Weekly Economic Update 06-01-2018

Party Like It’s 1999

In 1982, American musician Prince released an album and title track song, “Party Like It’s 1999.” This song became one of Prince’s most well-known titles which propelled him to rock-star status. Little did he know in 1982 that in 1999 the economy and stock market would be booming. The party was just getting started and most American’s were dreaming of becoming dot-com millionaires. Unfortunately, in September 2000, the music would come to a screeching halt — the party was over.

Going into the September 2000 investors were aggressively positioned for the economy to continue flying high. Stocks were up, interest rates were rising, the price of oil was up, copper was up, emerging markets were up, and the factory data was riding its cycle highs. For the American economy and investors, things could not be better. The ensuing crash caught most investors by surprise and it would take years before their wealth finally recovered.

Over the next two years following the bust, the S&P 500 fell 50%, the Dow Jones Industrial Average fell 38% and the once-hot Nasdaq-100 fell 83%. Americans began referring to their 401(k)’s as 201(k)’s as they watched their wealth vanish in one of the most dramatic bear markets since the Great Depression.

Five years later the S&P 500 recovered, the Dow Jones Industrial Average only took four years, but the Nasdaq-100 took fourteen years to get back to its 2000 peak. By 2016 the memory of losing a substantial amount of money in tech stocks began to fade as investors once again started piling money back into the Nasdaq. Economic cycles tend to repeat because it can take several years or more for investors to forget their past mistakes.

Most investors probably don’t know what caused the tech bubble to burst. The Federal Reserve would be a good guess, but they were raising interest rates rather slowly, not unlike today. Investors drove the 10-year Treasury yield to 6.8%, but that didn’t break the economy either. The money supply was decelerating, but it was running at a 6% growth rate which is sufficient to sustain the economy. Commercial and Industrial loan growth was running strong at a 10% growth rate. None of the normal indicators suggested anything was wrong or that the stock market was about to take a nosedive.

The culprit was the U.S. Dollar. Between 1997 and the early 2000’s the value of the U.S. Dollar was relatively stable. But by mid-year, the dollar began to appreciate which caused stocks to fall and pushed the economy into a recession. As the dollar appreciated the Fed stopped raising interest rates, but it was already too late. The rampant speculation in the stock market coupled with a rising dollar led to a colossal unwinding of these speculative positions, which caused the stock market to crash.

As the stock market sold off, the Fed began to ease monetary policy by lowering interest rates, but the dollar continued to rally into early 2002. It wasn’t until the dollar began losing its strength in early 2003 that the stock market and economy finally bottomed.

The speculative positioning in the stock market was at high levels in 2000, but today the speculative positioning is at more extreme levels.

S&P 500: In 2000 the speculative long positioning was huge. Today, speculative long positioning is near its all-time highs, which were set back in early 2009.

10-Year Treasuries: In 2000 the speculative short positioning was at a record low, and today, the speculative positioning is at new all-time lows. The current short position is by far the largest short position in the history of U.S. Treasury bonds.

Crude Oil: In 2000 the speculative long positioning was at a record high. Today Crude has the largest recorded speculative long positioning of any commodity in history.

Copper: Copper is considered a hedge against rising inflation, and in 2000, the speculative long positioning was near record highs. Today, the speculative long positioning is at new record highs.

Eurodollars: Most people don’t know what a Eurodollar is, but it is a dollar deposit held in Europe or outside the United States. In 2000 there was the second largest short position in Eurodollar Futures in history, which is how foreign speculators bet on a falling dollar. Today the speculative short positioning on Eurodollars is at a record high.

U.S. Dollar: In 2000 the speculative positioning in the U.S. dollar was neutral, but today there is a large short position.

Most investors from large pension funds, hedge funds, institutional money managers, and retail investors are positioned on one side of the market. Investors being overly concentrated in risk assets isn’t the only problem with this market. The American Association of Individual Investors, who surveys cash levels in brokerage accounts, found cash levels are near the historic low which was previously set back in 1999.

Low cash levels can be an asset or a liability. In a falling equity market, cash-rich investors may see lower stock prices as a reason to buy more stocks. But in a falling equity market, low cash levels can be a liability. Bloomberg recently reported there isn’t enough cash in brokerage accounts to buffer the extremely high levels of margin debt investors are holding. Should stocks enter a bear market, those who own stocks on margin may be forced to sell their stocks as prices are falling. When investors are forced to sell into a falling stock market, stock prices fall even faster.

In 2000, there were large market makers at investment banks called “prop desks,” which are proprietary trading desks where brokers trade with their firm’s money. In a recent conversation with a gentleman who used to work at a prop desk, he said that after the Great Financial Crisis prop desks disappeared. Instead, market liquidity is now being provided by computer algorithms which didn’t exist prior to 2009.

Nobody knows if these computer programs will provide liquidity during the next market downturn, but former Fed Chairman Janet Yellen previously stated that one of the biggest risks in the next bear market could be due to a lack of liquidity. She indicated the Fed may not have the ability to react fast enough to provide liquidity should the algorithms choose not to provide it. We do know in periods, although brief, where the computer algorithms stopped providing liquidity in a particular stock, and its price plummeted in a matter of minutes.

If all of this sounds like a cocktail of disaster for stocks, it is. But, it gets worse. In addition to over-speculation in equities, low cash levels and computer algorithms managing liquidity, volatility selling across multiple asset classes is also popular among investors large and small.

Volatility is the normal fluctuations of an asset. Every stock investor knows the higher the potential returns of a stock, the greater the price fluctuation will be. Previously large institutional investors and pension-fund managers would hedge their portfolios with volatility because they cannot easily buy and sell securities without moving the market. After the Great Financial Crisis, the financial services industry thought it was a good idea to allow investors of any size the opportunity to buy or sell volatility.

By selling volatility, investors are suppressing the natural movements of the stock market. When an investor shorts, or sells equity volatility, they can prevent large downward fluctuations in price. When investors see that risk assets barely drop on bad news, investors begin to believe risk assets are safe. Little do investors realize that volatility is being deliberately suppressed to make stocks appear less risky than they are.

As I wrote in an article last year, investors of all sizes from large state-run pension funds to small retail investors are shorting, or selling volatility. Today the short volatility trade has spread to other asset classes. I didn’t know until recently there was an index that tracked oil volatility, let alone the fact that investors can sell oil volatility. Investors aren’t just selling oil volatility, they are selling equity, currency, bond, and copper volatility at record levels.

To summarize where the markets are, now, there is the largest speculative positioning, both long and short, across multiple asset classes in history. Cash levels are near historic low levels while margin debts are at record high levels. Computer algorithms are providing liquidity to markets, but nobody knows if they will during the next bear market. And if all of that doesn’t make you nervous, investors are suppressing volatility across multiple asset classes.

It was the U.S. Dollar that unwound the markets in 2000 and the dollar could cause the unwinding of this market. Each one of the positions I outlined in this update requires the dollar to continue weakening for them to remain profitable. Most analysts and experts believe the dollar will continue weakening, but to determine the likely direction of the dollar, we need to examine the money supply and interest rates.

When the U.S. money supply is growing faster than the money supply of other major countries, the dollar tends to weaken. The domestic money supply is decelerating while the money supply of our major trading partners is accelerating. The Fed is tightening our money supply, while other central banks continue to ease, which means the dollar should rise.

Interest rates also play a factor in exchange rates. When interest rates in one country are higher than another, the currency in the country with the highest interest rate will appreciate. Currently, 10-year Treasury yields are the highest of all G10 countries, which also suggests the dollar should rise.

The dollar was the trigger which broke the economy and ended the party in 1999 and now the stage is set for an encore performance. Due to speculative positioning, volatility selling, low cash levels, and low liquidity, the risks in today’s equity markets are more extreme than they ever have been.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

U.S. markets were closed for the holiday, but Asian and most European markets were open. The Italian stock market entered a bear market as selling intensified. Oil began to sell off on news that Russia and Saudi Arabia will bring prices down to $60 per barrel.

  1. What happened to the stock market on Tuesday?

Investors came back from the holiday to find foreign markets selling due to renewed fears that Italy may leave the European Union. I’d try to explain what is going on with the Italian government, but it is too convoluted to explain. Simply, if the Five Star party wins, there’s a chance Italy may leave the EU and possibly default on Italian government bonds held by the European Central Bank. Given Italy is the third largest economy in the EU, it is too big to fail but too big to bail out.

US equities fell most of the day on this news but managed to stage a late afternoon rally. My insider connections are telling me liquidity in this market is getting very thin, which could lead to a much larger sell-off in equities.

Investors fled to US Treasuries, which everyone said wouldn’t happen. Yields saw their largest one-day drop in more than two years.

Agricultural commodities gapped up into their sell zone again and were met with sellers. Buyers stepped in again, in late morning trading.

Gold did not get a bid, but I’m not surprised. I still expect gold to head down to the $1,265/oz level.

  1. What happened to the stock market on Wednesday?

Just disregard everything I wrote about equities yesterday and you have today. The U.S. equity market shrugged off the news in Italy and on no major news, equity prices rose.

Yesterday’s move down in price was partially in reaction to Italy and partially due to investors getting stopped out of their trades. Given stock prices held some minor technical levels yesterday, buyers stepped in. Volumes remained relatively low, suggesting the buying is mostly corporations buying their shares back and high-frequency traders front-running those trades.

The reason interest rates dropped sharply yesterday was due to short sellers being stopped out. As expected short bond sellers came back into the market but were met with buying interest. It’s possible the high in yields for this cycle has been set.

Large gold miner touched their 100-day moving average which has been a key moving average for the gold miners but failed to cross upwards. I still believe there is one last move down for the miners and for the physical metal. I expect within a week or two we should know.

  1. What happened to the stock market on Thursday?

In what has been a bizarre set of days, the market sold off, rebounded and sold back off today. Yields fell today but bounced back higher towards the close, but still closed lower.

The Personal Consumption Expenditures (PCE) data came out today, which is the Fed’s preferred gauge for inflation. On a year-over-year basis, the PCE fell last month. Nearly everyone has been saying rampant inflation is coming, but the data is not confirming. As I have mentioned, a decelerating money supply in the short-term can lead to higher inflation, but in the long term, inflation will fall.

The savings rate also fell after rising for the past two months. Further evidence that the decelerating money supply is squeezing household budgets. Low savings rates eventually lead to lower economic growth.

Agricultural commodities are being sold in the morning and finding buyers in late trading. They are within days of triggering the moving average trifecta, which is when the 50-DMA is higher than the 100-DMA, and the 200-DMA is below both. Last few times this has happened, agricultural commodity prices skyrocketed.

The large gold miners tagged their 100-day moving average for the second time but failed again. This suggests prices are likely headed lower as I have been expecting. If physical gold can fall with it and both hit their “Buy Zones,” this will provide a great deal of confidence to start buying in.

  1. What happened to the stock market on Friday?

It was risk off with every major equity index in the green for Friday. The nonfarm payrolls and household employment reports showed strong hiring for May. With a decelerating money supply, payroll growth will put a crimp on corporate profits, which have been detached from corporate earnings growth.

Corporate stock buybacks hit a record high last week but wasn’t enough to drive stock prices higher. Foreign investors continue to buy US stocks, but that isn’t enough either. The Fed’s liquidity drain is overpowering and will continue to keep a ceiling on stock prices until corporations and foreign investors run out of money. Once that happens, there will be no buyers left to keep stock prices up. If you don’t believe me, check a price chart of General Electric. Their stock fell 54% after their buyback program ended.

Bond yields fell, which is the opposite of what is expected. Most believe that low unemployment leads to high inflation, but without an acceleration in the money supply, inflation cannot occur. Speculators increased their short positions to the largest in history but yields still fell in today’s trading. The Smart Money has been buying bonds for the past two years and is likely increasing their positions which are offsetting the Speculators.

Physical gold failed to cross over its 200-day moving average, which should send prices down into my final targeted “Buy Zone.”

Agricultural commodities continue to find sellers each morning but find buyers by late afternoon trading. Weather reports show the Midwest and southeast are likely to experience very hot weather with some comparing it to the “Dust Bowl.” Any event, weather or otherwise, that disrupts crop progress, quality or output will send prices higher. Agricultural commodity prices are likely to rise this summer.

Momentum Update –

For a couple months I have been sharing with you my momentum charts in the weekly updates. I track weekly and daily momentum across a broad set of sectors. There has been a discrepancy between the weekly and daily data, which I fixed this past weekend. The daily data was generating too many false signals because it was running on a shorter scale than the weekly data.

I also built out the model by pulling in some additional sectors that were on my “to do” list. I then built a summary page to pull the daily data and built a color-coded overlay to identify which sectors had positive momentum. I even added some code where the spreadsheet will create recommended portfolio weightings based on the sectors with positive momentum.

I haven’t been able to replicate the underlying weighting mechanism I used for Portfolio Shield™. I am close, but not quite close enough. Once I get that figured out I will be able to run a backtest to see how the strategy works when rotating between different sectors based on momentum.

The momentum data is currently recommending a 20% short-equity exposure! It sees downside risk in this market and it is suggesting a hedge. Hopefully, I can get closer to how Morningstar® calculates this variable I use so I can run a backtest.

Morningstar® was very helpful and they provided me with the formula they use to calculate the variable I am seeking. Now it’s just a matter of reverse engineering it to match my data.