Sunday, March 25, 2018

For What It's Worth...

I could probably count on one hand the number of songs – that for whatever reason, I might stomach on repeat indefinitely. For What It’s Worth – by Buffalo Springfield, is one of them. I say this, because the opening refrain from the more than 50-year young classic, “There’s something happening here/ What it is ain’t exactly clear,” has been rattling behind my thoughts over the past month or so as I consider a few key markets and the mounting opaqueness of the current macro environment. Somehow I’m sure Steven Stills would be immensely disillusioned with the connection, perhaps something along the lines of  “It’s a protest song, pal – not a meditation on markets.”

That being said, and for what it’s worth… this uncertainly is more typically the case when strategists contemplate late-cycle market dynamics – and likely even more so today in the wake of less conventional monetary and fiscal policy approaches that have clearly muddled future growth and inflation expectations over the past decade.

What I’m struggling with presently, is in light of the most recent and once again tepid inflation data through February, the reality remains that for all of their extraordinary efforts, central banks worldwide have had relatively marginal influence on raising inflation and real growth. This truth is becoming harder to disregard with each passing monthly report, because despite a US economy operating at or beyond full employment – and within a mature and now synchronized global expansion, inflationary pressures have yet to materially surprise to the upside. 

Although markets became turbulent in February as attention turned to rates and the long-end of the curve, real yields also rose swiftly as growth and inflation expectations underwhelmed and were outstripped by nominal yields. Historically, real yields typically tend to rise with equities as growth expectations improve in the economy. While admittedly the window for interpretation is quite narrow and opaque, one could make the case that the opposite might be playing out today. 

In fact, when we look back at the past two years where the Fed has moved off of ZIRP and away from the extraordinary policy accommodations extended after the global financial crisis, real yields and benchmarks of underlying financial conditions have broadly declined even as the Fed has raised rates – arguably, because inflation and growth expectations rose more. 

Whether this was more or less a transient psychological boost away from the crisis policy stance maintained in the markets, rather than a material structural improvement in the economy – will be left to the historians and future noble laureates to debate and wrestle over in the decades to come. What’s concerning today as investors, however, is what this market dynamic might imply about the underlying health of the economy and the Fed’s resolute focus on maintaining future rate hike expectations this year and over the long run, despite the reality of underwhelming inflation and growth conditions. 

Moreover, considering the President’s recent tack towards more partisan economic advisors – like Larry Kudlow and David Malpass, the fantasy of higher growth expectations in an already mature and likely waning expansion becomes a dangerous strategy to double-down on. While anyone that works within and around finance will be mistaken regularly by the relative uncertainly of markets and forecasts, both of these economists have found themselves pushing policy initiatives and perspectives on the wrong side of history on more than a few pivotal occasions. We expect Kudlow’s latest outlook of 4 to 5 percent growth, and that – “We’re on the front end of the biggest investment boom in probably 30 to 40 years”, to have the same accuracy as his late-cycle predictions in 2007 and 2008.
“There’s no recession coming. The pessimistas were wrong. It’s not going to happen. . . . The Bush boom is alive and well. It’s finishing up its sixth consecutive year with more to come.” – December 7, 2007  
“Banks are taking significant steps to repair their balance sheets. Even though some people might not be happy with the speed, the reality is things are improving.” – January 16, 2008 
“I’m going to bet that the economy will be rebounding sometime this summer, if not sooner. We are in a slow patch. That’s all. It’s nothing to get up in arms about.” – February 5, 2008
When the facts change, I change my mind. What do you do, sir? – John Maynard Keynes

While I’m certain Kudlow and Malpass could benefit from more than a little reflection and consideration on why their perspectives on the economy and markets have been so consistently misplaced, we ourselves are now considering the idea that inflation might continue to underwhelm and how that might affect our market outlook and investment posture going forward. 

To be honest, our long-standing belief that nominal yields would continue to remain historically low over the long-term and across the transitional divide of the yield and growth supercycle – is more consistent with the current conundrum of relatively lackluster inflation and growth conditions, despite a mature economic expansion with historically low unemployment. 

The idea that a late cycle pulse of inflation could surprise to the upside was in part derived from our expectations with the US dollar and real yields, which did in fact roll over from their respective cyclical highs. 


In short, we’ve speculated that the dollar breakdown could precipitate a downstream condition where the reach of inflation outstrips growth, creating a tailwind for hard assets like gold that typically gain in a declining real yield market environment. With strong consideration to the most recent inflation data and trends – both domestically and abroad, we’re open to the idea that inflationary pressures may have run their course – for now. 

From a historic comparative perspective, we’ve viewed the current market environment against the template of the mid-1940’s, where a teflon equity market cycle greatly supported by the Fed and Treasury was eventually destabilized by less accommodative policy and surging inflation. Although it’s too early to determine which way – or under which economic and market conditions real yields trend over the next year, it’s worth reevaluating the 1937 analog that has been batted around by many over the past several years as a possible period to consider for prospective insights. 

Besides the more typical parallels drawn between the two major post boom and bust periods (e.g. ZIRP and QE – see Ray Dalio's comprehensive read from 2015), what’s interesting to note is when you look back at the mid 1930’s you find that real yields also moved lower – perhaps under the persuasion of a similar psychological boost  as the Fed began to tighten in the summer of 1936. 

Bridgewater Associates, 3/11/15
Following the second increase in reserves in March 1937, both short and long-term yields spiked. It wasn’t until the Fed tightened a third and final time in May 1937 that real yields began to trend higher, finally upsetting the ebullient swell in risky assets that had driven equities up 300 percent from the crisis lows of 1932. 

Admittedly, I panned the comparison over the past several years, predominantly because I viewed the markets further out on the long-term yield trough, and where equity market valuations (as defined by CAPE) were also downstream and beneath the secondary highs in 2007. In hindsight – and if history continues to resonate a certain cyclical pattern and rhythm, this perspective didn’t take into account the expanded proportions of the current long-term yield/growth cycle, that as I’ve described in past notes appears to influence a relatively proportional expansion of cyclical moves in CAPE. 
For example, the previous long-term cycle (as measured trough to trough – annually) stretched 40 years, with estimates of a symmetrical retracement decline of the current cycle stretching over two times that span. Considering the fact that every long-term cycle has trended below the previous over the past several hundred years, it’s not a stretch to believe the current span could extend even greater than twofold as long. Furthermore, the move in CAPE from its secular trough in 1982 – which also corresponded with the secular high in yields – to its secular peak in 2000, is 2.25 times the span of the previous cycle between 1921 and 1929. Applying this ratio to the span of the previous cycle between the secular valuation high in 1929 and the secondary high in 1937 (8x2.25), brings us to a secondary high in 2018 – as measured January 1st of each year. 

Granted, there is always a real risk of attempting to solve a puzzle that may not exist or be deciphered; we predominantly apply this kind of long-term comparative reasoning as a orienting backdrop for contrast and color against current market conditions. At the end of the day we still strongly believe in the inherent behavioral nature that markets cyclically express themselves as, and typically find greater utility than folly in filtering our thoughts through the wide-angle prism of history. 
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So, for what it’s worth… Despite our concerns with a shift higher in real yields, over the short-term we still expect gold to be under the dollar’s persuasion, which technically appears set for new lows. As we described in our note last month, we would be looking for a positive divergence in momentum from the US dollar index’s February low as suggestion that a more durable interim low is possibly in play.

Consequently, we are looking for gold to once again test its cycle highs – as it has rallied to varying degrees several weeks out after each of the previous five rate hikes. Should our concern that inflationary pressures are easing and that real yields have more room to move higher over an intermediate-term timeframe, we suspect gold to trade only marginally around the July 2016 highs, with likely greater volatility developing before a more lasting retracement decline would begin. In this respect, it wouldn’t surprise us to see gold trade in a widening range between 1400-1300 over the next several weeks.

That said, should these concerns be misplaced, we will be looking for gold to rally staunchly above the previous highs and not look back. Additionally, we would also like to again see silver begin to outperform gold, as it typically has under greater inflationary pressures. What’s interesting to note is that since the dollar’s breakdown over the past year, the silver:gold ratio has trended lower with the dollar, very much displaying the opposite dynamic of what was found between 2010 and 2011, where the dollar was plumbing the trough of its long-term range and silver cresting at a cyclical high. All things considered, we will be closing watching how precious metals behave over the next several weeks for greater intermarket insights.







Generally speaking, our newfound concerns with the direction of real yields and the markets perhaps more juvenile disposition within the long-term yield trough, does not greatly influence our relative performance expectations across most markets. It predominantly impacts our absolute performance outlooks within an intermediate-term timeframe, specifically with respect towards gold and the US dollar. 

We see no reason to become more bullish on equities here and still believe the parabolic breakdown will be respected, with lower lows and lower highs throughout this year. If anything, we’re leaning more bearish on an absolute performance basis towards equities – more bullish on long-term Treasuries, and still believe gold will strongly outperform equities across both intermediate and long-term timeframes.


Friday, February 9, 2018

Gravity & Greed

Besides death and taxes – whose ultimatums we continue to try and cheat - the only two things you can truly depend on showing up on a regular basis are gravity and greed. Over the past week, the two collided in the equity markets in rather spectacular fashion, with gravity taking the day.

Granted, it’s been a while since equity traders felt the strange sensation of gravity. So long has it been, that once pressures arose, there weren’t many on deck even capable of lifting a hand. Cue Mrs. Fletcher’s late 80’s desperate plea into the night, “I’ve fallen, and I can’t get up!” Unfortunately, the markets own LifeCall system also went down, as thousands of volatility shorts were crushed in the scramble, sending the VIX on its largest one-day spike ever.

For some of us, it’s only when gravity starts to take over that we begin to think critically about our bodies. Where did that gut even come from – and more importantly – what might it imply about our underlying health? For stocks, the usual suspects will point out a healthy US economy growing at a decent clip, with blue-chip American companies wielding strengthening market power – essentially, providing outsized earnings in a cheap capital and business friendly market environment. Throw in a healthy dose of global synchronized growth and the appetite to market and consume equities has been enormous.

Never mind that we’ve been feeding heavily from the trough for historically longer than nearly all previous equity cycles, even the typically prudent Jeremy Grantham and Ray Dalio’s of the world have recently suggested a nice finishing course of gluttony awaits us. Dalio’s blunt suggestion merely two days before the rally peaked – “If you’re holding cash, you’re going to feel pretty stupid”, is another way of implying – to hell with regret, come join the party. Of course in classic fashion at pivotal moments the market gods don’t discriminate between maven and monkey. In their eyes – we are all mortal.

Speaking of mortality and reflection, the bitcoin and crypto bandwagon that carried frenzied speculators up a rickety and near vertical ascent last year, now appears to be on the backside of the move, where the dominant hand of god – i.e. gravity, can exert its indiscriminate influence. Considering the elevation and means of transportation taken by these speculative pioneers, the road back may prove treacherous – if not fatal (see XIV “traders”).

For equity investors, the violent breakdown in the crypto market at the end of December was in hindsight (as well in foresight…) the leading speculative wave that broke first. Although equity gains were a mere pittance when compared to various crypto markets last year, the parabolic structures of the moves were quite similar, leading us to believe both markets may have put in their respective highs for some time – regardless of the benevolent economic backdrop that stocks still trade against today.

This is largely because of the inherent nature of parabolic trends, in that once the spell of a buying mania has broken, the unbridled chase that had carried the market without pause beyond more typical expectations, can not rekindle the same degree of momentum required to reestablish the uptrend. Eventually, through the markets subsequent failures to reestablish upside momentum with higher-highs, larger and more sophisticated capital looses trust and sells, thus reinforcing the markets now negative trading dynamics.

From this perspective – and considering our most recent thoughts towards equities long-term prospects (see Here), we will be looking for a lower retracement high and eventually a lower low in the coming weeks and months. We say eventually a lower low, keeping in mind we suspect the current breakdown leg that began just last week has yet to find an interim tradable low. Sizing up the move relative to more recent parabolic breakdowns (e.g. silver, circa 5/2011), gives us a target range in the S&P 500 between 2500 and 2550.

As expected, the 10-year yield continued to climb above the highs from last year, which corresponded with the broader breakdown in equities last week. With the 10-year yield now flirting below our upside target range ~ 3 percent, longer-term Treasuries again have entered an attractive window for longs, as we suspect demand will return as the Fed ultimately defers to equity market weakness – rather than further hawkish leanings tied to potential inflationary concerns. 

Moreover, looking back at our long-term chart of the 30-year Treasury bond, the most recent leg lower, now trades near long-term trend line support – a possible target we have been on the lookout for over the past two years.That said, yields could continue to overshoot over the near-term, before the market becomes more confident that the Fed will restrain from further tightening. 

We would guess that in this scenario, the risk of a swifter break lower below our initial target range in the S&P 500 would increase if yields continue to rise, as it did coming into the fall of 1987 when Treasuries took their final leg lower.








Peaking around at other markets – a word of caution towards those dip-buyers in oil today. Should yields again trade lower, it’s a decent bet that crude would mimic the trend, as it has over the past year.


Although gold failed to capitalize on equity market weakness and break above its current cycle highs from July 2016, the modest retracement bounce in the dollar was largely at fault. Generally speaking, the cyclical unwind in the dollar continues to make progressively negative momentum (RSI) lows, an indication technically that further weakness is still unfurling, before a more tradable interim low is reached with likely a positive momentum divergence (e.g gold, circa 7/2013). Cyclically, the dollar continues to loosely follow the previous cycle decline, which remains naturally bullish for the euro and gold.

Thursday, January 11, 2018

the Inevitables

In what’s becoming a bit of a New Year’s tradition, the Bond Kings are out with some early ruminations on the prospective end of the three-decade young bond bull. Never one to pull a punch, Bill Gross of Janus Henderson went full-bear (not to be confused – although admittedly, quite similar to – fubar), bluntly stating on Twitter, “Bond bear market confirmed today.”

While definitely less sanctioning, although still glazed with concern, Jeff Gundlach of DoubleLine eyes 2.63% on the 10-year yield as a trigger to sell long-term Treasuries, with a break above the late 2013 highs ~3 percent on the 10-year as the delineating line in the sand for the secular cycle.

If it all rings too familiar, they did issue similar pronouncements last year – practically to the day – calling for the end of the secular rally in bonds.
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Jeffrey Gundlach said the 10-year Treasury yield topping 3 percent would signal the end of the three-decade long rally in bonds. 
“Almost for sure we’re going to take a look at 3 percent on the 10-year during 2017,” Gundlach, the chief executive officer of DoubleLine Capital, said Tuesday during his annual “Just Markets” webcast from New York. “And if we take out 3 percent in 2017, it’s bye-bye bond bull market. Rest in peace.” 
Bond manager Bill Gross at Janus Capital Group Inc. has a different threshold. He said in an investment outlook released earlier in the day that benchmark Treasuries above 2.6 percent would spell the end for the bond bull market. 
“The last line in the sand is 3 percent on the 10-year,” Gundlach said. “That will define the end of the bond bull market from a classic-chart perspective, not 2.60.” – January 10th, 2017Bloomberg
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Although we do find merit (over a much shorter timeframe) in Gundlach’s “KISS” technical criteria of simply using a higher high to trigger a shift in market posture, as we commented on last January (see below), we view both approaches as broadly misplaced from a historical read of previous long-term cycles, where a trough is formed and largely proportional with the broader cycle (trough to trough). Contrary to the explosive secular peak and reversal in yields in 1981, the trough is a long-term process in-of-itself, inevitably breaking overhead trend line resistance as a range is extended laterally.
This week, markets are knocking on that inevitable door – the question is, secularly speaking: Does it hold any broader significance if and when we walk through it? Considering the massive and overarching size of the secular cycle (see Here) and echoing our thoughts below from last January – we don’t believe so.
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While Gundlach and Gross have a semantic squabble over the upside threshold in yields that might delineate the end of the three-decade old bull market in bonds, perhaps they should stop viewing the bond world as round and come to the apparent reality that it’s more flat than circular here in the trough of the long-term cycle. 
In this construct, the unidirectional sovereign yield winds died – or more appropriately – transitioned, years back in 2011 and 2012. Although short-term yields and the dollar have risen in tandem as the US economic expansion led the world out of the financial crisis, long-term yields have taken a more lateral path into the trough with what we suspect will be doldrum conditions blowing east to west at best – rather than the prevailing winds we experienced out of the north for thirty years. How long the journey along this yield equator will take is anyone’s guess, but by our estimation of previous long-term cycles (most recently, Here), likely has further seas to float before the strong updrafts of the Westerlies can bring us to the higher-latitudes of a "New World". - January 19th, 2017 Market Anthropology
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That said – and considering our suspicions of a continuing trend of higher realized inflation, we wouldn’t be surprised if the 10-year was squeezed for a spell firmly over Gross’ threshold and up to Gundlach’s line ~ 3 percent. In this scenario – and maintaining our approach since early 2014 (see Here) to a potential troughing range in long-term yields – use the span between 1.5 and 3 percent in the 10-year yield as a guide towards opportunistic trading windows in Treasuries.

With the release of the December CPI report tomorrow morning, markets will have fresh catalyst to work through as they skate towards the first Fed meeting of the year at the end of this month. Despite this mornings PPI report coming in weaker than expected, year-over-year performance in the US dollar hit an over 6-year low coming into 2018, which as we have shown in the past leads the trend in real yields (shown below through 10-year less CPI/year-over-year).
Although the threat of inflation appears to be receiving wider attention in the financial media these days (see Barron’s coverDecember 30th, 2017) – and pundits have cited the risk as impetus for the recent rise in yields, a broader impact to underlying market psychology has yet to take place, one we suspect will eventually adversely affect the lofty and ebullient sentiments currently entrenched in equities.

Moreover – and getting back to Gundlach’s initial trigger of 2.63 percent on the 10-year yield, we would look for that break above last years highs to coincide with broader market weakness in equities and potentially an upside breakout in gold. While gold would likely benefit from the more typical safe haven demand, we would also expect real yields to continue to decline as inflation outstrips the reach of nominal yields.