Uncertain Economy and Uncertain Fed

October 13th, 2015
in contributors

Forward Markets: Macro Strategy Review for October 2015

by Jim Welsh with David Martin, Forward Markets

U.S. Economy

In February when we wrote the March 2015 Macro Strategy Review (MSR), we predicted that there would be very little acceleration in average hourly earnings in coming months from the 2.2% annual increase that had prevailed since the spring of 2010.

Follow up:

This was contrary to what the Federal Reserve (Fed) and most economists expected since monthly job growth was running in excess of 200,000 jobs per month and the unemployment rate was falling. Since last February, job growth has continued to average more than 200,000 new jobs per month and the unemployment rate has fallen from 5.7% in January to 5.1% in August. But, according to the August 2015 employment report, average hourly earnings were only up 2.1% from August 2014. The Fed is likely surprised that wage growth hasn’t accelerated and we suspect that the Fed and many economists are still of the view that better wage growth is right around the corner. It seems timely to review our analysis from last February and whether better wage growth in coming months is really in the cards.

Many economists, including members of the Federal Reserve, have noted that the current 5.1% unemployment rate is low by historical standards. While the U-3 unemployment rate gets the headline every month, the U-6 unemployment rate, an alternate measure of the labor market, probably provides a better measurement of the actual amount of slack in the labor market. The U6 rate includes those working part time but who would prefer full-time employment. In August, there were 6.5 million workers who fit into this category, so this is not an insignificant group. The U6 rate also includes those who are marginally attached to the labor market, since they still want to work but have become discouraged. In August, there were 5.9 million discouraged workers who were still looking in from the outside of the workforce. When these 12.4 million workers are included in the calculation, the amount of slack in the labor market soars from the 5.1% official U3 unemployment rate to 10.3%. Thus, the spread between the U3 and U6 unemployment rate in August was 5.2%.

To determine if the spread of 5.2% is still excessive, we have used data from the Bureau of Labor Statistics for the U3 and U6 from January 1994 through August 2008 to calculate the average spread. During this period, the average monthly spread between the U3 and U6 rates was 3.85%. Clearly, the current spread of 5.2% is still well above the long-term average. To establish a benchmark for annual wages and exclude the impact of the financial crisis on wage growth, we calculated the average annual gain in monthly wages from January 1994 through August 2008 using data from the Federal Reserve Bank of St. Louis. The average monthly increase in wages during this period was 3.32%. We then compared the U3-U6 spread from January 1994 through August 2015 and saw that wages rose faster than 3.32% when the U3-U6 spread was less than 3.85% and wages rose slower than 3.32% when the spread was above 3.85%.

We expected that changes in the U3-U6 spread would precede changes in wage growth by some period of months based on the trend in the spread, especially as the spread rose above and dropped below the 3.85% average. We confirmed our hypothesis when the spread dropped in 1997, when the spread widened in 2001 and when the spread again tightened in 2006.

In January 2008, the U3-U6 spread rose above 3.85% and stayed right around that level through August 2008. After the financial crisis exploded in September 2008, the U3-U6 spread soared and it didn’t take long for it to have an impact on wages. Annual wage growth peaked in October 2008 at 3.92% and fell below 3.32% in April 2009. The U3-U6 spread remained quite wide until September 2011 when it peaked at 7.3%—3.45% above the 3.85% average. Between September 2011 and October 2012, the U3-U6 spread narrowed only to 6.9% and wage growth didn’t stop falling until October 2012. Since October 2012, the U3-U6 spread has gradually improved, but it is still fairly wide, which likely explains why annual wage growth has not risen faster than the 2.2% rate in the past five years.

The U3-U6 spread was 5.3% in August, well above the 3.85% labor slack tipping point. This spread suggests that wage growth in coming months is likely to remain muted until the spread narrows considerably. If the last 21 years is any guide, the spread will have to drop under 4.5% before we could confidently suggest that wage growth is realistically poised to increase consistently. Consumer spending represents 70% of U.S. gross domestic product (GDP). If wage growth remains stuck at 2.2% or so in coming months, as we expect, the U.S. economy is not going to pick up much steam from an increase in consumer spending.

Revenue growth for companies in the S&P 500 Index has been hard to come by in 2015. In the first quarter, revenue fell by -2.9%, by -3.4% in the second quarter and by -3.3% in the third quarter and is forecast to drop -1.4% in the fourth quarter. A portion of the decline is attributable to the loss of revenue from energy firms due to the large decline in oil and natural gas prices. According to Yardeni Research, the energy sector accounted for 10% of S&P 500 revenues a year ago, so it has reduced overall revenues by about 5%. The strength in the dollar has played a bigger role since almost 50% of S&P 500 revenue is generated abroad. The trade-weighted dollar is up almost 17% from a year ago, so it has lowered revenue by more than 8%.

In recent weeks, we have heard a number of well-known strategists reference the rate of change in the dollar over the past year as a reason to be more optimistic about S&P 500 revenue and earnings growth in coming quarters. They base this supposition on the fact that the annual rate of change in the dollar index has fallen from 26.3% in March, when the dollar index peaked at 100.38, to 11.9% as of September 18. The former U.S. chief equity strategist for J.P. Morgan went so far as to say that the lower rate of change is turning the dollar from a headwind into a tailwind. The annual rate of change may be meaningful to a strategist, but it is ridiculously superficial when one considers how the real world works. Since May 2014, the euro has lost 19% of its value versus the dollar.

Imagine you’re a sales rep for a U.S. company trying to a sell a product that competes with a European company that produces a very similar product in terms of price and quality. The potential customer likes you and thinks your product is just what they have been looking for. But when it comes down to price, the European product will cost $0.81 while yours will set the potential customer back $1.00. Does the customer care more about the rate of change in the dollar index or the fact that your product costs 23.4% more than the comparable European product? In the real world, the readjustment of the euro versus the dollar will continue to be a headwind for quite a while. As we discussed last month, the dollar has strengthened against a wide range of currencies that are not represented in the dollar index. The trade-weighted dollar index is above its March high so the headwind from the dollar strength has actually increased since then.

Federal Reserve

The Federal Reserve is between a rock and a place they have never been before. The Fed does want to move off the zero percent boundary it has maintained since December 2008 so it has some leverage to deal with the next economic slowdown. The Fed’s balance sheet has ballooned to $4.5 trillion and there are $2.6 trillion in excess reserves, which represents an operating challenge. Fed members will need to go through a learning curve to avoid any missteps down the road since they have no experience in managing the federal funds rate in this environment. Fed officials have labored over the past 15 years to make their communications more transparent in order to reduce market volatility when there is a change in monetary policy. In some respects, their efforts have made them prisoners of their own communication. In terms of news coverage in September, the only domestic issue getting more attention than the Fed is Donald Trump.

The Fed decided to leave rates unchanged at the September Federal Open Market Committee (FOMC) meeting, which is what we expected and hoped for. As we noted in the September Macro Strategy Review (MSR):

“Domestically, GDP growth is okay and job growth is decent, but wage growth remains stuck in neutral at 2.1%. The trade-weighted dollar index continues to make new highs, which means the export headwind from a more expensive dollar is getting stronger. The decline in the price of oil is dragging inflation expectations lower and inflation remains under the Fed’s 2% target showing no concrete signs of accelerating. We don’t think the Fed is oblivious to the renewed wave of deflation and the economic and financial stresses that are likely to result from low oil prices and the significant declines in EM currencies. Raising rates now could easily precipitate more dollar strength, an EM currency crisis or a plunge in oil prices well below $40 a barrel as concerns about global growth increase. We know the Fed wants to begin to normalize rates, but the global financial system is more fragile now than most investors realize.”


The post-FOMC meeting press release stated:

“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

The FOMC said it is monitoring developments abroad, which suggests a decision on when the Fed will raise rates will be dependent, in part, on non-U.S. data. Although China has garnered the spotlight due to the collapse in the Shanghai Stock Exchange Composite Index since mid-June, the more substantial risk to the global economy and financial markets is more likely to come from other emerging market (EM) countries. The People’s Bank of China (PBOC) lowered its primary interest rate on August 25 for the fifth time since last November, cutting it from 6.0% to a record low of 4.6%—a reduction of more than 23% in the cost of money. Since last November, the PBOC has lowered banks’ reserve requirement ratio from 20% to 18%, freeing up more than $400 billion for potential new lending.

Significant changes in monetary policy normally take six to 12 months to have an impact on an economy, which means the cumulative effect of the monetary easing by the PBOC since last November will begin to support China’s economy in coming months. There is a high level of angst about the slowdown in China’s economy and how it may weigh on global growth in coming months. Since the positive impact from the PBOC’s easing of monetary policy is likely to show results in coming months, there is a real possibility that the concern about China may be overdone. We are not suggesting that the Chinese economy is likely to accelerate anytime soon, but the drumbeat of negative economic reports may begin to sporadically include a report or two that exceeds expectations. If we’re right, China’s economy is likely to stabilize in coming months.

Although the rate reductions and additional lending will help stabilize China’s economy in the short run, it will not address the more important imbalances that must be addressed. Since 2007, China’s total debt has nearly quadrupled, rising from $7.4 trillion to $28.2 trillion. China’s debt-to-GDP ratio has soared from 158% to 282% as of June 30, 2014. Much of the new lending is being used to roll over existing loans that are often overdue. Rather than allowing companies to default, Chinese banks were instructed by the government to provide new loans, according to a Financial Times story in May 2015. While these new loans will make it appear that banks’ nonperforming loans are under control, they are only postponing the day of reckoning. More importantly, the increase in lending will do little to increase economic activity and, if used to expand production capacity, will only worsen China’s excess capacity problem and produce price deflation. In 2013, Chinese authorities named 19 sectors plagued by excess production capacity. We suspect the slowing in China’s economy has only made this problem worse, which is why China’s producer price index (PPI) has been negative for more than three years.

The government also appears to be increasing local government spending in order to support the economy. In August, infrastructure investment rose 21% from a year earlier, up from 15.8% in July, according to banking and financial services company Société Générale. An audit of local government debt in early September found it had reached $3.8 trillion at the end of 2014, up 34% from June 30, 2012. The recent push to increase local government spending has likely pushed the level of debt higher. As long as debt is growing faster than GDP, China is on an unsustainable course that eventually ends in misery. Japan has proven that the road to perdition can be delayed for a long time, so China has time to right its ship. The challenge is whether Chinese officials will be politically capable of accepting the slower growth that will accompany less reliance on debt, loose lending and infrastructure spending to spur economic growth.

Several years ago, China determined it needed to increase consumer consumption as a percentage of GDP and lower investment as a percentage of GDP in order to ensure stable long-term economic growth. At the end of 2014, consumption represented 38% of GDP while investment made up 47% versus 34% for consumption and 49% for investment previously. China’s progress toward its long-term goal of rebalancing its economy has been modest and the recent decision to increase infrastructure spending and nonproductive lending is a step backward, even if it provides some short-term support.

Emerging Markets

We think the risk of an “event” that causes a dislocation in the global financial markets is more likely to come from another emerging market economy rather than China. Global markets sold off sharply after China moved to lower the value of the Chinese renminbi by 4.4%. Since China wanted to avoid being labeled a currency manipulator by Washington politicians, it allowed its currency to remain pegged to the dollar’s value even after the dollar experienced its largest rally in the last 40 years. Starting in May 2014, as the value of the renminbi kept climbing along with the dollar, Chinese exports became more expensive relative to many other currencies. For most of the past 15 years, exports were an engine of growth, but the appreciation of the renminbi due to dollar strength has caused export growth to turn negative. As we noted in the September MSR, the PBOC will seek to lower the value of the renminbi through a gradual process over time.

The rally in the dollar began in May 2014 after the euro experienced a key weekly negative reversal during the week of May 9. The nearby table shows how much a host of currencies have declined since May 9 versus the dollar and, by proxy, the renminbi. It also underscores the pressure on China to devalue the renminbi more over time. The consternation in financial markets after the Chinese devaluation looks silly when compared to the currency declines experienced in many other countries. This suggests that while the majority of investors are fixated on China, the real danger is likely to come from one or more of the countries listed in the table.

Emerging market debt is now 167% of GDP, up from 117% in 2007, according to the Bank for International Settlements. The significant increase in debt means corporations and households are forced to spend a greater share of their income on debt service. Unfortunately, a significant portion of the newly accumulated debt was denominated in dollars. The amount of dollardenominated loans in EM countries has soared from $6 trillion in 2009 to $9.6 trillion in June 2015. The cost for EM companies to service unhedged dollar-denominated debt has increased proportionately to the amount a local currency has depreciated. Imagine the cash flow squeeze on companies in Mexico, South Africa, Malaysia, Turkey and especially Brazil, whose currencies have plummeted by 20% or more. In response to depreciating currencies and falling commodity prices, banks in Asia and Latin America tightened lending standards in the second quarter, according to an analysis of 122 banks by the Institute of International Finance in August. We suspect the additional weakness in currencies and commodities during the third quarter have led more banks to tighten credit further.

Borrowing costs in the emerging market bond market have been going up over the past year. As governments and companies attempt to roll over debt in coming quarters, they will be forced to pay a higher interest rate to attract buyers. Since last fall, the six-month London Interbank Offered Rate (LIBOR) has risen from 0.32% to 0.54%. In addition, according to Dealogic, the margin on syndicated loans has averaged 2.4% this year in emerging markets, the highest margin on record going back to 1996 and even higher than in the 1997-1998 Asian emerging debt crisis when it peaked at 2.1%. These figures represent the average, which does not provide a clear picture of the funding problems some countries are facing. Since August 2014, five-year government bond yields have soared from 8.5% to 15.0% in Brazil while five-year yields in Turkey jumped from 6.6% to 10.8% just since January 2015. For many emerging countries, the combination of currency depreciation, higher debt levels, tighter bank lending standards and higher interest rates is a horror show just in time for Halloween.

If there is a mini-crisis brewing in an EM country, Brazil, as the seventh largest economy in the world, is the most likely candidate. Standard & Poor’s recently lowered Brazil’s credit rating to junk status. On September 23, the 10-year yield on the Brazilian government bond reached 16.4% while the Brazilian real fell to its lowest level since it was introduced in 1994. S&P also downgraded 60 major corporations, including Petrobas. Petrobas has $134 billion in debt, including $90 billion in dollar-denominated debt. In the first half of 2015, revenue was down 27% from the first half of 2014, plunging from $71.4 billion to $52.0 billion. Any hint of a default by Petrobas on bank loans or bonds would prove unsettling.

The iShares MSCI Emerging Markets Index ETF (EEM) made a low of $30.00 on August 24, but we don’t think that represents THE low. As we’ve discussed, the fundamentals are getting worse and the risk of at least a mini-crisis is rising. The economic weakness in any number of EM countries is likely to increase in coming months, which increases the risk that one or more governments could collapse. This could easily become a contagion that spreads quickly and causes a larger tremor in global financial markets than when China devalued its currency.

Emerging Markets – Technical

In the September MSR, we reviewed a chart of the iShares MSCI Emerging Markets Index ETF and in preparing the October letter we discovered that a couple of the prices referenced were incorrect, so we’re providing our updated technical analysis of the price pattern. 6 Macro Strategy Review www.forwardinvesting.com As the nearby EEM chart shows, after a large increase, markets often experience an A-B-C set of waves where they A) decline, B) rebound and then C) decline again. In 2011, EEM fell in wave A from $50.43 on May 2 to $33.42 on October 4, a loss of $17.01.

If EEM equaled that decline from the wave B high of $45.35 on September 14, 2014, for wave C, it would fall to $28.84. The low in 2008 was $18.22 on November 20, which was followed by a rally of $32.21 to $50.43 on May 2, 2011. If EEM retraces 61.8% (a common Fibonacci number) of the $32.21 rally, it would drop to $30.52. If an emerging market country unravels, EEM could retrace 78.6% (another Fibonacci number) of the $32.21 rally and fall to $25.11. Wave 1 within wave C was a drop of $8.62 ($45.85 to $37.23). If wave 5 within wave C is equal to wave 1, EEM would fall $8.62 from the wave 4 high of $33.35 and reach $24.73. On August 24, EEM posted a low of $30.00, but we expect that low to be exceeded.

The decline in EEM since its high in September 2014 is only four waves and we expect a fifth wave to cause it to make a lower low than $30.00. From a big picture perspective, if wave C equals wave A, EEM would drop to $28.84, with a crisis potentially causing it to decline to $25.11. All these calculations suggest that if EEM drops into the range of $24.73–$28.84, it may be completing an A-B-C correction from the May 2011 high. If our analysis is correct, this would represent a good long-term buying opportunity.

Emerging Markets – Valuations

Emerging markets are becoming attractive from a valuation perspective. Based on Robert Shiller’s cyclically adjusted priceearnings (CAPE) ratio, EM valuations are cheaper today than they were in 2009. In February 2009, the EM CAPE ratio bottomed at 9.91. On July 31, 2015, the CAPE ratio was down to 10.02 and is now surely lower than in 2009 since EEM is more than 10% below its July 31 price level. Three-year returns have been especially good after the CAPE ratio dropped below 15, as the nearby table illustrates. We would, however, offer four caveats. First, the data set only covers the last decade, so it is too short to “take it to the bank.” Second, China’s economy is not going to grow nearly as fast as it did between 2005 and 2015, which will have a dampening effect on growth throughout emerging market economies. Third, debt levels throughout emerging markets are much higher, which will also act as a constraint on future growth. Last, EM equity markets are inherently more volatile than equity markets in advanced economies, so a higher level of risk management is called for. We think this risk can be better managed if one uses a tactical approach rather than a buy-and-hold allocation approach to emerging market equities.

We have been warning market participants for more than a year of the problems that are now intensifying throughout the EM sector. News is only bad if it is negative and comes as a surprise. We’ve done a good job of being ahead of the curve regarding the EM sector, so the recent carnage has not been a surprise. If an EM dislocation causes a further decline in EM equity markets in coming weeks or months, we would look at it as a long-term buying opportunity. The challenge of course is that the level of volatility could become extreme if an EM country unravels, which is why the technical levels we discussed could prove helpful.


The other shoe is about to drop for energy companies, the first being the plunge in oil prices from over $100 a barrel to less than $50 a barrel. Now, banks are in danger of more bankruptcies, defaults and forced mergers in 2016. Some firms were able to insulate the loss of cash flow from lower oil prices by hedging a portion of their production. According to investment bank Simmons & Company International, 36 U.S. drillers had hedges to sell 33% of their production for an average of $80 a barrel in 2015.

Next year, they only have 18% of their production hedged at $67 a barrel. Oil companies are required to write down the value of assets when the value of those assets falls below what is listed on their balance sheets. According to independent research firm IHS Herold Inc., 66 oil and gas producers have written down $59.8 billion through June, which tops the previous full-year record of $48.5 billion in 2008. Exploration and production companies are required to value drilling properties and oil reserves based on the prior 12 months. In October 2014, oil prices were still above $80 a barrel. For the 12 months ending in June, the price used to value assets included values through October, so the average was $71.50 a barrel. However, because oil prices collapsed last November, the average price could be below $50 a barrel at the end of December. This suggests more companies will be forced to write down more assets in coming months. The impairment to cash flow from lower oil prices makes energy companies even more dependent on bank lending to maintain operations. However, the decline in oil prices reduces the value of untapped oil reserves in the ground, which is part of the collateral that banks require to back loans. Banks are likely to cut credit lines and potentially refuse to roll over existing loans since collateral values have fallen so much. This will lead to more bankruptcies, defaults and forced mergers well into 2016. Since the beginning of August, there have been more than $10 billion in defaults by six energy firms, according to Fitch Ratings. The default rate among U.S. energy companies has risen to 4.8%, the highest level since 1999 and well above the broader U.S.

corporate default rate of 2.9%. The default rate for exploration and production companies has jumped to 8.5%. The yield on a basket of junk-rated energy bonds has soared to 11.0% from 5.9% a year ago, the highest since July 2009 at the bottom of the Great Recession. In the September MSR, we thought oil was likely to establish a low between $32 and $40 a barrel. Oil traded below $38 a barrel on August 24 and then jumped to near $50 a barrel by August 31. According to the U.S. Commodity Futures Trading Commission, hedge funds had established a large short position in oil futures in mid-August when oil was trading near $43 a barrel. Clearly, this dynamic rally of more than 25% in one week was driven in large part by short covering. Hedge funds held an even larger short position in oil futures in mid-March. On March 21, when the spot price for West Texas Intermediate (WTI) oil was $46 a barrel, we thought oil could rally to $55–$59 a barrel and then to $62 a barrel. Hedge funds were caught “short” in mid-March and late August, which explains why these oil rallies were so dynamic.

We think another sell-off in WTI oil is likely. Although U.S. production has dipped from 9.6 to 9.3 million barrels a day since the peak in April, the peak summer driving season has just ended, so the demand for gasoline and the oil to produce it will fall. Refineries in the U.S. have been running at 95% of capacity since July 17, according to Energy Department data. This is the highest level of utilization since 2005. Historically, the normal utilization rate during the peak summer driving season has been 91%. The higher rate of utilization was driven by a 6.5% increase in demand for gasoline from 2014 as more Americans took advantage of cheaper gas prices by driving more. Despite the extra demand for gasoline and oil, WTI oil is more than 20% lower than in July. Between the end of August and the end of October, refineries shut down for normal maintenance. Over the last 20 years, the average drop in refinery utilization has been 4.8%. However, in years when the utilization rate was 95%, the decline in utilization has been higher, likely due to the wear and tear from higher usage. In 2004, when the utilization rate was 95%, the decline in the utilization rate was 7.1%. Based on current capacity, the demand for oil from refineries could fall by 1.3 million barrels a day during October if the utilization drops to 88%. Potentially, the drop in refinery demand is almost four times the fall off in oil production, which means stockpiles of oil held in storage are likely to begin climbing in coming weeks. We doubt the oil market will greet the increase in stockpiles as good news when it is reported by the Energy Administration Agency each Wednesday in October.

Last year China consumed more than 12% of global oil production. Although China’s consumption will climb in coming months, the rate of increase will be less than last year. If our assessment of the emerging markets is on target, demand for oil from emerging economies will certainly show less growth, and in some countries it may actually decline for a period of time. Although it will take Iran six to 12 months to significantly ramp up its production of oil, the oil it has in storage and in tankers can be added to global supply fairly quickly. At a minimum, we think another decline in WTI oil is likely and could retest the late August low. If a dislocation in an EM country develops that disrupts global financial markets, WTI oil could make a run at the 2008 low near $34 a barrel.

Dollar – Technical

In the April MSR, we thought the dollar index had entered a consolidation/corrective period that would include a fair amount of choppy trading. We thought the dollar index would decline to 92.60–94.77 from the mid-March high of 100.38 before another rally took hold. In the July MSR, we revised our downside range to 90.20–93.30 and thought a decline into this range would complete the correction that commenced after the mid-March high. The dollar reached a low of 92.52 on August 24 before reversing higher.

As noted previously, we expect the dollar to rally above 100.38 in coming months. We think European Central Bank (ECB) president Mario Draghi will drop a few more hints that the ECB is considering extending the September 2016 deadline on its quantitative easing (QE) program or increasing the amount of its monthly purchases. Foreign currency traders will jump on the short-theeuro bandwagon as they did in May 2014 after Draghi noted that the strength in the euro had lowered inflation in the eurozone more than the ECB wanted. If the euro falls to a new low as we expect, the 6%–7% decline from current levels would almost be enough to push the dollar to a new high since the euro comprises 57% of the dollar index. The new high could also come as a result of more weakness in EM currencies, even though they have no representation in the dollar index. If EM currency weakness spills over into global financial markets, the dollar will strengthen as a result of a flight to quality. Our guess is that the dollar index can reach 103.00–106.00 in coming months.

Euro – Technical

In the May 2014 MSR we suggested shorting the euro when it was trading above 1.3800. In the April 2015 MSR we suggested covering a portion of the short position when the euro traded under 1.0650, which it did in mid-April, since we thought the euro could rally to 1.1100 – 1.1500. In the July 2015 MSR, we thought the euro would exceed the 1.1472 high it recorded on May 15 and rally to 1.1700 – 1.1850, which would complete the countertrend rally from the mid-March low. We suggested using a portion of the short trade that was covered below 1.0650 to re-short the euro above 1.1700. On August 24, the euro traded above 1.1700 before reversing lower. We would use 1.1575 as a stop on that portion of the short trade. We think the euro will at least fall below its March 2015 low before a significant rally is likely.

At the September 3 meeting of the ECB’s Governing Council, the ECB lowered its forecast for GDP growth in 2015 to 1.4% from 1.5% and lowered its estimate of inflation to 0.1%. More importantly, Draghi laid the groundwork for the ECB to expand its QE program:

“The Governing Council wanted to emphasize its willingness to act, its readiness to act and its ability to act.”

Toward that goal, the ECB increased the share of an individual bond issue it can purchase from 25% to 33%. This change will make it easier for the ECB to increase the $66.7 billion in its monthly purchases of government bonds. We suspect the euro will weaken in anticipation of an expansion in the ECB’s QE program if growth fails to pick up and inflation remains well below the ECB’s 2% inflation target.

Gold – Technical

In the August MSR, we laid out the reasons why gold was likely to make an intermediate low under $1,081 and be followed by a rally to $1,200–$1,224 before year-end. We noted on July 22 that gold had closed below $1,100 for the first time since March 2010 and had declined for 10 consecutive days, the longest losing streak since 1996. Our guess was that gold would make a trading low between $1,050 and $1,081. Gold bottomed at $1,077.25 on July 24, rallied above $1,160, and then pulled back to $1,098.45 on September 11. According to the Commodity Futures Trading Commission’s Commitments of Traders report in mid-September, speculators had the lowest long exposure to gold in late July and early September than at any time in the last 12 years. Speculators have historically been wrong about the intermediate trend in gold, especially when they are overly bullish or bearish, as they are now. We expect gold to rally to $1,185–$1,224, with a chance it could rally up to $1,300 in coming months as long as it holds above $1,085.

Bonds – Technical

Hedge funds and other speculators held the largest net aggregate short position in all the interest rate contracts traded through the Chicago Mercantile Exchange in mid-September, according to the CME Group. When the Fed announced it was not raising rates at its September 17 meeting, Treasury bond prices rose, which pressured those who were short to buy back their short positions. Technically, the interesting aspect is that despite the Fed’s decision, and the subsequent buying (short covering) it coerced, the yield on the 10-year U.S. Treasury bond was unable to fall back into the channel we’ve often discussed. Since early June, the only time the 10-year Treasury yield did reenter the channel (between the two red trend lines on the nearby graph) was when the stock market was falling apart on August 20, 21 and 24. After the stock market stabilized, the 10-year yield popped outside the channel on August 25.

The inability of the 10-year yield to re-enter the channel indicates that the path of least resistance is for the 10-year Treasury yield to rise and eventually climb above 3.03%. As we wrote last month, we don’t think the move higher in yields will begin in earnest until later this year or early 2016. This suggests being short bonds is the right side of the market to be on, using the upper boundary of the channel as a stop. This strategy should offer some risk management if a mini-crisis develops in emerging markets. As this is being written on September 23 and based on the chart, the stop on a short position would come in near 2.07%.


In the August MSR, which we finished writing on July 23, three days after the S&P 500 closed at 2,128.28, we made the following points:

“The stock market is at the second or third most expensive level in the past 100 years based on a number of valuation methods… and the market’s internal strength has weakened considerably since late April [based on the NYSE advance-decline line and the percent of stocks above their 200-day average]. All that remains before a 4%–7% correction occurs is for a reason to sell to appear. 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 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 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 1,850.”

We thought the market was okay as long as the S&P 500 did not close below 2,044.

The S&P 500 closed below 2,044 on August 21 and traded as low as 1,867 on August 24 as the Chinese stock market plunged and oil traded under $40 a barrel. Once the S&P 500 closed below 2,044, our proprietary Major Trend Indicator (MTI) turned negative for the first time since November 30, 2011. The MTI suggests that the stock market is vulnerable to a decline of more than 10% and potentially a bear market. After the Fed announced it would not increase rates on September 17, the S&P 500 rebounded to 2,021 before violently reversing lower. In our weekly technical review on Monday, September 14, we discussed that the most surprising outcome would not be if the Fed does not raise rates, but that the market experiences a rally failure as investors’ concerns about global growth are reinforced, resulting in a wave of selling pressure. The Fed’s post FOMC meeting press release stated:

“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

As we have discussed, there is the potential for an unknown amount of stress from the large declines in emerging market currencies and overleveraged energy companies in coming months. At a minimum, global economic growth will be slower, even if the U.S. remains relatively stable. The risk of a recession in the U.S. is low, but that doesn’t mean U.S. financial markets are not vulnerable. The S&P 500 rallied from a low of 1,074 in October 2011 to a high of 2,134 in May 2015. A 38.2% retracement of the 1,060 point rally would bring the S&P 500 down to 1,729. We have no idea if this is what lies ahead. We do know that the market’s technical health deteriorated for months prior to the sharp sell-off in August and the health of the global economy is likely to get worse before it improves.

This combination suggests that surprises are more likely to be negative than positive. If the S&P 500 does fall to 1,729, it will have declined by 19%, which is almost identical to the percentage decline in 2011. We would also expect central banks to intervene with more accommodation to try to minimize the economic fallout from such a decline.

  1. Press release, Board of Governors of the Federal Reserve System, September 17, 2015.
  2. Jack Ewing, “Draghi Says E.C.B. Is Ready to Expand Stimulus, but Not Yet,” The New York Times, September 3, 2015.
  3. Press release, Board of Governors of the Federal Reserve System, September 17, 2015.

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.

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

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.

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

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.

A Fibonacci number refers to a number sequence in which each number is the sum of the previous two numbers. The concept was introduced to the West by Italian mathematician Leonardo Fibonacci.

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.

London Interbank Offered Rate (LIBOR) is the interest rate that banks in the London interbank market charge each other for short-term loans. It is the world's most widely used benchmark for short-term interest rates.

Major Trend Indicator is a proprietary technical tool that measures the strength or weakness of the market and helps identify bull and bear phases. During bull markets it helps indicate when the market may be vulnerable to

a correction, and during bear markets it helps identify a potential rally.

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.

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.

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.

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.

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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