V- or M-shaped correction?
Last week I mentioned that there are few “V-shaped” corrections and plenty with a “W-shape”. There are also a few with an “M-shape”, leading to a major market sell-off. Here are some examples on Dow Jones Industrial Average.
2001 is the only good example I can find of a V-shaped correction.
It rolled over later in 2002 into a more conventional W-shape bottom with several tests of support at 7500.
This was followed by the banking crisis of 2008 which started with an M-shape in 2007. Successive false breaks above resistance (orange arrows) were followed by breach of support (red arrows)…before Lehman Bros filing for bankruptcy on September 15 led to a major capitulation.
2011 is nowadays considered a secondary movement but at the time caused widespread alarm. Starting with an M-shaped top, it broke support in August before forming a W-shaped bottom with several tests of support at 11000.
2015 was a more conventional W-shape precipitated by falling oil prices.
Now, in 2018, we have the makings of either a W-shaped correction or an M-shaped reversal. The false break above resistance at 26500 is definitely bearish but was followed by a bullish higher low at 24000.
There are three possible options:
- Completion of a W-shape correction, with breakout above 27000;
- An M-shaped reversal, with a fall below 23500; or
- A lengthy consolidation reflecting uncertainty, as in 1999 to 2001.
At this stage, option 1 is most likely. Buybacks and strong Q3 earnings are likely to counter bearish sentiment.
That would change if we see:
A negative yield curve, where the 3-month T-bill rate crosses above 10-year Treasury yields;
Rising troughs above 1% on the S&P 500 21-day Volatility Index; or
Bellwether transport stock Fedex follows-through below support at 210.
Remember that there is nothing stable in human affairs; therefore avoid undue elation in prosperity, or undue depression in adversity.
~ Socrates
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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%.
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.
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.
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.
The Nasdaq 100 tells a similar story, with primary support at 6300.
* 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.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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.
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.
It’s the Fed’s job to remove the punch-bowl before the party gets out of hand.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
ASX 200: Miners rally but banks a worry
The ASX 200 found support at 6120/6150, with a long tail indicating buying interest. Follow-through above 6250 would suggest another advance. Breach is now unlikely but would warn of a test of the rising long-term trendline at 6000.
A rally on resources stocks helped support the overall index. Expect the ASX 300 Metals & Mining index to test 4000.
Miners were helped by a weakening Aussie Dollar. Breach of support at 71 US cents offers a target of 69 cents. Trend Index peaks below zero warn of strong selling pressure.
Banks, on the other hand, are weakening. The ASX 300 Banks index broke support at 7700, with a declining Trend Index warning of selling pressure. Expect a test of primary support at 7300.
Falling broad money and credit growth warn of a contraction — unless an unlikely Chinese-led mining boom can keep the wolf from the door.
House prices are falling.
Returns on bank equity are declining due to increased capital requirements, lower credit growth and narrow margins.
I remain cautious on Australian stocks, holding over 30% cash in the Australian Growth portfolio.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
It’s a bull market
The US economy continues to show signs of a robust expansion. Net capital formation is rising (as a percentage of GDP) as it is wont to do during a boom. In layman’s terms net capital formation is the net growth in physical assets used in the production of goods and services, after allowing for depreciation.
The Wicksell spread has turned positive. When return on investment (we use nominal GDP growth as a surrogate) exceeds the cost of capital (reflected by low investment grade Baa bond yields) that encourages new investment and economic expansion as in the 1960 – 1980 period on the chart below.
Real bond yields, reflected below by Baa yields minus core CPI (blue line) on the chart below, are also near record lows. Low real returns on bonds support high stock earnings multiples.
Fed Chairman Powell summed up the situation in a speech on Tuesday this week:
…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.
The biggest risk is that investors get carried away and drive earnings multiples sky high, but gradual rate increases from the Fed and the threat of tariff wars appear to be keeping animal spirits in check.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Treasury yields confirm bond bear market
10-Year Treasury yields respected their new support level at 3.00%, confirming a primary advance.
Breakout above 3.00% also completes a double-bottom reversal, signaling the end of a three-decade-long secular bull market in bonds.
The yield differential between 10-year and 3-month Treasuries is declining but a flat yield curve does not warn of a recession. Only if the yield differential crosses below zero, with short-term yields rising faster than long-term, will there be a recession warning.
Real returns on long-term bonds — the gap between the green and blue lines below — remain near record lows.
Only if the gap widens (real returns rise significantly) are we likely to see downward pressure on stock valuations, with falling price-earnings multiples.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
How will a bond bear market affect stocks?
10-Year Treasury yields broke out of their triangular consolidation at 3.00%, while the Trend Index recovered above zero signaling a fresh advance.
Importance of resistance at 3.00% is best illustrated on a long-term monthly chart. Yields declined for more than three decades (since 1981) in a bond bull market but the rise above 3.00% completes a double-bottom reversal, warning of rising yields and a bond bear market. Target for the advance is 4.50%.
The yield differential between 10-year and 3-month Treasuries has declined since 2010, prompting discussion as to whether a flat yield curve will cause a recession. Interesting that the yield differential recovered almost 20 basis points in September, with long-term yields rising faster than short-term. Penetration of the descending trendline would suggest that an imminent negative yield curve is unlikely.
How would a bond bear market affect stocks?
Capital losses from rising yields on long-maturity bonds would increase demand for shorter maturities, driving down short-term yields and causing a steeper yield curve. A bullish sign for stocks.
Inflation is low and the rise in long-term yields is likely to be gradual. Another bullish sign.
The last bond bear market lasted from the early 1950s to a peak in September 1981. Higher interest rates were driven by rising inflation ( indicated below by percentage change in the GDP implicit price deflator). The 1975 spike in inflation was caused by the OPEC oil embargo in retaliation for US support of Israel during the 1973 Yom Kippur war.
Stock prices continued to climb during the bond bear market, apart from a 1973 – 1974 setback, but the Price-Earnings ratio fell sharply in ’73-’74 and only recovered 10 years later, in the mid-1980s.
Alarmists may jump to the conclusion that a bond bear market would lead to a similar massive fall in earnings multiples but there were other factors in play in 1975 to 1985.
First, crude prices spiked after the OPEC oil embargo and only retreated in the mid-1980s.
The rise of Japan also threatened US dominance in global markets.
We should rather examine the period prior to 1973 as indicative of a typical bond bear market. The S&P 500 Price-Earnings ratio was largely unaffected by rising yields. Real interest rates actually decreased during the period, with the gap between 10-year yields and the inflation rate only widening near the 1981 peak.
At present, real interest rates are near record lows.
We can expect real interest rates to rise over time but that is unlikely to have a significant impact on earnings multiples — unless there is a strong surge in long-term yields ahead of inflation.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Silver warns of further Gold weakness
Precious metals tend to trend or consolidate together, driven by similar investor motives. Spot silver is testing primary support at $14 per ounce, while a Trend Index peak at zero warns of selling pressure. Breach of support would signal a primary down-trend.
Gold is still testing support at $1200/ounce but Trend Index peaks below zero warn of selling pressure. Respect of the descending trendline indicates another decline with a long-term target of the 2015 low at $1050/ounce, similar to silver.
Currencies
The Yuan continues to test support at 14.5 US cents.
The Dollar Index continues to test support at 95, despite the weak Yuan. Bearish divergence on the Trend Index warns of selling pressure but long tails indicate support. Breach of support at 95 is uncertain but would signal a correction to test 91 — boosting demand for gold.
The Australian Dollar continues a strong down-trend, with Trend Index peaks below zero warning of selling pressure. Expect a test of the 2015/2016 low at 70 US cents.
Gold Stocks
The falling Aussie Dollar has partially cushioned local gold stocks from weaker gold prices but gold is more volatile than the Dollar. The All Ordinaries Gold Index (XGD) is expected to break support at 4550, offering a long-term target of 4000/4100.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
Wage increases haven’t made a dent in profits
Average hourly earnings growth continues to rise, albeit at a leisurely pace. Average hourly earnings for all employees in the private sector grew at 2.92% over the last 12 months, while production and nonsupervisory employee earnings grew at 2.80% over the same period. The Fed is likely to adopt a more restrictive stance if hourly earnings growth, representing underlying inflationary pressures, exceeds 3.0%. So far the message from Fed Chair Jerome Powell has been business as usual, with rate hikes at a measured pace.
Rising wage rates to-date have been unable, up to Q2 2018, to make a dent in corporate profits. Corporate profits are near record highs at 13.4%, while employee compensation is historically low at 69.5% of net value added. Past recessions have been heralded by rising employee compensation and falling corporate profits. What we are witnessing this time is unusual, with compensation rising, admittedly from record low levels, while profits rebounded after a low in Q4 2016. There is no indication that this will end anytime soon.
Weaker values (1.17%) on the Leading Index from the Philadelphia Fed reflect a flatter yield curve. A fall below 1.0% would be cause for concern.
Our surrogate for real GDP, Total Payrolls x Average Weekly Hours Worked, is lagging behind recent GDP growth (1.9% compared to 2.9%) but both are rising.
Another good sign is that personal consumption expenditure, one of the key drivers of economic growth, is on the mend. Services turned up in Q2 2018 after a three-year decline. Durable goods remain strong. Nondurables are weaker but this may reflect a reclassification issue. New products such as Apple Music and Netflix are classified as sevices but replace sales of goods such as CDs and videos.
There is no cause for concern yet, but we will need to keep a weather-eye on the yield curve.
Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.
~ George Soros
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.