The U.S. stock market could see a significant correction based on overextended valuations.
The U.S. bond market benefits from a strengthening U.S. dollar and safe haven status.
The precious metals market benefits from low bond yields and emerging inflation.
In this article I'll go over the most prominent market moving correlations to give a thorough market outlook for the coming months. This way, investors know what to expect in the future. I'll also briefly touch my favorite correlations in the process.
1) Let's start with the stock market.
I've indicated many times already, that's we're in a stock market bubble. The Buffett rule says that the ratio of a country's total market valuation to its GDP is a very good indicator of whether the market is undervalued or overvalued. Clearly, today we are overvalued to an extreme of 124%. (Chart created by Gurufocus)
This overvaluation goes even further. While GDP growth expectations are dropping, the overvaluation could keep increasing in the coming months when GDP growth slows down. The following correlations show that GDP is definitively slowing down.
The 10 year treasury bond yield can be viewed as the fixed-income market's assessment of current nominal GDP growth on a year to year basis. Lately, we see that the 10 year and especially the 30 year U.S. treasury bond yield have collapsed to 2.40% and 3.16% respectively. They were much higher in January 2014. This tells me that GDP growth is collapsing as the following chart from FRED suggests. The drop in bond yields also indicates to us that money velocity is still slowing down, we will talk about that later on when we come to the bond market.
Another way to evaluate GDP growth is to look at the ISM Manufacturing PMI. In August 2014, the PMI printed a number of 58, which tells me that there is hope of a recovery despite a drop in bond yields and money velocity.
But overall, I think GDP growth is slowing down, which is not a positive for the stock market.
Another favorite correlation of mine is to look at the balance sheet of the Federal Reserve, because it is highly correlated to the stock market. The following chart clearly shows that the Federal Reserve has been winding down its asset purchases. So a drop in the stock market is imminent according to my knowledge. Marc Faber and George Soros both suggested a correction in the stock market. Marc Faber talks about a 30% correction and George Soros bought puts to protect against a drop in the stock market.
Other indicators pointing to a lower stock market include a decline in the Dow transportation average, a flattening out of total credit growth, the employment to population ratio rolling over, consumer sentiment topping out, high P/E ratios. So there is a lot of reason to be bearish about equities.
2) Now let's go over to the U.S. bond market.
We know that the Federal Reserve is winding down QE. We have a correlation that says that the Federal Reserve balance sheet is correlated to the U.S. bond yield. As long as Janet Yellen sticks to her plan to stop asset purchases by the end of this year, there is a good chance that bond investors will have good returns.
Another symptom of a rising bond market can be seen in the strengthening U.S. dollar. As you can see on the chart below, the euro has started to top out, which tells me that wary investors are slowly flocking into the U.S. dollar and its U.S. bonds (for its safe haven status) while expecting a stock market correction in the near term.
More evidence of lower U.S. bond yields can be found in the velocity of money, which isn't picking up at all. This is a sign that the economy really isn't picking up speed.
As long as the Federal Reserve doesn't increase interest rates, we will keep getting lower bond yields. So it is very important to predict when the Federal Reserve will finally increase interest rates. There are many metrics to predict this event. First we need to look at the employment to population ratio. As long as this ratio doesn't increase, the Federal Reserve can't increase interest rates as it will trigger a recession with rising unemployment. The chart below suggests that the recovery is far from strong enough to start thinking about a rate hike.
The second metric to predict a rate hike is the consumer price index which measures inflation. When inflation shows itself, the Federal Reserve needs to hike interest rates. We're far from seeing double digit inflation at this time, but it is starting to appear.
The conclusion is that U.S. bonds are a pretty good investment right now as we aren't seeing much of inflation and aren't seeing much of a strengthening employment picture. The unwinding of QE will add to this strength in the U.S. bond market.
3) Finally, let's talk about precious metals.
The 2 most important metrics to predict the direction of precious metals are bond yields and inflation. The following chart combines the two metrics. Lower U.S. bond yields and higher consumer price inflation will trigger higher precious metals prices. 2014 was a pivotal year as we saw a huge decline in U.S. bond yields and a moderate rise in inflation. Gold did pretty well this year and as I expect U.S. bond yields to continue to drop, gold prices will be supported. So it basically comes to predicting the CPI and the U.S. bond yields. We already know the U.S. bond yields will drop, but what about the CPI?
The Consumer Price Index is correlated to many things. My favorite correlation is capacity utilization for the total industry in the U.S. Since the recession of 2008, capacity utilization has recovered very well and stands at 79.2 in July. This suggests that inflation expectations will be growing in the coming months and we'll see the CPI creeping upwards. On a side note, I expect that inflation will be further increased by the decrease in excess reserves (bank deposits minus loans) of which I talked about here.
I also keep an eye on the money supply growth as an increase in money supply is the basic definition of inflation. You can monitor the money supply here. As you can see, we're still on track to make new highs. You might have heard that George Soros increased his positions in gold miners to leverage himself in gold. In particular, he positioned himself in Allied Nevada Gold (NYSEMKT:ANV).
For more near term price fluctuations I mostly look at the managed money short positions to see if a short squeeze in precious metals can occur. Silver for example, is ready for a short squeeze at this moment as the amount of shorts has substantially increased this past week (Chart created by Correlation Economics). A peak in shorts typically points to a bottoming price level.
It also pays off to take a look at the premiums in gold and silver, which I report here on a weekly basis. Today we see record high premiums in silver at the Shanghai Stock Exchange, which means that silver is the place to go to right now (Chart below on silver premium created by Correlation Economics).