Alan's Alert 8-2-2021

 

Over the weekend I dove head-first into what the odds of another lockdown truly are and what it would actually look like.  I came to the realization that it is probably going to happen.  The government is trapped in an echo chamber.  They are desperate to keep a stranglehold on the power that they got from the first round of lockdowns.  In fact, roughly an hour ago, Posobiec tweeted again:

 

What will be interesting this time around will be the public’s reaction.  The first round of lockdowns worked because the public had been whipped into a frenzy about covid.  It was a completely unknown disease and the media pounded the “novel” portion into the public’s head.  It was constantly repeated that this wasn’t the flu.  The reports out of China looked dire.  Anybody remember seeing the videos of people falling down face first in the streets of China?
 
This time around, things are different.  We have several vaccines available, some people now have had the virus and have natural immunity, and the public has witnessed the devastation that a lockdown has on the economy.  To be able to pull off a repeat of the March 2020 lockdown, looks like a tall task.  If it happens, I believe we will have a bifurcation.  Blue states will jump at the chance to lockdown once more.  Red states will be leery.
 
There is a chance that this is completely overblown and there will be no lockdown.  The administration could authorize some other kind of emergency measure and avoid a shutdown of the economy. 
 
Ultimately, my job as an investor isn’t to decide what policy is best, it is to see through the smoke and mirrors to understand what the market’s reaction will be.  Unfortunately, we have only one instance of data on what a lockdown does to the stock market and that data isn’t good.  The last lockdown saw a deep drawdown of the all the general market indices.  Even silver crashed by 30%.  Oil by 68%.  However, had you bought at the end of March, you would be sitting on terrific gains.  Since this lockdown could look different, it is anyone’s guess how the market will react.

 

 

 

 

 

 

Construction spending continues to decline from its pre-shutdown peak.  This is bad news for the continued expansion of the economy.

 

Construction spending is split into two categories, residential and non-residential.  A closer look reveals a big slowdown in non-residential construction.  This tells me that businesses reliant on providing services to construction companies will begin to contract.  This should worry anyone who believes in the skyscraper effect.  The theory was put forth by a British economist named Andrew Lawrence in 1999.  It has been refined over the years by Dr. Mark Thornton.  Dr. Thornton has a book named, “The Skyscraper Curse” which you can read for free on Mises.org.  I’ve not read it but I’ve listened to several of Mark’s interviews and read a few of his articles on the subject.  These two stand out to me in particular; Skyscrapers and Business Cycles and this interview with the Mises Institute.  The takeaway, when the construction of new skyscrapers stops, economic hardship is not far behind. 

 

 

The Federal Reserve posted new data for the assets and liabilities of commercial banks in the US on Friday.  The decline of commercial and industrial loans continues while non-commercial loans and leases saw a small increase.

 

 

 

It looks like the economy is running out of steam.  How will the economy continue its expansion phase without new loans and business expansion?  Where will new growth come from?  Meanwhile, deposits at banks continue to run above trend.

 

 

Consumers are now sitting on a stockpile of cash in the bank.  Ironically, the banks don’t want it.  They’ve been furiously sending it back to the Fed in hopes of achieving any sort of return.  Even if that return is 0.05%

 

 

Earlier this year, New York Fed President John Williams had indicated that the repo markets were working as expected.  The Fed has spilled liquidity into the banks, now the Fed is mopping up the excess through these facilities.

 

 

Finally, I wanted to take a quick look at interest rates.

 

The 10-year minus the 2-year treasury is still in positive territory.  The spread has come down sharply since the peak at the end of March. 

 

Looking at the big picture, rates appear to be flatlining.

Typically, this is great news for investors.  Flat/declining rates mean that investors should go long growth vs value stocks.  Fixed income is also a good buy.  Emerging markets and commodities would struggle.  The trouble is that the rates at starting so low that they don’t have far to fall.  This could be a very short rally for this trend.

 

 

Alan's Alert 7-29-2021

 

Today is part 2 of our saga, Adventures in Money Printing.  Yesterday I looked at a couple of the big whoppers of the last 20 years in the market.  These were instances where the yield curve had signaled something was wrong.  The money supply then told the tale of the tape when it came to the crash of the stock market.  Today I’m looking at instances where the money supply was weak but the yield curve never went negative and how the market reacted. 

 

Our return to our epic tale, Adventures in Money Printing, starts in 2003.  This was right on the heels of the 2001 recession.  The yield curve was in positive territory and things should have been humming along smoothly. 

The money supply figures coming into 2003 were strong.  The high plateau at the end of 2002 which pushed the market higher in 2003, continued its strength into the middle of the year.  You can see this with the navy-blue line in the chart below.

Something went haywire at week 34.  When we traditionally see a plateau, instead we see a spike higher, then a big drop which bottoms out on week 45.  This runs well below the trend for 7 weeks.  Money supply then made a feeble attempt to push higher to close out the year.  Starting in 2004 (green line), you can see that the money supply had a rough start to the year.  By week 16, the story had changed and it had a strong showing for the rest of 2004.

 

Looking at the S&P500, twelve weeks after the money supply bottomed in 2003, the stock market stalled.

It then proceeded to trade sideways in choppy fashion until the beginning of November.  This is when it started to pick up.

The S&P500 gained over 26% in 2003.  In 2004 it gained 8.6%.  This sounds like a pretty good return despite the choppy start to the year.  In 2005, however, it barely gained 5%.

 

2005 was the light-blue year in the above money supply chart.  You can see from its lackluster activity, that it was not a good year.  The money supply dragged along the bottom at the beginning of the year.  It then had a low peak, followed by another slow-paced effort, eventually bottoming out on week 30. 

 

From this period of 2003-2005, we can draw the conclusion that when there isn’t a signal from the yield curve that trouble lies ahead, it takes several weeks of below trend data to have an effect on the stock market.  However, the effect can play out over a long period of time unless the money supply numbers pick up and run above the trend.

 

 

 

 

 

The next era I want to highlight is the post financial crisis era of 2009-2012.  This was supposed to be the big recovery after the big crash.  However, 2010 and 2011 both struggled to keep steady upward momentum.  Some of this could be tied to investor’s nerves after such a spectacular crash in 07-08.  Another factor in play was how the Fed’s new tools were going to be utilized (QE, operation twist, etc.).

A quick peek at the yield curve showed that banks had the ability to make lots of money.

The market had a different story to tell.

In two instances in 2010 and one in 2011, investors were seeing choppy action.  Do you think this could have been predicted by the money supply figures?

 

At the end of 2009 (light blue with green circle), money supply was exhausted.  It hit the trough at week 25 then hung down there for 16 weeks.  From this lackluster action, we can figure that capital goods markets would see more sellers than buyers.  From the low negative print on week 36, it took 20 weeks before problems started to show in the S&P500.  You can see it as the first dip in the green box at the beginning of the year.  The S&P500 then had a rebound but it would not last.  My second green oval, this time in weeks 4-14 of 2010, came into play.  This time around, it took 12 weeks from when the money supply went negative before the stock market showed serious weakness.

 

I also took a look at 2011.  It had similar choppy action in the market in the 3^rd quarter that year.  The money supply ended 2010 high and then showed softness at the beginning of the year (blue circles), but I think this irregular stock market action is better explained by investor’s worries about the Fed and the Eurozone crisis.  This is why relying on the money supply alone is unwise.  There are always many factors in play at any one moment.  To think that one tool can save your capital is a fool’s errand.

 

 

 

 

Our grand finale in our epic saga of Adventures in Money Printing will conclude with the 2014-2019 era.  Some of you might have been subscribers of Robert Wenzel when he called both the slowdown in the money supply in 2015 and his call in 2018. 

First off, what did the yield curve have to tell us?

From 2013-2019, it looked like the banks would have no trouble borrowing short to lend long and make a tidy profit.

 

At the beginning of 2015, Robert had emphasized how strong the money supply growth was.  By the end of May, he began to warn that the money supply had dipped and was starting a steep decline.  In mid-June, Robert said, “I have pointed out before that there is a tendency for the money growth to decline this time of year for seasonal reason, but whatever the reason, a drop in money supply is a drop.  There is a very strong possibility money growth will rebound later in the year.  However, the decline in money supply growth is so dramatic that I am advising extreme caution with regard to the US stock market.” (Daily Alert 6-26-2015). 

Then on July 17, 2015, Robert recommended risk-oriented traders to go short. “Risk oriented traders should now switch and trade from the short side. However, I caution that the potential for whipsaw action is exists both in the stock market itself and in the trend in money supply growth. For most this is a time to keep high cash levels (50% cash) and remain on the sidelines until a direction is much clearer.” (Daily Alert 7-17-2015).

 

Here’s what the money supply chart looked like:

Robert had it pegged because 4 weeks later, the stock market dropped (blue box).

I included the weakness at the beginning of 2016 in my blue box but in truth, the Chinese market hit a down phase in the business cycle at that time.  This caused a big selloff in the US market because investors panicked.  Robert had called this as a buying opportunity and he was proven correct as the market rallied through 2017 ending with a dramatic spike in January of 2018.

 

By late 2018, a new story was developing.  The stock market suffered ups and downs through the first two quarters.  This is directly attributable to the dismal growth in the money supply at the beginning of the year (orange circle) and the lower peak than previous years.  After the trough, it began it’s plateau in line with prior data.  However, something went wrong.  It began to run below trend.  Robert captured this in his Daily Alert on 9-14-2018 with, “If money supply continues this sluggish, the economy could be in real trouble at some point in 2019.  And the general stock market could start a major break at any time between now and the first half of 2019.”  

Then on October 5^th, Robert’s Alert led with this headline:

He had nailed it again.  Over the next three months, the market searched for support.  It didn’t find it until Christmas Eve, when the plunge protection team was called in to get to work, causing the market to rally through the next quarter.

 

 

 

Reflecting back to our current money supply situation, we are in a different era.  The spectacular increase in the money supply in 2020 and the hot start to the year in 2021 have turned up the heat on the stock market, the housing market, and the bond market.  This has also led to increases in all the inflation indicators such as the CPI, PPI, and PCE.  Once the market gets adjusted to the increase in the supply, it becomes dependent on it to reach new highs.  We have run above trend for a long time.  At some point, we’ll need to come back into the fold or the Fed will risk running much too hot on the inflation front.  

Some disclaimers; I’m not currently predicting a crash.  I’m not trading on the short side.  I am keeping a close eye on the money supply, the yield curve, and margin debt.  These will be signaling, in advance, of a change in the market.  Right now, I’m neutral on the general market and have no positions in the S&P500.  I’m continuing to hold positions that would benefit from price inflation.

Alan's Alert 7-28-2021

 

After yesterday’s money stock report, I thought I should take some time to review previous money stock reports in a hope that it would shed a little light on the current situation.

 

The reason that the money supply report is so important is that it signifies whether money is plentiful or scarce.  When money is plentiful, it is able to bid up the prices of goods in the capital goods sectors.  The most liquid capital goods sector is the stock market, followed closely by the bond market.  Housing is also a capital goods sector but is less susceptible to fluctuations in the money supply reports.  This is due to the fact that when people buy a house, they tend to stay in that house for a long period of time.  Also, when you go to sell a house, it typically takes many weeks.  Once a buyer and seller come together on an agreed upon price, the banks get involved.  Most people require a mortgage; hence a bank has to be brought in on the transaction.  Once the bank gets onboard, a real estate closing can run up to 60 days before it gets finalized.  This makes housing much less liquid.  When people (or corporations, hedge funds, pension funds, etc.) own stock, they can quickly and easily sell it.  Prices can quickly fluctuate to find an equilibrium between buyers and sellers.  This makes owning stock more liquid.  The same goes for the bond market.  Since there is a large pool of buyers and sellers, equilibriums are found quickly.  When money becomes scarce, there are fewer buyers.  When there are more sellers than buyers, the price must come down to find the equilibrium. 

 

This brings me to Alan’s trading rule #1; for every buyer, there must be a seller.  When you are buying a stock, option contract, futures contract, or bond, someone is on the other side of that trade selling it to you.  I think this idea gets forgotten in our world of online brokers and market maker liquidity.  Do you think that person selling you that stock made money before they sold it to you?  Do they expect the price to go down, is that why they sold?  What makes you think that you know more than they do?

 

Our first foray into the adventures of money printing, is a look back to the 07-08 financial crisis.  One of the first clues that signified there would be an issue was that the yield curve had gone negative.

After the yield curve goes negative, banks struggle to make money.  When banks issue loans, they borrow money on a short-term basis and lend it out on a long-term basis.  When the yield curve goes negative, banks lose money on new loans.  Since the US operates on a fractional reserve system, banks only need a fraction of the funds necessary to create new loans.  This means that the banks can loan out money they don’t have.  This expands the money supply.  Once new loans aren’t issued, the banks stop expanding the money supply. 

 

This is what the money supply looked like from 2004-2008.  You can see that there is a seasonality to the flow.  It looks like a series of waves.  It starts high at the beginning of the year, drops slightly, rises, drops further, then rises, plateaus, then rises again to end the year.  2008 is in yellow with the blue boxes.  You can see that year looks quite different than the rest.  It started similarly to other years but then rose much higher.  It peaked at 16% on week 17.  After this high rise, it then plummeted lower than any other year.  My calculation of the money supply actually put it at a negative amount for 5 straight weeks, bottoming at -3% on week 30.

This caused havoc in the S&P500.

I’ve pointed out the specific weeks that were highlighted in the money supply chart with the high (week 17) and lows (week 27 and 30) on the S&P500 chart.

On week 17, the S&P closed at $138.55.

On week 27, the S&P closed at $128.04.

On week 30, the S&P closed at $126.13.

At the beginning of Sept, the S&P closed at $127.99, but then the plunge began. By the beginning of Oct, $115.99 (down 9% month-over-month).  By the beginning of November, $96.83 (down 17% month/month).  By the beginning of Dec, $82.11 (down 15% month/month).

There were many other factors that fueled the 07/08 financial crisis but the money supply data told the tale of the tape for the S&P500.  There was about an eight-week lag between the low of the money supply data and the beginning of the stock market crash.

 

 

 

Our next adventure in money printing takes us back to 2000-2002.  Again, the first clue that something was going wrong was spotted in the yield curve.

The curve had been dragging bottom for a long time, but once it went negative, the stage was set.

 

 

The money supply curve looks similar to the earlier example.  We have a wave to start the year, then a lull, a peak, then a trough, it then climbs to a plateau before it ramps up at the end of the year.  I put a red box around weeks 36-47 in 1999.  This was a lower plateau than previous years.  It also lasted longer.  This was a hint that choppy action for the market was dead ahead.  We then moved into the year 2000.  I’ve used orange arrows to highlight the peak and trough.  The peak in 2000 was achieved on week 18 and was higher than the previous two years.  It then plunged below the trough trendline and went negative by week 27.  Its plateau was similar to the previous year which was not enough to push the market higher.  By 2001 the Fed tried to juice the money supply.  It started off the year hot, rising to a peak on week 16 of 17.5%.  It then dropped off to a low of -1.7% in week 29.  The entire year of 2002 was sluggish.  The money supply was below the trendline by week 11 but the trough was shallow.  It then plateaued higher than 1999 & 2000.  This helped to stabilize the market.

 

Approximately 8 weeks after the red box in 1999, we had choppy action in the stock market.  There was a push to a higher range.  Then, 8-10 weeks after the negative money supply data on week 27 in the year 2000, the crash began.  The market never stabilized until 10 weeks after the money supply's high plateau in 2002.

 

 

While our current situation is similar to both of these instances.  There is one glaring difference.  That is the yield curve signal. 

 

While it did run negative in the summer of 2019, it was not nearly as long or deep as the previous two instances.  Tomorrow I’ll expand our adventures in money printing to look at instances where the yield curve didn’t go negative and we had a slow down in the money supply.  I believe that the current phase of the economy will be more in line with those instances and give us a better look into what we are dealing with.

 

 

 

Alan's Alert 7-8-2021

 

Another day, another labor report.  Unemployment insurance weekly claim reports were updated this morning by the Department of Labor.  Below are the charts for initial claims and continued claims;

Initial claims are continuing their trend lower.  Today’s report showed an increase in claims, but the trend is the key.  With initial claims at 373k, we are still 168k claims above where we were pre-pandemic.

Continued claims were reduced 145k to 3,339,000.  Again, well above the pre-pandemic baseline but continuing the trend lower.

In the DOL’s data release, we got a look at the change in those receiving pandemic related unemployment money.

Looking closely, you can see that 464,663 people have been removed from the pandemic unemployment benefits.  However, there are still over 10.7M on some form of pandemic related unemployment assistance.

 

In more broken record adventures, the FOMC released the minutes of their June meeting yesterday.  A lot of words were used but not a lot was said.  Members were surprised that the actual rise in inflation was larger than anticipated.  However, this did not set off any alarm bells.  In a repeat of the 1970s, the rise was attributed to supply constraints or bottlenecks and not monetary policy.  The word ‘bottleneck’ was used 8 times in their meeting minutes.  There was talk of reducing the number of mortgage-backed securities (MBS) and treasury bond purchases.  Ultimately, they kicked the can and stated that they would, “continue assessing the economy’s progress toward the Committee’s goals..”.  If one of those goals is full employment, the Fed will be behind the curve.  The disconnect in the labor market will be here until those 10.7 million Americans on the emergency pandemic relief join the labor force.  Unfortunately, the vast majority won’t leave the dole until the relief is ended in September.  By then, it will be too late for the Fed.

 

 

Yield Spread Check

The above chart shows the spread between the 10-year treasury interest rate and the 2-year rate.  The spread is well within positive territory with a difference of 115 basis points.  While there has been a sharp downturn since March, keep in mind that a recession generally does not hit until the spread is negative.

 

 

 

Alan’s Options Primer

Volume 2

Today is post 2 of 3 in my options primer series.  If you watched the videos, you’ll be ahead of the game today.  As a reminder, I only have two rules when trading options.  They are hard to follow but there is only two of them.  My first rule of trading options, do not trade options.  My second rule of trading options, DO NOT TRADE OPTIONS.

 

Option contracts represent an agreement to exchange a specific number of shares of a particular stock, at a preset price, on an exact date.  The number of shares in a standard contract is 100.  The preset price is called the strike price.  The exact date is called the expiration date.  Unlike stocks, all option contracts expire.  This is one of the many reasons that it is very easy to lose money trading options.  Another thing to keep in mind, buying an option offers the right, but not the obligation to purchase (or sell) the underlying stock.  The vast majority of contracts that have value at expiry are settled in cash, not stock. 

 

There are two types of option contracts, calls and puts.  By purchasing a call contract, you are indicating that you want to purchase the underlying stock.  A put contract means the opposite, that you want to sell the underlying stock.  

 

Now, it is important to remember that a trade can move against you, making your options go down in value rapidly.  It’s vital to set mental limits on how much you are prepared to lose.  Not every trade is going to work out in your favor.  It is best to cut your losses and have enough ammo to fight another day.  Seeing a position down 50%, 80%, or 90% is mentally taxing and can negatively impact your future trades because you’ll think about “making up” the loss.

 

There are three primary factors that determine an option contract’s price.  They are; the price moves of the underlying stock (delta, gamma), time until expiry (theta), and volatility (vega).  These factors are given Greek letters because the pricing of option contracts is based on mathematical formulas.  The most popular of these formulas is the Black-Scholes model.