A Fork in the Road?

From the October 4, 2015 HRA Journal: Issue 240

Oy, that Coffin!  More indecision?  ‘Fraid so.  I still see a bear market confirmed before year end as the likely scenario. But, as of a couple of days ago there is a new storyline in town.  This new one involves the Fed throwing up its hands and giving up on the idea of raising interest rates.  That’s not what Fed governors are saying but it’s what an increasing number of traders believe.

I don’t believe the new storyline yet myself and I don’t expect the Fed to admit to it if they do.  Unfortunately, the Fed now has less credibility than a Baptist preacher in a whorehouse.  They brought that on themselves by wimping out repeatedly in the past two years so I’m not sympathetic. If the trend in earnings and GDP I discussed in the main editorial comes to pass the Fed’s hand will be stayed no matter what they want. 

That won’t save the bull market if the economic readings get really ugly. If they are just mediocre and rates stay at zero Wall St could push higher in a long if shallow uptrend.  The good news is that in that scenario commodities and especially gold and silver go along for the ride.  If you prefer that fork in the road your positioning should start now.  If you fear the bear you can wait though precious metals miners may not get a lot cheaper.  Note that the second scenario would ultimately end in a bear market, and probably a much worse one than I currently expect –but it might not arrive for a couple of years. 


The chart above is precisely the same (but updated) as the version that graced the front page of the last issue.    You can see how the markets have progressed since then. It’s even more plain that the current market pullback isn’t a replay of last October’s V shaped bottom or the two or three that preceded it. 

Bulls will be, and perhaps should be, heartened by the right side of the chart that shows a strong bounce as this is written.  That’s good but we’re not out of the woods just yet.  There is no easy way to tell whether we’ve just seen the second half of  a lasting double bottom.  That is possible but this sort of high volatility fluctuation is also common as long term trends are breaking down. At a minimum we need a closing high above the mid-September “Fed-day” spike above 2000 before I’d assume that a long term uptrend is back in play.

Traders remember the steepest most violent parts of past crashes but bear markets usually start with something milder and more hesitant. A crash, if it happens, often comes months after the official top.

Charts are nice and all but I’m a fundamentalist at heart.  We still need to look past the chart and see why markets are trading the way they are.  That will give additional clues on where things may be headed in the near and medium term.  Recent events and economic readings indicate two potential and quite divergent paths from here forward.  I think the market has again reached at a fork in the road. It shouldn’t take long to get a firmer sense of which path it will take but it’s too early to be sure.  I’ll look at the more bearish version first then discuss a potential bullish “out” that may be developing now. 

A noted above, I want to see the S&P get back above the 2000 level.   Until the S&P can get (at least) above the false breakout after the last Fed meeting we’re still in a downtrend. That’s simply a statement of what is, not a prediction.  On the basis of current evidence the market’s most likely direction is still down.

As you know, market breadth is something that has concerned me for a while.  It’s common near major tops for market breadth to narrow as a smaller and smaller number of hot stocks do the heavy lifting for the whole index.

The recent bounce in the market was concentrated in “hot” sectors like consumer discretionary, healthcare and got an additional boost from oil stocks.  If oil manages a comeback it could bring other hated sectors like materials along for the ride. That would indeed be encouraging but so far it’s still a blip.

To get a better sense of the overall temperature of the market I’ve displayed XVG, the Value line Geometric Index, above.  This index of over 1700 stocks is calculated to be equally rather than market cap weighted.  In other words it tracks the aggregate percentage change in individual share prices rather than the total market value of the companies in the index.  It gives you a good sense of whether the market in aggregate is displaying rising or falling share prices, or neither.

As you can see it looks quite a bit different from the S&P, especially in the past few days. XVG topped in April and was down several percent before the fireworks in August.  Significantly perhaps, this broader index did NOT make a double bottom in September as the S&P may have.  It fell below both the August and the October 2014 lows. 

XVG is still in a clear downtrend and has a lot of work to do before it’s going to look positive.  The better known market weighted Russel 2000 index isn’t as negative as XVG but it looks less healthy than the S&P too.  RUT hasn’t fallen below last October’s low yet but it did break the August low and is still in correction territory.  Everyone focuses on the S&P but the weaker broad and unweighted indices should keep us cautious unless they join the party.

Another very good reason to stay defensive is highlighted by the chart below.   This long term trace of consensus earnings expectations recently turned negative for the first time since 2009.  I view EPS expectations as a “leading-lagging” indicator.  Buy side analysts that generate these estimates tend to be optimistic (they’re called “buy side” for a reason) and only bring down estimates when exogenous events like oil prices or guidance from the company being covered forces the issue. 

Historically, EPS estimates almost always drop as earnings season nears. Analysts get guidance or whispers and alter estimates to match or come in slightly below expected earnings.  It’s a quarterly game and the reason that breathless headlines about “earnings beats” get nothing but eye rolling from me.

Cynicism aside, it IS significant that the recent earnings estimates are negative.  You can see from the chart that this is not a common occurrence. I think this chart goes farther to explain bearish retail sentiment than anything else.  We’ll see how reported Q3 earnings end up but it looks close to guaranteed we’ll have back to back quarterly earnings decreases. It’s not just about oil and there’s no way to put a good spin on this.  

A seasonal oil rally could still cheer investors even while earnings are being reported but I don’t know of an instance where were had back to back earnings declines and didn’t get a 20% pullback. This isn’t good.

On the broader economic front, the two charts on the next page summarize the current situation and potential dangers.  The top chart is a long term trace that compares the Institute of Supply Management (ISM) Purchasing Manager’s Index, a compilation of regional US Fed activity surveys and growth in US real GDP. 

The first thing to note is that the ISM and regional Fed surveys do indeed seem to work as leading indicators.  Good to know.  PMI surveys are structured so that a reading of 50 indicates zero growth. 

As you can see from the chart these surveys have been good leading indicators that growth would slow, but not perfect leading indicators of recession.  Really deep dips do precede recessions but mild ones may only indicate slower growth. This makes sense as these indicators are weighted towards the goods producing sectors. A lot of service activity isn’t captured and could still be positive.

Based on the current readings we’re not in the danger zone but the recent drop has been steep and hasn’t bottomed yet.  It’s highly likely based on these surveys we will see a drop in the growth rate in Q3 and Q4.  I consider this significant since the second half of the year has been stronger and salvaged US growth readings in the past 3-4 years.  It’s looking like 2015’s GDP number will not be pretty.

The lower chart on this page is the Atlanta Fed’s GDPNow estimate, with an end date of October 1st.  GDPNow is designed to mimic the calculation method used by the US Bureau of Economic Analysis to generate its official GDP estimates.  The initial official estimate will come out in late October and won’t actually be final until a couple of months later after revisions.  The Atlanta Fed generates this real time estimate for the use of Fed itself but makes it publically available. 

Keep in mind this is a real time estimate that changes constantly as new data is input.  It’s very much subject to change but still useful since it’s a current snapshot. It doesn't have the huge lag built into the official survey.

As you can see from the right side of the chart GDPNow has fallen off a cliff in the past few days.  This is NOT due to the September payroll numbers.  The index dropped after the inclusion of the first estimate of the September trade balance from the US Census Bureau on September 29th.  That estimate calls for a fairly awful trade deficit of $67 billion.  Remember imports-exports is one of the key numbers in the GDP calculation.   A widening trade deficit comes right off the top.

This number will keep changing as new data comes in but there is currently a huge gulf between the GDPNow estimate of 0.9% Q3 growth and Wall St consensus of about 2.5% growth.  Unless this fully resolves in the favor of Wall St, which I doubt, it’s another nail in the coffin of the bull market.  Conspiracy theorists will note that this calculation is used by Fed Governors.  It’s possible they knew the dip was coming when they held rates though I personally doubt it.  

The most recent data point that swayed the market was, of course, the September employment numbers.  As has been widely reported this was another awful number and a big “surprise” to the Street.  New jobs came in over 50k below consensus and both the August and July estimates were revised downward. August was a particular shock for Wall St as that month has seen upward revisions the past three years.  

Wage gains and hours worked were, again, awful.  No wage gain and a slight decrease in average workweek.  I’ve said it many times before but I’ll keep repeating it.  Until the US economy starts generating larger wage gains outside the island of Manhattan we will not see a sustainable acceleration in growth.  

Traders were agog and aghast at strong car sales in September.  They were indeed impressive but part of a continuing trend of sales concentrated in areas of cheap credit.  Consumers didn’t pay cash for those cars.  They took out cheap loans.  Nice, but not a long term sustainable trend.  We’ve seen that movie before and know how it ends.

I’ve probably scared you enough.   With the bad stuff out of the way I’ll briefly describe the potential road out from a looming bear market that may be forming up now.  I consider this optimistic scenario less probable but that could change in coming weeks.

The simplest bullish interpretation comes from the S&P chart on page 1.  While I’m not convinced yet myself we did just see a retest of the 1870s level on the S&P.  That may indeed be a bottom and it’s a totally valid reading of the situation if you’re bullish. Time will tell.

The other potentially bullish factor comes from the Fed itself.  I stated in the last issue I thought the Fed should have raised rates at the September meeting.  Indeed, I think they should have done it 18 months ago.  The way the market reacted to the Fed’s stand pat announcement tells me I was right about that.  I think the Fed has just experienced the final credibility breakdown I was worried about.

Traders did not react with joy when then Fed announced no rate increase.  Unlike many recent similar instances traders almost immediately got scared and started wondering what the Fed knew that they didn’t.  The fact the Fed lowered both forward GDP estimates and interest rate assumptions didn’t exactly help.

In the two weeks since the Fed meeting there have been plenty of speeches given by individual Fed governors. Most of these have tried to sell the idea that there is an increase coming soon and that They Really, Really Mean It This Time

Bond traders are utterly unconvinced and even more cynical about the Feds motives.  The yield curve doesn’t price in the first rate increase until March and only prices in one 25bp rise in all of 2016.  That tells you what bond trader think about growth prospects but, ironically, also points to a potential out for the market.

A falling yield curve and flattening US growth picture could put a near term top on the US Dollar.  The chart above shows the US Dollar Index for the past year.  After surging for months and topping around the 100 level early this year the index has gone nowhere. It’s been in a slight downtrend but that could soon steepen.

Virtually everyone has been bullish on the USD for the past 18 months.  As I predicted, the Dollar topped out when the ECB started its QE program but it hasn’t fallen back much.  That makes sense if you expect both higher economic growth and higher interest rates in the US.  Those two main determinants of currency cross rates have favored the US.  I didn’t expect a drop in the USD unless we had a bear
market and/or weakening US economy. That could be changing.

I think the Fed still wants to raise rates but it will be increasingly risky to do it.  If growth slows as much as I expect the Fed could hold off raising rates for a long time.  That basically removes the main underpinnings of the USD bull market.   

Add to that a worsening trade picture and you’ve got a currency that should drop.  That could be the markets out.

Remember, the USD is not just a side effect to the issues that have plagued markets this year.  Its front and center. Part of the reason so much money has flowed out of emerging markets is that a soaring dollar means these markets need to post large gains just to stay even in USD terms.  It’s become a feedback loop were hot money exiting drives down EM currencies, drives up the dollar and scares more money out of EM markets and so on.

This isn’t just an investment flows issue. Many emerging markets (Brazil is a prime example) have huge amounts of corporate debt denominated in USD.  Collapsing local currencies have created a disaster waiting to happen as these companies face falling revenues and ballooning USD debt loads.  Little wonder traders have run, not walked, away from these markets.

In addition to easing pressure on foreign firms—and central banks—a falling USD would have a positive impact on commodities.  Again, this would ease problems in many commodity producing countries. If this is how things pan out some of the biggest beneficiaries will be “commodity currencies” like the CAD and AUD.

If this sounds suspiciously like a gold bug narrative that’s because it fits that too.  If traders come back to the “lower forever” narrative for the Fed there is a lot of downside in the Dollar and precious metals would be a direct beneficiary.

The gold chart above shows gold spiking when equity traders panic then falling back but holding its lows.  If the market moves to a “ZIRP forever” mentality I expect gold and silver to keep moving higher.  Under this scenario the bottom would be in on at least a medium term basis. 

Gold needs to clear and hold first the August high then the $1200 level to get any respect.  The jury is still out.  More weak US economic readings would help, as would any sign of strength from either China or Europe.

Ironically, this scenario could bring back the Wall St bull market, at least for a while.  If the Fed really leaves the field we could get another weaker extension to the Wall St run which would include commodities and especially precious metals this time.  The ultimate end game after that run might be uglier but that’s for later. In the meantime, beleaguered resource traders could elbow their way to the punch bowl before it’s taken away for good.  Either fork in the road could help us.  The “optimistic” no 2015 bear market route would be quicker though it could end with something nastier later.

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