Beware 2-2.5%, Credit Ratings, And Debt

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Michael Bryant
Summary

Buffett argues that a stock market crash would not happen until the 30-year treasury hits about 5%.

S&P downgraded the nation's credit rating when debt to GDP hit 100%.

Dept to GDP is 106% and is projected to hit 112% by 2021.

The bull just does not want to die! The current market is the second longest bull market since World War II. As of November 6, the bull market would be 104 months long since it started on March 6, 2009. The longest was 113 months long in the 1990s. So 9 more months, or on August 6, 2018, would make it a tie. But will the bull market last that long? Yes, when Trump’s administration falls apart or when a black swan event like war breaks out, that could be the beginning of a stock market crash. But ignoring politics and the never-ending possibility of war, could just interest rates and the debt crash the markets? And when would that happen?

As I stated in my July 10 article, the last bullish rounded bottom technical indicator in the long-term graph of the Dow (DIA) gives a peak target of 21,560 by September 2018. The index closed at 23,377 on October 31. The index could fall to 21,560 (7.7% decline), could wipe out the entire Trump Trade and fall back to 17,888 (23.4% decline), or could fall to 14,093 (39.6% decline). The dark red line connects many of the peaks between 2012 and 2015. This line intersects the current price, meaning price growth could slow or a peak could be soon.

Source: Google Finance

The S&P 500 (SPY) also had a bullish rounded bottom technical indicator with a peak target of 2,431 by September 2018. The index closed at 2,575 on October 31. The index could fall to 2,431 (5.8% decline), could wipe out the entire Trump Trade and fall back to 2,085 (19.2% decline), or could fall to 1,577 (38.9% decline). The dark red line connects many of the peaks between 2010 and 2015. This line intersects the current price, meaning price growth could slow or a peak could be soon.

Source: Google Finance

The Nasdaq (QQQ) also had three bullish rounded bottom technical indicators with the first giving a peak target exactly at the actual 2007 peak. But the timing was way off. The last rounded bottom gave a peak target of 5,893 by August 2017. The index closed at 6,727 on October 31. The index could fall to 5,893 (12.1% decline), could wipe out the entire Trump Trade and fall back to 5,046 (24.7% decline), or could fall to 4,363 (34.9% decline). The dark red line connects many of the peaks between 2012 and 2015. This line intersects the current price, meaning price growth could slow or a peak could be soon.

Source: Google Finance

The bullish cup and handle technical indicator for the Russell 2000 (IWM) gives a target of 1,305 by July 2018. The graph also formed a bullish rounded bottom technical indicator, which gives a different peak target of 1,467 by November 2017. The index closed at 1,503 on October 31. Based on the target, the index could fall to 1,467 (1.5% decline), could wipe out the entire Trump Trade and fall back to 1,163 (21.9% decline), or could fall to 1,033 (30.7% decline). The dark red line connects many of the peaks between 2014 and 2016. This line intersects the current price, meaning price growth could slow or a peak could be soon.

Source: Yahoo Finance

The Dow, S&P 500, Nasdaq, and Russell 2000 have targets below the current price. Both the Dow and S&P 500 have targets for September 2018. The Nasdaq had a target for August 2017, while the Russell 2000 has targets for November 2017 and July 2018. It does seem like all indexes could peak within the next year. Let’s see if the 1-year graphs show anything else.

Source: Stockcharts.com

The Dow formed a bullish rounded bottom, and the target would be 22,700 (a decline of 2.78%) by November 2017. The W%R and RSI are both overbought. Two of the three times when the RSI and W%R were at similar levels, the index peaked.

Source: Stockcharts.com

The S&P 500 (SPY) formed a bullish rounded bottom with a target at 2,535 (a decline of 1.78%) by November 2017. The W%R is overbought, and the RSI is almost overbought, but only one of the three times when the RSI and W%R were at similar levels, the index peaked.

Source: Stockcharts.com

The Nasdaq formed a cup and handle with a target would be 6,730 (a 0.4% increase) by December 2017. The W%R and RSI are both overbought, but only two of five times the W%R and RSI were at similar levels, the index fell.

Source: Stockcharts.com

The Russell 2000 (IWM) formed a bullish rounded bottom with a target at 1,545 (a 2.5% increase) by December 2017. Both the RSI and W%R are neither overbought nor oversold. Only one of three times the W%R and RSI were at similar levels, the index peaked.

The 1-year technicals for the Dow and S&P 500 give targets below current price, while the Nasdaq and Russell 2000 give targets above the current price. The Dow, S&P 500, and Nasdaq were in or near overbought territory, but only the Dow and S&P 500 had a bearish downward cross in the MACD.

The jobs report for September was a warning sign that the economy is starting to fall. The economy lost 33,000 jobs in September, far lower than the expected increase of 90,000 jobs and “the first monthly decline in seven years.” While Hurricane Harvey and Irma really hit the economy hard considering that Houston is about 3% of the nation’s GDP, why have the other hurricane disasters since 2009 not caused a loss in jobs?

Harvey is estimated to cost $65-$190 billion in damage, while Irma is estimated to cost $50-$100 billion in damage. To compare, Hurricane Sandy cost an estimated $70.2 billion in damage in October of 2012. But Hurricane Sandy saw job gains of 150,000-200,000. The job losses seem to be not just a temporary cost of the storms, but part of a cyclical downturn. The August jobs report, which happened before the storms, was also a disappointment. In that report, the nation created 156,000 jobs, a decrease from the previous two months and below expectations of 180,000 new jobs.

Source: U.S. non-farm payrolls forecast

Job growth was a big focus of Trump’s agenda. Thus, the entire Trump Trade may be wiped out, meaning a decline to where the indexes were on Election Day, November 8, 2016. That would be 17,888 for the Dow, 2,085 for the S&P 500, 5,046 for the Nasdaq, and 1,163 for the Russell 2000. Thus, if the Trump Trade collapses, the Dow, S&P 500, Nasdaq, and Russell 2000 would fall 23.67%, 19.22%, 24.70%, and 22.88% respectively.

But the VIX Volatility Index gives a pretty good hint that the market has not peaked just yet. The VIX is often seen as the calm before the storm, and thus could be a warning sign. But according to the graph below, the VIX likely needs to rise to the mid-20s for the S&P 500 to see a peak before a market crash. The VIX was at about the same level in 2007, and it took nearly a year before the S&P 500 peaked in 2008.

However, two of the last three corrections (shown in orange) happened not long after the VIX hit a low around 15. In the other correction, the VIX stayed around 12 for nearly 3 years before a correction hit. Thus, wait until the VIX hits at 12-15 for a possible correction and mid-20s for a peak before a crash.

Source: VIX Volatility Index and S&P 500

It seems unlikely we will go to war with North Korea, so the market should probably ignore the threat. China has already said long ago that it will protect North Korea if the U.S. attacks first, and it will not protect North Korea if it attacks the U.S. first. The U.S. would likely not risk a war with China, and North Korea is probably not crazy enough to fight the U.S. alone. It seems that North Korea is trying hard to get the U.S. to attack first. And it is very important that the U.S. does not take the bait.

But even if we did go to war, the market probably would not crash unless the war becomes like World War II. As I stated in my May 2 article, in the Korean War, the Dow only fell about 5.5% in the first few days before recovering everything it lost in the next two months. World War I only saw a 10% pullback in the Dow, and stocks finished the war up. Only World War II saw a 50% crash, and stocks finished the war flat.

While the market is overvalued based on the P/E ratio and the Shiller P/E ratio, both which are near pre-crash highs, Warren Buffett points out to watch future interest rates and the 30-year treasury, saying that “everything in valuation gets back to interest rates.” Buffett thinks stocks will continue rising till long-term rates are 5.00-5.25%.

The 30-year treasury is currently at 2.95%. According to the graph below, the 30-year treasury rate seems to be on a 30-year downtrend of about -0.22% per year and may hit 2.67% by October of 2018 and 2.45% by October of 2019. So unless the 30-treasury starts to increase, the rate when stocks start to fall maybe much lower than 5%.

Source: 30-Year Treasury Constant Maturity Rate

Since the 1980s, the 30-year treasury has almost always been above the Fed Funds Rate. Further, since the 1980s, recessions always happened right after a peak in the Fed Funds Rate. So finding where the Fed Funds rate meets the 30-year treasury would be a warning for a recession. The Fed Funds rate was 5.00-5.25% in 2007, and the 30-year treasury was 4.91% at the S&P 500’s peak on October 12, 2007, just before the crash. The smallest Fed Funds rate that happened just before a recession was 3.50% in the late 1950s.

The current Fed Funds rate is 1.00%-1.25%, and the next Fed meeting is December 12-13. Yellen plans to raise rates one more time this year and three times next year. Thus, rates would likely be 1.25%-1.50% by the end of 2017 and 2.00%-2.25% by the end of 2018. Rates are expected to hit 2.8% by the end of 2019 or 2020, which would be higher than the estimated 30-year treasury rate.

If the Fed Funds rate ends 2019 at 2.8%, the intersection of the Fed Funds rate and the 30-year treasury would be in July 2019. If the Fed Funds rate ends 2020 at 2.8%, the intersection of the Fed Funds rate and the 30-year treasury would be in September 2019.

Source: Effective Fed Funds Rate and the S&P 500

But could short-term rates rise faster than planned, pushing down the 30-treasury further? Yes. In quantitative easing (QE), the Fed bought bonds, increasing the money supply. This helped push short-term interest rates lower despite near zero Fed Funds rate from December 2008 to November 2015.

  • During QE1 (December 2008 - June 2010), the Fed’s balance sheet grew by $1.4 trillion, the 30-year treasury rose 0.35%, and the S&P 500 fell 166 points (13.36%).
  • During QE2 (November 2010 - June 2011), the Fed’s balance sheet grew by $570 billion, the 30-year treasury rose 0.27%, and the S&P 500 rose 114 points (9.31%).
  • During QE3 (September 2012 - October 2014), the Fed’s balance sheet grew by $1.7 trillion, the 30-year treasury rose 0.49%, and the S&P 500 rose 581 points (40.43%).

Thus, QE1, QE2, and QE3 grew the Fed’s balance sheet grew by $3.5 trillion, increased the 30-year treasury by 1.11%, and caused the S&P 500 to rise 529 points (42.59%). If QE1-QE3 is reversed, the 30-year treasury could fall by about 1.11%. It is also possible that the S&P 500 could fall 529 points (20.50%).

Source: Fed’s Recent Balance Sheet Trends and the S&P 500

The Fed plans to start “unloading $10 billion worth of assets a month and then scaling up gradually over time until it is shedding $50 billion a month, starting in October 2018.” This has an effect of decreasing the money supply, and thus increasing short-term rates and likely decreasing the 30-year treasury rate.

  • sale of $10 billion a month for October 2017 – December 2017
  • sale of $20 billion a month for January 2017 – March 2017
  • sale of $30 billion a month for April 2017 – June 2017
  • sale of $40 billion a month for July 2017 – September 2017
  • sale of $50 billion a month for October 2018 – September 2019

Assuming the Fed follows the above timetable to reduce its balance sheet, the 30-year treasury could fall an additional 0.093% by September 2018, and the S&P 500 could decline by 44.3 points (1.7%). By September 2019, the 30-year treasury could fall an additional 0.279%, and the S&P 500 could decline by 132.9 points (5.2%). But this only reduces the balance sheet by $800 billion, so the timetable could be extended if necessary. Thus, the 30-year treasury could be 2.60% by September 2018 and 2.38% by September 2019.

If the Fed Funds rate ends 2019 at 2.8%, the intersection of the Fed Funds rate and the 30-year treasury would be in May 2019. If the Fed Funds rate ends 2020 at 2.8%, the intersection of the Fed Funds rate and the 30-year treasury would be in July 2019.

But the 30-year treasury could rise as a result of the debt limit fight. Congress escaped an October 1 federal shutdown and an October 3 partial default thanks to President Trump, who bypassed party lines to forge a surprising deal with Democrats in Congress to extend the U.S. debt limit and provide government funding until December 8. If Congress did shutdown the government and threatened a partial default, it could have caused credit rating agencies to downgrade the nation’s debt again.

While it is said that the U.S. has never defaulted on its debts, it has restructured them or delayed payment in 1790, 1861, 1933, and 1979. In May of 2011, Paul Ryan claimed that “bond holders would be willing to miss payments for a day or two or three or four if it put the United States in a stronger position to make future payments.” This thought caused investors to panic when Congress waited till just hours before the August 2 deadline to raise the debt limit.

On August 3, the nation’s debt “surpassed 100% of gross domestic product for the first time since World War II.” On August 5, Standard & Poor’s cut the nation’s AAA credit rating, causing the 30-year treasury to temporarily jump 0.12%. From July 22 – August 19, the S&P 500 declined 16.5%. Could it happen again? Any hint at a lower credit rating or a default would not only cause interest rates on the nation’s debt to rise, but it also “could trigger a recession.”

If the Fed Funds rate ends 2019 at 2.8%, the intersection of the Fed Funds rate and the 30-year treasury would be in October 2019. If the Fed Funds rate ends 2020 at 2.8%, the intersection of the Fed Funds rate and the 30-year treasury would be in February 2020.

Also note that the credit rating was lowered two days after the nation’s debt surpassed 100% of gross domestic product. The nation’s current national debt is $20.454 trillion, and the Congressional Budget Office estimates the national debt will be $23.964 trillion exactly four years later. That is a $3.510 trillion (up 17.16%) in four years, or $877.5 billion per year. GDP is currently expected to be $19.20 trillion by the end of this quarter and is calculated to be $21.26 billion by 2021.

Thus, the current Federal debt to GDP is 106.40% and is estimated to be 112.70% by 2021. Cyprus, which went through a financial crisis in 2013, is right next to the U.S. at 107.80%. Unless Congress starts lowering the debt, it seems like another credit downgrade will be soon.

The intersection of the estimated 30-year treasury and the estimated Fed Funds rate seems to be sometime in 2019. Fellow contributor Andrew McElroy wrote that the nation could see a possible recession about 17 months on average after the assumed December Fed rate hike. That means a recession could strike in May of 2019. This also goes well with the inverted yield curve shown below. The 10-year treasury minus the 3-month treasury note yield curve predicted a recession in 2001 and 2008.

Both times the market crashed after the inverted yield curve hit zero. However, the crash was about 4 months after the first cross in 2000 and about 1.5 years after the first cross in 2006. It seems that an inversion would happen somewhere between mid-2018 and mid-2019. And a crash followed by a recession could come 4-18 months after the first inversion.

Source: Daily Treasury Yield Curve Rates and the S&P 500

Conclusion:

While North Korea continues to be a headache, the growing debt, rising interest rates, and slowing job growth will eventually crash the market. Besides accumulating cash to hedge against any such decline, I would recommend buying gold (GLD), which gained 25.7% during the crash from October 12, 2007–March 6, 2009. And it appears that a shortage in gold could be coming. From its graph below, the metal formed a bullish rounded bottom with a target of $1,396/oz. by December 2017. The W%R is oversold, while the RSI is more oversold than overbought.

Source: Stockcharts.com

One could also buy bitcoin (COIN), as I found it to be an alternative “digital gold.” I would recommend buying the actual coin and keeping it in cold storage instead of buying Bitcoin Investment Trust (OTCQX:GBTC). Each share of GBTC sells at a premium, equals 0.09227639 bitcoins, 0.09227639 Bitcoin Cash, and 0.09227639 Bitcoin Gold, and has lately underperformed bitcoin. From bitcoin’s graph below, the cryptocurrency formed a bullish rounded bottom with a target of $6,775 by end of November 2017.

Source: Coindesk.com

From its graph below, GBTC formed a bullish cup and handle with a target of$1,000 by the end of November 2017. While the W%R is very overbought, and RSI is almost overbought, the MACD formed a bullish upward cross.

Source: Stockcharts.com

But whatever you do, do not exit the market completely, as the beginning technicals prove “don’t time the market.”

Disclosure: I am/we are long GBTC. 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.