Market Disconnect – Speculation Scenario – That May Be Premature

August 19, 2013

Some of the “more common” contra-cyclical manifestations are currently not following the “rules”, which could imply the onset of a complete breakdown, i.e. we may be on the cusp of a situation where the Dollar, US Equities (leading Global) and US Treasuries are all breaking down together – which would be a disaster.  I am going to propose a scenario based on Pro & Contra-cyclical logic as follows.

Assumptions

  • I know there is always a risk that equities will float higher on a sea of money a-la Zimbabwe, but that is less likely since the current sea of money is not getting out into the economy – it is largely “trapped” in the banking system, shoring up their liquidity ratios;
  • Higher inflation usually precedes higher interest rates, but currently there is little evidence of inflationary pressures.  There is a higher risk of deflation than inflation, especially in the face of declining global growth expectations and declining consumption (real wages), which would traditionally favour lower interest rates.  Lower infl. &  interest rates bring the reality of “negative Real returns” back into focus;
  • When Equity markets decline significantly, Governments usually reduce interest rates as they try to stimulate spending and the economy – this also brings the reality of negative “Real” returns back into focus;
  • When Equity markets decline significantly, there is usually an “initial” sell-off of Gold to free cash to cover margin calls – where-after Gold rises.  Such a sell-off in Gold will probably cease immediately any renewed QE speculation surfaces and/or when the reality of “negative Real returns” manifests;

Fact?

  • Rising unemployment at the hand of robotics, automation, computer algorithms etc. is likely irreversible until the current imbalances in the global economy have been addressed and the transition to a significantly even exponentially accelerated “multi-tech revolution” economy has been successfully navigated.  This will take at least a decade and will, in the interim, result in declining tax revenues;
  • Firms are biased in favour of outsourcing skills, which is making employment increasingly temporary and, accordingly, access to credit increasingly difficult.  In an era where the global economy was driven to the edge by easy access to credit and the cure to the current global economic woes is deemed to be to “encourage spending” (i.e. incur more debt), economic growth is unlikely;

So let us look at some key market components with the aid of some charts:

The Dollar

It should first be noted that the Dollar Index (DI) is a joke for the following reasons:

  • One cannot measure currencies relative to each other when they are all being devalued, as all the little boats in a leaky bucket fall with the level of the water.  i.e. One cannot really have an index of currencies like the Euro, UK£ and Yen when all are “Fiat currencies”, that are being printed in excess i.e. devalued to protect their countries’ respective trade advantages;
  • The strengthening currencies of the US’s major trading partners like China (2nd biggest), Mexico (3rd), India, Brazil etc. are excluded from the DI;
  • Neither the currencies comprising the DI nor their weighting in any way reflect the trade weighting of the US’s major trading partners.  Ex Wikipedia:- The US Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. It is a weighted geometric mean of the dollar's value compared only with … 6 other major currencies which are:
    • Euro (EUR), 57.6% weight
    • Japanese yen (JPY) 13.6% weight
    • Pound sterling (GBP), 11.9% weight
    • Canadian dollar (CAD), 9.1% weight
    • Swedish krona (SEK), 4.2% weight and
    • Swiss franc (CHF) 3.6% weight

 

Charts with discussion below:

At present it is difficult to tell if the DI is going to break to the upside as the daily MACD is oversold (see left), or the downside (see red dashed arrow far right), which is my anticipated scenario.  There is a bearish divergence on the Weekly chart (red dashed arrows) and Weekly MACD seems to have plenty of room to move down although the Weekly Stochastic (PKS) is oversold (it can easily stay low).  The Monthly Stochastic (PKS) is clearly bearish and over decades, I have found the influence of the longer term oscillators will dominate in the longer term, so the overall picture seems bearish.

It is my contention that the DI is going to break out to the “significant” downside for the following reasons:

  • Many countries are either considering or already trading oil in currencies other than the Dollar – the Petro-Dollar trade was the “founding force” of the Dollar’s “reserve currency” status – i.e. this undermines its historic reserve status;
  • Most of the “Eastern/BRICSA” countries are entering into bilateral trade agreements to trade goods, resources and commodities in currencies other than the Dollar – i.e. less demand for Dollars – undermines reserve status;
  • Most countries with significant Dollar surpluses are trying to reduce their exposure to the Dollar and/or have ceased purchasing US Treasuries;
  • Aside from lip service, the US is exhibiting little inclination to adopt austerity to reduce debt and or deficits, whereas the EU and UK are, at the very least, trying to do so to a greater of lesser extent.  i.e. The US seems hell-bent on trashing the Dollar. One gets a sense that they want the Dollar to become so weak that they are competitive into the West (rest) and or even the East??;
  • From a technical analysis perspective, there is a high probability that the Dollar Index will break out of the Pennant/Triangle to the downside – see also Elliott Wave count which typically breaks to the downside with Wave 6;
  • There are considerable signs that Commodities have bottomed and that prices could rise for the foreseeable future, which would imply a weaker Dollar.  Is commodity inflation about to lead interest rates higher???  This is counterintuitive as demand for commodities usually drops with equities!

 

The S&P500 - (Interactive Chart courtesy of Yahoo Finance – they are great)

From the point of view of technical analysis, the Daily (left) is approaching the 38.2% Fib retracement and the Stochastic (PKS) is oversold, so we could see a bounce.  However MACD reflects considerable room to move to the downside, which could provide more pull.  The weekly oscillators are all bearishly aligned and showing considerable downside potential.  The Monthly (not shown) is also rolling over from an extremely overbought situation after a 4.5 year bull market run.

For a longer term perspective, the pattern below could provide more bearish news:

As I see it, the S&P is more likely to follow the suggested Elliott Wave Count than to make a small correction to 1550 before bouncing higher off the upper line (see blue projections).  If this was a false breakout, the S&P500 is likely to drop 50% to below 800.  I suspect this was a false breakout (bigger than usual) for the following reasons:

  • There is considerable evidence that High Frequency Trading has pushed markets higher (and sometimes lower) than they would have gone in a normal trade environment i.e. this last peak was “artificial” not fundamental;
  • The search for yield in a low interest rate/low return environment has driven equities higher than was justified by earnings – ditto “artificial”;
  • The rise to new record highs in the face of “zero” earnings growth prospects, at a time when all economies in the world are slowing down, made no sense;
  • No matter what the statistics say, the US consumer is significantly poorer than a decade ago and maxed out i.r.o. credit, unemployment is close to 1930’s Depression levels and the US is not growing – see my previous article;
  • US Equity markets have been rising for 4.5 years and are overbought in all time frames on almost all oscillators;
  • Equity markets usually correct more than 10% in Sept/Oct and they only corrected about 8-9% last year, so we could easily be in for a correction of at least 20%;
  • Governments are increasingly clamping down on the very “illegal” activities of banks and large corporations that facilitated much of their recent profitability and this is likely to lead to lower earnings;

Bonds

Could be serious?  Normally when Equity markets correct significantly, bond yields drop (bonds rise) as Government attempts to re-stimulate the economy.  This time, equity markets have dropped fairly significantly yet the 30 year T bond has dropped below previous support as yields rose (charts below).  Is the bond market telling us that this equity correction is not serious or is there a disconnect in the traditional contra-cyclical behaviour where Bonds rise when Equities decline significantly.  If there is a disconnect the Bond market may be telling us more QE is likely to follow this correction (and any banking crises) and that this would be inflationary.

Looking at the charts of the 30-year (TYX) and the 10-year (TNX) further below, all the way back from 1978, one sees that the 30 year has broken above the primary resistance line and could soon break above the secondary (dotted) line at above say 4.1%.  Contrarily, the 10 year has yet to break out above resistance.   Does this imply anticipation of inflation in the long term but not yet in the short term? 

Bottom line, interest rates cannot continue to decline indefinitely, so we know that higher rates are coming.  i.e. The question is no longer “If”, but “When”.  EVEN BIGGER BOTTOM LINE: We all know that equities do not perform well during times of rising inflation and rising yields.  Contrarily, Commodities usually do.

Below the 30-Year TYX followed by the 10-Year TNX:



What needs to be remembered is that the Fed REALLY CANNOT AFFORD HIGHER INTEREST RATES as their cost of debt becomes seriously problematic, so in the face of falling equities coupled with rising rates they are likely to be more quickly biased in favour of trying to keep rates low – i.e. More QE??  What should also be remembered is that the last strong rise in Commodities was driven by speculative trading in a search for yield following the injection of significant “QE” (Fiat Monies).

Gold

Gold takes a knock every time there is talk (and only talk) of “tapering”.  However, if equity markets tank – which currently seems likely, Banks and Equity markets could be in trouble, which raises the likelihood of more rather than less quantitative easing.  This would naturally favour a perpetuation of the “Negative Real Rates/Returns” scenario that ultimately underlies every Gold Bull Market.  Couple this with

From the point of view of technical analysis (see chart below), I suspect that the Bottom is in because the Monthly spot chart on the right shows that Gold bounced above the 61.8% Fib retracement of the entire move up from 2009.  However, Gold still has a number of hurdles to overcome before we can confidently say that the bull market has resumed (bottom is in).  Firstly we need to get past the 38.2% Fib retracement of this entire move, which is at about $1420 (see weekly chart).  Secondly we need to get over the Red resistance lines on the monthly chart at say $1520.  Finally we need to get over the Red resistance line at $1800 and the previous peak at $1920 before we can say that the bull market has clearly resumed.  Bottom line, there is a lot of work to be done.

The ultimate question of course is “why should Gold continue to rise to new bull market highs”.  I do not want to elaborate on that this time around, since substantiation of that suggestion would make this report too long.  However, ultimately the key driver of any Generational Gold Bull market is “Negative Real Rates/Returns” – i.e. Returns are lower than inflation.  These can manifest when rates are at historic 200 year lows, as they recently were, or when inflation is high, rates are playing catch up and equities are underperforming as we may soon see.

COMMODITIES

Commodities seem to have broken above resistance twice and could be setting up to rise.  As mentioned before, this is counter-intuitive, since they normally fall with equities as the expectation of demand declines with poorer equity growth prospects.  However, as mentioned before, the real likelihood that there will be more rather than less QE could be underpinning commodities and could lead to renewed interest in commodities.

Conclusion

We all know that recessions are needed to rid the markets of excesses arising during the previous growth phase, thereby rebalancing the markets and that the endless QE and artificially low bond yields aimed at circumventing recent recessions have created unsustainable imbalances.  We also know that Equities are toppish on all oscillators after rising for 4.5 years and, with declining global growth coupled with negative earnings growth prospects, a significant decline into seasonal weakness is an extremely high probability.  If Equities decline significantly (20%-50%), I postulate the following!!!:

  • Equities decline significantly – QE level or rising – i.e. no risk of “tapering” QE;
  • High risk of a mega bank collapsing – cause? Bond Market collapse, Derivatives on the wrong side of the “market resets” or Hi Freq. Trading;
  • Now Either:
    • Equities go down and Yields go down – Yields to ?NEW? lows;
    • New/near record lows in Yields = New/near record highs in Bonds;
    • Lower Yields = resumption Negative Real Returns = Rising Gold;
  • OR:
    • QE causes commodities to rise and inflation to manifest;
    • Bonds yields rise and the bond market collapse commences – investment banks in trouble;
    • Gold rises as “negative Real returns” (inflation higher than Bond yields and negative equity yields) manifest and as it reverts to its traditional role as a store of value in times of crisis.

Based on this alone I think the Generational Gold Bull Market is not over, higher Gold prices are baked in the cake and the ultimate exponential rise lies ahead.  However, I think the final exponential rise will be driven by higher inflation followed by higher rates, which will follow the nearer term low in yields.  My expected timing is for Gold to peak between 2016 and 2018 at over $8000.  My fear is that Western Governments pass legislation that will make ownership of Gold increasingly difficult or even illegal. 

My personal view is that this Fiat money experiment that has lasted 100 years will end badly and that the increasingly influential emerging economies, coupled with strong economies like Germany, will insist on a resumption of the Gold Standard as there has to be a mechanism to settle/resolve huge trade surpluses.  Infinite deficits such as the US has engineered is outright theft – see “Modern Fraud Money Explained” at http://www.jhbcoinexchange.com/critical.php and click on PDF doc link.

Eelco Robert Lodewijks was born in South Africa.  He has  a BSc Civil Engineering from University of Cape Town and a MBA from UCT.   Mr.  Lodewijks lectures Advanced Excel and Advanced Financial Modelling in Excel on the international circuit (including Hong Kong, Singapore, Brunei, Malaysia, Dubai, Kuwait, RSA, Mauritius, Zambia, Nigeria, Uganda, Tanzania and Zimbabwe).   His early career was spent in construction site management on large multi-million Dollar projects, both in South Africa and the Middle East, where-after he did his MBA. 

The world’s gold supply increases by 2,600 tons per year versus the U.S. steel production of 11,000 tons per hour.