Captain's Log, Part 3: November 14th, 2014
What's creating some indecision in the markets, you may ask?
Why, it just might be the Fed taking away the punch bowl sooner than expected! Or could it be a new Cold War with Russia? Or is it the looming currency wars? Or could it be all of the above?
The good news is that Ebola is fading away as one of the most pressing concerns…
Macro-Economic Developments: The Fed eyes latest job data
According to Fed Chair Janet Yellen this week, the Federal Reserve has concluded that the unemployment rate is probably the best single indicator of current labor market conditions, and a good predictor of future labor market developments. Below is a chart of the seasonally adjusted Unemployment Rate, which is trending very nicely in the right direction:
The Hiring rate is also a key measure of labor market dynamics, and it too is trending in the right direction.
The Quits rate increase signals that workers perceive that their chances to be rehired are good, and that labor demand has strengthened (at least, that is the prevailing assumption…another might be that unemployment benefits may be less grief than holding onto a job perceived to be too hard or under-compensated…)
Finally, the U6 Unemployment rate includes all those who are either unemployed or who are "marginally attached" to the workforce, or who can only find a part-time job. That trend is also moving in the right direction.
Given these rather encouraging statistics, St. Louis President James Bullard said that "labor markets continue to improve and are approaching or even exceeding normal performance levels", and that over the next year, it will become more and more difficult to point to labor market performance as a rationale for a near-zero policy rate". He further said that "low inflation in the US economy is no longer enough to justify the current rock bottom setting for short term interest rates", and repeated his views that interest rates should be increased above their near zero levels early next year.
Several issues ago, I pointed out that an improving economy might actually hurt the stock market, as interest rates increased, labor cost pressures increased, and a strong US dollar hurt sales overseas. In addition, at some point down the line, higher bond interest rates will lure some investors away from riskier and more volatile equities, and back into the relative security of bonds, especially as the baby boomers begin to retire in waves. We will naturally have to depend on our charts to tell us when equities are being put under pressure and when other asset classes appear more attractive. But at present, domestic equities still hold the best promise of growth and real returns.
Geopolitical Developments: Another Cold War could be brewing
In a disturbing but not surprising development this week, Putin continues to ignore Ukraine sovereignty. NATO officials have seen Russian tanks, artillery, air defense systems, and Russian combat troops entering Ukraine this week. Naturally, Putin characterizes these troops as Russian "volunteers," as if he has no control over these forces…Donetsk, the industrial hub held by pro-Russian separatists remains the site of heavy artillery bombardment. The cease fire deal reached in September has apparently crumbled. Almost a million people have fled their homes since the fighting in Ukraine started back in April, following Russia's annexation of Crimea.
On Wednesday, it was revealed that Russia would start sending long range bombers into the Caribbean and Gulf of Mexico, in a reciprocity move. Russian Defense Minister Sergey Shoigu said that "we have to maintain Russia's military presence in the western Atlantic and eastern Pacific, as well as the Caribbean and the Gulf of Mexico", and that Russia would be boosting its security in Crimea. Shoigu also said that Russia would expand its presence in the Arctic region around Alaska and Northern Canada, including full radar coverage so that it could meet "unwanted guests". Shoigu blamed NATO for fomenting "anti-Russian moods" and reinforcing foreign military presence next to Russia's border. Russia's provocative new maneuvers are designed apparently to counter the build-up of NATO forces in Ukraine, and sending a strong message that "if they can do it to us, we can do it to them".
These increasing tensions may signal the emergence of another cold war between the West and Russia-just what the world does not need from a global growth or security perspective.
The Oil Glut Continues: Energy firms get hit; Consumers win
Last week we covered the current oil glut in detail and remarked how it could take months, if not a year, for equilibrium to be restored between supply and demand. Nonetheless, the 3 strong week performance up from the bottom in early October indicated a possible reversal of the strong downtrend since mid-June. Our ill-timed entry on Monday into ERX, the leveraged energy ETF, highlighted the fact that just because prices decline hard, they still may not be done going down after a brief bounce.
When one of our Sell indicators hit this volatile ETF on Thursday, we sent out an urgent alert to sell the ERX at market to stem further losses. Our protective stop was a long way down from our entry, because our stops are tied to the underlying volatility of the instrument-and ERX had just been through a very volatile phase.
We shaved about 3% off our nice 24% portfolio performance due to this position, but given the outlook for oversupply to continue for a while, it did not make sense to risk waiting until our default Sell Stop was hit. The indicators had already turned bearish enough to signal a Sell, and there technically appeared plenty more room to the downside, because of the prevailing weekly downtrend the ERX was in. The reversal we saw in the charts last week turned into the classic "head fake" that unfortunately is unavoidable from time to time. See the chart below.
Chart courtesy of stockcharts.com.
On Thursday, US crude oil futures settled at their lowest level since September of 2010, at $74.21 per barrel. Brent crude also fell to a 4 year low, below $79 per barrel, on fears that China could experience further economic contraction, while Saudi Arabia refuses to cut production and bear the brunt of the economic pain. Developing economies had once been a major support for oil, but new supply from North America is now outpacing demand. The US produced an estimated 9.06 million barrels a day of crude oil last week-the highest since March of 1986. The only period higher than that was in the 1970s when US production hit 10 million barrels per day. Just 6 years ago, there were weeks with less than 4 million barrels a day. In the meantime, autos are getting better mileage every year with engine advancements and lighter frames; hybrid cars and electric cars will also significantly reduce gasoline consumption.
Until we see OPEC make moves to curtail production, and a strengthening in demand from emerging markets, it appears unlikely that the current glut will lessen significantly-it always seems to take more time for equilibrium to be restored that one might think. You can see from the ERX chart above that the 21 week moving average (gold colored line) changed from positive to negative in mid-September. Currently, that longer term trend line is still down, and it will take some time for the predominant trend to become positive once again. The only way that a positive trend can be maintained is if global growth accelerates, and production is voluntarily curtailed by the oil producing nations-neither of which prospect appears likely in the near future.
Europe, Japan, and the Currency Wars
Photo courtesy of Morguefile.com
Central Bankers in Japan and Europe are attempting to stave off a deflationary cycle by monetizing debt-creating new money to buy under-performing loans, and essentially replacing the losses with newly created credit. The problem is that doing so lowers currency valuations. Lower currency valuations make exported goods from that country "cheaper" relative to goods in other countries with stronger currencies. A country like Japan, which is seeking to drastically devalue its currency to counter its long deflationary cycle with some "inflationary forces", is in essence "exporting" its deflation. How? Just consider what domestic competitors must do to save their customer base from being lost to Japanese suppliers. They must somehow lower their prices, or risk losing sales-both of which hurt their bottom lines. Having lived through a devastating currency price war in my former career, I can tell you that nothing but pain can come from fighting one.
Europe may be forced by a falling Yen to do the same. The ECB may have to devalue the Euro to get things moving again in Europe. Fighting deflation through monetary policy requires printing more money, which by definition causes "monetary inflation", thus decreasing the purchasing power of the underlying currency, and increasing the price attractiveness of goods and services offered for sale in that currency. Hence, a "race to the bottom" oftentimes ensues between countries with stagnant economies (brought on by too much sovereign debt which sucks money away from current productive uses).
Both Europe and Japan have way too much sovereign debt. They also have stagnant economies (often caused by too much of a debt burden, high taxes, and/or an aging population that spends less). Their only way out of a deflationary spiral is to inflate their currencies to make it easier to pay back their enormous debt loads-or create much greater overall demand by attracting many more immigrants to live there and increase the birth rate (an unlikely proposition at best). Japan's debt is already 200% of its GDP. It has an aging population. It is a rather closed society culturally. Birth rates are down. What other choice does it have but to export its deflation? And what other choice does Europe have in response?
Mateys, I think we need to keep an eye on these currency wars, as accommodative Central Bank monetary policies in Europe and Japan, combined with a lack of fiscal discipline within the sovereign nations in those regions, could ultimately cause the US Dollar to continue its newfound path upward, which in turn could have a negative impact on the sales and earnings of global companies domiciled in the US.
Fortunately, as a percentage of GDP, US imports only account for about 17% of our GDP-rather modest in relation to most other countries. More importantly, US exports only account for about 14% of the US GDP, which helps ameliorate the impact of international currency wars. The US is actually fairly self-reliant, especially now that hydraulic fracturing has made hundreds of millions of barrels of domestic oil and gas economically recoverable. Thus, while currency wars could indeed impact the bottom lines of domestic companies that export heavily into Europe and Japan, the overall impact on the US economy may be muted, compared to those countries that heavily rely on imports and exports for the health of their economies. Perhaps that is why emerging market ETFs have struggled this year to gain traction. See the chart of the leveraged emerging market ETF (NYSEARCA:EDC) below. The chart tells the whole story-it's simply a fluctuating cycle of prices within a flat trend, and still looks unattractive.
Chart courtesy of stockcharts.com.
In contrast, our markets look rather strong, as shown by the total US market ETF, the VTI:
Chart courtesy of stockcharts.com.
The fact remains, US equities still appear the most attractive, from a trend standpoint, especially if bought on the next dip…
An Ebola update: Progress through quarantines and curfews
Photo courtesy of CDC.gov
The World Health Organization's October projection of 10,000 potential Ebola deaths per month by December now looks unlikely, thanks in large part to quarantines and curfews. From December 2013 through November 9th, 2014, WHO has reported 14,098 confirmed, probable and suspected cases of Ebola virus disease (EVD) in six affected countries (Guinea, Liberia, Mali, Sierra Leone, Spain and the United States of America) and two previously affected countries (Nigeria and Senegal). There have been 5,160 reported deaths--an increase of 830 cases and 200 deaths since November 4th.
Distribution of cases: Countries with widespread and intense transmission:
- Guinea: 1,878 cases and 1,142 deaths as of November 9th, 2014;
- Liberia: 6,822 cases and 2,836 deaths as of November 8th, 2014;
- Sierra Leone: 5,368 cases and 1,169 deaths as of November 9th, 2014.
A three-month state of emergency was declared in Liberia in early August, with a 9 p.m. curfew and soldiers and police officers patrolling the streets. Communities were quarantined, including the seaside slum of West Point, home to about 75,000 people. This week, the President of Liberia announced an end to a national state of emergency, citing progress in the fight against Ebola. There were fewer new cases of Ebola in the week ended Nov. 4th than in any week in the preceding 3 months. Liberia has set a goal of zero new cases by Christmas.
What looked like a potential threat to global travel a few short weeks ago now looks less frightening than the upcoming flu season, thanks to the generous assistance primarily from the US financially, medically, and militarily.
So mateys, let's hold our current positions with confidence and patiently await new buy signals as they present themselves. We would rather have a full slate of 6 positions at present, rather than an empty slot caused by our sale of ERX, but none of the other leveraged ETFs we watch were at an ideal entry point this week. We will have to content ourselves with a 1/6 position in cash, available for better buying opportunities down the line.