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posted on 22 May 2016

Janet's Line In The Sand

by Lance Roberts, Clarity Financial

Another week of volatility, but with no real resolution to the burning question of "where do we go next?"

This past week, the release of the FOMC meeting minutes from April did little to solve the overall confusion. On Friday, I noted some key highlights from the minutes:

"Participants generally agreed that the risks to the economic outlook posed by global economic and financial developments had receded over the inter-meeting period.

Participants also raised concerns about "unanticipated developments" associated with how China manages its exchange rate.

Still, Fed officials signaled they weren't overly worried about the apparent [Q1 GDP] slump, judging it was temporary and "could partly reflect measurement problems and, if so, would likely be following by stronger [gross domestic product] growth in subsequent quarters."

The view wasn't unanimous. Some officials worried that softness in consumer spending and declines in business investment may be a sign of a more persistent slowdown in economic activity."

There is a tremendous amount of "hope" built into those statements. And despite the continuing call of economic growth which has remained terminally elusive, the Federal Reserve is faced with numerous challenges ahead.

The central bank already missed the "window of opportunity" for normalizing rates in a manner that doesn't hamper the recovery. This is evident when you look at Janet Yellen's proprietary index that Yellen herself has stated as critical for Fed movement.

LMCI-chart-momentum2

As I have repeated discussed in the past, since payrolls tend to track corporate profits by about six months AND the small business confidence gauges are in decline, there will be weakening, not strengthening, in employment as the year progresses.

Such a slowing in payrolls will put the Fed in a difficult position since their entire premise on hiking rates has been a rise in inflation to 2% and a fall to 5% in unemployment. Both have now been achieved. This is why, when combined with a forthcoming Presidential election, the Fed will likely remain quite permanently on hold.

As Rick Reider at Blackrock recently summed up:

"To be sure, we live in a world that always has risks and headwinds. But given the many headwinds to Fed movement today, the central bank could have taken the opportunity to move earlier in the year when the headwinds weren't as strong and it was being aided by historically easy global monetary policy in Europe and Japan.

Now, the central bank is left with a more difficult set of decisions going forward, as it weighs the costs and benefits of maintaining interest rates at 'emergency conditions.'"

For Yellen, it is critical the market holds the current level of support. A break below that level will certainly send markets lower looking to retest February lows once again while completely derailing the Fed's plans for hiking rates.


The Line In The Sand

As of Friday morning, as I am writing this, the "good news" is the market rebounded sharply off of the critical support level at 2040. That level has been acting as the "line in the sand" since April, and as stated above, a violation of that level will likely send stocks heading rapidly lower.

Furthermore, the markets have returned to a short-term oversold condition which has historically provided a catalyst for high prices. Again, this is a very short-term condition that can be exhausted very quickly.

SP500-Chart1-052016

The "bad news" is that the rally on Friday failed to break back above the 50-day moving average. A failure to reclaim that ground by close of business on Monday will return the 50-dma back into resistance versus support.

However, stepping back to a "weekly" price chart, we see the market bouncing off of the short-term moving average putting the new downtrend resistance line at 2090 in focus.

SP500-Chart2-052016

On a weekly basis, the markets remain extremely overbought following the rally from the February lows. This suggests that on an intermediate-term basis the path for prices is likely lower despite the potential for a short-term rally as shown in the daily chart above.

I realize this is a bit confusing, but this is the nature of the markets. For executing a buy or sell of an asset in the market, I like to use daily analysis to determine the "timing" of the transaction.

However, from a portfolio management perspective, I am a long-term investor. Therefore, I need to understand the intermediate to longer-term TRENDS of asset prices. As long as prices are trending positively, I want to remain invested despite potential short-term volatility that may exist. When asset prices began to trend negatively, I do NOT want to be heavily tilted towards RISK.

Currently, despite all of the volatility since last May, the markets have not fully changed their trend from positive to negative. Not yet, anyway.

The weekly chart below shows the market versus a 1-year and 2-year moving average. Currently, the 1-year moving average is just 1-point shy of crossing below the 2-year moving average. Historically, this has only occurred at the peak of the last two bull markets and represents the trend change process. The bottom part of the graph is a moving-average convergence divergence indicator (MACD) which acts an an early warning sign that risk should be reduced in portfolios. That signal was registered in May, 2015 which is when I reduced equity risk in portfolios by 50%.

SP500-Chart3-052016

Furthermore, if we step back even further and look at a monthly chart we see more signs of ongoing deterioration currently. As shown below, there are many measures of the market currently issuing warning signs. These warning signs should not be readily dismissed against a very short-term advance in the market. The longer-term dynamics act like gravity against extremely short-term, headline driven, price volatility.

SP500-Chart4-052016

While the market is currently holding support, keeping current allocations in place, the "gravity" of longer term price dynamics are dragging markets down to earth. But this is the normal process of a market top in progress. As the old saying goes:

"Bull markets die with a whimper, not with a bang." - Unknown


Bull Markets Lose Support

Along with this idea that "bull markets" die with a whimper is the loss of one of the major supports of asset prices since 2009. Lu Wang touched on this issue last week for Bloomberg:

"After snapping up trillions of dollars of their own stock in a five-year shopping binge that dwarfed every other buyer, U.S. companies from Apple Inc. to IBM Corp. just put on the brakes. Announced repurchases dropped 38 percent to $244 billion in the last four months, the biggest decline since 2009, data compiled by Birinyi Associates and Bloomberg show."

Stock-Buybacks

"'If the only meaningful source of demand in the market is companies buying their own shares back, then what happens if that goes away?' said Brad McMillan, chief investment officer of Commonwealth Financial Network in Waltham, Massachusetts, which oversees $100 billion. 'We should be concerned.'"

It is not just repurchases that companies are cutting. As the profits recession continues for a fourth straight quarter, cost cutting will become a "thing" again as companies search for cash.

The number of firms that have slashed dividends are now at a seven year high. As noted by Political Calculations just recently the pace of dividend cuts in the second quarter is now running well ahead of the first quarter of this year. Most importantly, as shown in the chart below, the pace of dividend cuts are more normally associated with recessionary economic environments.

cumulative-announced-dividend-cuts-in-US-by-day-of-quarter-in-2016-snapshot-2016-05-09

Furthermore, as economic and profit weakness continues to weigh on corporate balance sheets, delinquencies are rising. As noted by Wolf Richter this week:

"Delinquencies of commercial and industrial loans at all banks, after hitting a low point in Q4 2014 of $11.7 billion, have begun to balloon (they're delinquent when they're 30 days or more past due). Initially, this was due to the oil & gas fiasco, but increasingly it's due to trouble in many other sectors, including retail.

Between Q4 2014 and Q1 2016, delinquencies spiked 137% to $27.8 billion. They're halfway toward to the all-time peak during the Financial Crisis in Q3 2009 of $53.7 billion. And they're higher than they'd been in Q3 2008, just as Lehman Brothers had its moment.

Note how, in this chart by the Board of Governors of the Fed, delinquencies of C&I loans start rising before recessions (shaded areas). I added the red marks to point out where we stand in relationship to the Lehman moment:"

US-delinquencies-commercial-industrial-loans-2016-q1

"Business loan delinquencies are a leading indicator of big economic trouble. They begin to rise at the end of the credit cycle, on loans that were made in good times by over-eager loan officers with the encouragement of the Fed. But suddenly, the weight of this debt poses a major problem for borrowers whose sales, instead of soaring as projected during good times, may be shrinking, and whose expenses may be rising, and there's no money left to service the loan."

So, as asset prices remain suspended based mostly on a "fear of missing out," there is a more distinct air pocket appearing beneath the surface. With support after support disappearing from the market, the risk of a sudden plunge in asset prices has grown markedly in recent months.


Scariest Chart Out There

The following is an excerpt from a post at Hedgeye by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy.

"During the entire period from 1952Q1 to 1994Q4, household net worth tracks the trend line very closely. Since 1995Q1, however, household net worth has been consistently above the trend line and the gap has been getting progressively larger. Such behavior would be a concern in any circumstance, but it is particularly troubling because we know that the previous two boom cycles were followed by busts. The recent rise in household net worth has not been accompanied by a correspondingly large increase in output or the price level. Hence, it too does not appear to be supported by economic fundamentals - it appears to be unsustainable."

thornton4_large

"The Fed's monetary policy has contributed to this problem. First, by keeping the federal funds rate below its own estimates of the normal or natural rate for much of this time and way below the normal rate for nearly a decade. The second, by unnecessarily purchasing a massive amount of government and mortgage-back securities, which Fed Chair Yellen and her colleagues are reluctant to sell. I don't see the Fed doing anything different anytime soon.

I predict that the current level of household net worth is not sustainable. I believe that some unforeseeable event will prick the bubble, perhaps this year. The result will be recession which will, unfortunately, be accompanied by more misguided monetary and fiscal policies. I call this monetary and fiscal policy insanity: Keep doing the same thing and expect a different result! I would love to be wrong, but I doubt I will be."

This is not 1995, 2011 or 2012. The dynamics behind the market itself are flashing warning signs where ever you dare to actually look. Being aggressively exposed to equity risk is looking ever more dangerous as we head into the summer months.

The problem is that markets can remain irrational far longer than logic would dictate. Therefore, I continue to urge caution while waiting for the market to finally declare itself either a "bull" or a "bear." But, I will say my "bearish spidey senses" are tingling.

"But not even a world war can keep the stock market from being a bull market when conditions are bullish, or a bear market when conditions are bearish. And all a man needs to know to make money is to appraise conditions." - Jesse Livermore

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