Forward Markets: Macro Strategy Review for August 2015

August 10th, 2015
in contributors

Macro Factors and Their Impact on Monetary Policy, the Economy and Financial Markets

by Jim Welsh with David Martin, Forward Markets

U.S. Economy

In the June Macro Strategy Review (MSR) we analyzed the 11 recession recoveries since World War II. We found that the current recovery had averaged an annual increase of 2.36% in gross domestic product (GDP) growth compared to an average gain of 5.36% for the other 10 recoveries.

Follow up:

After GDP contracted in the first quarter, we said stagnant wage growth, below average business investment and the export headwind from the stronger dollar would likely keep second quarter GDP growth to less than the 2.36% average annual growth rate since June 2009. Our estimate of 2.36% for second quarter GDP was made to underscore the relative weakness of the current recovery and our belief that the rebound this year would be far less than the 4.1% increase in last year's second quarter.

The Federal Reserve Bank of Atlanta has an ongoing estimate of GDP called GDPNow, which is updated after every economic report and refreshed almost daily. When writing the June MSR during the third week of May, the GDPNow estimate for the second quarter was 0.7%. As of July 17, it had increased to 2.4%-pretty close to our guess of 2.36%, which is why we're mentioning it as this commentary is being composed on July 21. The Bureau of Economic Analysis (BEA) will report its advance estimate of second quarter GDP on July 30. Wholesale inventories jumped 0.8% in May, which should give second quarter GDP a lift; the stronger dollar, however, is still a headwind. In May, exports fell 0.8%, which will be subtracted from GDP. It's good to remember that the BEA will provide two revisions with more complete data after its July 30 report. This is one reason why the ongoing GDPNow report is so helpful.

Employers added 223,000 jobs in June, according to the U.S. Labor Department. Job gains have averaged 208,000 per month so far in 2015, which is down from a monthly average of 260,000 in 2014. As we discussed in the March MSR, last year’s job growth was boosted significantly because the Emergency Unemployment Compensation (EUC) program was terminated at the end of 2013. The EUC program was expanded in 2008 to provide unemployment benefits for up to 99 weeks once the 26 weeks of state benefits ended and was extended 12 times by Congress. Last January, the nonpartisan National Bureau of Economic Research published research by economists from the University of Oslo, the Institute of International Economic Studies and the University of Pennsylvania. These economists studied how job growth changed in the states offering more generous benefits than neighboring states after the EUC program ended. The researchers determined that paying people more not to work meant they had less incentive to find a job.

Once the EUC program ended, job growth was more robust in the states that had previously offered more generous benefits. The research concluded that of the 3.05 million jobs created in 2014, 1.80 million occurred because people were more motivated to really look for a job after the EUC program was terminated. With that understanding, it’s not a surprise that job growth has slowed in 2015 compared to 2014. In the January MSR we said if oil prices remained below $60 a barrel, as we expected, job growth related to oil and gas development would flip from being a positive for the economy into a negative. About 70,000 oil-related jobs have been lost so far in 2015, which equates to an average loss of about 11,600 jobs per month.

In May, average hourly earnings rose 2.3%—the largest increase since August 2013—raising many economists’ expectation that wages were finally about to accelerate. In the July MSR we said it was more likely a statistical fluke. In June, average hourly earnings fell back to just a 2.0% increase. However, the magnitude of the decline may have been exaggerated since the Labor Department conducted its survey on June 12. Since August 1994, there have been 32 instances when the survey was conducted on the 12th of the month. In 25 of the 32 occasions that the survey was conducted on the 12th of the month, average hourly earnings were flat or declined in that month with increases in the month before or the following month.

Statistically, the odds favor an increase in average hourly earnings in the July payroll report. That said, we still don’t expect a consistent acceleration in wage growth until the spread between the U-3 unemployment rate (U3) and U-6 unemployment rate (U6) begins to trend below 5.0%. In June, the U3 was 5.3% and the U6 was 10.5%—a spread of 5.2%. Historically, solid wage growth above 3.3% hasn’t occurred until the U3-U6 spread was below 3.85%. The current spread suggests there is still too much slack in the labor market to expect an upward trend in average hourly earnings to develop in the next few months.

Consumer prices rose 0.3% in June from May, but have risen only 0.1% from a year ago, according to the Labor Department. The 23.3% decline in gasoline prices from a year ago was the primary reason for the annual increase in the Consumer Price Index (CPI) being so low while the 3.4% jump in gas prices in June was responsible for the large 0.3% monthly increase. An outbreak of avian flu resulted in an 18.2% rise in the price of eggs, which also added to June’s food inflation. Due to the volatility in energy and food prices and the insignificant impact that monetary policy exerts on energy and food costs, the Federal Reserve (Fed) prefers to look at the core personal consumption expenditures (PCE) price index, which excludes energy and food. Over the last year, core inflation, as measured by the Consumer Price Index (CPI), was 1.8%, just below the Fed’s target of 2%.

However, this estimate is being distorted by one key component. In calculating the cost of shelter, the Labor Department computes costs for owned homes by estimating what it would cost to rent a comparable living space. The problem with this methodology is that rental prices for apartments have been rising faster than in the past as younger people delay when they buy their first home due to student loans, getting married later in life and starting a family later. Owners-equivalent rent accounts for 31% of the Labor Department’s core inflation estimate. Core inflation would have been less than 1% rather than 1.8% if the 3% increase in rents in the owners-equivalent calculation was excluded.

We understand the logic of excluding food and energy, but not only does everyone need food and use energy, they also need a place to live. This logic suggests one should not accept these numbers at face value and instead should put them into the context of the current environment. Inflation has not been just 0.1% over the past year nor has it been 1.8%. The Fed’s preferred core PCE index is up 1.2% over the last year, which is probably a fairly accurate reading. On a side note, the upward pressure on rents will likely begin to subside within the next year. The U.S. Department of Commerce reported that construction of multifamily housing surged 28.5% in June, which put apartment construction at its highest rate since November 1987. As those apartments are built, rent increases will be dampened.

Federal Reserve

Fed Chair Janet Yellen has said the Fed is data dependent and there will be two more employment reports (July and August) before the Fed's Federal Open Market Committee (FOMC) meeting on September 16. Since the strength of the labor market is so important to the overall health of the economy, these reports will strongly influence whether the Fed decides to raise the federal funds rate at the September meeting. Our view has been that the Fed will raise the federal funds rate once before the end of the year, not twice as indicated by 10 of the FOMC members at the June meeting.

In the Fed’s semiannual Monetary Policy Report, Yellen told the House Committee on Financial Services,

“If the economy evolves as we expect, economic conditions likely would make it appropriate at some point this year to raise the federal funds rate target, thereby beginning to normalize the stance of monetary policy.” 1

We have criticized the Fed for maintaining its zero interest rate policy (ZIRP) for almost seven years due to its untended consequences. By maintaining ZIRP for so long, savers and older Americans have received $470 billion less in interest income since 2008. This decline in income has led to a big increase in recent years in the percentage of those over 65 years old who continue to work to replace the loss of interest income. Corporations have repurchased $2.5 trillion of stock since 2010, with much of the activity funded through borrowing.

The overindulgence in stock buybacks has come at the expense of lower business investment, which is likely to lead to less innovation and economic growth in coming years and a loss of productivity in the short run. In a speech on July 10 at the City Club of Cleveland, Janet Yellen discussed productivity:

“The most important factor determining continued advances in living standards is productivity growth...We do know that productivity ultimately depends on many factors, including our workforce’s knowledge and skills along with the quantity and quality of the capital equipment, technology, and infrastructure that they have to work with.” 2

The quantity and quality of capital equipment is dependent on business investment, which has been below average during this recovery. The five-year average of productivity is hovering just above the lowest level of the past 60 years, certainly for more than one reason. The low cost of money, weak business investment, cost of complying with government regulation and lack of political focus on improving productivity are just a few of the reasons. Unless productivity is boosted, future generations will have to accept a lower standard of living throughout the course of their lives.

If companies can achieve a better return from buying back stock due to ZIRP rather than increasing business investment, stock repurchases will remain the game plan until interest rates rise and make them less attractive. In her July 15 congressional testimony, Janet Yellen also said:

"We're close to where we want to be, and we now think the economy cannot only tolerate but needs higher rates."3

That sure sounds like an acknowledgment of the unintended consequences of ZIRP.

Based on the federal funds rate futures, which are priced off expected overnight rates, the odds of a rate increase in September is about 35%. We have found that the federal funds rate futures do a poor job of forecasting future rate increases, so the odds the Fed will act in September may be higher than the futures are implying.

Economists Jing Cynthia Wu and Fan Dora Xia have constructed a shadow federal funds rate based on longer-term Treasury yields. Their work estimates where the federal funds rate would be if it could go below zero percent. The shadow funds rate is maintained by the Federal Reserve Bank of Atlanta and at the end of June indicated that the federal funds rate should be trading at -1.41%. This rate suggests to us that in the era of quantitative easing, the Federal Reserve has succeeded in causing Treasury bonds to be mispriced. It also hints that Treasury bonds could be vulnerable to a sharp decline. An analysis of the 10-year U.S. Treasury bond’s chart pattern suggests a spike in yields is possible.


Between October 2013 and May 2015, the yield on the 10-year Treasury bond was contained in the downward channel as indicated by the parallel red trend lines on the nearby chart. After briefly dropping below the lower trend line in January, the yield quickly popped back up into the channel. Since late May, the yield has held above the upper red trend line after failing to reenter the channel on July 7.

As this is being written on July 22, we believe the 10-year Treasury yield could make one more attempt to reenter the channel, so a drop below 2.19% and possibly as low as 2.10% seems likely. If this occurs, we would interpret an increase in the yield out of the channel and above 2.24% as an intermediate negative, since it would indicate a failure to reestablish the downtrend. The yield on the 10-year Treasury bond reached its lowest level on July 24, 2012, at 1.394%, and rose to 3.036% on December 31, 2013, an increase of 1.642%. The yield posted a secondary low on January 30, 2015, at 1.651%. If the intermediate trend has turned negative, the yield is likely to rise above 3.036 in coming months and potentially reach 3.293% if it follows the same 1.642% increase from the 1.651% low in January. We think the stock market would likely decline if a spike above 3.036 occurs in the 10-year Treasury yield.


A number of tailwinds are going to support growth in the eurozone in coming months. Bank lending has finally turned positive and was up 0.5% in May. That growth rate is less than the 2.5% growth in the first half of 2011 and pales when compared to the 10% rate of growth in 2007-2008. Nevertheless, it is heading in the right direction. Bank lending is extremely important in the eurozone since banks provide 70% of credit, so small- and medium-sized businesses are dependent on credit availability from their local banks. In the U.S., banks provide only 35% of credit creation, showing the importance of bank lending in the eurozone. The broadest measure of money supply, M3, has been rising since the middle of last year and is now at its highest level since 2009. The rate of growth is less than half of what it was in 2007-2008, but it too is heading in the right direction.

One of the reasons we thought the European Central Bank would encourage a lower euro was the positive effect it would have on exports. As we discussed in the May 2014 MSR, a cheaper euro would benefit all the countries in the eurozone, but it would especially help the less productive countries, such as Italy, Spain, France and Portugal. The euro is down 20% versus the dollar since May 2014, which means eurozone companies have a significant pricing advantage, especially against U.S. firms.

Foreign sales represent 46% of S&P 500 Index sales and numerous U.S. multinational companies have cited the strength of the dollar as the main reason why their revenues were soft or down in the second quarter. The drag from the stronger dollar is not going to dissipate as quickly as some economists and the Fed expect. It won't likely happen until the euro rallies or U.S. companies decide to cut prices to regain market share.

However, a significant rally in the euro is unlikely and U.S. companies will have to accept much lower profit margins if they choose to cut prices. The competitive price advantage eurozone companies now enjoy will persist for at least the balance of 2015 and likely well into the first half of 2016.

We have expected the eurozone to grow about 1.5% in 2015 and a modest improvement is possible given the tailwinds we've cited. However, the eurozone is still carrying a massive debt load of $4.60 for every $1.00 of GDP, the structural problems that have plagued economic growth in France and Italy have not been addressed, and global growth is not likely to pick up much.


As we noted in the June MSR, actions speak louder than words. The only uncertainty surrounding China was whether China would be willing to report GDP growth under 7%, which was not the case in the first quarter. On July 15, China reported that GDP grew 7.0% in the second quarter, miraculously matching its target for growth in 2015. In response to skepticism about the GDP report, a spokesperson for China's National Bureau of Statistics said the GDP figures weren't inflated and the improvement was "hard won." Anyone can achieve a better score and win if armed with a pencil and an eraser.

Although China's industrial production rose 6.8% in June, it is less than half of 2010 and 2011 levels and comfortably below its level in 2012 and 2013. Retail sales averaged 13.88% from 2010 through 2014. After posting a year-over-year record low of 10.0% in April, retail sales have improved and were up 10.6% in June. However, the rebound in industrial production and retail sales may stall in coming months. Car sales have been slowing from a year-over-year gain of 3.7% in April and 1.2% in May to a rare decline of -3.4% in June. According to the China Association of Automobile Manufacturers, the inventory of cars has risen to more than 50 days to sell, above the association's warning level of 45 days. Unless car sales improve, car production will be reduced in coming months to bring inventories down. Since China measures GDP based on production rather than sales, as in the U.S., any slowdown in car production will lower GDP.

The slowdown in car sales will only exacerbate the problem of excess steel production capacity that has progressively plagued China since the slowdown in real estate construction began two years ago. Worldwide excess steel production capacity is 553 million metric tons per year, according to UBS, with much of the excess in China. To put this statistic into perspective, 553 million metric tons a year is enough to build 75,000 Eiffel Towers or 10,000 aircraft carriers every year. With insufficient domestic demand, China has resorted to exporting its excess production in a big way.

Last year China exported 94 million metric tons of steel, more than the total output of the U.S., India and South Korea combined—the third, fourth and fifth largest producers in the world. Excess global capacity has exerted significant downward pressure on steel prices. Since March 2, 2011, steel prices have plunged 47.1%, from $970 a metric ton to $513 in mid-July and are off 57.4% from their record peak of $1,203 on July 28, 2008. The steelmaking process begins with the processing of iron ore, so the boom in China’s steel production over the past decade boosted demand for iron ore.

To feed China’s apparent insatiable demand for iron ore, mining companies around the world borrowed extensively to build networks of mining pits, heavy duty extraction equipment and railway lines to ports to ship iron ore to China. Between 2004 and 2014, the world’s largest mining companies accumulated nearly $200 billion in net debt, a 600% increase from 2004. Since earnings only rose 250% during this period, according to consulting firm EY, operating leverage increased significantly, making these companies vulnerable to falling iron ore prices.

Since February 2011, iron ore prices have slid a stunning 75%. According to an analysis of EY’s data by the Wall Street Journal, if the top mining companies devoted all their earnings less investment spending to paying down debt, it could take up to a decade for these companies to clean up their balance sheets. In 2013, Chinese authorities named 19 sectors plagued by excess production capacity. Among them were cement, aluminum, chemical fiber, paper, steel and rubber. Between 2000 and 2013, China’s annual tire production tripled to almost 800 million tires as China became the world’s largest auto market, according to the Freedonia Group. Chinese tire exports increased tenfold between 2000 and 2013 as Chinese tire makers unloaded excess production.

The dumping of excess tires elicited complaints from tire manufactures in the U.S., Brazil, Turkey, India, Columbia and Egypt and eventually tariffs on Chinese tire imports. According to the China Petroleum and Chemical Industry Federation, the more than 300 tire makers in China operate at just 70% of capacity. This is well below the 85% utilization rate needed for China’s tire manufacturers to turn a profit. Rather than closing unprofitable facilities, Chinese tire producers just keep spinning their wheels. It cannot be determined how much of this bad business practice is due to political pressure to keep production running so job losses can be avoided. We suspect it plays a role, especially in state- owned enterprises. In June, China’s Producer Price Index (PPI) fell -4.8% from a year earlier, the lowest since 2009. China’s PPI has been negative since April 2012—39 consecutive months. The depth of the decline in June suggests that China’s excess capacity and the deflation it is generating in sales and profits is not going to reverse any time soon.

Between 2000 and 2014, China increased its exports from $249.2 billion to $2.343 trillion, almost a tenfold increase. In terms of total global merchandise exports, China's share soared from just 3.8% to 12.2%. China is known globally for its exports of just about everything. What investors are coming to realize is that China's most important export during much of the past 15 years was Chinese demand for raw materials. In addition to exporting goods, China also exported the demand for the raw materials to build the factories to produce the manufactured goods it exported, to build domestic infrastructure and housing for Chinese workers, and to create the electricity to power Chinese factories.

China's demand for raw materials lifted growth in Brazil, Australia and many emerging economies that exported their raw materials prior to the slowdown in China's economy. Brazil's GDP almost tripled from 2006 to 2012, rising from $892.1 billion to $2.616 trillion, but has since contracted more than 10% to $2.346 trillion in 2015. China was not the only reason Brazil's GDP grew so much between 2006 and 2012, but it certainly played a big role. The slowing in China's economy since 2011 has changed the nature of China's demand for raw materials and the impact of its exports. Rather than lifting prices of raw materials, the slowdown in China has caused the price of many commodities to fall significantly. And, with the goods it exports, China has been exporting deflation.

According to the Labor Department, consumer prices for tires in the U.S. have fallen in 23 of the past 32 months, a total decline of -6.5% since July 2012. Prices of all goods imported directly into the U.S. from China have fallen in 20 of the past 38 months, by a total of -2.2%. During the same period, the CPI rose 4.16%. While lower prices are nice for U.S. consumers, they are tough on domestic producers who are forced to cut prices to compete with Chinese imports.

The slowdown in China's economy has prompted the People's Bank of China (PBOC) to lower its benchmark lending rate four times since last November, down to 4.85% in June-a record low. The PBOC also lowered its reserve ratio by 50 basis points in June for some banks and cut the reserve ratio from 20.0% in February to 18.0%. The lower reserve ratio frees up money so Chinese banks have more money to lend. In the April MSR, we said we expected additional cuts in the reserve ratio and interest rates. Lower rates will help reduce the burden of interest expense on overindebted businesses and local governments. As we've discussed previously, China's total debt has almost quadrupled to $28.2 trillion in 2014, up from $7.4 trillion in 2007.

As a result, China's debt-to-GDP ratio has increased from 158% to 282% as of June 30, 2014, according to the McKinsey Global Institute. Local governments are set to issue $451 billion of debt this year. Even if the PBOC's actions are successful and banks do increase lending, most new lending is being used to roll over existing debt. While the capacity of local governments to roll over existing debt is important since it will mitigate the potential for a liquidity problem for local governments, it will not contribute to an acceleration of economic growth. At best, the monetary easing implemented by the PBOC has helped stabilize the economy and should prevent further slowing.

According to an analysis by Bloomberg, each $1.00 of additional debt in 2014 only contributed $0.20 to GDP growth, compared to $0.80 in 2007. China suffers from a hangover resulting from a decade of overinvestment, which has resulted in too much debt, excess capacity and deflation in producer prices.

Despite cutting interest rates to a record low and lowering the reserve ratio, M1 money supply has barely improved and remains near the lowest level of the past 15 years. The flow of money into the economy has not accelerated and suggests GDP is not likely to pick up in coming months.

Even though the Chinese economy has at best stabilized (in our view, GDP is under 7%), Chinese stocks have responded to the PBOC's stimulus. Since the first rate reduction last November, the Shanghai Stock Exchange (SSE) Composite Index has doubled from 2,500 to 5,166 on June 12. The rally in the SSE Composite unleashed a torrent of speculation. The number of trading accounts exploded from one million last October to almost 13 million in June. Trading volume on average represents 3.0% of market value compared to just 0.3% on the New York Stock Exchange (NYSE).

A good portion of trading has been fueled by traders using margin, which rose more than fivefold to $365 billion in mid-June, according to official data. At its peak in mid-June, the price-earnings (P/E) ratio of the high tech Shenzhen Stock Exchange Composite Index had risen to 68.9 compared to 18.5 for stocks worldwide. Just when Chinese speculators thought the SSE could only go up, the music stopped and what went up too fast fell even faster. In less than one month, the SSE shed 33.9% from its intraday high on June 12 to an intraday low of 3,421 on July 8. In the process, the decline wiped out roughly $3 trillion in market wealth or almost one-third of China's $10.3 trillion in GDP.

The crash in China's stock market certainly has negative implications for the economy and financial system. Losses absorbed by individual investors could lead to less spending. Many owners of small companies have borrowed money from banks to fund expansions in their business, using their company stock as collateral. A further decline in the stock market could jeopardize small businesses and result in loan losses for banks. To avoid undue economic damage, the China Securities Regulatory Commission authorized $338 billion in credit lines from commercial banks to fund share purchases by securities firms. The news was enough to create a daily key reversal in the SSE on July 8. On July 9, we noted the key reversal in a tweet (@JimWelshMacro) with the expectation that the SSE had the potential to recover 900 points of the 1,800 points it lost and recover to 4,200. While the extension of credit to security firms was successful in halting the decline, the additional debt could become problematic should the SSE fall below the lows of July 8 and cause more margin selling.

We don't think the decline and volatility in the Chinese stock market will be a meaningful drag on growth compared to the issues of too much debt, excess capacity and deflation in producer prices, but it certainly is not a plus. China has reported that its economy grew 7% in the first half of 2015. We think China is unwilling to acknowledge that growth is less than its 7% growth target as a matter of national pride. According to Citigroup, China's economy grew 4.6% in the first quarter, while the Conference Board pegs it at 4.0%. What happens to growth in China matters a lot; since 2000 it has been the incremental driver of global growth. On July 9, the International Monetary Fund (IMF) lowered its forecast for global growth from 3.5% to 3.3% as the slowdown in China is contributing to a slowing in developing countries that are tied to China. Brazil's economy is expected to contract -1.5% this year after exports to China for soybeans and natural resources fell -11.8% in 2014 and remain weak.

The IMF noted that governments have pushed debt to dangerously high levels and central banks are constrained by the lower limits of rate reductions. This is a theme we have discussed repeatedly over the last two years, most recently in the May MSR. Irrespective of the PBOC's efforts, we do not expect growth to accelerate as China continues to wrestle with a slowdown in real estate investment and a debt-to-GDP ratio of 286%.

Emerging Economies

In our October 2014 MSR, we wrote that emerging market (EM) 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 long-term upside target for the dollar. On Friday, March 13, the dollar reached 100.38, so many emerging economies with dollar-denominated debt may be approaching a breaking point. As we discussed in the April MSR, the number of dollar loans in EM countries have soared 50% since 2009 to $9.2 trillion as of September 2014, according to the Bank for International Settlements. According to the IMF, $650 billion has flowed into emerging markets in recent years as a result of quantitative easing by the Federal Reserve. As we noted last December, there was a significant risk that some of this money would flow out of emerging economies as their currencies depreciated, which would then cause further depreciation.

As noted in the April MSR, the decline in EM currencies has the potential to cause a more pronounced slowdown in the countries whose currencies have the most dollar-denominated debt. The cost of a $100 million denominated loan in an EM country that experiences a 10% decline in its currency versus the dollar would increase the cost of the loan to $110 million. It would also increase the interest payments by 10%, taking a 10% bite out of current cash flow. This scenario could force companies in EM countries 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.

As we discussed in the April MSR, the Asian and emerging market crisis in 1997-1998 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 1996, the average foreign debt was 14.8% of GDP versus 18.4% as of September 30, 2014, an increase of 24.3%. The concerns we wrote about in last October's MSR have been resonating with global investors. The iShares Emerging Markets Local Currency Bond ETF has been trending lower in earnest since last September and is down almost 20%.

This decline suggests that global investors are aware of the rising risk of EM debt and the potential for defaults. As we said last October, we don't think defaults in EM debt are likely to have the same global impact as they did in 1997-1998, but the higher level of volatility in EM currencies is likely to have an impact that extends beyond the individual countries before the end of 2015, which could prove unsettling for global equity markets.

Crude Oil - West Texas Intermediate (WTI)

Since last October, the number of oil rigs has plunged from 1,609 to 638 as of July 19, a decline of 60.3%, according to oilfield service company Baker Hughes. The huge decline in oil rigs' production in recent months fueled expectations that a decline in the supply of oil would follow and support much higher oil prices. As we discussed in the May MSR, U.S. production has barely dropped since oil frackers have lowered their cost of production over the past year from $75 a barrel to $60 a barrel through amazing innovation. We noted in the June MSR that production in Saudi Arabia had increased to 10.3 million barrels a day in April, which was maintained in May. Saudi Arabia shows no willingness to lower production. The fundamental problem of too much supply relative to global demand is why oil prices plummeted more than 50% between June 2014 and January 2015 and the imbalance has not improved since then. Our expectation has been that WTI oil would retest the January low near $45 a barrel and potentially fall below $40 a barrel.

As we discussed in the January MSR, companies rushed to cash in on the boom in shale oil development in the last four years and many firms used borrowed money to finance their operations. Since 2008, companies have issued almost $500 billion of junk bonds, which represents close to 20% of the high-yield bond market. In the May MSR, we said that if WTI oil does fall below $40 a barrel, the lack of liquidity in the corporate bond market could lead to large price declines and a few defaults. Defaults will make headlines, prove disruptive and potentially contribute to 10%+ decline in the stock market, but are unlikely to prove a systemic threat. As oil has sold off in recent weeks, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has been trending lower and is not far from last October’s low.

On March 21, when the spot price for WTI Oil was $46.00 a barrel, we thought it was possible for oil to rally up to $55.00–$59.00 a barrel as WTI finished off the C-leg of an A-B-C rally from the low. In the May MSR, we revised the target to $62.00 a barrel based on how the C-leg portion of the rally had unfolded. The spot price for WTI closed at $61.36 on June 10. The September futures contract made a low in January and March just below $50.00 a barrel. Although it closed below $50.00 today, July 22, a bounce to $53.00- $54.00 a barrel is possible. We expect lower prices after most any bounce. According to the Energy Information Administration, the commercial inventory of crude oil was 463.9 million barrels on July 21, an 80-year high for the time of year.


Our investment approach combines fundamental and technical analysis, which is unusual since most economists and financial advisors rely almost exclusively on fundamental analysis. While fundamental analysis is important, combining it with technical analysis can provide a more complete view since it incorporates market prices. When prices fall below or rise above critical levels, technical analysis helps us quantify when we’re wrong so we can help advisors and investors do a better job of managing risk. Keeping losses small supports our philosophy that the best way to make money is to limit losses, and technical analysis can do that in real time. In our experience fundamental analysis too often follows market reversals, and by the time the “news” comes out, keeping losses small is difficult.

In the March MSR, we discussed a number of fundamental reasons why gold and gold stocks could rally. We also noted that gold had bottomed near $1,180 twice in 2013 and if it closed below $1,175, the potential for a decline below $1,130 would increase. On April 24, we noted that gold had once again fallen below $1,180, after it had rallied to $1,224.50 on April 6. In our opinion, this was poor trading action and we thought a drop below $1,165 would lead to a test of the $1,141 level and a break of $1,141 could lead to a decline to $1,050. Gold made an intraday low of $1,081.30 on July 20. In March we were wrong about the fundamental reasons to expect a rally in gold and the gold stocks.

However, by incorporating technical analysis into our risk management we were able to help keep losses small. On July 16, the August futures contract settled at $1,143.90, just above the prior low near $1,141 and last November’s low just above $1,131. On July 17, China released an update of its holdings of gold reserves for the first time since April 2009, more than six years ago. The timing of the release was either pure coincidence or strategically timed since China reported that its gold reserves were roughly half of what market participants had thought. Since the news was deemed bearish, the market greeted the news with selling and gold promptly broke below the prior lows and $1,100. Our take was the opposite.

China wants to build up its gold reserves so the Chinese yuan can become a reserve currency. As it stands, China’s gold holdings place it fifth in the world, behind the U.S., Germany, Italy and France and ahead of Russia and Switzerland. Was releasing its holdings just as the gold market was approaching prior lows and doing it for the first time in six years China’s plan to cause a sharp decline so it could buy on the weakness? China surely has long-term designs to not remain the fifth largest holder of gold reserves, so the announcement in our view is actually bullish since in coming quarters China will be buying the gold investors in the market had thought they already owned.

As this is being written on July 22, gold has declined 10 days in a row, the longest losing streak since 1996. Today, gold closed below $1,100 for the first time since March 2010. In coming days, there are likely to be a plethora of articles explaining why gold has plunged by more than 40% and why the Market Vectors Gold Miners ETF (GDX) has lost 79% since September 2011. The inference in these articles is that anyone considering buying gold or gold stocks now should seek psychiatric help. In our opinion, with sentiment so negative, now is exactly the time to consider buying, especially since our technical risk management avoided so much of the decline in gold. The intensity of the selling pressure in recent days suggests that a choppy period is likely in coming weeks as underwater investors sell into oversold rallies. Our guess is that a trading low is likely to be established between $1,050 and $1,081. If a low develops as we expect, a rally to $1,200–$1,224 before year-end will be possible.


The range in the S&P 500 so far in 2015 has been 7.47%, the narrowest trading range for a year since 1928, when data for the S&P 500 began. Since February 9, the range has been just 4.65%, which is amazing given the high level of volatility that has occurred in so many other markets. On the surface it looks as if the "market" has gone nowhere this year, which is why looking under the surface can provide a better sense of whether the market is gaining internal strength and holding its own, as would be expected in such a flat trading range, or if it is losing internal strength. As we have discussed in the last two months, 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 an intermediate or major market top is recorded, as it did in 2007 and numerous other instances going back to 1928.

The A/D line was well below its peak made on April 24, when the S&P 500 was just two points from making a new intraday high and closing high on Monday, July 20. The horizontal trend line on the A/D line chart connects highs in the A/D line on March 2, March 23, June 23 and July 16 and the low on May 7. The failure of market breadth to improve enough to allow the A/D line to climb above the horizontal trend line is a sign of weakness. The A/D line often leads the way and since April 24 it has now made a lower high and a lower low and completed what looks like a top, especially since it remains below the horizontal trend line. Another method of measuring the market's internal strength is to look at the number of NYSE stocks that are trading above their 200-day average as the S&P 500 approaches a new high. In a strong market, more than 70% of NYSE stocks will consistently trade above their 200-day average, which was the case in the first six months of 2014.

In a healthy market, more than 60% of stocks will trade above their 200-day average. As the percentage of stocks above their 200-day average falls, it is a sign that fewer stocks are participating and indicates that the internal strength of the market is weakening. On July 20, when the S&P 500 was so close to a new high, only 37% of NYSE stocks were above their 200-day average. Just before last in the Chinese stock market and defaults in EM debt. If a cluster of reasons appear, the S&P 500 could test last October's low near year's sell-off during September and October, the percentage of stocks above their 200-day average was 68.0% on September 2. In October 2007, the percentage of stocks trading above their 200- day average was 49.2%.

The stock market is at the second or third most expensive level in the past 100 years based on a number of valuation methods (Shiller's cyclically adjusted P/E ratio, Tobin's Q ratio, the market's capitalization as a percentage of GDP), and the market's internal strength has weakened considerably since late April. All that remains before a 4%-7% correction occurs is a reason to sell. We've discussed several things that could cause an increase in selling pressure: a spike in the 10-year Treasury yield, a drop in oil to below $40 a barrel that triggers a sell-off in high-yield energy bonds or raises concerns about global growth, a resumption of the decline 1,850. If a decline of 10% or more occurs in global equity markets, we would expect the central banks around the world to come to the aid of equity markets, just like the People's Bank of China.

Last month we said that a close below 2,067 would likely confirm that an intermediate high in the market was in place. After the S&P 500 closed below 2,067, it tested the next level of support at 2,040-2,045 on July 7 and July 9. On July 10, we tweeted (@ JimWelshMacro) that we expected a rally based on how oversold the market had become and also because the put-call ratio indicated that bearishness had become excessive. As this is being written on July 23, the potential for one more rally to our cited range of 2,140-2,160 remains intact, as long as the S&P 500 does not close below 2,044. Should the S&P 500 rally to a new high and the A/D line fail to make a new high, it would provide further evidence that the market is making an important top.

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.

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.

Cyclically adjusted price-earnings (CAPE) ratio measures the value of the S&P 500 equity market.

Debt-to-GDP ratio is a measurement 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 a country's ability to pay back its debt.

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

M1 is a measure of 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.

M3 is the broadest measure of money used to estimate the entire supply of money within an economy.

Market breadth is a ratio that compares the total number of rising stocks to the total number of falling stocks.

Personal Consumption Expenditures (PCE) is a measure of price changes in the goods and services consumed by individuals.

Price-earnings (P/E) ratio is a measure of the price paid for a share of stock 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 measures the average change in selling prices received by domestic producers of goods and services over time.

Put-call ratio is a ratio of the trading volume of put options to call options. It is used to gauge investor sentiment.

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.

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

Shanghai Stock Exchange (SSE) Composite Index is a market composite of all A and B shares traded on the Shanghai Stock Exchange and provides a broad overview of the performance of companies listed on the Shanghai exchange.

Shenzhen Stock Exchange Composite Index is a market-cap-weighted index that tracks the stock performance of all the A-share and B-share lists on the Shenzhen Stock Exchange.

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.

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% in order to stimulate economic activity during times of slow economic growth.

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.

ETFs are shown for illustrative purposes only and are not an offering of sale.

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