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posted on 07 August 2016

Between A Rock And A Hard Place

by Lance Roberts, Clarity Financial

Several weeks ago, I commented on the fact that if I were Janet Yellen I would have hiked rates in July by .50 bps.

Here was my reasoning at that time:

"First, with the markets making new all-time highs, there is a "price" cushion available for the markets to absorb a rate hike without breaking important downside support as shown below."

Chart updated through Friday's open.


"Secondly, with Central Banks globally flooding the markets with liquidity, as discussed yesterday, a further 'shock absorber' is currently engaged in softening the impact of a rate hike.


"Lastly, the economy is likely going to show a bit of 'strength' in upcoming reports, with slightly stronger inflationary pressures. This pickup in economic strength will be another inventory restocking cycle following several months of weakness. As has been in the past, it will be transient and that strength will evaporate as quickly as it came.

If I were Janet Yellen, I would hike interest rates by .50 bps immediately in a surprise announcement and use the price and Central Bank liquidity cushions to soften the blow."

Of course, she didn't do it. As expected. I bring this up because Friday's employment report which showed a 255,000 job increase for July, combined with upward revisions to the prior two months, puts Ms. Yellen in a very tough spot to NOT raise rates in September.

But here is what is interesting.

While Ms. Yellen is being pushed into a corner of hiking rates, thereby further tightening monetary policy, the rest of the world is flushing the system liquidity. The latest participant in the QE process was the Bank of England (BOE) this past week which lowered interest rates, announced a bigger than expected QE program and loosened restrictions on bank lending.

BOE (2)

This follows the European Central Bank and Bank of Japan all doing the same thing. With global economic growth shrinking rapidly, BOE reduced economic growth expectations from 2.3% to just 0.8% for 2017, Ms. Yellen is banking on stronger economic growth in the future to support higher rates.

However, the "bond market ain't buyin' it."

As shown in the chart below, interest rates are a function of economic growth, wages, and inflation. Therefore, interest rates are confirming the low inflation/low growth environment in the U.S. and will unlikely be able to withstand a further tightening of monetary policy at this juncture.


The black line is a composite index of the annual rate of wage growth, GDP, and inflation. With this metric on the decline, interest rates are set to decline further.

Ms. Yellen is likely going to "punt" again on raising rates in September given the proximity to the Presidential election cycle, however, she shouldn't. The market and seasonal bounces in the economic data are giving her temporary cover to make her move, it is questionable whether she will have the same opportunity after the election.

This is a gamble she could well lose.

Employment Not A Strong As Reported

Back to the employment data for a moment. The large number in July of 255,000 defies the payroll tax collection data. Remember, the BLS takes a phone survey of individuals asking them what their employment status is, or is not. The corporate tax receipt data is an actual measure of the amount of payroll taxes being paid for all employees. (Which do you think is a more accurate measure?)

As Nick Colas of Convergex recently noted:

"Looking at individual tax/withholding receipts (available from the U.S. Treasury) for the month of July, there is a reason for caution on both indicators. July "Withheld" receipts - those tax and withholding payments that come straight from wage earner pay stubs - are down 1.0% year over year.

Also worth noting: YTD non-withheld tax receipts (such as those that come from 'Gig economy' workers) are down 6.5%, and July's comp is 15% lower than a year ago.

Last, corporate tax receipts are down 11% YTD, and if the current pace of these payments holds it will be the first negative comp since 2011. Bottom line: if the tax man isn't as busy, can the U.S. economy really be expanding?"

colas witholdings

But then there is also the ongoing seasonal adjust "fudgery" going on with the employment data this week as well.

"As Mitsubishi UFJ strategist John Herrmann wrote in a note shortly after the report, the 'jobs headline overstates' strength of payrolls. He adds that the unadjusted data show a 'middling report' that's 'nowhere as strong as the headline' and adds that private payrolls unadjusted +85k in July vs seasonally adjusted +217k.

In Herrmann's view, the government applied a 'very benign seasonal adjustment factor upon private payrolls to transform a soft private payroll gain into a strong gain.'"

Southbay Research also blasted today's seasonal adjustment factor, this is how the seasonal adjustments look like relative to history.

seasonal adjustment_0

The +85k unadjusted number also confirms the trends of fixed and non-private residential investment. Businesses hire against the demand for their products and services. This is why, as shown in the chart below, the historical relationship between employment and fixed investment is extremely high....until now.


Importantly, there are two takeaways from this data:

  1. Currently, the markets don't care about what is really happening in the economy, but whether the data keeps the "punch bowl" available. Liquidity is key to supporting asset prices at current levels.

  2. However, eventually, the markets WILL care about this data when the economy slows to a point where recessionary forces are no longer deniable.

For now, we are not at the second point as of yet. Therefore, the bullish bias remains intact as long as Central Bankers remain accommodative and keeps interest rates suppressed. Of course, the ongoing liquidity push is distorting market dynamics to a point that will lead to some very bad things in the future.

So enjoy the party for now. Just don't be the last guy out of the door when the cops show up.

1-in-1200 Year Event

Jesse Felder wrote a great piece on Friday picking up this point of liquidity driven exuberance.

"Today's euphoria is directed squarely at yields and what some have come to call, "bond alternatives." Treasury bond yields have fallen to record lows but what is even more stunning is just how far certain, yield-focused segments of the equity market have soared in recent months. Not only have they set new record-highs in terms of valuation, they have done so to a degree that should almost never happen.

Michael Lebowitz shared a chart today showing the utilities sector, one of the most popular yield-focused segments of the equity market, trading at 3 standard deviations, also called "sigma," above its long-term average. Jeremy Grantham defines a bubble as a 2 sigma event, which should occur every 44 years or so. This 3 sigma event in utilities is statistically the very same degree of overvaluation we witnessed in residential real estate at the height of its recent bubble and should only occur once every 1,200 years, according to Grantham."


"I asked Michael to share his data with me so I could run the numbers on consumer staples stocks, as well, another very popular focus of those looking for, 'bond alternatives.' I found that they currently trade 2 standard deviations above their 10-year average valuation (in terms of enterprise value-to-EBITDA), also meeting Grantham's definition of a bubble.

In other words, there is in fact a bubble in the markets right now. It's a bubble focused in STUB (staples, telecom, utilities and bonds). And it's not likely to end any differently than any other bubble we have witnessed over the past couple of decades."

But that doesn't mean it will end today.

Or tomorrow.

Or next month.

Just understand that the emotionally driven bias of the herd can keep stocks detached from underlying realities far longer than logic would deem possible.

But it does end.

It ends badly.

And it ends when you aren't paying attention.

Still Waiting On A Correction

So, am I buying equities to move portfolios to the current target allocation?

Not yet.

Three weeks ago, when the market broke out of its 18-month consolidation process, I laid out the case to increase equity exposure in portfolios. I am repeating that case here for new readers of this missive.

"This week, I am adjusting the model allocations up to 75%. Review last week's missive for the individual sector analysis for recommendations leading up to the model change."


"However, while I am changing the model, this does not mean going out and clicking the 'buy' button on everything you can find. We must now wait for the right entry point to increase equity allocations to the new model weights."

The consolidation over the past two weeks DID pull the deviation back from 3-standard deviations above the 50-dma to just 2-standard deviations. This didn't solve much of the problem as of yet.


Importantly, the market is now trading at one of its highest levels of deviations from the 200-day moving average that we have seen over the last couple of years. As I have explained in the past, like a rubber band, prices can only be stretched so far from the moving averages until they eventually "snap back."


Lastly, my friend Dana Lyons recently made some excellent comments the very low levels of inverse ETF volume which has historically denoted short-term market peaks. To wit:

"On the other end of the spectrum, very low levels of inverse ETF volume can be a sign of complacency, indicative of market tops of varying degrees (though, like most metrics, the 'top' signals are less reliable than the bottom signals). A low level of inverse ETF volume may indicate that investors have very little in the way of 'hedges' and, therefore, may be especially vulnerable in a decline.

This notion is relevant presently as, on a 10-day basis, relative inverse equity ETF volume has dropped to its 2nd lowest level in more than 5 years."



"As the table indicates, the sweet spot for weakness occurs in the range between short and intermediate-term, specifically 2 weeks to 3 months. By 1 month, 4 of the 5 events had experienced a drawdown of at least -3% (January 2015 was the exception). By 2 months, the median drawdown was -6.5%. So while this occurrence may turn out differently, the track record certainly is not pretty."

All the data points to some sort of corrective action over the next two months (as discussed last week) which will provide a better risk/reward setup for increasing equity exposure. This is, of course, provided that important technical supports are not violated in the process returning the market back to its previous consolidation channel.

Remaining patient is tough. But waiting for the "right pitch" always leads to a better outcome than swinging at everything being thrown.

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