The Shrinking Economic Pie

May 13th, 2015
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Macro Strategy Review, May 2015

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

The global economic pie is shrinking relative to the growth rates of the past and that’s a problem. According to the International Monetary Fund’s (IMF) World Economic Outlook database, worldwide gross domestic product (GDP) growth during 2013–2014 averaged 3.10%, compared to 2006–2007, which averaged 5.15%.

Follow up:

While GDP growth has declined, the chasm between growth in advanced economies and developing countries has not changed much. GDP growth in advanced economies has slowed -47.37% from 2.85% in 2006–2007 to just 1.50% in 2013–2014 while growth in developing countries has downshifted -45.06% from 8.10% to 4.45%, respectively. As this data indicates, the worldwide slowdown in growth has been evenly distributed and not merely concentrated in either advanced or developing countries.

The widespread impression that the global economy has deleveraged in the wake of the financial crisis is a fallacy—it is more leveraged now than it was prior to the financial crisis, based on the ratio of total global debt to GDP. In February, the McKinsey Global Institute published an extensive review of debt levels in 22 developed and 25 developing countries. The McKinsey analysis found that global debt had increased from $142 trillion in 2007 to $199 trillion in 2014. The $57 trillion increase in global debt represents a surge of 40%, far exceeding the 23% gain in global GDP during the same period. The global debt-to-GDP ratio rose from 269% at the end of 2007 to 286% as of June 30, 2014. The title of the McKinsey study was apt: “Debt and (not much) deleveraging.”

Although total global debt has increased 40% since 2007, the McKinsey Global Institute did find a couple of silver linings. The growth rate in global household debt slowed from 8.5% during the period of 2000–2007 to 2.8% in 2007–2014. Lax mortgage lending standards contributed to the excessive addition of mortgage debt prior to 2007 while tighter standards after the financial crisis curbed growth. The net result is that household debt is now growing in line with global GDP growth as compared to the debt binge prior to 2007. When household debt grows in line with GDP growth, household incomes are more likely to grow fast enough to prevent a rise in defaults on mortgage, credit card and auto debt.

The increase in debt and leverage by banks prior to 2008 was a major contributor to the financial crisis. A number of U.S. investment banks increased their leverage ratio from 12-to-1 in 2004 to almost 30-to-1 in 2007. A number of large European banks had leverage ratios of almost 40- to-1 just prior to the financial crisis. When home values fell in many countries, the excessive leverage decimated bank balance sheets and threatened the global financial system. Financial institutions have significantly lowered the growth rate of debt since 2007 from 9.4% to 2.9%. The deleveraging of bank balance sheets in the wake of the financial crisis is a strong indication that the global financial system is in far better shape than it had been and is capable of handling the next business cycle downturn and any unanticipated economic shock.

The same cannot be said about government debt and leverage. In response to the financial crisis, governments around the world increased spending to offset the decline in private demand as unemployment soared, consumers stopped shopping and businesses slashed spending. Much of the increase in government spending was financed with debt, which grew 60% faster in the seven years following the crisis than the precrisis level (9.3% versus 5.8%). The growth rate in government debt poses a perilous challenge for the global economy in coming years since the current level of government debt is already high enough to impair its capacity to deal with the next economic slowdown. Faced with another recession, we have no doubt that politicians around the world will respond with another round of deficit spending to minimize its impact—as that’s how they have repeatedly responded every time a recession threatened their reelections.

Mae West famously said too much of a good thing could be wonderful, but we don’t think debt is one of those things. We don’t know how much debt is too much, but the economic engine of the global economy is certainly more at risk now than it was 30 years ago, even though global interest rates were far higher back then.

Most governments consider a deficit of 3% of GDP to be healthy, but the flaw in this perspective is it ignores the impact of “healthy” deficits over time. Total debt as a percentage of GDP doubles in just 24 years if a country maintains a “healthy” 3% annual deficit, meaning the long-term threat from continually running “healthy” annual deficits is that cumulative debt reaches a level that can hardly be described as healthy. However, any slowdown in government deficit spending will dampen growth in the short term unless household and corporate spending picks up the slack. That’s not likely in the short run since the global economy is suffering from a lack of demand due to a combination of high unemployment and underemployment, weak wage growth and excess capacity that has depressed business investment.

The Congressional Budget Office has estimated that a 1.0% increase in Treasury yields across the maturity spectrum would add $150 billion in interest expense to the annual U.S. government budget. Debt-to-GDP ratios in Europe and Japan are far higher than in the U.S., so their budgets and economies are even more vulnerable to higher interest rates. Any meaningful rise in global interest rates in coming years could accelerate budget deficits to well above 3% of GDP as interest expense on the mountain of accumulated sovereign debt soars—one reason central banks, especially in advanced economies, will find it extraordinarily difficult to normalize interest rates in coming years. This situation exposes an inherent conflict of interest between fiscal and monetary policy that has never been so pronounced and has the potential to further compromise central banks’ independence.

The level of GDP growth impacts the amount of cash flow generated in the form of personal income, corporate profits and government tax revenue. As economic growth accelerates, the ability to service debt becomes easier and the risk of defaults on mortgages, auto loans, corporate bonds and bank loans declines. Debt levels are higher now than in 2007 while global economic growth has slowed significantly and is only expected to reach 3.50% in 2015, according to the IMF. Even with that improvement in growth compared to the last two years, it will still be more than 30% slower than in 2007. In this respect the leverage in the global economy is more precarious than in 2007.

In the next few years, the global economy will be vulnerable to either a slowing from current growth levels or an increase in interest rates. Navigating these issues amounts to the economic equivalent of threading the needle since even a modest increase in interest rates is likely to disproportionately weigh on future growth as a larger share of cash flow will be needed to service debt. Any slowdown in the global economy would push central bankers even deeper into the uncharted territory of negative interest rates, unlimited quantitative easing (QE) and currency depreciation. The risk of deflation will continue to lurk in the shadows until the ratio of global debt to GDP actually declines.

Even though interest rates, especially in advanced economies, have spent years at their lowest levels in history, economic growth has fallen far short of historical norms. Big deficits and cheap money have failed to engender sustainable growth. This economic reality provides an insight into just how difficult it will be for the Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BoJ) to ever “normalize” short-term interest rates. Any increases are likely to be modest and stretched out over an extended period of time. Beginning in June 2004, the Fed increased the federal funds rate at 17 consecutive meetings. Nothing close to that will happen in this cycle. The pace of central bank rate increases in the next few years is likely to make a tortoise look like the Road Runner. The BoJ may never increase rates in our lifetime and the first increase the ECB effects will be to raise rates from below zero percent to zero percent. Welcome to the brave new world of modern monetary policy that is more effective in distorting market outcomes than generating actual economic growth.


Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said in an interview with the New York Times in early February, “If monetary policy…is distorting what might be normal market outcomes…” In the March Macro Strategy Review (MSR) we wrote that we found this statement to be exceedingly disingenuous as the purpose of the Fed’s monetary policy since the financial crisis has been the intentional manipulation of Treasury yields and inflating the wealth effect of the stock market. It would be fair to say that the ECB has taken the distortion of market outcomes to a new level through its QE program launched on March 9. As of April 22, more than half of eurozone government bonds have negative yields, according to Bank of America Merrill Lynch. In other words, investors that purchase a seven-year German bund will pay the German government 0.07% a year for the privilege, or they will pay the government of Spain 0.116% for owning a one-year Spanish bond.

Negative interest rates are forcing banks throughout Europe to rebuild computer programs, update legal documents and reconstruct spreadsheets to account for negative rates. The Euro Interbank Offered Rate, or Euribor, is the base interest rate used for many banks loans in Spain, Italy and Portugal. More than 90% of the 2.3 million mortgages outstanding in Portugal have variable rates linked to Euribor. Portugal’s central bank recently ruled that banks would have to pay interest on existing loans if Euribor or any additional spread falls below zero percent. Spanish-based Bankinter has been forced to pay some customers interest on mortgages by deducting that amount from the principal the borrower owes.

While the unusual effects of the ECB’s QE program are making headlines for distorting normal market outcomes, the improving health of the banking system in Europe may provide the bigger economic punch. The ECB’s second quarter survey of bank lending showed that the net percentage of banks expecting a rise in loan demand reached 39%, up from 17% in the first quarter.

Banks expect a small net easing of their credit standards to businesses during the second quarter but a further tightening of their credit standards for mortgages. Since banks provide more than 70% of credit creation in the eurozone (compared to 35% in the U.S.), the improvement in lending in coming months will put more money to work in the real economy, which should lift GDP growth to 1.5% or so in 2015. Not great, but certainly better than the 0.9% increase in 2014 and contraction in 2012 and 2013. In our opinion, the coming improvement in bank lending is more important than the ECB’s QE program.

Euro – Technical

In the May 2014 MSR, when the euro was trading above 1.380, we suggested shorting the euro. In last month’s MSR, we said that from a money management perspective, it seemed reasonable to cover a portion of that short position if the euro dropped under 1.065, and on April 13 and 14 the euro did trade under 1.065. As this is being written on April 24, the euro is trading at 1.086.

We expect the euro to rally to 1.110–1.150 in coming months as the timing of the first Fed rate increase is pushed back and better economic news from the eurozone spurs some short covering by the legion of traders expecting the euro and the dollar to reach parity. In recent weeks the euro has been under pressure by another episode in the ongoing Greece drama/comedy. The fact that the euro has not made a new low despite the headlines suggests any “resolution” could ignite a new wave of short covering.

Dollar – Technical

The dollar peaked on March 13 at 100.38, just shy of our long-term target of 101.00-102.00. After the Fed lowered its GDP and inflation targets for 2015 and 2016 as part of its March 18 meeting, the dollar sold off sharply as traders who had expected the Fed to raise the federal funds rate in June sold the dollar and bought the euro.

Last month we thought the dollar had entered a consolidation/ corrective period that could last two to four months and include a great deal of choppy trading. After a fair amount of choppiness, the dollar traded as high as 100.27 on April 13, coinciding with the euro falling under 1.065 versus the dollar. As of April 24, the dollar is trading at 97.18. We still think a decline to 92.60–94.77 is likely before another dollar rally takes hold.

U.S. Economy

Quarterly GDP growth has bounced above and below its 2.46% average since 2010, providing a number of head fakes along the way. After third quarter 2014 GDP was reported to have boomed 5.0%, many economists raised their GDP estimates for 2015 to 3.0%–3.5%. We expected growth to slow to less than 3.0% in the first half of 2015 as dollar strength curbed export growth, low oil prices and excess capacity kept a lid on business investment and weak wage growth kept consumer spending in check.

After gasoline prices plummeted by more than $1.00 a gallon in the fourth quarter 2014, many economists expected consumers to go on a spending spree. After years of weak income growth we thought consumers were more likely to save some of their energy windfall, pay off some debt and spend only the remaining third. Visa has tracked consumer spending trends and concluded that consumers have been spending about 25% of their gasoline savings. According to the Federal Reserve, Americans lowered their credit card balances in February by the largest percentage in nearly four years. The personal savings rate was 5.8% in February according to the Commerce Department, the highest since the end of 2012. After declining for three consecutive months, retail sales rebounded in March but were still below their peak in November.

Compared with March 2014, retail sales were up only 1.3%, well below the 4.5% annual gain from the previous 12-month period. Industrial production has also been weak since November due to a significant decline in oil and gas drilling and manufacturing exports. The level of industrial production was up 2.0% in March 2015 from March 2014. With all of this information in mind, estimates for first quarter GDP have been slashed, dropping to 1.4% from their 3.0% estimate made in January, according to a survey of 62 economists by the Wall Street Journal in the first week of April.

This past winter was the tenth most severe since 1960, which certainly played a role in suppressing economic activity in the first quarter. Consumer confidence levels jumped in response to the decline in gasoline prices in the fourth quarter 2014 and have fallen back as gas prices have ticked up. Consumer confidence levels still remain well above 82—the level that has historically been supportive and coincident with economic growth. We expect the economy to pick up in the second quarter but not so much as to convince the Fed to raise the federal funds rate in June.

We have previously discussed how the Fed’s low interest rate policy has really hurt retirees who are dependent on certificates of deposit (CDs) to provide a safe, steady income stream. In 2007,a 5-year CD yielded more than 5.0%. Today, a 5-year CD provides Euro Reversal a return of 1.5% or so—70% less income than in 2007. According to an estimate by reinsurance company Swiss Re, U.S. savers have received $470 billion less in interest income since 2008. We suspect the Fed’s low rate policy is also affecting people who are within 10 years of retirement, which includes tens of millions of baby boomers.

The nest egg that seemed large enough to provide a comfortable retirement a few years ago doesn’t look as sufficient based on the level of interest rates today, which may be leading some baby boomers to cut back on spending and increase their savings to make up for the reduced income. The Fed’s low interest rate policy is having the perverse effect of curbing spending by older Americans, which will remain a growth headwind as more of the 76 million baby boomers prepare for retirement.

A Shifting Labor Landscape

In March, job growth slowed to 126,000 jobs, well below its 12-month moving average of 263,000. When the recession began in December 2007, the labor participation rate was 66.0%. A record 93.2 million Americans were not in the labor force in March, which caused the labor participation rate to decline to 62.7%, the same level it was at in 1978. There are a number of reasons why the rate has not risen during the recovery that began in June 2009. Compared to every other post-World War II recovery, economic growth and job and wage growth in the current recovery has been far weaker. In seven of the 11 post-World War II expansions after a recession prior to 2007, all the jobs lost during the recession were recovered within 24 months of the onset of the recession.

From the onset of the recession in December 2007, it took 77 months before all the lost jobs were recovered—more than three times as long as the majority of post-World War II recoveries. In March, average hourly earnings were up 2.1% over the past year, which means earnings growth has remained stagnant since 2010.

In the average post-World War II recovery, wages grew by more than 3% annually, which is 50% higher than the current recovery. With wage growth so weak, there has been simply less incentive for some of those not working to look for a job.

Demographics are playing a role in the weak job growth environment but not entirely because baby boomers are retiring. The first wave of baby boomers born in 1946 turned 65 in 2011 and many have retired and are not likely to reenter the labor force. This explains at least one-third of the 3.3% decline in the participation rate since December 2007.

Another contributing factor has been the increase in the number of Americans receiving Social Security Disability Income (SSDI) under the Social Security program. In 1960, just 0.5% of the total population received SSDI. By the end of 2011, that amount had risen to 5.0% after having more than doubled since 1991. Since 2007, three million more Americans are receiving SSDI benefits, according to the Social Security Administration. The reserves of the SSDI Trust Fund will be depleted in 2017 unless Congress acts.

The sharp increase in disability claims is curious since the workplace has certainly become safer for the average working American during the past 50 years, primarily due to the Occupational Safety and Health Administration (OSHA). Since 1970, OSHA rules and regulations have lowered nonfatal work related injuries by 60% despite a doubling of the labor force. What OSHA can’t do is prevent the aging of the population. We suspect that a portion of the three-million-recipient increase since 2007 is due to physical ailments that increasingly impact workers in their 50s, such as bad backs and carpal tunnel wrist problems. SSDI benefits are not age dependent like Social Security and Medicare, so even people in their 40s can begin to receive benefits that are paid for the rest of their lives. Older workers laid off during the recession and unable to find a new job or unwilling to accept a job paying far less than they previously earned could be tempted to apply for SSDI and take advantage of the government program.

The participation rate is also being held down by technology, which has replaced some jobs forever. Based on research by Duke University and the University of British Columbia, there has been a structural loss of jobs since the recession of 2001, particularly in occupations that require routine skills. In their analysis, the researchers divided the labor force into two primary categories (routine and nonroutine jobs) and two subcategories (manual and cognitive). A routine manual job would involve physical and rules-based tasks and include factory workers, machine operators, welders, home appliance repairers and plumbers. Routine cognitive jobs include secretaries, bookkeepers, filing clerks and bank tellers. Nonroutine manual jobs include janitors and home-health aides. Nonroutine cognitive jobs require skills like public relations, financial analysis and computer programming.

For those in nonroutine occupations, the recent recovery has been similar to other post-World War II recoveries, as job growth has come predominantly from nonroutine occupations such as computer programming and home-health assistance—another reflection of an aging population.

However, for those in routine jobs, the recovery has come up far short of prior recoveries. The percentage of the population working in routine jobs dropped from 30.0% in 2007 to 25.5% in 2009 and has not increased during the current recovery. The lesson going forward is that we need to educate and train students so they possess the skills needed for nonroutine jobs, with an emphasis on jobs that require some level of cognitive skills. Since the 1980s, such occupations have experienced an increase of 22 million new jobs. Technology will continue to eliminate jobs that can be automated, but the damage to the labor force can be minimized if education is refocused to produce more college graduates with nonroutine skills and training. In March, there were 6.7 million people working part time who desired a full-time job.

Another 6.1 million wanted a job but were too discouraged to look. These two groups, in addition to those who are out of work but are actively seeking employment, comprise the U-6 unemployment rate (U6), which was 10.9% in March. With the official U-3 unemployment rate (U3) at 5.5%, the spread between the U3 and the U6 was 5.4%. As we’ve discussed in previous MSRs, the average U3-U6 spread from 1994 until August 2008 was 3.85%. March’s spread is well above the historical average and suggests that an above-average level of slack remains in the labor market.

With the U3-U6 spread still so high, average hourly earnings growth is not likely to accelerate much in the next few months. The elevated U6 rate suggests that some of these 12.8 million people probably don’t have the knowledge and skills to perform nonroutine jobs. While making a college education more accessible and within reach of more students through government guaranteed loans seems like an obvious solution, we aren’t so sure.

Misguided Education Lending?

Since 1979, the percentage of 18- to 24-year-olds enrolled in college has increased from 25% to 42% in 2011, before slipping to 41% in 2013, according to the Census Bureau. College enrollment has soared from 11.57 million students in 1979 to 20.60 million in 2013, a 78% increase. In 1979, the average tuition for public and private colleges was $1,073 a year. In 2013, the cost of tuition had ballooned to $10,683 a year, a whopping 896% increase. Between 1979 and 2013, the Consumer Price Index (CPI) increased 222%, so the rise in tuition was quadruple the increase in overall inflation. Since 1999, tuition costs have risen 113%, more than twice as fast as the 40% increase in the cost of living. The availability of student loans and virtual lack of lending standards have contributed significantly to the 38.7% increase in college enrollment since 1999 and the surge in tuition costs.

Before 2010, most student loans were made by private lenders, such as Sallie Mae. In 2010, when Nancy Pelosi said Congress had to pass the Affordable Care Act (ACA) in order to find out what was in the legislation, she wasn’t kidding! As part of the legislation enacting the ACA, there was a bill mandating that the federal government take over the administration of the student loan program and provide a federal guarantee for all student loans. Federal direct student loan debt has climbed from $179.1 billion in 2009 to $938.4 billion as of February 2015, according to the Monthly Treasury Statement (MTS). Total student debt is $1.3 trillion, according to the Federal Reserve, which is more than the total amount of credit card debt and the outstanding balances on auto loans.

The U.S. Department of Education is tasked with administering the student loan program, but it is unable to get basic details about the 40 million Americans with a loan because of an archaic computer system. The Education Department doesn’t know if those with a student loan are defaulting, even after having their payments lowered through one of the forbearance programs sponsored by the Education Department. Approximately 75% of new student loans are made without any credit checks since the computer system lacks the ability to analyze data while making a new loan. Essentially, Congress voted for the federal government to take over a huge portfolio of student loans without first ascertaining whether the government had the capacity to adequately administer the program. It is hard to imagine any company managed so poorly remaining in business.

Payments on a student loan don’t begin until after a student graduates or drops below half-time enrollment. If someone has trouble making payments, he or she can ask for forbearance, which may allow the borrower to postpone payments for up to three years. While forbearance classifies the loan in good standing, interest continues to accrue. Once the period of forbearance ends, the monthly payment increases due to the accrued interest. Unless the borrower’s income has increased during the forbearance period, he or she is likely to have difficulty making the higher monthly payment.

According to the Education Department, the amount of loans in forbearance has risen from 12.5% in 2006 to 16.0% in 2014. That rate of increase may not sound alarming, but since the total amount of student loans has soared since 2009, it represents $125 billion of the $778 billion of loans currently under repayment. Borrowers can also lower their monthly payments through the Income-Based Repayment Plan and Pay As You Earn Repayment Plan programs. Enrollment in these programs has doubled over the past year to 2.2 million participants with $115 billion in loans outstanding.

Despite these payment relief programs, a record 19.8% of the 7.1 million borrowers with $103 billion in loans outstanding have defaulted. The high default rate forced the White House in February to increase the amount of loan “forgiveness” by $22 billion, which is a nice way of saying taxpayers will pick up the tab. According to the Congressional Budget Office and using fair value accounting rules, the student loan program will cost taxpayers $88 billion over the next decade.

If the government’s mismanagement of the student loan program wasn’t bad enough, the results for those taking out the loans are also disheartening. The graduation rate for those seeking a bachelor’s degree at all colleges is 59%. This means 41% fail to receive their degree, but many still have the legacy of a student loan to repay. In 2013 and 2014, the Council for Aid to Education administered its Collegiate Learning Assessment Plus (CLA+) test to 32,000 students at 169 colleges and universities. The CLA+ test measures the intellectual gains made between a student’s freshman and senior year and assesses attributes like critical thinking, analytical reasoning, document literacy, and writing and communication skills needed by professionals in the work world. The results indicate that 40% of students graduate without the complex reasoning skills to manage white-collar work.

A survey of business owners released in January by the Association of American Colleges & Universities found that 90% of employers judged recent college graduates as poorly prepared for the workforce in such areas as critical thinking, communication and problem solving. As it stands today, almost anyone can get a student loan to attend college in the field of their choosing. While this approach appeals to the warm and fuzzy ideal that everyone should have an equal opportunity to get a college degree, all degrees are not created equal once a graduate begins looking for a job.

Using data from 2009 and 2010, the Georgetown University Center on Education and the Workforce determined which majors had high initial unemployment rates and low initial median earnings for fulltime, full-year workers. The 10 worst college majors, starting with the worst, are: 1) anthropology and archeology, 2) film, video and photographic arts, 3) fine arts, 4) philosophy and religious studies, 5) liberal arts, 6) music, 7) physical fitness and parks recreation, 8) commercial art and graphic design, 9) history and 10) English language and literature.

Conversely, the majors with the lowest initial unemployment rates and highest median earnings were healthcare, business, science, technology, engineering and math. If the government is going to put taxpayer money at risk, it would seem reasonable to add a few more qualifications to guarantee student loans, like only guarantee them for majors that are far more probable to result in a well-paying job in which the loan is more likely to be paid off, rather than majors that are in less demand and pay poorly. Instead, the government guarantees every student loan irrespective of the major and prospects of the loan being repaid. Millions of students are likely to struggle to repay their student loan because they are armed with a nearly worthless degree.

The administration has responded to the problem it helped create by lowering repayment standards so ultimately taxpayers will be responsible for bad education policy. Search for “repaying student loans” online and you’ll find “Obama’s Forgiveness Plan” and “Obama Forgiveness 2015.” The current system will not only burdening taxpayers in the future, it’s saddling millions of students with a mountain of debt they will struggle to pay off. In coming years, we are reasonably certain that the student loan program will remain poorly administered, misguided and unable to prepare students with the nonroutine cognitive skills needed to lower the rate of underemployment, increase middle-class income and strengthen our economy. We are also fairly certain that the inadequacies of the student loan program will not be addressed anytime soon. What’s more likely is that another forbearance program will be announced before next year’s election in an attempt to help the middle class.

Crude Oil

As we explained last month, 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. This type of rally gives an oversold market the opportunity to become less oversold, which sets the stage for the next phase of decline. From a technical standpoint, we thought it was possible for West Texas Intermediate (WTI) oil to rally up to $55–$59 a barrel, finishing off the C leg of a corrective rally from the December low. On April 17, WTI oil climbed to $58.82 before pulling back to $55.73. Based on how the C-leg portion of the rally has unfolded, WTI oil could reach $62.00.

The rebound in prices makes it possible for low-cost producers to hedge their production at a profit by selling oil futures contracts. Although the June futures contract closed at $57.15 a barrel on April 24, the September contract closed at $60.50, which allows producers to earn an additional 5.8% more by hedging their production using the September contract. By locking in an acceptable profit, low cost producers have an incentive to maintain production and no reason to lower production.

Between April 8 and April 22, U.S. oil production dipped from 9.404 million barrels a day to 9.366 million, according to the U.S. Energy Information Administration (EIA)—a decline of 38,000 barrels, or 0.4% of daily production. After the EIA’s weekly report was announced on April 22, WTI oil rallied almost 5% on this “bullish” news.

Overlooked in all the excitement is that daily production is over 10% higher than the 8.42 million barrels per day last June when WTI oil was trading above $96 per barrel. Despite the 0.4% decline in daily production, the amount of supply still exceeds demand, so U.S. oil inventories continue to build.

Also overlooked is that OPEC (Organization of the Petroleum Exporting Countries) production increased by 890,000 barrels a day over the past month, according to the International Energy Agency. The issue of too much supply relative to global demand is still a problem and is the main reason why oil prices plummeted more than 50% between June and January. We think WTI oil will retest its prior low and potentially fall below $40 a barrel in coming months.

Gold and Gold Stocks

Last month, we thought that if the dollar experienced a correction, gold might have a window in which it could rally above the January high of $1,307. Gold rallied to $1,224.50 on April 6 and, as this is being written on April 24, has once again fallen below $1,180, which has been an important technical level. This is poor trading action and not what we expected.

A test of the $1,141 low is likely should gold fall below $1,165. A decline below $1,141 could lead to a further decline to $1,050. If gold holds above $1,165, a rally above the April 6 high of $1,224.50 is possible. The odds of a rally above the January high of $1,307 during the next two months have diminished.


Our view has been that the yield on the 10-year U.S. Treasury was likely to remain range-bound between 1.650% and 2.200% since we expected the economy to slow and the level of labor market slack to postpone a June rate hike by the Fed. Other than on March 6 when the yield popped to 2.240% after a strong employment report, the yield on the 10-year Treasury bond has traded within the expected range. With the odds of a rate increase in June likely off the table, we thought volatility would subside. On March 20, the yield was 1.930% and as of April 24 is at 1.924%.

The highest yield since March 20 was 2.009% on March 26 and the lowest was 1.845% on April 17, so volatility subsided and the trading range compressed to 16 basis points compared to the range of 60 basis points between January 30 and March 6. Even though growth should pick up in the second quarter, we don’t think it will be enough for the Fed to raise rates in June. These readings suggest the trading range is likely to continue, though a close above 2.170% would be a warning sign that the trading range may be ending.


The standard price-earnings ratio understates how expensive the stock market is since it overlooks the significant impact of stock buybacks on earnings. As we discussed last month, corporations executed $550 billion in stock buybacks in 2014, almost 6.5 times the $85 billion invested in equity mutual funds and exchange traded funds, according to the Investment Company Institute.

While no single valuation metric is without flaws, a composite of a number of metrics can provide a better insight of the market’s long-term relative valuation. Doug Short ( provides some great charts on his Advisor Perspectives website, including a chart with the combination of four valuation metrics. The current chart shows that the stock market is at its second or third most expensive level in the past 100+ years. With central banks doing everything they can to boost asset prices, this should come as no surprise.

Given the likelihood that rates will stay low for a long time and that central banks will respond with more accommodation should global stock markets experience a 10% or greater correction, the odds are high that valuations will ultimately become even more expensive. As we have repeatedly cautioned, the stock market does not decline because it is too expensive until a good reason to sell appears and convinces investors that it is in their best interest to lower their allocation to equities.

We rely on technical analysis to provide an early warning system as to when the market’s internal strength has weakened enough to make it vulnerable to bad news. The advance-decline (A/D) line is one of the better technical indicators since it measures whether the majority of stocks are participating in a rally or not. The A/D line has usually weakened before prices have reached their high, as it did in 2007, and before investors are given some very good reasons to sell stocks, like in 2008. The A/D line can also warn of intermediate declines, as it did in August and September of 2014. When the S&P 500 Index made a new price high on September 18, the A/D line was lower than its August 29 peak, warning that the market’s internal strength had weakened. After the A/D line broke below its rising trendline on September 19, the S&P 500 quickly lost almost 6.9% by October 15. As this is being written on April 24, the A/D line has just recorded a new high and is comfortably above its rising trendline. This position suggests that any correction is likely to be contained to less than 4%, unless it weakens as it did in the first half of September. A decline below 2,035 on the S&P 500 would likely open the door for a test of intermediate support at 1,970.

The S&P 500 continues to make higher highs and higher lows, so the price trend is positive. When discussing momentum, we often use a decelerating ball analogy. When a ball is thrown into the air, it starts rising at 60 mph and then gradually decelerates. Even though it may be gaining altitude, the rate of ascent slows to 30 mph, then 20 mph, then 10 mph, decelerating until it ultimately reaches 0 mph. Although momentum is still decent, it is showing signs of slowing.

The Major Trend Indicator (MTI), which measures the upside momentum of the S&P 500, continues to make lower peaks and is currently at its lowest level concurrent with the S&P 500 being at its highest level in several years. If the Dow Jones Industrial Average exceeds its prior high of 11,289, it could create a Dow Theory Non-Confirmation since the Dow Jones Transportation Average is well below its peak made in late November 2014. The Dow Theory is not foolproof, but when combined with the MTI and other technical indicators, it can indicate that the level of risk in the market is rising, despite the new high in the A/D line. Since making a new high on February 25, the S&P 500 appears to have traded in a triangle pattern that likely ended on April 17. The width of the triangle is roughly 80 basis points (2,119–2,039) and, when added to the low of 2,072 on April 17, suggests the S&P 500 could rally to 2,140–2,160. Most posttriangle rallies are quick and, more importantly, often represent the end of an intermediate rally. This information suggests that the probability of a 4%–7% decline will increase should the S&P 500 reach 2,140–2,160 and then reverse lower.

Definition of Terms

10-year U.S. 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.

Advance-decline (A/D) line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

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.

A bund is a German federal government bond issued with maturities of up to 30 years.

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

Consumer price index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.

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.

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 Theory Non-Confirmation is a theory developed by Charles Dow, Robert Rhea and others that uses the Dow Jones Industrial Average and the Dow Jones Transportation Average to determine the health of a particular market trend.

Dow Jones Transportation Average is a price-weighted average of 20 transportation 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.

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.

Q ratio is a ratio devised by Nobel Laureate James Tobin that suggests that the combined market value of all the companies in the stock market should be about equal to their replacement costs.

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.

Thomson Reuters/University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly and based on answers from 500 telephone interviews of persons living in the continental United States. 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.

Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.

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

Note: One cannot invest directly in an index.


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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