Category: US & Canada

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Two years is a long time

An outcome where neither Republicans nor Democrats control both chambers provides markets with reassurance that nothing too radical will emerge, making the outlook for the next two years appear more predictable and the settings more stable……But the complacency might be premature. ~ Stephen Bartholomeusz

With Democrats in control, Donald Trump is unlikely to get further tax cuts through Congress. Even a large infrastructure spending program, which both major parties support, is unlikely to enjoy a smooth passage through the House because of a polarizing President and a federal budget deficit already close to 5.0% of GDP.

The Fed will continue to raise interest rates in order to contain inflationary pressures, fueled by low unemployment and the current budget deficit. Rising average hourly wage rates warn that the Fed will be forced to act.

Average Hourly Wage Rate

Earnings growth rates are likely to slow because of higher interest rates, higher wages and higher input costs from imports and trade tariffs (although a strong Dollar may soften the blow). But there is no sign of this in Q2 2018, with profits rising and employee compensation falling as a percentage of value added.

Corporate Profits and Employee Compensation as a Percentage of Value Added

Restraint from buybacks in October — the four weeks prior to earnings releases are known as the “blackout period” — may have contributed to the severity of the recent correction. But now most earnings have been reported and buybacks are likely to return with a vengeance, taking advantage of low prices. I expect support at October lows to hold, though there is likely to be another test in the next few weeks.

Declining Twiggs Money Flow peaks on the S&P 500 warn of selling pressure and it is likely to take several months for confidence to be restored. Recovery above 2850 would be bullish, suggesting another advance.

S&P 500

The Nasdaq 100 respected its long-term rising trendline at 6600. Again, recoveries take time: there are few “V-shaped” corrections and plenty with a “W-shape”.

Nasdaq 100

Buybacks and strong reported Q3 earnings are likely to counter bearish sentiment but there is one wild-card. Trade is one of the few areas where the President still has the reins and he is likely to make full use of them. I suspect that the Chinese will attempt to wait him out, making conciliatory noises but doing little that is concrete, which is likely to frustrate Trump further. He may try to force a deal through before the next election in two years. That could only end badly.

The two most powerful warriors are patience and time.

~ Leo Tolstoy

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Nasdaq and S&P 500 rally

The Nasdaq 100 rallied now that mid-term election results are emerging largely as expected. Faith in the primary up-trend is growing but it will take several weeks, if not months, for confidence to be restored and memory of the correction to fade. Hesitancy and a second test of new support at 6600/6700 are likely. There are few “V-shaped” corrections of this magnitude. Most are “W-shaped”, as in the first quarter.

Nasdaq 100

The S&P 500 displays a similar rally but it will take time for Twiggs Money Flow to break the descending trendline and signal that buying strength is restored. Expect another test of support at 2600/2650.

S&P 500

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Buckley’s chance that rate hikes will slow

Average hourly wage rates are rising, with Production & Non-Supervisory Employees growing at an annual rate of 3.20% and All Employees at 3.14%.

Average Hourly Wage Rate

This is a clear warning to the Fed that underlying inflationary pressures are rising. There is Buckley’s chance* that they will ease off on rate hikes.

The Fed adopts a restrictive stance whenever hourly wage rate growth exceeds 3%, illustrated below by a high or rising Fed Funds Rate.

Average Hourly Wage Rate

The market is adopting a wait-and-see attitude ahead of Tuesday’s mid-term elections. Stocks like Apple (AAPL) have been sold down on strong volume despite good earnings results: earnings per share of $2.91 and revenue of $62.9 billion for Q4-18, compared to consensus estimates of $2.79 and $61.5 billion.

Apple

Optimism over a possible trade deal with China may not last the week.

A harami-like candle on the S&P 500 reflects indecision, while bearish divergence on Twiggs Money Flow warns of long-term selling pressure. Breach of 2550 is still unlikely but would warn of a primary down-trend.

S&P 500

The Nasdaq 100 tells a similar story, with primary support at 6300.

Nasdaq 100

* William Buckley was an English convict transported to Australia. He escaped when the ships laid anchor in Port Phillip Bay in 1803. The nearest permanent settlement, Sydney, was more than 1000 km away and, considered to have no chance of survival, he was given up for dead. Thirty-two years later, having lived among the Wathaurung Aboriginal people, he emerged from the bush when a settlement was established at Port Phillip in 1835. “Buckley’s chance” is an Australian colloquialism meaning having no chance at all.

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What we can learn from Black Monday 1987

The current sell-off has a similar feel to October 1987, where the crash was precipitated not by a single external shock or tectonic shift but by an accumulation of bearish sentiment that led to a major sell-off. Here is a brief timeline (with thanks to Wikipedia):

  • August 25, 1987, the Dow peaked at 2,722 points after a strong 44% run-up over the previous 12 months, with low inflation and falling crude oil prices boosting the recovery.
  • October 14, the index dropped 95.46 points (3.8%) (a then record) to 2,412.70.
  • October 15, Iran attacked the American-owned (and Liberian-flagged) supertanker, the Sungari, with a Silkworm missile off Kuwait’s Mina Al Ahmadi oil port. The Dow fell another 58 points (2.4%), down over 12% from its August high.
  • October 16, Iran hit another ship the next morning, the U.S.-flagged MV Sea Isle City, with another Silkworm missile. The Dow fell 108.35 points (4.6%) to close at 2,246.74 on record volume. Markets in London were closed due to the Great Storm of 1987.
  • Monday, October 19, 1987, the crash began in Hong Kong and spread West. By 9.30am the Footsie (FTSE 100) had fallen over 136 points. Later that morning, two U.S. warships shelled an Iranian oil platform in the Persian Gulf in response to Iran’s earlier attack. The sell-off reached the United States, with the Dow Jones Industrial Average falling a record 22.6% or 508 points to 1,738.74.

Dow Jones Industrial Average, October 1987

The total draw-down of 36.1% was at least partly attributable to fears that conflict with Iran would impact on oil prices but there were also underlying tensions relating to exchange rates after the 1985 Plaza accord as well as fears of rising inflation and higher interest rates. What should not be underestimated, however, is the effect of programmed trading as institutional investors dumped stock in response to falling prices.

We are currently witnessing a similar herd mentality, where investors sell because others are selling, without heed to the merits of the stock they hold. Just not as severe (so far).

Dow Jones Industrial Average

The Dow correction is secondary but a lot will depend on this week. Whether primary support holds at 23,500 and whether institutional sellers join the melee.

The Moral of the Story

Compare Dow values today to those in 1987. The recent peak of 27,000 is almost ten times higher than the peak of August 1987. There is a lot to be said for sitting tight.

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No explanation required

In the past week, I have seen a number of market commentators attempting to explain the current correction. Reasons given vary from rising interest rates, Fed shrinking its balance sheet, the impact of trade tariffs on manufacturing input costs and inflation, mid-term elections and peak growth in earnings.

Truth is, there is no single reason that could justify the dramatic market falls. Some of the reasons cited are insufficient while others are invalid. But no explanation is necessary. Market sentiment has simply shifted. The scale has tipped and more investors are taking profits than new money coming into the market. When that happens, prices fall. And falling prices become a self-fulfilling prophecy, scaring off new investors and panicking investors with a short-term outlook.

How long this will go on for, I cannot tell. But I am sure there are growing numbers of long-term investors picking through the debris looking for opportunities. And the greater the fall, the greater the opportunity.

Earlier in the week I cited Netflix (NFLX) as one such example. Price has fallen almost 20% in October 2018, while recently released earnings announced a 34% year-on-year increase in revenue for the third quarter and a 130% increase in operating income.

Netflix

Patience is required but opportunities abound.

East to West

A quick recap of markets.

China’s Shanghai Composite Index is in a primary down-trend, having broken primary support at 2650, but rising troughs on the Trend Index warn of strong support. I suspect this is government-orchestrated as investors have little reason for optimism.

Shanghai Composite Index

India’s Nifty is testing primary support at 10,000.

Nifty

Europe is in a primary down-trend, with the DJ Euro Stoxx 600 respecting its former primary support level at 365/366.

DJ Euro Stoxx 600

The Footsie is testing primary support at 6900/7000.

FTSE 100

Dow Jones Industrial Average is undergoing a strong correction. Bearish divergence on the Trend Index warns of a reversal but only breach of primary support at 23,500, completing a double-top, would confirm.

Dow Jones Industrial Average

Dow Jones Transportation Average is already testing primary support at 10,000. Reversal signals on both averages would confirm a bear market according to Dow Theory.

Dow Jones Transportation Average

But technology stocks play a far larger role than in Charles Dow’s day, more than a hundred years ago. The Nasdaq 100 is still a long way above primary support at 6,300. Bearish divergence on Money Flow warns of selling pressure, but only breach of primary support would confirm a bear market.

Nasdaq 100

The only thing we have to fear is fear itself.

~ Franklin D. Roosevelt, 1933 inaugural address

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President Trump should look in the mirror

President Trump has repeatedly attacked the Fed and his recent appointee Jerome Powell for raising interest rates. In an interview with the Wall Street Journal, the President made clear his displeasure, stating that he sees the FOMC as the biggest risk to the US economy “because I think interest rates are being raised too quickly”.

What the President fails to grasp is that his actions, increasing the budget deficit when the economy is thriving, are the real threat. Alan Kohler recently displayed a chart that sums up the Fed’s predicament.

Unemployment and the Budget Deficit

The budget deficit is normally raised when unemployment is high (the scale of the deficit  is inverted on the above chart to make it easier to compare) in order to stimulate the economy. When unemployment falls then the deficit is lowered to prevent the economy from over-heating and to curb inflation.

At present unemployment is at record lows but Trump’s tax cuts have increased the deficit. The Fed is left with no choice but to steadily increase interest rates in order to prevent inflation from getting out of hand.

Real GDP growth came in at a robust 3.0% for the third quarter, while weekly hours worked are rising.

Real GDP and estimated Weekly Hours Worked

It’s the Fed’s job to remove the punch-bowl before the party gets out of hand.

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Why you shouldn’t panic when stocks are getting slammed

Why you shouldn’t panic when stocks are getting slammed from CNBC.

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Tearing Teslas apart to reveal some of their best and worst decisions

Tesla has a few problems to sort out before it makes our shortlist.

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Nasdaq warns of broad market correction

Tech stocks fell sharply, with the Nasdaq 100 closing below support at 7400, warning of a correction. Twiggs Money Flow (21-day) cross below zero indicates medium-term selling pressure. Follow-through of the index below 7300 would signal a correction to test 7000.

Nasdaq 100

The S&P 500 has so far respected support at 2870. Breach would confirm  a broad market correction and test the rising LT trendline at 2800.

S&P 500

Asia

In China, the Shanghai Composite Index is headed for another test of primary support at 2650. Trend Index peaks at/below zero indicate long-term selling pressure. Breach of 2650 would offer a long-term target of 2000, the 2014 low.

Shanghai Composite Index

India’s Nifty is undergoing a strong correction. Breach of support at 10,000 would warn of a primary down-trend.

Nifty Index

Europe

Dow Jones Euro Stoxx 50 is again testing primary support at 3300. A Trend Index peak at zero warns of mounting selling pressure. Breach of 3300 would warn of a primary decline, with a target of 3000.

DJ Euro Stoxx 600 Index

The Footsie is also testing primary support, at 7250, but a recovering Trend Index indicates buying pressure.

FTSE 100 Index

Rising US interest rates are already hurting developing economies like India and China, and a looming US-China trade war would threaten a global contraction.

Only when the tide goes out do you discover who’s been swimming naked.

~ Warren Buffett

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Extraordinary times of low unemployment and low inflation

Unemployment fell to 3.7% for September, well below the long-term natural rate of unemployment. This normally signifies a tightening labor market, a precursor to higher inflation.

Unemployment and the Natural Rate

But growth in average hourly earnings dipped slightly, to 2.75% for the past 12 months. Underlying inflationary forces remain subdued.

Average Wage Rates

As Fed Chairman Powell suggested, the Fed may be overestimating the natural rate. In his speech on Tuesday Powell summed up the current situation:

…Many of us have been looking back recently on the decade that has passed since the depths of the financial crisis. In light of that experience, I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same.

This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.

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