Weekly Economic Update 09-21-2018

When Will the Stock Market Fall?

The U.S. economy is officially experiencing the second longest expansion in history and most financial experts believe the economy will continue to grow for several more years. A typical modern-day expansion runs about every eight years, but now we are fast approaching year ten, with still the weakest economic growth and most debt of any previous cycle in the history of our great country. So far this year nothing seems to be able to derail the unstoppable U.S. economy, even as the economies and stock markets of the rest of the world are stumbling.

Back in December 2016, the year-over-year growth rate of commercial and industrial loans has nearly contracted on a nationwide basis, which has always signaled a recession in the past. The Tax Cuts and Jobs Act of 2017, which was passed in December 2016, was enough to spur lending and keep the economy and the stock market from recessing. More importantly for the stock market, much of this money went into purchasing corporate share buybacks.

An estimated $1 trillion was pledged by corporations to repurchase shares of their stock in 2018. This money came from existing corporate cash flows, borrowing, and repatriating money held offshore. Arguably, American corporations didn’t need a tax cut, as, after deductions, the average American corporate tax rate is less than the average tax rate of their foreign competitors. But, and perhaps by design, corporations used the tax savings to buy back their own shares.

Corporate-share repurchases are mostly a tool for corporations to pay their executives more money. Under the Clinton Administration, executive pay was capped at $1 million. To get around that law, corporations granted their executives generous stock-option packages. To guarantee their executives a way to sell their stock, corporations, under the direction of the executive team, have repurchased large amounts of their stock. As the companies repurchase their own shares, executives have been selling their shares.

Corporations have been buying back more shares than their executives can sell, which has been keeping the U.S. stock market elevated, while foreign stocks markets continue to fall. Since the U.S. stock market seems invulnerable to all negative news, investors worldwide continue to pour money into U.S. stocks.

Globally, investors continue to buy U.S. stocks because they are still rising. Foreign stocks are falling, real estate values are flat or falling globally, and other asset classes are underperforming. Money is flowing into U.S. stocks because there is nowhere else for it go. This is like the U.S. stock market right before the Great Depression, when investors worldwide continued to buy U.S. stocks because there was no other alternative at the time. We all know how that ended.

Investors will continue to chase whatever asset class is rising until it stops rising. Once it stops rising, money will flow to the cheapest asset classes as investors look to buy low. The three least expensive asset classes, in no particular order, are agricultural commodities, U.S. Treasury bonds, and physical metals. Look for these asset classes to outperform when the cycle rotates.

At the end of August, corporations have repurchased a total of $850 billion worth of stock, which should have sent the stock market skyrocketing. Back in January and February, as the U.S. stock market peaked, the financial media was boasting about how stocks were about to experience a +50% move. Since then, stocks fell and rebounded to marginally set new all-time highs. It seems as if financial experts have overlooked the effects of the Fed’s monetary tightening.

While corporations have bought back $850 billion worth of stock, the Fed has tightened the money supply over the same period by $350 billion. The Fed has sold off $230 billion from their balance sheet and raised the Federal Funds rate twice, which has the equivalent effect of removing $120 billion from the money supply.

The reason we have not experienced a blow-off top in the stock market is due to the Federal Reserve tightening monetary policy. Taking a simple ratio of the reduction in the money supply ($350b) by the amount of corporate share buybacks ($850b), we get 0.41. This is the ratio that needs to be maintained to keep the stock market up.

The reason this ratio makes sense is because asset prices in our country are a function of how much money is in the system. As more money comes in, asset prices rise. This is why the Fed’s Quantitative Easing caused asset prices to rise, because money entered the system, even though it was largely held as excess reserves by the banks.

Through August, corporations averaged $106.25 billion per month in share buybacks, leaving $150 billion to be repurchased by year’s end. Should corporations continue buying at the same pace, which I believe they will, this will leave less than $50 billion in the last three months of the year. Meanwhile, the Fed is set to accelerate monetary tightening.

The Fed plans to unwind $40 billion in September and increase the amount to $50 billion per month starting in October. The Fed is expected to raise the Federal Funds rate at the end of September by 0.25%, which will remove $60 billion from the money supply. Not factoring in another potential hike in the Federal Funds rate in December, the Fed is set to reduce the money supply by $250 billion. Add in the potential December rate hike and the amount increases to $310 billion.

Using the monetary-tightening-to-share-buyback ratio, the number jumps to 1.67 ($250b / $150b = 1.67). This ratio suggests the Fed’s monetary tightening will overwhelm the amount of share buybacks through the end of the year. My expectation is that the stock market will be unable to continue rising against the Fed’s aggressive tightening.

In the last week of September, the Fed is expected to raise the Federal Funds rate and unwind $35 billion from their balance sheet. In the same week, several auctions by the U.S. Treasury have been scheduled, and while the exact amount is unknown, it is expected to be one of the largest weekly auctions in the history of the U.S. Treasury. When the U.S. Treasury borrows money, it also has the effect of tightening, or reducing liquidity, in the financial system.

In 2019, corporations have pledged to repurchase $700 billion of stock. The Fed, assuming no increases in the Federal Funds rate, will unwind $600 billion from their balance sheet. The ratio will fall to 0.85 in 2019, but still be well above the 0.41 level that has been keeping the stock market at elevated levels.

The Fed’s fingerprints have been all over every expansion and contraction since their inception in 1913. After years of easy-monetary policy, a tightening cycle always leads to a recession. Most financial experts predict the next recession will occur in late 2020 or early 2021 when the Federal Funds rate is predicted to be between 3-3.50%. None of these financial experts are considering the Fed’s balance sheet unwind.

When factoring the Fed’s balance sheet unwind, by the end of August, the effective Federal Funds was 2.96%. By the end of September, it will be 3.38%. Assuming no further increases in the Federal Funds rate, by the end of December, the effective rate will be 4.00%. This trend will continue until the end of 2019, where the effective Federal Funds rate will be 6.50% from just the Fed’s balance sheet unwind alone.

Based on the Fed’s path towards tightening monetary policy, the stock market should start to fall going into the fourth quarter. While there may be a short rally in 2019 as corporate share buybacks resume, corporations will need to pledge more than $1.5 trillion in buybacks to offset the Fed’s tightening.

While most investors are positioned for the stock market to continue rising for the next two to three years, those who understand how the Fed’s tightening works, realize the stock market could start to fall as soon as next month.

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Daily Market Briefs

  1. Thoughts from the Weekend


  1. What happened to the stock market on Monday?

Stock prices opened lower this morning as the mainstream media indicated the early move down was due to concerns over an additional round of tariffs against China. While the U.S. stock market is near its all-time highs, China’s stock market is at its lowest level since 2014. Today’s move down has nothing to do with tariffs.

The main reason the Chinese stock market is back at 2014 levels is due to the Fed’s monetary tightening. The Fed’s balance sheet is also back at 2014 levels, which shows just how much power the Fed has over global asset prices.

Treasury yields jumped higher at market open following news on Friday that speculators have increased their short position on Treasury bonds. Higher yields were promptly rejected, which sent 10-year Treasury yields back under the key resistance level of 3%. The next move for Treasury yields should be a retest of 2.8%.

Despite falling global crop production and yields, U.S. speculators continue to short agricultural commodities. Lower agricultural commodity prices have allowed longer-term investors to buy up future deliveries at rock bottom prices.

American farmers have largely been exempted from falling production and yields for now. As weather conditions change, so to will domestic production and yields. Looking forward, a bumper U.S. crop could be a strong bargaining chip for the Trump Administration as they continue to attempt to renegotiate our existing trade deals.

After months of ignoring President Trump’s intent to escalate the trade war, stocks finally reacted as President Trump is expected to enact an additional $200 billion of tariffs later today.

Treasury yields fell most of the day and for the fifth time in the past nine months, 10-year Treasury yields closed below 3%. It is more likely yields will retest 2.8% than breakout above 3.1%, despite the heavy short position.

Physical gold continues to hover around the $1,200/oz level while gold miners have underperformed. A large Vanguard gold mining fund is set to close and is still liquidating its mining stocks, which is putting downward pressure on the miners. I am looking for a rebound once the selling has ended.

Agricultural commodities continue to find buyers at these low levels despite global weather events, reduced production, and reduced yields. About every ten-to-twelve years, agricultural commodity prices rise as the sunspot cycle declines. We are on the cusp of that sunspot cycle right now, and if not for the heave short positioning, prices would be much higher.

  1. What happened to the stock market on Tuesday?

Chinese stocks jumped as President Trump’s next round of tariffs were only at a 10% rate instead of the initial 25% rate. The full text of the tariffs is below. U.S. equities also jumped in early trading on news that China will be responding with $60 billion of tariffs in the 5-10% range on August 24th. This too is less than expected, but perhaps investors failed to understand that President Trump will escalate the tariffs if China responds. Next week should be interesting.

Ten-year Treasury yields continue to move higher on weak volume as short-sellers believe American consumers can afford both higher consumer prices from tariffs and higher yields. For the moment this move appears to be purely technical in nature, as yields are reconfirming their high set back in April. Thirty-year Treasuries hit the top end of their supply zone, which goes back two years in length, which again, suggests the recent rise in yields is a technical move between large traders.

From the Office of the President of the United States: Today, following seven weeks of public notice, hearings, and extensive opportunities for comment, I directed the United States Trade Representative (USTR) to proceed with placing additional tariffs on roughly $200 billion of imports from China. The tariffs will take effect on September 24, 2018, and be set at a level of 10 percent until the end of the year. On January 1 the tariffs will rise to 25 percent. Further, if China takes retaliatory action against our farmers or other industries, we will immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.

Just when I thought the stock market was coming to its senses about the escalation of the trade war, the news reported that the stock market rose today on easing trade tensions. The U.S. is set to impose more tariffs on Monday and China is going to respond with more tariffs on Monday. If President Trump holds true to his words, there could be further escalations soon. Tariffs are nothing more than a stealth tax on American consumers.

Treasury short-sellers came in strong as buyers disappeared. Short-term yields are rapidly rising as the Fed is expected to raise the Federal Funds rate. To keep the yield curve from inverting, which is when short-term are higher than long-term yields, speculators continue to try to push yields higher.

From a technical perspective, there is a “gap” in 10-year Treasury yields at 3.058% set back in May. Ten-year Treasury yields closed today at 3.056% on light volume, indicating the recent buyers haven’t turned into sellers. Buyers want to buy at the lowest possible price and sellers want to sell at the highest possible price. When buyers see strong demand from sellers wanting to push prices down, they tend to allow prices to fall. Buyers don’t want to see previous buyers turn into sellers, so I expect buyers to arrive soon. Trading volumes increased on Treasuries going into the close as yields fell, which is indication buyers were waiting to buy.

It’s important to understand in a fiat money system, which we have, that monetary decelerations always lead to lower bond yields. Remove the speculative positioning from the short-sellers, and Treasury yields would likely be half what they are now. Save this thought for when the big Treasury short-squeeze comes.

  1. What happened to the stock market on Wednesday?

Today belonged to the Dow Jones Industrial Average, which cleaned up a “gap” from late January. Markets tend to leave a gap or two between the opening and closing prices, but this market has been meticulously cleaning up after itself. Bulls are looking to drive the market higher, while Bears are looking to the Fed’s continued tightening to bring stock prices down.

Treasury yields have been on a relentless tear to the upside lately and both 10- and 30-year yields closed gaps that formed back in late May. The only rational explanation for this recent rise in yields is the possibility that insurers are raising cash to pay claims from the damage caused by hurricane Florence. Insurers generally hold excess cash in the form of U.S. Treasuries, which they sell when they need cash. With a record short position on Treasuries, that is likely even shorter now, yields had only one direction to go – up.

Ten-year Treasury yields are back at their seven-year highs, while 30-year Treasury yields are at their four-year high. Since most bond investors are long-term investors, it is unlikely these former buyers will look to sell any time soon. As it stands, investors seven years ago and four years ago respectively, have received their dividend payments without any gain or loss to their principal. Their investment in Treasuries has been working as expected.

For those worried bond prices are about to collapse, keep in mind, 10-year Treasury yields are at their seven-year high and 30-year yields are at their four-year highs while speculators are at their shortest speculative position in history. If the speculators can’t get yields to press higher now, then it seems unlikely they are going higher. Plus, as the Fed tightens, history shows yields fall, which suggest the biggest short-squeeze in history is coming to the Treasury market. Should a short-squeeze occur, yields are going down further and faster than most believe.

  1. What happened to the stock market on Thursday?

Who is buying stocks at their all-time highs? Corporations. Margin debt growth has dramatically slowed due to higher interest rates. Retail and foreign fund flows have also slowed significantly. Corporations continue to repurchase their stock to allow their executives to cash in on their lucrative stock options. When the last marginal buyers are corporations, investors should consider how they are going to sell when corporations stop buying their shares back.

Treasury yields continued higher this morning as the number of initial jobless claims hit their lowest level since 1969. Yields then quickly fell as existing home sales remained flat for August, while as prices and inventory levels rose. Clearly higher interest rates are affecting home sales.

Every morning at 5 a.m. PST someone has been selling Treasury bonds to drive yields higher. It is unknown who is doing this or why, but there isn’t typically any economic data released at this time to cause yields to rise. Today’s reopening of a prior 10-year Treasury TIPS auction saw a very strong foreign demand, despite continued claims foreigners are no longer interested in holding U.S. debt.

Monday’s 2-year Treasury Note auction has a huge $19 billion of Fed-held bonds maturing. Tuesday’s 5-year Treasury Note auction also has a huge $19 billion of Fed-held bonds maturing. Not to be outdone, Thursday’s 7-year Treasury Note auction has a huge $19 billion of Fed-held bonds maturing. As bonds roll off the Fed’s balance sheet, liquidity will be drained from the financial system. This liquidity drain doesn’t include the 0.25% expected increase in the Federal Funds rate that will be announced at the press conference following the FOMC meeting next week.

Keep in mind, as the Fed unwinds and tightens monetary policy, Treasury yields should fall. Perhaps the recent rise in yields was to coerce short-sellers into selling more bonds to the smart money.

Both the S&P 500 and DJIA set new all-time highs today ahead of tomorrow’s quadruple witching day, where options and other speculative securities expire, along with a change in the sectors weightings for the S&P 500. Look for the markets to ‘gap’ down and volatility to increase tomorrow.

Ten-year Treasury yields were flat and 30-year Treasury yields fell. Knowing tomorrow is quadruple witching day, it is possible speculators were forced to short Treasury bonds lower to profit on their expiring options contracts.

Physical gold made a week attempt at trying to touch its overhead 50-day moving average but didn’t. The gold miners keep finding buyers, but sellers remain aggressive at keeping prices from rising.

Agricultural commodities started seeing increased volume, which caused prices to rise. Buyers have been coming in at the dips for over a year now, and this recent three-month consolidation near the all-time lows is an indication that sellers may be exhausted and unable to drive prices lower. Given the agricultural commodity, super-cycle is near, prices should start moving higher soon.

The growth rate M2 Money Supply fell back to 3.90% this week and remains 0.20% above the fifth quintile for the money supply. When the growth rate of the money supply falls below 3.70%, the economy has an extremely high probability of entering a recession, or worse, depression. As the Fed continues to unwind its balance sheet, the growth rate of the money supply should continue decelerating.

The Fed’s balance sheet fell this week by $2 billion. Next week the Fed is scheduled to unwind $57 billion across three auctions. It is unknown how much of it will be reinvested, but to stay on schedule for September, $33 billion needs to be unwound. Starting in October, the Fed will increase its unwind to $50 billion per month.

  1. What happened to the stock market on Friday?

Quadruple witching day is here as options and futures contracts expire, along with a planned adjustment to the weightings of the S&P 500. Normally volatility rises on quadruple witching days, but so far, the market is digesting the expirations and adjustments without any large moves.

Stocks were down slightly for the day and despite quadruple witching day, volatility remained muted. Treasury yields were flat but have seen buyers coming in the last few days as evidenced by higher trading volumes.

Physical gold started the day down as a very large amount of gold was dumped in early trading. The gold and silver miners reacted accordingly and were both down for the day. As hard as the gold Bulls are trying, the gold Bears continue to have the upper hand. With buyers continuing to come in, it suggests there may be one move down before a bottom is found.

Agricultural commodities were flat on the day, even as the news reports heavy crop damage in the Carolinas. The longer prices hold, the more likely prices are to rise.

Increased tariffs against China go into effect on Monday.