"Things Are Finally Starting To Get Interesting..."

Authored by Lance Roberts via RealInvestmentAdvice.com,

Market Takes A Tumble

Last week, I discussed the continuation of the “market melt-up.” To wit: 

“Since the beginning of the year, the acceleration in the markets has continued unabated. As I showed yesterday, the acceleration in the S&P 500 has now gone parabolic.”

“Never before in recent history has the market been this overbought and extended from longer-term averages which suggests that a correction that reduces such conditions is highly likely in the near-term.”

Well, this past week, the market tripped “over its own feet” after prices had created a massive extension above the 50-dma as shown below.  As I have previously warned, since that extension was so large, a correction just back to the moving average at this point will require nearly a -6% decline. 

I have also repeatedly written over the last year:

“The problem is that it has been so long since investors have even seen a 2-3% correction, a correction of 5%, or more, will ‘feel’ much worse than it actually is which will lead to ’emotionally driven’ mistakes.”

The question now, of course, is do you “buy the dip” or “run for the hills?”

Don’t do either one, yet.

Yes, corrections do not “feel” good. But they are part of a “healthy” market cycle. In more normal, healthy, bullish trends corrections should be used as buying opportunities to increase exposure to equity risk in portfolios.

However, the recent parabolic acceleration in the markets heading into the New Year was neither normal or healthy. Much of it had to do with the massive liquidity injection by the Federal Reserve at the end of 2017 as shown below.

But, after the stumble this past week, it will be interesting to watch the next the Fed’s balance sheet over the next month to see if they continue with their planned $30 billion / month reduction.

At the moment, this is the expected correction we have been discussing over the last several weeks. It is also something we had planned for by reducing overweight positions and adding a short-hedge to portfolios. 

With the markets on a short-term sell signal (noted by gold vertical dashed lines in the chart above,) the current correctional process is underway and still has room to go at this juncture. But, with the market now oversold on a VERY short-term basis a rally over the next week, or so, would not be surprising.

It is the outcome of that rally that is most important to the current bull market advance.

This is what we are looking for to drive our next set of portfolio actions:

  • If the market rallies back and sets a new closing high, the bullish trend will be confirmed and equity allocations will remain at target levels and hedges removed.
  • If the market rallies back BUT FAILS to set a new high, a series of actions will take place.
    • At the point of rally failure, portfolio hedges will be modestly increased.
    • If the subsequent decline breaks the previous low, the hedges will be further increased and tactical trading long positions will be reduced. 

Why is this important?


A Hint Of 1987

A recent article on Zerohedge discussing a view of Albert Edwards is salient to this discussion.

Certainly, as we explained at our Conference, the current conjuncture feels similar to just before the 1987 equity crash. All that was missing was the slanging match over the weak dollar between the US and Europe.”

He’s right. There are many similarities between today and 1987. Recently passed tax legislation reform, exuberance in the markets, and a strong market rally.

And then the crash.

But no one could have seen that coming? Right?

(We have an in-depth report, titled 1987, coming out next week ONLY for our newsletter subscribers and those who have expressed an interest in our soon to be released RIA Pro.

If you are not currently on our email list and want a copy of the report click here.)

Actually, there were five technical signals, that when considered along with fundamental factors should have been enough to warrant caution at a minimum…that is if you were paying attention.

The graph above,  from our 1987 article, highlights the technical indicators which are explained in the report along with a summary of the myriad of fundamental factors that preceded Black Monday. There are certainly many differences between today and 1987, but as we highlight in the report there are many similarities as well worth considering.

Along with plummeting stock prices in October of 1987, interest rates also declined sharply as money sought the relative safety of bonds.

It is here that I also agree with Albert Edwards:

“Every man, woman, and child seems to have decided that the US 10y bond yield has broken out of its long-term downtrend and we are in a bond bear market. Our own excellent Technical Analyst, Stephanie Aymes, shows that 3% (not 2.6%) is the key long-term breakout yield we should be watching. But she thinks that 2.64% was also significant as this means the RSI downtrend has now been broken and a run to 3% is now perfectly plausible. That though does not mean the bond bull market is over.”

With yields now closing on 2¾% and the 30y closing on 3.0%, many see this as a great time to dump bonds and switch into equities. Really?

“Well, I expect that the true extent of how close the US is to actual outright deflation, and hence how high real yields currently are, will soon be revealed. But before US 10y yields turn negative, expect them to visit 3% first.

He is absolutely right. Despite a rampant rise in the markets, the recent spate of economic growth has been due to massive natural disasters across the lower third of the U.S. The impetus from those rebuilding efforts are now running their course and we are already seeing a weakness in the numbers.

But wages are crushing it, and employment is booming?

Yes, wages are rising but only for the top 20% of workers.

And employment in the key demographic is not.


The Next Bull Market

Edwards is correct. There are several important points to understand about bonds.

  1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell back to $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.

The next bull market is coming, it just won’t be in stocks.

It will be in the U.S. Treasury market which will coincide with the next recessionary drag in the economy within the next 12-18 months (at the most).

As I have written previously, interest rates have everything to do with economic growth. Since economic growth is almost 70% driven by consumption, with savings rates extraordinarily low and debt hitting record levels, small increases to interest rates will have an immediate negative impact on the consumptive capability of U.S. citizens.

The chart below goes to my point. Currently, interest rates are 4-standard deviations above their 1-year moving average. (For an explanation read this.)

How often has this happened going back to 1965?

Never.

Negative events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. Given the current low level of interest rates, the next recessionary bout in the economy will very likely see rates near zero.

Furthermore, given rates are already negative in many parts of the world, which will likely be even more negative during a global recessionary environment, zero yields will still remain more attractive to foreign investors. This will be from both a potential capital appreciation perspective (expectations of negative rates in the U.S.) and the perceived safety and liquidity of the U.S. Treasury market. 

However, what you will notice is that each time rates were as overbought as they are currently, they coincided with either a recession, a correction, or a major market crash.

Could this time be different? Sure. It’s possible.

But probably, it won’t be. The stock market is a reflection of the economy, not the other way around. Higher interest rates are a drag on economic growth which will impact earnings and valuations for the market.

Not tomorrow. Or even next week.

But over the next several months, higher interest rates, if they remain elevated for long, will have a deleterious effect on the economy. 

Valuations will become problematic.

Furthermore, the safety of bonds becomes much more attractive when the yield is significantly above the dividend yield in stocks. (Why take the risk is stocks for a sub-2% yield when I can get 3% in a U.S. Treasury?)

That’s not hard math.

Things are finally starting to get interesting.

Comments

zorba THE GREEK any_mouse Sun, 02/04/2018 - 23:20 Permalink

Just wanted to say that as I predicted here on ZH, The Eagles have won their first Super Bowl by a score of 41-33. By the plethora of down votes that I received on that post, I see that there are many Patriot fans on ZH. Too bad, your team lost, because the Eagles are the best team in the World and they were due.  Get over it losers.

In reply to by any_mouse

eclectic syncretist IH8OBAMA Sun, 02/04/2018 - 17:03 Permalink

Usually, a bubble vacillates for quite a while before it pops forever. Japan was a notable exception when their stock market bubble popped in 1990. It just slowly deflated and never looked back, to this day.

http://www.macrotrends.net/2593/nikkei-225-index-historical-chart-data

Bitcoin is beginning to look like it's not going to be making a rebound back to the recent highs anytime soon as well.

https://www.coindesk.com/price/

Hopefully our current bubbles don't pop this way too. It seems almost certain bonds will be piled into at least one more time before the dollar vanishes.

In reply to by IH8OBAMA

J S Bach eclectic syncretist Sun, 02/04/2018 - 17:26 Permalink

It's amazing to me that people don't realize the exponentialness of our fiscal plight.  Ponzi schemes work and work until a crucial breaking point comes where sustainability becomes impossible.  And even though the Fed is a supposed bottomless pit of funds, its ability to control the "cycles" which it artificially creates will also become impossible.  What then?

In reply to by eclectic syncretist

BarkingCat Perimetr Sun, 02/04/2018 - 14:43 Permalink

Martin Armstrong predicts the exact opposite.

His prediction is that we are at the end of a public wave and going to a private wave, which means people jumping out of government bonds and moving into the stock market.

He's also predicting a flow of capital into the US from Europe, simply because as fucked up as the US, is Europe is infinitely worse.

In reply to by Perimetr

Theosebes Goodfellow The Real Tony Sun, 02/04/2018 - 21:39 Permalink

~ He's also predicting a flow of capital into the US from Europe, simply because as fucked up as the US, is Europe is infinitely worse."~

He may be right about capital flight out of Europe into the US stawks. But to me that's just shuffling deck chairs on the Titanic. I'm not in bonds, stocks or any other US Dollar denominated asset save land. I'm short the USD in a practical sense as I hold as little of them as I can to just cover the daily expenses.

Back in 2008 we made a deal with the Devil. We fucked Mother Nature. We saved banks that should have rightly gone under at the expense of the taxpayer. In doing so we put ourselves in a position where we could never again allow for high interest rates without destroying the country.

But these acts will not save the banks nor the nation. And the fall that is coming will be 100 times, 1000 times worse than if we had just sucked it up and taken the hit. If you do not agree, think of what a 5% or 7% 10y T-Bill would do to this country. Game over. If you think we can "grow the economy" enough to offset $20T, (or more), worth of debt you simply do not understand just how colossally huge that number is.

Say.....What's in your safe?

In reply to by The Real Tony

OverTheHedge Theosebes Goodfellow Sun, 02/04/2018 - 23:28 Permalink

Just to play devil's advocate, a high us interest rate would suck hot money from the entire world to Wall Street. The national debt might be an issue, but you can always print to cover that. If Goldman Sachs looked a bit wobbly, some backhanded deal to let them trade whilst "technically" insolvent would be instantly forthcoming, but perhaps not for the other tbtf - thin down the herd: there can be only one.

The world would pile into recession almost instantly, but Volker proved they don't care about that. What they do care about, is eurodollar recycling.

Smarter minds than mine will now explain why the above is nonsense....

In reply to by Theosebes Goodfellow

Theosebes Goodfellow OverTheHedge Mon, 02/05/2018 - 00:47 Permalink

I hear ya, Over. There are a couple of "challenges" to allowing the inflation genie out of the bottle, the least of which would be how to get that bitch back in her bottle. Or how to keep her reigned in enough to have her not destroy your economy. (It may happen regardless.)

There is no doubt that yes, everyone else in the world would rush their money here, (thereby cratering their own currencies). The old adage of "we get a cold, the world gets pneumonia" still holds true. I look at this the way I guess everyone else does, which is my own sense of risk/pain aversion. I'm not in a position to want to play casino anymore in a world where the Jon Corzines walk free. I have zero faith in "segregated accounts". I believe that the "Cypriot Haircut" is coming to a bank near you one day in the not-too-distant future, and I don't want to play.

Anyway, I need to get more exercise this year. I'm long vegetables and cut flowers, maybe some Chinese herbs and teas produced out my window. I've gone "country-plowboy not an urban-cowboy" as ol' Hank Jr sings, though I'm all into no-till. I'm even growing some popcorn seed this year.

So I will sit back and watch with interest, glad that I've got most of my foldin' money off the table. If things go really bad, I might buy back in once the blood-letting has run out, but then again, maybe not. YMMV.

In reply to by OverTheHedge

Jack Oliver OverTheHedge Mon, 02/05/2018 - 04:20 Permalink

What we are witnessing now is ‘Creative Destruction Economics ‘ ( Alan Greenspan mentioned it many times as ‘Head of the FED’ ! 

Which means - in essence - A one world currency - whereby - every ‘ resource’ on the planet - would be controlled by ONE currency ! ( no prizes for guessing who would be in ‘control’ of THAT) !!! 

The Rothschild’s tried this ‘NWO’ shit - way back in 1802 ( or something ) - didn’t work then, and it won’t FUCKING work now !!! ( end of ‘rant’ ) 

Russia and China are resisting - to make sure that never FUCKING happens ! 

ALL power to them !! 

If you deal with the REALITY - you will ‘cope’ much better. 

 

In reply to by OverTheHedge

Deep Snorkeler BaBaBouy Sun, 02/04/2018 - 13:53 Permalink

2018: A New Era of Trumpian Prosperity

Every factory at high productivity.

Every farmer's field has been planted.

Every healthy woman made pregnant.

Every able man with three job offers.

Every smart lad with handfuls of scholarships.

Every child with a Schwinn bike and a Slinky.

Every internet ad clicked upon, every Spam email a bonanza.

Cars, bars, flying to Mars,

victory in our foreign wars.

 

In reply to by BaBaBouy

Farqued Up Justin Case Sun, 02/04/2018 - 21:53 Permalink

There will be no war with NK. The United country will participate in the Winter Olympics and the little Rocket Man is a puppet of the Rothschilds and isn’t nearly as stupid as we think. Somebody in Trump’s cadre should be planning an extraction in Zug, SW with some of those Vietnam tunnel dogs.

The Cabal is whipped beyond recovery. Meanwhile, has anyone seen Jeff the Sessions? Murder and fraud have no limitations on time for sentencing but I think Pedophilia may have some deadlines after which, the perps walk.

In reply to by Justin Case

Oldwood zorba THE GREEK Sun, 02/04/2018 - 12:03 Permalink

Nothing that happens does so for no reason and that reason seldom is unplanned. Running up to suck in every dime of sideline or discretionary capital, even to the point of also run in up even more debt. Sure, much of it will be unpaid, but much of it will, sucking even more capital out of any remaining pockets of wealth. No only have they inflated consumer confidence, but even that of Trump, the heir apparent of the impending doom.

Volatility drives the market's but destroys business and jobs. Each crash takes more and more permanently out of the work force and on to the roles of dependency....just where our Utopian progressives want them.

In reply to by zorba THE GREEK