Short Takes

Why Were Stocks Stuck In A Multiple-Year Range?

The Dow stayed inside the orange box below for over two years. Only the market knows the reason for the sideways action, but we can hypothesize the Fed’s desire to raise interest rates played a big role.

Why Were Stocks Able To Break Out?

Whatever was holding investors back for over two years must have changed in some material way given the Dow, S&P 500, and Nasdaq have all broken above their long-term consolidation patterns.

Something Has Changed

In the original Market Wizards book, Larry Hite, who developed a highly successful trend-following system, told Jack D. Schwager:

The second [useful] item is something Ed Seykota taught me. When a market makes a historic high, it is telling you something. No matter how many people tell you why the market shouldn’t be that high, or why nothing has changed, the mere fact that the price is at a new high tells you something has changed.

What Changed?

Once again, only the market knows the answer to the question above. However, we can hypothesize markets started to believe high levels of global debt would cause central bankers to remain ultra-loose and asset price friendly, as outlined in detail on May 11.

Any breakout can fail, but as noted above, the current set of breakouts have already passed the textbook window for a typical failed breakout. Could the breakouts still fail? Sure they could. However, as long as the S&P 500 can hold above the 2,100 to 2,135 range, the higher the odds equities have more upside. If the S&P 500 cannot hold 2,100, we will be giving our growth-oriented positions a shorter leash.

Investors Are Lost

Given valuations are high, earnings growth has been weak, and the U.K. recently voted to leave the European Union, it is easy to understand why investors are in the land of confusion regarding recent gains in the stock market. From Yahoo Finance:

“We have never had so many client meetings starting with statements such as ‘we are totally lost’,” Credit Suisse equity strategist Andrew Garthwaite said on Thursday.

A Consensus That the Market Is Not Confirming

In the original Market Wizards book, Bruce Kovner, a highly successful trader in interbank currency and futures markets, tells Jack D. Schwager:

What I am really looking for is a consensus that the market is not confirming. I like to know there are a lot of people that are going to be wrong.

If the recent breakouts in risk assets hold, it will be fair to say the market is not confirming the pessimistic consensus view on a wide variety of asset classes. Notice the previous sentence starts with “if”, meaning we will learn something either way (breakouts hold or breakouts fail).

Monthly Breakouts Are In The Books

The bearish case regarding a wide variety of investments is easy to understand. However, the consensus view is always easy to understand. It is more difficult to understand what the drivers are behind the Dow’s recent break from a consolidation range that dates back to 2013 (see below). The top chart shows the Dow as of the end of June; the bottom chart shows the last day of trading in July.

Facts Say Gold Can Add Value To Stock/Bond Portfolio

High valuations are one reason investors are “totally lost” regarding the binary flip back to risk-on in July. While stocks and bonds are both stretched, physical gold is now rallying after a multiple-year decline.

This week’s video makes the historical case for considering gold as a possible compliment to a portfolio of stocks and bonds. If you are skeptical about gold, the facts may surprise you.

Debt And Central Banks

Only the market knows why the S&P 500 was able to break out to a new monthly high after going nowhere since 2014. However, one logical explanation is the excessive amount of global debt which is driving global central banks, as outlined on July 19.

The NASDAQ completed the trio of monthly breakouts by closing above the monthly highs set in 2015. Notice on June 30 (top chart below), the NASDAQ had made a series of lower monthly highs (see red A, B, C); it had also printed two lower monthly lows (orange A and B). The second chart has a much improved look after price was able to close above the monthly highs set in the spring of 2016 and second half of 2015 (see green points C and D).

How Can These Charts Help Us?

If the breakouts above hold over the next four weeks, it will be much easier to give the bullish case the benefit of the doubt. However, if the breakouts fail, we will be giving our positions shorter risk management ropes. Price and marginal shifts of the key fundamental bullet points described on July 22 will guide us.

More Kale Smoothies On The Way

Regardless of whether or not the Bank of Japan’s statement this week is well received by the financial markets, the trend has been and will continue to be to print more in an effort to prop up an over-indebted global economy. China is a good example of the limitations of endless “stimulative” kale smoothies. From The Economist:

The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax.

China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever. When the debt cycle turns, both asset prices and the real economy will be in for a shock. That won’t be fun for anyone.

Gradual Shift To Helicopter Money

No central bank, including the Bank of Japan (BOJ), wants their policies to be associated in any way with the term helicopter money. However, given central banks are already engaging in direct-injection stimulus, including the Bank of Japan buying stock ETFs, over time a move toward purer forms of helicopter money is a high probability outcome. From CNBC:

Citi has forecast a “gradual shift towards helicopter money” by advanced economies, as countries struggle to boost growth and inflation in uncertain geopolitical climes.

The bank’s report came as the Bank of Japan started a two-day meeting on Thursday, after which it is widely expected to launch another major stimulus program. Prime Minister Shinzo Abe is seen announcing a fiscal stimulus package as well, which a report by news agency Jiji put at 28 trillion yen ($267 billion).

Direct Move To Helicopters Unlikely

Central planners in Japan have been doing a lot of talking recently, which means a disappointing reaction to the BOJ’s statement is well within reason. From MarketWatch:

The Bank of Japan starts a two-day policy meeting today and some investors expect it to team up with the government to announce more extreme stimulus measures on Friday. Prime Minister Shinzo Abe already said Wednesday that he is preparing a ¥28 trillion fiscal stimulus—much greater than previous expectations for a 10 trillion yen stimulus. Still a number of traders say the market may have priced in such expectations already, setting investors up for disappointment.

It becomes a bit easier to comprehend the S&P 500 pushing to new highs when viewed in the context of central planners throwing around stimulus figures in the neighborhood of 5% of a country’s total GDP. From Reuters:

The Japanese government is planning direct fiscal spending of around 7 trillion yen ($67 billion) to help fund an economic stimulus package totaling more than 28 trillion yen, two people briefed on the matter told Reuters on Thursday. That amount - at just a quarter of the total package - could disappoint some market players bracing for bigger outlays given the massive headline figure, equal to more than 5 percent of gross domestic product.

High levels of debt, tepid global growth, and hyper-dovish central bank policies have helped push a somewhat odd trio of ETFs to new highs, as outlined on July 22.

The 1994 case demonstrates the longer stocks go sideways, the bigger the move we can expect after a successful breakout. However, even under the successful breakout scenario, a retest of prior resistance may be in the cards, which is exactly what happened in early 1995. In 2016, the Dow Jones Industrial Average (below) may be in retest mode.

Reflation Trade

Given the high levels of global debt, the lesser of the evils alternative typically is to try to inflate it away. The chart below, showing the performance of materials stocks (XLB) relative to Treasuries (TLT), is one way to monitor the battle between inflation and lingering concerns about deflation.

Like the XLB/TLT ratio above, the ratio of energy stocks (XLE) to Treasuries (TLT) also has some work to do. With a Fed statement coming Wednesday and one from the Bank of Japan before the end of the week, these ratios should provide some insight into the market’s reaction.

Stocks vs. Bonds

The S&P 500 (SPY) has not yet broken out relative to long-term Treasuries, but has made some progress relative to intermediate-term Treasuries (IEF). If the SPY/IEF breakout below holds, it will improve the odds of the S&P 500’s recent push above 2,134 holding.

Markets Move On Shifts At The Margin

Markets are constantly monitoring and assessing data on numerous fronts (earnings, interest rates, debt, etc.). Market prices are determined by facts in hand and expectations about future outcomes related to each data set. Therefore, changes at the margins of the data sets tend to be what move markets.

Earnings: Weak With A Possible Silver Lining

If you were told corporate earnings were on track to decline for five or six consecutive quarters, you would not guess the S&P 500 would be breaking out to new highs (as it did earlier this month). Earnings season for the current quarter remains a work in progress, however some marginal trends are emerging. From CBS Moneywatch:

And as is typical, the results have been coming in ahead of expectations: 68 percent of S&P 500 companies reporting to date have beaten their consensus earnings estimates. But the results haven’t been good enough to end the ongoing corporate earnings recession, now in its fifth consecutive quarter. And what’s worse, early indications are that blended S&P 500 earnings are now set to decline in the third quarter as well.

The Shift At The Margin Shows Some Improvement

If the economy is heading for a recession, which may or may not be the case, we would expect earnings to be getting worse. Earnings growth is still ugly on a year-over-year basis, but the recent trend is showing some marginal improvement, rather than deterioration. From CBS Moneywatch:

Overall, FactSet analysts note that the expected second-quarter S&P 500 earnings decline stands at -3.7 percent, an improvement from the -5.5 percent decline they expected last week and at the second quarter’s end. Yet, even factoring in the typical improvement in average earnings growth during an earnings season, they believe it’s likely the quarter will end with an outright decline in profitability on a year-over-year basis. Third-quarter earnings expectations have now fallen into negative territory as well — suggesting the earnings recession could stretch to six consecutive quarters.

Hypothetical Example – Earnings

A year-over-year earnings decline of 3.7% does not sound good, but it shows marginal improvement relative to last quarter’s decline of 6.5%.

To illustrate the concept of marginal shifts in data sets, we can take a look at earnings growth over the next three quarters. The blue areas below show the data we have in hand today (knowns). The red and green areas show two very different and hypothetical paths for earnings growth for the coming quarters (unknowns).

It seems obvious to say “if earnings improve, it will be a positive for stocks”. What is not so obvious in the short run is that “if earnings growth is negative, but not as bad as the previous quarter, that represents incremental improvement”. Earnings declined by 6.5% in Q1 2016, which is quite a bit worse than the current decline of 3.7%. The 3.7% is not etched in stone since earnings season is not over yet, but odds say this quarter’s decline will be smaller in magnitude relative to last quarter’s.

Example: Marginal Shift In Rate Expectations

A recent example of markets reacting to a marginal shift in expectations was the Fed’s dovish about face between January and June 2016 (see headlines below).

When the Fed backed off their multiple rate hikes script, markets adjusted. Keep in mind, the Fed did not say they are on the cusp of adding new liquidity to the financial system; they simply said they planned to drain less liquidity than the market expected, which represented a marginal shift in liquidity/interest rate expectations. A similar shift will occur with corporate earnings; the question is will the shift be in the marginal “getting better” or “getting worse” camp.

Time And The Margins Will Tell

If the new information at the margin follows the green or bullish path below, it will help explain why the S&P 500 was able to break out to new highs. Conversely, if the market’s marginal new data follows the red or bearish path below, it is likely the recent push to new highs in stocks will revert back to the “failed breakout” category. Time, the charts, and the data will tell.

Other Marginal Data Sets

The recent breakouts by bonds (TLT), stocks (SPY), and gold (GLD) tell us quite a bit about current expectations regarding a wide range of potentially market moving data sets, as outlined in detail on July 22.

A Tale Of Two Markets

The two S&P 500 (SPY) charts below paint a starkly different picture from a risk-reward perspective. On June 27 (top), the S&P 500 was below prior resistance, inside the long-term trading range, below the 50-day, and below the 200-day. As of July 22, the S&P 500 was above prior resistance, above the long-term trading range, above the 50-day, and above the 200-day.

Even if the S&P 500’s breakout above 2,134 holds, some “give back” or even a retest of prior resistance may be needed to bring in additional “waiting for a pullback” buyers.

What Messages Are Being Sent By The Markets?

This week’s video breaks down the fundamental messages being sent from recent action in stocks (VTI), bonds (TLT), and precious metals (GLD). The messages from this diverse set of asset classes shed light on investor perceptions about the economy, valuations, earnings, central banks, and global debt.

Busy Final Week Of July

It will not be a quiet summer week in the financial markets. From CNBC:

The coming week is packed with lots of potential market movers, starting with the release of earnings from about 35 percent of companies in the S&P 500. There’s also a Fed meeting Tuesday and Wednesday, the Democratic National Convention starting Monday and a much anticipated Bank of Japan meeting at the end of the week. Before the week even gets underway, the G-20 meets in China over the weekend, and next Friday, stress test results are expected for those worrisome European banks.

Retest Is One Of Many Scenarios

The big picture still looks good relative to the S&P 500’s breakout from a multiple-year consolidation pattern (see below). In terms of common action after breakouts, price often (not always) wants to retest the breakout area. The market will make the call over the next few days. The potential significance of the S&P 500’s breakout was outlined on July 12.

Stocks Make Progress Versus Bonds

The S&P 500 vs. intermediate Treasuries (IEF) chart below has cleared two hurdles this week: (1) the thin downward-sloping blue line, which dates back to the S&P 500’s 2015 peak, and (2) the multiple-month consolidation box. The longer those breakouts remain in place, the higher the odds the S&P 500 will hold its breakout above 2,134.

The S&P 500 vs. long-term Treasuries chart has not cleared the hurdles described above. Both charts remain helpful in terms of the sustainability of the bullish breakout in equities.

Energy Testing Overhead Resistance

If energy stocks (XLE) can break out from what may be a consolidation/bottoming process, it would also improve the bullish case for the broader stock market. For now, XLE is still below an area of potential resistance.

Total Debt Is Much Worse Than 2007

Global debt levels have increased at a rapid rate since the financial crisis. Debt, of course, has to be taken in the context of an economy’s ability to generate value. From Mauldin/Dillian:

The US has a 103% debt-to-GDP ratio. It’ll go up a lot under either Trump or Clinton. Italy’s debt to GDP is about 170% or so; Japan is at 240%. There really isn’t any chance that Japan is going to pay you back, or Italy, or even the US, once you take out-of-control entitlements into account.

Default, Extend And Pretend, Or Inflate

Debt has been and continues to be a well-known problem, and yet, it just seems to keep growing and growing. The easiest way to reduce the economic drag from bloated debt is to grow your way out of the problem. For numerous reasons, that has proved to be a difficult task.

If growth does not pick up, there are three major ways to deal with debt: (1) default, (2) extend and pretend, or (3) inflate. From Mauldin/Dillian:

Nobody is going to default here. You want to talk about Financial Armageddon… that would be it. Greece hasn’t had a lot of luck with extending and pretending. They’re in this sort of endless depression. I doubt anyone would want to copy them. Nope, everyone is going to inflate, which is the stealth way to default. There has already been open discussion about helicopter money in Japan (essentially the BOJ retiring or canceling outstanding debt).

Central Bankers And The Law Of Diminishing Returns

This week’s stock market video looks at how we got to this point and what are the possible next moves from global central bankers. The video takes a detailed look at the economic limitations of zero rates, QE, and helicopter money.

What Is The Market’s Current Read?

When the Fed was talking about entering a traditional interest rate hiking campaign, the markets were having difficulty coming to grips with a rising inflation scenario. However, once the Fed flipped the interest rate playing field in the first half of 2016, inflation-protection assets started to catch a bid. Notice gold started to turn just as the Fed backed off their “four rate hikes in 2016” stance (late January-early February 2016).

Does The Market Feel Inflation Is Imminent?

Given the look of the charts for long-term Treasuries (TLT) and intermediate-term Treasuries (IEF) below, the markets do not appear to be overly concerned about inflation in the short run.

However, like anything in the markets, that tame read on inflation is subject to change in the coming months; something we will continue to monitor closely.

Stocks, Bonds, And Gold All Holding Up Well

The mathematical readings from our market model for stocks, bonds, and precious metals all reflect bullish trends. The demand for all three assets classes aligns with an expectation that central banks will continue/expand their ultra-dovish policies (good for stocks and bonds), along with a growing acceptance that inflation/currency debasement may be the preferred long-term approach to deal with overwhelming global debt levels (good for gold and silver).

The Fed Who Cried Wolf

Just weeks after Janet Yellen outlined a new normal marked by low rates, the chatter has started about hiking again as early as September. Are investors buying it? Not really, the market, as of 10:30 am ET Tuesday, is pricing in an 81% probability the Fed does nothing at their September meeting.