Managing Lower Momentum

April 9th, 2015
in contributors

Macro Strategy Review, April 2015

by Jim Welsh with David Martin and Jim O'Donnell, Forward Markets

U.S. Economy

The slowdown in the U.S. economy continues to unfold as we expected, although the weather has accentuated the trend. For the third straight month retail sales fell, posting a 0.6% decline in February. Excluding the volatile categories of autos, gasoline, building materials and restaurants, sales were flat. Annual retail sales were up 1.7% from February 2014. Business sales were down for the sixth consecutive month, dropping 2.0% in January—the largest monthly decline since March 2009 when it appeared the world might be ending.

Follow up:

The Institute of Supply Management’s (ISM) overall purchasing managers index (PMI) dropped 0.7% to 51.8 in March and the new orders gauge is near a two-year low. Capacity utilization retreated for a third straight month to 78.9%. The weakness in the ISM’s New Export Orders Index and the lower rate of capacity utilization suggest business investment is not likely to improve much in coming months. Capital expenditures, which represent about 13% of GDP, will also be negatively affected by the decline in energy-related business investment.

The economy added 295,000 jobs in February, marking the twelfth straight month of adding over 200,000 jobs and the best streak since 1995. The official U3 unemployment rate fell to 5.5%, the lowest since May 2008, bolstered in part because more discouraged workers left the labor force. The participation rate remains at 62.8% where it has hovered for the past year, near the lowest level since 1978. The U6 unemployment rate, which includes part-time workers seeking full-time work and discouraged workers, dipped from 11.3% in January to 11.0% in February, narrowing the spread between the U3 and U6 rates to 5.5%.

As discussed in detail in last month’s Macro Strategy Review (MSR), since 1994 when the U3-U6 spread has been well above 3.85%, average hourly earnings growth has been weak. In looking at the U3-U6 spread since 2010, it’s easy to see why wage growth has been so slow in the past five years. This reality was confirmed in February as average hourly earnings only grew 2% from a year ago. The current U3-U6 spread suggests wage growth is unlikely to accelerate anytime soon.

According to the New York State Comptroller, Wall Street’s overall 2014 bonus pool was $28.5 billion, or an average of $172,860 for each of the 167,800 workers employed by Wall Street firms. This compensation was in addition to their annual salaries or wages. According to the Bureau of Labor Statistics, there are 1.03 million full-time workers paid an hourly wage of $7.25. If each of these workers work 40 hours per week for 52 weeks, their combined earnings would total only $15 billion. In other words, for these workers there was no bonus pool.

GDP growth is likely to remain under 3% as dollar strength curbs export growth, low energy prices and excess capacity keep a lid on business investment, and weak income growth throttles consumer spending.

Federal Reserve

In the March 2015 MSR, we noted the following:

“There are more reasons to remain ‘patient’ even if they remove the word from the March FOMC [Federal Open Market Committee] meeting statement. The Fed’s own model suggests that a 10% appreciation in the trade-weighted value of the dollar shaves about 0.75% off the level of GDP over a two-year period. The trade-weighted dollar index has risen by 15% since last summer, which suggests a drag of more than 1.00% on GDP. Partly as a result of the rally in the dollar, the pace of GDP growth has moderated, core inflation is well below 2% and there is plenty of slack in the labor market. A stronger dollar in response to a rate increase would only strengthen the headwind already evident in the fall off in exports, decline in import prices and increase in the trade deficit.”

On March 16 we penned a note for advisors that addressed the challenge the Fed faced with so much attention on the word “patient”, which included the following statement:

“The Fed has labored over the past 15 years to make [its] communications more transparent in order to reduce market volatility when there is a change in monetary policy. In some respects the efforts [of Fed members] have made them prisoners of their own communication. They shifted from using the phrase “a considerable time” to “patient” to ease investors’ concerns. The consensus has concluded that the Fed will raise rates two meetings after the word patient is removed. If the Fed does remove patient, [it] will use many other words to soften the impact and attempt to create some flexibility.” On March 18, the Fed did remove the word patient from the FOMC statement, but as Fed Chair Janet Yellen emphasized, “Just because we removed the word patient from the statement doesn’t mean we are going to be impatient.”1 To back up her words, the Fed lowered its targets for both GDP and inflation for 2015 and 2016. Back in December 2014, the Fed estimated that GDP growth would be between 2.6% and 3.0%. The new forecast is for growth to slow to between 2.3% and 2.7%. The Fed’s new forecast is now in line with our view that growth is likely to slow in 2015—contrary to the expectations of most economists.

Wages comprise 65% of the cost of goods sold, so if the Fed is going to achieve its goal of increasing inflation to 2%, wage growth will have to materially accelerate from the 2% range of the past five years. We think wage growth will be the primary factor in guiding the Fed’s decision on when to increase rates. Our guess is that the Fed will need to see an increase in average hourly earnings above 2.5% and be confident that wage growth will continue to trend higher.

Our analysis of the U3-U6 spread suggests the Fed is likely to remain patient beyond June even if the Fed doesn’t say so. In the aftermath of the 2007-2008 financial crisis governments around the globe ran huge Keynesian deficits that succeeded in stabilizing growth but did not return economies to precrisis growth rates. After six years of crisis-level interest rates just above 0% and three quantitative easing (QE) programs, the Federal Reserve is first in line to lift interest rates. As investors confront the consequences of the end of the Fed’s zero interest rate policy (ZIRP) at some point in 2015, there is a real risk that the bond market may not be as patient as the Fed would like and overreact with another tantrum. ZIRP has potentially pushed too many conservative investors to reach for income and assume more risk than they otherwise would. In 2007, a conservative retiree could earn more than 5% per year on a 5-year certificate of deposit (CD) compared to less than 1% now. The dearth of income from retirement savings has led many retirees to take part-time jobs to replace the loss of income they had planned on from conservative investments.

In 2014, corporations were able to sell more than $1.5 trillion worth of bonds, including $344 billion of junk bonds, as investors snatched up anything with a decent yield. However, the corporate bond market may be vulnerable since its level of liquidity isn’t what it used to be. There are far more corporate bond assets in exchangetraded funds (ETFs) now than in 2004, and ETFs make selling off very easy. As mentioned earlier, the last time the Fed increased interest rates was in 2004 and it did so at 17 consecutive meetings. If institutional investors and financial advisors become concerned that the Fed is planning to consistently increase rates through 2016, they may lower their allocations to ETFs and mutual funds that hold corporate bonds. As ETF providers and mutual funds liquidate corporate bond holdings into a thin market, their selling could lead to a quick plunge in corporate bond prices and further increase selling pressure. A decline in corporate bond prices could leave conservative investors with capital losses that far exceed their annual income stream.

Utility stocks recently provided a glimpse into the risk that could be awaiting corporate bond investors in coming months (see the following section on oil prices). Utility stocks have been a favorite of income-seeking investors as they offer a yield well above that of money market funds, are generally considered less volatile than the stock market and had been performing well. In December 2013, the Dow Jones Utility Average (DJUA) offered yields in excess of 3.00%, which caught investors’ attention. Between December 18, 2013, and January 28, 2015, the DJUA rose 37.80% compared to a gain of 10.57% for the S&P 500 Index. At its high of 657.17 on January 28, the DJUA’s yield was 2.17%, comfortably above the 0.80% annual yield for 5-year CDs and much better than the puny return provided by money market funds. From its high, however, the DJUA, in less than six weeks, fell -13.74% to 566.90 on March 11. It may take years of dividends for those unlucky investors to recoup their loss of principal.

Technical analysis can provide insights that fundamental analysis often overlooks since fundamental analysts are far more focused on the economy, monetary policy and corporate earnings. Although most of the content in each month’s MSR discusses fundamentals, behind the scenes we do incorporate technical analysis into our work, and the combination has been very helpful. The recent reversal and decline in the DJUA is a good example. In the week ending January 30, 2015, the DJUA experienced a weekly negative key reversal when it made a higher high, reached a lower low and closed lower than the prior week. Weekly key reversals are of particular value when they occur after an index has experienced a large rally or decline. The DJUA’s historical performance suggested a fall to at least the prior range of support between 585 and 605 was likely. During the week of February 20, the DJUA indeed dropped within the support range as expected to 588.63, bounced to 611.40 and then fell to 566.90. That bounce above the support range provided an opportunity to sell into strength before it fell again. Technical analysis can provide a level of risk management that is difficult to achieve with fundamental analysis alone.

Oil Prices

In the January 2015 MSR we included a section titled “The Disparate Impact of Lower Oil Prices.” We discussed our belief that the price of oil would fall until a new equilibrium between supply and demand could be established, which might take longer than expected since countries and companies dependent on oil revenue were likely to increase production to replace some of the lost revenue due to the recent decline in the price of oil. Until producers could agree to cut production, we thought oil was likely to remain under $60 a barrel and, in the short run, potentially fall to under $40 a barrel. Despite a sharp decline in the number of drilling rigs in the U.S. in recent months, U.S. production has continued to increase. According to federal data, as of March 6, total U.S. production hit a high of 9.4 million barrels a day, as producers have focused on their best fields to pump more oil. U.S. crude oil supplies are at their highest level in more than 80 years, according to the Energy Information Administration (EIA). The EIA estimates that 80% of excess oil production storage space in the U.S. is already filled, the remaining storage space likely to be filled by July. Commercial crude storage facilities in Europe may be more than 90% full while facilities in South Korea, South Africa and Japan are at more than 80% of capacity, according to Citigroup, Inc. Among industrialized nations, commercial oil and petroleum product stockpiles could hit an all-time high of 2.83 billion barrels by midyear, according to the International Energy Agency.

The reason so much oil is building up in storage is the widespread belief that oil prices will be higher later this year and in 2016. With oil prices per barrel in the mid $40s as of March 21, producers believe it would be foolish to sell now since more supply would likely push prices even lower in the short run. Although it costs money to store oil, if oil rises above $60 a barrel as many have predicted, oil producers will make a profit even after paying storage costs. The key point that may be underappreciated is that sooner or later all that supply sitting in storage will find its way into the market. If oil prices start increasing as hoped, producers will begin releasing the oil in storage, which is likely to limit future price increases until storage levels are down to more normal levels. After a large decline, markets often experience an A-B-C corrective rally where they A) bounce, B) decline as selling pressure resumes and then C) bounce again. Technically, it’s possible that oil could rally up to $55 or even $59 a barrel, finishing off the C leg of an A-B-C rally from the December low, before another selling wave begins. This type of rally gives an oversold market the opportunity to become less oversold, setting the stage for the next phase of decline. Producers aren’t the only group betting on higher oil prices. There have been strong inflows into energy ETFs this year, which has led to a large increase in long positions in oil futures contracts. According to the New York Mercantile Exchange, speculative funds hold 500,000 long contracts in anticipation of higher oil prices. Last June, when West Texas Intermediate (WTI) oil prices were north of $105 a barrel, speculative funds held 550,000 long contracts, just before oil prices were cut in half. With producers and speculators positioned for higher oil prices, the oil market is vulnerable to another gut-wrenching decline should oil prices weaken again. The speculative contracts, which are highly leveraged, could come under

pressure if oil falls below $40 a barrel, adding to selling pressure as they did when oil prices plunged during November and December. A deal with Iran regarding its nuclear program could also be a trigger for selling since it could lead to more Iranian oil coming to market in coming months.

In 2008, oil prices bottomed around $32 a barrel. If oil prices drop below $40 a barrel, as we expect in coming months, the low in 2008 could act as a magnet and bring prices down to at least test that level. With so much oil in storage, the real risk is that marginal oil producers may have no choice but to sell oil at the worst possible time because they have no other option. Since 2008, energy companies have issued almost $500 billion of junk bonds, which represents close to 20% of the high yield bond market. If anything close to this scenario develops, the lack of liquidity in the corporate bond market could lead to large price declines and a few defaults. Some commentators have referred to the surge in oil-related borrowing as a bubble, even comparing it to the subprime housing bubble that led us into the financial crisis. We think these views overstate the potential magnitude of the problem. Defaults will make headlines, prove disruptive and contribute to a 15% or greater decline in the stock market, but they are unlikely to prove to be a systemic threat.

China

Since 2007, China’s total debt has nearly quadrupled, rising from $7.4 trillion to $28.2 trillion. According to the McKinsey Global Institute, China’s debt-to-GDP ratio jumped from 158% to 282% by the second quarter of 2014. If the pace of debt accumulation during the past seven years is maintained, China’s debt-to-GDP ratio could approach 400% by 2018. According to Lombard Street Research, most new lending is used to roll over existing debt. The surge in debt since 2007 has lowered the impact of each new dollar of debt on GDP growth from $0.80 to $0.20, so additional monetary stimulus from the People’s Bank of China (PBOC) may only impede the slowdown in growth rather than kick-start it.

Almost half the debt of Chinese households, corporations and local governments is directly or indirectly related to real estate. A study by the U.S. Federal Reserve found that property investment has grown from 4% of GDP in 1998 to 15% in 2014—a higher proportion than Japan experienced when its real estate bubble popped in 1989. When including home furnishings like appliances, carpet and furniture, the contribution to GDP approaches 23%. Property prices in 40 major Chinese cities rose 60% in the wake of the financial crisis but are now softening. Home prices fell 3.8% in February from a year earlier, according to private sector data provider China Real Estate Index System. Ominously, sales volume, which normally precedes changes in home prices, has declined sharply: down -7% in tier-one cities, -22% in tier-two cities and -15% in tier-three cities. The inventory of homes on the market has soared to 18 months of supply at current selling rates. This data suggests that property investment is likely to slow in coming quarters until the overhang of inventory is worked off and will weigh on GDP growth.

Local governments derive 35% of their revenue from land sales, which, as a revenue source, are far less stable than taxes, especially in the current environment. According to Deutsche Bank, land sale revenues fell 21% in the fourth quarter, which will certainly put a squeeze on local governments. These local governments have also been big borrowers in the shadow banking system, which, at $6.5 trillion, represents almost 30% of China’s $28.2 trillion in debt. To curb this off-the-books borrowing, China implemented new regulations in January 2015 to prohibit local governments from raising money off the books. These new regulations and the decline in land sales will most likely inhibit local government spending and hurt GDP growth.

The explosion in debt after the financial crisis funded a large expansion in industrial capacity to provide the materials needed during the property boom. With property sales and demand slowing, a severe overhang of excess capacity in property-related industries such as steel, cement and glass has developed. China produces as much steel as the rest of the world combined, but demand within China grew just 1% in 2014. Excess capacity in steel and other industries has led producers to cut prices so that the Producer Price Index (PPI) has been below 0% for almost three years. In January 2015, the PPI was 4.8% below January 2014. The only time it has been weaker since 2000 was during the nadir of the financial crisis. If Japan and Europe are concerned about deflation, you can bet China is too.

Since the Chinese yuan is closely linked to the value of the dollar, the depreciation of the yen and euro is squeezing Chinese exporters unmercifully. The yuan has soared 37% versus the yen since mid- 2012 and 27% versus the euro just since May 2014. The currencies of China’s Asian trade competitors have also slumped. The Taiwan dollar has lost -5.1% against the yuan while the Singapore dollar is down -11.0% and the South Korean won has tumbled -11.7%. In our December 2014 MSR we said the deflation battle was becoming a currency war and weighing on growth in China’s economy. So far China has responded by easing monetary policy while still maintaining the yuan’s peg to the dollar. Prior to March 16, the yuan had only dipped about 0.9% in 2015 versus the dollar after losing 2.5% in 2014. In the December MSR we said:

“China will ease monetary policy further”

—and it has. On February 4, the People’s Bank of China lowered the reserve ratio for banks from 20.0% to 19.5%, which will free up about $95 billion for lending. It was the first reduction in the reserve ratio since 2012. On March 1, 2015, the PBOC lowered the one-year lending rate by 0.25% to 5.35% and the deposit rate to 2.50%. Despite the easing moves by the PBOC, the growth rate in M1 money supply continues to languish. There is a high correlation between money supply growth and industrial production. The gradual slowing in money supply since its spike higher in 2010 pretty much mirrors the lessening growth rate in industrial production, which was up 6.8% year to date through February versus 8.3% in 2014. The excess capacity in property-related industries and weak money supply growth suggests a pickup in industrial production is not likely anytime soon.

The relative strength of the yuan versus a host of trade competitors and weak Chinese export growth (the European Union is China’s largest export market) will force the PBOC to cut rates again and consider lowering the value of the yuan to defend it exporters. The Bank of Japan and ECB are effectively exporting deflation to the rest of the world through the depreciation of their currencies. Their actions have resulted in 46 rate reductions by other central banks this year in an effort to weaken their currencies or stimulate their economies. Like water swirling around a bathtub drain, more central banks are being pulled into the vortex of protectionism devaluation. The currency protectionism playing out now is worse than the protectionism of the 1930s since trade comprises a larger share of global GDP and it affects all goods and services rather than just targeted products. If China moves to protect itself by lowering the value of the yuan, another wave of deflation will be unleashed in the global economy.

Although China is likely to make additional rate cuts and lower reserve requirements, there are a number of headwinds that may limit the effectiveness of additional monetary stimulus. Overall indebtedness is already high and each new dollar of debt is generating less GDP. Nonperforming loan losses are increasing at Chinese banks so an increase in new lending could be counterproductive. Further investment in property and basic industries will only increase excess capacity, which risks further declines in producer prices and more deflation. According to Citibank estimates, financial outflows from China averaged $50 billion a month in the last three quarters of 2014. When the PBOC lowered the reserve requirement, it freed up $75 billion of new money, but financial outflows exceeded the amount of new liquidity added. According to Westpac Bank, the amount of capital flowing out of China increased to $150 billion in the first two months of this year. The net effect is that less liquidity is flowing into the financial system despite the PBOC’s easing. To stem this outflow, the PBOC began buying the yuan during the week of March 16. The purchases lifted the yuan’s value versus the dollar by 0.9%, which is how much it had declined this year. We continue to believe that China is heading toward a liquidity event and will exhibit slower growth that will weigh on overall emerging market (EM) growth in 2015.

The global currency war has made China’s task of gradually deflating the debt and real estate bubbles far more challenging. China will do what is in its best interest, so expect additional cuts in the reserve ratio and interest rates and a potential depreciation of the yuan.

Emerging Economies

We discussed the economic fundamentals of China, Brazil, India and Indonesia in detail in the November 2013 MSR and concluded that these emerging economies were unlikely to return to prior growth rates in 2014 and beyond. We noted that these four countries had provided a significant share of the increase in global growth following the financial crisis. Much of the growth, however, was fueled by an unsustainable increase in credit. We expected credit growth to slow and with it economic growth. With the exception of India that slowdown has occurred. We expected the currencies of those countries with current account deficits (for instance, Brazil, India, Indonesia, Turkey and Mexico) to experience another test once the Fed decided to scale back its QE3 purchases. Let’s take a look at how these currencies have performed since December 2013. In our October 2014 MSR we wrote that emerging economies would be buffeted if the dollar index climbed to 89.00-90.00 and especially impacted if it reached 100.00-101.97, which was our longterm upside target for the dollar. On Friday, March 13, the dollar reached 100.38, making it vulnerable to the largest correction since the rally began in May 2014. The Fed lowering its GDP and inflation forecasts could also take some of the steam out of the dollar and lead to a correction. That said, the pressure on many EM economies with dollar-denominated debt may be approaching a breaking point, even if the dollar declines modestly.

Since interest rates in the U.S. have been lower than in many emerging economies since the financial crisis, borrowing in dollars meant less interest expense. Much of this debt was not hedged since the dollar was expected to depreciate as it has previously versus EM currencies. A weaker dollar lowers the total cost of the loan by the amount the EM currency appreciated. For instance, a $100 million loan would be repaid with $95 million of the local currency if an EM currency gained 5% against the dollar. Hedging the exposure to the dollar would eliminate the opportunity to realize the expected windfall from a falling dollar. Since 2009, the amount of dollar loans in EM countries has soared 50% to $9.2 trillion as of September 2014, according to the Bank for International Settlements (BIS). According to the IMF, $650 billion has flowed into emerging markets as a result of U.S. quantitative easing. As we noted in December 2014, there was a significant risk that some of this money would flow out of emerging economies as their currencies depreciated, thus causing further depreciation. The decline in emerging market currencies has the potential to cause a more pronounced slowdown in the countries whose currencies have the most dollar-denominated debt. Consider the $100 million loan we referenced previously and the impact of a 10% decline in the EM currency rather than a 5% appreciation. Adjusting for the currency decline, the loan will cost the company $110 million, rather than $95 million, and the interest payments will also increase by 10%, taking a bite out of current cash flow. This could force EM companies to lower expenses by laying off workers and cutting spending, resulting in a slowdown in their country’s GDP growth. Emerging market banks with dollar loans that are not hedged could incur losses that affect their capital base and future lending capacity.

In 1997–1998, the Asian and emerging market financial crisis was precipitated by a decline in EM currencies, especially for those countries that were carrying a high proportion of debt held by foreigners. What may not be fully appreciated by global investors is that the amount of foreign-owned debt is up significantly since 1997–1998 in a number of EM countries, according to data from the BIS. Of the 15 countries listed in the nearby table, 12 had more foreign debt as a percentage of GDP than they did in 1996. In 1996, the average foreign debt was 14.8% of GDP versus 18.4% as of September 30, 2014—an increase of 24.3%. The three countries that have seen an improvement in their foreign debt exposure (South Korea, Indonesia and the Philippines) were all key players in the crisis and obviously learned their lesson. Thailand, which was the first domino to fall in 1997, has lowered its foreign debt exposure from 59.1% to 19.7%, which is still above the average.

The Asian debt crisis was triggered on February 5, 1997, when a property developer in Thailand failed to make a scheduled interest payment. Within months, the Thai baht had plunged, leading to its devaluation on July 2. Days later, Malaysia was forced to intervene to support the ringgit and the Philippines devalued the peso on July 11. In the following months, the Singapore dollar came under pressure, Indonesia abandoned its defense of the rupiah and, on October 10, 1997, the Hong Kong stock market plunged 10.4% after bank rates were raised to 300%. Eventually the currency market weakness spread to Latin America and then to Russia, which announced it would default on its foreign debt in August 1998. In December 1998, the World Bank estimated that the Asian currency crisis had shaved 2% off global GDP growth. Between July 20 and October 8 of 1998, the S&P 500 plunged 22.45% in less than three months.

Although an emerging market debt default is unlikely to have the same impact as it did in 1997–1998, the higher level of dollardenominated debt and volatility in EM currencies will likely have an impact that extends beyond the individual countries most affected by the volatility in the currency market before the end of 2015.

Dollar – Technical

After peaking at our initial target of 95.00 – 96.00, we thought the dollar would fall back to 92.60 and consume more time in the process before running up to our long-term target of 101.00– 102.00. Instead, the dollar ran up to 100.38 on March 13. Part of the dollar’s strength has been predicated on investors’ expectation that the Fed would raise rates in June. We did not share that opinion. After the Fed lowered its GDP and inflation targets for 2015 and 2016, currency traders concluded that the Fed would not be raising rates in June and sold the dollar.

In reality, most of the decline was due to short covering in the euro. After the FOMC’s March 18 announcement, the dollar traded down to 94.77 before closing at 98.78. Our guess is that the dollar has entered a consolidation/ corrective period that could last two to four months, which could include a great deal of choppy trading and a possible decline to 92.60–94.77. Longer term, we believe the dollar is headed higher since we expect money to continue to flow out of the eurozone and emerging markets.

Euro – Technical

In the May 2014 MSR we suggested the following:

“Shorting the euro has potential to result in a profitable trade over the next year.”

At that time, the euro was trading near 1.380 and almost no one was talking about the coming decline in the euro that we expected. As the decline in the euro accelerated after the ECB commenced with its QE program on March 9, 2015, a number of forecasts surfaced projecting a decline in the euro to 0.820 or 0.850. It has been our experience that when extreme forecasts are made after something has either rallied or declined by a large percentage, it is time to expect a counter-trend move. The Fed’s dovish outlook for the U.S. economy initiated a surge of short covering in the euro, which had become a very overcrowded trade. In coming months, the euro has the potential to rally to 1.12–1.14 before the longerterm downtrend resumes. Additional short covering may be spurred by economic reports reflecting improvement in the eurozone. From a money management perspective, we think it reasonable to cover a portion of the short position we suggested last May if the euro drops under 1.065. As we noted in the March MSR, Germany is likely to benefit disproportionately from any improvement since it is the most productive economy in the eurozone; it generates 50% of its GDP from exports, so the decline in the euro would prove a boon. Longer term, we expect the euro to decline after any bounce since wealthy Europeans will want to protect their purchasing power by moving assets out of the euro and into other currencies like the dollar.

Treasury Bonds

Last month we noted that the economy had slowed as we expected, which we thought would keep a lid on yields. U.S. dollar strength combined with a high level of labor market slack (based on the U3-U6 spread) led us to believe the Fed would not increase rates in June as many expected.

We thought the yield on the 10-year U.S. Treasury was likely to remain range-bound between 1.650% and 2.200%. After the positive jobs report was announced on March 6, the yield on the 10-year Treasury soared from 2.112% on March 5 to 2.240% on March 6—the only time during this period it has been outside our projected range. As of March 20, the 10-year Treasury yield has dropped to 1.930%. With the odds of a rate increase in June most likely off the table, volatility should subside and yields should hold in the range we forecast.

Gold and Gold Stocks

If the dollar is nearing a more pronounced period of consolidation or outright correction, as we expect, gold may have a window in which it can rally.

As we cautioned in last month’s MSR, a decline in gold below $1,175–$1,180 was likely to lead to a run toward the November low of $1,130. Gold fell to $1,141 on March 17 and then rallied smartly after the Fed indicated on March 18 that an increase in rates in June was less likely than the gold market had expected. We still believe that gold has the potential to trade above the January high of $1,307 as long as it does not fall below $1,130.

Stocks

In last month’s MSR we compared the preeminence that General Motors enjoyed during the 1950s and 1960s to the current pedestal Apple rests upon. At that time the slogan was “As General Motors goes, so goes the nation.” We noted that a makeover was in order with a more current slogan of “As Apple goes, so goes the stock market,” since Apple’s stock had accounted for 141 of the 213 basis points the NASDAQ-100 Index had gained through February 23. We can only surmise that the decision-makers at S&P Dow Jones Indices read our comments and agreed: less than a week after the March MSR was published, they decided to put Apple in the Dow Jones Industrial Average (DJIA). Apple joined the 119-year-old venerable market barometer on March 19.

Apple is replacing the lower-priced AT&T and, since the DJIA is a price-weighted index, will increase the level of the DJIA’s volatility. If the 30 stocks in the DJIA were equally weighted, each would have a 3.33% impact. Due to its higher price, Apple’s weighting will be close to 4.66%, or 39% higher than an equal weight. It has not been uncommon in recent decades for a company’s stock to underperform after reaching the pinnacle of being added to the DJIA. Chart analysis of Apple’s stock indicates some caution may be warranted over the next year. Apple’s price pattern appears to be nearing the end of a five-step advance that began more than a decade ago (see the numbers in the Apple stock chart). The fifth portion of the rally began after Apple bottomed in early 2013 (number 4). Apple also appears to be nearing the completion of a final shorter-term five-step rally from the early 2013 low (see the letters A-E in the chart), which would potentially complete the longterm five-step rally (number 5). We think Apple will likely exceed its February 24 high of $133.80. After a potential new high, however, Apple could be vulnerable to a decline to $105.00–$110.00, if this pattern analysis is correct. Any decline of this magnitude in Apple would certainly drag on the DJIA given its heavy weighting. First quarter earnings may pose another headwind for the market when they start being released in mid-April. According to analysts’ estimates compiled by Bloomberg, earnings are expected to decline at least 3.2% in the first half of 2015.

Obviously, the earnings of energy-related companies are going to be weak, but dollar strength will weigh on companies that derive a good portion of their revenue and earnings from overseas. The slowdown in the economy during the first quarter is also likely to adversely impact domesticallybased companies. The S&P 500 is trading at 18.9 times earnings compared to its 16.9 average price-earnings (P/E) ratio since 1936. As we’ve discussed before, corporate stock buybacks have materially lifted earnings in recent years. If operating earnings were used to calculate the S&P 500’s P/E ratio without the lift from buybacks, it would be more overvalued than the 18.9 indicates. In February, $104.3 billion in stock repurchases were announced— that’s more than $5 million each trading day and enough to cover 2% of shares traded on U.S. exchanges, according to Bloomberg. According to the Investment Company Institute, corporations executed $550 billion in stock buybacks in 2014—almost 6.5 times the $85 billion invested in equity mutual funds and ETFs. It’s worth noting that corporate stock buybacks almost run on autopilot and will continue to be a major prop under the stock market until a good reason to sell materializes.

The Major Trend Indicator is at a relatively low level with the S&P 500 less than 1% from a new all-time high, as of March 22. If the market isn’t able to push above 2,140 after concerns of a June 2015 rate increase were diminished, it could prove a warning of at least a short-term high. A close below 2,040 on the S&P 500 would likely lead to more weakness while a close below 1,980 would expose the market to a deeper correction.

Definition of Terms

10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.

Basis point (bps) is a unit of measure that is equal to 1/100th of 1% and used to denote a change in the value or rate of a financial instrument.

Capital expenditure (capex) refers to the funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment in order to maintain or increase the scope of its operations.

Cash flow is a revenue or expense stream that changes a cash account over a given period.

Debt-to-GDP ratio is a measure of a country’s federal debt in relation to its gross domestic product (GDP). By comparing what a country owes to what it produces, the debt-to-GDP ratio indicates the country’s ability to pay back its debt.

Devaluation is a monetary policy tool whereby a country reduces the value of its currency with respect to other foreign currencies.

Dow Jones Industrial Average (DIJA) is a price-weighted average of 30 bluechip stocks that are generally the leaders in their industry and are listed on the New York Stock Exchange.

Dow Jones Utility Average is a price-weighted average of 15 utility stocks traded in the United States.

Federal funds rate is the interest rate at which a depository institution lends immediately available funds to another depository institution overnight.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.

Futures are financial contracts that obligate the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.

Institute of Supply Management (ISM) Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries based on surveys of more than 300 manufacturing firms.

ISM Manufacturing New Export Orders Index reports on the level of orders, requests for services and other activities to be provided outside of the United States.

ISM Purchasing Managers Index (PMI) measures the health of the manufacturing sector and is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

M1 is a measure of the money supply that includes all physical money, such as coins and currency, as well as demand deposits, checking accounts and negotiable order of withdrawal accounts.

NASDAQ-100 Index is a modified capitalization-weighted index that includes the largest nonfinancial U.S. and non-U.S. companies listed on the NASDAQ stock market across a variety of industries, such as retail, healthcare, telecommunications, wholesale trade, biotechnology and technology.

Price-earnings (P/E) ratio of a stock is a measure of the price paid for a share relative to the annual income or profit earned by the company per share. A higher P/E ratio means that investors are paying more for each unit of income.

Producer Price Index (PPI) is a family of indices that measure the average change in selling prices received by domestic producers of goods and services over time.

Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

Range-bound is when a market, or the value of a particular stock, bond, commodity or currency, moves within a relatively tight range for a certain period of time.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Short selling is the practice of selling a financial instrument that a seller does not own at the time of the sale with the intention of later purchasing the financial instrument at a lower price to make a profit.

U-3 unemployment rate (U3) measures the total number of unemployed people as a percentage of the civilian labor force. It is considered the official unemployment rate.

U-6 unemployment rate (U6) measures the total number of people unemployed and those marginally attached to the labor force, plus the total number of people employed part time for economic reasons.

U.S. Dollar Index is a measure of the value of the U.S. dollar relative to six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.

Volatility is a statistical measure of the dispersion of returns for a given security or market index.

Zero interest rate program (ZIRP) is a policy instituted by the Federal Reserve in 2008 to keep the federal funds rate between zero and 0.25% inorder to stimulate economic activity during times of slow economic growth.

One cannot invest directly in an index.

RISKS

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.









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