Saturday, September 7, 2013

Inflation, liquidity traps & scratched vinyl records

Markets were roiled this week as the escalating crisis in Syria took center stage.  Friday's price action was testimony to the "knee jerk" reaction of market players and trading algorithms to every news item out of the Mid East.  Here's a ten minute chart of the S&P 500 that illustrates what I'm talking about:

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The market swooned right after Russian President Vladimir Putin told reporters Russia will continue arms sales and aid Syria if the U.S. goes forward with a military strike. Headlines on Mr. Putin’s remarks hit the tape just minutes after the open of U.S. stock trading.

But in spite of all the volatility and after a slightly disappointing monthly employment report on Friday, the S&P still inched out a fractionally up the day and finished the week with a 1.36% gain.  The market is being buoyed on the prospect that any Fed tapering, should it occur, will be minimal.  At the same time, economic reports continue to show an incrementally strengthening economy with the auto manufacturers reporting stellar sales numbers and manufacturing gaining positive momentum.

Interest rates are moving higher and stocks seem to be taking it in stride, at least for now.  Here's a weekly chart of the US T-Note Yield going back to 2007:

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The yield on the Ten Year has penetrated long term resistance going back to July, 2007.  There's no arguing that rates are going higher!

 It's indeed difficult to debate those who argue we are in the beginning of a great normalcy after the historic economic and financial trauma of the past five years. 

Certainly, investors are betting on better economic times with commensurate stock performance.  Here's the Morgan Stanley Cyclicals Index comprised of thirty stocks from twenty five industries that are economically-sensitive and include autos, metals, papers, machinery, chemicals and transportation:

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The bottom panel is the price relative to the S&P 500 and its clear that cyclicals are outperforming the rest of the market; a sure sign that investors are optimistic on business and economic prospects six to nine months out.

I too, am optimistic on the economy and stocks and the further I look out, the more optimistic I am.  I believe there are enormous catalysts brewing, not only in our economy but the global economy, that will fire a secular bull market in equities that will dwarf the 1982 - 2000 bull market. 

However, I do see a potential impediment to that rosy outlook which I've already articulated in many blog posts and commentaries over the past two years.  And I'm going to briefly review them here again using new data while tweaking my concerns.

It's finally being acknowledged by some Fed governors that the low inflation rate we are presently experiencing might be more than transitory.  The concern is magnified in view of the expectation that our central bank is expected to curtail the asset purchases that have kept this economy afloat over the past five years.  My concerns, which I've articulated here( ) surround the possibility of our economy descending into a Japanese style deflation which has plagued that country for over two decades and which, even with recent radical monetary policy, they have not yet escaped.  I've posted some charts below to illustrate my concerns.

Here's a weekly  chart of the Dow Jones UBS Industrial Metals Index ($DJAIN):

(click on chart for a larger image)

Industrial commodities are going nowhere!

Two things must be remembered when we study commodities.  In a normal business cycle, they follow stocks and are the "Johnny come lately" asset class as a normal business cycle proceeds.  But we have not been in a normal business cycle since 2007!  Secondly, to be fair, commodity prices were severely inflated in the first decade of this century by unprecedented demand from China; that country being in the midst of a construction boom in anticipation of implementing a radical change in the geographic positioning of their population.

Here's a weekly chart of the Dow Jones World Basic Materials Index ($W1BSC):

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Essentially we have the same picture here.  There has been absolutely no upside pressure on commodity prices, especially commodities linked to industrial and business growth.  And this after the extraordinary efforts of our central bank to pump these prices up!

But let's take the other side of the argument and say that a normal business cycle has started and though commodities are starting from a very low point, their prices and attendant inflationary pressures will resume as the normal business cycle progresses.  Well then, we better start seeing measurable improvement on the two charts below.

This is an update of a very busy chart I've posted before of the Dow Jones UBS Industrial Metals Index with the S&P500 superimposed behind it.  It shows all the Fed monetary interventions and the impact on industrial commodity prices since those dark days of March, 2009:

(click on chart for larger image)

It's apparent that the Fed has been receiving considerably less "bang for its buck" since February, 2011 when the entire commodity complex topped out.  At the same time, the S&P surged higher.  What a classic divergence!  The question I have is: how is Fed tapering of asset purchases going to help this deteriorating situation?  Or is the normal business cycle going to take this trend in its stride?

How about this chart below?  This is a ratio chart of the iShares Barclays TIPS Bond ETF (TIP) divided by the iShares Barclays 7 to 10 Year Treasury Bond ETF (IEF).  The chart attempts to measure investor expectations of future inflation.  

(click on chart for larger image)

TIPS are Treasury Inflation Protection securities that are indexed to the Consumer Price index (CPI) and are purchased in order to protect investors from the negative effects of inflation.  When TIPS outperform Treasury notes or bonds, investors are anticipating a higher rate of inflation and are fleeing to a vehicle that will protect them from anticipated inflation.  When TIPS under perform, investors are more than willing to park their money in regular Treasuries which, up to recently, were yielding in many cases a negative rate of return.  The ratio had been struggling all year, recently bounced and now is struggling once more.  How is taking liquidity out of the system going to promote higher inflation expectations?

Lest anyone think I'm trying to build a bleak thesis for the future here's a positive "twinkle" in this situation.  I say a "twinkle" because we've seen this head fake before.  And regular readers of my blog are sick of this chart but I don't think anyone can deny it is a most effective way of measuring inflationary pressures in the economy.

The Velocity of M2 Money Supply measures the number of times one dollar is spent to buy goods and services per unit of time.  Here's the chart since the Fed started tracking this metric in 1958:

(click on chart for larger image)

The velocity of money has never been lower.  And, as a follower of grand super cycles and Kondratiev wave theory, it is no mystery to me why we are at the lowest point in this metric because the last bottom occurred in the 1930's!

But here's a closer view of the chart covering the last five years:

(click on chart for larger image)

It's pretty clear that the downside momentum is waning and it's flattening out.  But we saw this same flattening and uptick going into 2010.  So, the velocity of money will be my main indicator in understanding the inflationary pressures or lack thereof going forward.

I'm very bullish on stocks going forward and see a strong market going into year end.  If the thesis I've posited in this commentary as it relates to possible deflation comes to fruition, it will not be something that's immediately apparent in the coming months.  But it would be clearly seen by the first quarter of 2014.  And don't misunderstand, I hope I'm wrong when I posit this possibility.  I lay out concerns and probabilities I see for my readers and clients for their review and intellectual digestion.

What are the odds I place on such a scenario developing?  I believe it is still a minority scenario as Europe limps out of recession and given recent positive economic data coming out of China.  And we need to watch Emerging Markets which are "the tail the dog wags".  Actually, with all the bleak forecasts of a 1997 Asian Currency crisis redux,  both EM stocks and currencies had a good week as a number of central banks stepped in with radical measures to prop up their currencies in the face of capital flight.  Here's a weekly chart of the iShares MSCI Emerging Markets Index (EEM):

(click on chart for larger image)

EEM sported a nice long healthy candlestick last week.  I'll feel better once it penetrates the Fibonacci resistance on which it stopped "on a dime".

And here's the Wisdom Tree Dreyfus Emerging Currency Fund (CEW) which held multi year support last week but must be watched closely:

(click on chart for larger image)

To sum up, the market's initial and subsequent reaction to the Fed's policy decision after it's September 17th-18th meeting will address the concerns I've outlined in this blog post.  To reiterate, I believe we're in the beginning stages of a secular bull market that may develop beyond investor's wildest dreams.  However, in my humble opinion, the liquidity trap scenario which I've presented here should not be ignored.  We could get caught in a situation that can be likened to one of those old vinyl records that repeatedly skip because of a scratch.

Have a great week!