Looking back to the early 1900s, stock prices from peak to trough fall -68% on average and take twenty-three years, on average, to recover their Bear-market losses. For most retirees in their mid-sixties, losing more than half their money is a recipe for financial disaster. Tacking on an additional twenty years to recover, assuming no withdrawals, makes the next recession the worst one for retirees. Yet the data shows most investors are bullish on stocks, while the “Smart Money” remains bearish on stocks and the broad economy.
It may seem odd that the “Smart Money” is not as enthusiastic about the global economy as everyone else, but it is important to understand that every Federal Reserve monetary-tightening cycle leads to a recession. It is an inevitable fact of the design of our monetary system since asset prices are directly correlated to interest rates. Rising asset prices lead to increased lending, which propels our debt-based economy forward. When asset prices fall, lending demand falls along with the growth rate of the money supply, which is how recessions occur.
It is entirely possible the Fed’s monetary magic has finally eliminated the business and credit cycles, but it is highly unlikely. The “Smart Money” sees parallels between the 2007 stock market peak and today. Back in 2007, the housing market was driving the economy and stock market. Today, corporate earnings are driving the economy and stock market. Rising interest rates destroyed the housing market in 2007 when the collapse in the housing market flung the broad economy into a recession.
The economic data today is dismal, yet investors continue to ignore it just like they did back in 2007. There is a simple reason – in 2007, everyone believed that the housing market would never stop rising. Today, everyone believes the stock market will never stop rising and as a result, drive the economy upwards for decades to come. Just like housing prices could not keep rising against the Fed raising interest rates in 2007, corporate profits and the stock market can’t continue rising since the Fed raised interest rates.
There’s a secret that not many people know about the stock market and the bond market. It is this secret that makes my Portfolio Shield™ strategy work and as long as the dynamic between the stock and bond market continues in this fashion, Portfolio Shield™ will always reduce risk ahead of stock market declines. The strategy was not designed to make money in Bear markets, but to reduce risk. Making money in Bear markets is something that eludes most investors, but not the “Smart Money.”
On average, U.S. Treasury bond yields peak seven months ahead of the broad stock market. Ten-year Treasury yields peaked in October 2018. The S&P 500 recently peaked in April, which is exactly seven months apart.
This relationship between the stock market and Treasury yields is how the “Smart Money” knows when it is time to get out of stocks. The “Smart Money” starts buying bonds a year or two ahead of a recession, while they dump their stocks onto the unsuspecting public who by this point, cannot seem to get enough stocks in their portfolio. Rather than chase the stock market higher, investors would be wise to study the positioning of the “Smart Money” and invest alongside them.
Each week the “Smart Money,” Hedge-Fund managers, and other speculators are required to report their positions which are published in the Commitment of Traders (CoT) report. While the report reflects their positions as of the prior week, it does shed light on how they are positioned. The most recent report showed the “Smart Money” was short stocks, long U.S. Treasury bonds, long volatility and short the U.S. Dollar, which is an overall bearish picture for the U.S. economy.
The reason the “Smart Money” has chosen to bet against the masses is that the smart money understands for every action the Federal Reserve takes, there is an equal and opposite reaction to the broad economy. Since December 2015 until December 2018, the Fed raised short-term interest rates. From October 2017 to October 2019, the Fed will have sold off a portion of its U.S. Treasury bond holdings and Mortgage-Backed Securities, which has never been done by a central bank. If the intended purpose and result of lowering interest rates and buying bonds was to inflate asset prices, then raising interest rates and selling bonds will deflate asset prices.
Even though the full brunt of the Fed’s monetary tightening has not hit the broad economy, when it does, asset prices will fall just like they did back in 2000-02 and 2008-09. Unlike most investors, professionals or otherwise, the “Smart Money” knows at some point the lagging effect of the Fed’s tightening will kick in. Even though the lagging effects are evident in the housing market and have been showing up in the global economic data, the stock market will not fall until the “Smart Money” has sold off all their risk assets to the unsuspecting public who once again, believes stocks are going to rise for the next decade or longer.
While currencies are difficult to trade, as they can fluctuate for a myriad of reasons, the relative value of the U.S. Dollar has far-reaching implications to our economy and asset classes. Rather than look at each position the “Smart Money” is holding, by focusing on their belief the dollar will fall in value, their other positions will make sense.
The consensus view among investors, analysts, and economists are that the U.S. Dollar is going to fall in value. The two reasons this opinion is held is due to the amount of dollar-denominated debt in the global economy and past market cycles where the dollar appreciated in value as the U.S. economy slipped into a recession. Unfortunately, none of those views are overly accurate, as the appreciation or depreciation of the dollar can be tied to three other economic data points.
The dollar is sensitive to the change in inflation-adjusted U.S. Treasury bond yields. Calculating inflation-adjusted yields involves subtracting the inflation rate, which is expressed by the year-over-year rate of change in consumer prices, from the ten-year Treasury bond yield. When consumer prices rise faster than Treasury yields, the dollar tends to fall.
Currently, Treasury yields are falling as a result of the Fed’s monetary tightening cycle. The late, famed economist Milton Friedman proved that Treasury yields fall during periods of monetary decelerations, which occur when the Fed is tightening monetary policy. Yields also fall as governments take on an increasing amount of debt. Treasury yields are falling as consumer prices are staying elevated due to a combination of higher wages and tariffs, which means based on this relationship, the dollar should soon fall in value.
The U.S. dollar is also sensitive to inflation-adjusted wages. With wage growth slowing, as the economy and corporate profits slow, consumer prices are starting to outpace wages. The primary driver of consumer prices staying elevated can be traced back to rising wages and tariffs.
Commercial and industrial lending growth also affects the value of the U.S. dollar. As lending increases, so does the number of dollars created, which leads to an increase in demand for dollars. When the demand for dollars increases, so too does their value. During the prior two recessions, commercial and industrial lending growth expanded in the first six-to-nine months of the recessions, which is why the dollar rose in value. Currently, commercial and industrial lending growth is starting to decline, which means the dollar should soon follow.
Most investors will interpret a weaker dollar as a bullish catalyst for stock prices, oil prices, and the broad economy since a weaker currency generally leads to lower export prices. Normally this is true, unless the dollar, along with all other foreign currencies, falls together. Global central bankers, which includes the Fed, maintained easy monetary policies for nearly a decade. Most currencies appreciated from easy monetary policy, so it is likely that most currencies will fall alongside the dollar.
While stock prices historically benefit from a weaker currency as exports increase, if all currencies fall in value, there will not be any boost to stock prices. Even worse, stock prices tend to fall when the dollar falls, as a rising dollar is a sign of economic strength due to its correlation with higher wages, higher interest rates, and increased lending. The reason the “Smart Money” is dumping their stocks and buying volatility, is that volatility is a leveraged bet that stock prices are going to crash.
Treasury yields, which are in a Bear market, fall ahead of stock prices as a leading indicator of where the U.S. economy is headed. The “Smart Money” has been buying bonds for the past two years and large commercial banks have bought over $100 billion of U.S. Treasury bonds in the past twelve months alone. Banks sell bonds to raise cash to lend and buy bonds when they feel the economy is weakening or heading into a recession. The reason the “Smart Money” is betting big on bonds, is that 10-year Treasury yields are going to zero or near zero percent during the next recession.
The reason it is important to follow the “Smart Money” is that they have access to more information about the economy than anyone else. Many successful investors have built incredible amounts of wealth simply by following the “Smart Money.” When an investor takes time to study the economic cycles, the economic data, and the “Smart Money” positioning, they can find themselves in a position to make money in both Bull and Bear markets.
The coming opportunity is not just in U.S. Treasury bonds but in gold and Emerging Markets stocks. Emerging Markets, which did not follow the easing policies of the major central banks, are poised to have their stock prices benefit from a weaker dollar. Rather than taking a speculative position in gold, the “Smart Money” has been buying large quantities of physical gold for over five years. They are anticipating a strong demand for gold when the dollar weakens, as investors often buy gold to protect the value of their money when asset prices fall.
As far as crude oil goes, the “Smart Money” is short oil despite their belief that the dollar is going to fall in value. While there is an inverse relationship between the dollar and crude oil, is it not perfect. Crude oil prices tend to follow the economy, and since the global economy is headed lower and crude oil consumption falls when the economy slows, it makes perfect sense why the “Smart Money” is short crude oil right now.
Now you know why the “Smart Money” is buying bonds, gold and Emerging Markets stocks, as they anticipate a significantly weaker dollar coming soon. Based on the chart patterns for the dollar, it is showing the classical signs of a topping pattern. Those who believe the “Smart Money” is right, will look to buy Treasuries, gold and Emerging Markets stocks when they are low, just before they take off. Treasury bonds have already entered a Bull market, but gold and Emerging Markets stocks likely have not quite bottomed yet.
After all, the “Smart Money” wants to buy as much gold and Emerging Markets stocks as they can, and the best way to buy is to get others to sell. The “Smart Money” has been positioning themselves for more than five years to profit from the upcoming recession, and for those who are not already loaded in stocks, the opportunity is building as the global economy slows. The best part of following the “Smart Money” is that when stock prices bottom, investors who followed the “Smart Money” will have the resources to buy stocks and crude oil when they are cheap.
Stocks, Bonds and Gold (05/29/19 – 30 min)
Weekly Economic Update (05/31/19 – 33 min)