Gold and the Dollar direction

Crude Oil (WTI Light Crude) respected support at $45/barrel, with turmoil in Venezuela raising concerns over supply. Breakout above $55 would signal another rally but declining peaks on the Trend Index warn of selling pressure. Expect another test of $45. Breach of support would signal a decline to test the 2016 low at $26/barrel.

Crude Oil

The Dollar index is weakening. If China continues to support the Yuan, we may see a correction to test support at 92. A lot will depend on trade talks in the next two weeks but I expect continued Dollar strength and Yuan weakness.

Dollar Index

The PBOC increased support for the Yuan over the last month, leading up to the US-China trade talks, causing the Dollar to weaken.

Chinese Yuan/USD

Gold has ranged below resistance at $1350/ounce for the past five years. Expect another test of $1350 if the Dollar weakens. Breakout would signal a primary up-trend but LT Dollar strength is likely ….and a correction to test support at $1200.

Spot Gold in USD

A weakening Australian Dollar has helped Aussie gold stocks. The All Ordinaries Gold Index broke resistance at 5400, signaling a primary advance with a target of 7000. But that depends on further weakness in the Aussie Dollar (< 70 US cents?) and/or a stronger gold price (> $1350?)

All Ordinaries Gold Index

Conclusion: We are witnessing a rally in Gold due to global uncertainty but the LT outlook, with declining crude and a stronger Dollar, is bearish.

Deal or no deal

Brexit

No one knows what the outcome of Brexit will be but, whatever the outcome, it is unlikely to send global markets into a tail-spin. There is bound to be short-term pain on both sides but the long-term costs and benefits are unclear.

China

Far more likely to send investors scuttling for shelter is a ‘no deal’ outcome on US trade negotiations with China. I would be happy to be proved wrong but I believe that a deal is highly unlikely. There may be press photos with beaming officials shaking hands and tweets from the White House promising a rosy future for all (with or without a wall). But what we are witnessing is not straight-forward negotiations between trading partners, which normally take years to resolve, but a hegemonic power struggle between two super-powers, straight out of Thucydides.

Thucydides wrote “When one great power threatens to displace another, war is almost always the result.” In his day it was Athens and Sparta but in the modern era, war between great powers, with mutually assured destruction (MAD), is most unlikely. Absent the willingness to use military force, the country with the greatest economic power is in the strongest position.

One of the key battlefronts is technology.

“China is now almost wholly dependent on foreign chipsets. And that makes leaders nervous, especially given a series of actions by foreign governments to limit the ability of Huawei and ZTE to operate internationally and acquire Western technology.” ~ Trivium China

“To address this risk, President Xi Jinping aims to increase China’s semiconductor self-sufficiency to 40% in 2020 and 70% in 2025 as part of his ‘Made in China 2025’ initiative to modernize domestic industry.” ~ Nikkei

Xi is unlikely to abandon his ‘Made in China 2025’ plans and the US is unlikely to settle for anything less.

USA

The US economy remains robust despite the extended government shutdown and concerns about Fed tightening.

“Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they had expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.” ~ The Wall Street Journal

This is just spin. As I explained last week. Fed run-down of assets is more than compensated by repayment of liabilities (excess reserves on deposit) on the other side of the balance sheet. Liquidity is unaffected.

Charts remain bearish as the market views global risks.

Volatility is high and a large (Twiggs Volatility 21-day) trough above zero on the current S&P 500 rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Asia

Hong Kong’s Hang Seng Index is in a bear market but shows a bullish divergence on the Trend Index. Breakout above 27,000 would signal a primary up-trend. This seems premature but needs to be monitored.

Hang Seng Index

India’s Nifty has run into stubborn resistance at 11,000. Declining peaks on the Trend Index warn of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

Europe

DJ Stoxx Euro 600 is in a primary down-trend. Reversal below 350 would warn of another decline.

DJ Stoxx Euro 600 Index

The UK’s Footsie has retreated below primary support at 6900. Declining Trend Index peaks warn of selling pressure. This is a bear market.

FTSE 100 Index

This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

War is a matter not so much of arms as of money.

~ Thucydides (460 – 400 B.C.)

ASX 200: Hanging man

A hanging man candlestick on the weekly chart warns of increasing selling pressure as the ASX 200 approaches resistance at 6000.

Hanging man

Respect of 6000 is likely and reversal below 5650 would confirm the primary down-trend. Resolution of the US-China trade dispute or announcement of another massive Chinese stimulus could avert the bear market, but don’t hold your breath. Breach of support would offer a target of the 2016 low at 4700.

ASX 200

I have been cautious on Australian stocks, especially banks, for a while, and hold 40% cash in the Australian Growth portfolio.

‘It could be on the scale of 2008’ | SMH

Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

Read the full article from Ambrose Evans-Pritchard at smh.com.au: ‘It could be on the scale of 2008’: Expert sends warning on China downturn

Bullish in a bull market, bearish in a bear market

We are witnessing the transition from a bull to a bear market.

I subscribe to Jesse Livermore’s maxim (emphasis added):

“I began to see more clearly—perhaps I should say more maturely—that since the entire list moves in accordance with the main current…. Obviously the thing to do was to be bullish in a bull market and bearish in a bear market. Sounds silly, doesn’t it? But I had to grasp that general principle firmly before I saw that to put it into practice really meant to anticipate probabilities. It took me a long time to learn to trade on those lines.”

The second part of that quote is equally important. You determine whether a market is bullish or bearish by “anticipating probabilities”. Don’t take signals from the charts in isolation. You have to study general conditions.

Livermore gives a classic example in Reminiscences of a Stock Operator of how he anticipated a bear market in 1906 after the Boer War in South Africa had drained Britain’s coffers and the San Francisco earthquake led to massive insurance payouts, forcing insurers to liquidate large swathes of their investment portfolios. But he was wiped out as the market repeatedly rallied. He persisted and eventually was proved right when large rail stocks announced new stock issues. The fact that the issues were structured as instalment issues, with only a down-payment needed to acquire the stock, alerted Livermore that there was not enough liquidity in the market to absorb the stock issues. His broker extended him a line of credit and…

“I profited by my earlier and costly mistakes and sold more intelligently. My reputation and my credit were reestablished in a jiffy. That is the beauty of being right in a broker’s office, whether by accident or not. But this time I was cold-bloodedly right, not because of a hunch or from skillful reading of the tape, but as the result of my analysis of conditions affecting the stock market in general. I wasn’t guessing. I was anticipating the inevitable. It did not call for any courage to sell stocks. I simply could not see anything but lower prices, and I had to act on it….”

General conditions in the US are still strong.

Credit and the broad money supply (MZM plus time deposits) are growing at close to 5%.

S&P 500

Credit risk premiums are rising but are nowhere near alarming. A spread of more than 3.0% between lowest grade investments (Baa) and 10-year Treasuries would flag a warning.

S&P 500

The big shrink, as the Fed unwinds its balance sheet, is still a myth. Banks are drawing down excess reserves at a faster rate, so that liquidity is rising. The rising green line on the chart below shows Fed assets net of excess reserves.

S&P 500

But charts are bearish.

Market volatility is high and a large bearish divergence on S&P 500 Momentum warns of a bear market.

S&P 500

We need to look at global conditions to identify the cause for market concern: Brexit, slowing European growth, but primarily, a potential trade war with China.

It’s time to be cautiously bearish.

There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market.

~ Paul Tudor Jones

Get ready for economic slowdown | Trivium China

While we cannot rule out the chance of a large Chinese stimulus, senior officials are talking this down. In 2008/2009, China injected a whopping 19% of GDP to revive its flagging economy, compared to roughly 6.5% of GDP by the Obama administration at the height of the GFC. The size and scope of the stimulus achieved the desired result but had several undesirable side effects, including accelerating the property bubble and rapid growth expansion of the informal shadow banking sector as speculative fever grew.

From Trivium China:

At his meeting with businessmen on Tuesday, Li Keqiang [Premier of the State Council of the People’s Republic of China] also laid out his views on the economy.

In a nutshell: Things do not look good (Gov.cn).

  • “Downward economic pressure is increasing.”
  • “[We must] thoroughly prepare to react to difficulties and challenges.”

But Li stressed (again!) that the government’s response to this slowdown will be different than in the past:

  • “[We] will not rely on traditional measures.”

Instead, Li wants to take a more measured, precise approach:

  • “Macro policies should be stable, precise, and effective in order to counter external uncertainties.”

The top priority will continue to be improving the business environment, with a focus on three areas:

  • Eliminating government interference in business operations
  • Reducing taxes and fees
  • Making financing easier and cheaper to get

Get smart: If you haven’t gotten the message yet, you have not been listening. The government is not going to repeat the massive stimulus that it enacted 10 years ago in response to the financial crisis.

ASX 200 rallies but LT bearish

The Australian economy is creaking. This is not a time for the Treasurer to concern himself with a balanced budget, laudable as that long-term (LT) goal may be.

Household consumption is slowing, with falling car sales and international travel. Housing investment is about to go over a cliff. This time China is unlikely to rescue the damsel in distress with another record stimulus spend.

It’s time for the government to go big on infrastructure spending. Not school halls or pink batts but real infrastructure like transport and communications investment (5G for example) that will boost long-term GDP growth. We are going to need government (and private) infrastructure to offset the sharp fall in housing investment and prevent a serious contraction.

The ASX 200 rallied off support at 5400 and is headed for a test of resistance at 6000. What could go wrong? This is a bear market and one strong rally is not going to change that. Respect of resistance at 6000 is likely and would warn of another test of primary support at 5400. Breach of support would offer a target of the 2016 low at 4700.

ASX 200

Banks are vulnerable because of the falling housing market. The ASX 200 Financials Index is testing long-term support at 5400. Bullish divergence on the Trend Index indicates buying pressure but I believe this is secondary in nature. The primary trend is down and breach of 5400 would offer a LT target of 4000.

ASX 200 Financials Index

The Resources sector is in far better shape but bearish divergence on the  ASX 200 Materials Trend Index warns of LT selling pressure. Reversal below 10500 would confirm a primary down-trend.

ASX 200 Materials

I have been cautious on Australian stocks, especially banks, for a while, and hold 40% cash in the Australian Growth portfolio.

Gold: Bull or bear?

Gold is testing resistance at $1300/ounce and is likely to follow-through to the long-term (LT) ceiling at $1350. Trend Index  on the LT  monthly chart displays a large triangular consolidation, indicating uncertainty. Upward breakout would signal a primary up-trend but this is unlikely, for three reasons. First, this is a bear market. A decline is more likely for that reason alone. Target for a decline is the 2015 low at $1050/ounce.

Spot Gold in USD

Second, a strengthening Dollar is likely to weaken Gold. I have inverted the LT chart of the Dollar Index (and Trend Index) below so that it is easier to relate to gold. As the Dollar strengthened, denoted by a LT fall on the inverted chart, Gold has weakened. The Dollar index shows a broadening consolidation since 2015, with bull and bear traps, again indicating uncertainty. At present, the Dollar is testing resistance at 97 but is likely to follow through to test LT resistance at 100. Rising Trend Index troughs above zero (remember the scale is inverted) signal buying pressure.

Dollar Index inverted

Third, falling Crude Oil prices are bearish for Gold. The LT chart below compares spot crude  to  spot gold, both adjusted for inflation to bring earlier peaks into proper perspective. The LT relationship is clear: gold and crude tend to rise and fall together. Crude prices have recently tumbled, exerting downward pressure on Gold.

Gold and Crude Oil, adjusted by CPI

Conclusion: We are witnessing a rally in Gold because of global uncertainty but the LT outlook is bearish.

The Aussie economy is quietly falling apart | Macrobusiness

You’d have to be as blind as the RBA to miss the signals. GDP is made up of six components and they are not going well on balance:

  • government consumption is strong and likely to stay that way;
  • government investment is peaking as the NBN rolls off and infrastructure starts fade;
  • household consumption is weakening with car sales and international travel down sharply plus retail looking highly questionable;
  • business investment has been good and the outlook for six months is solid but it will track broader demand and housing investment is about to tumble;
  • inventories will ebb and flow;
  • net exports (volumes) are weak owing to China’s thermal coal blockade and the drought despite the LNG ramp up.

In short, the Australian economy is quietly falling apart and if it does not receive any new juice soon it is going to crater as we enter the Hayne Royal Commission recommendations, the federal election stall and Labor’s reform agenda. I have now downgraded my outlook for domestic demand from what was already bearish:

This is an environment in which unemployment will rise at a decent clip threatening much worse outcomes as that feeds back into asset prices.

That markets and economists are still forecasting rate hikes is ridiculous. That cuts remain off the radar of nearly all is bizarre.

By Houses & Holes (David Llewellyn-Smith). Reproduced with kind permission from Macrobusiness.

Comment: Time for the government to go big on infrastructure spending. Not school halls or pink batts insulation but real infrastructure like transport and communications investments (5G for example) that will boost long-term GDP growth.

PEmax and why you should be wary of Robert Shiller’s CAPE

Robert Shiller’s groundbreaking works, Irrational Exuberance and Animal Spirits, led to a Nobel prize in 2013 but we need to be careful of placing too much reliance on his CAPE as an indicator of stock market value.

What is CAPE?

CAPE is the cyclically adjusted price-to-earnings ratio, normally applied to the S&P 500, to assess future performance of equities over the next decade. CAPE is calculated by dividing the S&P 500 index by a moving average of ten years of inflation-adjusted earnings. Higher CAPE values imply poor future returns, while low values signal strong future performance.

Economists John Y. Campbell and Robert Shiller in 1988 concluded that “a long moving average of real earnings helps to forecast future real dividends” which in turn are correlated with returns on stocks. Averaging inflation-adjusted earnings smooths out short-term volatility and medium-term business cycles in the economy and, they argued, was a better reflection of a firm’s long-term earning power.(Campbell & Shiller: Stock Prices, Earnings and Expected Dividends)

Shiller later popularized the 10-year version (CAPE) as a way to value the stock market.

S&P 500 CAPE

Strengths

CAPE correctly identifies that the S&P 500 was over-priced in the lead-up to Black Friday (October 1929) and ahead of the Dotcom bubble in 2000. It also correctly identifies that stocks were under-valued after the Depression of 1920-21, during the Great Depression of the 1930s, and during the 2008 Global Financial Crisis.

Weaknesses

Some CAPE readings are rather odd. The rally of 1936, in the midst of the Great Depression, shows stocks as overvalued. Black Monday, October 1987, which boasts the highest ever single-day percentage fall (22.6%) on the Dow, hardly features. Current CAPE values, close to 30, also appear exaggerated when compared to current earnings.

Causes

There are several reasons for these anomalies, two of which relate to the use of a simple moving average to smooth earnings.

The simple moving average (SMA) is calculated as the sum of earnings for 10 periods which is then divided by the number of periods, 10 in our case. While the SMA does a reasonably good job of smoothing it has some unfortunate tendencies.

First, the SMA tends to “bark twice. If unusually high or low data is recorded, the SMA will rise or fall accordingly, as it should. But the SMA will also flag unusual activity, in the opposite direction, 10 years later when the unusual data is dropped from the average.

Second, the SMA is fairly unresponsive. If earnings rise rapidly, the SMA will lag a long way behind current values.

The third anomaly relates to the use of a moving average of earnings to reflect future earnings potential. Companies may incur losses at the low-point in the business cycle, especially in a severe down-turn like 1929 or 2008, but the impact on future earnings capacity is marginal.

Take a simplistic example, where earnings are $1 per year for 9 years but a loss of $5 is incurred in the following year.  When the business cycle recovers, potential earnings are likely to be $1, not $0.50 (the 10-year SMA).

Examples

All of these flaws are evident in the CAPE chart above.

Problem 1

Expect a fall in CAPE next quarter (Q1 2019) when losses from Q4 2008 are dropped from the SMA period.

Problem 2

Earnings multiples in the lead-up to Black Friday (1929) and the DotCom bubble (2000) are both overstated because of the lag in the SMA caused by rapidly rising earnings.

Problem 3

Potential earnings in 1936 are understated because of the sharp fall in earnings during the Great Depression, resulting in an overstated earnings multiple. The same situation occurs 2009-2018 when losses from 2008 inflate CAPE values.

Proposed Solution

I tried a number of different moving averages in order to avoid the above anomalies but all, to some extent, presented the same problems.

Eventually, I tried dropping the moving average altogether, instead using the highest previous four consecutive quarter’s earnings to reflect future earnings potential. I call this PEmax © (price over maximum historic earnings). PEmax matches normal historic price-earnings ratio (PE) most of the time, when earnings are growing, but eliminates the distortion caused by sharp falls in earnings near the bottom of the business cycle.

S&P 500 PEmax

PEmax overcomes distortions associated with the 1936 bear market rally, Black Monday in 1987 and our current situation in 2018.

Compare how the two perform on a single chart below.

S&P 500 PEmax compared to CAPE

The spikes on Black Friday and the Dotcom bubble are more muted on PEmax but still warn that stocks are over-priced relative to future earnings potential. The 1936 bear market rally is restored to its proper perspective. As is the 1987 Black Monday spike, by removing the distortion caused by declining earnings in the early 90s. The same happens after the Dotcom bubble. And again in 2009 -2018.

Potential Uses

The historic average (1900 – 2018) for PEmax is 12.79. For what it’s worth, standard deviation is 5.32 but this is not a normal distribution.

S&P 500 PEmax distribution

The median (middle) value is slightly below the mean, at 12.23.

Visual inspection of the data suggests that low values are skewed towards the first half of the 20th century. The average over the last 50 years (1969-2018) is 15.85 but, again, this may be distorted by the Dotcom era.

Based on visual inspection, we suggest using a PEmax of 15.0 as the watershed:

  • PEmax greater than 15.0 indicates that stocks are over-priced; while
  • PEmax below 15.0 presents buying opportunities.

Potential Weaknesses

PEmax has one potential weakness. If S&P 500 earnings are ever exaggerated by an unusual event, to a level that is unlikely to be repeated, potential earnings will be overstated and PEmax understated. Fortunately, that is likely to be a rare occurrence, where earnings for the entire index spike above actual earnings capacity.

Conclusion

PEmax ©, an earnings multiple based on the highest previous four consecutive quarter’s earnings, is a useful comparison of price to future earnings potential. It eliminates many of the distortions traditionally associated with price-earnings multiples, including CAPE. High PEmax values (above 15) suggest poor future performance, while low PEmax values (below 15) correspond with greater investment opportunity.