Eric-CoffinFrom the HRA Journal Issue 245-246 January 31, 2016

by Eric Coffin

It’s been a wild month, and a busy one. It’s convention season in Vancouver and elsewhere. I’m finishing this issue at conference number four for me in the past 10 days. That will be it for a month though so things should get back on track.

This is a long double issue. I’d recommend a pot of coffee. I’ve laid out my thoughts on what I think several markets and commodities will do this year. That gives me a chance to be wrong on multiple levels.

It’s very much a mixed message. I’m probably most comfortable about gold in the near term since I’m not comfortable about the upside of just about anything else until we see how a major market bottom will play out. As I point out in the editorial subsections there are some other metals that look like they should do well but none of us should forget the impact of sentiment. If we get into a crash phase of a bear market sentiment can overwhelm everything else, at least for a while.

I’m short term bearish but I think a bear market that resets some overvalued sectors and cleans out some mal-investment would be a good thing and I don’t expect it to last too long. A real sustained rally in oil and or a policy reversal would be the biggest “risks” to the bear market scenario. I don’t consider that likely, at least not soon enough to stop a bear market sized fall but if it does happen it would help most metals anyway.

I started out trying to cover as many markets/metals as I could in a single article but it soon became obvious that wouldn’t work. I’ve split the editorials into a number of sections since the supply/demand picture for individual metals is quite different even though they all have the same dark clouds hovering over them.

This first section is more about equity markets and what will impact them. My recent more bearish near term view hasn’t changed but there are a lot of moving parts. Central banks are getting more active again which adds another layer of complexity since some of them are acting against each other’s interests, even if unintentionally.

CENTRAL BANKS TERRIFIED

It’s no secret to any of you that central banks have been front and center for this entire bull market. ZIRP, QE and other forms of central banker largesse have kept the financial sector from imploding and bestowed bigger gains on that sector of the economy than any other. I’m often accused of cynicism (with good reason) but even I don’t think this is a situation central bankers have any comfort with.

This isn’t a case of central bankers helping bankster friends get ahead. I believe most central banks would love to cut the cord, step back, and let the markets find rational levels without them. But, given the economic backdrop, deflationary forces and imbalances in the international financial system they are terrified to leave it to its own devices. It’s that obvious fear on the part of central bankers as much as anything that has been making me bearish lately.

Central bankers as a group are seeing things that trouble them greatly and I don’t see how you put a bullish spin on that. No one moves their national bank to negative interest rates unless they fear dramatically bad consequences if they don’t. Ironically those that chastise the central bankers most should be fervently wishing they are getting things right. If not….

I closed out the editorial in the last issue by commenting that I thought the NY markets were due to roll over again soon. They did that in spades, and quickly. No sooner had the calendar page flipped over than the selling started on bourses across the globe.

In the past couple of sessions we’ve had a nice bounce, as you can see from the right side of the SPX chart below. The latest dip is one that can be (and is) interpreted differently depending on whether one is fundamentally bullish or bearish.

Bulls see it as another successful test of levels that are comfortably above bear market territory. They believe it’s all about China or oil and that those will either bottom themselves or fade from traders consciousness. Falling oil prices are good and China is too small in terms of trade flows to matter.

That is partially true but it’s also an oversimplification. Few in the current bullish camp expected the US economy to slow as much as it has. Cheap oil was supposed to be a boon. So far, not so much.

As I noted in my not so tongue in cheek comment prefacing the last issue expansions do die from mal-investment, stoopid, and lost momentum as management sees revenue stall and starts cutting back. Problems mount, the trend changes and “suddenly” things are going the wrong way.

Those of you that have read HRA for any length of time know I am not by nature a bearish guy. On the contrary if I get accused of anything it’s being too bullish most of the time. Supercycles will do that to a guy.

Well, as we know all too well it’s not your father’s supercycle anymore. As I note in discussions about individual commodities later in the issue supply and lack of visibility on China growth and demand are major stumbling blocks but so is sentiment.

BEARISH SENTIMENT SIGNALS

Sentiment is a tricky thing to measure but it drives markets. Everyone knows that and points to it when it comes to the commodity space but, strangely, many market strategists go quiet when the topic of major market sentiment comes up.

Take a close look at the SPX chart above. Think of it as a Rorschach test. If you’re bullish you may see a market defending important price levels successfully and ready to rock and roll. That’s not what I see.

I see a market that has tried and failed to reach new highs. Not once, but several times since the SPX notched its all-time high last May. Even the impressive move off the August-September lows that had bulls out in force and chiding anyone who saw storm clouds on the horizon couldn’t get it done.

We’ve started another bounce now, in both oil prices and the SPX. Bulls have another chance to win the day. I’ve seen sentiment swing to bullishness already and this rally is only a few days old. If you’re of a strongly bullish persuasion you’ll see that as a positive sign. It’s not.

Most of my recently bearish stance is based on economic metrics but some of it is based on sentiment too. There has been plenty of talk about “panic” and “extreme bearishness” but mostly, it’s just talk. I find it concerning that traders as a group are not more worried. For all the talk, measures like the volatility index VIX reached lower peaks on the recent deeper dive by the big indices. Complacency in the face of a market acting like the SPX has lately is not a positive sign. It tells me there are lots of potential sellers out there still.

Let’s start with the basic basics. Fluctuations aside, markets value earnings streams. At the end of the day earnings matter. The chart below shows reported (post accounting “magic”) and operating earnings for the S&P since 1990. Most of the time those earnings are rising. Obviously a good thing and the reason bull markets are more common than bear.

However, there have been three periods in the past 25 years in which both reported and operating earnings suffered multi quarter consecutive declines. Those periods were 1991, 2000-2001 and 2007-2009. I’m sure you recognize the dates. All of these periods directly preceded bear markets. Now there’s a fourth one. It started in late 2014 and continues today. These sort of multi-quarter declines of more than 10% in earnings are not common and they have a perfect track record as a bear market warning.

Bulls will counter — and they’re right — that most of this fall can be accounted for by oil and mining (yay us). That is true as far as it goes, though there are more and more sectors showing weakness. Energy in particular is more important as an economic driver than most people on Wall St or in Palo Alto want to believe. There are plenty of knock on effects starting to show up.

More to the point, does it even matter if the losses are predominantly in one area? I don’t think we know the answer to that though I see no reason to assume it will. Losses are losses. The ones that preceded earlier bear markets are not broken down by sector but problems tend to start in specific industries then spread. I would point out that in the last two bear markets things started in sectors (tech and real estate) that were not “supposed” to impact the rest of the economy. Until they did. Remember those speeches by Fed governors about the Sub Prime crisis being “contained”? Strip away the window dressing and the “it’s just oil” line sounds suspiciously like “this time it’s different”. Let’s hope so. But don’t count on it.

The map below shows countries where the national stock exchange is in a bear market (red) or correction (orange). There is lots of red on the map, though almost all of it is Emerging Market economies that we all know have been decimated or the most messed up EU countries. The US, UK and Germany are among the few countries that have dodged the bullet so far.

The lower chart below is an updated version of the bond spread chart I have shown in varying forms before. The picture here hasn’t gotten any brighter.

The spread between Treasury yields and those for High Yield bonds have reached the level seen during the Euro crisis and the last recession. “Junk” yields for bonds rated CCC or below have shot up even faster, reaching levels last seen just before the Financial Crisis blew wide open in 2008.

Bulls will give the same response here—that it’s all oil. A lot of it is but here too the sectors affected have been broadening. Moody’s recently added a slew of companies to its downgrade list and increased its Estimated Default Frequency (EDF) measure to 8% which means Moody’s expects 8% of non-investment grade bond issuers to default in the next 12 months. That is the highest EDF estimate since the Great Recession. Those bonds fund investment, capital formation, M&A activity and, yes, share buybacks across a host of industrial sectors. Unless new economic metrics and herculean PR efforts by central bankers can reverse the trend in bond market risk aversion there is more trouble ahead.

NO REPEAT OF 2008

I’m not expecting a repeat of 2008 but I see no reason NY shouldn’t experience a bear market this year. Hopefully nothing too extreme but there are simply too many things trending the wrong way for a 20%+ decline to be avoided much longer. If the current bounce in oil prices continues the SPX could conceivably get back through 2000 but I would be very, very cautious about chasing it. Be prepared to use rallies as selling rather than buying opportunities. This is no longer a buy the dip market.

Before moving onto other sections I wanted to comment on two issues, the odds of recession in the US and the yield curve as the final arbiter of recession risk.

The two charts below show the recent readings for the Philly Fed and Empire indices of economic activity. Both of this focus on industrial production and both are pretty ugly. Current wisdom about this on Wall St is similar to the oil market—it’s “too small to matter”. The strictly defined manufacturing sector IS a lot smaller than it used to be but a broader more realistic count that includes things like suppliers and transporters and after-market sellers still adds up to a big and relatively well-paid chunk of the workforce. It matters.

The lower chart below shows 45 years of readings for US nonfarm payrolls and the Fed’s own measure of industrial production. Two things should stand out on this chart.

Firstly, all recessions have been attended by steep declines in industrial production. This indicator tends to be slightly leading or coincident and, significantly, does not have a history of throwing off false positives. Every time industrial production has fallen as much as it has in the past few months a recession either immediately followed on was already underway.

Secondly, payrolls are almost always a lagging indicator. You rarely see changes in nonfarm payrolls go negative until a recession is already underway. Strange as it may seem with the plethora of economic metrics floating around the starts of recessions are notoriously hard to spot. They are never declared officially until after all the data revisions are done. It’s common for recessions not to be declared until they are almost over. In short, if you’re waiting for someone to ring a bell it could be a long wait.

About that Yield Curve thing.

I have seen scores of articles recently declaring that there is no possibility of a recession because there is no “inverted” (short term rates higher than long term rates) yield curve. According to the bulls this is an absolutely iron clad perfect indicator with no false positives or negatives. Ergo, no inverted yield curve, no recession on the way.

Not quite. I agree that for the past 50 or 60 years an inverted curve has been a reliable forward indicator of recession. That’s because we’ve been in an era of high interest rate volatility for that long. In some cases, like Volcker choking off inflation, the inverted curve was intentional, or at least pre-meditated. In others, like the years leading up to 2008 it was a policy error (rates pushed too fast) in a belated attempt to fix another policy error (rates too low for too long).

Take a look at the chart of the effective Fed Funds rate going back to the early 1950s from the St. Louis Fed. The grey bars are periods of recession. In just about every case there was a spike in short term rates leading up to the economic slowdown. This usually reflects the Fed trying to get ahead of the inflation curve. When short rates move up quickly like they did before many recessionary periods and long rates don’t follow you get an inverted curve.

Now look at the right side of the chart which I’ve circled in red. Notice anything unusual about that period? A bit out of place perhaps? The rate has been held at near zero for the past seven years. The only way we would get an inverted yield curve under current conditions would be if the whole longer end of the yield curve is deep in negative territory. That isn’t going to happen unless we’re in a depression.

If you go back before the start of this chart to eras that had low and stable interest rates the inverted curve is no longer much of a leading indicator. It only works as one if short term rates are high enough, which they simply aren’t now. If you wait for a yield curve inversion under current monetary conditions you’ll be way too late.

Based on the preceding data and plenty else I don’t have room to cover I expect a recession in the US this year. Probably quite a shallow one and perhaps just a couple of separated quarters of slightly negative growth that doesn’t make the cut to be called a recession officially.

I think both a bear market and recession are right on the horizon. I hope they are as I would like to get through them. The economy needs to wring out some excesses and doing it sooner would mean a less serious contraction.

Can it be avoided? Perhaps. If oil prices shoot up and the Dollar tops quickly enough this could cheer up both Wall St and emerging markets enough to forestall a recession. It would help metals too so I wouldn’t be complaining if it happens.

Japan just went negative on rates. I think China will view this as a gauntlet being thrown down. We could see more Yuan devaluation in response. Things could get very bumpy again soon.

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