are going to break below their recent low and keep going from there. Given how the miners performed early in 2008 going into the Bear market, this interpretation holds credence.

I mentioned last week that I added a momentum firm to our advisory team, but I didn’t mention that I also added a global macro advisory firm to provide additional research. Independently within 24 hours of each other, both flagged potential buy signals in the agricultural commodity space.

From a macro perspective supply, which is increasing, is falling faster than consumption. This indicates rising demand. Digging deeper into the supply versus demand forecasts, they show a very tight relationship, meaning there is no room for error. If there is a flood or drought or any disruption, prices could move higher quickly.

From a technical price perspective, prices have bottomed and held a horizontal trendline since early 2016. In addition, prices are near breaking out over a secular declining trendline traced back against the prior highs. From a technical trading perspective, this sector is near a bull market break out.

From a momentum perspective, giving us a completely different view, we see a similar trend. This sector isn’t just about ready to break out based on price movements, but also based on momentum.

We have a strong narrative: supply may not be enough to meet demand; potential technical price breakout, and potential technical momentum break out. Current prices on the ETF show it near its 52-week low and near its all-time low. What I also found interesting is that in 2008 when the stock market was melting down, this sector went vertical. This could be the biggest opportunity over the next 12 months or more.

Be aware we are not going to overweight the portfolios. I am looking for prices to confirm the shorter term moving averages and from there we will pick up long positions below both the target technical and momentum buy points. If prices close over the target momentum buy point I will begin adding long positions. Either way this is an opportunity to buy low.

US Dollar
The US dollar index broke through a key momentum level this week. I have said I believe the dollar is headed lower and this is a signal that more weakness is likely to come. A declining dollar presents opportunities; let’s look at a few:

US equities perform poorly when the dollar goes down. Given that stocks are already overvalued based on any number of metrics, the weakening dollar provides further evidence that stocks are headed down. This presents an opportunity to be short the major indices. MSA provides actionable points at when to be short based on momentum. We will wait until they give the signal.

Gold usually moves inverse the dollar but not perfectly. There are times the dollar and gold go up or down together. Normally a weakening dollar would be bullish for gold, but seeing how the hedge funds have backed off their long gold positions suggests this may be one of those time that gold and the dollar move together for a short time. Will hold any moves on this until prices bottom or there’s a momentum breakout.

Another way to trade the dollar falling is to short the dollar, which we aren’t going to do. The counter trade is to be long a foreign currency such as the Euro or Yen. It helps to know which currency to be long and what risk you face there. This is something I’m looking at, but I’d rather use the commodity allocation in the portfolio for agriculture than currency.

You may not have noticed this, but on Thursday before markets opened, the Brazilian stock market dropped 16%. This happened before markets opened, meaning nobody could react. Investors lost 16% the second markets opened. You may recall I had an interest in investing in Brazil, but something just didn’t feel right. Let’s just say it’s a good thing I didn’t. If you are reading this and you think that a big move like that can’t happen in US equities, then you are mistaken. It has and it probably will again. Overvalued markets tend to see sharp moves in the opposite direction.