Negative Bias & Increased Uncertainty Will Push The Stock Market Lower

Market action continues to disappoint and it is our belief that the lows hit in August and possibly last October could be retested. The S&P 500 is probably headed for a level of 1820 to 1865 for an additional decline of 3.5% to 6.0% in the near term. Relative performance on Friday sent a signal that the opening rally was weak when the Nasdaq Composite and the Russell 2000 were unable to hold early gains. Both indices are relative laggards to the S&P 500 and that typically doesn’t support the “buy the dip” thesis. Biotech’s and Pharmaceuticals are weighing on the Nasdaq, automobile stocks are taking it in the chin mostly due to the VW scandal, and money continues to rotate into safe haven investments such as treasuries and gold. The Vix continues to hold support at the $20 range.

The question will present itself once we get to those levels of whether we are in a correction phase with the likelihood of a market rally into the end of the year or a bear market with further downside risk. We probably won’t know the answer to that question until after it happens but remain cognizant of the risks and diligent in the implementation of our investment thesis.

We continue to believe that this downturn will be a correction and not a bear market. We don’t believe the U.S. economy is heading for a correction. In a recent Bank of America (via Business Insider) points out, “In a note to clients on Thursday, Bank of America's Michael Hartnett writes that while global earnings have declined and manufacturing activity around the world has slowed this year, we're a long way from levels that would get us thinking about a recession. So far, global earnings are down 9.6% peak-to-trough, but in Hartnett's view a 15% decline is needed for a "true recession-shock" to earnings. Global manufacturing PMIs are even further away from recession-type levels. This year global PMI — or purchasing managers index — is down 3.4% over the prior year, but still hanging in around the 50-52 range, indicating expansion in global manufacturing and nowhere near the 15% decline Hartnett thinks would more seriously indicate a recession.”  

The Atlanta Federal Reserve’s GDPNow indicator has been an exceptionally accurate gauge of economic growth and currently reads, “The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2015 is 1.4 percent on September 24, down slightly from 1.5 percent on September 17. The decline occurred on Monday when the model's forecast for third-quarter real residential investment growth fell in response to the existing home sales release from the National Association of Realtors.”

Further evidence according to Scott Grannis that we are not heading into a recession is as follows, “As the chart [below] shows, the past three recessions have been preceded by a significant rise in 2-yr swap spreads. Swap spreads, as I explain here, are essentially barometers of systemic risk. When they are as low as they are today—which is quite low, in fact—they tell us that financial markets are extremely liquid and it is very easy for those who are nervous to lay off risk on others. It's almost the opposite of the "don't shout fire in a crowded theater" phenomenon, because those who these days are worried and want to get out have almost no problem doing so. The problems happen when everyone wants to get out at once, which is what leads to high swap spreads. If everyone is feeling scared, if everyone is worried about the ability of others to survive, if money is scarce, then the underlying fundamentals have deteriorated significantly and there is something very wrong out there. Today, swap spreads are telling us that the economic and financial fundamentals are very sound; thus there is a very low probability of a recession.”

Chemical Activity Barometer (CAB)

We are active in the precious metals recycling space, working with companies that extract platinum, palladium and rhodium from spent auto catalysts. We assist in the aggregation, hedging and ultimate sale of metals to those manufacturers that create new auto catalysts for new automobiles. One of our biggest customers has been BASF, the chemical company so I have been tracking various stats within the industry. I came across an index created by the American Chemistry Council called the Chemical Activity Barometer that has proven to be quite useful, especially in a market environment such as the one we are in today.

Taken from their website, “American chemistry is essential to the U.S. economy. Chemistry’s early position in the supply chain gives the American Chemistry Council (ACC) the ability to identify emerging trends in the U.S. economy and specific sectors outside of, but closely linked to, the business of chemistry.

The Chemical Activity Barometer (CAB), the ACC’s first-of-its kind, leading macroeconomic indicator will highlight the peaks and troughs in the overall U.S. economy and illuminate potential trends in market sectors outside of chemistry. The barometer is a critical tool for evaluating the direction of the U.S. economy.

The index provides a longer lead (performs better) than the National Bureau of Economic Research (NBER). The CAB leads by two to fourteen months, with an average lead of eight months.”

How the Chemical Activity Barometer is Created

The CAB is a composite index which comprises indicators drawn from a range of chemicals and sectors, including chlorine and other alkalies, pigments, plastic resins and other selected basic industrial chemicals. It first originated through a study of the relationship between the business cycles in the production of selected chemicals and cycles in the larger economy during the period from 1947 to 2011. Other specific indicators used include:

• Hours worked in chemicals;

• Chemical company stock data; publicly sourced, chemical price information;

• End-use (or customer) industry sales-to-inventories; and

• Several broader leading economic measures (building permits and ISM PMI new orders).

The CAB is constructed using a five-step procedure similar to that used by the Conference Board to calculate composite indexes:

1. Calculate month-to-month changes in the component indices;

2. Adjust month-to-month changes by multiplying them by the component’s weighting;

3. Sum the adjusted month-to-month changes (across the components for each month);

4. Compute preliminary levels of the composite index; and

5. Rebase the composite index to reflect the average lead (in months) of an average 100 in the base year (the year 2007 was used) of a reference time series (the Federal Reserve’s Industrial Production index was used).

To update the CAB from month to month, steps 1 through 4 are followed to incorporate the most recent six months of data. The revisions to the base year (step 5) are made when the Federal Reserve changes its base year for the industrial production (IP) index.

CAB Recent Readings and Press Release

WASHINGTON (September 22, 2015) – The Chemical Activity Barometer (CAB), a leading economic indicator created by the American Chemistry Council (ACC), dropped 0.4 percent in September, following a revised 0.2 percent decline in August. The pattern shows a marked deceleration, even reversal, over second quarter activity. Data is measured on a three-month moving average (3MMA). Accounting for adjustments, the CAB remains up 1.2 percent over this time last year, also a deceleration of annual growth. In September 2014, the CAB logged a 4.1 percent annual gain over September 2013. It is unlikely that growth will pick up through early 2016.

The Chemical Activity Barometer has four primary components, each consisting of a variety of indicators: 1) production; 2) equity prices; 3) product prices; and 4) inventories and other indicators. During September chemical equity and product prices were down, production was flat, and inventories moderated.

The Chemical Activity Barometer is a leading economic indicator derived from a composite index of chemical industry activity. The chemical industry has been found to consistently lead the U.S. economy’s business cycle given its early position in the supply chain, and this barometer can be used to determine turning points and likely trends in the wider economy. Month-to-month movements can be volatile so a three-month moving average of the barometer is provided. This provides a more consistent and illustrative picture of national economic trends.

Applying the CAB back to 1919, it has been shown to provide a lead of two to 14 months, with an average lead of eight months at cycle peaks as determined by the National Bureau of Economic Research. The median lead was also eight months. At business cycle troughs, the CAB leads by one to seven months, with an average lead of four months. The median lead was three months. The CAB is rebased to the average lead (in months) of an average 100 in the base year (the year 2012 was used) of a reference time series. The latter is the Federal Reserve’s Industrial Production Index.

“Business activity cooled off in September,” said ACC Chief Economist Kevin Swift. “Chemical, other equity, and product prices all continued to suffer, signaling a likely slowdown in broader economic activity,” he added. “One bright spot continues to be plastic resins, particularly those used in light vehicles. Sales of light vehicles are on track to record a banner year, the best since 2000,” he said. Light vehicles are a key end use market for chemistry, containing nearly $3,500 of chemistry per vehicle.

Also at play is the ongoing decline in U.S. exports. According to Swift, global trade is lagging behind both global industrial production and broader economic activity with deflationary forces at play. With this month’s data, the CAB is signaling slower gains in U.S. business activity into early 2016.

We’ll be watching the CAB for negative growth readings going forward as another tool to assist in determining future investment strategy.

More Market Uncertainty

It’s bad enough to get confusing messages from our leaders on Monetary Policy but on Friday with announcement of Speaker Boehner stepping down as Speaker of the House next month adds a level of anxiety as it relates to Fiscal Policy. While his leadership has come under scrutiny from conservatives within his own party, his embattled position was still largely considered safe.

From the Washington Post, “John Boehner's decision to step down as House speaker next month almost certainly means the government won't shut down in the days ahead. It also could -- depending on how Boehner times his departure -- throw a big pile of chaos onto the U.S. economy. It puts the debt ceiling back in play. Sometime late this fall, Treasury Department officials have warned, Congress has to raise the limit on how much debt the federal government can hold. Debt ceiling clashes have been separate and very difficult fights from the battles over spending bills. And in this case, it's a much bigger deal for the economy than a short-lived shut down would have been.”

“The bigger threat in Washington's fiscal showdowns has always been the possibility that the government could exhaust its ability to borrow money before lawmakers reach a deal to lift the limit on national debt. If that actually happened, either the United States would default on debt -- roiling markets worldwide -- or it would start prioritizing who gets paid and who doesn't, from a group including Social Security beneficiaries, government employees and contractors and active duty members of the military. The only other option would be to pass a budget that balances immediately - a wild improbability, in a time when even the congressional Republican budget takes ten years to balance. "If you actually hit the debt ceiling, that's a disaster," said Joel Prakken, who founded the private research firm Macroeconomic Advisers.

Either default or large, sudden spending cuts would cut deeply into growth, at a time when the global economy still looks fairly weak. Even if Congress avoids the crisis, the possibility can discourage people from making important economic decisions in the meantime, until after lawmakers have made a deal and the danger has passed. As a result, economic activity slows.

Reaching the debt ceiling was always a risk, but Boehner's decision to step down raises new questions for investors, businesses and workers. With Boehner holding the gavel, at least they knew what to expect. "Changing leadership in the middle of the process is sure to be an extra complication," Prakken said. "We're watching it very carefully." If Boehner cuts a deal to raise the debt limit before he goes, as some Democrats are privately hoping, those fears go away. If he doesn't - and if his replacement comes to power vowing no more debt limit increases ever -- there's suddenly a lot to worry about.”

This turn of events will provide additional uncertainty for a stock market that can ill afford it at the moment. While House Majority Leader Kevin McCarthy (R-Calif.) is largely expected to fill the role, leaders from the Freedom Caucus have said point blank that they will not rubber stamp a new leader into power unless the members of that caucus are convinced of the new leaders commitment to conservative principles so important to the Tea Party movement.

From The Hill, “A co-founder of the conservative Freedom Caucus has a warning for any Republican hoping to replace outgoing Speaker John Boehner (R-Ohio): No one will get the promotion without our blessing.

Rep. Tim Huelskamp (R-Kan.), a sharp critic of Boehner, said Friday that there are roughly 40 members of the group — and another 20 conservatives outside of it — who won't back any new Speaker who fails their litmus test for conservative purity. And the group's leadership endorsements, he warned, will be “a collective, corporate decision.”

“We have enough votes in the House Freedom Caucus to prevent anybody from being Speaker. We will be a voting bloc,” Huelskamp said.”

Bottom Line: Market bias continues to be negative. We believe the market will retest the lows of August and quite possibly October of last year. We continue to incorporate a negative bias in our trading strategy looking for overbought situations in a down trending market. We do not believe at this point that we are heading for a full bear market and assume this to be a correction within the bull market. We will be watching and planning as such but are prepared to reconfigure should our assumptions turn out to be incorrect.

Joseph S. Kalinowski, CFA

Additional Reading

HSBC WARNS: The stock market 'is putting in a bigger top than eight years ago' – Business Insider

Furious Boehner allies lash out – The Hill

Freedom Caucus flexes muscle in Speaker's race – The Hill

 

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Something Isn't Right - Yellen Resistance

Credibility Crisis

The Fed decided to leave rates unchanged last week. The market seemingly received what was expected and longed for but sold off anyway. Our opinion in last week’s post was that the Fed risked losing credibility by not raising rates as the appearance that they were beholden to the stock market momentum. Indeed the news flow after the announcement focused on such consequences.

 Hawks, Doves and Chickens – Acting Man: “They are dead scared of being seen as setting off a market crash, and they know of course that more than six years of humungous money printing have achieved little besides blowing another bubble. In fact, the real economy, though not yet in recession, looks decidedly lame.”

Why the Fed couldn't raise rates – CNBC: “The one factor that held that power was the recent volatility (read: "selloff") in the stock prices. Simply put, the Fed still places far too much importance on the stock market as a tool for priming the economic pump.

The 10-percent selloff in U.S. stocks, and the much greater selloffs in China and other emerging markets, was THE factor that provided cover for the Fed's decision today. To me, though, the capital-markets volatility we have seen in recent months represents the downside to an ill-conceived policy of targeting stock prices as a way to spur economic growth. The Fed's explicit strategy all along has been to boost household wealth through stock and housing gains, hopefully causing a trickle-down effect. Now, heavily committed to that strategy, the Fed believes that if it moves to soon to tighten, it will risk reversing some of those (perceived) hard-fought asset-price gains.”

What was really at stake was repairing the Fed’s credibility in terms of successfully shaping US monetary policy and sending a powerful signal that the US economy is in strong shape.

The Federal Reserve is losing credibility by not raising rates now  - The Conversation: “Hoping to avoid previous bungled attempts to adjust monetary policy in recent years that led to significant market volatility, this time the Fed spent at least half of the year updating the language in its statements and gradually preparing the world for a hike. And since it did not deliver, this tells the world that the Fed is unable or unwilling to go against market expectations. As a result, the central bank will have to either delay the liftoff until the next meeting, slowly reshaping market expectations to be consistent with a hike at that point, or risk a financial panic if it decides on an unexpected policy shift sooner. Delaying the timing further would mean losing precious time in normalizing monetary policy, necessary so that the Fed again has the tools it needs to fight future economic downturns. There’s also the increased risk that the economy will overheat and cause inflation to spiral out of control. There is never a perfect time to start down this path; it is always possible to find reasons to delay. But each postponement requires even stronger data to justify an eventual liftoff the next time. The problem is that with the hesitant Fed sending mixed signals to the economy, that imaginary perfect day might not ever come.”

How The Fed Lost Its Cred  - Forbes: “The Federal Reserve bottled out Thursday when it decided not to raise the short term cost of borrowing money. It’s unfortunate, because the lack of action now removes any semblance of a fig leaf it could hide behind and still claim credibility. “Clearly, the FED does not even think it knows what it is doing,” writes Woody Dorsey of Market Semiotics. That seems to sum it up in a nutshell.”

Why Wall Street’s Stimulus Junkies Weren’t Thrilled by the Fed’s Rate Decision  - The Fiscal Times: “Cutting to the quick: Investors, it seems, are losing confidence in the Fed. While the Wall Street stimulus junkies should've been happy with the continuation of the status quo, there is now a nagging fear that credibility in central bankers is being lost — something that RBS' Head of Macro Credit Research Alberto Gallo took to Twitter this afternoon to reiterate. Moreover, the Summary of Economic Projections by Fed officials revealed that, at the median, policymakers now only expect a single rate hike by the end of 2015. The futures market is now pricing in a 49 percent chance of a hike at the December meeting (although Yellen noted that the October meeting was "live" and could result in a hike should markets and economic data improve).

But the kicker — the one that pushed large-cap stocks lower into the closing bell — was the appearance of a negative interest rate projection by a Fed policymaker on the newly released “dot plot.” Someone, it seems, expects federal funds policy rate to be in negative territory at the end of 2016. Four officials don't expect any hikes this year at all. Not only does this undermine confidence in the state of the economy, but it calls into question the efficacy of the Fed's ultra-easy monetary policy stance that has been in place, to varying degrees, since 2008.”

The Truly Stupid Case For More ZIRP  - David Stockman’s Contra Corner: “There you have it. The case for ease is that Wall Street prefers ease. Stated differently, the Fed and other central banks have generated such an humungous and incendiary bubble that they dare not risk puncturing it——even if it means indefinitely perpetuating the absolute lunacy of ZIRP.”

“The Fed is sitting on a powder keg. As my colleague, Lee Adler, noted the other day, the eruption of Federal Reserve credit since the early 1990s, but especially since the financial crisis, has inundated the banking system with excess reserves. To wit, so called “required” reserves are in the range of $95 billion, but excess reserves parked at the New York Fed amount to upwards of $2.6 trillion. So, as shown below, the Fed’s massive credit emissions never left the canyons of Wall Street.”

 

 

“Needless to say, this enormous reservoir of money caused a rip roaring inflation, but it was in the goods that Wall Street makes—-stocks and bonds—not the products and services generated by the factories, shops and offices located on main street.”

Developments Abroad

It appears much of the market dismay was rooted in a specific passage within the Fed’s policy press release. They go on to say (Emphasis added), “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad.”

Many market participants read this to mean the Fed is watching what is unfolding in the Chinese economy as a determinant for raising rates. So the question begs, if the Fed has pushed “liftoff” out into October or December, what is going to happen in China over the next several weeks to appease their concerns.

I am not an expert in the Chinese economy. I have never been there nor invest directly (I’ve bought a China ETF in the past). What I can say from my readings on the topic is that it appears the Chinese economy is going through a significant metamorphosis as it transforms itself from a manufacturing based economy to a service based one. John Mauldin from Mauldin Economics has views on China that I continually reference. He writes, “The China of today is not your father’s China. Fifty percent of the economy is now services. That part of the economy is growing – and evidently growing enough to offset the contraction in the manufacturing sector. And we must remember that China actually added twice as much to its GDP in either dollar or yuan terms in the past year than it did in 2003 when its growth was a “miracle.” That helps to put their reduced growth in context. As I have pointed out, the law of large numbers requires that their growth will be slower in percentage terms in future years.”

“The transition from an investment-driven export economy to a consumption-driven service economy will take years. Further, it won’t be easy for those on the industrial side of the house. While it may be hard to believe, over the years China has lost more steelworkers than the US and Europe have. They overbuilt steel mills. It seemed that every province wanted its own mills, and their production capacity just grew too large. It likely still is too large.”

“As Worth Wray and I wrote in A Great Leap Forward?, China is engaged in a transition from which it cannot turn back. Well over a billion Chinese are in various stages of joining the modern world. Our planet has never seen anything like this, so it’s no surprise that the process is rocky. The transition will continue regardless, because China has no other option.”

So China is going through a massive economic transition and it needs to resolve itself before the next Fed committee meeting. Yes that is a ridiculous statement but it puts into perspective the economic challenges that are likely to get worse before they get better.

So when the Fed says its monitoring developments abroad over the next few weeks to assist in the monetary policy decision making process they appear to be talking about the stock market. Once again this is a credibility issue. John Mauldin also writes, “It’s easy to assume that a country’s stock market reflects the condition of its economy, but that is not always the case. Further, what the stock market really does reflect is the consensus estimate of an economy’s future condition. More specifically, stock prices reveal future expectations for corporate profits.

This generally applies to both the United States and China. One key difference, though, is that most American stocks represent companies that seek to make profits. In China, that isn’t necessarily the case. The Chinese stock market includes many state-owned enterprises (SOEs), whose executives answer to bureaucrats in Beijing. The government views them as public policy tools. Everyone is happy if the SOEs make a profit, but profit is not the first priority. If US stock prices generally tell us more about the future than the present, except in times of serious over- or undervaluation, then Chinese stock prices tell us even less about either. Just as last year’s incredible run-up in Chinese stocks did not signal an economic boom, the ongoing decline does not signal an economic bust. The correlations aren’t just weak, they are nonexistent.”

Yellen Resistance

The global economy appears to be struggling. Corporate revenues and profits in the U.S. are shrinking year-over-year. Stock volatility is the highest it has been in years and the long-term market technicals are on the verge of breaking. Fiscal policy is a mess as always with another threat of a government shutdown on the horizon. And now the Fed has come out and told us that as soon as the stock market gains some traction, they’re going to smack it down by raising interest rates. How can anyone be excited about owning equities at this point?

As Chairman Bernanke provided support for equity markets in the past, it seems Chairman Yellen has just supplied Fed resistance for the market. After digesting the information for a day or two, it finally is clear to me why the market sold off the way it did when seemingly getting exactly what was wanted and expected. I could be wrong, certainly much of the macroeconomic complexity is above my pay grade but one can’t deny such curious action.

Something Is Wrong Here

As per the Fed’s dual mandate they are acting now to govern full employment that is expected during times of swelling economic growth and contain inflation from wage pressures from a robust labor market that is sure to follow. We’re told this is right around the corner. The only issue is that economic growth is anemic (especially as the global economy slows) and excessive inflation seems non-existent (especially as the global economy slows). Take a look at these graphics from Bloomberg and make note of the trend over the past several years.

 

 

We face a problem of slowing global economics. Declining demand for goods has impacted the commodity space and emerging markets significantly thus the spiral continues. This along with the stronger U.S. dollar has created an inflation dynamic that appears to be truly hindering the task at hand for the Fed. I read this article in The Economist that summarized the situation fairly thoroughly. “The challenge for the Fed is as follows. Many have interpreted Ms Yellen’s focus on the labour market as a signal that once slack is gone, rates will rise. This follows from a conventional model of the economy that says a tight labour market leads to inflation later on, as firms bid up wages and then raise prices to offset the cost. So strong has Ms Yellen’s emphasis on the labour market been that some analysts thought August’s jobs numbers were all that mattered for today’s decision. But the world economy is throwing a spanner in the works of this model. In the committee’s median forecast, inflation does not return to target until the end of 2018, despite three years of near-equilibrium unemployment.

If the world economy continues to weaken, the Fed will need an ever-tighter domestic labour market to meet its 2% inflation goal.  Ms Yellen would then find herself demanding “further improvement” in the labour market every month, even in the face of repeatedly strong labour market data. That would be a confusing message for markets, especially if unemployment falls beneath the Fed’s own estimate of its long-run sustainable rate and broad measures of underemployment fall further.

Ms Yellen’s focus on the labour market, then, does not mean that the Fed is ignoring the world economy. Quite the opposite; the gloomier the world outlook, the stronger the labour market must perform to justify a rate rise. In the coming months, markets should look to the world, as well as the jobs data, to predict when interest rates will, at last, take off.”

If deflation becomes a key import for the U.S. then the Fed’s job will get even more difficult. In this piece by Ozy, ““We are only one misstep from outright deflation in the West,” says Edwards, noting that the core level of inflation, which excludes food and energy, is around 1 percent in the U.S. and the eurozone, which is considered very low. He foresees more devaluations sending “waves of deflation to the West to overwhelm already struggling corporate profitability.” Edwards’ colleague, Robbert van Batenburg, a market strategist at SocGen, says, “There are many who believe this is just the beginning of the devaluation [by China.]” Or put another way, more devaluations will send more waves of cheaper goods raising the risks of deflation.

Why is this such a concern? After all, falling prices mean cheaper goods, right? (Also, put aside whether the government inflation statistics are a precise measure of this phenomenon.) Cheaper goods are great for consumers, but not for corporations that might have borrowed. Falling prices result in lower revenue, yet the debt companies owe stays the same. Likewise, the mortgage on your home doesn’t get reduced just because your salary dropped. In fact, it’s probably fair to say that many workers may already feel that their pay hasn’t kept up with the cost of living since the financial crisis — a form of relative wage deflation.”

What The Markets Will Tell Us

The market as a whole are at times more intelligence than its participants. All I can do is humbly attempt to interpret the battery of information that is provided. As earnings season wraps up and we now enter the pre-announcement season, we are seeing cracks in the corporate earnings picture as it relates to economically sensitive companies. Consider FedEx, certainly a gauge for sensitivity changes in the global economic outlook. They reported lower than expected earnings and lowered annual guidance citing slower demand for global freight services as one of the reasons. Caterpillar, another economically sensitive company met earnings expectations but missed revenue projections and guided lower going forward, also citing slower global economic growth and the deteriorating commodities sector. Pepsi, John Deere and Microsoft have all expressed concerns about the slowing global economic picture. The nuggets of information from these earnings reports are priceless but glum and should be ignored at one’s portfolio peril.

I viewed the following chart from BloombergBusiness.

 

It shows that leading into the Fed announcement the best performing sectors included Utilities, Consumer Staples and Health Care. The worst performing sectors included Materials, Financials and Industrials. This is discouraging for me because I would expect the exact opposite heading into a perceived Fed rate hike. A Fed hike should indicate strong economic growth, wage pressures, potential inflation and accelerating corporate fundamentals. To have utilities outperforming and financials underperforming heading into the Fed hike is just unusual for me. The market is telling us something is not right.

Even though the market was expecting the Fed to remain on hold, the market action last week exhibited perplexing price action. Treasuries and Gold moved higher on the announcement (safe haven instruments). Global stocks sold off but utilities and REITS held firm. Not the type of action one would expect to see in an economically strong situation and certainly not the place investors would be expected to move money in the face of rising interest rates. One of the hardest hit sectors was the financials. Banks and insurers sold off and isn’t exactly what an investor would expect in the face of rising interest rates. Something is out of order. A continuation of this pattern could spell serious problems on the horizon.

Yield spreads are also indicating fixed income investors may be anticipating something equity investors are not. We pointed out in the past that yield spreads and the stock market have been diverging since the start of the year. That gap has closed somewhat given the recent market weakness but the spreads are still tilting toward additional downside.

 

The lumber-to-gold ratio that we track has been trending lower since the start of the year as is the copper-to-gold and steel-to-gold ratio. By comparing these construction materials to a safe haven instrument can provide economic insight and market directional indications.

 

 

 

 

These market signals are concerning in our view and are worth watching. While we continue to believe that this is a moment of correction for the stock market and not a bear market that opinion can change with changes in the underlying analysis. In a blog post a few weeks ago, we noted that we will need to see the yield curve for the two and ten year flatten significantly (or invert) in order for us to be swayed closer to the bear market camp.  

So what’s Next?

We have been very fortunate thus far navigating the market. We inserted portfolio protection and built short positions prior to the crash of 2015 (see Time to Consider Portfolio Protection 8/9/15). We covered of short positions in anticipation of a bounce in the market and took long positions for our more risk tolerant investors (How We Position Ourselves From Here 8/23/15). In the note we wrote we were looking for a rebound in the S&P 500 to a level between our lower bound 2020 and upper bound 2070. We took off our long positions upon the Fed announcement (SPX briefly hit 2020) and we now expect additional downside from here.

From StockCharts.com, “The "rising wedge" pattern in Chart 2 strongly suggests that the short-term rebound in the S&P 500 has ended. A "rising wedge" is identified by two rising trendlines that also converge. A break of the lower line would confirm that the bounce has ended. The volume pattern (below chart) confirms that negative view. Volume was light during the price rebound, before turning higher on Thursday and Friday as prices fell. Although some of Friday's volume can be attributed to the expiration of futures and options, it was still the third heaviest trading day of the year. That suggests a lot of selling. It also suggests that a retest of the August low is likely.”

 

 

“My September 2 message addressed the question about whether the market is in a normal correction or something more serious. We'll find out soon enough. I've leaned toward the correction view (a drop of 10-15%), but a lot of longer-term indicators suggest a more serious decline (20% or more). The only way we'll know for sure is whether or not previous support levels hold. The daily bars in Chart 3 put the recent stock rebound in better perspective. Thursday's downside reversal day in the S&P 500 took place just shy of the 62% retracement line. (The Dow bounce ended closer to the 50% line). Those are normal spots for a counter-trend bounce to end. The SPX also fell short of its 50-day average. The 50-day also remains below the 200-day line which is a negative sign. The normal expectation is for a retest of the August low which means a loss of -12% from its May high. A drop to more important support at last October's low near 1820 would constitute a loss of -15% from its May high which is still correction territory. But that low has to hold if this is just a correction. The month of October is also very important. My August 26 message studied three previous downturns in 1987, 1998, and 2011. All required a retest of the first low before turning back up again. And all three bottoms took place during October. All we can say with some degree of confidence at this point is that prices are probably headed lower in the weeks ahead, most likely into October. How much lower will depend on whether or not previous lows hold. In the meantime, a very cautious stance is still warranted.”

 

 

Bottom Line: We have stated in the past that we would use a near-term bounce to close specific long investments. We have done that and will be using near-term overbought situations to take advantage of what we believe is a downward bias in the stock market. We believe this is a correction within the bull market currently and expect the market to bottom sometime in early 4Q15 before resuming an uptrend. Should the economic picture continue to deteriorate our view may shift to a more bear market investment thesis. We will be watching for clues.

Joseph S. Kalinowski, CFA

 

Additional Reading

Stock market tumbles: How the Fed caused a freakout – Fortune

Lots of Things Ray Dalio Knows he Knows – Pragmatic Capitalism

The Fed Stands Pat -- And So Will The Economy – Forbes

X-factor Report – Street Talk with Lance Roberts

Dangers Facing Stocks – Barron’s

Occam’s razor says the stock market is in a downtrend – Market Watch

 

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The above information should not be construed as a solicitation to buy or sell the securities discussed herein.  The publisher of this report cannot verify the accuracy of this information.  The owners of Squared Concept Partners, LLC and its affiliated companies may also be conducting trades based on the firm’s research ideas.  They also may hold positions contrary to the ideas presented in the research as market conditions may warrant. 

This analysis should not be considered investment advice and may not be suitable for the readers’ portfolio. This analysis has been written without consideration to the readers’ risk and return profile nor has the readers’ liquidity needs, time horizon, tax circumstances or unique preferences been taken into account. Any purchase or sale activity in any securities or other instrument should be based upon the readers’ own analysis and conclusions. Past performance is not indicative of future results.

 

 

 

 

Shackling The Invisible Hand

I was traveling in the South Eastern part of the U.S. on business last week and made a few observations. One evening while frequenting a local watering hole enjoying the New England vs. Pittsburgh game, there was a group of non-professional investors that started talking about the market. As I listened to their views with great interest, it struck me that a level of panic that I was expecting to hear wasn’t present. In our blog last week we pointed to several sentiment indicators that are falling to levels usually consistent with a near-term bounce. Indeed as a follow-up to that analysis the CNN Money Fear & Greed Index is signifying extreme fear in the market place and should be considered a contrarian bullish indicator. 

 

 

 

 

So where was the panic in the discussion with this specific group of people? I understand small sample size and geographic concentration so there isn’t much to draw upon to form a conclusion but I definitely thought it was quite curious. Then as I picked up the Wall Street Journal to read on the plane I came across the title, “On Stock Slide, Investors Say, “What, Me Worry?”. I attached the online version of the article here. The article states, “U.S. investors stayed cool in August despite a wild stock-market rout. Outflows from mutual funds and exchange-traded funds that invest in U.S. stocks dropped to their lowest level in six months, according to new data from research firm Morningstar Inc. Investors withdrew a net total of $4.9 billion from these funds last month, but that was down from $9.6 billion in July, according to Morningstar. The largest so far this year is a withdrawal of $25.9 billion in April. “The panic wasn’t that great,” said  Alina Lamy, a senior markets analyst at Morningstar. “There is still some confidence in the U.S. market.””

Perhaps there is a slight disconnect between these traditional sentiment indicators and actual investor behavior. Perhaps the side effects of unorthodox monetary policy (QE and Operation Twist) have had a profound impact of investor psychology in ways we cannot quite understand yet. As I try to think back in time and ask myself, does the market have a feel of despair to it? In 2008 and 2011 there was “blood in the streets” and true wide spread panic. Even in early 2000, before the major market damage was done, there was a feeling of inevitability that there was something bad coming. In early 2000, when the market caps of all these dot.com companies were astronomically high even though profitability was decades off in some cases one couldn’t help but feel worried. I wrote an article in early June 2000 entitled Reality Check.com and said 90% of the dot.com companies listed will be out of business in a year, and of the remaining 10%, 90% of those remaining will never show profitability. I listed a group of companies that I thought were in danger of failing. It was a good piece. I found a version of it in the Los Angeles Times for review.

I did some digging on further evidence that investor sentiment hasn’t quite washed out and found a few interesting tidbits on the subject. According to StockCharts.com DecisionPoint Rydex Ratio, “A great measure of sentiment is the DecisionPoint Rydex Ratio. Sentiment has traditionally been measured by taking polls of selected groups of investors, advisors, investing professionals, etc. Rydex is an unusual mutual fund company in that it publishes the total dollar amount of assets in each of its funds on a daily basis. This makes it possible for us to analyze sentiment based upon what investors are actually doing with real money. We do this by calculating a daily bear/bull asset ratio and monitoring the relationship between assets in the two types of funds. The first chart measures what the total assets are in each class. Currently total assets in bear funds has still not reached previous highs experienced in 2009/2011. The Rydex Asset Ratio is about .50 which tells us that there is more money in bull funds currently. When the reading is greater than 1, that tells us there are more assets in bear funds and money markets. Previous readings at 2009/2011 bottoms were nearly 2, meaning in a general sense that for every dollar in a bull fund there were two dollars in a bear fund.”

 

They also point out, “NAAIM stands for the National Association of Active Investment Managers. This professional group reports its exposure to US stocks on a weekly basis. The exposure index reflects the average exposure of NAAIM members. At previous market bottoms, they were not nearly as exposed as they are now.”

 

They go on to conclude, “Yes, sentiment indicators are contrarian, and although readings are sufficiently bearish to normally indicate a market bottom, we saw that these indicators can get even more one-sided or deeply oversold, especially at major market reversals. Observations at previous major market bottoms tell us people aren't bearish enough right now.”

In the latest Duke University/CFO Global Business Outlook, it appears the world’s leading Chief Financial Officers, presumably the people that have their finger on the pulse of corporate activity and productivity clearly view the market with a skeptical but confident eye. “CFO optimism about the U.S. economy has weakened but remains the strongest in the world. On a scale from zero to 100, financial executives rate the outlook at 60, down from 65 in the spring and 63 last quarter. As a result, business plans will soften somewhat. Capital spending is expected to increase only 2.4 percent at U.S. companies and earnings will rise only 3 percent. Merger and acquisition activity will continue, with the deals funded primarily by cash and debt. "Finance executives are eager to help their companies start building again," said David W. Owens, editorial director for CFO Research, "but they feel some drag from continuing uncertainties about government actions and consumer reluctance at home, and about economic conditions overseas, especially in China."”

Fifty-five percent of these CFO’s believe the market is still overvalued even after the current sell-off. So it appears that this group of individuals are taking a cautiously optimistic stance. There is some trepidation in the report but nothing that screams to me extreme panic. I would find that comforting if not for the unreliable benefits of heeding the advice of such groups.

In a white paper entitled MANAGERIAL MISCALIBRATION by Itzhak Ben-David, John R. Graham and Campbell R. Harvey they go on to conclude, “Over the past 10 years, we collected more than 13,300 S&P 500 forecasts, including 80% confidence intervals, from CFOs. We study the abilities of CFOs to estimate probabilities over time and in the cross-section and examine how these abilities affect the corporate policies at the CFOs’ firms.

We use several methods to show that CFOs are, on average, severely miscalibrated: their confidence intervals are far too narrow. For example, the 80% confidence interval for their one year forecasts contains only 36.6% of the realized returns. We find that confidence intervals are wider in periods of high market-wide uncertainty, but during these periods, CFOs are even more miscalibrated. We also show that the size of the confidence intervals is related to the dispersion of forecasts across CFOs.”

 

This last article I thought was fabulous and ties well into these observations. According to the blog Acting Man, Pater Tenebrarum released a piece entitled Oblivious to Risk – Investors in LaLa-Land. In it he writes, “Given current market volatility and the increasing amount of evidence showing that the global central bank money printing orgy of recent years has utterly failed to produce a so-called “self-sustaining” recovery, it is quite odd how nonchalant investors remain about the outlook for “risk assets” such as stocks.”

“This chart depicts the MSCI Global Index and contrasts it with a “macro confidence” indicator (“global risk sentiment”). This indicator does not take sentiment surveys into account – instead it is purely based on a variety of market prices and positioning data that are held to reflect investor sentiment. Not surprisingly, this indicator often has contrarian implications. It is quite stunning to what extent it is currently diverging from stock prices. Apparently, investor confidence not only hasn’t suffered, it has actually soared to a new high for the year:”

 

He goes on to summarize, “It is perhaps not surprising that investors have such faith in central banks saving their bacon – after all, it is common knowledge that unbridled money printing has been the main driving force behind asset price inflation. When central banks (or commercial banks with central bank assistance) are expanding the money supply, it is an apodictic certainty that some prices in the economy will rise. Given the manner in which new money enters the economy, it is quite normal that securities prices are among the first prices to rise, and clearly they are also among the prices affected the most by an expansion of the money supply…The market has delivered a warning shot in August, but it seems investors aren’t taking it seriously yet. This could turn out to be a costly mistake. If (or rather when) faith in the omnipotence of central banks crumbles, we could see an unusually severe market dislocation.”

He also points out an article in his blog entitled Attention: Investors lacking risk awareness on equities! This analysis is provided by behavioral finance firm sentix. They report, “The latest sentix data set reveals an alarming discrepancy: investors’ fundamental belief in equity prices is still rising despite falling economic expectations. Potential risks are especially lurking in the US market. Investors are turning a blind eye on possible adverse effects for equities as economic optimism fades.

The sentix Economic Index for September drops significantly for all major markets and regions. Notably expectations of economic acceleration are on the decline. Such drops in investors’ expectations are usually early warning signs for declining equity markets. By itself, economic expectations convey an alarming message. However, in combination with results shown by the sentix Strategic Bias for equities, which aims at capturing investors’ fundamental belief in equities, the signal is even more puzzling. Strategic Bias rises, especially for US markets (see figure).”

 

 

 

“Discrepancies of such magnitude reflect serious risks. Though, rising skepticism about economic expectations has not raised investors’ awareness regarding equity price developments – investors still perceive an engagement in equities as an investment without alternative. Moreover, investors’ blind trust in the power of central bank interventionism is threatening. Would behavior be consistent with expectations should reactions follow suit – with negative consequences for equity price developments.”

Bottom Line: While the sentiment indicators that we highlighted last week are indicating extreme deterioration in investor sentiment we find from actions of investors that sentiment hasn’t washed out to levels of extreme panic. We adhere to our conclusion from last week, “We expect continued market volatility with a near-term rally followed by market weakness into the end of 3Q and into 4Q before stabilizing and heading higher again. Intermediate and long-term momentum remains negative and we will be preparing to use overbought situations to protect and/or monetize further weakness. Should the global and U.S. economic picture continue to deteriorate, then we will readdress our thesis.”

Double Bottom Line: We are on alert for another potential downturn in the market. The technical picture makes the case for further weakness and a disappointing Fed release this week could make or break the current trading cycle.

 

Shackling the Invisible Hand

Speaking about this insane Pavlovian relationship between investor sentiment and central bank monetary policy, it got me thinking of the free market system. There have been quite a few examples lately of institutions of power trying to mold or manipulate markets. This battle against the free forces of “the market” can’t end well.

Example #1: The powers that be in China attempting to stem the falling Chinese stock market. In early July we wrote, “The near-term prospects may provide a bounce in the ETF but ultimately we believe there is little centralized regulation can do to stem a market correction. More importantly is the long-term concerns on the economic and financial stability in China. As such a key driver of global economic growth, a major economic, financial and social upheaval in China is enough to start the correction in U.S. equities that so many are talking about.”

We pointed out the enormous efforts by China to throw everything they had to stop the market decline at the time and in the end it seems their desired outcome has yet to be determined. Indeed from the time of that last post, the iShares MSCI China Index Fund (MCHI) is down an additional 15% on top of the 17% decline it suffered at the time of the writing.

This type of free market intervention has a low probability of success in our opinion.

Example #2: OPEC’s (Saudi Arabia’s) strategy of flooding the market with oil to drive prices lower and retain market share while hurting competitors. Admittedly at first I thought this strategy would work in the near-term but it is becoming increasingly clear that Saudi Arabia may have gotten out ahead of their skis. As we wrote in early August, “The Saudi Strategy calls for lowering the price of oil to cripple those producers at a higher cost point in order to maintain market share. The near-term manageable pain felt by the Saudi producers would be well worth the destruction of the U.S. shale boom and preservation as a leading producer. This is how I imagine the argument goes. The question arises if the Saudi’s miscalculated the ingenuity and efficiency of the American capital machine. It is true that U.S. rig counts have been in a free fall. That said, U.S. production has not as of yet witnessed a significant drop in reduction. True many of these drillers need to maintain production levels in order to meet interest payments on their debt and keep the operations going. The hope is for survival through a temporary depression in the underlying commodity. This also forces these companies to extract higher levels of productivity than in the past and a favorable turn in the supply – demand dynamic will have an exponential effect on operations and profitability. If it is found that these companies are unable to withstand the weakened business climate, there will certainly be bankruptcies. That said, it’s our opinion that the money behind many of these entities is fairly intelligent and there will also be restructurings, mergers and acquisitions that will make the overall industry that much more efficient and productive.”

It is our opinion now that this price war strategy is doing more harm to OPEC and is actually making our energy industry that much stronger. When we look at investing, we have our shorter term tactical positioning (we own XLE puts and are doing well) and our longer term strategic positioning (Why We're Investing in the Energy Sector). Our strategic investment position resides with the U.S. large cap energy sector offering value and allowing us to build positions while protecting our build from market weakness by putting in place portfolio protection. If all goes as planned, we will have had the opportunity to build our energy position without significant losses while doing so. Once investor sentiment in the sector aligns more closely to the favorable fundamental picture then we can unwind the protection investments while enjoying the upside of our accumulated positions while the market was weak. That is our strategy and we are executing it as best to our ability.

In our view, it is conceivable that Saudi Arabia will realize that their level of market control is deteriorating and they may shift gears as it relates to their current pricing strategy. According to OilPrice.com, “The IEA is of the opinion that prices may need to fall further in order to slow production enough to really reduce supplies, but perhaps that misses the point. Supply is a function of price, and if OPEC forces U.S. producers to become more effective in their own operations, then in the end that simply hurts OPEC’s own ability to control prices. There is nothing worse for a lumbering cartel than a nimble firm that can jump in and take profits whenever an opportunity presents itself. With that in mind, perhaps OPEC should spend less time waiting and more time figuring out how to optimize its own operations in response to prices.”

This type of free market intervention has a low probability of success in our opinion.

Example #3: The Fed’s unconventional monetary policy actions since the great recession. It is my belief that the Fed set out to stabilize our economy when things went south in 2008 and 2009. At the time QE and later Operation Twist were justified to provide confidence and liquidity to an economic system that was under extreme stress. The chart below highlighted in Business Insider shows the impact of QE on stock prices.

 

 

 

They write, “In a note to clients on Thursday, Morgan Stanley's Adam Parker sent around an updated version of his chart showing stock market declines since the financial crisis. Earlier this year, it looked like the stock market was getting over its addiction to QE, illustrated by the fact that the first stock market sell-off in a post-QE era saw a quick rebound. But with the recent 12% drawdown in the S&P 500, it looks like the market hasn't gotten used to going it alone. Or said another way, the market hasn't gotten used to not having what Parker called in June, "the stabilizing presence of QE."”

It is for this reason that we may be seeing unusual market sentiment activity and why we could be in for additional downside in the market. The unfortunate effects of the Fed’s monetary policy is the danger that the tail starts wagging the dog. The removal of their accommodation may cause just as much havoc as their reason for implementing it.

I have no idea what the Fed will do this week, but to prevent this moral hazard, loss of credibility and the perception of loss of control, I feel there is no choice for the Fed. They must raise rates sooner rather than later (September) to avoid looking weak and inconsequential at this point.

Being the most transparent Fed is a double edged sword and they need to remain vigilant as it relates to their core mandates and not be perceived as the market trader of last resort. Perhaps a visit to the good ol’ days when Alan Greenspan would testify to Congress and leave the rest of us asking, “what the hell did he just say?”

This type of free market intervention has a low probability of success in our opinion.

The Good (case for a Fed hike)

It's never taken longer for US businesses to fill a job opening – Business Insider: “Not only is the number of job openings in America the highest it's ever been, but it's also taking businesses a record amount of time to fill those openings. According to Dice Holdings' DHI-DFH Mean Vacancy Duration measure, it took US businesses an average of 29 days to fill a job opening in July. Dice bases the number using data from the the BLS's Job Openings & Labor Turnover Survey (JOLTS). A job is filled when someone accepts an offer to take an open position. "Longer vacancy durations and falling unemployment rates point to a considerable tightening of labor markets in recent months,” said University of Chicago's Steven Davis.  “Wage pressures are likely to intensify if the economy continues along this path." This is another piece of good news for the labor market, which is big considering the Fed's rate hike decision next week will have a lot to do with American jobs.”

“GDP is far from the rather exact number most people think. There are lots of ways to measure GDP; and recently, what is not measured has been the cause for some controversy, at least among economists who care about such things. Given that second-quarter GDP was revised up substantially on Thursday to a surprisingly high 3.7%, it is even more appropriate to look at how that number is created. Bloomberg ran a short article pointing out that if you took the oil slump out, it was much higher still:

 

The U.S. clocked its fastest rate of economic growth in nine years. Well, at least if you strip out the effects of a battered energy sector.

 

Oil and exploration companies this year have cut back on investment in response to a plunge in crude prices that gathered steam as 2014 drew to a close. If it weren't for such a dramatic reversal in demand for drilling rigs and wells, the economy would have posted its strongest pace of growth since the start of 2006.

 

Weapons of Economic Misdirection – Mauldin Economics: “Gross domestic product, which includes what consumers, companies and governments spend and invest, increased at a 4.5 percent annualized rate in the second quarter when outlays for exploration, shafts and wells are excluded. Can that really be true? Even without taking out the oil industry, GDP growth this quarter was about as good as it gets these days. It gets even better when you realize that nominal GDP was 5.85%, with a 2.09% implicit price deflator. Let’s review that for a second. Well above 3% growth, 2% inflation, the most popular measure of unemployment is down to 5%, and interest rates are still held to 0%? What is wrong with this picture? How in the name of holy righteous monetary policy can the Federal Reserve not raise rates at its next meeting? If they use the recent market turbulence as an excuse, they will lose all credibility as to being focused on monetary policy rather than looking at the stock market to determine what policy should be. They told us they wanted two percent inflation? Bingo – got it. Unemployment is moving in the right direction; and unless we get some disaster of an employment number in September (which doesn’t appear very likely), we have to be as close to the sweet spot for an interest rate hike as the Fed has been in seven years. Truly, I can see no reason for a delay other than some very misguided understanding of how the economy works. This zero interest rate policy is creating all sorts of malinvestment and inappropriate financial behavior, and we need to begin to move towards normalization.”

The Employment Report–Not Bad Enough To Derail Fed Action – Bob McTeer’s Economic Blog: “Like Wagner’s music, the August jobs report is better than it sounds. Not great, but good enough to permit a long-overdue tiny adjustment in the Federal Funds rate. Yes, 173,000 more establishment payroll jobs could have been better, but the farther we go in taking up the slack in a labor market with increasing mismatches between skills demanded and supplied, the harder it is to stay above the 200,000 rate. Besides, we should also count the 44,000 jobs added to the June and July estimates. And, given labor force shrinkage, an impressive 237,000 fewer people counted as unemployed, thus bringing the unemployment rate down to 5.1 percent. Five-percent unemployment here we come. Of course, the big question on people’s minds is what is the impact of this report likely to be on the FOMC’s decision on rates. Coming in the midst of all the financial turmoil recently, this report is probably a small argument for delay. However, if I were still a member of the FOMC—and remember I was known as the Lonesome Dove—I’d vote for a September increase anyway. Not so much because the jobs report was not as bad as it sounds, but because normalization is long overdue. Too bad opportunities were missed prior to August 11 when China made a sensible and modest adjustment in its currency management. But, even so, it looks like markets will continue to obsess over timing until the band aid is ripped off. I’ve been a victim, I think, of the frog in boiling water syndrome. I don’t know exactly when the prolonged emergency monetary policy became overdue for change, but I do believe it has. There is no emergency in the U.S. economy anymore. We aren’t doing well, but we are doing better than almost everyone else. And, don’t forget, we don’t measure our output on a per-person or per-worker basis, but on an aggregate growth basis. We can’t expect such a shrunken work force—some of it voluntary, by normal retirement, rather than involuntary because of cyclical weakness—to put up aggregate numbers to match those of a larger work force relative to population.”

 

The Bad (case against a Fed hike)

TOP BANKER: It is basic 'common sense' that the Fed should delay lifting rates – Business Insider: “It is the question of the hour: should the Federal Reserve lift interest rates this month, or delay? According to Laurent Bouvier, the head of the global industrials group at UBS, the answer is really pretty obvious… He sets out two key arguments against a 2015 rate hike: broken econometrics, and unexplained levels of inflation. He said in a note to clients: "The Great Financial Crisis followed by black magic-infused monetary policies have broken macro-economic models, preventing economists and central bankers from predicting future macro developments with much accuracy, if any, even in the short term." He provides a number of examples, such as the stronger-than-expected second quarter US GDP growth, and the weaker-than-expected first quarter US GDP contraction as evidence. "In that context, expectations cannot possibly be relied upon to guide the Fed’s decisions. Waiting for tangible and explainable evidence of a sustained rebound in economic activity is the only way forward." On a related note, the unexpected low levels of inflation support the idea that economists are no longer able to predict the future. The inflation index ex-food and energy is up 1.2% over the past year, according to Bouvier, below the 2% inflation rate targeted by the Federal Reserve. And that 2% target may be too low anyway, according to Bouvier. He said: "To effectively break away from the Great Financial Crisis and enter wholeheartedly into a new economic cycle, a higher inflation rate is not only welcome, but required as one of the lessons learnt from Japan."

Global Economy Nearing a “Structural Recession” – Wolf Street: “To the never-ending astonishment of our economists, global growth has been much weaker since the Financial Crisis than before it, despite enormous global stimulus from years of extreme central-bank monetary policies and record amounts of government deficit spending. This should not have happened, according to our economists. Fiscal stimulus and expansionary monetary policies beget economic growth, which beget even more economic growth. That’s the theory. And that’s precisely what hasn’t happened. All it did was inflate asset prices. But the global economy has been a dud.”

Fed Up with the Fed – Project Syndicate: “Even now, seven years after the global financial crisis triggered the Great Recession, “official” unemployment among African-Americans is more than 9%. According to a broader (and more appropriate) definition, which includes part-time employees seeking full-time jobs and marginally employed workers, the unemployment rate for the United States as a whole is 10.3%. But, for African-Americans – especially the young – the rate is much higher. For example, for African-Americans aged 17-20 who have graduated high school but not enrolled in college, the unemployment rate is over 50%. The “jobs gap” – the difference between today’s employment and what it should be – is some three million. With so many people out of work, downward pressure on wages is showing up in official statistics as well. So far this year, real wages for non-supervisory workers fell by nearly 0.5%. This is part of a long-term trend that explains why household incomes in the middle of the distribution are lower than they were a quarter-century ago. Wage stagnation also helps to explain why statements from Fed officials that the economy has virtually returned to normal are met with derision. Perhaps that is true in the neighborhoods where the officials live. But, with the bulk of the increase in incomes since the US “recovery” began going to the top 1% of earners, it is not true for most communities. The young people at Jackson Hole, representing a national movement called, naturally, “Fed Up,” could attest to that.”

There is no Defensible Argument for Raising Rates at Present – Pragmatic Capitalism: “I am a little stunned by the Fed’s insistence on leaving a rate hike on the table in September.  What is the purpose of this?  Worse, I have yet to hear a strong argument justifying this view.  So far the “logic” appears to amount to “we’ve been at 0% for too long”, “the Fed wants to raise rates so they can lower them later”, “we need to fend off financial instability” or “we just need to get that first hike out of the way”.  These arguments display a total lack of risk/reward analysis. First, the natural overnight rate is 0% because a banking system with excess reserves will bid the overnight rate down to 0% naturally.  People who argue that overnight rates have been “mispriced” or “manipulated” flat out don’t understand how reserve banking works. Second, raising rates 25 bps does not provide ammo for later on.  If cutting rates by 500 bps over the last few years didn’t spark a recovery then why would cutting from 25 bps?  Third, the Fed is contributing to global financial instability by watching the dollar climb ever higher so that argument doesn’t hold much water. Let’s look at things from a practical perspective here.  The last few months have been a game changer.  We know that global economies are teetering on the edge and that US financial conditions are tightening (as seen in break-even rates).  We know that a rising dollar is hurting corporate America.  We know that the commodity crash is being exacerbated by the dollar’s rise which is subsequently feeding through to the global economy. But more importantly, we know that raising rates by 25 bps will do virtually nothing for the US economy.  So, what we have here is a situation where the upside is literally nothing.  And the downside is the potential that the Fed will exacerbate turmoil in the global economy and potentially create a positive feedback loop where the foreign weakness actually bleeds into the US economy.”

3 Things: Fed Hike, Now Or Never, Claims – Street Talk with Lance Roberts: “The most anticipated, discussed and fretted about meeting of the Federal Reserve Open Market Committee (FOMC) is rapidly approaching. That meeting will answer the one singular question on every investors mind – will the Fed hike interest rates? The chart below shows that the Fed has maintained near zero overnight lending rates for a period longer than any other in history.”

 

“The consequence of extremely accommodative monetary policy has been a blistering run-up in financial asset prices as "savers" were forced to chase yield in higher risk areas. However, there has been little translation through the real economy that has continued to limp along. It is worth remembering that the Federal Reserve uses monetary policy tools in an attempt to foster full employment and maintain price stability. In other words, the Fed lowers interest rates to stimulate economic activity and spark some inflationary pressures. The raises interest rates when the economy begins to accelerate too quickly, and inflationary pressures are building to a point that it becomes a detraction to economic growth. The chart below shows the Fed Funds rate as compared to CPI.”

 

 

 

 

“In the late 90's Alan Greenspan began an interest-rate hiking campaign as inflationary pressures were building in the economy. The sharp increase in rates beginning in early 1999 ultimately led to a suppression of inflation as asset prices plunged, and the economy fell into recession. Then, starting in 2006, then Fed Chairman Ben Bernanke also launched a rate hiking campaign as housing prices, commodity prices (oil) and asset prices were rising sharply. The inflationary pressure build in the economy became a concern, and ultimately, increases in Fed interest rates once again quelled those concerns. Unfortunately, the quelling of inflation was combined with an unprecedented global financial crisis. In the next few days, Fed Chairman Janet Yellen will announce whether or not she will begin further restricting monetary accommodation by lifting the overnight lending rate. She will do so with both inflation and economic growth at levels lower than at any other time in history.”

The Ugly (The Fed is ruled by the Financial Markets at this point)

Deutsche Bank's top economist says the Fed won't make a move until markets give the all clear – Business Insider: “Deutsche Bank's chief US economist Joe LaVorgna doesn't think the Federal Reserve will raise interest rates until the market says it's okay. In a note to clients on Thursday, LaVorgna said that basically, the Fed is on hold until markets make clear that they are ready to handle a change in the Fed's posture. LaVorgna wrote on Thursday (emphasis his): Most importantly, the financial markets have to be discounting a reasonably high probability of an interest rate hike. In other words, the Fed will not surprise the financial markets with a tightening in policy. (Unfortunately, this is how monetary policymakers have conditioned the financial markets over the years.) The difficult part for the Fed will be convincing the markets that the funds rate can go up next month.

Tantrums – Macro Man: “As readers are no doubt very much aware, the Yellen Fed has gone through extraordinary pains to reassure markets that the lift-off and subsequent cycle will be transparent and as painless as possible; if the whole QE/ZIRP policies have been monetary heroin, it seems as if the Fed wishes lift-off to be monetary methadone.  As such, to engage in lift-off at a meeting in which the market is not fully priced would appear to endanger the Fed's intention to make it as painless as possible; after all, this is supposed to be a removal of an emergency policy, not a legit monetary tightening. However, there is a downside to letting the inmates run the asylum.  If the market throws a tantrum every time that it senses that lift-off is imminent, normalization can and will be delayed unnecessarily if the Fed slams on the brakes when it sees the toys flying out of the pram.  Moreover, market pricing is also a captive of conditional probability. The market is currently pricing in a 75% chance that the Fed will go by the end of the year.   Using the logic of "meeting market expectations", that should naturally imply that they will indeed raise rates by the December meeting.  However, if (or perhaps when?) the Fed stands pat this month, some portion of that 75% will vanish into the ether- that represented by the chance of a September tightening.  Perhaps the market will then price December as a 50/50 proposition.  From that point, it would only take a little more stock market indigestion, coupled with apparent hand-wringing from the usual sources, to nudge that percentage lower again, and then voila!  The market will be priced at a 1/3 shot again, "too risky" for lift-off to commence. Lather, rinse, repeat.”

VIX Spikes and Easy Money: Volatility Dependent Fed Policy – Pension Partners: “If the Fed isn’t focusing on economic data, what exactly are they “looking at?” It is becoming increasingly obvious that when they say they are “data dependent” what they really mean is they are “S&P 500 and market volatility dependent.” As I illustrated last December, it is the stock market tail that has been wagging the Fed dog in recent years. In 2010 and 2011 when the Fed was expected to begin “normalizing” interest rates, sharp stock market declines (17% and 21%) and spikes in volatility (above 40) derailed those plans and new rounds of easing (QE1/Twist/QE2) were initiated instead. With the recent 12% correction in the S&P 500, similar talk has begun. Ray Dalio predicted last week that the next major Fed move will be an easing (QE4) rather than a tightening. Few market participants are expecting the Fed to follow through with plans of a rate hike in September given the recent market volatility. William Dudley (NY Fed President) confirmed this last week in saying a September hike was “less compelling” given “financial-market developments.””

Joseph S. Kalinowski, CFA

Additional Reading:

On Oil Prices

GOLDMAN: Oil is on the verge of plunging to $20 – Business Insider

More Iranian Oil Could Hit The Market Now That Iran Deal Is Assured – OilPrice.com

On The Economy

The US job market has found an old sweet spot – Business Insider

America's small businesses are optimistic – Business Insider

US manufacturing sector growth slows in August: ISM – CNBC

The US economy looks like it's getting even stronger – Dr. Ed’s Blog (Via Business Insider)

Is a Recession Coming? – The BlackRock Blog

China vs. Yellen: 3 Scenarios That Will Determine the Fate of the Global Economy – The Fiscal Times

On the Fed

Will Fed Be Spooked by Specter of Chinese Recession? – The Street

You Deserve a Raise Today. Interest Rates Don’t. – New York Times

DEUTSCHE BANK: Here's our advice to the Fed – Business Insider

IMF: It's too soon to raise interest rates – CNN Money

Fischer Keeps Rate Hike Door Open, But Shouldn't – Street Talk with Lance Roberts

This is the worst argument for the Fed to raise rates – The Washington Post

The Fed and the Jobs Report - Bloomberg

 

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