Thursday, October 20, 2016

"Real" Negative

Following up on some points in last weeks note, gold has led pivots in equities by ~ 4 weeks, which points to a sharp decline in stocks headed into November. To show the relative congruence of the pattern, we broke them both out below with gold’s series set 4 weeks ahead of the S&P 500.
Longer-term, we suspect the primary difference is that as gold has been trading out of a cyclical low late last year, equities have been distributing across a broad top. This dynamic is expressed below by the same study – just weighted through performance, which saw gold marginally underperform the S&P 500 headed into the end of 2015 and consistently outperform equities this year on the way out. From our perspective, this largely has been driven by the shift lower in real yields late last year that disproportionally benefits assets like gold, with the next chapter largely dependent on how the Fed will handle what we suspect will be rising inflation data and how the market will receive their response with an economic expansion already quite long-in-the tooth. Hint, hint – difficult times ahead. 

With US inflation data set to rise sharply over the coming months – greatly supported by favorable comparisons to last years oil price decline, real yields are poised to challenge their respective lows from 2011. This week we received the September CPI report that matched headline, but slightly missed core inflation expectations on a month-over-month basis. That said, distilling the data through real yields, maturities on the long end – as expressed by the 10-year real yield, are on the precipice of joining the intermediate and short end in going negative. 

In other words – not exactly a rosy outlook for those Johnny-come-lately safe haven Treasury “investors” who helped push long-term yields to historic lows this year, despite US inflation data that appeared to have turned the corner in the back half of 2015. Moreover, should real yields push even further negative – which we strongly suspect they will (i.e. see late 1940's and 1970's), the swath of Treasury investors adversely impacted by negative real returns would swell appreciably.

On the flip side of the coin is gold, which as we’ve described in the past carries a strong inverse correlation with real yields and exhibits sharply positive returns in a negative real yield market environment, where the opportunity cost of holding a non-interest bearing asset like gold becomes highly attractive and where underlying market psychology is often affected by a broader loss of confidence in monetary policy and/or creditors future returns. From our perspective, we expect both. 

Thursday, October 13, 2016

Connecting the Dots - 10/13/16

As markets often do, the dollar humbled our outlook to-date for a Q4 breakdown, tacking on another ~ 0.9 percent in the US dollar index this week and flirting with the highs from July. Considering we’ve approached a prospective dollar break as further motivation for maintaining a bullish bias in precious metals and those assets strongly influenced by a weaker dollar, lower real yields and rising inflation (e.g. oil and emerging market equities), we thought this week’s action in the dollar warranted a few follow-up thoughts on any tactical adjustments we've considered. 

Moreover, taken in tandem with the ongoing weakness in long-term Treasuries that is also now flirting this week with a breakdown from the stoic uptrend that's extended since late December 2013, storm clouds have more than gathered on the markets horizon, which may portend a larger dislocation afoot. That said, please forgive the stream of consciousness below that likely wrestles across too much terrain  and for lack of continuity, is derived from many previous ideas and notes. 

We've shown throughout the year that gold has not only led the broader reflationary trend, but pivots in the equity markets as well. Considering last weeks outsized decline in gold, a corresponding move is approaching in equities. Should the S&P 500 continue to follow the leading footprints of gold, another small retracement rally into next week would be followed by a more severe breakdown. 

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We are also watching oil to see if it continues to follow the dollar's lead, which would indicate another retracement move lower is on the horizon. 
In the event that the decline in precious metals last week presages a larger dollar breakout or broader market squall, a short via EEM (iShares MSCI Emerging Markets ETF) may offer an asymmetric hedge to reflationary positions, as we suspect EEM's outperformance this year would suffer in either a correction predominantly confined to stocks or a more pernicious environment characterized by rising yields and a stronger dollar that could negatively impact markets across asset classes. From our perspective, should precious metals resume their decline next week, it would lend greater probability towards the latter outcome in our opinion. 

What has us concerned this week from an intermarket perspective, is a potential major breakdown in long-term Treasuries that could materialize with an equity market correction  i.e. risk parity be damned. And while we had looked for a breakdown in the Treasury market going into this summer that was setting up along the lines of the 1987 bond rout, long-term Treasuries broke out to new highs as the Brexit vote in the UK roiled global markets and pushed back a prospective rate hike by the Fed. With those expectations once again coming to roost as we approach the end of the year and the two final Fed meetings, Treasuries will need to find a quick bid to stave off a technical break that is potentially leading the move in stocks. 
Generally speaking, the 1987 market was characterized by a large reflationary move higher in equities and commodities, with the bond market breaking down some six months before equities crashed that fall. 
This year, asset classes have trended much closer together than in 1987, which presents potentially greater negative feedback risks, in the event that both stocks and bonds overlap corrections with a restrengthening US dollar. From our perspective, if the dollar breaks lower again it would greatly mitigate that risk, as a weaker dollar could smooth and diversify performances across asset classes, rather than further magnify a negative feedback loop in the markets.
Although a market crash like 1987 is an excessively low-probability outlier event, the reflection piqued our interest from a more variant perspective. Despite it's lurid place in the annals of market history, the 1987 stock market crash also proved to be an excellent buying opportunity. In the past (2011 S&P 500 see Here & 2014 Nikkei see Here) we have used the 87' performance and momentum profile of the S&P 500 to also project the less mentioned, but as important and subsequent bullish recovery over the following years. As such, we asked ourselves if today's outperformance in emerging market stocks gave back 30 percent between now and the end of the year, do you think traders and investors would still have the appetite to buy them? All things considered, and similar to participants behavior in the wake of 1987  not likely. 

And as improbable as the potential outcome may be, there are some performance similarities between the moves in the S&P 500 in 1987 and emerging market stocks today that both benefited disproportionately from the respective broad-based reflationary trends. Until the intermarket tea leaves are better revealed to us, we like the prospective hedge of a short position in EEM over the coming weeks. And should history repeat, we would also like to buy it back in spades next year. 
Despite carrying some heightened concerns in the currency and bond markets over the coming weeks, we still believe that both the US dollar and US real yields are in the process of turning down again and testing their respective cycle lows from 2011. These market dynamics are similar to how the two previous long-term real yield cycles culminated in the late 1940's and 1970's, that slowly rolled over and tested the bottom of the range, as inflation surprised with much greater reach than nominal yields.

We've described in previous notes the parallels with the 1940's and today, that range from the extraordinary support extended by the Fed and Treasury to the financial markets and the likeness in disposition of the long-term (nominal) yield and equity valuation (CAPE) cycles. Ultimately, as real yields waxed and waned between disinflationary/deflationary and inflationary market environments, it engendered varying bull and bear market cycles within equities and commodities, with the current market environment still most resembling the cyclical peak in equities in 1946.

While the 1970's are largely characterized as an inflationary and rising rate environment, when normalized through the prism of real yields, the similarities with today in varying equity and commodity market cycles is also apparent.
What's interesting to note is that the current uptrend in gold that led the broader reflationary trend last December, echoes the resumption of gold's uptrend in the late 1970's that began as the dollar rolled over with real yields and tested the long-term cycle lows. While gold's performance this year is not as exceptional as the 1976-1977 rally, the structure and momentum profiles are similar.  
Like today, the resumption of the bull market in gold was motivated by a downturn in the dollar, which again gained greater momentum in the back half of 1977 as the over two-year broad top in the dollar broke down.  
And although the current dollar bull was more than five times as large as the mid-seventies move, the broad top corresponds with today, that now in its 91st week also resonates with the flip-side of the cycle and gold's broad top carved between 2011 and 2013. This also dovetails into the inverse performance dynamics we've followed between the banks and gold miners this year.
As a postscript aside, we read an interesting piece last week in the Wall Street Journal (see Here) that resonated with our observations of Shiller’s CAPE ratio, if not from a simple pattern perspective. Basically, the Journal reconstructed CAPE to normalize a more consistent earnings measure, which as they described, was disproportionately influenced by severely depressed bank and business earnings during the financial crisis that had since inflated valuations. 

Because Shiller’s CAPE utilizes generally accepted accounting principles, or GAAP – and that these principles have been revised on multiple occasions over the past three decades, they looked for a more consistent measure by using the Commerce Department’s quarterly data on total U.S. after-tax corporate profits and the Fed’s data on the total value of US stocks, rather than the S&P 500. What they found was, “From the early 1960’s through 2008, the two CAPE measures moved nearly lockstep with one another. It is only after the financial crisis that the two measures diverge, with the corporate-profits CAPE rising much more slowly than Mr. Shiller’s measure does.”
Despite our reluctance to share the same bullish suggestion of the title that, "A close look at a Nobel Prize winner’s valuation metric shows that the market isn’t as highly valued as it appears”, the reconstructed ratio does resonate with our comparative observations of the 1930’s and 1940’s, which saw diminishing valuation peaks from the 1929 secular high. And although we’ve approached the CAPE high from 2007 as more or less a valuation “ceiling” of the current cycle, it did seem out of place that equities even reached the ceiling in this one. Perhaps as the WSJ suggests, the market isn’t as highly valued as it appears, but that certainly doesn’t make US equities a buy today from a historical perspective. A quick look back at the late 1940’s and the equity markets stumble across the transitional divide to the next growth cycle is a good place to start. Moreover, from a proportional perspective of the long-term yield cycle, which we’ve argued directly influences a dynamic and expanded range of CAPE, the potential stumble across the current transitional divide may last considerably longer than the last. That said, should the equity markets swiftly revalue as they did in 1946, we would again be selective buyers of emerging market equities, as we'd expect their outperformance to resume in a weak dollar and declining real yield market environment. 

Wednesday, October 5, 2016

Buy the Dip

As trading in the fourth quarter got underway this week, the bottom quickly fell out in precious metals, with gold and silver each finishing down in Tuesday’s session by more than 3 and 5 percent, respectively. When the dust settled, both assets had completely retraced the moves since the June 23rd Brexit vote roiled global markets.

While gold and silver had largely remained range-bound for the better part of the third quarter, lower support gave way as traders threw their gilded babies out with the bathwater as the tape was hit Tuesday morning with the hopes, fears and hype of higher rates.

The Hopes: as witnessed in the relief from the growing desperation in Europe that has seen European bank shares fall sharply with negative yields this year, led by Germany’s embattled Deutsche Bank, who’s market value has roughly been cut in half since January.

Stoking hope, was a report out of Bloomberg (see Here) Tuesday morning citing confidential ECB officials, that an “informal consensus has built among policy makers in the past month that asset buying will have to be tapered once a decision is taken to end the program.” And although they “didn’t exclude that QE could still be extended past the current end-date of March 2017 at the full pace of 80 billion euros a month”, the report elicited a taper-tantrumesque reaction in the government bond markets – as well as bank shares, with yields and bank stocks rising on both sides of the Atlantic.

The Fears: as in David Byrne’s, “My god what have we done?!” realization, that although low yields were welcomed by central banks to prop-up economic growth and stave off potential deflation, they’re not so good for bank profits and defined pension plans over the long run, as it inherently squeezes profitability and hence could eventually put the broader financial system at risk through substantially weaker banks.

Although fear of inflation was the tack he chose, Richmond Fed President Jeffrey Lacker’s closing remarks from his speech early Tuesday morning (see Here) made the favorable policy parallel to the Fed’s severe actions in 1994 that doubled the Fed funds rate from 3 to 6 percent over just one year. Notwithstanding the apparent absurdity of the comparison with today’s economic backdrop, the speech set the tone for the morning session and correlated with the sharp range break lower in precious metals and bid in the US dollar.

The Hype: Simply put, you know there’s serious confusion and divide within the Fed, and hence – the market, when a Fed president cites 1994 as a model policy blueprint and gives Greenspan credit for the preemptive action that “laid the foundation for the price stability we’ve enjoyed over the last 20-plus years”.

Ignoring the massive market dislocation that rolled the dice of systemic risk and took down among other investors – Orange County California, someone should remind Lacker that Greenspan’s aggressive preemption in 1994 also inverted the yield curve and took US economic growth from 5.6 percent per year to just 1.4 percent – in just three quarters.

If it wasn’t for luck and the nascent technology boom that was just getting started, his actions would have undoubtedly precipitated a deep recession and an immediate unwinding of tighter monetary policy, that would have destroyed the Fed's credibility in the market going forward. And although the Fed at that time had room to drive rates on both sides of the road, with US economic growth currently at 1.4 percent, the inevitable and likely severe contraction brought on by a similar tightening regime, would find the Fed out of road overnight and back to more unconventional policy measures that have already lost considerable efficacy and support within the market.

The Opportunity: With the range break lower this week, gold and silver are now trading back to levels from late June in another market environment significantly discounting the impact of higher rates. While a modest 25 basis point hike is not out of the question this December – and one we suspect is now being fully priced into the sector, it has paid to buy the dip in precious metals over the past year, as market participants become over zealous on the prospect of higher rates and ignore the real motivation of a weaker dollar and lower real yields.

The reality is that these misplaced expectations are eventually walked back, as market forces and the economic data largely prevent the Fed from enacting more conventional tightening regimes, let alone a severe outlier period like 1994. From our perspective, it would behoove Lacker to follow the median trend of the Fed's own dot-plot projections, that despite moving in the right direction over the past year, still have considerable room to fall in line with more realistic expectations within the long-term yield cycle.
As we've described in previous notes, this expectation gap ties directly into the performance of the US dollar that peaked with the Fed's dot-plot projections last year, and which we strongly suspect will again be hit on the downside with the realization that this isn't Kansas  or 1994 anymore.

Wednesday, September 21, 2016

Season's Greetings

Announcements, announcements, announcements!

What a terrible way to die,
A terrible way to die,
A terrible way to be talked to death,
A terrible way to die.

Announcements, announcements, announcements,

On the doorstep of yet another much-heralded Fed announcement and in the wake of the BOJ's tinkering last night, the US dollar sits fittingly at a crossroads: spring back to its stoic uptrend nearly 19 months dormant – or fall back through intermediate support just a few percent below. As circumstance would have it, today is also the last official day of summer, to which we say  get on with it. Bring on the Fed, bring on fall and bring on the fall in the US dollar.

While there’s certainly no shortage of bubble soothsayers these days, one that’s arguably on the precipice of deflating and which has followed the structure of exuberance – is the US dollar. And although we’ve written extensively of why, historically speaking, we believe the dollar is as extended as it became and remains (see Here, Here, Here, Here), it has largely been motivated by the Fed, or more precisely – the markets expectations with future policy. 

Framing the dollar as a proxy of confidence in the golden age of central banks, where it discretely took flight as the Fed led policy makers in the wake of the financial crisis and soared to icarus heights on misplaced expectations with more contemporary tightening cycles  we'd argue the apparent indecisiveness in the dollar's technical structure today aptly represents the unresolved tensions in the market that we believe will ultimately become unwound, as challenging economic conditions largely limit the reach of the Fed going forward.

- Click to enlarge images - 
Granted, we've found the circumstantial evidence  from both a quantitative and qualitative perspective, in favor of a weaker dollar for some time. The move was as extreme as the cycle high in 1985, as well as the dollar squeeze during the financial crisis. Both performance extremes served to cap the blow off move, as we expect a similar outcome today as the Fed's influence on the dollar continues to wane. From a bearish technical perspective, the next shoe to drop would be a weekly break below ~93 on the US dollar index, which would usher in the next phase (i.e. fear) of the retracement move lower, as expectations of a continuation of the dormant uptrend are largely abandoned. 

As we've described in previous notes, the dollar's influence on various markets is significant, with the abstract result that precious metals and commodities should benefit disproportionately, as real yields continue to move lower as inflation firms – but the reach of the Fed is increasingly limited by the economy. 
Overall, this market thesis remains on course, as our leading indicators in the silver:gold ratio and the Japanese yen appear to be taking the next step higher, which bodes bullish that the retracement decline in gold is over and the next leg down in the dollar approaches in Q4.  

Friday, September 9, 2016

Connecting the Dots - 9/9/16

After the beach grills cool and get covered for the season, a quiet reality sets in that summer is unofficially over and the first days of school are upon us. Our house remains filled with a thick bittersweet nostalgia from a perfect summer now passed, which joyfully took us from the shores of Alaska to Lake Placid and a few other memorable byways in between. Certainly blessed to experience just a snapshot of what this country composes, the enduring anthem of America the Beautiful still resonates as a fitting testament to the best of which she offers. And while the contrast today with the political and social backdrop is a poignant reminder of the complex environment that resides above, the reflection with nature reminds us that life – like the landscape behind it, rarely follows a straight line or that progress is often felt in the present through the repetitive peaks and valleys of a lifetime.
Smooth shapes are very rare in the wild but extremely important in the ivory tower and the factory. – Benoit Mandelbrot
Speaking of which, and perhaps drifting somewhere between progress and a lifetime… the recent batch of lackluster US economic data over the past week lends greater probability that the Fed chooses to pass on raising rates this September. Moreover, taking a look back and weighing the respective trends of these volatile series, the high water marks for each were set more than a year before, with a growing probability that they’re leveling off at best and trending down at worst. 

Although a painfully fluid transparency has provided lip service to both sides of the debate (most recently Here), one could argue the collegial window of academic deliberation within the Fed is narrowing each quarter, as the economy buts up against an expansion already long in the tooth in its 87th month. And while we don't foresee an imminent recession or one commensurate with the previous, a contraction is ultimately as inevitable as yesterday’s sunset. The almost fetish focus on rates by the media misses the mark, or more precisely – appears ignorant to cause and effect. Secularly speaking, rates would only be capable of leaving the trough on a lasting basis when growth materially picks up, which by most measures as well as historical precedence within the long-term yield and growth cycle – is likely years away.

To this point and picking up on our thoughts in recent notes, despite equities drift higher this year, financials have largely underperformed the broader indexes, which is rarely a healthy condition to sustain. From our perspective, the underperformance by the banks goes part in parcel with the upside limitations of the current cycle, which remains capped by the Fed’s capacity to materially raise rates, hence limiting bank profits and contributing to the contentious business environment they already operate within. Simply put, the weakened investment climate in the financials runs counter to what you historically see in a more lasting equity breakout, where the foundation of the broader market is built on the sector’s sturdy fundamental underpinnings, as investors commit capital with expectations of future growth.

That said, this hasn’t curtailed recent animal spirits in the sector, which as the comparative alluded to could see the banks sharply rebound on hopes that the operating environment within the financials will finally improve. And although the market called the bluff last December after the initial rate hike, it pays to never underestimate the capacity for denial by participants still under the influence of the former trend (appropriate example Here).
In recent notes we contrasted and compared the nearly mirrored action with the gold miners in 2012, who’s failed breakout was primarily driven by faulty causal assumptions with monetary policy and inflation that largely went unfounded through QE3. Today, we suspect a similar reversal could materialize in the financials and across the broader equity space, as the economic expansion matures and growth continues to underwhelm expectations; limiting the Fed’s capacity to materially raise rates – despite an upturn in inflation. 

From our perspective, inflation today is less tied to growth than the direction of the US dollar, which significantly strengthened as the US led the world out of the financial crisis and has weakened as the expansion matures and rate hike expectations diverge from more contemporary tightening cycles. Until the growth cues of stabilizing and rising yields materialize for a considerable period, the notion of a more secular continuation of a stronger US dollar is as misplaced as the dot-plot projections have been towards rate hikes over the past two years. As such, we expect the move in the dollar that strengthened to a relative performance extreme last year to largely retrace  leaving ample upside motivation for precious metals and commodities that exhibit a strong inverse correlation with the world’s most dominant reserve currency.
Although we've carried an opportunistic and bullish lean towards the broader equity rally over the last several months, we suspect it has limited upside from here and would prefer to be sellers than buyers as the September Fed meeting approaches. While the miners made their highs a week after the September meeting in 2012, we continue to like the prospects today in precious metals and commodities such as oil through Q4. 

Overall, we remain vigilant of the US dollar as a guide towards our outlook in precious metals and oil, with the dollar index approximately sitting between its lows from May and highs in July. While we suspect the index to soon break through weekly downside support ~ 93, should the dollar rally above the July highs, we would reassess our bullish expectations through the end of the year.