Weekly Economic Update 09-01-2017

When Buyers Become Sellers

The biggest generation in the history of the United States, or Boomers, are heading into retirement, with the first group of Boomers turning seventy and a half this year. They have created unparalleled economic growth over their working careers which has translated into incredible amounts of prosperity for our country. Now, as they leave the ranks of the working, they are looking forward to enjoying their “golden years.” But with the stock market at record highs, the Boomers may find themselves forced into becoming sellers when the next recession occurs.

Right now, the U.S. stock market is enjoying its second longest run in history or “Bull market.” A Bull market is any period of rising stock prices without a twenty percent decline in value. The longest Bull market was from October 1990, through March 2010 that lasted 113 months. This current Bull market started in March 2009 and will mark its 106-month anniversary in September. By April 2018, if it’s still running, it will be tied for the longest Bull market in history.

It is impressive that this run has gone 106 months, considering this is the worst economic expansion in history, going back to 1790. If not for corporate stock buy backs and central bank intervention, this Bull market would have likely ended more than a year ago. Nothing lasts forever and neither will this Bull market. Yet many believe the stock market is in the early stages of what will be a 20-year run for stocks, mimicking the long uptrend that started in the early 1980’s.

Based on that narrative, Boomers have gone “all in” in this market. Currently, they have about 70% of their investment portfolio allocated to stocks, while their bond and cash allocation near multi-decade lows. This is the highest allocation to equities since the dot com bubble burst in 2000 when the average Boomer was nearly 20 years younger. Memories of the past two Bear markets have faded, which is a scary since the average Bear market loss is -37%. If that were to happen again, it would be devastating to the Boomers.

According to the U.S. government, the average Boomer has $186,000 saved for retirement. A Blackrock survey indicates that number is closer to $136,000. The average Boomer has 1.1 million in assets, which is good, but when you look at the median number that filters out the top 1% of Boomers, the number drops to a sobering $200,000 in assets. Studies have shown that Boomers didn’t save enough for retirement and based on their investment allocation to equities, it validates their need to take the risk in the stock market. But going “all in” in this stock market will prove costly.

The problem is that investors now believe that central banks can prop up stock markets when, actually, there is no evidence to support that. Central banks have been intervening in stock market declines for over 100 years with no success. After getting burned twice in the last twenty years, Boomers will be quick to react to the next Bear market. Unfortunately, they will likely find out what a “no bid” market is, a market where there are sellers but no buyers. In the past, no bid market stocks have plummeted in a very short period of time. When Boomers can sell, they will seek the safety of the bond market, where they will buy bonds at a 5,000-year price high.

A Bear market will only be the beginning of the problems that Boomers will face. According to a recent government report, Social Security will need $46 trillion to shore up its liabilities. That’s twice the amount of the national debt! The problem with Social Security is that it needs at least three workers paying in for every recipient and currently the number of workers is under three and projected to continue falling.

State pensions are also underfunded to the tune of $4 trillion. The typical state pension has 60% of their investment allocated to stocks, meaning during the next Bear market, the $4 trillion liability is likely to rise. This problem occurred because state employees lobbied for an increase in benefits during the good times and the pension managers raised their target investment return above that of Warren Buffett’s 20-year average. In every sense, the state pensions promised benefits they had no means to pay.

Many state pensioners are hoping for a Federal bailout, but there’s no precedent for such an action. Kansas has cut benefits for retirees, while in other states, the states have pushed the cost of the problem back to the cities and municipalities where the retiree worked. In the cities and municipalities where that has happened, they ended up cutting staff and services in an attempt to make up for the funding shortfall. This will only be magnified on a national basis during the next recession as unfunded pension liabilities are likely to drop well below the current national average of 70%.

Private pensions aren’t much better off. While exact numbers are hard to find, unfunded liabilities are estimated to be in the hundreds of billions of dollars. But like their public counterparts, these pensions also invest in stocks and will also take a hit during the next Bear market. Those banking on a Federal bailout will be somewhat relieved to know that there is a safety net for them. Unfortunately, that safety net comes with limitations and the likelihood of benefit reductions.

If all of that sounds bad, that’s because it is and it will only get worse. The normal reaction to a recession and the prospect of having Social Security and pension income reduced will be to cut spending and downsize. When the stock market falls and deflation takes hold, asset prices will also fall. When you cut the average Boomer’s net worth by 40%, to match the average stock market decline, the $1.1 million number drops to $660,000 and the median $200,000 net worth number drops to a mere $120,000. Boomer spending will grind to a halt as they look to rebuild their accounts during the next Bull market.

Unfortunately, IRS law won’t be on the side of the Boomer’s as they will be forced to draw money out of their tax qualified accounts at 70 ½ regardless if they want the money or not. Even if they don’t want to draw money from their retirement accounts, the Required Minimum Distribution law states that once a person turns 70 ½, they must begin taking a distribution of 3.5% of the total value of their IRAs, with the percentage increasing annually.

When you start looking at the big picture, it’s easy to see how buyers today, will quickly turn into sellers tomorrow. When the economy recesses and we enter the next Bear market, people will sell in hopes of locking in their gains. As more Boomers retire, both public and private pensions will be forced to sell to meet their obligations. And as they reach 70 ½, every Boomer will be a seller, if they aren’t already.

The real problem is demographics. There’s a large aging population throughout most major industrialized nations and the younger generations are just too small to drive their economies. At this point, it’s up to the Millennials, but they have a huge amount of student loan debt and are entering a workforce with salaries that are less than the Boomers started at when adjusted for inflation. Let’s face it, it’s going to be awhile before the Millennials are buying homes and starting families. When they do, that’s when things will start to change.

Until then, it’s a problem with no solution other than perhaps decades of economic malaise. In an attempt to avoid that, central bankers have decided to print money to buy stocks, bonds, and debt in hopes to stimulate the economy. So far it hasn’t worked. The only question that remains is, when does the house of cards come down?

Video Topic of the Week

This week I’m discussing why the volume on the market has been abnormally low, this month’s Nonfarm Payrolls report, the ISM factory survey, consumer confidence and why natural disasters aren’t good for the economy. A brief mention on how central banks are still working to prop up the markets.

Chart of the Week – Correlation Concern

This chart is provided by Bloomberg that was created by Citi analysts, shows another indication that the business cycle has peaked and the next Bear market may be upon us.

Portfolio Shield™ Update

As expected, the momentum-algorithm has shifted into a defensive position by replacing the Russell 2000 position with U.S. Treasuries.

Weekly Sector Commentary

Broad Market / Economy

In terms of volume, as of Wednesday, there have been eight straight days where $5.4 billion or fewer shares have been traded. While that number may seem high, it’s actually very low. Last summer there was only one-day volumes were that low. Over the past five days, the market has risen on the backs of that light volume, which again, is also very unusual. Volume drops when markets peak, as a sign that buyers are exhausted. Rising prices on low volume means that those who are buying are paying a premium for each trade.

Another oddity is that present conditions consumer confidence remains very high, while the future conditions consumer confidence is falling. Outside of the government-massaged retails sales data that turned a -0.8% into a +0.6% for July, consumer confidence is not translating into the broad economy. There’s spending going on, but it’s not that great.

What is interesting is how the personal savings rate is back at pre-recession levels. When you dig into the data you find that one-third of consumer spending is coming from real income growth and two-thirds are coming from consumers spending down their savings. It’s not healthy.

The best explanation I can give is that the public remains hopeful for a meaningful income tax cut by the end of the year. I don’t believe that will happen. The last major tax reform was done during President Reagan’s term which took five years. Keep in mind, nobody in Congress has any experience with major tax reform and there are less than four months left in the year. Maybe there will be a tax cut passed this year, but I don’t think it will be the big one everyone is hoping for. Once the public realizes it’s not likely to happen, consumer confidence will plunge right along with the stock market.

Momentum stocks, which are Apple, Facebook, Amazon, etc. are driving the market. Nothing else really is. The leadership is getting very narrow. As one money manager put it, momentum stocks are like riding an elevator to the top, then an elevator shaft to the bottom. When these stocks finally peak out, the floor will fall out of the market.

And for some weird reason or another, everything closed up for the month of August or had a strong showing on the last day.

Market Reactions to Hurricanes

Looking back on hurricanes Andrew and Katrina, the S&P 500 briefly rallied, then had a mild correction. The US Dollar index rallied. The Nonfarm Payrolls Report took a hit the following month, which sets up the potential for a weak October payrolls report as the debt ceiling comes to a head.

U.S. Equities

The US equity market took an early hit after North Korea fired a missile over Japan after market close on Monday. Shortly after Tuesday’s open, markets shrugged off the drop. One should always be skeptical of moves around geopolitical or weather-related events unless the geopolitical event directly affects the US economy. If President Trump responds with an attack, then things might be different. The other interesting factor is an unknown buyer purchased 6,000 long S&P 500 futures contracts Tuesday morning at a cost of $731 million dollars. Either this deep-pocketed person believes the market is going up or they want to keep it up. Worth noting, Tuesday’s rebound was on the backs of two stocks. Yes, just two.

Sentiment has jumped back over the 50% line to 59%. Will be interesting to see how long this holds up.

U.S. Treasuries

With bond sentiment rising to 72%, it came as no surprise that 10-year Treasury yields dumped Monday night from 2.16% to under 2.1%. As risk-off attitudes returned on Tuesday, yields have started to move up to the key 2.12% range that I have stated repeatedly that if not held, would lead to a larger drop in yields.

International / Emerging Markets

International markets took a hard-hit Monday night. In local currency, some of the major European indices are rolling over from major topping patterns, which is a longer term Bearish signal.

U.S. Dollar

In the wake of the missile launch, the US dollar fell to a critically low level of support. Failure to find buyers here will likely send the dollar index down to $80 from its current price of $92. At the moment, courtesy of Hedge Fund Telemetry, there is a DeMark exhaustion signal flashing, which indicates a potential short-term rebound in the dollar. A falling dollar should be Bullish for commodities.

Also, worth noting as of Tuesday, dollar sentiment is at 10%, which signals extreme oversold conditions. While the downward trend may continue, there should be a short-term bounce. As of Friday sentiment is 16%.

Commodity Producers

On Monday prices broke to the upside on both the gold and silver miners out of their descending triangle patterns, which would normally signal that it’s time to buy. As prices moved up during the day, volume was average as of late, which is low over the longer term. According to classical charting, a break out of a pattern needs to come with one or several days of high volume. A low volume breakout is often meaningless.

Fortunately, social media is a quick way to find out what other experts think, which includes those who manage billions of dollars – hedge fund managers. The comments were that there were “no natural buyers,” which points to the lack of volume and that one should look no further than the US dollar for their answer. Gold usually rises as the dollar falls, and with the dollar falling, it nudged gold over its critical $1,300/oz. price target that we’ve been watching. When that happened, short sellers were stopped out which thrust prices upwards – without volume.

Because there was a technical price breakout, buyers stepped in at market close and the volume doubled in the final two minutes. Even so, that wasn’t an indicator of the big money buying. Adding in Hedge Fund Telemetry’s research, I found there’s a DeMark exhaustion signal on gold for Tuesday and the miners shortly thereafter, which points to this potentially being a false breakout.

This comes back to the reason for the breakout, which was the missile launch. So far there has been no indication of damage to the US economy, so this will likely be shrugged off quickly. But this move is very useful. It’s a signal for what is to come.

According to hedge fund manager Paul Tudor Jones, “If there is a sudden range expansion in a market that has been trading narrowly, human nature is to fade that price move. When you get range expansion, the market is sending you a very loud signal that the market is getting ready to move in the direction of that expansion.”

One thing I’ve noticed when studying classical charting is that in the 1920-30’s, when a chart broke out, it continued that move. In more recent times, as I follow the research of classical chartists, I have noticed that breakouts are followed by a retracement. In this case, a breakout on gold means it will likely retest the $1,300/oz. price level, which substantiates Jones’s view.

There has been a narrowly traded market in the miners, as we have looked at for the last six months. There was a price breakout but on low volume. Already as of Tuesday, that price move is fading. Which means my view that metals and miners are in the midst of a consolidation pattern in their longer-term Bull market is potentially spot on. What this means is that I should look for price support on the next move down and start buying if prices hold. This is further supported by rising gold sentiment, which when over 50%, as it is now, is an indication that prices are about to break out.

Based on the recent DeMark exhaustion signals and Yen sentiment, there should be either a short pull back or a consolidation. This is flashing a green light to begin a gradual move in. Friday and Tuesday will be a good signal on if the DeMark exhaustion signal is valid for one last confirming pullback before we start buying in.

Agricultural Commodities

Speculators remain the big reason commodity prices dipped. Futures traders have jumped on a shift on the price chart by shorting commodities, and as I’ve mentioned before, they think prices are going to historic lows. Yet with each move down in price, buyers have stepped in. Once the speculators cash out their short positions, prices should move back up quickly. It’s also unknown what effect the hurricane Harvey will have on crops and animal stocks, but it’s likely a positive for prices.

Harvey appears to be having an effect on cotton prices, as on a chart pattern, cotton looks like it is about to break out to the upside. From a momentum perspective, soft commodities make a key move upward on Thursday, which has been validated by a move up in prices.