Asset Prices are Starting to Fall and It’s Not a Good Thing
Asset prices, including stocks and real estate, are starting to lose value at a time when most investors are completely convinced asset prices are headed higher for another decade or more. The reason asset prices are starting to fall is that the relief valves on our monetary system are being prevented from releasing the mounting pressure.
Our monetary system is not well understood by most people since it is not taught in schools and it is marginally taught in most undergraduate economics courses. What I find interesting about our monetary system is that it will attempt to rebalance itself when imbalances are created. The current imbalance is causing asset prices to fall.
There are two primary relief valves for our monetary system – interest rates and the U.S. dollar. When they fail, or are being prevented from functioning as we are experiencing now, asset prices begin to fall to relieve the economy of mounting financial pressures. In one form or another, our monetary system will rebalance even if the primary systems fail.
U.S. Treasury bond yields, or interest rates, are the first release valve for our monetary system. When financial conditions tighten, as they are currently, interest rates fall to relieve pressure. Tight financial conditions are expressed as a reduction or a deceleration in the money supply. The money supply has been decelerating since 2016, which indicates financial conditions are tightening.
The late famed-economist Milton Friedman, who created the best model for how interest rates function, showed that tight financial conditions lead to lower interest rates. Based on 120 years of money supply and interest rate history, periods where the money supply is decelerating or contracting led to lower long-term interest rates. Why? It has a lot to do with how money is created in our economy.
Money is created when money is borrowed from a bank, who can leverage deposits up to nine times, allowing a bank to create money from thin air. Under periods of tight financial conditions, lower interest rates should lead to increased borrowing. As more money is borrowed, money enters the economy to alleviate the tight financial conditions created by an insufficient amount of dollars.
While Professor Friedman’s research is correct, interest rates have been rising as financial conditions tighten. Facts aside, since President Trump took office, investors have been convinced money-printing inflation is about to rear its ugly head.
History has shown interest rates rise to counteract money-printing inflation. In response to this accurate view, investors and speculators have taken the largest bet in history that interest rates will rise in hopes to generate a profit. Today they appear to be correct, but history will eventually prove them wrong as higher interest rates are causing further monetary tightening.
When interest rates are not allowed to fall, as they are now, the U.S. dollar acts as a secondary monetary relief valve. A rising, or strong dollar, also causes further monetary tightening. When the dollar is strong, those who own dollars tend to hold on to them, and those who want dollars, usually pay more to get them. Following President Trump’s victory, the dollar fell in value as investors believed President Trump’s policies would lead to a weaker dollar, even though Presidents have little control of the value of the dollar.
When comparing the monetary base to the U.S. dollar, the value of the dollar increased as the Fed implemented Quantitative Easing 1. In between Quantitative Easing’s, the dollar fell and resumed its ascent during QE 2-3. Both the dollar and long-term interest rates rose during QE 1-3 as the monetary system tried to counteract the Fed’s pumping of the monetary base. As the dollar rose in value in response to the Fed, it took more real assets, or foreign currencies, to buy a dollar.
In early 2018 the dollar started rising in value again as the Fed has been actively shrinking the monetary base. Investors and speculators are bidding up the price of the dollar, which is further tightening our monetary system. In the past, the dollar has appreciated going into recessions as investors perceive the dollar as a safe haven. The Fed has never contracted the monetary base before, so it is unknown if the dollar will continue to rise or if it will fall as the monetary base falls.
Currently, both monetary relief valves are being blocked from releasing pressure from tighter financial conditions, which is causing asset prices to fall. Normally falling asset prices, such as stocks and real estate, are not a big deal. Should a stock or home lose 10% of their value, it’s fine, unless there is a significant amount of leverage underneath. When consumers, investors, and businesses have borrowed heavily on their assets that could eventually fall in value, financial crises occur.
The last two recessions are perfect examples of asset prices falling to relieve the pressure from our monetary system. Following the bursting of the dot-com bubble, the tech-heavy Nasdaq-100 fell -80%, the S&P 500 fell -50%, and the Russell 2000 fell -47%. After yields rose into the peak of the bubble, ten-year Treasury yields fell from 6.8% to 2.9%, which generated a huge return for bond investors. The dollar also rapidly rose during 2000-2002 before it nosedived into the next recession, where it once again rose as a safe haven.
When examining the mortgage bubble, Treasury yields rose and the dollar fell as the Great Financial Crisis hit, before both reversed directions. Just like with the dot-com bubble, asset prices were obliterated. The Nasdaq-100 only fell -52%, the S&P 500 fell -57%, the Russell 2000 -60% and housing values fell -40%. Ten-year Treasury yields also fell from 5.3% to 2.0%, generating bond investors a healthy +25% return as the dollar also rose in value.
When the normal monetary relief valves fail, asset prices must fall to take pressure off the monetary system. The evidence the monetary system is being starved of money can be found in the M2 Money Supply data. On a year-over-year basis, the M2 Money Supply is currently growing at 3.85%, compared to its long-term average of 6.6%. Looking back to the early 1980’s, when money-printing inflation was a problem, the M2 Money Supply was growing at 12%+ on a year-over-year basis. The M2 Money Supply data confirms the economy is not generating enough money to maintain asset prices.
To alleviate the pressure from a lack of dollars, the monetary system needs either a weaker dollar, lower interest rates, or both. With investors and speculators trying to drive up both the price of the dollar and interest rates, they are increasing the pressure on the monetary system. Instead of allowing the monetary system to self-regulate, asset prices have been starting to fall for the past month with no signs of an imminent recovery. Financial conditions are rapidly tightening and the monetary relief valves are being blocked, which means asset prices must adjust downward to allow the monetary system to adjust to the lack of dollars.
The problem with falling asset prices is the debt lurking beneath. The drop in stock prices during the dot-com bubble wasn’t the problem, but the record margin debt underneath forced investors to continuously sell into a falling stock market. The same happened during the mortgage bubble as homeowners were forced to sell at lower prices or outright default to cover the debt on their homes. With record debt levels across the economy and margin debt two-and-a-half times larger than the record set during the dot-com bubble, a drop in asset prices could cause stocks and asset prices to crash.
Investors hoping for economic relief from the Federal Reserve are likely to be disappointed. The Fed is continuing to unwind their balance sheet by destroying $50 billion per month and based on the latest Nonfarm payrolls report, will likely increase the Federal Funds rate by +0.25% during their December meeting. A rising Federal Funds rate and further money destruction will only exasperate the pressure on the monetary system.
Once again, our economy finds itself at the same place as it did prior to the past two recessions, except few people have learned from the past. Wall Street has convinced investors that stock prices and interest rates will indefinitely rise, even if there is a recession. Yet the laws regarding our monetary policies and system haven’t changed since the past two recessions, which suggests that asset prices and interest rates will both fall during the next recession, as they always have.
Those who understand how the monetary system works and have been buying Treasury bonds must continue to be patient as their payday is coming. The “Smart Money” and the large banks are both buying Treasuries as well, as they also know a massive recession is approaching that will cause interest rates to plummet to new all-time lows.
The opportunity will be with those aren’t gambling on the stock market, but are taking the more prudent approach in the bond market. When stock prices fall during the next recession, most investors will do what they always have done – sell near the bottom.
Inevitably, those same stock investors will be buying Treasury bonds at the peak of the bond market, as existing bond investors happily cash in on their bond investments. Those who cash in on their bonds will have an unprecedented opportunity to buy stocks at what will likely be one of the cheapest valuations in history.
The next cycle in stocks is likely to be the next real Bull market that should last for more than a decade. For those who have cash or appreciated assets, such as Treasury bonds, they will have the opportunity to ride the next cycle in stocks all the way to the top. Just like the race between the tortoise and the hare, sometimes the conservative path has the biggest payoff.
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Daily Market Briefs
- Thoughts from the Weekend
There was an interesting discussion on FinTwit this weekend about how the BLS has been overestimating the number of new jobs created. Every February the BLS adjusts the previous year’s numbers based on the actual payroll tax withholding data. One expert who knew how the BLS makes this calculation felt there would be significant downward adjustments for 2018.
Even though the tax cut reduced tax withholdings, this expert said the numbers didn’t add up and will need to be revised down. Both personal and corporate tax withholdings have contracted on a year-over-year basis, which generally signals we are or are about to enter a recession. It doesn’t make sense that with unemployment near historic lows that tax withholdings would be contracting.
Bank of America Merrill Lynch GIS division posted a chart showing the recent positive correlation between the S&P 500 and 30-year Treasury bonds. Normally the two are inversely correlated, but lately, they have been positively correlated. The last time there was a positive correlation was just before the Great Financial Crisis of 2008-09. Look for my upcoming Friday update that will explain why higher interest rates during tight financial conditions lead to a recession.
JPMorgan reported that corporate cash repatriations, which have been used to fund corporate share buybacks, are slowing considerably. The report also noted that corporate share buyback announcements for the remainder of the year have fallen below $50 billion per month. As I previously talked about, with the Fed destroying $50 billion per month starting in October, there won’t be enough corporate share buybacks to drive the stock prices higher. The report didn’t include October’s data yet, but if last month’s drop in stock prices is an indication, it appears the corporate share buyback machine will no longer be able to support stock prices.
- What happened to the stock market on Monday?
Asian equities started the trading week down as China’s Caixin Composite PMI (factory survey) fell to its lowest level since February 2016, when the factory survey was on the edge of contraction. This is an indication we are winning the “trade war,” and also a sign that the Fed’s monetary tightening is affecting the global monetary system.
European and U.S. equities shrugged off the Asian routing as both markets attempted to move higher in early trading. Over the weekend investors were quick to point out how this week’s $83 billion in debt issuance by the U.S. Treasury will not find any buyers. Foreign investors have shied away from shorter-term Treasuries but have been strong buyers of longer-dated maturity bonds. Foreign investors know there is a global slowdown occurring and the best way to hedge that is through long-maturity bonds.
The Markit Manufacturing survey moved slightly higher while the broader ISM Manufacturing survey moved slightly lower. Both services PMIs were higher, indicated the service sector is more optimistic than the manufacturing sector.
Foreign bidders took an above-average 49% of today’s 3-year Treasury auction and domestic bidders took a mere 3% auction, leaving 48% to the securities dealers. Domestic investors continue to step back from shorter-term Treasury auctions as the Fed continues to commit to further rate hikes.
The stock market moved higher, but trading volumes were 20% less than average. The big traders were quiet going into tomorrows midterm elections. Ten-year Treasury yields moved down in overnight trading but ticked up slightly as stocks rose. Yields still closed lower on the day.
Physical gold was down a smidge and the gold miners were rather volatile all day but closed lower. Agricultural commodities tried to move higher but ran into sellers. As sellers continue to exhaust themselves, buyers will drive prices higher.
Corporations have spent $7 trillion on dividends and corporate share buybacks, representing 40% of the gains in the S&P 500 since the Great Financial Crisis. In addition, corporations have added $2 trillion of debt to their balance sheets, which will become a problem during the next recession.
- What happened to the stock market on Tuesday?
Trading volumes collapsed today as large money managers and traders wait for the election results. Retail investors continue to bid stocks higher based on all the articles showing how stocks tend to rally following midterm elections. While I haven’t had time to go back and look through the data points, I’m guessing not many of those post-midterm rallies were during a Fed rate hike cycle. Look for the large traders to sell against the recent buying by the public.
For all the investors who have said interest rates are going straight up and that foreign investors are shunning Treasuries, today’s 10-year Treasury auction saw 73.8% of the $27 billion tendered go to foreign bidders, which is a record high. Clearly, foreign central banks and investors are seeing something domestic investors aren’t.
Tomorrow the U.S. Treasury is auctioning off 30-year bonds, which will likely show strong foreign demand. Even though investors kept trying to press yields higher today, strong foreign demand will bring yields down.
Physical gold sold off a bit today as sellers remain strong at $1,240/oz and buyers remain strong below $1,200/oz. Knowing where the buyers and sellers are at is helpful when determining an entry point.
The major indices ended the day higher, but with trading volumes so low due to the midterms, today’s price action doesn’t offer any clues for what may come as the election results come in. Ten- and 30-year Treasury yields were slightly higher on the day. API reported a large build in crude inventories, which has sent oil prices down in after-hours trading. Since rising oil prices have been the excuse for rising bond yields, bond yields should follow suit. If you want to know what the markets think of the outcome of the election, keep an eye on the futures market tonight.
- What happened to the stock market on Wednesday?
With the election behind us, stock market Bulls shot the market up in early trading and are hoping for a big rally to take stock prices to new all-time highs. Stocks may not rally for the reason most people think. Hedge-fund managers and most active managers have performed poorly for the past two years. Hedge fund managers have done particularly bad this year, with some down double-digits, which may force them to play chase against retail investors who bought in ahead of the election.
Interest rates were down as the supply of unsold homes has reached their highest level since 2011, while mortgage applications have tumbled back to their 18-year lows. Clearly higher interest rates are not a function of inflation, otherwise, home buyers would be able to afford higher prices and higher mortgage rates. Yields will eventually fall.
The EIA reported crude and gasoline inventories rose more than expected. With oil production rising and demand falling, this is an indication of a slower global economy. Since interest rates have been coupled with oil prices for the past two years, this indicates Treasury yields should be falling. Oil prices fell after the report.
Today’s 30-year Treasury auction didn’t see as much demand as yesterday’s 10-year Treasury auction. Domestic bidders have disappeared with no comment from the U.S. Treasury to what is going on. Foreign bidders took a healthy 59.1% of the auction, which left nearly the rest to the dealers. As dealers take on more bonds, look for yields to fall so they can unload their inventory.
Stocks finished strong, but trading volumes were -35% below their 20-day average. This is not a sign the big money is moving back in. This indicates buyers are willing to pay any price to get in and the sellers are making them pay a huge premium.
Treasury yields were flat on the day, even though there has been strong foreign buying of Treasuries this week. A report came out late yesterday showing pension funds were big buyers of Treasuries in October. So far, all the claims that nobody wants to buy Treasuries are false.
Physical gold was flat, and the gold miners were down slightly. Agricultural commodities were a smidge higher on the day as buyers overcame sellers. This sector remains very close to a technical breakout to the upside.
- What happened to the stock market on Thursday?
The global economy continues to slow down as Japanese Machine Orders slumped -13.8% MoM, the largest monthly drop in more than two decades. Chinese automobile sales also fell double digits last month, indicating slowing consumer demand. Despite slower global growth, U.S. investors eagerly tried to bid up stock prices and bond yields as if our economy is immune to the rest of the world. It isn’t.
Trading volumes over the past week and a half have been very low, indicating the “Smart Money” and large money managers aren’t buying. Traders were counting on the big money to return to the market, but without them, it is more likely stock prices will revisit their October lows.
While I thought the Fed was meeting this month, it turns out they were just releasing their minutes from last month. Investors were hoping to read signs that the Fed is going to slow down the pace of tightening, but there were no such indications. There was nothing new in this report to indicate that the Fed is going to stop tightening monetary policy.
The probabilities are high that the Fed will raise the Federal Funds rate at the December meeting which concludes with a press conference on the 19th. As expected, stock prices and bond yields fell after the report.
I watched an interesting report on Treasury yields from a technical trader. I expected him to indicate that yields were going higher, but I was surprised when he said yields were headed lower. As I have pointed out, he too indicated that bank stock prices have been falling which usually means Treasury yields will fall as well. He also pointed out that momentum has not confirmed the recent peak, which is another indicator yields are likely to fall.
As I have mentioned, the “Smart Money” or Commercial Hedgers have been buying Treasuries. He pointed out that the “Smart Money” has taken the largest long position in Treasuries across 2-, 5-, 10-, and 30-year Treasuries. As he said, and I have as well, the “Smart Money” wouldn’t take such a large position if Treasury yields were going to continue rising.
He said to look for a break of 3% on 10-year Treasury yields to trigger the next bond Bull market. The only part of his presentation I disagreed with was his opinion that Treasury bonds would rise +10%. I believe they will go much higher.
Agricultural commodities sold down to their 100-day moving average and immediately found strong buying support. Repeated confirmations of a moving average are considered bullish.
In the minutes following the Fed minutes, stocks fell, and bonds rose. This is the proper move based on a tightening money supply. The computer algorithms reversed direction and tried to move stock prices higher and bond prices lower.
While this doesn’t make sense, the computer algorithms only know a post-Great Financial Crisis market, where stocks rise, and bonds fall. They are misinterpreting rising short-term interest rates to be the same as rising long-term interest rates. While they are trying to push yields higher, they are causing stock prices to fall as higher interest rates put downward pressure on asset prices – I will cover this in my Friday update.
Stocks closed slightly lower for the day, except for the DJIA which was up slightly. 10-Treasury yields where higher and are now staring at a double-top from their October highs. Meanwhile, 30-year Treasury yields were only up slightly. Equity trading volumes were lower than yesterday as the big money remains absent from the market. Defensive stocks continue to fall, which are highly correlated with Treasury yields, suggesting that 10-year Treasuries should be at 2.5%.
Physical gold held its 100-day moving average and needs to break over $1,240/oz with strong volume to show any signs of life. The gold and silver mining stocks were mixed on the day.
The growth rate of the M2 Money Supply fell slightly from 3.85% to 3.83%, just over the danger zone of 3.70% where recessions and depressions are prevalent. The back end of the data keeps falling, meaning the growth rate isn’t slowing as fast, but it’s on a smaller amount from one-year ago.
- What happened to the stock market on Friday?
Stocks headed down in early trading following strong a strong Produce Price Index report showing producer prices increased +0.6% MoM and +2.9% YoY. Probabilities of a December 2018 Fed rate hike are now at 80% and will likely rise going into December. The tighter monetary policy is, the worse it is for asset prices.
Peter Navarro, one of President Trump’s key China advisors, said this morning there wasn’t any prospect of a deal with China at this time. Stocks didn’t like this news either, as it indicates the meeting between President’s Trump and Xi will not lead to any breakthroughs.
Oil continues to fall on supply concerns and is now officially in a Bear market, which is anytime a security falls -20% from its peak. With a lot of jobs tied to the oil industry, this is not good news. Falling oil prices will dash inflation expectations, bring the ISM factory surveys down and cause industrial production to fall. Look for bond yields to fall in response.
The latest University of Michigan Buying Conditions survey showed consumer demand for housing and vehicles falling to 2013 levels with large durable goods holding steady. This is not good news for the real estate or automobiles industries which are already experiencing a slowdown.
While the broad market was down for the day, buyers came in to defend the S&P 500 at its 200-day moving average and the DJIA at its 50-day moving average. The Nasdaq-100 and Russell 2000 both remain below their respective 200-DMAs. In a Bull market the 200-DMA is a sign of support, but October’s drop was well below what is normal in a rising market. Until the stock market makes new all-time highs, investors should be cautious about buying any dips.
After revisiting their long-term resistance level, which I will show in today’s video, Treasury yields reversed direction and moved lower. They didn’t move enough to push any of the recent short-sellers out, but the price action was constructive that a Treasury rally could start in a near future.
Physical gold fared poorly as it crashed through its 50-day moving average but found buyers just over $1,200/oz. Buyers have been hanging out between $1,180-1,200/oz, an area of price support. As expected, the gold miners fell but held their 50-DMA. Silver miners are not far off their 6-month low. Technical chartists suggested today prices are likely to head a bit lower.
Agricultural commodities fell to their 50-day moving average, which is right below their 100-DMA and held. Bull markets begin with a cross of the 50-DMA and are confirmed by prices repeatedly holding their 50-DMA. A slight dip below doesn’t change the picture much in my opinion, but it is nice to see the Bulls defending the moving averages. Based on the chart, the Bulls need to fight hard into next week to complete a symmetrical chart pattern that is likely to lead to a breakout to the upside.