Buy The Breakout At Your Own Risk

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Includes: UUP, XBI
by: Austrolib

Summary

Quarterly M2 money supply growth rates are still below 2%, and this could persist into next week as well if the one-week average stagnates one more week.

Even though no flash crash has occurred yet, stocks are far from safe. I'm holding my puts, the last of which expire on October 20th.

The aftermath of Hurricane Harvey could end up negatively affecting M2 by encouraging cash withdrawals in Texas. More cash means less deposits to be lent out to expand M2.

A flash crash is still possible from here, and equity advances may just be extra cash already in the system now being put to work, but without new hot money to support a trend.

The S&P 500 is now within a hair of breaking out to new highs. Forgive me for abstaining from buying this breakout, but it doesn't look like it will last.

Six weeks ago, I wrote that we are 4 to 6 weeks away from a flash crash. Obviously, that hasn't happened yet. I based this on the weak M2 numbers that showed that the US money supply was growing at a snail's pace, and the fact that the flash crash of 2015, the financial crisis of 2008, and the market top of 2000 were all preceded by very low, sub 2% annualized M2 growth rates. Well, we've had some instability in the VIX the past few weeks but so far, nothing near a flash crash has happened.

I base the assumption that a big fall is still possible on the same evidence, namely, that the M2 numbers reported by the Federal Reserve are still stagnating quite badly. The annual growth rate of the quarterly M2 dollar supply is now growing at 1.6%, and has now been below the 2% mark for 5 straight weeks. While it does look like M2 growth will recover soon, it is hard to believe that capital markets will be able to trend consistently higher while M2 remains mostly stagnant.

The numbers that came in yesterday show that one week average M2 not seasonally adjusted came in at $13.6165 trillion, basically unchanged from a week ago and from two weeks ago as well. We are actually still lower on the one-week average than we were way back on April 17th at $13.6345 trillion.

I don't put all that much trust in the volatile one-week average, but over 4 months with no net growth there means that there is hardly any new money in the system since way back then, when the S&P was at 2,349. Despite what it looks like, falling back to those levels is still in the cards, and if so, I do expect stocks to rocket back up as quarterly monetary growth rates accelerate.

How soon, we all want to know? My money is already where my mouth is, and I still own put options on the SPDR Biotech ETF (XBI) out to September 15th and October 20th, but do not plan on accumulating any more. So if there is no serious downside action by October, my options will expire worthless. At that point, everyone can say I was wrong. Until then, it's still a waiting game.

Can stocks theoretically climb if money supply is stagnating? Yes, but only if cash balances already in the system are now being invested in equities. Either cash balances already in the system previously unspent (AKA dry powder) are now being poured into equities from commercial and institutional traders, or retail traders who have not otherwise invested in stocks at all until now are starting to do so.

Either way, there is only so much cash that either of these sectors has, and it will probably run out before M2 quarterly growth rates accelerate. In order for stocks to trend higher, more hot money is needed in the banking system. When will that be? Acceleration in M2 growth should occur around October by the trends I'm seeing on the H.6 reports.

But back to the latest H.6 Money Stock Measures Report. M2 for the last week in August will be reported on Thursday. Historically, that number can go either way next week. Hurricane Harvey may affect the M2 supply negatively if it forces Texans to withdraw cash from their bank accounts and turn M2 deposits into M1 currency. Withdrawing cash from deposits tends to drag on the money supply, because once cash is physical, it can no longer be loaned out under fractional reserve. We may find out if this "Harvey M2 shrinkage effect" indeed happened in next week's H.6 report.

In any case, if the one-week average stays stagnant or falls next week, the annual growth rate for the quarterly average will remain below 2% for the 6th week straight. This is what happened in 2015. So while from a technical perspective, the breakout (still not above all-time highs though) looks encouraging, the money is just not there to sustain a breakout even if no flash crash occurs.

The best-case scenario, in my view, is that the S&P keeps churning up and down around all-time highs for the next two to three months, so there is little point to buying stocks specifically now when monetary growth rates are so low. I still think though that a quick flash crash could occur at any time.

There are other headwinds for stocks besides money supply that make me quite suspicious of recent upside activity. First there are the constant leaks about President Trump wanting tariffs. If he gets them and a trade war is exacerbated, the dollar, already quite weak, could plummet fast. The dollar index (UUP) briefly broke through 3-year support at 91.88 earlier this week, but bounced from there. We now have a potential double bottom in the dollar index, but if this level is broken, there is no support until the mid-to-low 80s.

A falling dollar is sometimes bullish for stocks, but not a plummeting one. Especially during times when the money supply is stagnating, the dollar should not be falling so fast. Gold may be sniffing this out already and anticipating a fall in the dollar.

All in all, I'm not buying this advance, literally or figuratively.

Disclosure: I am/we are long UVXY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short XBI and long precious metals.

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