Weekly Economic Update 06-02-2017

Warren Buffet is Also Hoarding Cash
It might be hard to believe, but in 2014 Warren’s portfolio was holding about 50 billion in cash, representing about 20% of his total portfolio. Today that cash position has ballooned to 100 billion and is about 40% of his portfolio. He too has missed out on much of this post-election rally.

When asked about the cash and what his plans are, he said: “history is on our side” which could only be interpreted that he expects the economy to recess and the stock market to fall. He, like I, has no interest in paying bubble prices for stocks when they will be significantly cheaper soon.

Even JP Morgan in his time said he only chases 60% of any bull market run, leaving the tops and bottoms for other investors. He wasn’t good at market timing either, but he was smart enough to know when to take his chips off the table.

As this bull market nears its eight-and-a-half-year anniversary, one can only ask themselves how much is reasonably left in this market. And if a person is invested, they should ask themselves at what point is it wise to follow Buffet’s or Morgan’s advice and cash out. Unfortunately, the public has a negative view of cash in a portfolio when they should view it as an opportunity.

As equity markets peak, other asset classes that are bottoming will start to rally. Having cash to invest in those asset classes that are already low is much less risky than chasing one of the most overvalued equity markets in history. Despite being early to move to cash, even at 83 years old, Warren understands that as a long-term investor that you want to buy low and sell high.

Iron Ore Prices Continue to Plunge
Iron ore prices may not matter much to you, but if I told you the post-election equity rally was kicked off by a rise in iron ore prices, then they might. Especially since iron ore prices are all the way back down to where they were on November 7. If equity prices follow iron ore prices, and they usually lag by about 23 days, it continues to suggest the S&P 500 is not far from dropping 300 points to 2,100 which would wipe out the entire post-election rally.

Record Debt Levels
Over the past few months, I’ve talked about how debt levels were reaching and passing their 2008 highs. It’s now official: record government, corporate, credit card, auto and student loan debt. When I hear people say the economy and stock market are going higher when there is a record level of debt in the system it baffles me. It’s only possible to expand the economy if there is an expansion in credit. There is no other way!

Each week in the video portion I review the money supply and the rate of loan growth. I do that to gauge if they economy can continue to expand or not. When you have record levels of debt it also comes with obligations to pay on that debt. Unless there is strong wage growth, credit expansion, and moderate inflation, all this debt will cause the economy to collapse in on itself. Instead of seeing an expansion in wages and credit, we’re seeing a contraction in wages and a large contraction in credit. And now early signs that deflation is back. Combine those together and you have the recipe to create a recession.

Payroll Report Miss
This month’s payroll report was a big miss coming in at +138,000 jobs and downward revisions to the prior two months data. Over the past three months, the economy has created just over 120,000 jobs. While that may sound good, it’s rather weak and isn’t an indication a strong economy. I’m a bit surprised by these numbers because in the last Fed Beige book report that came out this week it showed that job growth and wage growth should be increasing. Perhaps this is just another case of optimism that hasn’t turned into reality.

The overall unemployment rate dropped to 4.3% which was largely due to 439,000 people leaving the labor force. Ouch. Wage growth, which showed signs of life last month, is running at 2.5% year-over-year, while inflation is at 2.2% year-over-year. Due to inflation, household spending power isn’t increasing much which explains while retail sales data remains muted.

Auto Sales Decline Again
On a year-over-year basis, this is the fifth month of sales declines for the automobile industry. This is a very weak trend that we haven’t seen since the depths of the 2009 recession. What this shows is demand for new cars has been exhausted. If this doesn’t turn around quickly then expect the auto sector to start laying off and idling plants in the later half this year. Based on historic trends this also means GDP numbers will be weak or decline over the next two years.

The Central Bank Put
After an eight-year rally from the last recession, investors are now finally convinced that the Federal Reserve has their back. If you’ve wondered why there hasn’t been a market correction since early 2016, it’s because everyone believes the Fed will step in on any market drop. That’s why stocks seem to stay up, investors have dumped their safe assets (bonds) and have overweighed their portfolios into stocks. No need to own any defensive asset classes if the Fed is in play. The Fed is talking about reducing their 4.5 trillion-dollar balance sheet and the stock market ignores that news, but they shouldn’t.

In a recent research piece by Macro Intelligence2 Partners, they show a graph of the US equity market capitalization has gone up as the Fed balance sheet has gone up – sorry I don’t have permission to share this chart. You may have heard me say that the entire market rally since 2009 has been built on central bank stimulus and when it goes away there will be little to support today’s stock prices.

As the Fed raises interest rates and seeks to reduce their balance sheet it will put downward price pressure on stocks. Without continued credit expansion, there’s no way this market can continue to run on weak growth. Nobody would expect a record high stock market during the weakest recorded growth of any market cycle in the history of the United States. Yet here it is right before us.

There are a few things as investors that we need to understand as the Fed seeks to reduce their balance sheet:

The stock market has risen due to the Fed expanding their balance sheet. As the balance sheet shrinks, so will stocks. Unless the Fed seeks to inject liquidity by lowering interest rates or another round of QE, they will not be able to prop up the stock market. Interest rates are likely to fall. Wait, what?

The Fed has publicly admitted that the purpose of Quantitative Easing was to bolster stock prices and create a wealth effect. They felt that if people were wealthier like they were in the late 1990’s then they would spend more. Unfortunately, the Fed failed to realize that most of the stock market is owned by the wealthiest people in the world. While many own stocks, they own very few, so an increase in a small balance doesn’t translate into feeling wealthy.

Because of QE, people sold safe assets to buy risky assets. Meaning they sold bonds to buy stocks. Therefore, we can look back and see clearly that during each round of QE that interest rates went up. They went up because investors sold bonds to buy more stocks. In turn, the Fed and other central banks bought those bonds.

Everyone thinks that when the Fed unwinds their balance sheet and puts these bonds back into the marketplace that it’s going to cause a surge in interest rates because there will be a massive oversupply in bonds. In reality, central banks have been buying bonds and eliminating the supply, which forced investors into stocks.

As the Fed’s balance sheet decreases so will stocks and investors will do what they always do when the stock market goes down – they will buy bonds. Since there will be a limited supply of bonds because the central banks control so many of them, there will be a large pool of investors chasing a small supply of bonds. That alone will drive interest rates down. And MI2’s charts confirm this: any mention of “tapering” over the past 8 years by the Fed has caused interest rates to fall.

Here’s your takeaway on this: if the Fed starts to reduce their balance sheet it is bearish for equities and bullish for bonds.

Video Topic of the Week
This week I discuss inflation and deflation, along with out each affects the American consumer. I also discuss how “real yields” affect stocks, the US dollar, and commodities. Real yields also predict if the economy is likely to inflate or deflate and what it means to your money. Charts showing real yields versus stocks, the US dollar and gold are included in the video.

I’ve decided to talk about equity blow off tops, how hedge fund managers are positioned in this market and where the “top” of this market may be. I’ll also review why stop-loss orders will not protect people when this market reverses and how to properly hedge downside risk.

Chart of the Week – Corporate profits versus the S&P 500
The markets have been excited about a quarter-over-quarter increase in earnings, but no mention of profits which declined on a quarter-over-quarter basis. Stock prices track profits more than they do earnings and this chart will show you how much stock prices would need to fall to get in line with profits. Preview – it’s more than you think!

Client Update
Powershares DB Agriculture (DBA)
This week we started a move into DBA. Prices have been holding steady against a horizontal trendline that was established in early 2016. Normally commodities trade inversely to the US dollar, which is falling, so there should be an upward move beginning soon. Even if not our purchases were right near the trendline which has shown to be a level of price support.

As I have mentioned in prior updates these positions are long-term in nature. In 2008 as the economy and stock market melted down this was one of the few sectors that outperformed. From May 2007 to May 2008 prices nearly doubled. When a new bull market breaks out in a stock, the next rally usually surpasses the prior high. We bought at $19.9x per share and the prior high was at $43 a share – I’ll leave the math to you.

On a side note our positions were bought directly from the dealer. Normally shares are bought and sold on the exchange and market forces dictate prices. When large trades hit an exchange, prices often adjust unfavorably as the trade hits the market. We have the option to buy directly from a dealer meaning our price is pre-negotiated before the trade is submitted. This allows us to lock in a price and avoid the problem of prices move unfavorably against us. The volume moves, but the price does not. This is how the big players trade; directly with dealers. I think it’s cool!

I may increase the position in the weeks that come, but any further purchases will be limited to the Moderate and higher risk portfolios.

Treasury Yields
After a weaker than expected jobs report, Treasury yields dropped. Yields are now on the edge of a technical breakdown which would send the 10-year Treasury yield down to 1.8%, which is where it was right before the election. This may be an opportunity to increase the duration risk in the portfolio. If yields do break down to 1.8% it’s likely they will drop below their all-time low, as I predicted a year ago that yields would eventually reach new lows.

Metals & Miners
Still no breakout in either right now. Due to the high volatility of these sectors, I am waiting for either a larger pullback or a break over a defined momentum structure. I get updates each weekend on momentum price targets and trendlines, and I update my charts accordingly. In the short term, the mining charts show signs of weakness. Long term the potential here in these sectors remains high due to the likelihood that record global debt and a weak global economy will lead to a financial crisis.

US Equities
The opportunity here isn’t in chasing the market to the top because once a top is set, reversals usually come just as quick. The best opportunity here is to wait until momentum breaks to short the market. Momentum usually catches trend changes before a technical downtrend starts. This data is provided throughout the week and every weekend as well. Charts are updated accordingly.

Bonus (37 min):

  • M2 Money Stock YoY% vs Recessions
  • Commercial & Industrial Loans
  • Consumer Loans
  • PCE vs Disposable Income
  • Cash Out Refi’s are Back!
  • Retail Stores Closing
  • Corporate Profits vs S&P 500
  • Nonfarm Payrolls Report
  • S&P 500 vs Citi Economic Surprise Index
  • Real Yields vs S&P 500 vs US Dollar vs Gold
  • Dow Jones Industrial Average Exhaustion Gaps & Volume Analysis
  • S&P 500 Momentum Level
  • 10-Year Treasury Yield (TNX) Support Levels & Price Targets
  • Gold Futures (GCM7) Support Levels & Price Targets
  • SPDR Gold Shares (GLD) Long-term Trendline
  • Vaneck Vectors Gold Miners (GDX) Support Levels & Price Targets
  • iShares 7-10 Year Treasury Bond (IEF) Support Levels & Volume

And corresponding charts

Weekly Economic Update Graphs 06-02-2017