Saturday, August 3, 2013

Of changing paradigms & secular bull markets

Markets finished at all time highs this week on the back of a positive PMI number from China and more improving stats out of the Eurozone.  Thursday's surprisingly positive US ISM Manufacturing report was the "icing on the cake" which served to validate the market's explosion higher.

Probably the most telling story of the week for me is captured on a chart you may have seen if you follow me on Twitter.  It's a five minute chart of the S&P 500 on Thursday with the Ten Year US Treasury yield superimposed on it (white dashed line):

(click on chart for larger image)
I'll be addressing the meaning of the price action in bonds and stocks a bit later in this abbreviated commentary after I point out some other interesting correlations I'm watching in the market.
There's been a positive correlation between gold and Emerging Market economies for awhile.  If you are a market technician or chartist this is probably not anything new.  However, I think we can develop a thesis regarding the global economy from what the charts below in conjunction with what other asset classes are telling us:
(click on chart for larger image)
I also "tweeted" this chart on Friday afternoon.  The top chart is the SPDR Gold Trust Shares ETF (GLD) which is the most popular way investors trade gold.  The bottom chart is the iShares MSCI Emerging Markets ETF (EEM).  Just a glance speaks to the similar pattern of the charts and both are currently snagged at their respective 50% Fibonacci retracement line.
My thesis is simple.  Without knowing which one will lead the other, it seems pretty clear to me that any turn up or down in either gold or the Emerging Markets will drag the other with it.  As of COB on Friday, GLD is in the midst of what could be construed as a bull flag pattern, which is a continuation pattern suggesting higher prices for the yellow metal.  I was impressed with the resilience of gold in the face of Thursday's incredible rise in interest rates although I was less enthused by gold's non response when yields made a significant move lower on Friday.  In any case, GLD is still holding the channel and we may see another leg higher if the pattern comes to fruition.  If this happens, my thesis is that EEM should follow higher.
The reaction of Emerging Market economies to the steady climb in US interest rates since early May and then Ben Bernanke's "pop the bubble" speech on June 19th was emblematic of central bank distortions created to stave off financial Armageddon.  The threat that the "punch bowel" (cheap money) would be taken away created serious liquidity issues in emerging markets as investors scrambled for the exits all at once.  But, in an ordinary environment, emerging markets can and do thrive in a rising rate environment.  I'll tie this in with my conclusions below.
I want to take a long term look at interest rates so my readers can gain a perspective on where we've been and what we're closing in on.
(click on chart for larger image)
This is a monthly chart of the US Ten Year Treasury Note yield going back to 1980.  In essence, it's a picture of the great bull market in fixed income which started in the aftermath of Paul Volcker's unprecedented decision to break inflation's back by driving interest rates higher.  The yield on the Ten Year peaked in September,1981 at 15.84% and bottomed in July 2012 at 1.394%.  As you can see from the red arrow we are quickly approaching a downtrend line established in June, 2007 which will be the "hurdle" I use to declare the end of the "great bull market" in bonds.  If we see a penetration of this resistance line it should be concurrent with a lift in commodity prices and gold.  And we should also start to see this turn up:
(click on chart for larger image)
This is the most recent update of the velocity of M2 money stock which is the most widely followed metric of money supply in the US economy.  The velocity of money is the frequency at which one unit of currency is used to purchase domestically produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.  And if more transactions are occurring between individuals, then it follows that with an increasing money supply, more transactions should eventually result in more money chasing the same or fewer goods and services.  And more money chasing the same or fewer goods and services equals inflation.  The only way this thesis is invalid is if more money is chasing more goods and services.  And we know this cannot be true because the level of economic activity is a shadow of what it had been prior to the GFC (Great Financial Crisis).
There is certainly no question in any one's mind that there's a lot of dollars floating around but the following chart serves to quantify that fact:
(click on chart for larger image)
The Adjusted Monetary Base is the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks. 
With the clear disparity between the two charts above we can only come to the conclusion inflationary pressures cannot be gaining momentum because most of the money that's circulating is not being used.
Gold and the Emerging Markets should give us the first signal that this is changing.  Being resource based and exporting economies, inflationary pressures should manifest themselves when real demand "kicks in" from the western consumer based economies, putting pressure on commodity pricing. 
For now, we are not seeing those pricing pressures in the industrial commodities I am following.  Yet, interest rates are beginning to predict these pricing pressures.  And the first chart I posted in this commentary suggests that the most recent antipathy stocks had developed regarding rising interest rates is changing.  On Thursday, stocks and Treasury yields rose in tandem during the day and on Friday, while rates did an "about face" and erased much of Thursday's gains, stocks barely budged.  This short term price action in two asset classes which have had an inverse relationship for the past five years speaks to one of the changing paradigms the financial markets are embracing after five years of a fear mentality that the GFC engendered.
Let me sum this all up.  Stocks are predictive of economic conditions six to nine months out.  As such, the recent price action suggests that the economy is gaining positive momentum.  We are seeing this in the economic data stream, not only in this country but also in Europe and in China and EM.  Rising rates are speaking to the same.  If stocks and interest rates are right (and I believe they are) then commodities and gold must follow.  And subsequently, inflationary pressures should begin to mount.  Moderate inflation will be a validation of a recovering global economy.  And I don't see runaway inflation developing for a variety of reasons I've stipulated in past commentaries. 
There will be a lag before commodities start pricing in a global recovery but we should start to see a move in the second half of 2013.  Otherwise, stocks and interest rates are giving us a "head fake".  And I don't believe this is true.
In one of my first commentaries this year I stated that we were on the verge of a secular bull market in stocks.  I now believe that this is truer than ever!  We still have much residual debt to work off from the excesses of the past twenty years ( & housing) and the market never gives us a smooth road to travel.  But aside from some potholes and bumps along the way, technological innovations and vast discoveries of oil and natural gas in multiple countries are creating a financial and economic renaissance that will melt seemingly overwhelming national deficits and produce economic wealth that most of us cannot imagine.
Have a great week!