The Bulls Ignore 9 Risks
Combining technical and fundamental factors can be very powerful. Far too often, analysts place too much weight on one or the other. The 9 risks below combine both fundamental and technical perspectives to show the bulls are ignoring a wide spectrum of information. This information, as a whole, indicates risk assets, particularly stock markets, will head lower, nationally and globally.
The bulls may ignore one factor, perhaps a few. However, ignoring a whole range of factors is risky.
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Dow Theory accurately predicted the high last year in the U.S. stock market. This worked because important fundamentals are wrapped up into the theory. Dow Theory states a new high in the market should be confirmed by a new high in the transports. The transports are nowhere near a new high. Fundamentally, if transportation is not doing well, goods and services are being distributed less widely than expected. People providing important services are transported via air all the time, and of course, goods are transported in many ways: rail, truck, air, etc. Therefore, this is relevant to services and goods.
- The Recession Alert Long Leading Index has over 50% of its components in recession. It is borderline on the trigger for recession. The components are widely varied fundamentals such as 19 labor market indicators, consumer sentiment, manufacturing overtime hours, 35 credit market indicators, and many more. I cannot post a graphic here, due to copyright issues. Only members of their service are allowed to see the work.
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The State Coincidences Index has been trending down for some time. This index measures economic activity in every U.S. state and then combines the measures into a single number. This provides an excellent perspective on the state of the U.S. economy and tends to predict growth. A DI3 below 65 is typically followed by a severe pullback in growth, if history is any guide.
DI1 DI3 Jan-16 74 76 Feb-16 68 76 Mar-16 70 78 Apr-16 62 72 May-16 60 70 - The CFNAI-MA3 has been trending down for some time as well. The CFNAI is a weighted average of 85 national economic indicators in the U.S. and is published by the Chicago Fed. An MA3 below -0.7 is considered recessionary, according to the Chicago Fed website here.
- We had a 38K employee print last month and a revision down to 123K for the month prior. The next number will be crucially important. The drop in CFNAI and the State Coincidences index predicted the drop in employment. Therefore, I anticipate the next number will not be rosy, considering the CFNAI and State Coincidences index have dropped further, recently. The 6/27 Markit Flash U.S. Service PMI indicates job creation has expanded at the slowest pace in a year-and-a-half.
- Europe is now in turmoil. (See below for more detail.)
- Japanese negative interest rates on commercial deposits will continue to push massive amounts of currency offshore, weighing on all Japanese denominated assets. The Japanese government may go even further negative, making the situation worse. (See below information, for further details.)
- There has been an inordinate amount of flooding, seemingly, in the U.S. this year. This is destruction of assets. According to the NOAA, we have already had 9 weather events each exceed $1B in damage this year. By comparison, 2015 had 10 events for the entire year. See the NOAA facts about the number of disasters here, or review this year's floods on the Flood List website for the U.S. More disasters means less money to spend on services and the general economy as we are forced to rebuild. Consider Jesse Livermore in Reminiscences of a Stock Operator. When he heard the news about the San Francisco earthquake, he anticipated a bearish effect on the market. Arguably, these 9 weather events likely do not stack up to that scenario. However, they are still bearish weight tugging at the economy.
- According to Recession Alert's most recent World Report, as of 5/31, 61% of the 41 OECD countries are in GDP contraction. Over 60% have negative LEIs (Leading Economic Indicators). This report lags 2 months, but LEIs predict economic growth. They do not report it, presently. Therefore, this is relevant. These reports were BEFORE BrExit. The next report will likely be worse. If the worldwide LEIs contract along with GDP, it will affect the U.S. negatively as growth slows even further worldwide. Since the U.S. drives much of the world's growth, this creates a negative feedback loop, AKA a downward spiral.
The bulls have been trained to "buy-on-the-dip." The market has reinforced this by not severely re-pricing in many years. It is no surprise, in light of the above, bulls are continuing to buy. They are ignoring these risks, as a whole.
One of the primary arguments I am seeing in the Seeking Alpha comments is the Fed will save the market.
1. The Fed has not always "saved the market" in the past. Recessions do occur. According to Wikipedia, we have had 47 recessions in U.S. history, and the bulls seem to think another is unlikely. History would suggest otherwise. We have had 14 since the Fed was created.
2. Many contend helicopter money or additional stimulus will be next. This is not assured. It is only speculation at this time. Furthermore, President Bush gave $600 as a tax refund to many citizens at the start of the Great Recession. It did not prevent recession. Why would similar measures prevent it now?
More on European Destabilization
These are fairly significant words coming from the Financial Times:
Brexit will increase Germany's political and economic supremacy in the EU - a prospect neither Berlin nor its partners welcome.
Brexit will harm the EU's cohesion, confidence and international reputation. The biggest consequence of all, therefore, is that Brexit will undermine the liberal political and economic order for which Britain, the EU and their allies and friends around the world stand."
The European situation seems to be highly polarized right now. Is the above anti-EU statement merely propaganda or reality? There appears to still be strong EU support among the member nations. However, is this really true? Will tumult boil to the surface? The bold quote above is either an incorrect assessment by the Financial Times, or it really is accurate, and cohesion in the EU is about to unravel, as German supremacy begins to rule heavy-handedly.
More on Japan
To summarize, negative interest rates on deposits are driving money out of Japan. Depositors are converting their currency, particularly to the U.S. dollar. Those that are stuck with the converted Yen are then buying Japanese bonds. This is why the Japanese Yen is strengthening, even in the face of BrExit. Negative interest rates on depositors is deflationary due to the flight from assets and the eventual purchase of bonds. When there is less demand on assets, deflation is created. A higher demand in treasuries is generally seen as deflationary as well. This is because it is evidence that money is not flowing into risk assets, and less demand in assets is deflationary.
See the 6/23 Nikkei Flash Japan Manufacturing PMI from Markit. Manufacturing in Japan is contracting, and the contraction in production is accelerating. Usually, stronger currencies encourage exports. However, in the case of Japen, their manufacturing sector is contracting in the face of a stronger currency.
Japan has not indicated it will reverse policy. Deflation will continue, and it will weigh on credit. As loans come under more pressure, people will find they owe more than they realized. Pressure on credit causes bankruptcies. For these reasons and other deflationary factors, the Japanese economy will suffer until something severely breaks, forcing policy to reverse.
Here is the Wall Street Journal article from April explaining the deflationary effects of negative interest rates on depositors in detail:
...the amount foreign financial institutions can charge to lend greenbacks to Japanese investors has surged. The premium for a three-month contract to exchange yen for dollars is now at ¥0.298, almost twice what it was a year ago.Foreign investors have been recycling the yen they get back into Japanese government bonds, traders say, even though yields on a range of these bonds have turned negative in recent weeks-meaning investors who buy them end up paying money to Japan's government. But the fee foreign institutions can charge to lend dollars is now so high that it outweighs the cost of holding negative-yield-bearing bonds, which remain the safest place for investors to park their yen."
There is a big difference in effect between negative interest rates on depositors and negative interest rates on treasuries. I see many comments on Seeking Alpha assuming the effects of both are the same. They are not. When depositors are charged, they move their money to avoid losing capital, plain and simple.
Conclusion
9 risks stack up. Ignoring the 9 issues listed is riskier than ignoring one or a couple of factors. As the weeks and months progress, we should see these factors weigh on the markets considerably, especially if comprehensive indicators such as the CFNAI and State Coincidences index worsen. Consequently, it would be wise to anticipate such a situation. I have been building a position in puts since 5/10.
This article is relevant to the S&P 500 (SPY), Russell 2000 (IWM), and any other index-like product (QQQ), (IVV), (VO), (VTV), etc.
Disclosure: I am/we are long PUTS ON THE RUSSELL 2000 AND DISH.