As it turns out, in twenty of the past twenty six years, according to the WSJ Market Data Group, the Dow Jones Industrial Average has moved the same direction for the year that it moved on the first day. This trend has occurred every year, in fact, since 2005. The correlation is weaker for the S&P 500. That index has moved in the same direction as the first trading day in fourteen of the past twenty six years.
Regardless of correlations, it's hard to make a viable case that much changed from the close of business on 12/31 and when the markets opened up on 1/2. Given the thin trading volume (most professional traders won't be back until Monday), the most likely reason for the sell off was some delayed tax loss selling on the first trading day of the year.
In any case, stocks took a beating on Thursday only to trade flat on Friday. The S&P 500 finished the holiday shortened week down 0.54% while small cap stocks as represented in the Russell 2000 finished the week down 0.43%.
Here's a daily chart of the S&P 500:
I had predicted that the S&P 500 would finish 2013 at 1860 and we got close but I was inevitably wrong. The S&P ended the year with a strong rally into the close of business on Tuesday, 12/31 where it traded as high as 1849.44 intra-day and closed at 1848.36 for the year. So, I came up a little under 12 points short of my prediction. I had misjudged the weakness we saw in early December which was the primary reason for my shortfall.
Treasuries finished the year piercing a milestone in interest rates. The Ten Year Treasury yield popped it's head above the 3% level on Tuesday only to fall back, closing on Friday at 2.99%. The Ten Year yield hadn't traded that high since July, 2011 right before the threat of Euro zone implosion sent yields to historic lows.
We're on the cusp of the interest rate that many market prognosticators warned would be the death knell of the stock market. So far, equities are taking the higher rates in stride. Here's a weekly chart of the Ten Year Treasury yield:
In the face of the Ten Year breaching the 3% level, gold defied the traditional inter market relationship between higher interest rates and lower gold prices and staged quite a comeback this week. The buying commenced on Tuesday with what could not be technically classified as a key reversal day but had all the earmarks of one, gapping higher on Thursday with significant follow through on Friday. Here's a daily chart of the SPDR Gold Trust Shares ETF (GLD):
While it did broach an important downtrend line with the move this week it is still too early to call this a positive change in the yellow metal's direction after the worst year it has had in thirty years.
Regular readers of my commentary know that I have placed much significance to gold's price movements in 2013, not just as a predictor of inflation, but more importantly as a deflationary indicator. And as such, I cannot dismiss the price action this week. Many attributed the gains to increased Chinese buying before their Lunar New Year, which, beside the Chinese fixation with gold is something they traditionally do. Some attributed the pop in precious metals to capital flows out of stocks to beaten up asset classes. However, I think Michael Gayed hit the nail on the head this week when he commented on CNBC that gold may be anticipating inflationary pressures. Ordinarily, low interest rates encourage gold buying when gross interest rates minus inflation turn into negative real interest rates. This had been the prevailing phenomena of the past four years but had seemingly changed in 2013 when interest rates started rising in May. But with the anticipation of inflationary pressures mounting we may well be in a negative real interest rate environment once again.
Admittedly, the thesis outlined above could be labeled as a "cart before the horse" argument because there is no apparent inflation on the horizon. Vast swaths of the global economy are still in a disinflationary or deflationary environment. But proponents argue under the thesis that the market, which is the sum total of all the knowledge, wisdom, fear and greed of all its participants, anticipates future events in its price action.
Well, if meaningful inflation is on the horizon the Velocity of Money is certainly not letting on that there is. Below are the latest readings as of 12/20/2013. The first chart shows the velocity of M2 since the Fed started tracking it in 1958. The second chart focuses on just the past five years:
When I made my prediction that the S&P 500 would reach the 1860 level by the New Year I also said we would have to reassess the situation at that time. Certainly, the first two trading days of 2014 which I've highlighted above has given me much to think about. But with light trading volume and many professional traders not back from the holidays it would be premature to make decisions based on some of the anomalies we have seen this week.
Regardless of theses, there is no rational way to explain gold's drastic about face this week while events in China and capitulation selling in Emerging Markets give me cause for concern. The sell off in the US stock market on Thursday was also unsettling though tax loss selling accompanied by light volume was the most likely culprit.
As we peer into the future, what can we deduce regarding the direction of financial markets? While NOTHING is guaranteed here's a few predictions I feel fairly comfortable making:
1. The US Dollar will strengthen in 2014. Assuming the Fed continues to taper it's asset buying program this year the Dollar will appreciate against the other major foreign currencies. Currency strength under normal economic conditions is usually positive for that country's equity markets. The test will be whether we are truly back to "normal economic" conditions. I think we are getting there.
2. Interest rates will trend higher as the Fed takes it's foot off the liquidity pedal. This will manifest itself mostly in the "belly" of the yield curve (five to seven year maturities) and there will be some pressure on longer term interest rates as well although I believe rising long term rates will be muted to some extent. So I don't see significantly higher mortgage rates.
3. China and the Emerging Markets (EM) are huge question marks in 2014. To the extent that China can resolve the excesses in it's shadow banking system and that EM can overcome the effects of the liquidity drain of Fed tapering will speak volumes on the strength of the "global recovery".
4. Gold will tell us much about the shape of the global recovery in 2014. Any positive traction in the yellow metal will be predictive of inflationary forces building in the global economy. As stated in many commentaries before, inflation is a necessary consequence of economic growth and prosperity in a fiat currency system. The fact that inflation has been so low speaks to the tepid nature of global economic growth. Gold's recent bounce off the $1,200.00 level set up a "double bottom" on the chart (see below) and if we can get momentum above 60 on the RSI (top panel) it will validate the strength of this move: