Weekly Economic Update 10-27-2017

Investor or Speculator?

Most people who have money in stocks would tell you that they are investors, meaning that they are in it for the long term. For an investor, that time frame could be anywhere from five to more than thirty years, but this current market has turned speculative. Investors will be quick to tell you that they invest based on corporate fundamentals and long-term price appreciation, but today, stock prices have gotten so far ahead of investors that everyone in this market is hoping that the economy catches up to valuations.

In the case of McDonald’s, that I profiled last week in my weekly update, its fundamentals were better five years ago than they are today! Few people understand that corporate executives have used financial engineering to manipulate their stock prices higher, so they can cash in on lucrative bonuses. Once you understand stock prices are only going higher because investors are bidding prices up, then you can conclude that investors are no longer investors, they are speculators.

Price-driven markets are a double-edged sword. As long as prices are increasing, everyone is happy. But when prices start to fall, everyone runs for the exit. Yet sentiment data confirms that the public is as bullish on future stock returns as they ever have been. Bullishness is fine when fundamentals confirm the price, but when fundamentals suggest stock prices should be lower, you have a momentum-driven market. Few investors understand that the recent price appreciation over the past eight years is nearly entirely due to the Fed printing money, which came in the form of three successive Quantitative Easings and corporate share buyback schemes. Even though the Fed is not officially tightening and share buybacks are rapidly falling, when the Fed tightens and corporations cut their share buyback programs that the economy and asset prices are going to deflate.

Falling asset prices aren’t an “if”, they are a “when”. Since the election, the year-over-year rate of growth in the United States money supply has fallen. Even though the Fed is slowly unwinding its $4.5 trillion-dollar balance sheet, it will have major repercussions in shrinking the growth rate of the money supply. The rate of growth in the money supply is critical because asset prices rise and fall with the money supply. As I shared with students in my recent Boomer Retirement Planning Class™, when you cut the money supply in half, asset prices must fall in half. Even though the rate of growth in the money supply peaked a year ago, bullish sentiment has driven stock prices well ahead of where they should be.

This is going to be a problem for investors because at some point the reduction in the money supply will become apparent. Stock prices will start to fall because each week there is less money circulating in the economy. Once stock prices start to fall, the mainstream media will become bearish on stocks and the truth about the poor-shape corporate balance sheets will be made known.

As investors and speculators run for the door, they will find out that due to the Fed’s policies, everyone is in risk assets. The evidence is strong, because trading volumes have plummeted, and stock ownership levels are at very high or all-time high levels. This means when investors decide to sell, there may not be many buyers on the way down, which is why I’ve said repeatedly that this is one of the, if not the most dangerous, markets in history.

The other reason this is the most dangerous market is that we are a part of the largest Keynesian monetary experiment in the history of all mankind. Never has so much money been printed by central banks around the world in an attempt to create prosperity. Unfortunately, history isn’t kind to money-printing schemes; every one of them in the past has led to a severe economic collapse.

This brings me to the topic of this week’s update: how to invest knowing things are likely to go very wrong. The simple answer is that prices will move opposite how they have recently moved. That means that stocks should fall, yields should fall, bonds should rise, oil should fall, real estate should fall, and precious metals should fall. It’s just a matter of following the money.

Yields – Bond prices rise as yields fall. If yields rose when the Fed was easing, then yields should fall as the Fed tightens. Keep in mind, if easing is inflationary and yields rose, then tightening is disinflationary and yields should fall. That would confirm the topping pattern I’ve seen in 10-year Treasury yields since the jump in yields after the election. If history is a guide, then yields should see new all-time lows as bonds see new all-time highs. Speculators, who trade futures contracts, cut their short positions in half last week which means they expect yields to fall as the Fed tightens. Plus, I expect the Fed will have to take the Federal Funds rate into negative territory to bail out the economy from this bubble, which is bullish for bond prices. I believe we’ll see double-digit returns for Treasuries before this is all over.

Equities – Being in stocks near the end of any expansion is dangerous territory because once the selling begins, it will be hard to stop. Many investors believe the Fed will bail out the stock market and keep it propped up, but that hasn’t kept stocks from falling during past recessions. There is definitely an opportunity to short equities but not until annual momentum is broken and the ISM Manufacturing survey data has fallen. Currently, the ISM is near its highest point in history, which would be synonymous with 5% GDP growth, but not even the Fed’s lofty projections have GDP growth that high. Remember, buy low and sell high. This market is high.

Precious Metals and Producers – Gold and silver are both assets, meaning they should fall as the money supply does. But the next time the Fed’s printing press starts to spin up, get ready for those metals to launch. Between the bank bailout and the three QE’s, the Fed printed 10’s of trillions of dollars. They’ll have to print even more next time, which is very bullish for metals because that’s when we’re likely to see inflation. We’ve reached a point where central banks are going to print and continuing printing until fiat (paper) currencies are worthless. I’m not expecting them to deviate from the path they’ve been on. I also don’t expect there will be much delay from when the next downturn begins and when the next QE begins.

Digging into the precious metals mining stocks, that is where the biggest opportunity is in the metals space. Mining stocks haven’t participated in this recent rally nor has there been much investment in future mines. That alone sets up a strong narrative for the mining sector. Not to mention China is on track to go live in two months with its Yuan for gold exchange.

For those who have been long-time readers, you know I have had a strong bias for the mining stocks because I believe the Fed is going to be forced into printing a huge sum of money to bail us out when the next recession hits. Based on charts alone, the mining stocks have been in a descending triangle pattern for nearly a year. A descending triangle pattern in bearish, which would setup a nice buy-in point. The downward move didn’t happen. There was a brief upside breakout attempt, but based on classical charting, upside breakouts of a bearish pattern without high volume are often false moves.

As the miners slip below their daily moving averages, it has validated the recent move up as a false move. What has transpired is a beautiful textbook inverse head-and-shoulders pattern for both the gold and silver miners. It’s more obvious with the silver miners, but the pattern is present on both. If that pattern is correct, then in the near future there should be the move down that I have been looking for in the market. This would confirm Peter Brandt’s view on where gold is headed and the decrease in the money supply that we should see through year-end. The upside potential when the miners (and gold) finally break out into their next bull market is substantial. Given that new bull markets see prices surpass the prior price peak, that suggests the miners could see a 200%+ return. Depending on how much the Fed prints, that number could be much higher.

Agricultural Commodities – This sector loves stagflation, which is any period where prices are rising faster than wages. This usually happens during periods of high unemployment. The next recession should see high unemployment and high prices as I expect the Fed to print its way out of the next crisis. During the last recession, agricultural commodities generated a near 100% return in less than twelve months. As cycles go, when the Fed prints, agricultural commodities will go first, followed by gold and then oil.

Oil – If you want to know where oil is going, follow the money supply. When the money supply falls, so does oil. Oil also tends to bottom at the bottom of a recession, then takes off from there. From a chart perspective, Peter Brandt has pointed out that there’s a long topping pattern in oil and I’ve noted that the oil producers are likely to see their stock prices decline based on the trend in their moving averages. I’m interested in oil at the bottom of the next recession when the Fed has the printing presses spooled up again.

The real question mark in all of this is the US Dollar. I was going to write about my thoughts on it and what it may mean to these different sectors, but to give it the space it needs, I’d probably have to add two pages. For the moment, I’ll shelve my views on that for a future update.

For those who have been long-time clients, you know I have had an interest in developing a sector-rotation model. There is a lot of historic data for which sectors tend to outperform depending on where we are in the business cycle, but that has been completely distorted by the global central bankers and their printing presses. While I’ve never given up on the idea, The Portfolio Shield™ algorithm likes rotational strategies – it was developed to rotate between different positions to capitalize on what is rising.

Rather than chase a strategy that rotates a large number of asset classes, I’ve recently been inspired to create a strategy that rotates depending on the money supply. What I find interesting about that idea is that nobody has created one; at least not according to my research. The concept is rather simple: there are certain asset classes that do well when the money supply is rising and there are a couple that do well when it’s falling. I’m going to work on a strategy that rotates through the strongest performing sectors based on the direction of the money supply, while using the Portfolio Shield™ algorithm to handle the rotation and allocation of the various investments. While I think the original Portfolio Shield™ concept is ingenious and the back-tested results confirm that, I think this could be the ultimate version of Portfolio Shield™ once I’m done. I’ll keep you posted. Until next week, follow the money!

Video Topic of the Week – Tightening

The Fed has been tightening for a month and it’s starting to show itself in the markets. This week I take a look at how you can tell asset prices are deflating.

Chart of the Week – History of QE

This week is a double bonus slide where we look at what happens to stocks and bonds when the Fed tightens. If you’re an investor, these are the only two slides you need to understand to know where the markets are headed.

Portfolio Shield™ Update

As I mentioned in the main update, I’m working on a strategy that moves with the inflationary and deflationary cycles that the Fed creates. More on that in the weeks to come.

Weekly Broad Market / Economy Commentary

I know everyone is concerned about bonds and to further expand on the piece above, when the Fed tightens bond yields eventually fall. Historically under these conditions, they can fall fast. When yields fall, bond prices rise. This recent rise in yields is probably due to the Treasury running low on cash. The last article I read stated that the Treasury will run out of money in early December unless a budget is passed. The moment a budget is passed, the Treasury can go out and raise funds. When they do that, yields fall.