Weekly Economic Update 04-13-2018

Hurricane Force Inflation

Since President Trump took office the mainstream media has been pounding the drum, predicting inflation is coming. Financial analysts are also sounding the inflationary alarm, as nearly every financial blogger, tweeter, radio host, author and financial advisor has models showing inflation is going to rapidly rise. Despite all the talk of inflation, outside asset prices such as stocks and real estate, it has been relatively tame. It’s not the Fed’s printing press that is stoking the fire of inflation, but the increasing rate at which money is changing hands – or the velocity of money.

The velocity of money is the rate at which money changes hands in a year. The belief is that the faster money exchanges hands, the faster inflationary forces will build. While the velocity of money is often misunderstood, its effects are powerful and worth exploring. For example, the Fed started tightening the money supply and market participants responded by driving up interest rates. Prices are determined by the supply of money and the demand for goods or services, not how fast money exchanges hands. But there are transitory periods where the velocity of money can affect asset prices.

Money is a medium of exchange which allows people to exchange goods and services for an intermediary. The frequency at which people exchange goods or services for money affects the velocity of money. Let’s say Bob sells eggs to Betty for $20, who then exchanges the $20 with Larry for apples and then Larry exchanges the $20 with Steve for mowing his yard. Assuming these transactions took place in a year, one $20 bill will have the economic effect of $60. The velocity of the $20 would be three because it was exchanged three times in a year.

The faster money is exchanged for goods and services, the more economic transactions money affects. Since 1999, which coincidentally is the same year the first Millennials graduated high school, the velocity of money has fallen from a peak of 2.2 (times per year) to 1.43. To put the velocity of money into context, it is currently at the same level it was in 1949. It wasn’t until the second quarter of 2017 that the velocity of money started to flatten before it rose slightly going into the fourth quarter of 2017. It’s easy to see the effects of an increase in the velocity of money, but the cause is often more elusive.

When consumers sense the government is going to devalue the currency, consumers will attempt to exchange their money for tangible goods and services. The recipients of that money will also attempt to exchange their newly received money for other tangible goods and services before it is devalued, which leads to the increase in the velocity of money.

Workers who are anticipating an increase in pay will often drain down savings to replace worn out or old items. If a large enough pool of workers is anticipating an increase in pay, this too will lead to an increase in the velocity of money. The debasement of a currency or a general increase in wages should lead to an increase in economic activity due to an increase in the velocity of money. This is exactly what the Federal Reserve was hoping would happen when they boosted bank reserves by nearly $4 trillion from their successive Quantitative Easing programs, but it didn’t lead to an increase in economic activity.

The appearance of a coming boom in economic activity is evident from the slight increase in the velocity of money that started in the fourth quarter of 2017. The savings rate has been falling, which is evidence that consumers are saving less. The growth rate in bank deposits has also been falling, which suggests that consumers want to hold less cash. Credit card usage over the past two years has been strong, and with a low unemployment rate, the picture is clear – the economy should be booming.

Yet starting in December 2017, retail sales contracted for three months straight and total assets at commercial banks have been falling. This suggests the economy may not be booming after all. This is the problem with the velocity of money – analysts typically focus on the effects of an increase in the velocity of money rather than the cause of the increase.

We know the Federal Reserve is literally destroying money every month. Starting in October 2017, the Fed began destroying money at a rate of $10 billion per month, which increased to $20 billion per month in January 2018 and now the Fed is destroying $30 billion per month. The destruction of money means there is less money in the economy, which would lead to an increase in the velocity of money. However, the Fed is focused on destroying the excess bank reserves that it created, so it’s unlikely this is the reason the velocity of money is increasing.

Another possible reason the velocity of money has increased is because of the recent personal and corporate tax cuts. Tax cuts allow workers, retirees, and businesses to keep more of the money they earn, but it doesn’t change the amount of money available in the economy. Early data shows the money from the tax cuts is being saved, not spent, because the cuts are temporary. Since the money is being saved, the tax cuts aren’t contributing to the recent increase in the velocity of money.

The most likely reason the velocity of money has increased is due to the two hurricanes that hit Texas and Florida. Insurance companies hold their reserves primarily in corporate and government bonds. While insurance companies do hold cash to pay claims, the damage from the hurricanes was substantial and far beyond their available cash holdings. Insurance companies would be forced to sell their bond holdings to pay claims, which brought money into circulation. As that money entered the economy, it triggered a temporary increase in the velocity of money.

There would have also been an increase in borrowing due to the natural disasters, as consumers and businesses likely needed to borrow money to cover deductibles and other expenses. This too would have led to a temporary increase in the velocity of money and an increase in economic growth.

Economic growth increased because of how we account for natural disasters. We count the replacement of homes, cars, and property as part of our Gross Domestic Product (GDP) growth, but we don’t subtract out the loss of any assets. If my house is destroyed by a natural disaster, I don’t take account for a loss, because it will be replaced by my insurance. However, the cost to replace the house does create economic growth. This is how we know the hurricanes caused a spike in economic growth starting in the fourth quarter of last year.

The three hurricanes, Harvey, Irma, and Maria were responsible for over $282 billion in damages. Harvey and Irma dissipated in September 2017, while Maria dissipated in October 2017. In the aftermath, insurers would be forced to dig into their reserves to pay for the damages.

In early September 2017, the 10-year Treasury yield was about to break out of its topping pattern which would signal a decline in interest rates. Hedge funds, or speculators, were positioned for yields to fall as they were long 10-year Treasuries. By mid-September, interest rates started to rise a bit, most likely due to the insurance companies selling their bond holdings to raise cash. As claims start to come in, which are paid as soon as claims adjusters can arrive at the scene of the damage, interest rates continue to rise.

By mid-October, speculators began shorting 10-year Treasuries. Yields started to rapidly rise. Over the next four months, which is in line with the time it takes construction crews to rebuild and insurance claims to be paid, Treasury yields continued to rise. By February 2018, most investors dumped their bonds for stocks and speculators took a record short position against 10-year Treasuries. The media focused on rising interest rates and inflation, but the likely culprit was the three hurricanes.

After claims are paid and upon policy renewal, insurance companies raise rates for the affected regions in order to rebuild their cash and bond holdings. Despite best efforts from the speculators, hedge funds seem to be unable to drive yields higher.

In the months to come, insurance companies will continue to pull liquidity out of the affected zones through higher premium payments. This will not affect the money supply, but it will pull money out of the affected regions where it will be put back into bonds and cash. The act of removing money from circulation into bonds will have the effect of reducing the velocity of money. As the velocity of money slows, bond yields should fall, stock prices should fall, and economic activity should also slow.

What investors should be worried about is that the Federal Reserve is interpreting this growth spurt as an inflationary risk. In the minutes from the recent Fed meeting, members stated the economy should continue to grow which will warrant further hikes in the Federal Funds rate and the continuation of the unwinding of their massive bond portfolio. As all this liquidity is drained and money is destroyed, the economy and the stock market may be the next disaster that strikes American shores.

Annual Momentum Update

This week I ran the algorithm through two large-cap indices, the Russell 100 Growth and Russell 1000 Value. The results were equally as impressive as the ones I shared with you last week, showing that a strategy using a break in annual momentum to sell before a major Bear market begins and a rise in annual momentum to buy at the bottom, works better than any strategy I’ve ever seen.

The risk-reward metrics are impressive: both had a high Alpha (showing they both outperform their benchmark), a low Beta (showing they both had less risk than their benchmark), and a high Sharpe Ratio (showing that the returns are from good management and not excessive risk). I’ve never seen anything like this in any other strategy!

I ran a test showing a strategy with 50% to the Russell 1000 Growth Annual Momentum and 50% to the Russell 1000 Value Annual Momentum, versus the S&P 500. The strategy beat the S&P 500 on a 1, 3, 5, 10 and 15 year period with substantially less risk.

I started running the algorithm through a few sector funds, which worked, but nowhere near as well as it does on the major indices. I’m not surprised by this, since sector funds tend to be more volatile, which doesn’t play as well with the annual momentum algorithm as major market indices do. My early thoughts were to create a modified version of the algorithm that just looks for major upswings in the sectors.

The concept is that when a sector is near a bottom that it is likely at some point to have a large upward move in price. Rather than commit to staying in that sector for years, what I am hoping is to create a modified algorithm that just attempts to find one of those large upward moves. If I am successful, and I hope I am, then the strategy would have a base in the major indices and rotate through different sectors to create excess returns.

I expect I’ll have time this weekend and next week to test some ideas I have to make the sector rotation algorithm work.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

The market jumped at open and then staged a large reversal by the close. The move in the early hours was a deliberate short squeeze. On Friday the data from the Commitment of Traders report showed that hedge funds started shorting the Nasdaq-100 index. Trader aggressively tried to flush out those shorts, which is why the major indices rose on low volume.

Any time the market rises on low volume, prices are not sustainable. By market close, sellers pushed the major indices into negative territory.

  1. What happened to the stock market on Tuesday?

China’s President gave a speech stating that he wanted to open China’s borders to imports. His speech was read by autonomous artificial intelligence (AI) trading programs which began buying future contracts on the major indices within seconds of his speech hitting the news.

What these AI trading programs don’t know is that President Xi had made these same claims before in the past. There really isn’t any truth to this at the moment, but the stock market did rise as sellers joined in. Until China allows their currency to float, nothing will change. By the close, sellers were back, which is further evidence that the big money is selling this rally.

  1. What happened to the stock market on Wednesday?

For some reason stocks seemed to like the higher Consumer Price Index (CPI) numbers and that we may launch an attack on Syria. Gold took off early in the morning, but as I expected, gold prices faded by afternoon.

The more interesting news was the huge 10-year Treasury auction. Unlike the past Treasury auctions, foreign investors backed away from this one, leaving the securities dealers to choke down the remaining supply. Perhaps foreign investors are responding to the threat of tariffs by reducing their purchases of Treasuries.

The reason I found this interesting is that bond yields didn’t spike after the poorly received auction. Yields rose following the auction but fell afterwards. Stocks wobbled, and the major indices closed in the red for the day. This is a classic example of a liquidity drain. Wall Street has to absorb the supply of Treasuries which is taking money away from risk assets.

Trading volumes were the lowest of the year, which shows a lack of buyers and sellers. With earnings season due to start on Friday, I expect muted action from the markets until then.

  1. What happened to the stock market on Thursday?

Thursday was a day for technical traders or people who look at trend lines and supports levels.

The S&P 500 tagged its overhead 9-year uptrend line for the third time in two weeks and failed. The DJIA tagged its overhead downtrend line as part of a descending triangle pattern and failed. Ten-year Treasury yields tagged its overhead 50-day moving average and failed.

Trading volumes continue to plummet, almost as if liquidity in the markets is drying up. Liquidity should be drying up because the Fed is actively mopping it up.

Thursday morning markets were bid up within seconds of President Trump tweeting about Syria. For some reason, the automated computer traders think that a reason to push stock prices up. The bigger issue here is that there aren’t many sellers in this market because the automated computer traders have been aggressively going after anyone who is short this market. Its go long stocks or go home. As buyers disappear due to lack of liquidity, it certainly puts into question how this market is going to keep going higher. Perhaps we will see a 1987 style -20% one-day plunge?

  1. What happened to the stock market on Friday?

Not much. Trading volumes were very low throughout the day but picked up towards the end once sellers arrived. This is a market for the Bulls to defend since they have forced out every short seller. If the Bulls don’t push the market higher, my guess is the sellers are going to drive it lower. The fear is when the quants or automated computer traders start selling. We’ve never seen that.

  1. Why are markets so volatile?

Some of the volatility suppressants are gone and even though volatility is relatively low, investors are finally seeing the stock market for what it is. When markets make large moves on low volume, investors should be concerned.

  1. Why does it matter if trading volumes are low?

It indicates there are few buyers. In a Bull market, buyers need to continue buying to drive prices higher. It also indicates that sellers haven’t started selling yet. Investors should be concerned about how far prices will fall when sellers realize that buyers are exhausted.

  1. But aren’t this quarter’s corporate earnings going to justify stock prices going higher?

It’s important to understand that everything is being manipulated to make the economy appear as strong as possible due to the corporate tax cut. Investors are hoping for +18% Earnings Per Share (EPS) growth for 2018, but they should be aware that the tax cuts will fade in the years to come. And at +18%, this is a huge hurdle for most companies to jump over. It’s also important to understand that 25% of earnings growth last year came on the back of the trade-weighted dollar depreciating by 10%. With the dollar no longer in free fall, earnings will not have that tailwind to help them. It is entirely possible that earnings may disappoint and that won’t be good for stocks.

Video Topic of the Week – Where are the Buyers?

Trading volumes are collapsing as the Fed continues to drain liquidity. What does this mean for the markets?

Chart of the Week – Smart Money

Is the Smart Money buying or selling? Tune in this week to find out!

Portfolio Shield™ Update

The April Morningstar® Investment Detail Report is linked below.