2016/02/09 Commentary: Fear & Loathing in Marketland (late)
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COMMENTARY (Non-Video): Tuesday, February 9, 2016
Fear & Loathing in Marketland
WARNING: Extreme bout of Yellen-itis possible!!
We need to allow that what we are going to review here is not news to our regular readers. These are themes and specific influences that we have been over many times since the beginning of 2015 (and even previous in some cases.) Yet that doesn’t make them any less relevant, as many of the market impacts that our previous analysis foreshadowed are only just hitting the broad financial market psychology. Most important is a key idea that many analysts and portfolio managers could not even begin to fathom from the early part of last year right through the end of 2015. Yet it is finally making its way into market perspective because activity has left it an unavoidable possibility:
The next financial crisis will occur when the investment and portfolio management community (and ultimately the investing public) realizes that the central banks alone cannot restore the robust growth from prior to the 2008-2009 financial crisis.
Any crisis will certainly not occur due to the sort of credit bubble seen into 2008 (as that does not exist to the degree apparent to informed observers back at that time.) And that central bank impotence is finally working its way into market psychology after so many months of most of the financial community waiting with bated breath for a more robust recovery based on micro-analyzing the central bankers’ every move (or lack of it at times.)
As we mentioned at many points in our past year of analysis, it is rather the case on this cycle (as articulated since January of last year) that the political class has accepted all of the central bank Quantitative Easing (QE) as a giant gift to help them avoid any of the heavy lifting involved in meaningful structural reform. While it has evolved in many ways since then, our www.Rohr-Blog.com January 2015 posts It’s Lack of Reform, Stupid! (Parts 1 & 2 on the 19th and 24th) basically summed up the reasons trouble was brewing if there was no change to quite a bit of the old order.
The reason that lack of structural reform is back to being so important now is the looming Congressional testimony from Fed Chair Yellen over the next two days. And whether the Fed’s ‘normalcy bias’ is maintained in the face of obviously deteriorating global and US economic conditions will likely determine the near-term fate of already struggling equities.
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NOTE: Back on the evening of December 8th we posted our major Extended Perspective Commentary. That reviews a broad array of factors to consider Will 2016 be 2007 Redux? For many who believe that the US economy is really strengthening and can once again lead the rest of the world to more extensive recoveries, this may seem a bit odd.
Yet there are combined factors from many areas we have been focused on since the early part of last year which are less than constructive for the global economy and equity markets. We suggest a read if you have not done so already.
We pointed out in December in the face of another likely Santa Claus Rally this was not an actionable view during the year-end equities rally. Yet it was (and remains) important background to utilize into 2016. This is much like our major late 2006 perspective on Smooth Rebalancing? …or… The Crash of ‘07? (even though the actual crash was deferred into 2008.)
Well Masked
The failure of central banks’ ability to restore growth did not become apparent simply due to equities struggling since last May (as we had warned in a major May 2nd post.) It was only truly obvious again last August in the wake of the release of the previous month’s FOMC meeting minutes on the 19th. Our post later that day led off with the (very rhetorical) question, Tail Risk Now Mainstream? That was the day before the September S&P 500 future cracked key 2,040-35 support, which culminated in the Chinese currency crunch two trading days later (August 24th) temporarily dropping it down to 1,831.
And other than the timeliness of our understanding that the Fed was already suffering from its substantial ‘normalcy bias’, and how pernicious that overly upbeat perspective might be for equities, that was also the beginning of the current bear market.
That’s Right: An Equities Bear Market
Now we must clarify two points on that. In the first instance we have always been big believers in the ‘Rule of Three.’ That is the number of factors necessary to sufficiently upset the equities to foment a sustainable reversal of any well-established bull market.
No one factor can reverse an equities bull market. We have seen many temporary disruptions along the way. That includes sporadic political disruptions that flare up in Eastern Europe and the Middle East, and the October 2014 Ebola epidemic scare. Yet no single influence tends to create a lasting selloff in the equities.
The reason the current underlying weakness has been so well masked is that the very cure so many folks felt was going to restore growth and inflation was actually a key contributing factor to disinflation. That was the degree to which all of that QE was actually encouraging companies that produce goods or materials to expand their operations. Of course, the political class liked that insofar as it appeared to be creating employment.
However, all of the businesses that felt they could not help but make money if the cost of funding was so very cheap also participated in the development of massive overcapacity in many industries. The obvious cases were of course energy and mining. And due to the lack of structural reform, continuing strong employment became the overriding incentive for many governments to support this as well. While the most glaring examples might be China and Europe, this is generally true across the globe, and depressing for equities.
And Retail Makes Three
Therefore in this case the industrial overcapacity combined with the lack of desire to shutter unprofitable businesses (due to the employment implications) gives us two of our three factors. The final one is the weakness of old line, mainstream retail operations. Just as everyone is so confident in the stronger services sector in the US and elsewhere, there is reason to be worried about that area as well.
Aside from the typical revisions that attend all the initial releases of US Employment reports, there is reason to be concerned about the hiring slippage in spite of the better Hourly Earnings and lower Unemployment Rate. That is the greater than usual number of layoffs in January. According to the Challenger Layoffs report, job losses were up 218% to 75,114. Of course, it is easy to note that January layoffs are especially typical in the retail trades after the holiday season.
However, Challenger pointed out that retail layoffs were 42% higher than in January 2015, and were at the highest levels seen since January 2009. In a television interview company head John Challenger noted that this would be very unusual in a generally improving economy. And even if that might be the case, there are signs that major closures of retail facilities by the likes of Walmart and other bricks-and-mortar retailers were eliminating jobs that would not return anytime soon.
There are a lot of old-line retailers under pressure from Amazon and others who are rightfully shifting to more digital presence that does not require old low level retail clerks. Whether or not that revives their overall fortunes is yet to be seen. Yet we can be sure that there will be less front-line retail shop employment in future. So we can add that retail employment weakness to the overcapacity and maintaining unprofitable businesses for our Rule of Three factors that will weigh on equities.
Bear Within a Bull?
The additional major point on the likelihood equities have entered a bear market is the importance of the ultra-long term trend perspective within our very negative view for the first half of 2016. It must be allowed that there can be major bearish phases within the long-term secular bull market in equities. That is partially due to the basic fundamentals whereby corporate managers must always find a way in the long run to create profitability. There is a reason it is axiomatic that the companies which survive significant economic downturns are the ones that will thrive in the ensuing economic recovery.
Of course, that may not be of much comfort to investors who suffer with commensurate weakness in the stock prices of those companies along the way. Yet, unless someone is postulating the end of capitalism as we know it, the market Cassandra’s tend to be wrong; even if only after substantial retrenchment of equities prices. The real question is almost always not whether equities are going to experience that substantial selloff, but rather just how far they will go while remaining in an overall bull trend? Needless to say, the answer to that question is often extremely disconcerting to committed long-term investors.
The Striking Technical Condition
So the question classically becomes, “How low is low?” As a way to put the current, potentially significant equities selloff in context, it is instructive to review how previous bear markets ended up being corrections within the mega-trend remaining up overall.
In that regard the only long-term trend evolution that was suitable for reviewing the 2008-2009 crisis selloff was in the longest data history available: the Dow Jones Industrial Average. Our data vendor is enlightened enough to provide that data all the way back to January, 1900. Of course the most relevant aspect of it is the trend up from the lows set during the Great Depression.
Using the ultra-long term trend channel from the 405 July 1932 low (and running the topping line across the 14,198 October 2007 high), the long term channel support in March 2009 was actually all the way down at 5,685. Yet the ultimate trading low was 6,470 that month. In other words, as bad as the equities looked, the DJIA actually missed getting down to the broadest up trend support by 85 points.
Two quick sub-points on that. Once again, that was surely of no comfort to any investor who saw their 401(k) get crushed on the selloff; or any portfolio manager who had to explain to them why they were doing great because they had lost 5% less than the overall market index. Trend projections are unforgiving things that do not really care about whether investors or portfolio managers are smart enough to read the trend tea leaves.
The important second point is that this is typical of broader bull markets: they never quite reach the major lower support prior to getting back into recovery mode in the major bullish trend. That leads us to the considerations for where the intermediate-term 2016 bear market might bottom out prior to returning to a more bullish long-term activity.
A Bear From This Far Down?
The first thing to keep in mind on the current technical condition of the markets is a key aspect if the front month S&P 500 future is as bearish as we believe it might be. In that case, it is only just breaking the broadest major trend channel support from the 666 March 2009 major cycle low.
And indeed that should not be a surprise, as it is always the case that the broad support for any major up trend is well below the last trading high prior to the sustained reversal. If it were not well back down at the lower bound, it could not be a major support. Bull markets are not confirmed at the new highs; that can only occur by holding the bottom of a selloff at the appropriate broad trend support.
And in the current activity, the DJIA is on a major monthly channel DOWN Break from 16,540 from three weeks ago that it actually never recovered back above on the rally over the past two weeks. On the other hand, the front month S&P 500 future monthly chart major channel support was in the 1,865-60 area three weeks ago. That means that it spiked below it on January 20th prior to recovering into January 21st anticipation of more accommodative perspective from Mario Draghi at the ECB press conference.
That means it has been ‘cleaning out’ back above the DOWN Break for the past couple of weeks prior to gapping below 1,865-60 area on the opening this week. That gap lower is very important, and is reminiscent of the gap back below 2,020-10 on the first trading day of the year. That is what is so important about the market response to whatever Janet Yellen has to say on Wednesday and Thursday. If a rationale for pushing back above the 1,865-60 area is not forthcoming, then the further weakness is almost assured.
A Bull From All the Way Down There?
As that would also seem to indicate it is just beginning the extended bear market swing to what is likely to be distended lower support, the question becomes once again, "How low can it go?" Let's allow there are many interim supports along the way, some of them actually reasonably substantial. However in any sustained bear trend quite a few of them will be knocked out on the road to reaching the ultimate lower support.
Consistent with our major support discussion of the 2007-2009 selloff in the DJIA, let's consider the broadest trend for the front month S&P 500 future. Using the major highs from October of 2007 and May 2015 as our reference line, the mega-trend support projection from the March 2009 low will the into the 1,200 area by late summer 2016. That sounds like more of a selloff than can be reasonably expected if indeed our assumption about the lack of 2008-style pernicious conditions is accurate.
But keep in mind that even the 2008-2009 bear market did not get down to its ultimate trend channel support. And we also assume that the current bearish phase is indeed just a more major correction than we've seen in a while within a long-term bullish trend. That begs the question of where the substantial support somewhat above the 1,200 area might reside, and what reasons there might be for the markets to hold up sooner than that far more depressed level.
Without going into all of the fine line details of previous hefty congestion and current major (in fact very major) Fibonacci retracement levels from the 2009 and 2011 lows, it would seem that 1,500 give or take 100 points is a likely general target. Obviously if we are right that the equities can weaken that far, we will also be focusing on more specific short-to-intermediate term indications to see if they are exhibiting bottoming activity once they get there.
Self-Fulfilling Prophecy
Quite a bit of the criticism of technical analysis that we have heard over the years is that so many folks staring at the same chart projections and technical indicators create a goodly degree of self-fulfilling prophecy. As Rhett Butler famously said in Gone with the Wind, “Frankly my dear, I don't give a damn." As long as we are prescient enough to know which indicators are going to be the most reliable in key market phases and benefit our subscribers with that insight, if that succeeds partially due to other folks following the same or similar analytics, so be it.
Yet on the fundamental side that is also the case to some degree. And that applies in extremis to the key factor why the equities might suffer due to the previous lack of structural reforms from the political class in the first half of 2016. It is also the same factor that will likely cause them to find a way to bottom out and resume the overall bullish mega-trend. It's called the US general election.
The worse the equities perform into this summer, the more it will encourage independent voters to switch presidential parties in November. Of course, there is a huge hostage to fortune this year in the form of the Republicans possibly nominating a candidate who too many independent voters find wholly unacceptable.
The Bear Will Be a Bullish Factor
While things appear very odd right now on the eve of the New Hampshire primary (literally this evening as we write), the GOP will hopefully end up with a candidate that will be seen as an effective manager and collegial individual who can span the partisan divide in ways that President Obama never even attempted. As part of his party’s attempt to hold onto control of Congress (which ultimately failed), the Democrats elected quite a few fairly conservative members.
As such, it should not be that hard for any centrist Republican President to develop bipartisan support for key reforms in critical areas like the tax code, labor rules and reining in excessive regulation; especially from the EPA on the environment as well as Dodd-Frank in the financial services area.
While that is still an extremely anticipatory scenario in the context of a US general election that is still almost nine months away, let's allow that economic or stock market weakness will likely drive those important independent voters into the arms of the Republicans. Once it is clear that a more free-market, business-friendly administration is on the way into the White House with a supportive Congress, the markets will not wait for the January 2017 inauguration to begin anticipating better times to come.
There is actually a great, relatively recent example of this in the 2004 US election. When George W. Bush ran against John Kerry in 2004 the economy and the markets were already in fairly good shape. Yet after the rally into April the equities typically churned sideways until late October. At that point the more free-market Bush surging in the opinion polls brought an equivalent bid in equities.
While quite a bit less radically partisan then this year, 2004 is also an excellent analog for competing political party manifestos creating uncertainty early this year into mid-year. That may lead to very much more upbeat assumptions depending on what the polls tell us as the election nears. Hence, there is a clear rationale for how our very negative expectations for the first half of 2016 may have every reason to reverse into this fall.
That's What Makes Janet Yellen So Critical
Whether the Fed is maintaining its ‘normalcy bias’ will be on display when Janet Yellen testifies before the US Congress on Wednesday and Thursday of this week. Her prepared statement that will likely be the same for both sets of testimony will likely be released shortly before her initial appearance in front of the House Financial Services Committee as 09:00 US Central Standard Time on Wednesday.
As mentioned in previous analysis, Friday’s US Employment report’s mixed indications have actually been toxic for the equities. The lower than expected Non-Farm Payrolls gain that might have been seen as encouraging more accommodation from the Fed was offset by quite a bit stronger than expected Hourly Earnings (up 0.50%) and the Unemployment Rate dropping down to 4.90%.
Those two items restored more hawkish Fed possibilities right into a weakening hiring picture. That made for more of a ‘this news is just good enough to be bad’ psychology for the equities. So whether we hear a slightly more accommodative Ms. Yellen on Wednesday and Thursday or more talk of “things are so good with the US economy that further hikes are necessary” is going to be a very important indication for a global economy that misses the previous accommodative stance from the Federal Reserve.
True for the Other Equities As Well
And as the more sophisticated observers among you are well aware, very strong anticipatory views only become truly meaningful once their implications are actually reflected in the overt market activity. This is exactly what is transpiring at present on quite a few fronts that the uninitiated still find surprising… but probably not our readers.
In spite of recent OECD Composite Leading Indicators pointing to Europe as the one place that is growing, the most recent set released Monday morning point to a downturn in Germany. And of course, Germany is the heart that drives the balance of the European economic body. Weakness in so much recent German data includes this morning's Industrial Production and Trade Balance. The only surprise for us is why anyone would be surprised that an export-oriented economy would be suffering as China and emerging markets weakened so markedly.
And this is after the previous weakness in the German IFO economic survey and Factory Orders. This is also very consistent with the DAX being the downside leader of all of the equities until the recent implosion of Japan's NIKKEI. While the US equities are only flirting with dropping below their August lows, DAX has traded as low as 8,772, well below the 9,325 seen in August and September.
The driver for that now seems to be questions over European bank profitability and balance sheet stability. Here again that is due to the lack of structural reforms during the recent cyclical recovery. And among the central bankers, Mario Draghi has been among the most outspoken on the need for those reforms. He has pointed out with varying levels of intensity at all of the ECB press conferences since early 2015 that the failure to implement those reforms could mean that most of the positive impact from QE could be squandered in the next cyclical downturn.
Conclusion
This gets back to our emphasis on the lack of structural reforms, and the implications of that are now being reflected in the market perceptions for corporate profitability and overall economic growth. All of the sometimes seemingly less than meaningful emphasis on the importance of reforms is now in the being actualized in weakness of the equities.
And as we had warned on many previous occasions, the next crisis is now upon us not due to financial services shenanigans or the over-leveraging of home equity by the public. It is much more so due to something the central banks cannot readily address…
…central bank Quantitative Easing being shown to not be effective in and of itself as a means to restore real economic growth. Fed Chair Yellen has an opportunity offer a temporary glimmer of hope. Whether she chooses to do so or sticks with the ‘normalcy bias’ from the December 16th decision will likely be the deciding factor that drives the near-term equities trend.
Extended Conclusion is available below
The COMMENTARY Extended Trend Assessment is accessible below.
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