Doom and Gloom about the US economy

A few days ago I received an e-mail from a friend of mine which asked my opinion about the prospects for the US dollar and the US economy. Below is his e-mail (in italics) and my reply.

Carl,

I have been reading more and more about the currency wars and getting concerned. 

Many people say that between the Fed printing USD and oil being priced in Chinese yuan the US dollar is doomed. This will eventually lead to hyperinflation here in the US as the USD loses its global currency reserve status.

I personally have no idea if this will actually happen.  I have read about Russia & China coming to an agreement where China will buy oil from Russia paying in Yuan and the views that other oil producing countries will begin selling oil in currencies other than the USD.

Do you have any thoughts on this? There is no shortage of websites pushing this end of the US dollar and USA coming soon but of course each website is also selling something to profit from this coming doom!

Otto:

There will be no hyperinflation without the Fed's cooperation. They seem very reluctant to let the inflation rate move much above 2%. The 10 year Tips - note spread predicts 2.6% annual inflation for the next 10 years so the market has a lot of confidence in the Fed's commitment to keep inflation low.

That said I think the Fed is much more concerned about domestic economic conditions than about the value of the dollar. But notice how they have dragged the Bank of Japan and the Swiss along in the QE compaign. The rest of Europe will soon follow or fall into the economic abyss. Since all the big powers will evntually embrace some version of QE and follow the Fed I don't see how the dollar is going to drop much in the long run because of monetary expansion.

The US is the strongest economic power in the world. Soon it will be the biggest oil producer and is already the biggest natural gas producer. It has the  freest market system and is home to the  most innovative business entrepreneurs. And you say that there is a danger that people might prefer to trade in yuan, not dollars?

  Apparently the message has not gotten through to the world's criminal classes - who spit on payments denominated in any restricted currency like the yuan. Free traders trade in dollars or euros or yen and trade in dollars is the biggest by far in volume.

China looks strong because they are getting up to speed after being impoverished by the 1949- 1984 experiment with central planning and communist repression. Russia looked strong in the 1950's because they were starting from a very low base, just like China today.

But if history offers any lessons it is that government controlled economies (of which China is an example even now) eventually hit a ceiling beyond which progress is no longer possible. This led to the collapse of the Soviet Union. It also happened in China starting around 1400 when the combination of the European Renaissance and Chinese imperial repression of  creative thought and action started China's long slide into poverty from which she is only just emerging.

The doomsters always have something to worry about and this has been true as long as I have been active in markets, a period of nearly 50 years now. Experience teaches that in the long run the doomsters are always wrong and are either forgotten or become a laughing stock for sensible people. I don't see any reason for thinking the fate of the current crop of doom predictors will be different.

I had a friend once who thought that the doomsters were all secretly financed by the Trilateral commission to scare the little guy into making stupid choices. I don't share his cynicism but it is certainly consistent with the facts.

Carl

more reasons for concern

Here is an image of the Chicago Tribune's front page today. It is really about the stock market, not the economy. The graph to the right shows the Dow industrials for the past 7 years.

This article also observes that stock market mutual fund inflows for US base funds were the highest ever in January 2013. This after actually being negative for a good part of 2011 and 2012.

Another interesting fact is that the weekly survey National Association of Active Investment Managers (NAAIM) shows a commitment to the stock market of over 100%, the first time this number has been over 100% since January 2007 (at which point the 2002-2007 bull market still had 9 months to go).

I think these observations adds to a growing body of evidence that this 47 month old bull market is getting close to its end. But I don't think this end is here just yet.Typically the maximum bullish sentiment occurs a few months before the highs in the market averages.

interest rates and the economy

What determines the level of the 10 year note yield (top chart)? I'd say that this yield depends on investor expectations about two things: the real rate of growth in the economy and the rate of inflation over the next 10 years. We can simplify this idea even further by saying that the level of 10 year note yields should roughly equal investor forecasts of the average annual rate of growth in NOMINAL (no inflation adjustment) gross domestic product  over the next 10 years.

As you can see in the chart investors are expecting nominal GDP to grow at about a 2% annual rate for the next 10 years. Since people expect inflation rates of at least 2% as far as the eye can see, this level of interest rates suggests that investors think that the real economy will not grow at all during the next 10 years!

You can get another read on this expectation by looking at the yield on the 10 year TIPS (inflation protected treasury notes) which were auctioned at a rate of a NEGATVE 0.63% a few days ago. People who bought these notes are paying the US treasury to take their money and spend it!!!  From a purely mechanical point of view the difference between the yields on the 10 year note and the 10 year tips represents investor's expectation of the rate of inflation over the next 10 years. In this case the difference is 2.60%. Put another way, the 10 year TIPS yield suggests that investors think the real economy will shrink by 0.60% per year over the next 10 years while inflation averages 2.00% per year! Of course there is probably a fairly big risk premium built into the negative TIPS yield so the forecast is not really as pessimistic as this. Even so I still think this is an incredible forecast for the US economy.

Is this forecast likely to be close to the mark? I don't think so. I think people are grossly underestimating the likely effects of the Fed's quantitative easing policy and the Fed's commitment to pursue that policy at least until the US unemployment rate drops below 6.5% (it is currently 7.8%). The Fed's policy is having an effect on the Euro which is steadily rising against the dollar (middle chart). The Euro is above it rising 200 day moving average as well as above its rising 50 day moving average, a bullish configuration if there ever was one. The market is pricing in not just the survival of the Euro currency but also the fact that the Fed's monetary policy is relatively loose compare with that of the European Central Bank. Liquidity in the US is increasing relative to Europe's. This will inevitably lead to a pick up in US economic activity relative to that of the EU and a further advance in the Euro against the dollar.

The market thinks that the Fed will also be getting help from the Japanese central bank in pushing upward world economic activity. The bottom chart shows the yen priced in dollars. This bear market in the yen is a forecast of a big expansion in yen liquidity relative to dollar liquidity (which of course is itself increasing). This would be an enormous change in policy by the Bank of Japan (if it occurs) and will have very positive effects on the Japanese and the world economies.

All in all I think the market forecast of only 2% annual growth in nominal US GDP over the next 10 years is plain silly. My own guess is that this number will come in closer to 5% or even higher. If I am right 10 year note yields are in the early stages of an advance which will last several years. You can see that the 50 day moving average of this yield has finally climbed above the 200 day moving average, the first time this has happened in years. This I think is a harbinger of a long term bear market in bond prices.

I' mmmmm baaack!

It's been more than a year since I have updated this blog. I have been dealing with a number of personal issues and consequently updates for this blog have been low on my list of priorities. Of more significance is the paucity of contrarian material in the news media over the past year. There have been lots of economic and political headlines but none directly mentioning the markets. So it has been hard to identify any new bullish or bearish information cascades.

I want to point out one change to which we contrarians will have to adjust. The print media, the mainstay of my approach to identifying information cascades, are rapidly declining in significance relative to electronic sources of information. This is going to make it harder to identify information cascades, especially the bearish ones which typically come and go quickly. As a concrete instance of this trend one can point to the demise of Newsweek's print edition. Time magazine is evolving into a tabloid and so I think its usefullness is diminishing too.

A big part of the art of investing, and particularly of contrarian investing, is the ability to adjust to changing circumstances and market environments. So going forward I will be trying to incorporate more electronic sources of information as indicators of market sentiment to supplement my readings of newpaper headlines and magazine covers.

My last post on this blog was in December 2011. In it I said that pessimism about the US and European stock markets was thick and that this meant that higher prices were ahead. A few days after that post long term contrarian traders were confronted with a mechanical sell signal on December 20 in the S&P 500 when its 200 day moving average dropped 2% from its high point reached earlier in 2011 (chart is above this post). I personally ignored this signal as a matter of contrarian logic - if pessimism dominated the markets at the time then this sell signal would turn out to be wrong (and it was).

There were other technical reasons to doubt the signal. First, the Dow industrials never got even close to generating a similar sell signal. Secondly, when the S&P's 200 day moving average achieved its 2% decline on December 20 the S&P was actually above its rising 50 day moving average (wavy green line on the chart above). At the very least this would have been reason to delay acting on the mechanical sell signal. The next time the S&P traded below its 50 day moving average was in mid-2012 after the 200 day moving average had resumed its strong up trend.

Aggressive contrarians had abandoned long positions in late August 2011 near 1200 in the S&P. Needless to say I repurchased my own aggressive contrarian long position on the one day dip right after Christmas of 2011 at about the 1255 level. It has remained undisturbed since then.

At the top of this post is an image of the January 26 front page of the New York Times. For the first time in a very long while there is a headline about bullish stock market performance pointing out that the S&P has closed above the 1500 level for the first time in five years.

Is this a sign of a bullish information cascade? I am doubtful about this possibility. I think the man on the street is still pretty much out of the stock market and pessimistic about the US economy.

Nonetheless, one must recognize that S&P average has been moving generally upward for 46 months, an unusually long time for a market advance. And the average is approaching the levels of two big tops at 1553 in 2000 and 1576 in 2007. There was a lot of pessimism around at the time of the 2007 top. This fooled me then into thinking that the worst that was likely on the downside then would be a 20% or so drop.But things got a lot worse than I imagined they could.  I don't plan to make this same mistake again. This is another reason for contrarians to take the headline above this post as an early warning of a possible storm ahead.

I think that both conservative and aggressive contrarians should now be looking for reasons to reduce the size of their long positions. Personally I think the advance from the November 2012 low point has further to go. I am looking for a move up to 1546 in the S&P. Once the market gets there, or if other bearish signs develop in the interim, I think it will be appropriate for aggressive contrarians to cut way back on their long postitions.

Conservative contrarians dodged a bullet in December 2011 when the S&P generated a mechanical sell signal which I ignored. I think it will be appropriate to take advantage of this fortunate circumstance to sell long positions at the same time that aggressive contrarians do even though this would violate the mechanical guidelines for conservative contrarians whichI set down in my book.

I will keep you posted on my thinking about these possibilities going forward.

what hasn't happened

There seems to be an emerging consensus that yesterday's EU summit meeting was a partial failure and a partial success - sort of like all the other EU initiatives taken to control a potential banking crisis.

There is an extraordinary conviction among investors that this half -success, half-failure result was too little and too late, that an Euro zone break up is inevitable and will have devastating, world-wide economic consequences. At least that is what I am reading in the print media and getting from on-line sources.

Here are a few headlines I found within minutes of searching on line for reactions to the summit. They are quite representative.

"Europe's blithering idiots and their flim-flam treaty" - Ambrose Evans-Pritchard, The Telegraph (UK)

"Europe's Disastrous Summit" - Felix Salmon, Reuters US

"Eurozone banking system on verge of collapse" - Harry Wison, The Telegraph (UK)

I think I am on safe ground in asserting that a very bearish investment crowd has developed around this theme during the past few months.

The odd thing is that the European stock markets as well as the US market have rallied today - not by a huge amount - but quite substantially. I also note that the Euro-currency has been trading quietly for the past two weeks in a narrow range a little above its early October lows.

This surprises me, and I think it means that the widely accepted view that a European crash is imminent is wide of the mark. I think the Euro will rally against the dollar from here and that European and US stock prices will advance well above their late October highs.

important update

In my last post I suggested that aggressive contrarians should wait until the cash S&P 500 closed above its 50 day moving average (red dash arrow) before reducing the current, above-average exposure to stock to below-average levels.



I had envisioned this happening around the 1220 level in the S&P. The market is currently trading there but the 50 day moving average is 30 points above the market. I think it is better to be safe than sorry, so I think aggressive contrarians should take advantage of current prices to reduce their stock market exposure to below-normal levels.

Panic II

This morning's editions of The New York Times and the Chicago Tribune presented the front pages you see above this post. Just as it did this past Friday the stock market has made it into the headlines. Generally speaking big rallies start a day or two after headlines like these appear in the newspapers. Today's 6% rally from yesterday's close is probably only the first stage of a bigger move which should take the S&P (daily chart above this post) back above the 1200 level.



Aggressive contrarians still have above average long positions which were increased from average levels while the S&P was in the 1250-1290 range. This latest break has dropped the average nearly 20% from its May 2 high on an intraday basis. Frankly, this is a much bigger drop than normally appears in the context of an ongoing bull market.



For this reason I think it makes sense to adopt a defensive strategy even though the 200 day moving average of the S&P 500 (red line in the chart) has yet to turn downward by 2%, the mechanical method I prefer for signalling a bear market. I think the thing to do now is to hold on to long positions for the time being, but to adopt the strategy of dealing with bear market rallies which was described on page 133 of my book. Wait for the S&P 500 to close 1% above its 50 day moving average (the black wavy line on the chart) which currently is at 1293 but falling rapidly. When this happens reduce stock market exposure to below normal levels.



The blue arrow projects this drop in the moving average linearly into the future. It looks like the market is likely to meet its 50 day moving average somewhere in the 1200-30 range.



My best guess is that the drop from the May high at 1370 is only the first wave down in a bigger decline. I estimate that the low of this decline will develop somewhere in the 950-1000 range.



Conservative contrarians are still carrying a normal stock market long position. I think this is the appropriate strategy until such time as the 200 day moving average drops 2% from its recent high.