Plenty Of Warning Signs - Financial Relativity Index Says 1Q'17 Correction Likely

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Investors should beware when politics start to cause them to stampede into positions and bid up stocks that were arguably over valued before the election.

What Trump is about to do is long overdue, but, I do not believe the road will be as easy as the market might lead investors to believe at this point in time.

The 7 signals which track the Financial Forces will either impede or support the stock market from making new highs going forward. Currently, all of the signals have moved into a position of market resistance.

What is not to love about this stock market rally since Trump was elected? Those who stayed put and did not sell the initial knee jerk reaction by the market to sell have been rewarded by a euphoric rise in market valuation as measured by the broad market indices (NYSEARCA:DIA) (NYSEARCA:SPY).

But investors should beware when politics start to cause investors to stampede into positions and bid up stocks that were arguably over valued before the election. Need I remind readers that over the last 8 years we had a stock market that rarely fell because the Fed kept interest rates at zero percent? Then, Europe and Japan central banks piled on with equally outrageous asset buying programs, including buying equities. But the central bank inflation which underlies stock market valuations does not seem to be top of mind to the minions who are racing into the fire in seeming support of the Trump "white knight" whose nationalist message combined with large tax cuts and infrastructure spending are going to put a "chicken in every pot".

Don't misread me as a Trump non-supporter. What he is about to do is long overdue, and I believe that the trade aspects of his platform must be executed in order to right the wrongs of the past 25 years. But, I do not believe the road will be as easy as the market might lead investors to believe at this point in time. I do get the positive market move based on the expectation of lower corporate taxes. It is hard to argue against a direct government subsidy to corporate cash flow. But are corporate tax cuts and an infrastructure program going to be enough short-term to keep the market at these lofty levels as the air in the stock market bubble is simultaneously released? The odds are not good on this bet as the indicators I track in the Financial Relativity Index empirically are currently indicating.

Every indicator in the model has either turned to caution or warning level as of the end of November 2016. The combined risk score of 37 in the model places the probability of a 10% or more drop in the market within the next 3 months at over 90%.

Financial Relativity Index Metric Review

Looking at the Market Risk Index, the risk recently moved to elevated status because of the current stock market trading pattern. When the market makes a sharp move higher over such a short period of time to a new all-time high, there is almost always a high probability of a next move being sharply down, not higher. Historically euphoric moves upward have been met with sharp resistance once the honeymoon that caused the emotionally driven move is over and reality settles in.

It is the market reality relative to history that should cause investors to be much more cautious at the present time. This reality is captured in the 7 signals which track the Financial Forces which will either impede or support the stock market from making new highs going forward. Currently, all of the signals have moved into a position of market resistance.

Credit Market Force: Reflects an over-stretch consumer and business loan lending market relative to GDP. In-depth review of this indicator is contained in the report found here. With rates now rising and reserve requirements stiffening, pressure will be on the lending sector to scale back on marginal loans rather than just rolling over questionable credits. This phenomenon will not be confined just to the United States as excessive central banks accommodation is scaled back in the world wide financial system moving into 2017.

BAA1 / 30 Year Signal: This indicator captures the relative spread between the US Treasury market and lower investment grade credit market. Typically a widening of the spread is the signal that occurs as the stock market moves into a downward move. Right now, the signal in the model is responding to the major upward move in rates in both the business loan and Treasury market. The spread has been maintained in the rate move at a cautionary level. However, rate spikes upward of the level seen in the last 30 days, which are expected to continue, do not historically bode well for stock valuations in the intermediate term.

Fed Policy Force: My how an election has changed the perspective of the FOMC members. And they say they make decisions independent of politics. Well, the political winds have changed toward tax cuts, infrastructure spending and most likely higher deficits and inflation. See why higher inflation is now likely here in the article Money Supply Conundrum: So Much Money, So Little Inflation, For How Much Longer?

The Fed is now expected to raise interest rates in December, and I would not be surprised if they continue to increase the Fed Funds rate moving into 2017 until the financial system breaks. Pulling back on monetary policy as fiscal policy becomes more active has been the Fed track record, and I don't expect anything different now, particularly given the extreme position that Fed policy was put into under the Obama administration. See more analysis on this topic here in the article Fed Trumped, Rates Up, What You Can Do.

10 / 5 Treasury Signal: Just as with the BAA1/ Treasury signal, this indicator is in warning mode because of the sharp move upward in Treasury yield curve across the board over the past 30 days. Currently the signal shows a risk-on market move as the yield curve has not yet flattened substantially. However, any change in the current upward slope in the yield curve if the Fed tightens in mid-December will not bode well for stocks heading into 2017.

Fiscal Policy Force: Too little, too late is the signal being flashed by this indicator at the present time. Clearly the market is paying up on the hope that government spending and tax cuts are going to intercept the downdraft of an overstretched lending market and moves upward in interest rates. However, the reality right now is that the current fiscal policy is still behind the curve, and will not catch up until later in 2017 and moving into 2018. Then the question will become whether the changes are enough to offset any changes in the credit market which are already underway.

Oil Market Force: OPEC surprisingly managed to get its members to agree to a 1M barrel production cut last week. This event is happening after 2 solid years of low capital spending around the world in the exploration for new oil reserves. Oil demand worldwide, however, is not expected to go down in the intermediate future.

On the contrary, expectations are that it will continue to rise. Prices rose sharply on the front-end of the oil futures curve after the announced OPEC deals. The short-term quick move in prices pushed the oil market indicator to cautionary status for the first time in many years. The oil market is now a likely headwind, not a tailwind for the economy in the intermediate term.

My oil market forecast is currently for a front month spike in prices by the summer of 2017. If this were to happen, the magnitude of the spike would very likely forewarn a more prolonged downward move for US equities. The market set-up for a mini-spike to the $60-$70 per barrel range is currently in place.

A more dramatic move would likely involve some form of geopolitical turmoil as Trump transitions into office. I do not see any geopolitical risk premium currently priced into the market at this time, as most market players are assuming the US oil industry can gear up in response to any threats, particularly if the price spikes higher.

One caution on this perspective, capital is not going to return to the US oil patch at a quick pace given the recent carnage; and, if a actual normal rate of return is demanded for new projects as interest rates move up, many projects will not get funded until oil prices are much higher.

US Dollar Recycle Signal: This last indicator is the most troubling to me as I see events unfolding in the US equity market currently. What this signal is currently capturing is an outflow of international money in the fixed income market, most notably US Treasuries. This trend is happening at the same time that the new Trump administration is coming into office with a fiscal plan which will require substantial increases in Treasury financing, at least in the short term, if not for the indefinite future. The plan is heavily focused on domestic investment and creating American jobs. However, the foreign money financing the US deficit is driven by US consumption of foreign exports.

There is a definite shift in the world market at the present time away from excess dollars being available to finance continual US deficits. The trend seems to be connected to the dramatic decline over the last two years in the US dollar price of oil. If this trend continues, and it appears that it will, look for much higher funding costs for the US government as well as much higher inflation pressures in the US economy, starting with the price of gasoline and petroleum based products imported into the US.

Managing your portfolio given current market conditions

All investors live with the some fear. Fear that they will make a stupid trade that costs as market collapses. And, in the case of today, I think the fear in many investors is that they are going to miss a historic rise in the stock market. The odds are better right now on a market collapse given the circumstances than a continued meteoric rise, at least in the short-term, regardless of how successful Trump is in "making America Great Again".

With that as a perspective, I continue to accumulate larger positions of short duration cash, or near cash assets, even though the interest rate is not yet commensurate with higher rates of inflation that I expect. The only long equity or near equity positions I have recently taken are in the oil sector. The alternative of doubling down on broader based risk assets at this time when there are multiple negative forces beginning to work through the financial system is not a good investment strategy in my opinion. Once the dust settles as the Trump transitions gets into full gear, better risk-reward uses for cash may become clear either in stocks or bonds. However, at this time, the long duration bond market is having a "bear" of a time. Smart investors should be paying attention to why this is happening.

Although the warning signs are clear, the market continues to move higher as this article is written. Stock buyers going too long at this time beware.

Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.