Passing The Stock Peaks

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

Quantitative easing inflates financial assets with lower interest rates. Quantitative tightening deflates financial assets with higher interest rates.

Stock market just passed the peak of the bull cycle.

Upstream oil industry has good potential from rising profitability.

Gold and silver may revive after the Fed rate hike in September.

Hypothesis: Dollar value analysis of an asset, the US Dollar being the dominant currency in the global Fiat system, is a meaningful way to view the asset through a different lens that represents the true worth by including the value of the dollar. The analysis may be useful as a leading indicator to anticipate market tops and reversals.

Introduction

Many recent developments are detrimental to more growth in stock prices. Negative factors are the rising oil price, global economic slowdown, rise in interest rates, central bank contractions and the escalation of trade wars. These factors will dent future revenues and earnings growth.

Globally, in anticipation of the slowdown of central bank balance sheet growth, many assets such as real estate, bonds and stocks have peaked. The US stock market may be the last one left at an elevated level.

Dollar Value Analysis

The US Dollar Index (NYSEARCA: UUP) is a measure of the value of the US dollar relative to a basket of foreign currencies.

The dollar value of an asset is simply the product of the asset with UUP. I replaced the dollar intrinsic with dollar value to clarify the new concept more adequately.

The dollar value analysis is more in tune with the global valuation of the asset, to combine the process by including the value of the US dollar. New charts in this article are used to track the trends of the dollar value assets.

Debt And Interest Rates

Global debts are so high that as interest rates accelerate higher, as shown in the illustration below, bondholders will feel the pain. The rising rates have spread from long term to shorter-term bonds, as stated in my 2017 articles. This is an update of the same picture with more data. Depending on the amount of liquidity being withdrawn from central banks, interest rates will rise further.

The best interest rate to track is probably the 3-month Libor, which directly or indirectly affects most global loans and bonds. When the 3-month Libor spikes, stock corrections likely will follow because of the rise in interest costs that lower earnings. Three-month Libor has risen from 0.3% in 2016 to 2.3% now. The increase of 1% per year of interest rate to the total global loans of $247 Trillion adds $2.47 Trillion in payments for debtors. As interest rates rise further in the coming years as depicted below, the debt crisis will materialize with increasing defaults. The great bond slide that started with TLT has spread to most global bonds.

The foundation of capitalism is inherently based on positive interest rate. When the interest rate approaches zero and goes negative for a long period, the entire global bond markets will eventually shake and crumble because central banks cannot buy up all the newly issued sovereign bonds without destroying the currencies, and they cannot keep the rates artificially low forever. The rise in interest rates globally will hurt all bondholders for the next few years.

The chart below tracks the 3-month Libor rate with the Fed Fund Rate since June 2016. The rise in Libor came in surges centering the hikes of the Fed Fund Rate. The next hike may happen in two weeks that will cause Libor rates to surge again.

Conditions And Timing For The Next Stock Bear Market

Unprecedented record global debts with quantitative tightening form the basis for interest rates to rise. The current US stock market is particularly dangerous because:

Below is a list of threats to the stock market in the next 3 months:

  1. Election anxiety and political uncertainty
  2. Interest rates increasing and quantitative tightening (Fed)
  3. Liquidity reduction and withdrawal from other major central banks
  4. Trade war escalations in driving prices higher stroking inflation
  5. Contagion of emerging market debt and economic instabilities
  6. Technical resistance for peaks with waning FAANG
  7. U.S. dollar strength
  8. Oil prices rising (above $70)
  9. Increase in Treasury auctions to reduce capital/liquidity
  10. High leverage (Margin)
  11. Seasonality superimposed with election emotion swings
  12. Economic strength weakening
  13. Earnings growth declining by rising costs

The ongoing trade wars likely will hasten the downfall of stocks in creating global fear and uncertainties. With the US mid-term election coming up, political sparks will fly which will shake investor’s confidence.

The flash crash of 10% on August 24, 2015 is becoming probable again within the next 3 months. A review of the conditions listed above will help in determining the timing to trim stock allocations.

Inflation And Financial Markets

The UIG (underlying inflation gauge) has increased to 3.33% in June and is accelerating. Wages are also trending up. Rising inflation will force the Fed to hike interest rate further from the current 2% in order to catch up with inflation.

Despite the oil importing country’s efforts to keep oil price down, the price has rebounded strongly since June 2017. The rise this year is all about global demand exceeds supply by about 0.5 million BOPD that will continue at least till year-end. Higher energy expenditures will put more burden on consumers and business.

As rates rise, increase in interest expenses will also pressure debtors to divert more funds to service debts, instead of discretionary consumptions. The chart illustrates some of these effects that affect the earnings of companies since last November, when both oil price and interest rate rose rapidly. In the next 3 months, the weight of higher interest costs and rising oil can depress stocks, similar to the S&P 500 correction on Jan 26, 2018.

The 7-month tri-polar chart below, bonds, dollar and stocks usually have an inverse relationship among each other; continual weakness in one may drag the other one down that will eventually boost the next one. For example, in late January, the falling dollar and bond pulled stocks down. This is a good concept and a way to track the performance of the three main financial assets. During times when both stocks and bonds fall, dollar or cash is the asset to own.

The 38-month chart below tracks the performance of the dollar index (UUP) in blue, the S&P 500 (SPY) in orange and dollar S&P 500 (UUP*SPY or $SPY) in beige. By including the value of the dollar, $SPY shows the real valuation of the stock market. $SPY serves as an alternative to objectively view the market from a global standpoint. Although $SPY first peaked on January 26, $SPY formed a higher peak on August 31 because of the strength of the dollar since April. This may be the last peak for stocks for the next few months, and potentially for the current 10-year bull cycle.

It appears from the 38-month dollar value analysis chart below that all three pillars of the US financial system have peaked or peaking. Dollar Long-term bond (UUP*TLT or $TLT) in gray peaked two years ago, followed by the Dollar (UUP) in light blue 18 months ago. Although there is a counter-trend rally this past 6 months for both the long-term bond and the dollar. And finally, dollar S&P 500 (UUP*SPY or $SPY) in beige peaked on August 31. The analysis is an attempt to reflect the real financial strength of each asset which can be followed to detect any change of trends.

There are headwinds ahead as we approach the mid-term election in November. The issues of higher budget deficits will be in focus again as more treasury bonds are auctioned in the coming months. Increasing short-term interest rates can push the long-term rates higher too. New increases in interest rates are negative for stocks.

Due to the foreign currency weakness since April, the US dollar rose 7% recently. The latest bounce pushed up the real value of US stocks and bonds, as shown in the chart below to the point that the dollar value pseudo-market ($TLT + $SPY) in dark blue made a new high on August 16, higher than the one on January 26.

The same happens to the dollar pseudo-system ($ + $TLT + $SPY) in dark gray. In both instances, the dollar value pseudo-market and system lead the pseudo-market system by 1-4 weeks, which can be helpful as warning signs for the stock market itself. This is a simplistic but robust way to gauge the health of the system, by combining the dollar, long-term bonds and stocks.

The strength of the US system appears impressive, but this may be the last peak of this 10-year bull run.

The rest of the global bonds and stocks do not perform as well and have declined substantially. Especially if the currency value of each country is included. The global stock market formed a distinct peak back in late January which might have marked the end of the bull run, front-running and reflecting the contraction of money growth by central banks. As the withdrawal of liquidity accelerates, the ill effects will become more apparent towards year-end.

The vicious cycle of global financial asset deflation has started. The weakest and most sensitive links, the falling emerging stocks and bonds, are the canaries. Flight to safety is the ongoing theme, the US financial markets are no exception.

The following chart shows the daily change and its 5-day average of the pseudo US financial system. The daily change is vividly heading down, which means the system is weakening.

The 38-month chart below shows the performance of each asset with rate hikes. Generally, gold performs nicely after each rate hike. The same setup is happening again by the end of September.

Gold and silver futures are so heavily controlled by the major bullion banks, they literally hold all the strings that influence these markets in the short term. With many emerging and developed countries accumulating physical gold as reserves, gold is up by about 6% per year in the last 30 months. This trend is still intact despite gold is at a low now.

The recent weakness in gold and silver will likely end very soon. Favorable seasonality for the metals persists till November. Any political or geopolitical turbulence which weakens the dollar and the stock market will help the precious metals.

Oil Price And Companies

My predictions on oil price for the past two and a half years have been quite correct. But of course, there were big fluctuations in prices from the projected trend. In hindsight, the variances were caused by efforts of the major oil importing countries to suppress prices. Demand is exceeding supplies by about 0.5 million BOPD in 2018, which is reflected in global storage reduction. Oil price outlook for the next 3 months remains good till the end of the year.

Above $55, oil companies are quite profitable from an investment standpoint. At price levels above this threshold, earnings will accelerate higher. The oil company indexes XOI or XLE are lagging oil price and appear to be fairly attractive. Of all the major oil companies, Exxon Mobil (NYSE:XOM) is the laggard and the most undervalued with good upside.

Conclusion

The declines have started for global financial assets, ahead of the end of quantitative easing by central banks. Interest rates are set to rise, which will suppress both bonds and stocks. The upstream oil industry is the best sector from the rising profitability standpoint. Gold and silver have good upsides after the coming Fed rate hike.

(For discussion purpose only, not intended for any investment advice)

Disclosure: I am/we are long XLE.

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