Weekly Economic Update 05-05-2017

Transitory or Reality
The Fed has sent clear signals that they intend to raise rates two more times this year, but who knows if they will. They cited the weak first quarter data as transitory, which the stock market is happy to go along with. There are things that don’t add up: new car sales have dropped four months in a row, credit card companies are writing off bad loans and consumer spending is flat – just to name a few.

While I don’t think the first quarter data was transitory, it is likely that the second quarter data will be better. Just don’t expect it to show 3-4% growth that everyone is hoping for or you might be disappointed.

Budget Passed Through September and What It Means for the Markets
If I asked what caused the market to start going up in November, most would say the election – fiscal stimulus, tax cuts, deregulation, health care reform, earnings… it was none of those. It was the US Treasury.

When the US Treasury started running low on funds in November it pulled money out of savings which it holds at the Fed. When the Treasury pulls money from the Fed, especially when the Fed is low on funds, and puts that money out into its member banks for the government to pay bills it has the effect of causing interest rates and asset prices to rise. It looks and feels like an injection of liquidity into the markets even though it was never intended to be that.

Now that a spending bill has passed the Treasury will be able to go out and raise funds by issuing bonds. Once they get that money they will most likely put it back into savings. When they do that it will have the reverse effect – asset prices and yields should fall as liquidity is pulled out of the markets.

Are Corporate Earnings Really That Good?
There seems to be a lot of excitement over earnings this quarter, even though Earnings Per Share (EPS) has not eclipsed the cycle peak set back in 2014. Despite all the excitement over earnings looking good, there are several things that just don’t make much sense. On one hand earnings are beating analysts’ expectations and on the other hand, the economic data is showing signs of weakness. I’ve asked myself, how is it possible that companies are doing so well when nobody else is? What am I missing?

First quarter GDP came in at 0.7%. Productivity growth, or how productive an employee is at work, fell last quarter. Employee costs increased by a strong margin. Consumer spending has dropped. Under a weak economic backdrop, why are corporations suddenly doing well? And if they are, why are corporate insiders selling stock? If the outlook was good, they shouldn’t be selling.

A company called New Constructs has a robo-algorithm that pours through financial statements of companies looking for answers to the same questions I have. In a recent article, they found that there was a discrepancy between the GAAP reported earnings and the economic earnings. Economic earnings look for distortions in the balance sheet compared to the industry standard GAAP method. What they found was that in 2015 and 2016 companies hid billions of dollars’ worth of write-downs of assets in the footnotes. As a result, these write-downs created the appearance of low GAAP earnings. As companies report today it appears their earnings are strong, but economic earnings have slowly been in a decline since 2012.

With analysts pumping up stock prices and earnings forecasts for next quarter, it makes perfect sense why corporate insiders are selling. They realize that at some point in the future they are not going to meet expectations and when they don’t, usually stock prices fall. Anytime you hear that corporate insiders are buying or selling, it’s because they know something we don’t. In this case, they must know they can’t continue to grow their GAAP earnings, so they are likely selling their stock while it’s still high.

Short Volatility
In the video portion of this week’s update I have a couple comments on what was a strong jobs report. I’m also going to go over volatility again and how short sellers have been massively suppressing volatility despite data that shows rather high economic uncertainty. These short sellers have no idea how volatility works and what will happen when volatility spikes. Even professional volatility traders have stopped trading volatility because all these short volatility traders are misusing it. I can tell you this, when volatility spikes and all these shorts are forced to cover, it will rock the stock market. You will hear it; it will be that big!

Client Update:
S&P 500: On March 1st and April 24th (the Monday following the French elections) the indexed “gapped” up. A gap move is anytime a security has a jump in price over the previous close. Normally prices open and close near the same point, so this jump in price looks like a gap on the price charts.

There are a few different kinds of gaps, but once a gap can be properly identified it gives a signal as to where prices are likely headed. When prices gap up after an extended run in an overvalued market they are referred to as an “exhaustion gap.” Exhaustion gaps are easy to identify because they occur on a day with high volume, a strong price move and at the end of a long upward trend. In the week or two following the move up, prices will move back down below where the gap started on low to below average volume. This is a sign that the only players left are the public or retail investor.

This is exactly the move that happened after the March 1st gap, which we can now properly identify as an exhaustion gap. The more recent on occurred on April 24th, and while prices have not fallen to ‘close the gap’ there’s still some time remaining for that to happen. If it does close the gap later this week or next, the market will have two clear exhaustion gap signals.

The reason this is significant is because one exhaustion gap after a long run up usually signals the beginning of a move down. It is at this point that the ‘smart money’ senses the only players left are the retail investors, so the short sellers will enter soon after to drive prices down. Based on my research and that of others, the major support level for the S&P 500 is near the 2,100 level or about 12% lower that the index is currently. If prices fall below the 2,100 level, that will indicate a major shift in momentum and we will likely be on the cusp of the next Bear market.

There are many that still believe stocks have one major move back up before the next Bear market begins and even some that believe the market will rally for another three to five years before falling apart. While I don’t subscribe to the later view, I’m not ruling out one last move to a new all-time high. If the exhaustion gaps are correct, there’s a much stronger chance the top has already been set.

US Dollar: The trade-weighted dollar index, DXY, has been quietly falling since the start of the year. Usually, US equities perform well when there’s a strong dollar, so this suggests that if the dollar continues to fall, US equities are likely to start falling as well. Correlations aren’t always exact, but the sectors that perform well under a falling dollar are precious metals, Treasuries, and European equities.

I have my eye on European equities; I know the smart money has headed over there, but I’m not seeing any strong price moves that indicate we should be there. Plus, I feel there’s a much greater opportunity with the metals and miners. It’s a simple risk / reward analysis: if volatility spikes, which I believe it will, it will affect the entire global equity market. While there may be an opportunity in Europe, I think the downside risk is greater than the upside return. This is especially true if the European Central Bank scales back their Quantitative Easing program, which many believe they will do.

On a side note, I believe the dollar is on the cusp of a major technical and momentum break which should push it down for the next three years. The reason I believe prices are likely to fall for three years is due to a lagging correlation between the dollar and 10-year Treasury yields. The dollar trails yields by two to three years and if this relationship holds, the dollar is about to catch up with the big drop in yields that started back in 2014 that lasted through mid-2016.

Metals & Miners: As I mentioned we were forced out of the miners’ positions two weeks ago. A sell signal triggered when a clear “island gap reversal” and a strong price and volume move down occurred after the miners touched its recent top. Since then prices on the miners have been in free fall and last week retail investors made a large move out.

This is good news: retail investors sell the most at the bottom and buy the most at the top. At this point, I am just waiting for a signal to move back in, which I believe should be happening soon. This recent drop hasn’t changed my macro view of the opportunity in this sector, it’s just increased the upside potential once prices bottom. Given the Nonfarm payroll report is due on Friday and the French elections on Sunday, it’s prudent to hang tight for the moment. Either way, I remain poised to dollar cost average back in once the signals are clear.

Interest Rates: I believe deflation is coming back and the key driver of that trend is the year-over-year price change in oil. The Consumer Price Index (CPI) follows oil and interest rates follow the CPI. Based on the recent drop in oil I expect the CPI to continue falling. Yields will bottom shortly after the bottom of the next recession. This happens because the public buys most at the top, which in this case will be bonds. As the public buys bonds that will suppress interest rates even further.

Long-Term Outlook: My long-term outlook hasn’t changed. The Fed and the news are quick to discount the first quarter data as transitory because the survey data is putting hope into the second quarter, third quarter and fourth quarter data. Historically first quarter data is often weak, but the hard economic data continues to point to further weakness.

At current valuations, stock investors are likely to expect very low returns going forward, even after dividends. Arguably investing in Treasuries, despite their low yields, will offer a better return over stocks.

I still stand by my call that the next recession is going to bring stocks prices down by around 50%. That number shocks people, but it’s not farfetched. Returns following an exhaustion gap (let alone what’s looking like two) usually are between -40% to -60% when going from an overvalued market into a recession. Investors forget that valuations (and stock prices) can and have fallen that much in past recessions.

The only abnormality here is the stock market. Usually, stocks start to sell off before the onset of a recession. That hasn’t happened yet, but if the [potentially] two exhaustion gaps are a signal, the initial drop could come sooner than later. My goal is still to avoid the big drop that comes with the next recession (and profit on the drop) while investing back into equities and inflationary asset classes (oil) at the bottom when valuations are cheap.

Supporting Articles
Below are the articles mentioned in this update. Some of these are more advanced than others, but if you’re looking to expand your knowledge and you have time to read them, they are very good. Plus, the charts are usually easy to follow and very thought provoking. I hope you enjoy them!