Evidence Of Developing Liquidity Crisis: XLF And GDX In Sharp Decline Simultaneously

Jul. 16, 2022 10:03 AM ETARKK, DBC, DIA, GDX, GDXJ, GLD, IAU, IVV, IWM, MDY, QQQ, RING, RSP, SHV, SHY, SLV, SPY, TBT, TIP, TLT, VGSH, VOO, VTI, VTWO, XLE, XLF, KBE, KBWB, QABA, FTXO, KRE, KBWR, IAT91 Comments
Paul Franke profile picture
Paul Franke
18.04K Followers

Summary

  • Steep stock market losses are highly correlated with a tandem material drop in banks/brokerages and gold/silver miners.
  • Such a condition is associated with a liquidity crunch, inverted bond yields on the duration curve, and economic recession.
  • Over the last 15 years, only the late 2008 Great Recession and March 2020 pandemic shutdown have witnessed a similar setup. Both included an equity implosion and recession.

Federal funds rate increase. Arrow with growth of federal fund rate and stamp of federal reserve FRS symbol.

Bet_Noire

Wall Street analysts believe "Dr. Copper" is a terrific indicator of the economy's health, and I cannot disagree. Academic studies have proven out a highly positive correlation between major copper price changes and the direction of the manufacturing economy or stock market. From my 35 years of trading experience, when copper is rising quickly to new 52-week highs, the U.S. economy usually performs well over the next year or two. Conversely, when copper is collapsing, like it has done since the spring of 2022 (-40%), more often than not a serious economic slowdown or recession is approaching.

StockCharts.com

StockCharts.com

Banking and Gold Assets in Steep Decline

Perhaps much more worrying for the financial markets, banks/brokers and gold/silver miners rarely fall in tandem. These two sectors of the market, basically the critical lending and hard money industries, are the BEST indicators of liquidity in our economic system. Below are 2-year charts of the main ETFs tracking these important sectors, namely the Financial Select Sector SPDR (XLF) and VanEck Vectors Gold Miners (GDX) products. You can review below their sharp price drawdowns "concurrently" over the past three months.

StockCharts.com

StockCharts.com

StockCharts.com

StockCharts.com

What has taken me by surprise is the rapid slide in gold/silver and related mining equities since the beginning of June. This should not be happening if the stock market was primed and ready to rise. The material deterioration in hard money worth vs. the dollar is likely signaling the Fed may be overtightening monetary policy as it adds pressure on the economy to slow it down, all an effort to contain inflation rates nearing out-of-control status. Honestly, the majority of 20% bear markets in stocks usually see gold miners in a rising, defensive trading position. Watching both banks and gold/silver decline in unison is exceptionally rare in our fiat money-printing currency world.

So, this is the main thrust of my concern. Over the last 15 years, a sharp nominal 3-month price drop of -15% or greater for both the XLF and GDX over the same span has only occurred a total of 6 months. That's 3% of the time. Shockingly, the ONLY times both groups sell off together to this degree is during a liquidity crunch, which often leads to a recession. I have graphed the idea below, using red arrows and boxes to pinpoint the two previous instances of (1) August-November 2008 during the Great Recession and banking crisis [including the idiotic Fed decision to allow Lehman Brothers to fail], and (2) March of 2020, the COVID-19 pandemic crisis month of economic shutdowns. The next instance started days ago.

YCharts by SA

YCharts - Author Reference Points

YCharts by SA

YCharts - Author Reference Points

YCharts by SA

YCharts - Author Reference Points

Unfortunately, these two ETFs are new inventions with a limited history. Not pictured, but also important to contemplate, other instances of weak banks/brokers and gold miners in tandem existed during parts of 1981-82, the span Fed Chairman Volcker raised short-term interest rates into double digits causing a deep recession to halt imbedded inflation; late 1983 before a 20% stock market decline into 1984; the October 1987 stock market crash; early summer 1990, just before the Iraq/U.S. Gulf War recession; the autumn 1998 Long Term Capital Management bailout-related selloff in U.S. equities; the fall 2000 Dotcom Bust start; and, late summer 2002, at the tail end of the original Tech crash and related recession. Since 1980, these are the only examples of this double whammy bank/gold sector selloff condition over 3-months. Interestingly, many of these spans also witnessed an inverted Treasury yield curve, similar to July 2022, as the economy was sliding into recession.

Final Thoughts

Gold should lead the stock market higher when the final bottom is in. I discussed this usual setup at major turning points on Wall Street in my article posted during late May here. Both the early 2009 spike and April 2020 explosion in gold predated strong upturns for the U.S. equity averages. I fully expect this cycle pattern will be no different.

There’s a small 10%-15% chance the major decline in banks and gold miners is more of a coincidental indicator of a contraction in money creation, instead of a “leading” signal of trouble for the financial markets. The best example of this is the 1987 stock market crash. Gold miners did not fall to a level of -15% over three months until the day of the infamous 20% crash, with the next trading session open proving the bottom. However, gold bullion prices were in a rising trend during late 1987, before and after this monumental panic. Right now, gold is in serious decline. In 1987 Fed Chairman Greenspan engaged in emergency money printing between the major banks to support the economy. Today, the Fed is boxed into another modern record increase in short-term rates in late July to halt inflation. My suggestion to time a bottom on Wall Street is to keep your eyes open for a rebound in hard money metals pricing.

I decided on Thursday to liquidate my 40% equity position in stocks through my 401(k) plan, and am now sitting at 100% cash (the same as January 1st), waiting for a better reentry point. Friday near the close, I purchased SPDR S&P 500 ETF (SPY) put options to hedge the rest of my "long" market exposure in a regular brokerage account, so I can sleep at night the rest of July.

In the middle of June linked here, I explained one last move lower for equities this summer was likely. It appears the more radical market price slide in my scenario #2 from that effort is about to occur. I would much rather own beaten down technology names for the long-term, and many of my articles since the spring have focused on this group. I absolutely would avoid cyclical and commodity plays like oil/gas the rest of the year. A severe recession in the second half of 2022 may look something like the 2008 Great Recession liquidity crisis. I explained in my article during early July here how the first-half 2022 commodity boom may repeat the 2008 scenario of straight up morphing into straight down in a weak demand, recessionary environment.

Because of the YoY CPI print of 9.1% this week for June, and dramatic unexpected weakness in gold/silver, I am moving my worst-case scenario downside from 10% to 20% over coming months for the S&P 500 index. Unless the market collapses before the next Federal Reserve meeting on July 26-27, I think the world's primary central bank will have to hike rates another 0.75% to 1%, to retain credibility in its inflation fight.

The truly bad news is historically after a stock market tank of 25% over six months (like 2022), with an economy slipping into recession (which is the present Atlanta Fed's GDPNow forecast), interest rates have typically peaked and reversed into some sort of decline to support a world fading into financial crisis. You have to go back to the 1970s and early 1980s stagflation period to find another instance of rising interest rates despite negative "real" GDP.

https://www.atlantafed.org/cqer/research/gdpnow

GDPNow - Atlanta Fed

My conclusion is today's liquidity crunch and pressure on stock quotes will continue this summer, until it's clear we are in recession and/or panic selling hits. If the economy holds up and the stock market fails to drop materially, the Fed will not be able to begin a new bank easing cycle. Under this scenario, ever higher interest rates and the draining of liquidity into the autumn will continue. To a degree, we are now trapped. Either we get a mild recession now, or a deeper one later in the year. Pick wisely. Hint: optimists and opportunists should be rooting for a large stock market drop sooner, rather than later. I wish I had a better outlook to report, as I was relatively bullish at the May bottom in stock market pricing. If you are searching for a silver lining, Wall Street could be preparing for a significant bounce-back next year. Yet, trading may be a little wild another month or two. Buckle up is my suggestion.

Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

This article was written by

Paul Franke profile picture
18.04K Followers
Nationally ranked stock picker for 30 years. Victory Formation and Bottom Fishing Club quant-sort pioneer.....Paul Franke is a private investor and speculator with 36 years of trading experience. Mr. Franke was Editor and Publisher of the Maverick Investor® newsletter during the 1990s, widely quoted by CNBC®, Barron’s®, the Washington Post® and Investor’s Business Daily®. Paul was consistently ranked among top investment advisors nationally for stock market and commodity macro views by Timer Digest® during the 1990s. Mr. Franke was ranked #1 in the Motley Fool® CAPS stock picking contest during parts of 2008 and 2009, out of 60,000+ portfolios. Mr. Franke was Director of Research at Quantemonics Investing® from 2010-13, running several model portfolios on the Covestor.com mirror platform (including the least volatile, lowest beta, fully-invested equity portfolio on the site). As of August 2022, he was ranked in the Top 5% of bloggers by TipRanks® for stock picking performance on positions held one year. A contrarian stock picking style, along with daily algorithm analysis of fundamental and technical data have been developed into a system for finding stocks, named the “Victory Formation.” Supply/demand imbalances signaled by specific stock price and volume movements are a critical part of this formula for success. Mr. Franke suggests investors use 10% or 20% stop-loss levels on individual choices and a diversified approach of owning at least 50 well-positioned favorites to achieve regular stock market outperformance. The short sale of securities in overvalued, weak momentum stocks as pair trades and hedges is also a part of the Victory Formation long/short portfolio design. "Bottom Fishing Club" articles focus on deep-value candidates or stocks experiencing a major reversal in technical momentum to the upside. "Volume Breakout Report" articles discuss positive trend changes backed by strong price and volume trading action.

Disclosure: I/we have a beneficial short position in the shares of SPY either through stock ownership, options, or other derivatives. 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: This writing is for educational and informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. Any projections, market outlooks or estimates herein are forward looking statements and are based upon certain assumptions and should not be construed to be indicative of actual events that will occur. This article is not an investment research report, but an opinion written at a point in time. The author's opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. The author expressly disclaims all liability for errors and omissions in the service and for the use or interpretation by others of information contained herein. Any and all opinions, estimates, and conclusions are based on the author's best judgment at the time of publication, and are subject to change without notice. The author undertakes no obligation to correct, update or revise the information in this document or to otherwise provide any additional materials. Past performance is no guarantee of future returns.

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