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posted on 12 May 2016

Japan Is Searching For A Wormhole

Written by

Are Central Banks Starting to Lose Control Over Markets? MacroTides Investment Outlook: 10 May 2016

In 1935, Albert Einstein and Nathan Rosen used the Theory of General Relativity to propose the existence of "bridges", or wormholes through space-time. Wormholes connect two different points in space-time, creating a shortcut that could reduce travel/time distance, and the creation of a very different reality. A wormhole could allow Japan to travel to a place and time in another universe where the Japanese economy would be spared the fate of a super nova that collapses in upon itself ending in a black hole.

wormhole.380x220

Unfortunately, the existence of wormholes has yet to be proven, so Japan will inexorably slide toward a debt deflationary collapse within the next decade.

It wasn't supposed to end like this. In the fall of 2012, Prime Minister Abe was elected on an economic platform that relied on a significant depreciation in the Yen, a doubling of the money supply, and a restructuring of Japan's static labor market. The 3 arrows of 'Abenomics', as it was dubbed, was expected to increase GDP growth and inflation to an annual rate of 2% and finally reverse the affects of deflation that had weighed on the Japanese economy for more than 20 years.

The lack of success of Abenomics since 2012 reminds me of the 1955 song "Sixteen Tons" about working in a coal mine. "You load sixteen tons and what do you get? Another day older and deeper in debt." In February, the Ministry of Internal Affairs and Communication reported that Japan's population contracted by 0.7% between 2010 and 2015. Nearly a third of all Japanese citizens were older than 65 in 2015.

Since the early 1980's the birth rate has hovered around 1.4 children per woman, far below the 2.1 birth rate needed to sustain population growth. The persistent low birth rate has caused each succeeding generation to be smaller than the proceeding generation. The proportion of working age citizens will shrink even as Japan's population shrinks, and adversely affect economic growth in coming decades. The Population Division of the U.N. Department of Economic and Social Affairs estimates that Japan's population will fall from 127 million in 2015 to under 100 million by 2060.

welsh.mt.2016.may.fig.1

Since 1990, Japan's total debt to GDP ratio has climbed from 530% to 650%, the highest in the world. For each $1.00 in GDP, Japan has $6.50 of debt. There is very little chance that this mountain of debt will be repaid. The only reason Japan has been able to avoid a financial crisis like Greece is that more than 90% of the debt is owned by Japanese institutions and savers.

In 1975, Japan's savings rate was 23.1%. The future funding of Japanese debt will become increasingly more difficult since the savings rate fell below zero percent in 2014 for the first time since records began in 1955. Japan could run short of the savings it needs to internally fund its debt by 2020, according to Goldman Sachs.

This means Japan will be progressively dependent on the kindness of strangers to fund its debt and I suspect strangers will demand higher yields. After adjusting for inflation, wages declined -0.9% in 2015. Despite pressure from Prime Minister Abe, Japanese corporations offered union workers a pay increase of $13 a month for 2016 compared to increases of $35 a month in 2015. The savings rate is not likely to increase anytime soon since wage growth is virtually nil, so most Japanese workers don't have the excess income to save.

welsh.mt.2016.may.fig.2

In the fourth quarter of 2015, GDP contracted by -1.1% and has contracted in five of the past twelve quarters. For all of 2015 GDP grew 0.4%, well below the Abenomic's goal of 2% growth.

Trade used to be the backbone of the Japanese economy. In March exports were -6.8% below March 2015 and have fallen for six straight months. This is remarkable given the huge decline in the value of the Yen since October 2012, which was intended to make Japanese goods cheaper and spur a surge in exports. The decline in exports is also a reflection of the lack of growth in the global economy. In March, Japan's all items Consumer Price Index was down -0.1% from a year ago, while the core CP was up +0.7% from March 2015. Both inflation measures have been trending in the wrong direction and remain below the BOJ's 2% inflation target. According to a survey by the Bank of Japan (BOJ), inflation expectations fell to a three year low in the first quarter.

welsh.mt.2016.may.fig.3

In response to Abenomic's inability to generate economic growth and inflation of 2%, Bank of Japan Governor Haruhiko Kuroda announced on January 28 that interest rates would be a negative -.1%. Rather than weakening the Yen as expected, the Yen rallied on the news and Japanese stocks fell.

In February consumer sentiment fell by the most in more than two years. Many senior citizens purchased safes to hoard cash due to fears commercial banks may eventually charge them interest on their deposits.

In April, Nippon Life Insurance suspended the sale of a savings product that had generated $3.2 billion in revenue in the prior nine months due to negative rates. Banks have experienced smaller profit margins and trading in Japan's short term money market has plunged by more than 70%.

In response to the unprecedented backlash to negative rates from politicians, business leaders, and the public, BOJ governor Kuroda has been called into Parliament repeatedly to answer questions about the negative rate policy. As of March 10, Kuroda has visited Parliament 25 times, which is more than triple any prior BOJ governor has been called to Parliament since 2003. Given the breadth of the blowback the BOJ has received since it announced its negative interest rate policy on January 28, it was not a surprise that the BOJ decided not to push rates deeper into negative territory at the April 28 meeting.

Since the financial crisis central banks have been very successful in getting the outcome they wanted. The Federal Reserve wanted to lift asset prices through quantitative easing and equity and home prices rose. The European Central Bank wanted sovereign debt yields to fall throughout the European Union after Mario Draghi said the ECB would do 'Whatever it takes', and bond yields promptly collapsed. In the fall of 2012, Japan wanted its currency to decline and by mid-2015 it had lost more than half of its value versus the dollar, while the Nikkei 225 soared 140% from October 2012 until mid 2015. It is thus noteworthy that the Yen has rallied more than 10% since the BOJ adopted negative rates, which is the exact opposite of what the BOJ wanted. This is significant and may be the first concrete sign that the sway over global investors central banks have exercised to manipulate financial markets is beginning to wane.

The Euro has also strengthened since the ECB adopted negative rates and expanded its QE program. The People's Bank of China has expanded credit by $1 trillion in the first 3 months of 2016 to stimulate growth, but the Shanghai Composite has continued to languish.

The Fed, ECB, and BOJ have endeavored to spur an increase in inflation toward 2% for years without success, and sustainable economic growth in the U.S. and E.U with only modest success.

I don't know when the light bulb turns on and global investors realize that central banks are impotent. I believe it is not a question of if that happens, only when, and these signs suggest that central banks are on the clock. This reality will not dissuade the BOJ from doing more. My guess is they will increase their purchases of stocks and may intervene directly in the foreign exchange market to push the Yen down. Given the overwhelming negative response to negative rates, the BOJ will be reluctant to go more negative with interest rates.

China

In recent months Chinese securities regulators, media censors, and government officials have issued warnings to economists, investment analysts, and business reporters who have delivered less than rosy assessments of the Chinese economy. This censorship tells us far more about the real health of the Chinese economy than the Chinese government saying GDP grew 6.7% in the first quarter. Chinese authorities would not be trying to muzzle analysis that casts doubt on how well the economy is performing, if the criticism wasn't true.

Gao Shanwew, a well known chief economist at Essence Securities, spoke at an investment conference in Hong Kong in mid-April. He told the audience that "A lot of the official data aren't reliable" and the Chinese economy still faces "big problems." Two days later he said those remarks were "made up" and issued a report that was devoid of any critical comments.

Policy actions in the first quarter suggest policy makers are responding as if growth in the first quarter was far weaker than reported. Credit expanded by $1 trillion in the first quarter, which represents 10% of China's GDP. In the wake of the 2008 financial crisis, China launched a stimulus program, which coincidently was also 10% of GDP. The size of the current stimulus program begs the question: Is the state of the Chinese economy that dire? During the last 15 years, exports were a driving force behind China's double digit growth. After exports plunged in the wake of the financial crisis in 2009, China's stimulus program, coupled with fiscal stimulus from every major country in the world, enabled exports to rebound strongly in 2010 and hold above 20% year over year (Y-O-Y) through 2011.

After peaking in July 2010, the quarterly YOY figures illustrate how export growth has been trending lower for years. In the first quarter of 2016, exports were 10% below where they were in the first quarter of 2015, and the weakest since 2009, even after jumping 11.5% in March. Since trade is a two-way street, the weakness in China's exports is also a reflection of the overall health of the global economy, which is why demand for Chinese goods around the world is weak.

welsh.mt.2016.may.fig.4

The huge size of the 2008 stimulus program led to many of the problems that beset the Chinese economy today. China's debt to GDP has soared from 150% in 2008 to 300% today. While the increase in debt initially lifted China's GDP growth rate to 10.4%, it has since slid to 6.9% in 2015. GDP increased by only $175 billion in the first quarter, even as debt increased by $1 trillion. For each $1 dollar of new debt, GDP only grew by $0.16. The imbalance between economic growth and debt is unsustainable and will end badly, despite the censoring of negative analysis.

welsh.mt.2016.may.fig.5

In the wake of debt induced growth in since 2008, China is left with an enormous amount of excess capacity in industries that do not have the cash flow to service their debt. Cities were built that in some cases are empty. China's cement, glass, aluminum, and steel makers are among the most heavily leveraged companies, and most are running at less than 70% of capacity. China's steel makers have the capacity to produce 1 billion tons of capacity, four times the capacity of U.S. steel companies. In April, the International Monetary Fund found that nearly 600 companies had almost $400 billion of debt that was considered at risk, accounting for 14% of total corporate borrowing.

The impact of the first quarter surge in credit is apparent. Cement production jumped 24% in March from a year ago, while steel production climbed 2.9% versus a 5.7% decline during January and February. Business investment by state owned enterprises (SOE) increased by 23.3%, compared to just 5.7% for private firms. The difference reflects the reliance of policy makers to execute policy initiatives through state owned banks and directed lending to SOE's.

China requires its banks to hold 150% of their bad loans in cash. As discussed in the April commentary, nonperforming loans have begun to increase for China's banks, forcing banks to increase cash reserves. In the first quarter, Industrial and Commercial Bank of China, the world's largest lender by assets, lowered its cash to bad loan ratio to 141%. Bank of China, the fourth largest lender in China, lowered its ratio to 149%. The China Banking Regulatory Commission has not revised the guideline or commented. If China's banks hold less cash for bad loans, they can lend more which appears what policy makers want.

The People's Bank of China has proposed a plan that is truly breathtaking in its level of desperation. State owned enterprises are burdened with too much debt, excess capacity, and an inability to repay bank loans. Banks have addressed this problem up until now through the practice of "evergreening", whereby banks roll over loans simply to repay old debt. As I noted in the April commentary, banks net profit fell to 2.43% in 2015, down from 30% in 2011, when the economy was buzzing after the post crisis stimulus program.

In order to address the debt burdens of SOE's and bank's low profitability, the Peoples Bank of China (PBOC) has proposed an ingenious scheme that will make conditions look better, but do nothing to address China's fundamental problems of excess capacity and overleveraged banking system. The PBOC's scheme will allow over indebted companies to issue equity to banks in lieu of paying back nonperforming loans. This would allow a company to reduce its debt leverage and boost cash flow since interest payments would no longer be required. Banks would be allowed to remove the value of the nonperforming loans off their books. This will make their balance sheets appear stronger.

This slight-of-hand bookkeeping will postpone any meaningful restructuring of pernicious excess capacity in SOE's, and undermine the long term solvency of the Chinese banking system.

Banking rules generally forbid commercial banks from taking ownership positions in non-financial companies. However, China's State-owned Assets Supervision and Administration Commission is pushing for changes in the rules to help heavily indebted state companies. Any doubt the rules will be changed?


Author's note: The volume for last year in stocks has been advanced by 12 months in the graphic below.


welsh.mt.2016.may.fig.6

The surge in liquidity in the first quarter has not lifted the Shanghai Composite, but it has surfaced in a number of commodity markets. The margin for trading stocks is 50%, but only 10% for commodities.

On March 7, the price of iron ore rose 20%, its biggest one-day move ever. By April 21, iron ore was up 52%, a 15 month high. Egg futures have surged by more than 30% since early March, along with the price for cotton, corn, copper and steel rebar. In mid-April, the frenzy made the steel rebar contract the most actively traded futures contract in the world, exceeding oil and currencies contracts. On April 22, $261 billion of futures were traded in a single day, exceeding the trading volume in the Shanghai Composite when stock trading was the rage in March 2015. During April, $330 billion in iron ore futures were traded, double the turnover in February, and four times the amount traded internationally in physical iron ore in a year.

The speculation in commodity futures markets is not an indication of actual demand in the Chinese economy. In the short run, the Uber stimulus provided by the PBOC has lifted retail sales, industrial production, and fixed-asset investment. This has and will continue to allay concerns in the short run about the Chinese economy. However, investors need to understand that this represents only a short term fix that increases the risk of a hard landing in China.

welsh.mt.2016.may.fig.7

George Soros recently said the debt problem in the Chinese economy:

"Eerily resembles what happened during the financial crisis in the U.S. in 2007 and 2008, which was similarly fueled by credit growth. Most of the money banks are supplying is needed to keep bad debts and loss-making enterprises alive."

As I wrote last month:

"Even China can't afford to keep throwing good money after bad loans."

U.S. Economy

In the first quarter GDP slowed to 0.5%, down from 1.4% in the fourth quarter. The factors that contributed to the slowdown are likely to improve in the second quarter. Consumer spending slumped to 1.9% compared to 2.4% in the last quarter of 2015. Income growth, as measured by four week average of the annual growth rate in withheld income and employment taxes, dropped from 4.2% in early January to just 2% in March. It has since rebounded to 4.5% as of May 3, which will provide consumers the wherewithal to increase spending. This was reinforced when the Labor Department reported that average hourly earnings rose 2.5% in April. Wage growth has finally begun to creep higher after languishing for more than 5 years at an annual rate of 2.2%.

welsh.mt.2016.may.fig.8

Companies reduced inventories in the first quarter, which shaved 0.33% off of GDP. If sales pick up in the second quarter, companies will need to replenish inventories, which will add to GDP growth in the second or third quarter. The largest drag came from non-residential fixed investment which lowered GDP by -0.60%. Most of this decline came from a decline in equipment and structures which reflects the dramatic cuts in spending by energy related firms. This drag is likely to lessen since oil companies have been slashing spending for more than a year.

In 2014, GDP rebounded in the second quarter by +4.6%, after contracting -0.9% in the first quarter. Second quarter GDP jumped 3.9% in 2014, after rising only 0.6% in the first quarter. GDP is poised for a rebound this year as well, if consumers open their wallets a little more, inventories are pared, and energy companies don't lower spending as much as they did in the first quarter. I don't think the economy will snap back as much as it did in 2014 and 2015. However, the improvement should be enough to resurrect the discussion of a possible rate increase at the Fed's June 15 meeting. Since the Federal funds futures peg the odds of a June rate hike at less than 10%, investors will be unpleasantly surprised by the prospect, since I think it will result in a rally in the dollar. If this unfolds as I expect, many of the markets that have rallied since February 11 could experience a fairly sharp correction before the end of June.

Federal Reserve

When the Federal Reserve held its FOMC meeting on April 26-27, much had changed since their prior meeting on March 16, when the Fed said:

"global economic and financial developments continue to pose risks, and inflation is expected to remain low because of earlier declines in energy prices".

By April 27, international financial markets had stabilized and were well off their February lows, unemployment claims had fallen to their lowest level since 1973, the dollar was lower by 4%, the CPI for services was up 2.7% from March 2015, and oil prices had rebounded by more than 60% from their low in February.

In my Weekly Technical Review on April 25, I thought the hawks on the Fed board would make the case for a rate hike in June. The hawks are concerned that the Fed could fall behind the inflation curve and be forced to raise rates more aggressively in 2017, which could cause more volatility in the stock market and threaten the economy. I also thought that if there was a chance for a rate hike in June, the hawks on the Fed would suggest that the Fed needed to 'communicate' this potential to markets. During the week of May 2, three district presidents (Williams San Francisco, Lockhart Atlanta, Dudley New York) gave a speech or an interview in which they supported the Fed's projection of 2 rate hikes in 2016, with John Williams saying 2 or 3 increases were possible.

As the Fed and individual Fed governors have emphasized, the Fed is data dependent. The expectation of two rate increases in 2016 is predicated on economic data coming in as they have forecast. Given the Fed's forecasting record, no one should interpret any statement by any Fed governor as gospel, since the Fed's forecasting record is no better than the average economist and has consistently been overly optimistic regarding growth for years.

When the Fed reduced projected rate increases in 2016 from 4 to at the March FOMC meeting, the Fed was trying to align its forecast with market expectations. With GDP growth slowing to just 0.5% in the first quarter, market expectations shifted, with most participants only expecting one increase, with it likely occurring after the election at the December meeting.

With 3 district presidents saying two increases seemed reasonable last week, I think the Fed is telegraphing that a June increase was discussed at length during the April FOMC meeting. The minutes of the April FOMC meeting will be released on May 18, and could move markets if my suspicion is correct.

The comments by the district presidents also represent an attempt by the Fed to keep market expectations from drifting too far away from the Fed's projection of two increases. The bottom line is that the Fed wants each meeting to retain the potential of a rate increase, and for market participants to be prepared for this potential. Even though Fed members don't know whether they will vote for an increase in June, they do not want to surprise financial markets if they do. If I'm right about the economy rebounding in the second quarter, the hawks on the FOMC will have more bargaining power at the June 15 meeting.

Dollar

As discussed in the May 2 Weekly Technical Review, I thought the dollar would bottom between 92.00 and 93.00 in the first half of May. "The price pattern has, or is close to, completing a big A, B, C correction of the dollar's 21 point move up from its low of 79.00 in May 2014." Based on how the dollar traded on Tuesday May 3, the low may have occurred. From a high of 100.39 in March 2015, the dollar dropped to 92.62 on August 24 (Wave A), before rebounding to 100.51 on December 2 (Wave B). The dollar then dropped to 91.88 last Tuesday before reversing and closing at 92.93. This appears to be the end of Wave C.

Click for larger image.

welsh.mt.2016.may.fig.9.600x400

The dollar has closed higher on the last 6 consecutive trading days, which is quite the change from the prior 6 trading days when it declined each day. Nothing is for certain, but this is the type of trading action one would expect after a correction which lasted for almost 14 months. What makes this even more impressive is that the dollar rallied after the April jobs number was reported on Friday morning. After closing at 93.78 on Thursday, the dollar spiked down to 93.09 in the minutes after the jobs number was released, and then rallied sharply to close at 93.88. More often than not, how a market responds to the news is more telling than the news itself.

Before the final wave of selling commenced on April 19, the dollar tried to climb above 95.20, but failed on April 14 (95.21) and then on April 22 (95.18). I would be very surprised if the dollar would close above this area of resistance on the first attempt. This suggests the dollar will likely run into some selling pressure between 94.80 and 95.21.

In a perfect world I would like to see the dollar hold above 93.62 on any correction. According to analysis by Morgan Stanley, the negative correlation between the dollar and stocks, emerging markets, and commodities is the highest in 20 years. The Morgan Stanley Global Risk Demand Index reached a negative 86% in early April, and was minus 76% on May 5. Eventually I expect the dollar does to close above 95.21, and if it does, selling pressure on commodities, emerging markets, and the stock market will intensify. If the economy perks up as I expect, and talk about a potential rate hike in June increases, volatility is likely to pick up meaningfully in many markets before the end of June.

The C wave correction shaved 8.63 points off the dollar index. A 50% retracement would bring the dollar up to 96.20. After the trading low on August 24, the dollar rallied to 96.60-96.70 in September and October. This suggests the first leg up is likely to run into stiff resistance between 96.00 and 96.70, and at that point, could be vulnerable to a period of consolidation/correction that could last a number of weeks. Any meaningful pullback in the dollar during the summer would provide commodities i.e., oil, gold, etc. a chance to bounce, and the S&P a window to make a new high.

Oil

I didn't think Saudi Arabia would agree at the DOHA meeting on April 17 to freeze oil production and allow Iran to boost its oil production. After Saudi Arabia declined to freeze production, oil prices dropped to $39.00 a barrel (June contract) on April 18, and were down -10.7% from April 14. When selling was unable to push prices even lower on the Doha news, oil reversed higher and closed at $41.19 a barrel on April 18. As I said previously, how a market responds to the news is more telling than the news itself. Since that reversal, oil prices have continued to rally as a number of short term shortages have lowered the amount of oil coming to market.

On April 17, Kuwaiti oil workers went out on strike which lowered Kuwait's oil production for a few days from 3 million barrels a day to 1.1 million barrels (Doha meeting coincidence?). Pipeline problems in Iraq and Nigeria have resulted in the loss of 800,000 barrels a day. In recent days, a huge wild fire in Alberta has caused the reduction of another 1 million barrels in daily supply. Production will rebound in coming months as pipeline problems in Iraq and Nigeria are repaired and production is reestablished in Alberta Canada.

In the past year, shale oil production in the U.S. has dropped from 9.6 million barrels a day to under 9 million barrels a day. However, the rally in oil prices has tossed a lifeline to marginal producers in the U.S. that were close to going out of business had oil remained under $30 a barrel. As oil prices recovered in March, the percent of oil production that producers have hedged has increased significantly. The ability to hedge future production is likely to allow many companies to continue pump oil, even if oil prices fall again. Ironically, the increase in hedges makes the likelihood of another large decline later this year more likely, as more production remains online due to the hedges the rally provided.

In the short run, oil will run into overhead resistance if it trades up to $48.00 a barrel. If the dollar rallies as I expect heading into the Fed's June 15 meeting, oil could drop below $40.00 a barrel and potentially test the early April low near $37.00 a barrel.

Gold and Gold Stocks

In my March 6 update entitled "The Coming Correction in Gold and Gold Stocks" I thought gold and gold stocks were likely to experience a correction in coming months based on positioning in the futures market. On March 7, gold traded in a range of $1260 to $1274.90 before closing at $1265.10. As I'm writing this on May 10, gold is trading at $1265.00. However, gold has been more volatile than this suggests. After the Bank of Japan did not ease policy further on April 28, the Yen soared, the Dollar broke below its support at 93.80, and gold rallied from $1240.00 to $1306.00 in three days. This surge triggered the stop on the 10% short position I recommended on March 30 in the inverse gold ETF (DGZ) ($14.54), when gold traded above $1274.00 and GDZ traded under $14.00. I actually increased my short position to 15% when DGZ traded down to $13.85.

Click for larger image.

welsh.mt.2016.may.fig.10.600x300

The positioning in the futures that I cited in the March 6 report has become even more extreme. When gold rallied up to $1306.00, trend following large speculators increased their long position to 271,648 contracts, which is a bigger position than when gold was trading near $1900.00 in September 2011. Commercial speculators are considered smart money, since they actually use gold. On the rally above $1300.00, they increase their short position to -294,901 contracts, which is slightly more than the -287,634 contracts they were short as gold was topping in September 2011. There are no sure things, but the positioning in the futures market suggests gold could be vulnerable to a decline that shakes out the trend followers.

Bullish sentiment is quite high so it will take a fundamental reason to dampen the exuberance. The prospect of the Fed raising rates could provide the perfect excuse for a bout of profit taking that becomes intense, if gold triggers stops by closing under $1228, and especially below $1206.00. Later this year, I think gold can trade above $1400, so the coming dip is a buying opportunity.

It is not often that I can say that I was right and wrong at the same time! In late December, I thought gold and gold stocks were setting up for a good rally in the first half of 2016. This is what I wrote:

"How much of a rally in gold and gold stocks is likely given this back drop? I think gold is poised to rally at least back to its recent high at $1191 within the next six months. Should it climb above $1230, a rally to $1300 is possible. If the Gold Bugs Index (HUI) is able to close above 140, a rally to 180 (May 2015 high) is likely and possibly to 200-210 (January 2015 high). If gold makes a run at $1300, HUI could rally to 230-250 (Highs in June-August 2014)."

I turned cautious on March 6 when gold was trading around $1265 and HUI was 175.00 and the gold stock ETF (GDX) was $20.40. What I failed to anticipate that while, gold essentially traded sideways for almost two months, HUI and GDX would rally more than 30%!

In the last two months, the ratio between gold and gold stocks narrowed more than at any time in the past 30 years. If gold tests its low at $1206.00 in coming weeks, HUI and GDX could drop to 190.00 and $21.00. The key to this forecast is how the dollar performs in coming weeks.

Stocks

Even though corporate earnings have declined for three consecutive quarters, the S&P has managed to hold not far below the highs in May 2015. Granted the S&P experienced a sinking spell last August and early this year, but recovered quickly on the back of central bank interventions. The other significant supporting factor has been stock buybacks. In 2015, companies repurchased $572.2 billion of their shares, up 3.3% from 2014. Last year's total fell just short of the record of $589 billion in 2007.

welsh.mt.2016.may.fig.11

In the first quarter S&P 500 buybacks were $17.96 billion, up slightly from the fourth quarter. Almost 25% of S&P 500 companies reduced their share count by more than 4% from a year ago in the first quarter. In 2015, U.S. corporations took on $800 billion in new debt, but only used $90 billion for investments in plant, equipment, and inventory.

Financial engineering may lift corporate earnings, but it is at the expense of our country's future. If that statement seems too strong, just look at how low productivity growth has been during this recovery. This is just one of the unintended consequences of the Fed's low interest rate policy.

A company's forward earnings yield is expected earnings divided by the price of its stock. It is the opposite of the price earnings ratio. For S&P companies the forward earnings yield is 6.1%, according to Yardeni Research. The pretax AAA corporate bond yield is 4%, which means there is an incentive for companies to borrow money and boost their earnings yield. In June the ECB will begin purchasing corporate bonds, which will create the opportunity for large multi-national U.S. corporations to borrow more cheaply in Europe and use the proceeds to buy back their stock. This suggests that stock buybacks will continue to be one of the major props under the stock market.

The advance / decline line (A/D line) is a daily running total of advances minus declines. When it is rising, it indicates that more stocks are going up than down, and it falls when declining stocks outnumber advancing stocks. The A/D line is probably the oldest technical indicator, and although not perfect, it does a very good job of quantifying the trend of the stock market. After peaking at the end of April last year, the A/D line continued to make lower highs and lower lows, which was one of the reasons I thought the market was vulnerable to the declines that occurred in August and to start this year.

Click for larger image.

welsh.mt.2016.may.fig.12.600x400

Since the low in February, the A/D line has been quite strong, and on April 12 the A/D line exceeded the peak from April 2015. This is a positive development and suggests that the S&P is likely to make a new all time high above the May 20 high of 2134. In the short term, I think the S&P could be vulnerable to a correction of 4% to 7%, if the dollar rallies as I expect.

The weakness in the dollar since January has led analysts to increase their estimates for earnings for the second half of 2016 predicated on a lower dollar. If the dollar instead rallies, estimates will be lowered. If the S&P closes below 2033, a decline to 1996 or 1960 is possible by the end of June.

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