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Chart In Focus Perhaps The Only Chart That Matters (For Now).
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November 21, 2013There are a lot of different indicators and studies that technical analysts use, and all of those tools came into usage due to some degree of merit. But the one factor which seems to be trumping everything else lately is what the Fed is doing with its QEternity program, which shows no sign of stopping anytime soon, or maybe ever. This week's chart compares the SP500 to the total assets held by the Fed. That plot is made up from the total of the Fed's Treasury holdings and its mortgage backed securities (MBS), which are sometimes referred to as "agency" debt products. The agencies which that title refers to are Fannie Mae, Freddie Mac, etc. Putting the chart together this way helps us see just how important the Fed's purchases have been to the task of sustaining the bull market for stocks. Whenever the Fed has decided to change the slope of the green line, the slope of the SP500 has also changed in a dramatic way. That makes it such an important question to contemplate a "tapering" off in the rate of growth of Fed assets, or even an outright end to quantitative easing (QE).
This chart also helps us see just how critical the Fed's actions were in bringing about the awful bear market of 2007-09. Back then, the Fed just held Treasuries, and it did not start buying agency debt until January 2009. The Fed's holdings of Treasury debt peaked in August 2007 at $790 billion, and over the next 17 months the Fed sold off more than $300 billion of those holdings. That's right, in the middle of the worst liquidity crisis in decades, with banks folding and with Congress handing out tax rebates, the Fed was pulling liquidity OUT of the banking system.
When the Fed finally stopped pulling liquidity out of the system and started adding it back in again in early 2009, the market turned upward, and the banking system and economy started working their way back toward health again. Given the now obvious importance of the Fed's actions on financial market liquidity, why did they decide in 2007 and 2008 to pull so much money out of the system by selling so much of their Treasury holdings during that bear market? That will be a great question for the historians to uncover. But what I can say is that the man who orchestrated and conducted those sales, the former president of the New York Fed, left that job in early 2009 to become the new Treasury Secretary. So you can draw your own conclusions. Will all of this QE someday bring us inflation? Of course it will, because it already has. In recent decades, many people including Fed officials have come to think of "inflation" as what happens to consumer prices. But the original definition of inflation refers to the excessive expansion of the money supply. QE is inflation. So far, innovation and productivity gains are keeping prices from running away in step with the growth in the money supply. But rather
than allowing consumers to enjoy the benefits of those lower prices, the Fed is confiscating that benefit for its own purposes, insisting on 2% annual growth in consumer prices instead of the "price stability" mandate given to the Fed by Congress. When will it all end? That is a hard question, because it goes to the thinking and the decisions of the 12 voting members of the FOMC. As a markets analyst, I am accustomed to analyzing the collective decisions of millions of people. THAT can be modeled. Forecasting the decisions of 12 people is a much harder task. But it is worth noting that back in 2007, the A-D Line actually peaked 3 months before the Fed's Treasury holdings peaked. And the April 2010 stock market top preceded the end of QE1. Likewise, the market peak in 2011 arrived before the end of QE2. So it is not reasonable, given these historical events, to conclude that one can just wait to hear news about the end of QEternity in order to know when the top for stocks is going to arrive. Tom McClellan
This is one of those low-level reports and comprises part of the bigger national ISM reading that we saw yesterday. Typically we don’t report and while there is no consensus ahead of the forecast, the leap in the current index to 69.5 from an already expansionary pace of 59.3 is startling. The business outlook index advanced by 6.0-points to 69.6 while the quantity of purchases reading jumped to 50.0 from 42.9. The prices paid index rose roughly 3-points to 59.5. The biggest mover, however, was the revenues index, which surged to 65.8 for a net gain of 13.7-points and compares to a 3m-average reading of 55.1. Also impressive within the component pieces is the index for expected demand six-months ahead, which rise by 3-points to 63.2 remaining above its 3m-average pace of 62.0. Chart – New York’s regional ISM skyrockets
BOTTOM LINE Paul Volcker took office as Fed Chair on Aug. 6, 1979, and killed the bubble in money market funds. His successor Alan Greenspan took office Aug. 11, 1987, he felt the need to “mark his territory” and brought about the famous crash of that year. When Ben Bernanke took office in June 2005, that marked a top for the bubble du jour then in housing. Now Janet Yellen is presumed to achieve coronation on Jan. 31, 2014; so what bubble will her ascension kill? While we wait for that answer, investors are likely to pause in the Fed’s headlights, waiting for a possible word from the Dec. 17-18 FOMC meeting before mounting a Santa Claus rally into year end. T-Bonds are oversold, but likely to stay that way until early February. Gold is forming a mid-cycle bottom now halfway through its 13-1/2 month cycle. That ought to be worth at least an attempted gold rally.
Where Rogue Waves Live Our recent Chart In Focus article comparing the current market to 1929 has garnered a lot of attention, and some criticism from other analysts who note that the magnitudes of the price movements are different. In our view, the raw magnitudes of price movements are less important than the resemblance of the dance steps. Contemplating a 1929- style crash and ensuing further damage is always important, because that event pretty well defines the risk of what could happen in the market. The big bear market of 1974 also is a memorable lesson of how bad things can be. And the big factor that both of those great bear markets share is that they occurred at about the same point in the market’s 40-year cycle, which happens to be where we find ourselves right now. The back side of a cycle tends to be where the “rogue waves” live. That is a topic we addressed previously in MMR 427, which you can go back and review with this link. A rogue wave is an oceanographic phenomenon, where choppy seas occasionally lead to a giant wave that seems to borrow energy from adjacent waves to mount a giant crest, and an equally deep trough right next to it. They can swallow ships whole.
They can also occur in the financial markets. Here is a link to a 2010 story we did about a rogue wave in oil prices. One of the findings we have made in looking at a lot of market cycles is that the back side of a cycle, heading down into the next cycle low, tends to be where rogue wave type events are found. The chart below shows a couple of great examples of rogue wave type behavior in the SP500 during the declining phase of the then-operative 9-month cycle. The key is that the excursions above and below “sea level” are symmetrical just like in ocean rogue waves. But determining what constitutes “sea level” for prices that are trending is much more difficult. Still, the idea of the back side of a cycle being a more violent place for prices is one that seems to be somewhat universal, and not just a feature of the 40-year cycle shown in the first chart. For anyone who has ever flown in a small plane, this principle is also somewhat similar to what happens when the prevailing wind flows past a mountain. The vortices and eddies in the airflow occur on the back side of the mountain, as shown in this diagram on page 2. So to understand the declines of 1929-32 and 1973-74 as rogue wave events can help us to
better understand how price movements fit into the 40- year cycle, which also shows up as an important period for real estate bubbles, gold rushes, economic wars, and other cyclical events. The 1942 and 1982 bottoms were not the lowest price lows, but they were the lows from which the new strong uptrends began. The top chart on page 8 looks at a total return plot for the DJIA, aligning the 1942 and 1982 bottoms. The nominal gains for the DJIA itself following those two bottoms were different, with the bull market of the 1980s and 1990s much stronger than the one in the 1940s and 1950s. But if we imagine that we could have “owned” the DJIA and reinvested the dividends, then the two plots look much more similar. This is because dividend yields used to be a lot higher many decades ago, and companies have migrated away somewhat from the old approach of using dividends to return wealth to shareholders. The two plots have not marched in lock-step all the way, with rallies and corrections occurring at slightly different times. But the overall shape of each plot is comparable, and suggests that the period between now and the next 40-year cycle low due in about 2022 should be a choppy sideways one.
So is the current upward excursion by stock prices (courtesy of QE) a breaking away from that pattern? Or is it just a case of the current market wandering a little bit off the path, an excursion which will have to be paid back later? .
The middle chart shows a comparison of the SP500 Index from that period in the 1970s and the current period. There is some degree of pattern correlation, although it is definitely not the best pattern analog we have ever seen. 1973 also had a big drag from the Watergate scandal which was deepening at that time, and then the Arab oil embargo following the Yom Kippur War also really harmed the U.S. economy. We thankfully don’t have an oil embargo going on now, but we do have the prospect of the Fed yanking away the one big factor, QE, that is holding up the market right now. One point that is interesting about any sort of discussion about the possibility of a bear market like 1929-32 or 1973-74 is that the current market’s chart pattern does not match up that well to other notable bear markets. Below is a comparison to the crash of 1987, aligned as close as possible to the 1929 comparison featured in the Chart In Focus article. The patterns just do not match up that well. We can slide them left or right, and it really does not get any better.
So the point is that not all setups for a big stock market decline are the same, but some are. The other point worth noting for any time anyone employs any price pattern analogs is that all such correlations break up eventually. Usually they will pick the point at which one is most counting on them to continue working. So just because a pair of periods may look correlated now does not mean that they will continue to be displaying such correlation at any particular point in the future.
