Monday, March 27, 2017

Connecting the Dots - 3/27/17

Most of the observations we’ve noted over the past year, with respect to similarities with market conditions in 1987, have been from a comparative perspective with long-term Treasuries. In hindsight, you could see this directly derivative of our thoughts on the collapse in oil prices that began in the back half of 2014, that from a relative performance point of view had few market parallels – the closest of which now appears to be the major supply-driven decline in 1985-1986 that took over 60 percent off the price of oil, as the global economy slowed while supplies remained robust. That said – and as frequently the case with looking back at nearly all market history, there are significant macro differences between the two periods, likely resulting in vastly different long-term outcomes.

The breakdown in the oil market at the end of 1985 coincided with already broadly disinflationary market conditions, as the bond market had rallied from July 1984, out of the retest of the secular lows from the fall of 1981. Technically speaking, what happened next was also quite significant. When oil prices began to crash in December 1985, inflation expectations declined as Treasuries broke out above the previous highs at the end of 1982. Looking back, this marked a major sea change in the markets with respect towards yields, as long-term Treasuries recorded their first “higher high” in the markets in decades.
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Fundamentally, this was a major benevolent force now supporting equity investors and a headwind towards commodities, as market participants gained greater confidence that inflation expectations were receding from the historic highs at the beginning of the decade. Generally speaking, declining yields and diminishing inflation supports growth as corporations can reduce financing costs, while also broadly boosting private consumption as the cost of living becomes cheaper. Downstream, the net effect is often quite positive towards equities by raising price/earning multiples. Considering this was occurring directly on the backside of the largest secular rise in yields in centuries, the infancy of the longest and strongest bull market in equities in history is quite understandable today.

This is also why in as much as there have been certain intermarket similarities with the disinflationary and reflationary sub-cycles of the mid-to-late 1980’s, longer-term, the markets current disposition within the trough of the long-term yield cycle will likely result in materially different outcomes. Simply put, we currently lack the positive potential energy of a continuation of the secular disinflationary downtrend that fostered the greatest bull market in equities in history. From our perspective, the most probable macro outcomes over the next chapter in the markets will either be through muddled stagflationary growth (our bet– or another scare with deflation. This thesis basically falls on the future prospects of the US dollar, whose continuation higher from here would likely cause widespread concerns, as inflation expectations could collapse again with less room available globally for central banks to mitigate.

Headed into 1987, the Fed began moving towards tightening monetary policy as conditions domestically and in the global economy had improved. And although equities had benefited for years from the benevolent disinflationary economic shift, the uptick in economic confidence and reassurance by Fed action manifested with a powerful reflationary move across equities and previously collapsed commodity markets, like oil. At the same time, it also precipitated a large sell-off in Treasuries that had benefited for years as inflation expectations declined from secular highs. The net effect saw equities rally more than 20 percent over three months as one of the greatest bull markets in long-term Treasuries abruptly came to an end. Long-term Treasuries would eventually retrace all the way back to the previous highs from 1983 and find support as the equity markets broke down in the fall of 1987. When the dust settled, the large reflationary blow-off enjoyed by equities over the past year was completely retraced. However, the respective long-term secular bull markets in bonds – as well as equities, quickly resumed momentum higher into 1988.

Over the past few years there have existed certain intermarket similarities with the disinflationary collapse in oil and yields in 1985/1986 and the strong and broad-based reflationary move that followed, as the global economy stabilized and the Fed began tightening in 1987. Consequently, trends across markets; namely, in equities, Treasuries and commodities have expressed a certain historical likeness, as current economic conditions in the US and globally have improved over the past year, corresponding with a strong reflationary rally across equities and commodities and a deep sell-off in Treasuries, as the Fed has moved to tighten monetary policy.
Where we believe the markets stand today, is near – or directly past the peak of where classic animal spirits have pushed equities and highly speculative commodities – like oil, probably too high and too fast. When it comes to US equities, we still believe there is much greater risk at current valuations, that cyclically speaking, the bull market has exceedingly ephemeral motivations. Although the unique conditions that helped precipitate the crash in 1987 will almost certainly not repeat again, we do at the very least expect a complete retracement of the large reflationary rally in US equities that had manifested over the past year as economic conditions improved. 
Moreover, where we suspect market histories to diverge is over the intermediate to long-term, where the outperformance by US equities today has run commensurate with strength in the US dollar, which we believe is in the process of breaking down from a cyclical high (see Here).

From an intermarket perspective, we view the breakdown in Treasuries last fall as both a significant contributing factor for the final push higher beneath stocks and a leading signal that the uptrend in the dollar  as well as equities, were poised to follow suit lower this year. Besides the significant distinction of where the markets sit within the long-term yield cycle that helped create an even stronger move in Treasuries and equities in 1986 and 1987, respectively – the disposition of the US dollar today is contrary to where it traded through the disinflationary and reflationary sub-cycles of the mid to late 1980’s.

Back then, the dollar index had peaked at its secular high in Q1 1985, and declined for nearly 3 years until directly after the stock market crash in December 1987. Following the crash, the dollar traded higher for much of the next 2 years with the equity markets. 
Today, the dollar has trended inverse to that period, with the large leg higher occurring in the back half of 2014 as oil and yields broke down. Looking back a bit further, the dollar bottomed-out in April 2011, which closely corresponded with outperformance by US equities since then and a leading proxy to short-term yields.

Although the economic data over the past year has markedly improved, the markets characteristically jumped ahead of the hard economic data, with sentiment surveys remaining at or near multi-year highs – while realized figures on retail sales, housing, and construction and manufacturing have been considerably less exemplary (See NY Fed vs. Atlanta Fed and Here). Our read of the intermarket tea leaves suggests that the continued weakness in the US dollar this year and the most recent collapse in the more speculative macro corners of the markets (like oil), more likely points towards a disappointing resolution between the hard and soft economic data series, lower nominal and real yields and a likely exhaustion of the broad-based reflationary move. Moreover, using the retracement decline in long-term Treasuries into the fall of 1987 as a guide towards where they found support with the breakdown in equities, long-term Treasuries have already met a similar retracement pattern directly beneath the previous highs from 2012. 
Connecting the dots even further, the overhead resistance in longer-term yields – extending from the pre-crash 1987 highs, has to-date managed to provide resistance for the current move. That said - and as we've commented on in earlier notes (see Here), unlike Gross and Gundlach's respective KISS approaches, we're less inclined to give technical secular criteria to a bear market in bonds today, primarily due to our bearings within the trough of the long-term yield cycle, which inevitably will break the overhead trend line resistance as the range is further extended laterally.
Consequently, should Treasuries follow the structure of the 1987 A-B-C decline, the final leg lower could cause yields to briefly break above the trend line resistance extending from the 87' high. Taking into account that market positioning in long-term Treasuries remains historically crowded on the short-side, while highly reversionary economic sentiment measures persists near multi-year highs  we wouldn't recommend a speculative position today and still prefer to be short US equities over the intermediate-term. 
Although we firmly do not expect equities to crash along commensurate lines with 1987 and only use comparative charts for possible touchstones with current momentum, the structure and relative strength signatures of the last moves have correlated, albeit faster and stronger in 1987. 
After starting the week nearly 0.5 percent lower, the US dollar index currently resides on trend line support extending from the July 2014 breakout. Should the index follow the leading breakdown pattern in bonds, we would estimate that the dollar will have a shallow bounce next week, before breaking below trend line support sometime in April. 

Tuesday, March 21, 2017

The $'s April Showers Can Bring May Flowers to Gold

Regardless of how hawkish the Fed frames possible future rate hikes this year, we suspect a cyclical breakdown in the US dollar index to unfold. Moreover, by our estimates of the leading market breakdown in US Treasuries last November, the window for a dollar break appears to be now open and extended through April.

Similar to the failed breakout in long-term Treasuries last summer that subsequently resulted in the severe correction in bonds, the dollar index has followed the retracement pattern in long-term Treasuries as it currently flirts with last November’s upside breakout ~100. Should the index break below current levels, long-term trendline support will be tested directly below ~98.50 and likely fail.
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As we’ve noted over the years, the relationship between Treasuries and the dollar is highly dynamic, and at times – quite muddled – depending upon the time frame and markets you look at. Granted, this is true for all markets, yet even more so with Treasuries, in part due to the range of durations and also when intermarket correlations are interpreted through yields that inherently behave inverse to their corresponding bond. Simply put – it’s complicated to read and even more confusing to describe.

That said, from a macro perspective we have viewed the dollar following cyclical trends in long-term yields by several years, while over the intermediate term the dollar has followed more structural pivots in Treasuries by several months. 
Shorter-term – and as frequently seen in most intermarket relationships, correlations fluctuate between the positive and negative poles, with long-term Treasuries and the dollar index most recently exhibiting an inverse correlation extreme coming into January – the last of which was present during the previous cyclical top in the dollar in the first half of 2002. Consequently, when Treasuries broke down from the failed breakout last November, the dollar broke out. Since then, however, the dollar fell short of making new highs this month as long-term Treasuries recently made new lows.

Our interpretation is that the dollar is set to follow Treasuries breakdown lead with the last lagged pivot (~5-6 months) of the cycle, which should mark a pattern break as the dollar turns cyclically lower without a corresponding leading move lower in Treasuries. As we described in previous notes, while we wouldn’t be surprised to see a final leg lower in Treasuries manifest along the lines of the 1987 breakdown to complete the move, over the longer-term we like them from a relative performance perspective to equities. Moreover – and further out on the risk continuum, we still like the prospects of precious metals and commodities that should benefit as the US dollar turns down.

While over the near-term and through an anticipated cyclical pivot lower in US equities, we favor gold here – as it tends to find greater support through broader market weakness than higher beta commodities like silver and oil, on a relative performance basis over the long-term they should all outperform stocks.

Wednesday, March 1, 2017

The Next Market To Break *Should* Be Stocks

It was the summer of 1987 and despite some flirtation with teenage adolescence, we found ourselves on the weekends renting table space in large hotel conference rooms, selling small plaques of cardboard to mostly middle age men seeking to speculate on the prospects of the likes of Bo Jackson and Jose Canseco. No sales pitch required; all that was asked was plenty of product – i.e. baseball cards, and the capacity to keep a straight face while raising prices each week to seemingly absurd levels. If our parents didn’t know better or weren’t driving us, we were either selling drugs or worst. Our take – roughly a few hundred each weekend, went a long way for a 12 year old kid in the burbs, even at the glitzy Short Hills Mall.

Although unbeknownst to our more youthful perceptions of the world, our little racket in North Jersey was less an anomaly and more indicative of the times. Conspicuous speculation, wealth and greed were all on daily display, manifesting later that year as life imitated art with the crash on Wall Street, just as we would be introduced to Hollywood’s Gordon Gekko. It was also the year of Donald Trump’s coming out party in the media as a brash, young and ambitious billionaire businessman, eager to leave his mark on the country he professed to understand better than anyone.

Some 30 years later, the writing on the wall and skyscrapers by the developer’s son from Queens, appears to have fulfilled his own ego’s expectations in 1987. And while he tripped and nearly crumbled in debt just a few years after his larger than life entrance, the P.T. Barnum of real estate and panache is having a monumental third act return. Whether he can deliver on his promises of “Making America Great Again” – is another debate entirely. What’s not in question, however, are some of the touchstones in the markets from 1987 that have resonated with us over the past year, just not from the typical perspective that most analysts have viewed them against.

Notwithstanding the current move in equities that through Monday had matched a January 1987 record in the Dow of 12 consecutive record high closes, we have looked at 1987 from time to time over the past year not exactly through the prism of equities, but mostly long-term Treasuries – which coming through last spring looked vulnerable to a breakdown similar to the one that took hold in the spring of 1987.
One historical period that we have been following for possible insights is the market environment headed into the spring of 1987, where investors had pushed long-term Treasuries significantly higher over the previous two years on the back of a sluggish global economy and a collapse in oil prices. It wasn’t until the global economy stabilized and oil prices began moving higher that the Fed began to raise rates in April 1987. This shift, following several years of disinflationary market conditions that had greatly buttressed the trend in Treasuries – came to an abrupt end that spring. Headed into October, the price on the 30-year Treasury bond had fallen by over 20 percent.The Next Market To Break Might Not Be Stocks 5/12/16
From an intermarket perspective – and in the wake of the major breakdown in Treasuries that manifested last summer akin to 87', we would argue that the move in equities is likely much more mature than the echo of the record January 1987 sounding that some have recently pointed to for more bullish intermediate bearings. Their reasonings being, that although the markets may be near-term extended, like in January 1987, they still gained another 30 percent over the following 8 months. The old market adage applied  overbought can still become more overbought. That said, what the data mining ignores here is similar to the benevolent rotation out of bonds and into equities that supported the reflationary blowoff that began after Treasuries broke down in the Spring of 1987, stocks have been under this same strong reflationary momentum since last summer.

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What’s happened this week of note, and which has helped firm our own near-term expectations, is that several Fed presidents have more than candidly implied that the March meeting is very much in play for another rate hike. And although we had recently suspected that more hawkish posturing would adversely impact precious metals over the short-term, long-term Treasuries now again look vulnerable as well, which would closer resemble the final leg lower in Treasuries in 1987 and the curtain call for equities that fall.

In 1987, the initial breakdown leg in the 30-year Treasury bond registered a decline of ~14 percent. After remaining in a trading range for another 3 months, bond prices fell roughly another 10 percent, before finding a low as the equity markets broke down. Through the end of last year, the 30-year Treasury bond had fallen ~16 percent from its highs last summer. Although we still believe long-term Treasuries offer good relative value to investors as the limits of the US's mature economic expansion become increasingly visible this year, the more than 2 month trading range now appears susceptible to further near-term weakness, akin to the final leg lower in 1987.
Moreover – and as we described last May in The Next Market To Break Might Not Be Stocks, a final leg could find support at the long-term trend line extending from the 1987 crash low. In the four previous occasions that the 30-year Treasury bond exhausted with a long-term RSI momentum extreme, it eventually found support at this rising trend line, which we guesstimate would come into play another 6 percent lower ~ 140. That said, tactically we do not feel the opportunity warrants taking another swing on the short-side of Treasuries here as the market is still listing with short positions and as we feel the economic data will again eventually disappoint. As such  and from a comparative risk/return perspective, the more compelling intermediate-term strategy is short US equities, not Treasuries. 

Similar to the broad reflationary move in 1987 that drafted oil higher with equities, extreme caution is warranted in oil as well, as we suspect the eventual pivot to be broad based. This also applies to precious metals higher beta assets like silver, which could disproportionally underperform in the turn. Although we had in our previous note looked for a breakout in the silver:gold ratio to accompany the next leg higher in precious metals, when contrasted with the set-up in 1987, the recent breakout may prove to be short lived.


As a parting postscript, we thought we would also offer up our opinion to those chasing what we believe to be the speculative du jour of the day – bitcoin. 

Get out while you can. 

Thirty years later and those same baseball cards are worth a fraction of what we had sold them for in 1987. For bitcoin investors, we fear the fall will be even greater – as in, worthless.