What Will It Take to Break the Market?
Stocks seem to have detached from reality. It seems they no longer follow fundamentals, economic data, or earnings. It now appears as if they magically rise, regardless of whether the news is positive or negative. Most investors couldn’t care less why stocks are rising, so long as they continue to rise. Anyone who has invested in the stock market knows stocks don’t rise indefinitely. At some point the market will break, but what could possibly be the trigger to break the current market?
Stock prices used to rise and fall with industrial production which makes sense. As output increases, so does economic growth and this leads to increased stock prices. During recessions, output decreases, along with economic growth, and stock prices fall.
The current economic expansion has been running for ten years which is two years longer than the typical eight-year expansion we normally experience. To say the economy is overdue for a recession is an understatement. Between the Fed’s Quantitative Easing, the Fed lowering the Federal Funds rate to zero for eight years, and the Trump administration’s tax cut, it appears this expansion will keep going.
All expansions have an expiration date, mostly due to the Fed tightening monetary policy. When the Fed tightens monetary policy, the money supply begins to decelerate, which cuts the cheap-money flow that is propping up the speculative part of the economy. In the late 1990’s, speculation was in tech stocks, in the mid-2000’s it was in housing, and today it is back under the stock market.
The purpose of tightening the money supply is to slow down the origination of new loans which is how new money enters the economy. As new money enters the economy, it multiplies several times through the banking system before the money dies. As money passes through the economy there are inherent lags in the system. The Fed makes gradual adjustments to monetary policy in hopes to find the ideal mix to sustain economic growth.
Unfortunately for the Fed, the economy is far too dynamic for there to be an ideal monetary policy that will lead to sustainable growth. By maintaining a loose, or easy-money policy for nearly a decade, the Fed ends up creating massive bubbles in the economy. As the Fed tightens monetary policy, those bubbles get squeezed until they pop.
While the bubbles should be obvious to most people, bubbles don’t become apparent until after the fact. There is a bubble in the stock market, corporate bond market, in residential real estate, corporate real estate, and automobiles and junk bonds just to name a few. However, the catalyst that will kick off the popping of these bubbles isn’t as obvious. I believe the U.S. dollar, the government bond market, volatility, or oil prices could be the trigger that leads to one or more of these bubbles popping.
The first potential catalyst is a rising U.S. dollar. While President Trump has been outspoken about wanting a weaker dollar, the dollar usually rises when the Fed tightens monetary policy and it also rises when global trade slows.
One of the reasons a rising dollar is a potential problem is because many U.S. companies generate revenue from outside the United States. A strong dollar reduces the amount of profit generated from overseas revenue. While the major stock indices are flying high on the boost from the recent tax cuts, corporate profits are still below their 2014 high. A rising dollar could quickly cut into profit margins, which could lead to lower stock prices. Since the U.S. economy is now a function of rising stock prices, lower stock prices would likely lead to a deceleration in economic growth.
The other reason a rising dollar is a potential problem is due to a large amount of dollar-denominated debt held by foreign governments. There is $11.5 billion of known dollar-denominated debt borrowed by foreign governments who borrowed in dollars when interest rates were low. As the dollar rises in value, so does the cost to service this debt. Foreign governments get dollars by exporting goods and services to the United States. As trade slows, so does the flow of dollars.
Foreign governments are then forced to tap their dollar reserves to pay on these debts, but there isn’t enough money in foreign dollar reserves to pay it. This is how a rising dollar can lead to foreign-currency crises, which is currently happening in several countries. Should any of these foreign governments default on their dollar-denominated debts, it can have serious repercussions to the banks who lent the money. For countries who have excess dollar reserves, a rising dollar is an opportunity to invest in U.S. Treasury bonds.
Foreign central banks tend to hold large amounts of U.S. dollars because exporters receive dollars when they trade with the United States. Since exporters don’t need large amounts of dollars, they convert some of their dollars to local currency and the dollars eventually end up at the foreign central bank. Foreign central banks can hold dollars for reserves, spend them, or buy U.S. Treasury bonds.
Holding large amounts of U.S. dollars in reserves will lead to inflation so foreign central banks tend to purchase large amounts of U.S. Treasury bonds. Foreign central banks can profit by holding Treasuries from the regular dividend payment, from appreciation if interest rates fall, and from further appreciation if the U.S. dollar is rising in value. When the dollar is rising, foreign central banks tend to purchase more Treasury bonds.
The reason U.S. Treasury bonds could be a catalyst is because there is currently the largest amount of speculative short interest against Treasury bonds. Investors and speculators are betting interest rates in the United States are going to go higher and one of the best ways to profit from that is by shorting Treasuries. When the dollar rises, foreign banks tend to increase their purchase of Treasuries, which could lead to a huge short-squeeze.
As I wrote in last week’s update, when short sellers are squeezed out of their positions, they must buy the underlying security they are shorting to close out their short position. Should foreign central banks continue buying Treasuries, this could force the largest Treasury short-squeeze in history which could send Treasury bond prices to new all-time highs.
The reason this is a problem for speculators is because cash levels in brokerage accounts are at the lowest level in history. To get the money to buy Treasuries, should a short-squeeze occur, those speculators will need to sell other positions to buy Treasuries. It is highly likely speculators will sell stocks to raise cash to buy Treasuries. Should speculators begin selling stocks to buy Treasury bonds, volatility will likely spike.
In February 2017 volatility surged which led to the failure of a short-volatility Credit Suisse managed Exchange-Traded Fund. Within minutes of the market closing on that fateful day, investors in the Credit Suisse short-volatility fund lost several billion dollars. However, investors weren’t deterred by this loss and are back shorting volatility to the level they were in February 2017. The next time volatility spikes, I don’t believe the markets will be so forgiving.
Volatility is a measurement of expected future fluctuations in equity prices. For reasons beyond logical explanation, Wall Street made such products available to the public, who have poured money into them without much regard to the risks. The Fed’s Quantitative Tightening program should cause volatility to rise, as Quantitative Easing caused volatility to fall.
Just like the looming short-squeeze in Treasuries, there is likely to be a short-squeeze in volatility. When the short-squeeze in volatility occurs, speculators who are short volatility will be forced into buying volatility to hedge their losses. As volatility rises, stock prices usually fall.
With cash levels in brokerage accounts at record-low levels, speculators who are short volatility will likely need to sell stocks, which will cause volatility to rise. This will lead to a feedback loop where speculators need to sell stocks to buy volatility which will cause stocks to further fall and volatility to accelerate to the upside. While its hard to say what could make volatility rise, oil prices could be another potential catalyst for a major market shift.
Oil is a proxy for economic growth. When domestic oil inventories are falling faster than expected, it tells investors there is a growing demand for oil. When oil inventories are rising faster than expected, it tells investors demand for oil is weak and economic growth is slowing. Since the presidential election, speculators have taken the largest speculative bet in the history of oil that oil prices are going to rise. Ask any oil trader and they will tell you oil is the most manipulated market to trade.
Each week our government reports on various inventory levels for crude oil, gasoline, and distillates. While inventory levels have been falling, most people don’t realize this is a deliberate act. Large oil-company executives have been selling their company stock, which is public record, while speculators drive the price of oil higher. When the government reports on current oil inventories, it does not include the oil still below ground nor the oil being stored on tankers.
There are many oil tankers sitting outside ports throughout the world that are full of oil that doesn’t have any buyers for the oil. In addition, there are underground salt domes in Louisiana that my sources tell me are full of oil. Yet investors also look at oil as an indication of inflation, as energy prices are one of the largest components in the monthly Consumer Price Index. Speculators have used the appearance of strong oil demand as a reason to short U.S. Treasury bonds.
Should oil inventories rise, oil prices will fall and speculators should begin to exit their long positions. As oil prices fall, so do inflation expectations, along with Treasury bond yields. It is possible a drop in oil prices could kick off the largest short-squeeze in the history of Treasury market while driving oil prices down at the same time. With China set to cease purchasing U.S. crude for Iranian crude in September, it is highly likely U.S. crude inventories could rapidly rise.
I don’t know which of these catalysts will occur first, but with the Fed actively decelerating the money supply, I believe the Treasury short-squeeze or a rising dollar will be the first. My concern is that one of them will trigger a domino effect causing all of them to pop. With 85% of all stocks owned by the wealthiest 10% in our country, with 45% owned by the top 1%, it will be a race between the rich and the wealthy to see who can get out the fastest before the next Bear market hits.
Q&A with Steve – Your Questions Answered
- Thoughts from the Weekend
While the Fed’s balance sheet unwind doesn’t seem to be affecting the U.S. stock market, foreign markets saw mostly red Sunday night. Agricultural commodities jumped in Sunday night trading as rumors of forty days of rain are coming to the Midwestern growing region.
- What happened to the stock market on Monday?
U.S. markets were closed for Labor Day.
- What happened to the stock market on Tuesday?
While the stock market seems to be immune to the Fed’s Quantitative Tightening, foreign stock markets are feeling the dollar liquidity drain. After rising into the holiday weekend, U.S. equities were down slightly, but the bigger news was in the bond market.
Speculators who have been betting against the Treasury market since February are losing money as they are forced to pay the monthly dividend for shorting the Treasury market. Rather than capitulate, the speculators came out aggressively shorting the Treasury market.
Perhaps these speculators should read the Fed’s weekly H.8 report where it shows banks are adding to their Treasury positions. The big banks are backstopping the Treasury market as speculators sit on the largest short position in the history of the Treasury market.
From a technical perspective, there is a huge line in the sand at 2.8% on 10-year Treasuries. The next time yields move below 2.8%, it’s highly likely we will see the beginning of the largest short-squeeze in the history of the bond market which should send bond prices much higher.
Foreign investors are starting to buy agricultural commodities while U.S. investors continue to short. Between the hurricanes and the lack of rain, another big short-squeeze could be coming to this sector. With agricultural commodity prices some 10-20% higher outside the U.S., it’s only a matter before these short-sellers are squeezed out.
As expected, both physical gold and the gold miners headed down today. Based on the recent price action, there were signs that the sellers were going to win out. There is either going to be one more move down before buyers arrive or there is going to be a much larger move down. This is what I am watching for an entry point. The seasonality for gold and silver is upon us, so I just need to wait until a bottom is set before taking a position.
- What happened to the stock market on Wednesday?
U.S. equities started the day down and continued to move down as social media companies are testifying to Congress today. But the dip in the stock market was largely blamed on a technical issue at the New York Stock Exchange, that once resolved saw buyers coming back into the market.
In overnight trading, both Asian and European equities were down, which is an expected response from the Fed draining dollar liquidity from the global economy. So far U.S. stocks have been immune to the Fed’s liquidity drain.
Treasury yields popped up to 2.9% yesterday as short-sellers find themselves in an increasingly weak position. Yields fell in overnight trading but popped once again after U.S. markets opened. After 10-year Treasury yields tagged the bottom side of its 100-day moving average, buyers stepped in and yields fell.
The U.S. and Canada are resuming their trade talks today and a decision to add an additional $200 billion of tariffs on Chinese goods could come as early as tomorrow. President Trump is believed to enact a second round of tariffs on China with this one encompassing 50% of all Chinese imports. Unlike last time, China will not be able to directly respond to in-kind.
July’s trade deficit came in at $50.1 billion, almost $5 billion higher than the June’s revised trade deficit. China represents $36.8 billion of last month’s trade deficit, which adds further fire to President Trump’s potential announcement for further tariffs.
After the NYSE “glitch” was resolved, buyers came back into the market to push prices back up. By the end of the trading day, all major indices were in the red except the DJIA.
Treasury yields were flat on the day as sellers cannot seem to push yields much higher. I remain impressed that the speculators are so convicted about rising bond yields that they are willing to hold a losing position. Due to the ongoing costs of shorting Treasuries, it’s only a matter of time before the biggest short-squeeze in the history of the Treasury market kicks off.
API reported a smaller than expected crude oil draws with Cushing inventories slightly above expectations, and gas and distillate inventories also rising. Tomorrow morning the official government inventory reports are due.
Agricultural commodities continue to find buyers in overnight trading while U.S. investors continue to hold large short positions. Sellers couldn’t push prices down today. With a huge short position on agricultural commodities, it won’t take much for the Bulls to kick off a short-squeeze in this sector.
Gold miners continue to face a wave of selling which is likely to send the large gold mining ETF price back to its 2016 lows. Should buyers fail to materialize there, it’s likely prices of that ETF will fall to their 2015 lows, which was a huge buying opportunity back in 2015. Investors who bought at the bottom more than doubled their money in a six-month period.
- What happened to the stock market on Thursday?
Emerging Markets have officially entered a Bear market as the largest Emerging Markets ETF (symbol: EEM) is now down 20% from its peak earlier this year. Emerging markets are a proxy for market liquidity, so as emerging markets stocks fall, so should U.S. stocks.
Factory orders slid 0.8% month-over-month, which isn’t a big concern as factory data can vary from month to month. It will only be an issue if factory orders continue to slide. Germany factory orders were also down 1.0% in July on the back of a 3.9% slide in June. Germany is the fourth largest economy in the world and a major exporter, so this is a red flag.
ADP reported +163,000 jobs created in July against expectations of +200,000 jobs created – a big miss. With the official government payrolls report due tomorrow, this is a potential early warning that job growth is decelerating.
The United States has agreed to provide India with high-tech weapons in exchange to hold up U.S. sanctions against Iran. Meaning India should stop buying Iranian oil.
The market is in a risk-off mode with stocks down, volatility up and bond prices up.
The growth rate of the M2 Money Supply ticked up slightly to 4.02%, which has been decelerating since 2016. Be aware, historically when then the growth rate of the money supply falls below 3.70%, our economy experiences recessions and depressions. The recent money supply data has yet to take into account last weeks balance sheet unwind, so it’s likely we are headed toward 3.70% soon.
Stock buyers came in mid-morning in attempt to push stock prices back up and volatility down. Keep in mind, the current market is highly leveraged to the extent that stock prices must rise indefinitely. The recent trend has stocks falling in the morning and buyers coming in mid-morning. With cash levels in brokerage accounts at or near historically low levels, buyers don’t have much dry powder remaining.
Ten-year Treasury Bulls successfully defended its 100-day moving average and 10-year yields closed below their 50-day moving average. The long bond yields were also down today, closing below their 100-day moving average. With a record amount of short interest on Treasuries, falling yields puts the market closer to a massive short-squeeze. Watch for yields on 10-year Treasuries to fall below 2.80% before the short-squeeze kicks off.
Short-sellers came back in to push agricultural commodity prices down but for a change, they ran into a wall where recent buyers did not want to sell. This is a potential sign a bottom in prices may be at hand.
Physical gold tried to rally today but closed flat. The large gold miners were down slightly but are lacking any strength from buyers. I still believe there’s one move down before buyers arrive and if they don’t show up there, it’s likely large gold mining stock prices will see their 2015 lows. In my opinion, should prices fall to their 2015 lows, it will be a huge opportunity to buy. The last time this happened, gold miners returned 150% in a six-month period. We remain poised to move.
- What happened to the stock market on Friday?
The big news was the August Nonfarm Payroll report which showed a strong headline number of +201k jobs created last month. June and July’s payroll numbers were revised down -50k, which took some shine off this month’s report. The birth-death model showed 104k jobs in August were to newly self-employed, which is a statistical number created by the BLS. Adjusting for the B-D model and the prior month revisions, the August payroll report was closer to +47k jobs created.
Wage growth improved to +2.9% YoY which promptly sent Treasury yields higher. Unfortunately for Treasury Bears, rising wages does not create inflation. Despite rising wages, home sales and auto sales have been decelerating last month, which is evidence increases in wages are being eaten up by rising consumer prices.
Wall Street is now fully pricing in a September rate hike by the Fed and odds of a December rate hike increased from 60% to 70% this morning. The Fed remains behind the curve and will be forced to continue tightening.
President Trump announced this morning that he is prepared to add an additional $267 billion in tariffs on China in addition to the yet-to-be-announced $200 billion in tariffs he is expected to announce today. Stocks and Treasury yields abruptly fell on this news.
Even after President Trump said there will be unofficially $200+ billion in tariffs coming to China, the stock market barely reacted. U.S. equities closed down slightly on the day and Treasury yields rose as speculators believe higher-than-expected wage growth will lead to inflation. It won’t.
The Canada-U.S. trade talks are stalling. The U.S. is expected to send Japan a bill, but for what exactly is unknown. This isn’t expected to go well with the Japanese. Despite all the negative news, corporate share buybacks are keeping the U.S. stock market elevated compared to the rest of the world. This too will not last.
Physical gold was flat for the week and the large gold miners, while up slightly today, were down for the week. The large gold miners are looking to hold a weak resistance level going back to 2014-15, but I don’t expect it to hold. I still believe there is one more, maybe two more moves down before the bottom is in.
Agricultural commodities appear to be showing a bottom as trading volumes dropped off and short-sellers seem to have run out of interest in shorting agricultural commodities. Some buyers stepped in today, which pushed prices up a bit. If buying strength continues to build, there will be a big short-squeeze coming. The last several times the shorts have been squeezed out of the agricultural commodity space, prices have gone straight up.
Portfolio Shield™ Update –
The monthly rebalance went smoothly and the new process for routing trades through the TDA block desk is working very well. The strategy remains fully allocated to equities for the month of September.
Once the Treasury bond short-squeeze kicks off and bond prices rise, I expect Portfolio Shield™ to begin hedging with Treasuries. Look for this to happen next month.