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posted on 01 September 2016

Marco Tides Monthly Report For September 2016

by Jim Welsh

The Fed - No Credibility, No Bubbles, But Distortions Aplenty

The Federal Reserve began using "Forward Guidance" prior to June 2004, when it increased the federal funds rate from 1.0% to 1.25%. By providing forward guidance about the future course of monetary policy, the Fed believes it will help individuals and businesses in making decisions about spending and investments.

fed.open.board.meeting

Each year the Fed publishes its forecasts for GDP growth and inflation for the next three years. The forecasts have proved wildly optimistic in terms of GDP growth in 14 of the last 16 years, which forced the Fed to constantly revise their forecasts lower. It's hard to see how individuals and businesses can make important investment decisions when the basis for those decisions is embarrassingly inaccurate. More importantly, the Fed believes forward guidance will be effective in limiting volatility in financial markets, if markets are not surprised by policy changes.

This expectation was challenged on May 21, 2013 when Fed Chairman Ben Bernanke mentioned the idea of the Fed gradually reducing its $85 billion of monthly bond purchases at some point in the future. In reaction to his comment, stocks and bonds overreacted in what became known as the "Taper Tantrum". In one month, the yield on the 10-year Treasury bond soared 33%, rising from 1.88% to 2.51% on June 21, 2013. The S&P 500 peeled off a quick -7.5% between May 21 and June 24, 2013. This outsized reaction looked silly when the Fed failed to make any changes to the amount of bond purchases for twenty months after Bernanke's comment and the Taper Tantrum.

welsh.month.2016.sep.fig.1

If anything, the experience of the Taper Tantrum seemed to push the Fed to try harder and allow forward guidance to play a more significant role in how it conducts monetary policy. Post FOMC statements have become longer and more detailed, and the frequency of speeches by district presidents has increased. These efforts have not been constructive.

During FOMC meetings each district president is encouraged to express their economic view and opinion about monetary policy. The collegial atmosphere this creates during meetings is constructive as it allows a consensus to form. However, market participants are often pummeled with speeches offering very divergent views from district presidents about their outlook for economic growth, inflation, and the implications for Fed policy in public speeches. This has only increased confusion in markets and damaged the Fed's credibility.

In recent weeks, one district president said he didn't think any rate increases were appropriate in 2016, while another said one increase was likely warranted, and a third said it was possible the Fed might raise rates twice before the end of 2016. This type of forward guidance is worthless and sounds more like the Tower of Babble. Fed Vice Chairman Stanley Fischer made the following comment at a conference in September 2013 in Hong Kong.

"You can't expect the Fed to spell out what it's going to do. Why? Because it doesn't know."

The Fed's go to phrase over the last two years has been to tell markets that it is data dependent, which has little value due to the inherent volatility of economic data points (i.e. monthly employment reports, data revisions). If the Fed doesn't know, why say anything? Given the Fed's forecasting track record in recent years, it would be more appropriate to call it forward misguidance. Deciphering the speeches of district presidents, and performing an autopsy on FOMC statements has surely increased employment on Wall Street since all this noise is taken very seriously.

welsh.month.2016.sep.fig.2.3

In a rare example of unanimity in April and May this year, every district president went out of their way to voice support for a rate increase at the June meeting. This was a clear example of forward guidance, as the Fed endeavored to prepare financial markets for this eventuality. When the May employment report showed that only 38,000 jobs were created, which suggested the labor market had suddenly swooned, the Fed did a quick 180 and decided to do nothing at the June meeting.

Remember coming into 2016, the Fed projected it would raise the federal funds rate 4 times in 2016. At the March FOMC meeting the Fed revised its estimate to just 2 increases in 2016. In his September 2013 Hong Kong speech, Stanley Fischer also said,

"If you give too much forward guidance you take away flexibility."

At the end of the day, if the Fed doesn't know what it's going to do, which is the case most of the time, and looks foolish when it gets it wrong, what real value does forward guidance provide? In a word - nothing. Coming into 2016, the federal funds futures were pricing in a 98% probability of a December rate. By February the probability had fallen to under 20%, soared to more than 80% in late May, before falling back under 20% in late June. It currently is pricing the odds of a December increase as 50-50.

If the Fed's forward guidance was even marginally effective, the swings in the federal funds futures would be much smaller. If there is anything that should be clear, forward guidance has diminished the Fed's credibility. Fool me once, shame on you. Fool me twice, shame on me. At this point, the Fed should stop fooling itself and accept that forward guidance has failed to achieve what it was intended to accomplish.

In an interview on Fox Business News on August 16, William Dudley, president of the New York Fed, said he didn't see any signs of asset bubbles that are "particularly disturbing". The S&P/Case-Shiller Home Price Index is back to the high it reached in 2006. Although wage growth has been about 50% less than the average post World War II recovery, median home prices compared to median income are not as overdone as they were in 2006.

Compared to the Dot.com mania in 2000, Shiller's Cyclically Adjusted Price/Earnings ratio (CAPE ratio) is not signaling a bubble in the stock market. How much comfort that comparison provides might be tempered knowing that the CAPE ratio is at its third highest level since 1880 other than 1929 and the manic levels in 2000.

welsh.month.2016.sep.fig.4

High valuations in and of themselves do not cause large declines in the stock market. There is an important distinction between high valuations and nasty bear markets, which occur only after investors are provided numerous good reasons to sell. Mutual funds and other institutional investors have a long only bias. Institutions need to be convinced that the fundamental outlook has materially changed, and that it is in their best interest to sell stocks.

The market is overvalued but it can and likely will continue to grind higher, until the technical underpinnings of the market weaken and reasons to sell materialize and reverse the existing bullish psychology.

While current Fed policy may not have generated the obvious bubbles experienced in technology stocks in 2000 and housing in 2004-2006, policy has led to a number of behavior and investment distortions. Individually these distortions don't compare to the bubbles in equities and housing. Collectively they may prove to be more significant.

The investment theme "There is no alternative" (TINA) is a direct result of the Fed's suppression of interest rates through its Quantitative Easing (QE) programs and near zero interest rates for eight years. Between 2008 and October 2014, investors learned that the S&P went up whenever the Fed was executing a QE program, and declined when a QE program ended. After trading sideways since May 2015, the S&P500 has exceeded the May 2015 high by 3%, after the Bank of England cut rates and restarted its own QE program. The Fed's QE programs succeeded in boosting equity prices but also contributed to an increase in income inequality. This is a distortion that has not received as much attention as it deserves, since it doesn't lend itself to catchy populist slogans.

welsh.month.2016.sep.fig.5

Central Banks have conditioned investors' psychology into believing that central banks will do whatever they can to prevent volatility from swamping equity and bond markets. Historically low yields on 10-year sovereign bonds have enabled investors to rationalize higher equity valuations, even though low rates are the result of central bank manipulations rather than natural forces.

In the U.S., investors have dismissed five quarters of declining earnings because there is no alternative. The European Central Bank (ECB) and Bank of Japan (BOJ) have upped the ante by adopting negative interest rates. Theoretically, since the 10-year German Bund yield is below 0%, German equities could be reasonably priced at infinity!

In the Fox interview Dudley said the bond market "looks a little bit stretched", in part because major central banks are "creating a search for yield globally" through their bond buying programs.

In 2016 consumer staple and utility stocks reached extreme valuations simply because they offer yields above the yield on 10-year Treasury bonds. As Dudley noted,

"The 10-year Treasury yield at 1.5% is pretty low in an environment where we think we are making progress towards our objective. We're pretty close to full employment, and we think inflation is going to trend to 2% over the next couple of years."

Should the 10-year Treasury yield rise to just 2.0%, investments that have become over owned and overpriced could lose more than what they yield in a short period of time.

In a speech at the Aspen Institute on August 22, Vice Chairman Stanley Fischer noted that productivity increased 1.25% per year from 2006 to 2015, compared to 2.5% from 1949 to 2005. Fischer said,

"A 1.25% percentage point slowdown in productivity growth is a massive change, one that, if it were to persist, would have wide-ranging consequences for employment, wage growth, and economic policy more broadly."

As I have discussed previously, productivity grew just 0.4% between 2009 and 2015, which coincides with Fed policies that have encouraged stock buy backs funded by increased debt. According to the Federal Reserve, outstanding corporate debt as a percentage of GDP is back to levels in 2001 and 2009. The surge in debt has occurred as companies have slashed business investment, so they can buy back their own stock, since on paper buying back stock lifts earnings and appears less risky than investing in research and development.

welsh.month.2016.sep.fig.6

Reduced business investment lowers GDP growth in the short run as it has in recent quarters. More importantly, it will lower future productivity growth in coming years, which as Fischer noted will have wide ranging consequences, none of which are positive. Weak global growth and global excess capacity have certainly encouraged corporations to trim business investment. But monetary policy has also played a meaningful role, and if the Fed wants to better understand why business investment has been so low in recent years, all it has to do is look in the mirror.

In my opinion, the Federal Reserve should increase the federal funds rate by 1.0%, and then announce it is shelving its policy of forward guidance that has done more harm than good, which is the definition of failure. Yes, global financial markets would sell off, maybe sharply. Markets would subsequently stabilize and appreciate not having to endure the torture of listening to district presidents and FOMC members providing often diverging views every week.

Central banks need to treat financial markets as grownups and not baby them by holding their hand with misguided policies like forward guidance.

Central banks should also abandon the notion that increasing asset values will lead to a sustainable economic recovery. The current recovery is the weakest post World War II recovery in the U.S, Europe, Japan, and many emerging market economies, despite the monetary Viagra applied by the Fed and other central banks.

The empirical data is clear - it has not worked. Continuing to do more of the same thing while expecting a different outcome is insanity as Einstein said. History is likely to show that central banks caused more distortions than economic growth from all their ministrations and manipulations.

FOMC MEETING ON SEPTEMBER 21

Since mid-August a number of key FOMC members have made comments inferring a tilt toward increasing rates before the end of the year. On August 18, San Francisco Fed president John Williams said the Fed should move to raise interest rates "sooner than later". In an interview on Fox Business News on August 17, William Dudley, President of the New York Fed stated,

"I think we're getting closer to the day where we're going to have to snug up interest rates a little bit. And that's good news."

On August 18, new analysis by the New York Fed found that between 2013 and 2015 nearly 2.3 million workers earning between $30,000 and $60,000 were hired. That was nearly 50% more than the hiring in high-wage or low-wage categories in the same period. After the analysis was released, William Dudley said,

"For the first time in quite a while, we are seeing gains in middle-wage jobs actually outnumber gains in higher and lower-wage jobs nationwide."

This research is significant since it shows the labor market has been stronger than previously thought, supporting those FOMC members favoring a rate increase. Vice Chairman Stanley Fischer noted in a speech on August 21 at the Aspen Institute, that

"We are close to our targets. I expect GDP growth to pick up in coming quarters, as investment recovers from a surprisingly weak patch and the drag from past dollar appreciation diminishes."

Clearly the Fed is attempting to use forward guidance to prepare financial markets for the potential of a rate hike at the September meeting. The Atlanta Fed's GDP Now estimate for the third quarter was 3.4% as of August 25. If the August employment report released on September 2, shows more than 150,000 jobs were created and prior months are not revised materially lower, the odds of a September rate increase will jump, especially in light of recent statements by key Fed FOMC members. The data dependent Fed will lose even more credibility, if the August jobs report and other data is decent, and they don't act.

CENTRAL BANK CARTEL

On August 9, the New Zealand Central Bank cut rates to a record low of 2.0%. In the wake of the Brexit vote, the Bank of England restarted its quantitative easing program and lowered its rate to 0.25%, the lowest in the bank's 322 year history. Since 2008, a number of advanced economy central banks have dramatically expanded their balance sheets to spur economic growth and lift inflation to their target of 2%. Despite unprecedented efforts, economic growth remains subpar and inflation low.

The Fed isn't the only central bank to be surprised by unintended consequences from the largest experiment in monetary policy in history. Two years ago the European Central Bank (ECB) cut rates below zero percent to encourage consumers to spend more by punishing savers, push banks to lend more by charging them for deposits at the ECB, and entice corporations to borrow and invest more in response to record low interest rates. While this logic may have made sense to the academics at the ECB, it hasn't for consumers, banks, and companies in the real world.

welsh.month.2016.sep.fig.7.8

Consumers in Germany, Denmark, Switzerland, and Sweden are saving more now than at any time since 1995, when the Organization for Economic Cooperation and Development (OECD) began collecting data. According to the OECD, savings rose to 9.7% in 2015 and is expected to rise to 10.4% in 2016.

According to a survey by the German Savings Banks, 40% of the respondents cited the ECB's monetary policy and low interest rates as their biggest savings concern. Who would blame them given the change in the interest rate available on savings accounts? In the mid-1990's, it took 9 years for savings to double as interest income compounded, according to Frankfurt based Union Investment. At current rates, it would take 500 years.

welsh.month.2016.sep.fig.9

Germany is the largest European Union (EU) country so as consumers save more and spend less, economic growth will be lower throughout the EU. Household spending as a percent of GDP has fallen 2.5%, from 55.4% in 2013 to 54% in 2015, according to the OECD. I have no doubt this 'more savings less spending' phenomena is happening throughout the EU.

Another factor is the unsettling nature of ultra low or negative rates since no one has ever experienced this before. At a basic level, consumers and companies perceive that the economic outlook is not healthy, which is why central banks have pushed so hard on a string. This appears to have created a psychology that has hurt confidence and engendered a need to hold more of their assets in cash. According to Moody's Investor's Service, non-financial corporations' it rates in Europe, the Middle East, and Africa increased their cash balances by 5% during 2015. As a percent of revenues, cash balances were 15% in 2015, versus 13% in 2014, an increase of 15.4%. In Japan, cash held by non-financial corporations' increased 8.4% in the first quarter from a year ago. In the second quarter Japan's GDP grew at an annual rate of just 0.2%, and would have been negative if not for an increase in government stimulus spending.

As negative interest rates and central bank bond buying distorted global bond markets, the value of negative-yielding bonds reached $13.4 trillion in mid-August, about 35% of outstanding debt. If a bond is purchased with a negative yield and held to maturity, the buyer is guaranteed an investment loss. This is irrational behavior, not dissimilar to those investors who thought buying tech stocks in 2000 at 100 times sales made sense.

The only way an investor can profit from buying a bond with a negative yield is if the bond is sold after the yield becomes even more negative. If this sounds like a corollary to the greater fool theory, it should since it is. According to Moody's there has been a sharp increase in the number downgrades of sovereign debt ratings since the first quarter of 2015. This suggests the rush into sovereign bonds, which has pushed sovereign yields down around the world, is occurring as the economic underpinning of numerous countries is deteriorating.

welsh.month.2016.sep.fig.10

In 2010, the ratings of sovereign debt experienced a marked pick up in downgrades, which preceded the sovereign debt crisis in Europe in 2011. If the current increase in downgrades accelerates, global bond investors may be in for a few unpleasant surprises. Should conditions spook negative yield bond buyers at some point in the future, and several trillion dollars of bonds are sold in a short period of time, the financial disturbance will not be referred to as a tantrum.

The risk of seismic selling hitting the global bond market is real, especially since most investors complacently believe interest rates will remain low for far longer. Central Banks were established to be the lender of last resort, as they were in 2008. In the next crisis, central banks will be the sovereign and corporate bond buyers of last resort.

EMERGING ECONOMIES

The distortion caused by monetary experiments in advanced economies has spread, as the reach for yield has moved into emerging market securities. Although issuance of corporate dollar denominated debt has slowed since the end of 2014, the amount of outstanding debt has almost tripled since the 2008 financial crisis. Of all nonbank debt, roughly 46% is now in dollars compared to 38% in 2008, according to the Bank of International Settlements (BIS). A third of that is held by corporations in emerging markets. On August 19, the BIS warned that a corporate-debt binge for emerging market countries that started in 2010 is coming due now.

welsh.month.2016.sep.fig.11

Between 2016 and 2018, repayments will total $340 billion, 40% more than during the past three years. The BIS said,

"The high level of corporate debt has contributed to overheating in some of these countries, thus increasing the risk of financial distress in the coming years."

The BIS targets Brazil, China, and Turkey as the most vulnerable to a domestic banking crisis because of high levels of private debt and servicing costs. Ironically, the countries whose bond market have fared best are Brazil and Russia. Both countries have been in recession due to the significant drop in oil and natural resource prices, and are not likely to experience healthy growth until commodity prices recover far more.

welsh.month.2016.sep.fig.12

Brazil and Russia's currencies have experienced a huge rally, which means buyers of bonds could face both a currency risk and a default risk if each economy struggles more than what is priced in. Based on the BIS analysis the risk from emerging market bonds exists beyond these countries, and investors would be wise to pay attention in coming months.

Central Banks - Pushing the Envelope

The shift toward the wildest experiment in monetary policy in history began more than 20 years ago and well before the 2008 financial crisis. The federal funds rate peaked at 20% in 1980, leading to a reversal in the trend in inflation that had been rising since the early 1960's. As inflation trended lower, the Fed was forced to lower the federal funds rates to lower levels to fight the recessions in 1990 and 2001 by pushing the 'real' fed funds rate into negative territory. This represented a new threshold in Fed policy.

The Fed also realized that it needed to keep the fed funds rate lower for longer in the wake of the modest 2001 recession to get a recovery to take hold.

welsh.month.2016.sep.fig.13

The severity of the financial crisis made it clear that a negative real federal funds rate would not be enough to stabilize the financial system, which is why the Fed launched QE1. I think the Fed made the right decision to implement QE1, but the Fed left the monetary reservation when it adopted QE2 and QE3 to boost equity prices and home values. The inclusion of asset prices is well beyond the Fed's mandates of full employment and stable prices.

Earlier this year, Janet Yellen said,

"I certainly myself couldn't have imagined six, seven years ago that we would be employing the policies we are now."

What was once unimaginable is now routine, so much so, that Chair Yellen said in her Jackson Hole speech the Fed could in the future expand its balance sheet by another $2 trillion through more QE, and would consider buying corporate bonds and other securities.

The Bank of Japan and ECB have gone where no central bank has gone before. In addition to buying government bonds in its quantitative easing program, the Bank of Japan began buying stocks in 2013 and has expanded it three times. At the end of July, the BOJ owned 1.9% of all the stocks listed on the Tokyo Stock Exchange. In the ECB's quantitative easing program, it can only buy sovereign bonds that yield more than -0.40%. Since the ECB has already purchased more than $1 trillion of sovereign debt and so much sovereign debt is yielding less than -0.40%, the ECB expanded its QE program in March to include corporate bonds and increased the amount of its purchases from $65 billion to $90 billion a month.

Since March the average yield on euro investment grade corporate bonds has fallen from 1.28% to 0.65%, according to Barclays. Because the ECB has purchased less than $20 billion of corporate as of August 12, much of the yield decline is attributed to front running by investment funds ahead of the ECB. The ECB has described the characteristics of the bonds it wants to buy, so investment firms and corporations are working hard to sell bonds that the ECB will buy. In these sales, corporations will sell the bonds into the bond market, and the buyers know the ECB will then buy the bonds from them.

In what I believe is a major development in the normal process of distributing new bonds, the ECB has participated in two private placements. In a private placement, the issuing company doesn't publish a prospectus or make a press announcement, since the ECB is buying the bonds directly from the company. This process eliminates even the appearance of transparency. This appears to be another example of a central bank extending its reach into the functionality of free markets and well beyond the original mandate of any central bank.

The most concerning aspect is the Fed, ECB, and BOJ have yet to describe their exit strategy and the impact the unwinding of the $25 trillion of purchases will have on markets down the road.

Infrastructure is a hot topic, not only in the U.S election, but in Europe as well, since its economic growth is stuck in neutral at 1.5%. Increasing infrastructure spending is seen as a smart way to boost growth in the short run, reduce the costs incurred by drivers and companies from driving on pothole filled roads, and increase the safety of the 67,000 bridges (11% of all bridges in the U.S.) that have been deemed unsafe by civil engineers and in real need of maintenance.

When the increase in infrastructure spending comes, and I think it is only a question of when not if, I doubt the Treasury will auction infrastructure bonds as they do with all other Federal debt. Instead, I think the Federal Reserve will buy the debt issued by the Treasury directly, as long as the bonds are earmarked specifically for infrastructure projects. The ECB will buy the debt directly from the issuing country.

In her speech at Jackson Hole on August 26, Janet Yellen said the Fed could expand its balance sheet by another $2 trillion to ward off to ward off a slowdown. Why bother waiting for a slowdown? If the calls for infrastructure spending increase in 2017 as I suspect, the Fed could buy $1 trillion of infrastructure debt, so there is no slowdown to contend with. By purchasing the infrastructure bonds directly from the Treasury Department, rather than waiting for them to be auctioned in the market, the Fed would eliminate the risk of higher bond yields as the bond market absorbs the increase in bond supply.

Dollar

The long term chart pattern in the dollar index suggests that the bull market is still intact. The correction which began in March 2015 is wave 4 of a 5 wave advance from the 2008 low. If correct, wave 5 of the advance is likely to lift the Dollar to 106.00 - 110.00 sometime in 2017.

On January 26, I thought the Dollar would decline. In early May, I thought the Dollar was poised for a rally, and it moved up from 91.88 on May 3 to 97.50. At a minimum, I expect the Dollar to push above the high at 97.50 and potentially reach 98.50. The only question is whether the correction from March 2015 to May 2016 was all of wave 4, or only the first 3 legs of a 5 leg triangle. If the triangle is in force, the Dollar should peak in coming weeks between 97.50 and 99.00. This would represent wave D of the triangle, and be followed by another correction for wave E. As long as the Dollar holds above 93.00, the rally to 97.50 - 98.50 is intact.

Often, perception trumps reality. If currency markets perceive that the Fed might increase the federal funds rate twice before year end that is almost as good if they do. There is another shoe that could drop that could boost the Dollar.

Click for larger image.

welsh.month.2016.sep.fig.14

Italian banks are the weak link in the European banking system. Of total loans, 17% of Italian bank loans are nonperforming, 10 times the level of U.S. banks. Since 2008, the amount of impaired loans has quadrupled to $400 billion. Italian banks continue to make loans to companies that are behind on their payments since the Italian court system is so dysfunctional. On average, it takes eight years to clear a solvency case brought by a bank against a dead beat company. A quarter of the cases take 12 years.

GDP growth since 2000 has averaged less than 1% annually, which is why the unemployment rate is 11.6%, while the youth unemployment rate is 35.5%. Young workers can often only get 90 day Temporary employment contracts. Since any laid off worker can take their employer to court, which can take up to 4 years to resolve, companies won't hire permanent workers.

Italy's Prime Minister, Mateo Renzi, is asking Italian voters to approve major reforms to the political system that could turn into a quasi-Brexit vote. If the referendum in late October doesn't pass, Renzi has vowed to resign, would could ignite Itexit - Italy's exit from the European Union. Even if the referendum passes, change will take time and Italian banks may not have enough time to fix their woefully undercapitalized balance sheets.

Either way, the Euro could be vulnerable to a decline below 1.00, which would lift the Dollar Index by more than 5% since the Euro represents 57% of the Dollar Index. If I'm correct about the Dollar rallying to 106.00 - 110.00, it will occur due to a big drop in the Euro.

Gold and Gold Stocks

If the Dollar rallies, it will likely prove a headwind for gold and the gold stocks. The key is whether gold is able to hold the July 21 low of $1310.70. As long as gold does not rally above $1367, I think the odds favor gold eventually breaking below this level, even if it first bounces back up to $1360 in coming weeks.

The positioning in the futures market shows that large speculators still hold near record long positions, while commercials are holding near record short positions. This suggests there is more downside risk coming. If/when gold closes below $1310, a decline to near the pre-Brexit low on June 23 of $1253.70 could follow quickly. If gold follows this course, the gold stock ETF (GDX) could fall below $24.50, and possibly as low as $22.50.

Grains

I have never discussed corn and wheat before, but the U.S. is likely to post the longest stretch of falling food prices in 50 years. Milk prices are down 11% from a year ago, while the price of a dozen eggs has fallen 40%. The glut is so severe that dairy farmers have been dumping millions of pounds of excess milk on fields. On August 29, corn prices fell to $3.11 a bushel, down from more than $8 a bushel in 2012. Wheat prices have plunged from over $13 a bushel in 2008 and $8 a bushel in 2012, to less than $4 a bushel. Grain prices have been falling due to bumper crops in the U.S. and globally, and less buying of U.S. crops after the dollar rose sharply in late 2014. As one corn farmer said, "We cannot stand $4 a bushel corn."

In the next year, farmers are likely to plant less corn and wheat, which should result in smaller harvests in coming years. If my assumption is correct, corn and wheat prices are likely to rally in 2017 and 2018. My guess is that corn will make a low between $2.50 and $3.00 a bushel in coming months. Wheat could post a low between $3.25 and $3.75 in coming months. At some point in the next two years, corn could rally to over $5.00 a bushel, and wheat could top $7.00 a bushel. If this analysis proves correct, corn and wheat could provide a return of 80% to 100% during the two to three years. Stocks and bonds are expensive, so looking for assets that are out of favor and cheap could prove profitable. The easiest way to invest in corn and wheat is through their ETFs - CORN and WEAT. While easy, they are expensive. The annual expense for CORN is 2.92% and 3.34% for WEAT. The primary expense driver is the cost of rolling over futures contracts within the ETF structure.

welsh.month.2016.sep.fig.15

welsh.month.2016.sep.fig.16

Stocks

Dividend payouts from S&P 500 companies for the past 12 months amounted to almost 38% of net income, according to FactSet, the most since February 2009. In the second quarter, the dividend payout of 44 companies exceeded their net income, the most in a decade. The high dividend payout ratio is not likely to increase much further from 38%, and companies paying out more than net income will need to see earnings improve or consider cutting their dividends.

welsh.month.2016.sep.fig.17

In response to the Fed's zero rate interest policy and QE lowering bond yields, a torrent of money since 2010 has flowed into investment grade and high yield bonds, REITs, and dividend equity funds. A breakdown of the ten S&P 500 sectors illustrates how over owned Consumer Staples, Utilities, and Telecom stocks have become. Compared with the previous 18 years, Consumer Staples are in the 99th percentile, while Utilities are in the 94th percentile.

welsh.month.2016.sep.fig.18

In the first two quarters of 2016, S&P 500 companies returned 112% of their earnings through dividends and stock buybacks to shareholders, well above the 82% average of the past 15 years, according NYU's Stern School of Business.

In a June 27 interview on CBS radio in Chicago I was asked about the investors buying Utility and Consumer Staple stocks even though they were expensive. Given how crowded the trade in Utilities and Consumer Staples has become, the rush out could be painful, if the stock market rallies in coming months to a new high. The Utility and Consumer Staples sectors are over bought, over owned, and overvalued. Although both have declined since early July, I think the correction is not over. The Fed is going to increase rates, which provides those long these sectors a reason to lighten up. Given how over owned they were in early July, I suspect there is more selling yet to come.

welsh.month.2016.sep.fig.19

The Consumer Staples and Utilities have been market leaders since late last year. Normally, (unfortunately, these are anything but normal times), the stock market experiences a correction when it undergoes a leadership change. Just about every sector has been exploited during the rally, so most sectors are overbought and vulnerable to at least a short term pullback of 3% to 5%. On the NYSE, 80% of stocks are above their 200 day average, which is a good statistical indication of how overbought the market has become.

The Major Trend Indicator (MTI) is a proprietary measurement of how strong or weak the market is. Generally, the MTI will make a series of lower highs prior to a correction of more than 7%. In 2015, the MTI made lower highs prior to the sharp decline in August and September. The pattern was repeated when the MTI made lower highs in November and December, presaging the sharp fall in January and February of this year. The MTI provided a bear market buy signal on February 25, and confirmed that a new bull market was in place on March 30.

Click for larger image.

welsh.month.2016.sep.fig.20

The MTI has surpassed the high it recorded in April, which is a sign of strength. This suggests that a correction of more than 7% is unlikely in the next few months, until the technical underpinnings of the market deteriorate. In recent weeks, the MTI has flattened out and begun to marginally curl lower. This is supportive of a modest decline of 3% to 5% in coming weeks.

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