Written by Jim Welsh
Macro Tides Monthly Report 05 April 2018
My approach combines both fundamental analysis and technical analysis, which is unusual. Most economists, strategists, and financial advisors rely almost exclusively on fundamental analysis, which focuses on the economy, interest rates, and estimates for corporate earnings. Technical analysis utilizes measures of price momentum, moving averages, and chart pattern analysis of major markets.
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I believe the combination of both disciplines is better, since each provides a different perspective. The probability is higher that my analysis is on target, when the fundamentals and technical indicators are aligned, especially at major turning points in the economy and stock market. In this month’s commentary we’re going to review the technical chart patterns in Treasury yields and the S&P 500 and use them to corroborate why economic fundamentals support the conclusions implied from technical analysis.
In the December issue of Macro Tides one section was entitled “The Rise of the Bond Vigilantes in 2018” and I discussed what the chart pattern for the 10-year Treasury bond indicated:
“According to Bloomberg, the probability of the Fed raising the federal funds rate in December and 4 more increases in 2018 is less than 6%. This could be the ideal set up to awaken the bond vigilantes in the U.S. that have been hibernating for years.”
The chart below is from the December 2017 Macro Tides.
Click on any chart below for large image.
The December discussion continued:
“In this scenario, the yield on the 10-year Treasury bond will pop above the March 2017 high at 2.62% and likely test the high of 3.03% from December 2013. From the bottom in July 2016, the 10-year Treasury yield rose from 1.336% to 2.62% or an increase of 1.28% for wave A. The decline from 2.62% in March 2 2017 to 2.034% in September 2017 represents wave B. If wave C is equal to wave A and rises 1.28% from the September low of 2.034%, the 10-year Treasury yield could reach 3.30%. This suggests that a test of the December 2013 high is probable. I suspect that yield hungry pension funds and insurance companies would be aggressive buyers as the 10-year yield approaches 3.0%. At a minimum, a tradable rally could commence from near 3%.”
On January 24, I posted the following note on LinkedIn:
“After years of slow growth many have forgotten that the fiscal stimulus being added will make the economy more cyclical in terms of the business cycle than at any time during this recovery. If correct, the bond market is poised for a ‘recognition’ point when investors realize that inflation is actually moving higher. If this develops it could lead to an overreaction. I suspect that the stock market might not appreciate the competition higher yields pose.”
The message provided by technical analysis was clear and fundamental analysis was supportive of the outlook for a breakout above 2.62%, the high for the 10-year Treasury yield in March 2017. In the December Macro Tides I discussed several reasons why the economic fundamentals indicated that wage inflation and core inflation was likely to climb in coming months and lead to higher interest rates:
“My research indicates that when the U6 unemployment rate minus the U3 unemployment rate was less than 3.85%, the labor market was tight enough to cause wages to rise faster than their longer term average of 3.32%. In the October employment report, the U6 rate fell to 7.9% and the U3 rate dipped to 4.1%, so the U6-U3 spread in October was 3.8%. This is the lowest in nine years, and if maintained in coming months, is at the level that has led to higher wage growth since 1994. Wage growth is finally ready to accelerate in coming months from the 2.5% average in recent months. In October the headline CPI index jumped above the core CPI which has normally led the trend of the core CPI. If the headline continues to rise in coming months, the core CPI is likely to follow. As you can see, since early 2012 the headline CPI rate has consistently held below the core rate which is why this could be a nascent warning of additional inflationary pressures in coming months.
(Chart updated through January compliments Doug Short Advisor Perspectives.)
March discussiion continued:
The New York Federal Reserve has developed its own measure of inflation which it calls the Underlying Inflation Gauge (UIG) and is composed of 346 sub-components. The UIG includes the data subsets included in the CPI and PPI but adds data from the ISM survey, Labor market indicators, money supply measures, and financial market prices on commodities, debt instruments, and stock averages. Historically, the UIG has moved up and down before changes in the CPI. In October the UIG rose to 2.96% which is well above the core CPI and the highest since 2005 – 2006. Interestingly, this is the last time the economy was above the CBO’s measure of the economy’s maximum sustainable potential.”
The UIG rose to 3.06% in February as reflected in the updated chart.
A review of the chart for the 10-year Treasury yield below shows how accurate the combination of technical analysis and fundamental analysis was in anticipating the trend in yields.
The 10-year Treasury yield broke out above the March 2017 high of 2.62% on January 19, as noted by the black horizontal trend line. After the Labor Department reported that Average Hourly Earnings had soared to 2.9% in January, the yield soared to 2.854% on February 2. It then rose to 2.943% on February 21 after the minutes of the FOMC’s January 31 meeting were released and appeared hawkish. After dipping to 3.795% on March 1, the 10-year Treasury yield retested the February 21 high by climbing to 2.936% on March 21 before reversing lower.
As anticipated yield hungry pension funds and insurance companies became aggressive buyers as the 10-year yield approached 3.0%. On March 29, the 10-year yield dropped to 2.739%. The red arrows indicated where I suggested shorting Treasury bonds in August and early September in anticipation of lower prices and higher yields. The green arrows note where I suggested covering the short trades after bond prices had fallen in early February.
As I noted in the December Macro Tides, the probability of the Federal Reserve raising the federal funds rate in December, with 4 more increases in 2018, was less than 6%. I thought this might be the ideal set up to awaken the Bond Vigilantes in the U.S. that have been hibernating for years. By March 21 the probability of the Fed increasing rates 4 times in 2018 had soared to 38%. This seemed like an overreaction and suggested that a contrarian view might be appropriate.
In the March 4 issue of Macro Tides I showed a chart of the positioning in Treasury bond futures and explained why the unwinding of short positions could cause Treasury yields to fall:
“There are technical reasons why Treasury yields could fall in coming weeks. The positioning in the 10-year Treasury futures market suggests the next major move in yields is down, not up as most investors expect. Granted this is a tough call since the deck seems stacked against yields falling. Commercials are considered the smart money and are holding a near record long position (red line middle panel chart below). Speculators are holding a large short position that is almost as large as in January and February 2017. As of February 26, they were long 631,797 contracts (green line middle panel chart below). In January and late February of 2017, as the 10-year yield was topping near 2.60% they were long 644,599 contracts and 594,711 contracts. A decline in yields would generate losses on those short positions, which is what occurred after Treasury yields fell and bond prices rose after March 2017. To stem their losses Large and Small speculators would buy Treasury futures thereby pushing Treasury prices up and yields down further.”
In my February 26 Weekly Technical Review I refined the yield target for how far the 10-year Treasury yield might decline after peaking near 3.0%:
“The price pattern for the 10-year Treasury bond indicates that the high last week may have been wave 3 of the rise in yields since the low in early September. If this pattern is correct, wave 4 would allow the 10-year yield to fall below 2.80%, possibly as low as 2.74%.”
The wave labeling is provided on the 10-year Treasury bond chart above.
Technical analysis of the 10-year Treasury yield chart suggested that yields were likely to fall from the February 21 peak. The question was what fundamental reasons might provide the impetus for a decline in yields. I thought the 2.9% increase in Average Hourly Earnings in the January employment report announced on February 2 likely overstated the increase.
As I discussed in the February 12 Weekly Technical Review:
“State mandated increases in the minimum wage began on January 1 and were included in the January calculation for Average Hourly Earnings (AHE). But the average workweek was down 0.2% in January and hours worked were down 0.5% due to bad weather. Average Hourly Earnings for Production and Nonsupervisory workers, which represent 82% of the workforce, rose just 2.4% from January 2016. Conclusion – the 2.9% increase in AHE was likely overstated in the January employment report and could dip when the February employment report is announced on March 9.”
In the March Macro Tides I concluded:
“Average Hourly Earnings will come in lower than 2.9% for February which should enable bond yields to fall for a period of time. Since the employment report on February 2, the bond market has begun to price in a fourth Fed rate increase. If wage growth temporarily moderates, the bond market may scale back its expectations for a fourth hike.”
When the February employment report was released on March 9, wage growth moderated to 2.6% from a revised rate of 2.8% in January. The decline in wage growth in February defused the inflation fears that had lifted Treasury bond yields after the January employment report and allowed Treasury yields to fall.
In the January issue of Macro Tides I discussed why I expected consumer spending to slow in the first quarter. I noted:
“The combination of low savings, higher credit card debt, and the delay in receiving the increase in net pay until February can be expected to lower consumer spending in the first quarter.”
The expectation was that consumers would increase savings and pay down credit card debt which would curb their spending. Retail sales were down in January and February falling at an annual rate of 1.3%, the weakest since October 2008. Consumer credit growth fell from an annual rate of 9.8% in November to 4.3% in January (the latest available figure), as consumers paid down debt and charged less. As consumers were spending and charging less, they increased the savings rate, which rose from 2.4% in December to 3.2% in February.
The weaker than expected economic news forced Large Speculators to cover their short positions, lifting bond prices and Treasury yields down.
The chart pattern of the 10-year Treasury yield suggested that from the wave 3 high on February 21, wave 4 would allow the 10-year yield to fall below 2.80%, possibly as low as 2.74%. (Chart of 10-year Treasury yield above) The 10-year Treasury fell to an intra-day low of 2.717% on April 2, before closing at 2.732%. The 10-year yield is expected to exceed its prior high of 2.943% on February 21 for wave 5.
In the April 2 Weekly Technical Review, I recommended shorting Treasury bonds by using the 1 to 1 short bond ETF (TBF) at $22.77, or the 2 to 1 ETF (TBT) at $36.45 on April 3. A stop was recommended if the 30-year Treasury yield fell to 2.930%. The technical pattern is clear. The question is “What fundamentals could cause Treasury yields rise to, and possibly above their February 21 highs of 2.943%?“
Although Average Hourly Earnings (AHE) dipped in February to 2.6%, wage growth is likely to resume its upward trajectory in coming months. As I discussed in the March 12 Weekly Technical Review:
“Production and Nonsupervisory workers, which represent 82% of the workforce, saw their pay increase from 2.43% to 2.52% in February. By itself an increase of 0.09% is not earthshaking, but it does underscore that under the surface wage pressures continue to build. This reinforces my expectation that after a brief lull in wage inflation, wage inflation will likely accelerate before Labor Day. As the chart below illustrates (chart compliments Dave Martin AlphaStream Analytics), AHE for Production and Nonsupervisory workers has made higher lows and higher highs since 2013 which is the definition of an uptrend. If AHE exceeds 2.62% in coming months it will set another new high and better the high recorded in July 2016.”
As I discussed in the February Macro Tides, the increase in the minimum wage to $11.00 by Walmart in January would pressure other employers to increase wages to keep quality employees:
“The pace of wage growth will also be boosted by the wage increases announced by large employers like WalMart (1.5 million workers) which will pressure other employers even outside of retail to raise pay to keep workers from defecting to WalMart and competitors increasing pay.”
In February, CVS which employs 240,000 workers announced it was also increasing its minimum wage to $11.00 an hour. The February survey by the National Federation of Independent Businesses found that 31% of its members were planning on increasing worker compensation. This is highest level since 2000 and one of the highest levels since the NFIB began its survey in 1986. Small businesses are increasing wages to retain experienced employees. The timing of the teacher strikes in West Virginia, Arizona, and Oklahoma are symptomatic of the movement toward higher wages that is likely to intensify in coming months.
The Dollar has declined by more than 14% since peaking in early January 2017, which will continue to cause import prices to rise in coming months.
According to the Federal Reserve, a 10% decline in the Dollar will add 0.5% to core PCE inflation after a two quarter lag.
The March ISM Manufacturing survey found that 78.1% of respondents reported that they were paying higher prices, the highest level since 2011.
The New York Federal Reserve’s Underlying Inflation Gauge (UIG) has been a good leading indicator of changes in core inflation since 1995. The UIG was comfortably above the core rate of inflation in February, which suggests core inflation is headed higher in coming months. The annualized rate of core inflation has accelerated and is now above 3.0% which implies inflationary pressure is building. Although the amount of tariffs on goods at this point is relatively small as a percent of GDP, they will increase the prices American companies and consumers pay for goods in coming months.
In the 28 years since 1980 there have only been 6 years when all 46 countries followed by the OECD were growing: 1987, 2004, 2005, 2006, 2007, and 2017. Such broad synchronized growth is good for the global economy and the U.S economy. Consumer spending will pick up in coming months after consumers increase their savings rate to a more comfortable level and pare back their credit card debt. Companies will increase business investment modestly to take advantage of the opportunity to write off 100% of any investment. The fiscal stimulus will lift GDP growth progressively during the remainder of 2018 and at least the first half of 2019.
Within the next six months, the Unemployment rate will drop to 3.9%. This should be as much of a wake-up call for the bond and stock market, as the 2.9% increase in Average Hourly Earnings was on February 2. In coming months, a combination of factors – wage growth resuming its uptrend, import inflation rising, business investment improving, and fiscal policy boosting GDP growth – will resurrect inflation pressures and fears in the bond market that the Fed might increase the federal funds rate a fourth time in 2018.
Higher interest rates will act as a headwind but not so much as to weigh on GDP growth in 2018, although 2019 might prove more of a problem. The Federal Reserve will be shrinking its balance sheet by $600 billion in 2019, even as the budget deficit soars above $1.1 trillion. Given that supply – demand imbalance, there is a real risk that longer term interest rates could spike higher in 2019. In 2018 the stimulus from the deficit will add more to GDP growth than higher rates subtract from growth. The trade dispute between the U.S. and our trading partners at this point represents more of a skirmish than an all-out trade war. That said the folly of man cannot be dismissed as history teaches anyone who bothers to learn. As I wrote in the March Macro Tides:
“By their nature trade negotiations are complicated and difficult and President Trump just raised the stakes with comments like this. ‘Trade wars are good and easy to win.’ History has taught a very different lesson. Trade wars are never good and no one wins.“
Stock Market
As mentioned earlier, I posted the following note on LinkedIn on January 24:
“The bond market is poised for a ‘recognition’ point when investors realize that inflation is actually moving higher. If this develops it could lead to an overreaction. I suspect that the stock market might not appreciate the competition higher yields pose.”
The yield on the 10-year Treasury bond broke out above its March 2017 high of 2.62% on January 19, and the S&P 500 topped on January 26. The recognition point was provided after the 2.9% increase in Average Hourly Earnings was announced on February 2 in the January employment report. Bond yields spiked higher on February 2 and the stock market tanked. The S&P 500 shed 1.4% on February 2 and proceeded to lose 10.2% from its close on February 1 to the intra-day low of 2532 on February 9 in just six trading days.
In recent months the technical chart patterns in Treasury yields were helpful in corroborating why economic fundamentals would support the conclusions implied from technical analysis. The technical chart pattern in the S&P 500 has also been especially helpful, as volatility has soared before equity investors were provided fundamental reasons to sell.
As I have discussed in the Weekly Technical Reviews (WTR) since early February, the decline from the January 26 peak in the S&P 500 to the low on February 9 was instructive. The decline from the January 26 high in the S&P 500 to the low on February 9 was clearly 5 waves, which is labeled wave (A) (chart pg. 7). This indicated that the decline was merely the first part of a larger corrective pattern. The completion of the 5 wave decline also indicated that the S&P 500 was likely to rally in an up, down, up pattern.
In the March 5 WTR, I explained why the rebound from the February 9 low at 2533 might end between 2800 – 2806:
“Based on how the S&P 500 has traded since the January 26 high at 2873, it is possible to guestimate a price target for (C) of (B). The 78.6% retracement of the 340 point decline from 2873 to 2533 is 2800. Wave (A) traveled 256 points (2789 – 2533 = 256). If wave (C) of (B) is 61.8% of wave (A), the S&P 500 would reach 2806 (256 * .618 = 158 + 2648 = 2806). So using two different measurement techniques, there is a price target of 2800 and 2806.”
Technical analysis of the pattern in the S&P 500 allowed me to offer this investment advice:
“If the S&P 500 trades above 2789 and you don’t like the idea of watching the S&P 500 subsequently fall to 2533 or possibly 2449, you should 1) hedge your portfolios, 2) do some selling, or 3) go short using a stop above 2840.”
The S&P 500 traded up to 2802 on March 13 before reversing lower and falling to 2554 on April 2.
Technical analysis provided a roadmap of how the S&P 500 would trade prior to the escalation in trade tensions between the U.S. and China, the uproar over the data breach at Facebook, and President Trump’s negative tweets about Amazon. Technical analysis suggests that the S&P 500 is likely to experience more weakness in coming months. From its low of 1810 in February 2016 the S&P rallied 1063 points before topping on January 26 at 2873. If the S&P 500 corrects 38.2% of this advance, the S&P 500 would fall to 2470, while a 50% retracement would target 2340 for a low.
The S&P 500 fell 340 points in wave (A). An equal decline for Wave (C) from the March 13 high at 2802 would bring the S&P down to 2462 which is close to the 38.2% retracement target of 2470. These price targets do not preclude the potential for the S&P 500 to rally back to 2674 – 2695 and possibly 2730 in the short term.
The fundamental news that is most likely to cause another decline is an increase in Treasury yields, if inflation climbs as expected. A further escalation in trade tensions could create concerns for economic growth in the second half of 2018.
While first quarter corporate earnings are expected to be very good, it is certainly possible that investors will use the good news to sell. This could affect technology stocks since they have become over owned and investors may choose to lower their exposure after the recent bout of weakness. If tech stocks and stocks in general don’t rally if earnings meet forecasts, another selling wave could develop before the end of April.
London Inter Bank Offered Rate (LIBOR)
Since December 2015 the Federal Reserve has raised the federal funds rate 6 times for a total increase of 1.50%. Over the same period the 90-day London Inter Bank Offered Rate (LIBOR) has risen from 0.30% in December 2015 to 2.32% on April 4. This is significant since there are upwards of $3 trillion of adjustable rate consumer loans and almost $4 trillion of corporate bonds tied to LIBOR. Consumers who have mortgages, credit cards, and student loans based on LIBOR will progressively feel the pinch from the rise in LIBOR in coming months, as will corporate borrowers.
There is likely to be a gradual increase in individual and corporate defaults, as overextended borrowers are pushed over the edge. In the short run this will not pose a problem for the economy. However, if the Federal Reserve increases the federal funds rate another 5 times by the end of 2019, the drag from higher rates will threaten the economy and increase the risk of a recession in the second half of 2019 or 2020. The next recession is going to expose a number of problems that are lurking just under the surface.
Seeds for the Next Crisis Are Already Sown
Since 1966 the per capita growth in spending on Medicaid for state and local governments has soared more than 2,000%. Since 1967, the annual growth rate of Medicaid spending has averaged 7% compared to tax revenue growth of 3%. According to data from the Council of State Governments, the top three spending priorities in 1964 were education, highways, and welfare. In 2014, Medicaid was states’ second largest expenditure. Nearly 70 million Americans depend on Medicaid for their health care, which includes 28 million children. The increase in Medicaid spending is forcing many states to spend less on what they want and more on what they must. Since 2008, state and local governments have cut 286,000 jobs, and now employ 19.4 million workers. The squeeze is only going to intensify in the next 10 years. The cost of Medicaid is projected to exceed $1 trillion in 2026, up from $595 billion in 2017.
Education spending is one area that has already been slashed due to the increase in Medicaid spending. In 1980, 48 states fully funded their college budgets from tax revenues rather than from tuition. By 2016, students in 24 states paid more than half of their tuition at public schools. According to the State Higher Education Executive Officers Association, state funding for higher education has been cut from 12.9% of state budgets in 1995 to 9.9% in 2017. Medicaid spending has shifted the cost of higher education from states to middle class families, which partially explains why the amount of student loans has rocketed from $240 billion in 2003 to $1.3 trillion in 2017, and includes 44 million people. Student loans have forced many college graduates to delay getting married, starting a family, and buying a home which has weighed on economic growth in the current recovery.
Medicaid spending has also curbed spending on new infrastructure since 2003 and especially since the financial crisis. I suspect that state and local governments have also been forced to reduce the budget allocation for the maintenance of their existing infrastructure, which is why more than 10% of all the bridges (65,000+) in the U.S. are structurally deficient. Major water main leaks seem to occur on a monthly basis in San Diego, since so many of the pipes are more than 60 years old. I can only imagine the size of the problem in many older cities that also have a far less temperate climate.
Pension spending is another area that is absorbing an ever larger share of state and local government budgets. The problem was exacerbated by the 1990’s bull market which enabled many states pension funding to become over funded. In 2001 the average funding level for state pensions was 100%. Rather than maintaining the status quo, many states including Pennsylvania, California, and New Jersey (usual blue suspects?) increased retirement benefits.
The plunge in the stock market in 2008 and the subsequent weak economic recovery pressured state budgets, which by state law must be balanced. Many states chose to reduce their annual contributions to their state funded pensions so they could fund other priorities and balance the budget. According to Public Plans Database, which monitors 170 large public plans, the average funding rate in 2016 was down to 72%. The level of underfunding is alarming in light of the all-time highs the stock market reached in 2016 and that bond prices in 2016 were also near a record high. It is likely that the average funding rate may be far lower than 72%.
In calculating the amount of underfunding, states base their estimates on the assumption that their pension assets will earn an average annual return of 7.0% to 8.0% over the next 30 years, with an average of 7.34%. This is wildly optimistic since the yield on 30-year Treasury bonds is less than 3.0% and equity valuations are in the 96% percentile of the past 100 years. Based on current valuations, equities are projected to return less than 3% annually over the next 10 years.
The American Legislative Exchange Council (ALEC) surveys 280 state pension funds. In its 2017 analysis it calculated state pension underfunding using a risk-free rate of 2.142%. This rate was derived from an average of the 10-year and 20-year Treasury bond yields over the course of 12 months spanning April 2016 to March 2017. ALEC estimated that state and local governments’ unfunded liabilities now exceed $6 trillion, a whopping $18,676 for every man, woman, and child, or nearly $50,000 for every household in America. The average funding rate was 33.7%.
The 7.34% return used by states is not realistic and the ALEC’s risk free return of 2.142% is understandable, but is likely too pessimistic. The mid-point between these return assumptions is 4.75%, and is probably in the ballpark of what state pensions will average during the next 30 years. This assumption suggests that state pension funding is realistically closer to 53% than 72%.
History suggests that the Federal Reserve is likely to increase interest rates until the economy buckles and enters a recession. Whether that occurs before the end of 2019 or in 2020 is unknowable at this point, but the odds of another recession developing at some point is almost a certainty. The stock market has usually fallen by 30% or more during a recession and tax receipts will be lower than projected in state budgets. This combination has the potential to create a state and local government funding crisis that will likely result in a decision by the Supreme Court.
Most people are unaware than state law prohibits reducing benefits for retired state employees, which means tax payers are responsible for making up the funding shortfall. Most taxpayers are not going to accept significant tax increases to fund overly generous retirement plans for public employees that politicians failed to fund, especially if the crisis develops during a recession.
The only way benefits will be lowered is after the Supreme Court rules that the benefits were too generous and the amount of tax increases required threatens the economic well being of the average American. In the coming years taxpayers will be confronted with threats by politicians to cut firefighters and police protection and higher user fees for basic services, since there just isn’t enough money in the budget to fund everything.
Corporate debt as a percent of GDP is now higher than it was in 2000 or 2007. If interest rates on corporate bonds rise in the next two years, interest expense will consume a greater proportion of cash flow. The new tax law imposes limits on how much interest expense a corporation can deduct. This could prove challenging for companies with a low credit rating that issue high yield or junk bonds and must pay a higher interest rate to attract buyers. In recent years yield hungry investors were willing to purchase high yield bonds with fewer and fewer protections. In the shadow of the financial crisis in 2011, high yield bonds with low covenant protections comprised only 23% of the total sold. In 2017 that had risen to 65% as investors were only concerned with capturing a few more basis points of yield.
The spread between High Yield and Treasury bonds fell to 1.92% in late January from a peak of 5.6% in February 2016. During the next recession the default rate on high yield bonds will soar since covenant protections were so low. The spread will likely exceed the high in February 2016, but not the high in 2008 when the spread rose to 14.5%. Investors who reached for yield will pay dearly and experience double digit losses on their high yield bond funds.
Housing prices have continued to rise supported by a growing economy and a dearth of inventory of homes for sale. The number of homes for sale peaked in January 2009 at 12.2 months of supply and subsequently fell to 4.1 months in March 2013, and has remained under 6 months of supply ever since. Inventory initially remained low since so many homeowners were under water and simply couldn’t afford to sell unless they needed to. Despite the increase in homes prices, more than 30% of homeowners remain underwater.
Student loans have kept many first time home buyers on the sidelines, in an apartment, or in their parent’s basement. As the Federal Reserve kept short term rates near zero percent and used its Quantitative Easing programs to bring mortgage rates down, many homeowners were able to refinance and get a mortgage with a historically low rate. With mortgage rates moving higher, an increasing number of homeowners are unwilling to move and give up their unbelievably low mortgage rate. This new phenomenon will contribute to keeping the inventory of homes for sale low.
The combination of higher homes prices and mortgage rates is bringing the Affordability Index down. By early 2019 the Affordability Index could drop to the levels last seen just before housing prices peaked in 2006. While the low level of inventory of homes for sale is likely to lift prices further, the ratio of median home prices to median income is already higher than it was in 2006.
This suggests that home prices are extended and could be vulnerable to another decline as mortgage rates rise and the economy slips into a recession by the end of 2019 or 2020. If the past is any guideline, the level of inventory of homes for sale will rise once homeowners realize home prices are falling. The increase in supply would be expected to further weigh on home prices. The only time supply didn’t increase was in the shallow recession of 2001 which was a business recession and not a consumer led contraction. The Federal Reserve lowered the federal funds rate to 1.0%, automakers offered 0% financing for the first time in history, and importantly home prices were actually cheap.
Whenever the next recession appears policy makers will have far less ammunition to reverse the economic contraction. I have no doubt Congress will pass a stimulus plan but the budget deficit could easily be $2 trillion or higher, and the Federal Reserve will launch QE4 and cut rates to 0% or lower. Federal debt has grown by $9.3 trillion since 2009, but GDP increased only $2.78 trillion, which means each $1 of debt only generated $0.297 of GDP growth. The epitome of less-bang for each buck spent.
Dollar
In coming months, the Dollar index has the potential to rise to 94.50 – 95.00. I would suggest establishing a partial position (up to 50%) in the Dollar ETF (UUP) now and add to the position if UUP trades below $23.15 in anticipation of a subsequent rally to $24.50 to $24.70 in coming months.
Please note these instructions are for qualified accounts since UUP will send a K-1 for tax purposes in March 2019 for taxable accounts. For nonqualified (taxable) accounts that want to avoid the hassle of a K-1, the Profunds Dollar fund (RDPIX) tracks UUP closely and is a good alternative.
Emerging Markets
The combination of higher interest rates in the U.S. and a stronger Dollar could prove a heavy burden on the $10 trillion of EM debt denominated in Dollars between now and Labor Day. A retest of the February low near $45.00 on the Emerging Market ETF (EEM) would represent a buying opportunity for at least a partial position.
Euro
On February 16 I established a partial short position in the Euro inverse ETF (EUO) which is leveraged 2 to 1 at $19.89. After Trump announced his decision to proceed with tariffs on March 1, I sold my position in the Euro inverse ETF EUO at $20.38. I reestablished the position on March 8 at $20.25. If the Euro marches to a new high I will add to this position. The trend line connecting the high in 2008, 2011, and 2014 comes in near 1.2630 which I expect to contain any Euro rally.
Gold
My bias is that Gold is not likely to breakout to the upside. If Gold fails to breakout, a close below $1306 would set Gold up for a decline to $1275 and potentially $1250. A close above $1368.00 would represent a breakout and likely be followed by a rally above $1400.00 and potentially up to $1450.00.
Longer term I still expect Gold to rally above $1450 so the challenge is finding a good entry point, without enduring the pain if Gold does suffer a quick swoon to $1250. Go long if Gold does breakout and closes above $1368.00, with a stop on a close below $1356.
Gold Stocks
The relative strength of Gold stocks (GDX) improve modestly last week but has yet to signal that a sustainable period of relative strength has begun. If Gold breaks out above $1368.00, GDX has the potential to rally above $23.15 and potentially reach $24.75 – $25.50 if the relative strength really improves. If Gold breaks out, buy GDX above $23.20 using a stop of $22.45.
If Gold fails to break out and subsequently drops below $1306, GDX could decline to $20.50 and potentially to $19.43.
