Global stock market correction
Strong red candles across major market indices warn of a global correction.
Breach of 3650 on the S&P 500 would warn of a test of the strong band of support between 3250 and 3400. Bearish divergence on Twiggs Money Flow continues to warn of long-term selling pressure.
The European Stoxx 600 threatens a similar secondary correction with a test of support at 375.
The Footsie is testing support between 6300 and 6500, while Money Flow reversal below zero warns of strong selling pressure. Breach of 6300 is likely and would indicate a strong correction, with primary support at 5500.
The reaction on China’s Shanghai Composite is of similar weight to the S&P and STOXX. Breach of medium-term support at 3400 would warn of a test of primary support at 3200.
The reaction on Japan’s Nikkei 225 appears secondary and likely to test the rising trendline at 26000.
The Seoul Composite is similar, with a rising trendline at 2700.
Selling on India’s Nifty 50 is heavier, flagged by a sharp fall in Money Flow over the past three weeks. Support at the rising trendline is unlikely to hold — which would mean a test of support at 12500.
Conclusion
The correction across global stock markets appears secondary at this stage and likely to test medium-term support levels. Selling is heaviest on the FTSE 100 and India’s Nifty 50. These are the canary in the coal mine and should be monitored for unusual activity. Further falls on strong volume would indicate that sellers are overwhelming support.
Can the Fed keep a lid on inflation?
Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.
Click to playBoth are right, just in different time frames.
Putting the cart before the horse
The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.
Money supply and interest rates
Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.
Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.
In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.
Wealth effect
Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.
High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.
Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.
The role of the Fed
Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:
“…..to take away the punch bowl just as the party gets going.”
In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.
The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.
Federal government debt is currently above 120% of GDP.
GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.
With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.
Conclusion
Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.
Insider selling
Jesse Felder on insider selling in January 2021:
S&P 500 bubble risk
S&P 500 valuations are higher than the 1929 (Black Friday) Wall Street crash and the October 1987 (Black Monday) crash. The Dotcom bubble is the only time in the last 120 years that the ratio between Price and highest trailing earnings (PEmax) was higher.
PEmax eliminates distortions in the price/earnings multiple caused by sharp falls in earnings during recessions. The current multiple of 26.93 compares the index at December 31, 2020 to highest trailing earnings of 139.47 (for the 12 months ended December 2019) rather than expected earnings of 95.22 for the 12 months ended December 2020. Highest trailing earnings in such a case are a far better reflection of future earnings potential than more recent results.
Payback model
Using our payback valuation model, we arrive at a fair value estimate of 2331 for the S&P 500 based on:
- highest trailing earnings of 139.47;
- a long-term growth rate of 5% (the highest nominal GDP growth achieved in recent years was 6.0% in Q2 2018); and
- a payback period of 12 years — normally only used for stable companies with a strong defensive market position.
The LT growth rate required to match the current index value (3851) is 12.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was in double-digits.
Conclusion
Stock prices are in a bubble of epic proportions. Risk of a major collapse remains elevated.
Danielle DiMartino Booth On The Future Of The Federal Reserve
The Battle for Democracy
“Democracy isn’t liberal or conservative, not left or right — at least it isn’t supposed to be. Millions of Americans currently believe that democracy isn’t working, or even that it isn’t worth saving. The battle to prove them wrong isn’t over, it’s just begun.” ~ Garry Kasparov
Markets that are likely to outperform in 2021
There is no reliable benchmark for assessing performance of different markets (stocks, bonds, precious metals, commodities, etc.) since central banks have flooded financial markets with more than $8 trillion in freshly printed currency since the start of 2020. The chart below from Ed Yardeni shows total assets of the five major central banks (Fed, ECB, BOC, BOE and BOJ) expanded to $27.9T at the end of November 2020, from below $20T at the start of the year.
With no convenient benchmark, the best way to measure performance is using relative strength between two prices/indices.
Measured in Gold (rather than Dollars) the S&P 500 iShares ETF (IVV) has underperformed since mid-2019. Respect of the red descending trendline would confirm further weakness ahead (or outperformance for Gold).
But if we take a broad basket of commodities, stocks are still outperforming. Reversal of the current up-trend would signal that he global economy is recovering, with rising demand for commodities as manufacturing output increases. Breach of the latest, sharply rising trendline would warn of a correction to the long-term rising trendline and, most likely, even further.
Commodities
There are pockets of rising prices in commodities but the broader indices remain weak.
Copper shows signs of a recovery. Breakout above -0.5 would signal outperformance relative to Gold.
Brent crude shows a similar rally. Breakout above the declining red trendline would suggest outperformance ahead.
But the broad basket of commodities measured by the DJ-UBS Commodity Index is still in a down-trend.
Precious Metals
Silver broke out of its downward trend channel relative to Gold. Completion of the recent pullback (at zero) confirms the breakout and signals future outperformance.
Stock Markets
Comparing major stock indices, the S&P 500 has outperformed the DJ Stoxx Euro 600 since 2010. Lately the up-trend has accelerated and breach of the latest rising trendline would warn of reversion to at least the long-term trendline. More likely even further.
The S&P 500 shows a similar accelerating up-trend relative to the ASX 200. Breach of the latest trendline would similarly signal reversion to the LT trendline and most likely further.
Reversion is already under way with India’s Nifty 50 (NSX), now outperforming the S&P 500.
S&P 500 performance relative to the Shanghai Composite plateaued at around +0.4. Breakout would signal further gains but respect of resistance is as likely.
Growth/Value
Looking within the Russell 1000 large caps index, Growth stocks (IWF) have clearly outperformed Value (IWD) since 2006. Breach of the latest, incredibly steep trendline, however, warns of reversion to the mean. We are likely to see Value outperform Growth in 2021.
Bonds
The S&P 500 has made strong gains against Treasury bonds since March (iShares 20+ Year Treasury Bond ETF [TLT]) but is expected to run into resistance between 1.3 and 1.4. Rising inflation fears, however, may lower bond prices, spurring further outperformance by stocks.
Currencies
The US Dollar is weakening against a basket of major currencies. Euro breakout above resistance at $1.25 would signal a long-term up-trend.
China’s Yuan has already broken resistance at 14.6 US cents, signaling a long-term up-trend.
India’s Rupee remains sluggish.
But the Australian Dollar is surging. The recent correction that respected support at 70 US cents suggests an advance to at least 80 cents.
Gold, surprisingly, retraced over the last few months despite the weakening US Dollar. But respect of support at $1800/ounce would signal another primary advance.
Conclusion
Silver is expected to outperform Gold.
Gold is expected to outperform stocks.
Value stocks are expected to outperform Growth.
India’s Nifty 50 is expected to outperform other major indices. This is likely to be followed by the Stoxx Euro 600 and ASX 200 but only if they break their latest, sharply rising trendlines. That leaves the S&P 500 and Shanghai Composite filling the minor placings.
Copper and Crude show signs of a recovery but the broad basket of currencies is expected to underperform stocks and precious metals.
The Greenback is expected to weaken against most major currencies, while rising inflation is likely to leave bond investors holding the wooden spoon.
Jim Bianco forecasts higher inflation in 2021
Jim Bianco from Bianco Research:
“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”
The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.
Stock prices: Jay Powell is talking through his hat
Daily COVID-19 cases in the US continue to climb, reaching 236,211 on Thursday 17th.
Unemployment claims jumped by 1.6 million in the week ending November 28, exceeding more than 1 in 8 of the total workforce (Feb 2020).
Initial claims under state programs climbed to 935,138 (unadjusted) by week ending December 12, compared to 718,522 for w/e November 28, while initial claims under pandemic assistance programs run by the federal government jumped to 455,037 compared to 288,234 for w/e November 28.
Further escalation of both daily COVID-19 cases and unemployment claims is likely before vaccine distribution achieves a wide enough reach to make a difference. A major obstacle will be public reluctance to get the vaccine shot:
As states frantically prepare to begin months of vaccinations that could end the pandemic, a new poll finds only about half of Americans are ready to roll up their sleeves when their turn comes.
The survey from The Associated Press-NORC Center for Public Affairs Research shows about a quarter of U.S. adults aren’t sure if they want to get vaccinated against the coronavirus. Roughly another quarter say they won’t. (Associated Press, December 10, 2020)
Federal assistance
Further federal assistance may soften the impact of rising unemployment on the economy but Senate leaders are yet to conclude a deal. Both sides claim to want a deal but it seems unlikely that agreement will be reached before the Georgia run-off elections on January 5th. If the Democrats win both seats, and a Senate majority, they will not need to compromise. Unfortunately, large numbers of the least fortunate will suffer before then. Real leadership from the White House, needed to break the logjam, is sadly absent.
Jay Powell and stock prices
Jay Powell says he is relaxed about stock prices:
Stocks at record highs and bond yields not far from their historic lows are telling two different stories, but Federal Reserve Chairman Jerome Powell said he isn’t worried about the disparity.
In fact, the central bank chief said during a news conference Wednesday, the low rates are helping justify an equity surge that has gone on largely unabated since the March pandemic crisis lows.
“The broad financial stability picture is kind of mixed I would say,” Powell said in response to a CNBC question at the post-meeting media Q&A. “Asset prices are a little high in that metric in my view, but overall you have a mixed picture. You don’t have a lot of red flags on that.” (CNBC, December 16, 2020)
There is just one problem: bond yields are distorted by the Fed and do not reflect market forces.
S&P 500 PEmax
If we take the S&P 500 Price-Earnings ratio based on the highest trailing earnings (PEmax), this eliminates distortions from sharp falls in earnings during a recession. The current multiple of 26.69 is the second highest peak in the past 120 years, exceeded only by the Dotcom bubble. By comparison, peaks for the 1929 stock market crash (Black Friday) and 1987 (Black Monday) both had earnings multiples below 20.
Payback model
If we use our payback model, we arrive at a fair value estimate of 2169.50 for the S&P 500 based on:
- projected earnings for the next four quarters as provided by S&P;
- a long-term growth rate of 5%, equal to nominal GDP growth in recent years; and
- a payback period of 12 years, normally used for the most stable companies (with a strong defensive market position).
The LT growth rate required to match the current index value (3709.41) is 14.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was spiraling out of control.
Conclusion
Stock prices are in a bubble of epic proportions. Risk is elevated and we are likely to witness a major collapse in prices in 2021 unless inflation spikes upwards as in the 1970s to early 1980s.