Written by Jim Welsh
MacroTides Report for June 2016
One of the more popular songs in 1986 was entitled, “The Future’s So Bright, I Gotta Wear Shades”. As it turned out, the song was not very prescient since GDP growth has been progressively weaker in the four post recession recoveries recovery since Timbuk3’s song hit MTV.
During 1982-1990 recovery GDP growth averaged more than 4%, almost double the 2.1% rate of the current recovery which will celebrate its seventh anniversary this month. This result is startling in light of the unprecedented monetary and fiscal accommodation provided since June 2009. The Federal Reserve expanded its balance sheet from $900 billion in 2007 to $4.5 trillion today. Between September 30, 2007 and September 30, 2015, the federal government accumulated $9.15 trillion in new debt, which increased total federal debt to $18.15 trillion from $9.0 trillion. The combined stimulus of $12.75 trillion represented more than 80% of the $14.8 trillion in GDP at the end of 2007.
The fact is that GDP growth has been slowing for more than 40 years, so this multi-decade trend has been in place for a long time. Understanding the factors that have contributed to this unwanted outcome can help in assessing what it might require to reverse slowing GDP growth, and the odds of that reversal occurring.
Since 1980 total credit market debt as a percent of GDP has soared from 160% to 330%. With U.S. GDP near $18 trillion, a ratio of 330% represents almost $60 trillion in total market credit debt. In 1983, total federal debt was $443 billion, which became $1.8 trillion in 1990. By 2000, federal debt grew to $4.3 trillion, and when the financial crisis hit in 2008 it was up to $8.6 trillion. In the eight years between 2007 and 2015, another $9.1 trillion was added to the tab, doubling federal debt outstanding.
Some progressive economists have suggested that this recovery has been sub-par because the amount of fiscal stimulus was inadequate. If only the government had spent another $1 or $2 trillion, then everything would have been just fine. And they’re serious!
The decline from the peak of total credit market debt of 370% in 2007 was due to homeowners defaulting on mortgages and other forms of debt, and deleveraging by “too big to fail” banks. It would have been a far healthier sign if the decline in debt had been the result of higher incomes enabling consumers to pay off their debts, rather than defaulting.
The surge in debt literally and figuratively borrows demand for goods and services from the future. Despite this debt boost to GDP growth since 1980, GDP growth slowed during each subsequent recovery. If that doesn’t scare you, it should. Each new dollar in debt generated fewer cents on the dollar in GDP growth in each subsequent recovery – literally getting less bang for every buck of additional debt.
The solution is mathematically straightforward, if we want to stabilize and ultimately lower the ratio of total market credit debt to GDP. Until debt grows at a slower pace than GDP growth, the ratio of credit market debt will rise. For instance, if GDP grows at 2% and debt grows at 2.5%, the ratio will rise. If GDP grows by 2% and debt grows at 1.5%, the ratio will decline. It’s that simple.
One of the reasons GDP growth has been stuck at 2% since 2009 is that the growth in debt has slowed, and there’s the rub. If we want to secure our nation’s future, we need to accept slower debt induced growth in the coming decade and beyond. Or we can increase our dependence on debt to spur growth in the short run and increase the risk of financial ruin ten to twenty years from now.
It is worth noting that the cumulative increase in federal debt since 1983, from $443 billion to $18.15 trillion occurred irrespective of which political party controlled the White House or Congress. This is one of the more important issues our country needs to address since it affects almost every American, directly or indirectly. Yet no presidential candidate has bothered to mentioned the financial iceberg the U.S. is sailing toward, let alone beginning an objective fact based discussion.
While there is the potential of managing the government’s handling of the federal budget more responsibly in coming decades, there isn’t much that can be done about the demographic challenge posed by the Baby Boomer generation. The retirement of baby boomers represents a double whammy for federal and state budgets, since each retiree will stop generating tax revenue and instead, become a drain on Social Security, Medicare, Medicaid, and health care costs in general.
Since 1960, the average age for a woman to marry rose from 20 years old to 27 in 2015. The mean age of women giving birth has increased from 27.3 years of age in 2004 to 28.3 years old in 2014. Men are now waiting until they are 29 before getting married, up from 22 in 1960. Since 2007, the total fertility rate has fallen from 2.12 babies per woman to 1.86 in 2014, a decline of 10%. In 2015, births fell 0.3% and remain well below the 2.1 rate demographers say is needed to replace current levels of population.
Eighteen years after the birth rate began to decline in 2007, the number of young working age people entering the labor market will begin to dip, and continue to fall until at least 2033. This shortfall will continue until the birth rate climbs above 2.1, which could take another decade, or until 2043.
The elder dependency ratio compares those who are 65 years and older to the productive workforce as defined as those between the age of 20 and 64 years old. Based on Census Bureau data and forecasts, the elder dependency ratio has begun an increase that will continue until 2036 before leveling off. The ratio illustrates that during the next 20 years there will be fewer workers paying into Social Security and Medicare as Baby Boomers ride off into the sunset. (Chart below provided by Doug Short, Advisor Perspectives.)
In 2025, the oldest baby boomers will be 79 years old, and the youngest 61. The burden on Social Security and Medicare will be near its peak, just as the impact from lower birth rates between 2007 and 2015 translates into less tax revenue for both programs. In the 2015 Social Security report by its Trustees, the Social Security Fund is under funded by $26 trillion, or by a stunning 31%. In order to close the underfunded gap, the current 12.4% social security tax would have to rise to 16.2%. A tax increase of this magnitude would materially slow economic growth, as it would lower disposable income immediately for every worker.
The payout of future social security benefits will be spread out over the next few decades, diluting its positive impact on GDP growth. The alternative is to cut benefits for social security recipients, which will hurt aging retirees and GDP growth, since they will have less money to spend. If the underfunding is ever addressed, the solutions to keep social security viable – tax increase or benefit cuts – will be a headwind for GDP growth. This is another issue that will affect the vast majority of Americans, but has been M.I.A. in presidential election discussions.
The slowing of GDP growth since the mid 1970’s coincides with a huge increase in government regulation as measured by the number of pages published in the Federal Register, which details every rule and regulation passed by Congress. In the 1970’s the number of pages in the Federal Register exploded from 170,325 pages to 450,821 pages, an increase of 265%. In the 1980’s, 1990’s, and the first 10 years of the 21st century, the number of pages grew 117% in each decade. Between 1993 and 2015 the actual number of rules and regulations soared from 4,369 to 94,246 in 2015.
During this 23 year period average annual GDP growth was 2.54%. The compounded annual increase in final rules and regulations grew 14.2%, or 5.5 times faster than GDP growth. According to the Competitive Enterprise Institute’s annual survey, Federal regulatory costs in 2015 were $1.885 trillion, or roughly 10% of GDP. Researchers at Lafayette University in 2010 found that the per employee cost of federal regulatory compliance was $10,585 for businesses with 19 employees or less, and $7,755 for employers with more than 500 employees. Given the increase in regulation since 2010, these per employee costs are probably higher today. The mounting surge in regulatory compliance costs is certainly a contributing factor in wage stagnation, fewer business formations, and slowing growth during the past 30 years.
I would be remiss if I didn’t also note that regulation has real measurable benefits. A sizable portion of regulatory costs are offset by the increase in the safety of the food, drugs, air and water we consume (except Flint, Michigan). According to a study by the World Resources Institute, carbon emissions in the U.S. fell between 2000 and 2015, even though the U.S. economy grew 9%. This decoupling of carbon emissions and economic growth is historic and even occurred in industrial sectors where emissions fell 16%.
The industrial sector is normally a sector that generates a lot of emissions. This achievement was driven by utilities switching from coal to cheap natural gas as a result of the fracking boom. This success would not have occurred without the push from government regulations that pressured utilities to move away from coal.
That said the extraordinary increase in rules and regulations in the past 40 years has contributed to slowing economic growth. Like a garage that is filled with items no longer used by a family, the regulatory morass in the U.S. needs a thorough spring cleaning. While a streamlining of excess government regulation would not provide a quick-fix to improve economic growth in the short term, the positive benefits would accrue over time, just as the cumulative burden of too much regulation has progressively weighed on growth.
The pace and impact of technological advances appears to be accelerating, but viewed in the context of the past 150 years, transformative innovation has slowed and lessened its contribution to productivity growth. While the newest smart phone from Apple or Samsung is cool, does it compare to the impact of the introduction of the telephone on productivity and society?
Between 1912 and 1930 the price of a car plummeted 63%, so the proportion of Americans that had access to a car soared from 2% to 89.8%. Did the introduction of an affordable automobile contribute more to productivity and economic growth than the hip Tesla?
So much of what our modern society takes for granted was invented at the beginning of the 20th century. The following innovations transformed the U.S. economy and society from being agriculturally based to an urban society, which fostered the birth of the middle class: Electricity, electric elevators, small electric machines, transcontinental airplanes, refrigerators, washing machines, frozen food, sewing machines, public waterworks providing drinkable water, sewer pipes, anesthetics, xrays, antibiotics, radio, and many other inventions.
The point is that some inventions are more important than others. While the internet and the accessibility to information and the capability to communicate to anyone around the world is amazing, it isn’t as powerful as the innovations that reached critical mass 100 years ago. Amazon may have revolutionalized the way products are purchased without having to go to a store, but has found more success in cannibalizing the profit margins of competitors than in generating profits.
I have no doubt that it is not a question of if but when a breakthrough in battery technology occurs that will have a major impact on how energy is used. Blockchain technology will change how data and information is stored and protected in coming years. Artificial intelligence will be further developed and produce outcomes H.G Wells would be amazed by. If the past is any guide, it is that creativity and hard work produce innovations that improve the standard of living of the average American over time.
Unfortunately, demographic changes are going to put enormous strains on government programs during the next decade and prove disruptive to society and financial markets, before the new innovations can truly make a big difference.
Productivity peaked in the 1950’s and 1960’s, and although it rebounded between 1994 and 2004, it has significantly weakened during the past decade. In the last five years, productivity has averaged a meager 0.5%. According to the Economic Cycle Research Institute (ECRI), the labor force is expected to grow 0.5% annually. When combined with productivity growth of 0.5% a year, ECRI estimates that GDP growth could average only 1% in the next five years, unless productivity growth picks up.
A meaningful increase in productivity is not likely since business investment has only increased at an annual rate of 1.2% since 2009. This is in sharp contrast to the 1980’s and 1990’s when business investment (private non-residential) averaged 3.0%. The fruits of those investments were realized when productivity growth jumped to 3% between 1994 and 2004. Business investment fell to 2.2% between 2001 and 2007. Given how low business investment has been since 2009, productivity growth is not likely to exceed 1.0% in coming years. This suggests GDP growth isn’t going to accelerate from the 2.2% average of the past five years, and if productivity does not rise to 1%, GDP growth could drop under 2% in coming years.
The dearth of business investment since 2009 has coincided with a surge in corporate stock buybacks. The reluctance to invest was outweighed by an enthusiasm to repurchase stock, which coincidently enriched corporate executives holding stock options. Since 2010 corporations have repurchased $3 trillion of stock, often after borrowing the money to fund the purchases. This is just one of the negative unintended consequences of the Federal Reserve’s zero interest rate policy.
In order to increase business investment and improve productivity the Federal Reserve would need to raise interest rates enough to reduce the allure of financial engineering that has been used to prop up earnings. That’s not going to happen anytime soon since marginally higher interest rates will increase the debt service burden of the $60 trillion in total credit market debt.
Higher rates would also interest expense in the Federal budget and future budget deficits and total federal debt. According to the Congressional Budget Office, a 1% increase in Treasury rates will increase interest expense and the budget deficit by $150 billion.
Congress could provide incentives for companies to increase business investment, but that would lower corporate tax receipts and widen the budget deficit. Even with incentives many companies might be reluctant to take advantage of them, since very few industries are running near capacity and adding more production would appear questionable.
The issue of excess capacity isn’t just a factor in the U.S., but is a global problem exacerbated by China’s reluctance to close unprofitable factories. The risk of deflation comes from too much debt globally and excess capacity which is pressuring prices, despite unprecedented efforts by central banks to produce more inflation.
While failing to induce a pickup in inflation, central bank policies have forced pension funds and insurance companies to take on more risk to produce a return of 7.5%. In the past 20 years, the allocation to bonds has fallen from 100%, when the AAA corporate bond yield exceeded 7.5%, to just 12% in 2015.
Investments in Private Equity and Real Estate Investment Trusts have climbed from 0% to 25%.
This sounds like an accident waiting to happen, as the standard deviation of the new ‘diversified’ portfolio is almost triple the 1995 version. This is just another example of the unintended consequences of unconstrained monetary policy.
Income inequality is a hot topic and for good reason. Median income is virtually unchanged from 16 years ago, which explains why so many voters are disenchanted. (Chart provided by Doug Short, Advisor Perspectives) For many middle class Americans it hasn’t mattered which party controlled the White House or Congress, since they’ve made virtually no progress.
According to the third annual survey of households by the Federal Reserve, about one-third of adults (76 million people) are either “struggling to get by or just getting by“. One of the more striking findings was that nearly half of all respondents said they couldn’t cover an unexpected expense of $400, or could so only by selling something or borrowing money.
Legislation to increase the minimum wage to $15 an hour is too simplistic and not the answer. Less than 5% of the labor force earns the minimum wage, so it won’t have a broad economic impact. The legislation doesn’t differentiate between a 16 year old working for the first time and a 22 year old trying to support a child. It ignores the fact that the cost of living is much higher in major cities like New York compared to Biloxi Mississippi. Levying the same minimum wage across the country will hurt many small businesses located in areas where the cost of living is much less. Large companies will be incentivized to replace $15 an hour workers with technology. Wendy’s announced it will be installing kiosks so customers can place their own orders without relying on a $15 an hour employee to enter the order for them. Raising the minimum wage to $15 an hour might make for nice campaign slogans, but the reality won’t live up to the hype.
The one issue that affects the largest number of Americans is the economy. GDP growth has been trending lower for four decades, while debt and government regulations have surged. Social Security and Medicare represent promises the government cannot fulfill based on demographic trends that are irreversible.
After ignoring these issues for too long, we have reached the stage that there are no easy fixes or solutions. The first step is educating the average voter so they understand what’s at stake and how they will be impacted if nothing is done. A true leader has the courage to be straightforward in acknowledging the problems we face, without pointing fingers and assessing blame, and is capable of convincing people why action is needed now. A true leader is willing to ask everyone to make a small personal sacrifice, since that is what it will take to prevent, or at least minimize, the financial upheaval that is coming based on the multi-decade trends I’ve discussed.
With so much at stake, it is truly disheartening to listen to the political discourse that dominates the news. Rather than any discussion of any of the issues I’ve covered, the focus is on issues that are trivial in comparison. At this late hour, it’s a question of priorities. If the economy affects almost every single person in this country, why does it seem the election will be determined by immigration, abortion, and transgender bathrooms that combined affect less than 5% of the 322,716,018 people in America, rather than an agenda to restore economic growth?
The May employment report was a negative surprise even though the unemployment rate fell to 4.7% from 5.0%, and wages increased by 2.5%. The Labor Department reported 38,000 jobs were created in May and it revised down the March and April totals by 59,000. When job growth was strong in 2015, almost every revision was an addition to the prior month’s total, not a reduction.
The number of workers working part time because they can’t find full time employment jumped by 484,000, and now totals 6.4 million underutilized workers. Since the Labor Department’s monthly employment survey is derived from firms that are well established, it attempts to estimate job creation from small start up firms.
In May, the Labor Department’s birth-death model (new businesses minus closing businesses) added 224,000 jobs that it guesses were created in May. The birth-death model is based on historical data, and has often thrown off bad information at inflection points in the economic cycle, by over adjusting just before a downturn and under adjusting as the economy recovers from a recession.
According to the Economic Innovation Group, a net increase of 420,000 of net new businesses were established in the 1990’s, representing a growth rate of 6.7%. From 2000 through 2007 the growth rate slowed to 5.6% as 400,000 net new businesses were formed.
Since 2010, the number of new businesses has grown at a rate of 2.3%, as only 166,000 new firms have been launched.
This data suggests that the Labor Department’s model may be overstating the number of jobs being created each month, so actual job creation may have been even lower in May than the 38,000 reported.
In May 2014, the Federal Reserve announced its labor market conditions index (LMCI). The LMCI combines 19 labor market indicators. The Fed emphasizes this point about the LMCI:
“One essential feature of our factor model is that its inference about labor market conditions place greater weight on indicators whose movements are highly correlated with each other and when indicators provide disparate signals, the model’s assessment of overall labor market conditions reflects primarily those indicators that are in broad agreement.”
The Fed researchers tested the LMCI back to 1976 and the quarterly results are presented in the dark blue bar chart above through March 31, 2014. As you can see in the above chart, the LMCI did a very good job of turning negative before the five recessions noted in gray. (1980, 1981-1982, 1990, 2001-2002, 2008-2009)
One of the nineteen indicators in the LMCI is the number of temporary workers, since changes in the number of temporary workers is often a leading indicator for the labor market. As the economy emerges from a recession, business confidence is low so employers choose to add temporary workers until signs of a recovery are more certain.
When economic growth slows, temporary workers are the first to go since employers want to keep their more experienced employees. The number of temporary workers fell in the months leading up to the recessions in 1990, 2001, and 2008.
Since December, 274,000 temporary jobs have been eliminated.
From 2011 through 2015 temporary jobs grew five times as fast as overall employment, so the reversal since December is noteworthy.
The decline in temporary jobs is not the only warning sign. The number of goods-producing jobs has fallen for four consecutive months and a total of 1.2%. A decline of this magnitude occurred in November 1969 prior to the 1970 recession, May 1974 during the recession in 19731974, October 1989 just before the shallow recession in 1990, and in May 2007.
These warnings are supported by the monthly LCMI, which turned negative in January and became more negative after the May employment report. The -4.6 reading in May 2016 is far deeper and more pronounced than at any time since the deep recession in 2008-2009.
In the first quarter, banks increased lending standards for large, medium, and small firms for the third consecutive quarter. Some of the increase is likely related to banks involved in lending to energy firms, but not all of it. Higher lending standards are a head wind and one of the reasons growth has been tepid, and will continue to weigh on any economic improvement until standards are lowered.
In addition, the percent of banks reporting an increase in demand for loans has been negative for the last two quarters. The lack of demand for loans is an indication of slow growth and is another reflection of weak business investment.
The global economy is not likely to provide much lift in coming months since the Bank of America-Merrill Lynch Global Liquidity tracker is still negative, which suggests the global economy is not likely to improve materially in coming months. On June 7, the World Bank lowered its estimate for 2016 growth to 2.4% from 2.9% in January. “The global economy is fragile, and growth is weak “, said World Bank economist Ayhan Kose.
After a weak first quarter, in which GDP grew only .8%, the Atlanta’s Fed GDPNow model estimates the rebound in the second quarter is up to 2.5%. After a weak first quarter in 2014 and 2015, second quarter GDP rebounded by 4.6% in 2014 and 3.9% in 2015. As noted in the May issue of Macro Tides, I didn’t think GDP would snap back as much as it did in 2014 and 2015, and so far that’s on track.
The slowdown in job growth in recent months and the information provided by the Fed’s Labor Market Conditions Index suggests a strong rebound in job growth is not likely. If anything, job and wage growth could soften in coming months and crimp consumer spending. The rebound in gas prices isn’t a positive since it lowers disposable income. And it’s hard to see how the November election will lift consumer confidence in coming months, since both nominees are viewed negatively. Growth in the second half of this year may be challenging and there is a rising potential of a growth scare that could upset the stock market since valuations are high.
In the May issue of Macro Tides I thought that a June rate increase had been discussed at length at the April 27 meeting, and could move markets if confirmed when the minutes of the April meeting were released on May 18. That proved prescient as the Dollar and Treasury yields jumped, while gold and stocks sold off.
Irrespective of the May jobs report, I still think the Fed wants market participants to be prepared for the potential of a rate increase at each meeting. Even though Fed members don’t know when they will raise rates, they do not want to surprise financial markets when they do.
The weak May employment report eliminates the potential of an increase at the June meeting, but it doesn’t rule out July. Fed members want to nudge rates up over time so rates are high enough so that they can be lowered sufficiently to offset any slowdown or recession in the future.
A federal funds rate of 0.37% won’t cut it, which is why incoming data must be weak enough to forestall the Fed’s bias to increase rates whenever the data allows. I’m not sure most market participants understand this bias. Janet Yellen is supposedly a fan of the Fed’s LMCI, and with the labor market one of the Fed’s primary mandates, I suspect most FOMC members are familiar with it as well. If so, why did so many Fed presidents in recent weeks talk up the potential of a June rate hike? I think the statements affirm a consensus to raise rates when possible and prudent, so the Fed can lower rates to cushion a slowdown, rather than being forced into another quantitative easing program because the federal funds rate is only 0.37%.
The Federal Reserve has indicated that the fully normalized rate for the federal funds rate in coming years is 3.25%. I doubt the federal funds rate will exceed 2.0% at any point in the next four years, let alone get to 3.25%. With total market credit of $60 trillion or 330% of GDP, the U.S. economy would sag under the weight of more expensive money, if the Fed increased short term rates to 3.25%. The interest expense in the federal budget would potentially add $200 billion to $300 billion to the annual budget deficit, if the federal funds rate was increased to 3.25%.
If the second quarter rebound stalls as I think is likely, the Fed will remain data dependent and could find the opportunity to raise rates is problematic.
In last month’s commentary, I thought the Dollar had made an intermediate low on May 3 and would rally until it ran into stiff resistance between 96.00 – 96.70. At that point, I thought the dollar could be vulnerable to a period of consolidation/correction that could last a number of weeks, and provide commodities i.e., oil, gold, etc. a chance to bounce, and the S&P a window to make a new high.
Since the high in the dollar on May 30, gold has rallied 4%, oil is making a new recovery high, and the S&P is at the high for 2016 and closing in on a new all-time high. After bottoming at 91.92 on May 3, the cash dollar index topped at 95.97 on May 30, a rally of 4.4% in less than 4 weeks.
The weak employment report took the legs out from under the rally, and today (08 June) the dollar dropped to 93.43, which is barely below the 61.8% retracement (93.46) of the 4.05 point rally. As long as the dollar holds above the May 3 low, I expect the dollar to push higher to 97.00 to 98.00 in coming months.
A long term a rally above 100.51 is coming.
The dollar recorded a key monthly reversal in May, which is technically a long term positive. My guess is it will not be sparked by Fed policy, but by events outside the U.S.
In the May commentary I wrote,
“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.”
After the minutes of the Fed’s April 27 meeting were released on May 18, gold plunged from $1285.00 to under $1200 on May 31. Gold has since rebounded and traded as high as $1267 on 07 June, boosted by the weak employment report.
The question is whether the recent low represents the entire correction in gold and gold stocks, or just the first part of a deeper and longer corrective period. I think the odds favor the latter. The positioning in the futures market still shows producers and commercials (smart money) short, and trend followers (dumb money) long. My guess is that after covering a portion of their short positions when gold traded down to $1200, the smart money has added to their short positions with gold trading above $1260.
Today the gold stock ETF (GDX) made a new high, but momentum is diverging. When GDX closed at $25.83 on April 29, the RSI was a strong 74.6. Today, June 8, GDX closed at $25.97 the RSI is only 63.3. Unless GDX is able to push its RSI above 70, this large divergence will be significant on any price reversal. It was my expectation that gold would trade under $1206 and that GDX would trade under $21.00. Gold traded under $1200, but GDX only fell to $21.94 on May 25. If gold does trade under $1200 in coming months, GDX will likely trade below $21.00.
In the May commentary I noted that
“The rally in oil prices has tossed a lifeline to marginal producers in the U.S. which were close to going out of business had oil remained under $30 a barrel. 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.”
For the first time since August 2015, the total number of drilling rigs has increased, according to the Baker-Hughes weekly rig report. In the June 3 report, the number of oil rigs increased by 9, and for the first time since mid January oil production increased, according to the Energy Information Administration. The biggest lift to oil prices in recent weeks has come from oil supply disruptions, rather than from an increase in demand.
If global growth is close to the World Bank’s estimate of 2.4% and the U.S. doesn’t accelerate in the second half of 2016 from the 2.5% range in the second quarter, the demand for oil may not match estimates. As oil production resumes in Canada and U.S. production edges higher in coming months, the supply / demand imbalance is likely to reemerge.
When oil was trading above $50 a barrel last October, producers were short -185,180 contracts. In the week ending May 31, producers had increased their short position by 56% to -289,478 contracts, when oil was trading under $50 a barrel. In the short term, the price momentum is too strong to think about going short. But there is a good short trade coming in oil, since a decline below $40 a barrel is likely before year end, if the supply / demand imbalance reverts as I expect.
In the May issue of MacroTides, I said,
“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. If the S&P closes below 2033, a decline to 1996 or 1960 is possible by the end of June.”
The dollar rallied I as I expected, but the S&P did not close below 2033. On May 19, the S&P traded down to 2026, before closing at 2040. As the dollar corrected, the S&P has made a new high for 2016 and is close to making a new all-time high.
At the February 11 low, the market was extremely oversold and sentiment was in the dumps. The market has now become overbought and sentiment far more optimistic. As I discussed in the April 25 Weekly Technical Review, the low in February may represent wave 4 from the March 2009 low.
If correct, it suggests that wave 5 began at the February 11 low and could potentially lift the S&P to 2360 in early 2017. My goal has been to identify the top of wave 1 and the low of wave 2. I originally thought wave 1 of wave 5 from the February low ended at the April 20 high of 2111. I expected the S&P to decline below 2040, with a decent potential that the S&P could fall to 1970, before wave 2 of wave 5 would be complete.
The S&P did drop to 2026 on May 19 and today (Wednesday 08 June) traded above 2020, less than 15 points from an all-time high. So the obvious question is whether the low of 2026 was the end of wave 2? I don’t think so. Instead, I think wave 1 from the February low will end soon, probably no later than the firstw eek of July. The expiration of the June stock index futures occurs on June 17, which is normally positive for the market, and end of quarter window dressing could also be supportive.
If wave 1 of wave 5 ends soon, the S&P should be set up for a decline below 2026 before wave 2 finishes. If I’m wrong, and wave 2 of 5 ended on May 19, it should be obvious, since the market would be entering wave 3 of wave 5, and should explode higher on much stronger volume.