Written by Jim Welsh
Macro Tides Monthly Review 03 July 2018
At its June 13 meeting the Federal Open Market committee FOMC voted to increase the target for the federal funds rate to 1.75% – 2.0% from 1.50% – 1.75%. The increase was widely expected so it was not a surprise. What was a surprise was that FOMC members indicated a willingness to increase rates 4 times in 2018 rather than the 3 times they projected last December. Market participants had lowered the probability of a 4th hike to just 30% before the FOMC meeting.
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In the June 11 Weekly Technical Review I discussed why I thought the Fed would signal its intention to raise the federal funds rate a fourth time through its dot plot:
“There is strong economic data to support a tilt toward a fourth rate hike within the Fed. In May the unemployment rate fell to 3.8% which is the lowest since April 2000. If it drops to 3.7% in coming months as seems likely, it would be the lowest since October 1960. By any assessment the Fed has achieved its goal of maximizing employment. The FOMC has been surprised that wage growth hasn’t been stronger causing some members to question the validity of the Phillips Curve and the efficacy of the Non Accelerating Inflation Rate of Unemployment (NAIRU) on wage growth in the current environment. It would be a mistake to think they have abandoned NAIRU. The Federal Reserve’s preferred inflation is the Personal Consumption Expenditures index (PCE) and the PCE is hovering just below 2.0%, so the Fed is very close to achieving its second mandate of stable prices after years of falling short. If just one of the 6 members who expected 3 increases upgrades their assessment of the economy and inflation and now supports 4 rate hikes, the Dot Plot will show 7 members favoring 4 increases and 5 who support 3 increases. This subtle shift in the Dot Plot might be enough to unsettle financial markets.”
One of the FOMC members did switch their projection from 3 increases to four, so the dot plot displayed 7 members favor 4 increases with 5 supporting 3 increases. The S&P 500 recorded its best level since the April 2 low on June 13 at 2792.
The FOMC updated its March estimates for GDP growth, unemployment, and PCE inflation. The FOMC increased its estimate for 2018 GDP to 2.8% from 2.7% and lowered its target for the yearend unemployment rate to 3.6% from 3.8%, which was already achieved in May.
The FOMC expects PCE inflation to rise to 2.1% from 1.9% in March and the core PCE to reach 2.0% from 1.9% in March. In coming months, growth will be supported and spurred by additional fiscal stimulus as tax cuts increase consumer spending and business investment. The Federal Reserve of Atlanta’s GDPNow forecast is estimating GDP growth of 4.1% in the second quarter as of July 2. The Federal Reserve of New York’s Nowcast pegs GDP growth of 2.8% for the second quarter as of June 29. Over time the New York Fed’s estimates have been closer to the Commerce Departments’ report of quarterly GDP. My guess is that GDP grew above 3.0% but probably less than 3.5%, depending on inventory growth and the trade figures for June which won’t be leased until August.
The Conference Board’s Leading Economic Index (LEI) remains in a strong uptrend which suggests that odds of a recession developing before the end of 2018 is remote. Historically, the LEI has provided many months of lead time before the onset of a recession as it did prior to the shallow 2001 recession and 2008 financial crisis.
The percentage of small businesses in the monthly survey by the National Federation of Small Business (NFIB) planning to increase compensation is the highest in 34 years. With the labor market continuing to tighten in coming months, wage growth should increase from the 2.7% rate in May. The June employment report could show wage growth of 2.9%. Coupled with the tax cuts consumers will have more money to spend. However, some of the increase in disposable income will be eroded as inflation rises.
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The core rate of inflation in the Producer Price Index (PPI) and Consumer Price Index (CPI) are above 2.0% and show every sign that they will continue to climb in coming months. In May the Core PPI was 2.4% and the core CPI was 2.2%, so both are comfortably above the Fed’s 2.0% PCE inflation target. As these measures of core inflation remain above 2.0%, they will exert upward pressure on the PCE and gradually pull it up to and possibly above the Fed’s 2.0% target. Fed Chairman Powell said the Fed would respond “if inflation were to persistently run above 2%.” The core PCE was 2.0% in May reaching the Fed’s target for the first time since April 2012. If it rises above 2.0% in the next three months, the bond market is likely to respond before the Fed.
The Federal Reserve of New York’s Underlying Inflation Gauge (UIG) is a composite of 105 separate data points so it is very comprehensive. In May it rose to 3.27% from 3.21% in April and continues to rise at a relatively steep incline implying it will increase further in coming months. Historically there has been a high correlation between the UIG and future core CPI levels in the following 15 months. Based on its current level and trend, the UIG is forecasting that the core CPI will rise to 2.8% during the next 15 months. It seems likely that inflation will continue to rise in coming months which is why the FOMC anticipates the need for a fourth rate increase in 2018.
The Federal Reserve will lean against the cyclical forces that are generating an inflationary impulse, as fiscal stimulus narrows whatever slack is remaining in production and the labor market. The Federal Reserve has never had to deal with a surge of fiscal stimulus near the end of a business cycle. Fiscal stimulus has always been used to offset economic weakness during a recession and not applied to a recovery that is now the second longest in history.
In response to the 2001 recession, the Federal Reserve slashed the federal funds rate from 6.5% in 2000 to 1.0% in 2002. The budget deficit reversed from a surplus of 2% of GDP in 2000, as capital gains taxes soared during the dot.com bubble. As the economy slipped into recession, tech stocks lost more than 80% of their value wiping out capital gains taxes, and a modest tax cut caused tax receipts to plunge and the budget deficit to increase to almost 4% of GDP.
The budget deficit shrank from 4% to 1% of GDP and the Fed increased the federal funds rate from 1.0% to 5.25% in 2006, as the economy grew between 2003 and 2007. After the financial crisis the budget deficit rose to 10% of GDP and the Federal Reserve lowered the federal funds rate to .25% and then launched 3 rounds of Quantitative Easing to stabilize the financial system and resuscitate economic growth. As the recovery took hold in 2010, the budget deficit fell to 2.0% in 2016 but then began to rise even though the economy continued to grow about 2.1%.
Since December 2015 the Federal Reserve has been increasing the federal funds rate while the budget deficit has continued to worsen. This has never occurred before.
The future path of the budget deficit will largely be determined by the rate of economic growth during the next few years. The projections by the White House are way more optimistic than the IMF, Federal Reserve, and Congressional Budget Office. The White House believes the tax cuts and investment incentives will not only lift GDP in 2018 but in 2019 as well, and then enable the economy to coast along at 3.0% in the following years.
As I have discussed previously, the two primary drivers of GDP growth over time are labor market growth and the level of productivity. According to the U.S. Bureau of Labor Statistics, employment is projected to increase by 11.5 million over the 2016-2026 decade, increasing from 156.1 million to 167.6 million. This would represent a growth rate of 0.6 percent annually. That would be faster than the 0.5 percent rate of growth during the 2006 – 16 decade, which was affected by the recession in 2007 – 2009, but half as fast as the 1.2% rate from 1996-2006.
Annual productivity growth averaged 1.92% in the 50 years since 1967, 2.03% in the past 20 years, 1.21% during the past decade, and just 0.78% in the last five years. An investment friendly tax policy should result in an increase in business investment, since businesses will be able to write off 100% of an investment. To the extent business investment increases, productivity will rise from the pathetically low level of the past 5 years. An increase in productivity to an average of 1.50% per year would almost double the level of the past 5 years and be 25% higher than the average during the past decade. If productivity increases to 1.50% and the labor market grows 0.6% as projected, the sustained pace of GDP over the next five years could rise to 2.10% or so. Even if productivity rebounds to the longer term average near 2.0%, annual GDP would average 2.60% after labor market growth 0.6% is added.
The Congressional Budget Office (CBO) estimates that each 0.1% increase in GDP during the next decade will generate $270 billion in additional revenue for the Treasury. If GDP growth averages 2.60% rather than 3.0% during the next decade, the budget deficit will be $1.2 trillion larger than the White House has estimated. The CBO has estimated that the increase in federal debt would increase interest expense in the annual federal budget from 1.6% of GDP in 2018 to 3.1% in 2028.
While the White House projects GDP growth to be maintained at 3.0% through 2022, the Federal Reserve, Congressional Budget office (CBO), and International Monetary Fund (IMF) all expect GDP growth to fade after 2019 and average less than 2.0% between 2020 and 2022.
I think the White House is too optimistic about how much productivity will improve during the next five years, so GDP growth is not likely to average 3.0%. It is also possible that all the forecasts could prove too optimistic since none include a recession before 2023. The current recovery is already the second longest ever, but every forecast assumes it will last another 4 years.
The challenge for the Fed is discerning how much of the strength in the next six months or so is due to fiscal stimulus and how much is due to longer term investment plans and higher consumer spending from better wage growth. I’m not sure there is any way the Fed can make the distinction with a high degree of confidence. The members of the FOMC will thus wade through incoming data groping for clarity as the Fed has always done. The record is not good since the Fed has invariably raised rates one time too many, which has led to every recession since the Fed was established in 1913.
Not highlighted in the above graphic are the recessions that occurred in 1949, 1954, 1958, and 1961 that lasted between 8 and 11 months in duration.
To think this time will be any different is probably foolish, especially since the members of the Fed are facing a unique set of circumstances. The economic impact of the tax cut is fairly predictable, since there have been many tax cuts over a period of decades providing economists much data to analyze. Economic growth will accelerate in 2018 and then fade during 2019.
The same cannot be said about the scope and fallout from a trade skirmish let alone a trade war. Although it is well understood that disputes that cause a decline in world trade are negative for economic growth, no one knows how the current dislocation from tariffs will evolve since to date there is no resolution in sight. For the Fed this is truly a wild card.
After the U.S passed the Smoot-Hawley Tariff Act in June 1930, our trading partners enacted tariffs in response and global trade plunged by 60% within 18 months deepening the Great Depression. The decline in tariffs since the 1930’s was a boon to spurring an increase in trade and with it an increase in global GDP. Trade as a percent of global GDP rose from 24% in 1960 to 60% in 2007. After dipping to 53% after the financial crisis, it rebounded to 60% before falling again. The U.S. was an active contributor as U.S. tariffs on imports fell from 20% in 1937 to 1% in the 1990’s. If all of the proposed tariffs already announced are implemented, U.S. tariffs on imports will rise to almost 5%, according to Goldman Sachs Investment Research.
The announced tariffs to date have already impacted the prices of aluminum, steel, and agricultural products. U.S firms importing steel have seen their prices soar by more than 40% since January, while farmers have seen the price of corn, wheat, and soybeans plunge by more than 12% since early June.
On June 27 the Alliance for Auto Manufacturers estimated that if the proposed tariffs on cars take effect the price of the average car will rise by $6,000 from $32,500 and result in the loss of 195,000 jobs. While the total amount of announced tariffs might only represent less than 1.5% of U.S. GDP, the psychological impact from the uncertainty generated by current and potential future tariffs could be far larger, as any company involved in global trade postpones investment, hiring, or expansion plans.
If the trade skirmish develops into a trade war, the U.S. economy could be vulnerable to a sudden loss of momentum. Although the Fed’s mandate is to maximize employment and stable prices, the FOMC would respond to the economic fallout from a trade war by suspending interest rate hikes.
The headlines surrounding the immigration issue and tariffs may be affecting Consumer Confidence and consumer’s expectations for future growth. Since early 2017 the Expectations component has been hovering between 100 and 110 and fell to 103.2 in June. If it falls below and remains below 100 in coming months, it could indicate that consumer spending could subsequently weaken and contribute to a slowing in growth.
Vehicle sales of cars and trucks have held above 16.8 million units for more than 3 years, other than a 1 month dip in August 2017 to 16.4 million. If vehicle sales fall and remain below 16.8 million units, it would be another warning of coming economic weakness. The automakers have tried to offset the rising cost of vehicles by extending loan repayment plans from just over 62 months in 2009 to more than 69 months now. Despite the extension the average monthly car payment has increased from $460 at the beginning of 2013 to over $520, an increase of more than 13%.
Home prices continue to rise faster than incomes and mortgage rates are up so housing affordability has declined further. The gap between the median home price and Average Hourly Earnings has grown quite large, so existing home sales have stagnated.
Since early 2016 Existing Home Sales have hovered between 5.3 million and 5.7 million and were 5.4 million in April. The annualized rate for pending homes sales has fallen for five consecutive months. Because a home goes under contract a month or two before it is sold, the Pending Home Sales Index generally leads Existing-Home Sales by a month or two, which suggests Existing Homes Sales may soften in coming months. .Should they fall and remain below 5.3 million it would be a sign that housing will add less to future economic growth, since they comprise 80% of housing activity.
Although home prices are overpriced on the coasts and other major cities, they are not as broadly expensive as they were in 2006. Nevertheless, during the next recession home prices are likely to fall where they are most extended. Any price decline in home values will not lead to a financial crisis since leverage within the banking system has been reduced significantly.
The risk of a recession before the end of 2018 is low based on the Leading Economic Indicator as already noted. However, Consumer Confidence, Vehicle Sales, and Homes sales should be monitored, as they might provide an advance warning of an impending reversal in the LEI. However, as the lift from the tax cuts begins to wane in 2019 and the progressive drag from higher interest rates intensifies the risk of a slowdown or recession beginning will increase before the end of 2019. As discussed in the April Macro Tides:
“The 90-day London Inter Bank Offered Rate (LIBOR) has risen from 0.30% in December 2015 to 2.32% on April 4 and 2.34% on June 15. 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. The next recession is going to expose a number of problems that are lurking just under the surface.”
While a decline in home prices is unlikely to trigger the next financial crisis, there are other candidates that collectively could make a recession worse if not trigger one. In the April Macro Tides entitled “Seeds for the Next Crisis Are Already Sown“, three issues were addressed. The coming showdown in Medicaid spending will force many states to spend less on what they want and more on what they must. 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. During the next 10 years, the cost of Medicaid is projected to exceed $1 trillion in 2026, up from $595 billion in 2017.
The underfunding of state and local government pensions in the next decade will further cripple budgets and force a choice between cutting retiree benefits, spending cuts in other programs, or aggressively raise taxes. States assume their pension assets will earn an average of 7.34% during the next 30 years, which seems wildly optimistic, with 10-year and 30-year Treasury bonds yielding less than 3.0%. If state and local pension funds average an annual return of 4.75% during the next 30 years, they are 45% underfunded or by $3 trillion to $5 trillion.
As noted in recent months, 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 months investors have been buyers of high yield corporate bonds while shunning higher quality investment grade corporate bonds. Over the past year, the high yield bond index is up 2.8% while the investment grade index has lost 2.8%. The U.S. economy is in good shape and not likely to experience a recession in 2018, so investors have been willing to assume the additional risk inherent in high yield bonds even though the quality of high yield bonds has deteriorated. According to Moody’s Investors Service and FridsonVision LLC, Covenant Quality has fallen from 3.4 to 4.6 or by 35% since 2012.
In its semi-annual financial stability report, the Bank of England (BOE) sounded an alarm on June 27 over global debt markets, with some sectors posing a risk to the stability of the financial system in their view. The BOE highlighted corporate borrowing in the U.S. and noted that in the first quarter corporate borrowing had ballooned to 290% of earnings. The BOE cited looser lending standards, a surge in high risk lending, and noted that a large share of the loans were being securitized and sold to investors around the world. In addition, the BOE wrote that corporate borrowers may struggle to repay their loans if interest rates continue to rise or global growth falters. Points made in prior issues of Macro Tides.
The BOE also identified Italy as another source of risk stemming from the challenge it faces in paying its debts. As noted in the June Macro Tides:
“Italy’s debt as a percent of GDP is 131.8% compared to an EU average of 83.1%. There is virtually no chance that Italy will be able to grow sufficiently to repay its debt, leaving restructuring as the only viable option since default is out of the question.”
During the next global recession, Italy will be in the Intensive Care Unit.
It’s not a question of if there will be another recession in the U.S., only when. At the end of 2017 Total Credit Market Debt (TCMD) for the U.S. was hovering just under 350%, which means for each $1 of GDP the U.S. is servicing $3.47 of debt. In an effort to prevent a debt deflationary spiral the Federal Reserve and other central banks will reinstitute their Quantitative Easing playbook, and governments around the world will run massive budget deficits.
My expectation has been that the response by central banks and governments will only provide a temporary respite and be followed by a wave of deflation, as expressed in the June Macro Tides:
“Any meaningful slowdown in global GDP growth could result in a spike in debt defaults and another financial crisis that could prove more difficult for central banks to manage. Interest rates are far lower than in 2007 so the stimulus from lowering them won’t be as effective as it was after the financial crisis. Government debt has climbed from 58% in 2007 to 87% of global GDP in 2017, so governments will be hampered in running large budget deficits to cushion the social dislocations from a recession. I have no doubt that politicians around the world will try to spend and central banks will launch more Quantitative Easing programs to combat the next global recession. The $64 question is whether financial markets will have the same confidence in the ability of central banks to adequately manage a bigger problem with less ammunition and no bazooka. Initially markets will due to the relative success after the financial crisis. But a healthy degree of skepticism will be warranted.”
I was heartened to view a similar view expressed by Paul Tudor Jones in a June 18 interview. Paul Tudor Jones is one of the most respected investors in the world. As this interview also discloses he is one of the world’s most generous philanthropists as well. I highly recommend listening to the entire interview but the following quote begins just after the 19 minute mark:
“Just imagine when the next recession comes. Oh my God. It will be interesting. The next recession is really frightening since we won’t have any stabilizers. We’ll have monetary policy which will exhaust very quickly but we don’t have any fiscal stabilizers.”
The Bloomberg Commodity Index includes the different asset classes within commodities and doesn’t overweight energy as much as other commodity indexes. Historically, commodities have experienced a significant rally near the end of each business cycle as the demand for raw materials spikes. Despite a synchronized recovery during 2017, there has been no significant broad based rally in commodities. Economic growth has slowed modestly in the first half of 2018 in the European Union, Japan, and China, even as growth in the U.S. strengthened in the second quarter. The chart pattern in the Bloomberg Commodity Index (BCI) may be signaling an important message.
From the high in 2011 the BCI fell in 3 waves (in blue) to the low in January 2016 in what should be a 5 wave decline. Wave 3 sub-divided in 5 waves as noted in red. Wave 4 began in January 2016.
Since January 2016, the BCI has potentially been forming an a, b, c, d, e triangle for wave 4 in blue (below). The attempt to breakout above the blue horizontal line appears to have failed and the BCI recently fell below the green rising trend line connecting the July and December 2017 lows. Crude oil represents 15% of the BCI so the recent breakdown is due to the escalation in trade frictions that hit grain prices hard. It would be far more ominous if the BCI declined below the black trend connecting the January 2016 and June 2017 low, since it would increase the probability that the BCI was falling to a new low in wave 5 from the high in 2011. A decline of that magnitude would be indicative of a wave of deflation. The global economic fundamentals are healthy now, but a trade war could change that.
No one conceived that World War I was possible since no one could fathom that mankind could blunder so badly and allow a World War to develop. And yet it did and 20 million people perished and another 21 million were casualties. After such a horrific experience the notion of another World War barely 20 years after the end of World War I was simply inconceivable. And yet, between September 1939 and August 1945 it is estimated that 60 million people died in World War II, or roughly 3% of the world’s population in 1940.
Since President Trump first announced tariffs on steel and aluminum, the consensus opinion has been that a full-blown trade war was unlikely, since everyone knows no one wins a trade war. If history has taught one lesson more than any other, it is that mankind has been extraordinarily consistent in the art of self destruction. But I don’t want to dwell too much on negative outcomes. The consensus is probably right. After all President Trump assured us that trade wars were easy to win.
Dollar
In the March Macro Tides I expected the Dollar to rally and provided an upside target:
“The Dollar chart suggests a rally to near 95.00 is possible in coming months.”
On May 29 the Dollar reached 95.02. In the June Macro Tides I wrote:
“The Dollar is likely to push to a modest new high after a modest correction of 1.5% or so.”
The Dollar dipped to 93.19 on June 14 and then pushed to a new high on June 28 at 95.53. Based on the price pattern in the Dollar it has completed a 5 wave rally from the February low and is now set up for a meaningful decline.
During the week of June 18 State Street Global Markets sent out a survey asking ‘What is driving the Dollar?’ None of the 4 choices provided asked about sentiment or positioning, which can be extremely useful in identifying trend changes. In January 2017 90% of currency traders were bullish the Dollar, which was one reason why I thought the Dollar was poised for a decline.
The Dollar peaked in January 2017 and fell -14.8% until February 2018, despite 3 rate increases by the Fed. The majority of investors would have expected the Dollar to rally as higher rates attracted foreign capital, especially given the negative rates in Europe.
At the low in February 2018 only 10% of currency traders were bullish, which was one of the reasons I expected the Dollar to rally from 88.25. In February and March there was a record long position in the Euro, as I noted in the February 26 Weekly Technical Review:
“The positioning in the Euro futures suggests the next big move in the Euro is down irrespective of any short term squiggles.”
The Euro subsequently fell 7.6% by late May, and with a 57.6% weighting in the Dollar Index, was the main reason why the Dollar was able to rally 8.0%. After more than an 8% rally since February 2018, 90% of traders are now bullish the Dollar.
Stocks
The Dollar rallied almost 5% in the second quarter and is likely to be cited by multi-national companies as a headwind, when second quarter earnings are announced, leading some to lower their earnings guidance for the second half of 2018. With oil prices, interest rates, and wages climbing input costs are rising for many companies, presenting them with a difficult decision. Do they raise their prices, or hold prices steady to maintain market share, even though profit margins would be squeezed? My guess is it will a little of both and dependent on the industry sector. The stock market may not like either choice since higher prices will lift inflation and potentially invite a stronger reaction from the Fed, while a narrowing in profit margins will lead to slower profit growth.
The second quarter is likely to be the high water mark for GDP growth. The global synchronized recovery has hit a soft patch and might also temper earnings projections for the remainder of 2018. If growth does fade a bit in the third quarter, analysts may lower their earnings forecasts for the fourth quarter, which could weigh on stock prices. If inflation rises as expected, the Federal Reserve will proceed with another rate increase at their meeting in September. For years stocks benefited from extraordinarily low interest rates which spawned the acronym T.I.N.A. – There Is No Alternative. That is no longer true as investors can now earn more from a 1-month Treasury bill than the average dividend return for the S&P 500.
There is the potential for a decline below 2600 in the S&P 500 based on the price pattern in the S&P 500, and the S&P 500 could fall below the February 9 low of 2532. In the June 25 Weekly Technical Review the following instructions were provided:
“A 15% short position is warranted if the S&P 500 rises above 2730. Increase it to 30% if the S&P 500 trades above 2740 and to 45% if the S&P 500 climbs above 2755. A stop above 2780 should be used.”
The S&P 500 traded up to 2746 on Wednesday June 27. If the decline materializes as expected, it could set up a strong year-end rally.
Parabolic Curves and their Aftermath
Parabolic curves are created by human emotion and psychology and are accompanied by a really good story that creates a veneer of authenticity enabling investors to rationalized irrational behavior. The first known parabolic occurred in Holland between 1634 and 1637 and involved tulip bulbs, which arrived in Europe from the Ottoman Empire. A growing interest in natural history and a fascination with the exotic among the wealthy meant that goods from the Ottoman Empire and farther east fetched high prices. Tulips had a cache that no other flower could match. Scottish journalist Charles Mackay wrote a book entitled, “Extraordinary Popular Delusions and the Madness of Crowds“, about the phenomenon and is considered a classic:
“The wealthiest merchants to the poorest chimney sweeps jumped into the tulip fray, buying bulbs at high prices and selling them for even more. Companies were formed for the sole purpose of trading tulips, which reached fever pitch in late 1636.”
At the height of the market, the rarest tulip bulbs traded for as much as six times the average person’s annual salary.
In 1711 the South Sea Company was established initially to trade slaves. After King George I of Great Britain became governor of the company in 1718, the company achieved an aura of respectability and was granted a monopoly on trade in the South Seas in exchange for assuming England’s war debt. Investors warmed to the appeal of this monopoly and the company’s shares began their rise from 128 in January 1720 to 1,000 in August. By December 1720 the shares were trading at 124.
Sir Isaac Newton, one of the geniuses of all-time, was an early investor in the South Sea Company stock. After selling his stake at a good profit, he watched the stock continue to climb, virtually defying gravity. Newton went on to repurchase a good deal more South Sea Company shares, at more than three times the price of his original stake. When the shares crashed he lost almost all of his life savings. After his humbling experience, Newton allegedly said:
“I can calculate the movement of stars, but not the madness of men.”
Parabolic curves follow a distinctive pattern which is plain to see in the charts of the Tulip Bulb Craze, the South Sea Company, the Japan Nikkei in the late 1980’s, the rise in the Nasdaq Composite between 1995 and 2000, and most recently Bitcoin. The quickly lose 70% or more of their value after spiking to a high.
What prompted my renewed interest in parabolic curves was a chart showing how Facebook, Apple, Amazon, Alphabet, and Microsoft (FAAM) have performed during the past 15 years. Netflix wasn’t included since its market value is not close to $1 trillion, but its chart pattern sure looks like a parabolic. Netflix is up more than 100% in 2018. The upward curve in each of the FAAM stocks since 2016 has become more vertical, which is one of the hallmark characteristics of every parabolic curve.
All of these companies are well established with great businesses, enabling investors to rationalize almost any valuation. These companies are not comparable to the dot.com bubble, so a ‘crash’ of 70% is not like. But that doesn’t mean they aren’t vulnerable to a healthy 10%+ correction along the way. This has occurred for each stock on several occasions since 2009. The problem for the stock market is that its leadership is thinning. The Financials and Industrials have rolled over and the capitalization of Utilities and Consumer Staples don’t have a big enough weighting in the S&P 500 to offset any weakness in the 5 FAANG stocks that comprise 12.5% of the S&P 500.
If the S&P 500 is going to fall below 2600 or the February 9 low of 2532, the FAANG stocks must tumble, and I think they will.
Gold
As anticipated in the May Macro Tides:
“If the Dollar moves toward 94.50 in coming weeks/months, Gold has the potential to close below $1306 and decline to $1275 and potentially $1250.”
The Dollar rallied to 95.53 on June 28 and Gold fell below $1250. Extreme bearish sentiment and improved positioning in Gold futures suggests a good trading low is likely to form soon. The percent of bulls in Gold has been hovering near 10% for two weeks, which suggests that negativity toward Gold is well entrenched. As of June 26, Large Speculators were holding their second smallest long position in the past 18 months. In the three prior instances Large Speculators were holding such a small long position, Gold subsequently rallied between 10.1% and 15.1%. Gold is near or at an intermediate trading low and could get a lift if the Dollar tops as expected.
In the May 14 WTR, I recommended:
“Buy a 50% position in Gold or the Gold ETF GLD, if Gold trades under $1301.”
On May 15 Gold traded under $1301 and the Gold ETF GLD opened at $122.82. Last week the instructions were to add another 25% to Gold or the Gold ETF GLD if Gold traded under $1264, which occurred on June 26. GLD opened on June 26 at $119.28. I recommended adding another 25% if Gold traded under $1250. Gold traded under $1250.00 on June 28 at 8am when GLD was trading at $118.45. The average purchase price for the entire GLD position is $120.84.
Gold Stocks
A 50% position is recommended if GDX trades under $21.80 and a 100% position if GDX falls below $21.56, using a close below $21.16 as a stop.
Emerging Markets
In the June Macro Tides I noted that EEM has made a series of lower highs and lower lows since its high in March, which is the definition of a downtrend:
“If the U.S. equity market corrects in the third quarter as expected, EEM could trade under $45.00.”
Dollar strength and the trade war with China enabled EEM to trade down to $42.15 in late June. EEM is off almost 20% since the March peak. Establishing a 33% position if EEM trades under $42.00 is warranted. EEM could trade down to $38.25, especially if the S&P 500 tests the February low of 2532.
Emerging Market Bonds
Establishing a 50% position in the Emerging Market ETF EMB, if EMB falls below $105.00 is warranted. Increase it to 100% if EMB drops under $103.80.
Treasury Yields
In early May I recommended buying TLT at $116.50 in anticipation of a rally to $121.00. (TLT traded under $116.50 on May 17) In the May 29 Weekly Technical Review (WTR) I wrote:
“I would recommend selling half of the TLT position tomorrow since it closed at $122.24 (on May 29) and has more than achieved the price target.”
On May 30 TLT opened at $121.00. In the June 25 WTR I recommended selling the remaining half if TLT traded up to $122.10. TLT traded above $122.10 on June 27. The average selling price was $121.55.
As noted for the last 3 WTR’s:
“The 30-year Treasury yield is likely to at least challenge the 2.954% low on May 29 in coming weeks.”
On June 29 the 30-year yield touched 2.954%. That created the third low within .002% of each other, so this has become an important technical pivot point. The low in September was 2.651% and the May high was 3.247%, a range of 59.6 basis points. The 50% retracement of the increase from 2.651% to 3.247% is 2.949% very close to the 3 trading lows.
This creates a trading opportunity to short the 30-year Treasury bond, using the recent trading lows as a stop. Establishing a 50% position in the inverse Treasury bond ETF (TBF) below $22.76 is warranted using a stop at $22.42. On June 27 TBF made closed below the May 29 low (red line), but the RSI was higher, (green line) which is a positive divergence.