Introduction: This article uses intermarket analysis of the most important financial and industrial indicators to conclude that the risk of a 20-50% new bear market in stocks is now likely enough that investors should consider taking evasive action. While this article is technically oriented, it starts from the following fundamental standpoint: liquidity may be drying up. This phenomenon may have been at least partly behind the past week's crash in the precious metals.
Setting the stage: Just one example before going to the charts. Evidence of illiquidity now involves an investment icon, as Seeking Alpha reports today in Wall Street Breakfast:
P&G looks to save $2B by delaying payments. Procter & Gamble (PG) is reportedly planning to save up to $2B by extending the time it takes to pay suppliers to 75 days from 45 days. P&G hopes to sweeten the pain by working on an arrangement in which banks would pay the suppliers, possibly early, and then receive the money from P&G later on.
P&G would seek to preserve cash if it is experiencing slower business conditions than expected and/or slower payments from the retailers that sell its products.
Technical considerations: On April 1, I wrote: Copper Drops Again, May Be Sending A Warning To Global Investors. Then, "Dr. Copper's" price had just broken below $3.40/lb. It has now dropped to $3.20. It is breaking down from a multiple head and shoulders pattern. Here is the futures chart covering the past 14 months, from FINVIZ (which allows a 5+ year chart showing the complex bearish chart pattern):
The trend is down and the divergence between copper and the S&P 500, as judged by its tracking ETF (SPY) has become extreme. As the following three charts show, the SPY has risen from the starting point of each chart, whereas copper, interest rates, and the broad Continuous Commodity Index have all fallen.
|Compare:||JJC vs S&P 500 Nasdaq Dow|
The charts of many other important industrial commodities, such as oil and platinum, track that of copper.
The above is an important divergence. At least as important is the correlation between interest rates and stocks. The world is experiencing its lowest interest rates ever. The U.S. is not even extreme, with the 10-year bond (TNX) yielding 1.70%. This yield is in a renewed downtrend, as it has been every spring beginning in 2010.
Beginning in the summer of 2011, it diverged from the SPY:
|Compare:||^TNX vs S&P 500 Nasdaq Dow|
Next, we see a comparison between the GreenHaven Continuous Commodity Index Fund (GCC) and the ten-year Treasury bond, showing how closely a broad measure of commodity prices has been moving in the same direction as interest rates:
|Compare:||^TNX vs S&P 500 Nasdaq Dow|
Bond investors are forecasting a low nominal growth world. After their rebound off the 2008-9 bottom, so are commodities. Stocks are forecasting something better. Stocks are being outvoted, which implies that either bonds and commodities turn around and catch up stocks, or that stocks "catch down" to those asset classes.
Getting back to the illiquidity theme, the hits just keep on coming. Bloomberg.com reports today on increasing strains on banks in Europe in IMF Sees 20% of Corporate Debt Unsustainable in Parts of Europe. A key paragraph for stock market bulls reads:
"While large diversified companies may sell assets -- including foreign units -- to reduce leverage, potential profitable sales are likely to negatively affect their revenues and earnings," the IMF said. "Furthermore, additional cuts in operating costs, dividends and capital expenditures may also be required, posing additional risks to growth and market confidence."
Dividend cuts? Investors often forget that dividends are discretionary. Stocks are not bonds. (They are also not tangibles that have an infinite lifespan such as metals.)
As the above charts show, not only are U.S. stocks well above where they would be to be in better accord with commodities and bonds, the sponsorship of stocks has moved toward weaker hands. A number of reports have demonstrated that the amount of stocks that have been purchased on margin approximated the peak level from the 2007 period. In addition, speculators on stock index futures continue to be net long in multi-year record levels, especially on the "mini" contracts. The most important of those are futures on the S&P 500:
The green line represents commercial hedgers, who take the opposite side of the trade from the speculators, both large and small (red and blue lines, respectively). The "mini", the bottom graph, shows that at the major 2011 low, the speculators were massively short the market. Now they are "all in" on the bull case just as the intermarket fundamentals are accelerating away from stocks.
Is there danger ahead for these speculators?
Comment: The bull case on stocks might respond something like this:
"Yes, but most corporations see rising profit margins from lower commodity prices and from lower cost of debt. So what 's wrong with these divergences? They are all to the good."
I would respond that on the margin, a modest decline in input costs is good, but if those costs drop a lot, that sends a message of oversupply and declining demand. The same is true for interest rates, as most corporations are net borrowers. Rates are so low now that a further declining trend can only indicate declining demand for credit. You may have noticed that banks are not really competing for deposits anymore.
Since this article is basically technical, it must be said that a dictum of technical analysis is to point to either a time or a price (i.e., outcome), but not both. One could have written something like this in August 1998, before the Russian bankruptcy and LTCM fiasco triggered a brief but powerful correction. Then the economy surged, the NASDAQ nearly tripled off its correction lows to its highs. Eventually, both the economy and the NASDAQ made any summer 2008 bears correct-- but only in 2001.
One never knows either if one will be right, or if so, when that will be demonstrated.
Nonetheless, I'm worried enough by these divergences to be down to only a nominal allocation to stocks, in favor of greater allocations to cash and bonds.
Summary: Two giant markets, commodities and bonds, are in close agreement about the declining trend of nominal GDP growth. This is at variance with the message being sent from the U.S. stock market, which remains bullishly-configured and which benefits from fast nominal GDP growth.
Divergences generally require a trigger to cause them to revert toward their prior trend. In this case, spreading evidence of illiquidity and demand weakness in multiple markets and types of businesses suggest that U.S. stocks are now under pressure to "catch down" toward the others. The mess in the eurozone may be the trigger, just as the accelerating mess with the U.S. housing market was a trigger for global and U.S. markets in 2008.
The degree of divergence between the different markets discussed herein is now so great that for U.S. stocks to simply to catch down to commodities and bonds at their current levels, a large decline would be appropriate. However, should interest rates and commodity prices decline further, stocks are at risk of a discontinuous downward event.
There is of course no way to assign an odds ratio of any important adverse movement in stock prices actually occurring, or of pinpointing any timing of such an event. The operational question for stock market participants is simpler. It is whether to raise cash or hedge a stock market decline in other ways.