Wednesday, November 30, 2016

Connecting the Dots - 11/30/16

Despite the enduring enthusiasm in equities since the US presidential election, we continue to follow the proxy pivots in gold that has broadly led the trend in equities by approximately 4 weeks over the past 2 years. Should the relationship persist, we would guesstimate a pivot lower in equities approaches over the coming week. And while the S&P 500 has fully benefited from the unbridled capital outflows from Treasuries and safe haven assets that helped inspire fresh all-time highs across most indexes over the past 2 weeks, emerging market equities remain in lock step with gold’s leading structure that points towards another leg down after the current retracement rally exhausts. 
That said, it would not surprise us to see US equities underperform (on a relative performance basis to EEM) on the downside, as we expect similar to last year’s dynamics going into and after the December Fed meeting, another sell-the-news reaction in the dollar manifests. A good leading indication that the dollar rally has run its course would be for gold and silver to find their respective lows over the coming week or so as the equity markets begin to turn down. We indicated below the two previous examples over the past two years of where a similar dynamic had developed. 

The US dollar index has again broken above 100 for the fourth time in the past two years, which has closely correlated with cresting rate hike expectations of the Fed. The last time the CME Group’s Fed Fund Futures probability for this December meeting rose above 90 percent was the first week in January of this year – before global market pressures significantly reduced expectations, which very likely had a negative feedback effect on the near-term outlook for growth and hence the economic data downstream in the following months. Despite participants mood in yields and rate hikes pivoting 180 degrees since the lows in July and some marquee money managers becoming increasingly more bullish on US economic growth in the wake of a Trump victory, US markets are still at the mercy of a fragile global equilibrium that is invariably adversely affected by a much stronger US dollar and tighter financial conditions worldwide – not to mention a domestic economic expansion already historically long in the tooth. 

Consequently, we tend to defer to much longer-term perspectives on yields and growth that despite what the interim rally might suggest, continues to point towards a lower-for-longer market environment well into the next decade. 
While we do expect the current weakness in Treasuries to extend into early next year and that yields would be more supported than the dollar over the coming years as we foresee the uptrend in inflation continuing, both markets are confined by a much broader construct that we believe is not yet under a more secular persuasion or has digested and crossed the transitional divide to the next major growth cycle. This long-term outlook remains for equities as well, as 2200 on the S&P 500 was our secondary target back in January, if the market found support at the Meridian – as it did a few weeks later. And although it wasn't our base case scenario back then, we still hold the respective extremes (both bullish and bearish) as outlier probabilities, with now considerable less upside opportunity today from a long-term historical perspective.
Expecting US growth will now resume a trajectory last seen during the halcyon days of the 1990’s, or that yields on the 10-year will again rise above 4 percent, is putting the cart well out in front of this horse, regardless of whether it was the Fed – or now Trump, holding out the carrot or waiving a large stick. Less we forget, we've been whacked plenty and have eaten trillions of bushels of carrots over the past decade with little to show for it in terms of growth. Sticks and carrots may have helped repair it, but only time will heal these wounds.

Although the US equity markets have enjoyed recent strength since the election, the honeymoon appears to be ending and we expect the new members of the bull brigade to have their gilded growth thesis tested as the equity markets could again become the sharp tip of the sword prodding at the sides of the Fed next year.

Monday, November 14, 2016

Clear & Present Danger

While the list of US money managers pivoting bullish last week on the US economy and equity markets reads like a who's who list of hedge fund titans, the broader reflationary trend that had displayed cracks in its foundation last month (see Here), once again began to quake and break down.

The main forces at work cleaving performance within the markets were longer-term Treasury yields and the US dollar, the impacts of which were mostly absorbed by US equities to date while emerging market stocks, precious metals and commodities took the full impact of a much stronger dollar and surging Treasury yields. 

What's interesting and perhaps lost or largely ignored over the short-term, is that although many strategists and managers now see an intermediate-term catalyst for US equities and a rejuvenation of inflationary forces here in the US  emerging market stocks that had significantly outperformed within the wider reflationary trend this year, now face a clear and present danger as yields break materially higher and as the dollar targets its highs from last year. 

Our comparative with the 1987 breakdown in long-term Treasuries would indicate a near-term low is imminent of a first leg down within a broader ABC corrective decline. We estimate this pattern would work out to an eventual target for the 30-year Treasury bond of around 140 next year.
Considering the recent intermarket developments, we continue to like the protection of a short position in EEM, that is still loosely following the breakdown of the reflationary outperformance of US equities in late 1987. For more on our thought process behind this position, see Here. While we never expect history to repeat in perfect cadence or proportion, intermediate-term support was broken last week that from our perspective points to further declines.
This negative outlook also applies to oil, that continues to follow the inverse performance of the dollar, which is now targeting its highs from last year. 
Although US equities came up a bit short in open market trading of our corrective decline target of around 2050-2060 in the S&P 500, we still think it warrants following the leading pivots in gold that now suggests another leg lower is approaching. 

Wednesday, November 2, 2016

Connecting the Dots - 11/2/16

Notwithstanding the fluid polling data of the approaching US presidential election – or the outcome of today’s less-anticipated November Fed meeting, the equity markets continue to wilt lower and follow gold’s leading footprints, left roughly four weeks back. Should the relationship continue to prove prescient towards stocks, we would guesstimate an initial target for the move in the S&P 500 of around 2050-2060.
That said, there are potentially short-term positive developments working against a broader market dislocation that had raised concerns a few weeks back (see Here), as gold has nearly retraced the entire decline from last month; long-term Treasuries have found a bid within the current equity market weakness and the breakdown in the US dollar rally this week. As described in that note, from our perspective the magnified risk of negative feedback pressures building across asset markets would be greatly heighted with a restrengthening US dollar and higher yields. As such, should the equity markets take another leg down as we suspect they will and upside momentum continue to bleed from the dollar, the utility of maintaining a reflationary hedge  such as the aforementioned EEM short, would diminish considerably in the wake of further equity market weakness. Long story short, a window to cover approaches. 

Overall, while it wouldn't surprise us to see the recovery rally in gold cool a bit if and when the equity markets stabilize, we're encouraged by the recent break in the US dollar and action in the silver:gold ratio that continues to bode bullish towards higher prices in the precious metals sector. Moreover, drawing on the historical parallels in real yields and the dollar from the mid to late 1970's, gold continues to walk the line – regardless of the buildup to the US presidential election.  

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. 

- Click to enlarge images -

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.