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posted on 27 January 2016

Central Bank Malpractice And Global Investor Culpability

by Jim Welsh

Macro Tides Investment Outlook - 26 January 2016

Macro Factors With Impact On Monetary Policy, The Economy, And Financial Markets

As discussed in the January 13 Weekly Technical Review, I thought the S&P would break below the August 24 low of 1867 and likely test the October 2014 low of 1820. At its nadir on Wednesday January 20, the S&P500 was down 11.3% from its close on December 31.

At one point during trading on January 20, there were 3000 issues down on the NYSE compared to just 100 issues that were up. I've been watching the stock market for more than 30 years and a ratio of 30 stocks down for each 1 up has happened a handful of occasions. A rebound in oil prices on Wednesday January 20 helped the S&P to close at 1859, 2.6% off the intra-day low of 1812. Before the market opened on Thursday morning, comments from the president of the ECB, Mario "Whatever it takes" Draghi, helped the market to rally further on Thursday and Friday.

After the ECB's governing council meeting, Draghi disputed the notion that central banks are running out of options to counteract the disinflationary forces from weak global demand and business investment, excess capacity in developing countries, and the plunge in oil prices. Draghi stated, "We are not surrendering, we don't give up". For all we know those may have been General Custer's last words at Little Big Horn in June 1876. To further make his point, Mario went on to say "We have plenty of instruments to deploy" and "no limits" on how far they might be deployed. In December the ECB lowered the rate it charges banks to hold assets overnight to a negative -.3% to force banks to increase lending. Conceivably, the negative deposit rate could be lowered even more, but banks are not going to increase lending if economic growth and the credit worthiness of borrowers does't improve.

I have no doubt that the ECB will do more, since everything they've done has failed to generate solid economic growth in the European Union or an increase in inflation. In 2015, GDP in the Eurozone was 1.5%, and is not likely to improve much in 2016. In January Markit's survey of 5,000 purchasing managers fell to an 11-month low, so manufacturing in the EU has slowed just as it has in the U.S. Citi Research has forecast growth of 1.7% this year, and an inflation rate of .5%, which is way below the ECB's 2% target. Bank lending is likely to be one of the headwinds in 2016 that limits how much GDP growth improves. Bank lending is responsible for 70% of credit creation in the EU, compared to 35% in the U.S. The EU is thus far more dependent on a healthy banking system. Although banks throughout the EU are in much better shape than in 2012, problems remain. EU banks are still dealing with $1 trillion of nonperforming loans, which represent about 5% of total bank assets. Italian banks hold more than 25% of the EU's total of non-performing loans, and represent 12% of Italian bank assets. Until nonperforming loans shrink throughout the EU banking system, lending is apt to be somewhat constrained as banks continue to strengthen their balance sheets to meet the Basil III standards in 2019.

Although extreme monetary accommodation by the Federal Reserve, ECB, and Bank of Japan has not achieved the desired economic result, it has boosted equity values well beyond reasonable valuations. In the U.S., stock prices in mid-2015 reached the second most expensive level since 1900, based on the Buffett Indicator. (Chart by Doug Short, Advisor Perspectives) The Fed expected (hoped) consumer spending would accelerate as consumers felt wealthier, especially those in the top 10%. Although the growth in consumer spending was a decent 3% in 2014 and 2015, it wasn't enough lift GDP above the 2.5% growth rut the economy has been mired in for the last 4 years.

As I have discussed many times, one of the unintended consequences of the Fed's monetary policy has been the dearth of business investment. Rather than taking the risk of investing in research and development or purchasing more efficient equipment, companies have chosen to capitalize on the extended period of low interest rates by buying their stock, often with borrowed money. Since 2009 companies have increased investment by 43% and dividend payouts by 67%. Share buy backs have soared 194%, or 4.5 times as much as business investment. Reducing share count may increase earnings per share in the short run, but the lack of business investment is sure to mean less innovation and productivity during the next three to five years. It should come as no surprise then that productivity growth since 2009 has been a dismally low 1%. But it has created a windfall for executives whose compensation is tied through stock options to the value of their company's stock. SEC rules preclude a portfolio manager buying a stock in their personal account before purchasing it for clients. However, the SEC has allowed corporations to purchase almost $3 trillion in share buybacks since 2010, despite what seems like an obvious conflict of interest between executives and share holders.

As of September 30, 2015, buybacks in 2015 were approaching the prior peak in 2007 and may have surpassed it by the end of 2015. Stock buybacks plunged by more than 75% in 2009, after the S&P had lost more than 57% of its value. In other words, companies bought high, but didn't buy when stock prices were cheap. I suspect the misallocation of capital from stock buybacks could prove more costly from the current buyback binge, since corporations have borrowed so much to purchase stocks that are clearly overvalued. Stock buybacks have played a significant role in lifting stock prices in recent years. A lessening of buybacks would also weaken this source of demand, and leave stocks vulnerable to a deeper decline.

Corporate profits as a percent of GDP reached their highest level in 50 years in 2015, while wages and salaries as a percent of GDP were at a 50 year low. Despite the Fed's unprecedented accommodative monetary policy, GDP growth has averaged just 60% of the average post "World War II recovery, a paltry amount of business investment, and an increase in income inequality. Given the Fed's 'success', should we be surprised that the campaign of an avowed socialist is resonating, especially with young people.

The Fed's post FOMC statement on January 27 will likely repeat that they are data dependent and will note the healthy employment growth in recent months and their expectation that the U.S. economy will continue on the path of moderate growth. They are likely to acknowledge that inflation remains below their target of 2%, and that they will monitor global developments. My guess is that investors will read between the lines and infer that a rate hike at the March meeting is a low probability. The stock market is still oversold on an intermediate basis and sentiment has become more cautious. The AAII and Investors Intelligence weekly surveys have recorded more bears than bulls for a number of weeks, and put buying has become overly fashionable. If a modestly positive spin is put on the FOMC statement, the S&P is likely to rally above 1909, with a run up to 1934-1950 likely, with a push up to 1990-2010 possible. Given how much the market has been moving in a matter of hours, this rally may only last a couple of weeks. As I noted in the January 13 Weekly Technical Review, my proprietary Major Trend Indicator (MTI) turned bearish on January 6 when the S&P closed at 1990 and below 1993. This was an important level since it was the initial high on August 28 after the August 24, 2015 low, and the low for the month of December. The bearish signal from the MTI suggests that the stock market has entered a bear market. Despite the expected rebound in coming days or weeks, a decline below last week's low at 1812 is likely sooner or later.

The dichotomy between the real economic impact of central bank accommodation, and investor's Pavlovian positive response to any hint of additional easing, borders on irrationality. I'll use the following metaphor to illustrate. A good friend comes down with the common cold. After two weeks of over-the-counter medications and no improvement, your friend visits the doctor, who prescribes an antibiotic. Two weeks later, your friend is running a fever of 103 and is admitted to a hospital. After tests and more medications, your friend's condition worsens and is admitted to the ICU. Granted the global economy is not in the ICU, but global growth is well short of the 5.2% in 2007, and after seven years of unprecedented monetary stimulus and coordination, is likely to be around 3% in 2016.

As your friend's health deteriorated, the last reaction you would have is more optimism about the outcome. In other words, as your friend failed to respond to the prescribed treatments, your confidence in the doctor's ability would have waned, not increased. Central bankers have been treating the patient for seven years, but a sustainable recovery in the U.S., EU, Japan, and the global economy remains elusive. Despite this economic reality, it is amazing to me that investors still view central bank promises of more of the same failed strategy as a reason to buy more overpriced stocks. One day global investors will wake up and realize their mindless bullishness has been unwarranted. If and when that day arrives, global equity markets could be especially vulnerable, since investors will no longer believe central bankers can come to the rescue.

Fed Policy and the Dollar

The Fed has forecast that it will increase the federal funds rate 4 times in 2016 and 4 more times in 2017. The odds that the U.S. and the global economy will warrant 8 rate hikes within two years is virtually zero, or about as likely as the Cubs winning the World Series in 2016. As mentioned, I think the Fed's FOMC statement will allow investors to conclude the Fed will not raise rates in March. If correct, the Dollar may weaken as global investors become more confident that there will not be 4 increases in 2016 and 4 more in 2017. On the surface it seems so obvious that the dollar will continue to rise. The Fed is going to raise rates, while the ECB pursues more accommodation, while the Bank of Japan and People's Bank of China contemplate more easing. This is why the majority of global investors are bullish the dollar and already positioned for the Dollar to rise and the Euro to fall. Although Mario Draghi was explicit in raising expectations for more ECB accommodation, the Euro did not weaken as much as onewould have expected, since so many global investors are already short the Euro. After Mario's comments, the Euro only fell -1.3% and, as of January 26, was only down -.4%. If the Euro closes above 1.1020, a bout of short covering could easily lift it to 1.1275 to 1.1400.

The Euro represents 57.6% of the Dollar index, so a 3% rally in the Euro would shave 1.5% off the Dollar index. The Dollar index has struggled to break out above the 100.36 high reached on March 13, and is thus ripe for a modest pullback. However, the Trade Weighted Dollar index presents an entirely different perspective. The table nearby shows how much different the weightings are between the Dollar index and the Trade Weighted Dollar, which includes many emerging market currencies. As of January 15, the Trade Weighted Dollar was +6.5% above its March 13 peak, while the Dollar index is about -1.0% below its March high as of January 25.

This difference is important since it reflects the decline in the Chinese Yuan and continued weakness in other EM currencies, even as the Euro and the Dollar index have tread water since last March.

Dollar denominated debt in emerging countries has soared from $6.0 trillion in 2010 to $9.6 trillion in June 2015. International bank loans to EM countries have increased in the last five years from $1 trillion to $3 trillion. The risk of defaults and nonperforming loans has risen significantly, as many EM currencies have declined since mid-2014 versus the dollar by 15% to 25% and more. A further increase in the Trade Weight Dollar index will only intensify the burden of dollar denominated debt and weigh on emerging countries growth in 2016 and 2017. This suggests that global growth is not likely to pick up in 2016, which is another reason why I don't think the Fed will be able to hike rates 4 times in 2016 and 2017.

If the Dollar index does decline modestly in coming weeks, it should be positive for risk asset in general. When the Dollar index fell by -7.1% between mid-March and mid-May, the emerging market ETF (EEM) rallied 15% and oil jumped 20%. However, during this period, the Trade Weighted Dollar only dropped by -4.3%. This shallow decline, compared to the -7.1% fall in the Dollar index, presaged the subsequent breakout above the March high in the Trade Weighted Dollar index. If the Trade Weighted Dollar continues to display positive relative strength versus the Dollar index during a correction, I would expect the Dollar index to ultimately breakout above 100.36 at some point in 2016. If I am wrong about a near term correction in the Dollar index, and it closes above 100.36 in coming weeks, risk assets will not rally and likely endure another selling wave.

Gold and Gold Stocks

On December 30, I recommended gold and gold stocks. Since December 31, the gold ETF (GLD) is up 5.7%, and the gold stock ETF (GDX) is up 1.8%. The S&P has lost -6.8% since the end of the year. If this strong relative performance can be maintained, it will attract money (hedge funds) that are always looking for whatever is working. Selling 25% of GLD if it trades up to 111.00 and 25% of GDX at 14.98 seems prudent, especially if the Dollar index does manage to close above 100.36 in the next several weeks. I would use a stop on GLD of 102.40, and increase it to 104.50 if GLD trades above 110.00. I would use a stop of $13.16 for GDX, and increase it to $13.40 on half of the position if GDX trades above $14.50.


As expected last spring, oil tested its 2008 low and subsequently dropped below $28.00 a barrel. The imbalance between supply and demand has not improved and is likely to worsen in coming months. Iran is bringing more oil to a market that has been suffering from a glut of oil for 18 months. In February and March, oil refineries will shut down for maintenance, which could reduce demand for oil by 500,000 to 1 million barrels a day. However, in the short term, too many traders are short oil, since the trend has been negative and fundamentals are so clearly unfavorable. If the Dollar index weakens and risk assets in general rally, oil could run up to $36.00-$38.00 a barrel. After a short covering rally of this magnitude, the fundamentals are likely to reassert the long term down trend and lead to at least a test of $30.00 a barrel.


On January 6, the Major Trend Indicator generated a bear market signal when the S&P closed at 1990 and below 1993. This level was important since it was the high on August 28 after the August 24 low, and it was the low in December. Historically, it has been a negative portent for the stock market when the S&P falls below the December low in January.

In my January 13 Weekly Technical Review I thought the S&P was likely to close below the August 24 low of 1867, which would at least lead to a test of the October 2014 low of 1820. This unfolded on January 20, when the S&P dipped to 1812 before rebounding. From its high of 2134 in May, the S&P lost 322 points. If the dollar declines as I expect, the S&P is likely to rebound to 1934-1950, and would recover 61.8% of its losses if it rallied to 1990-2010 is possible. This rally is likely to be choppy, as the market is buffeted by negative news. The most important point is not how much the market rebounds in the short term, but that another decline is coming. My guess is the S&P will drop to 1750 and potentially 1600 before this bear market is over.

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