As Geopolitical Risk Recedes, Analysts Search Again for the Magic Chart

Tom Cleveland

The analyst community, if anything, is very predictable. Forecasting prowess may not be its strong suit, but this shortcoming never gets in the way of a healthy attempt to find the “Holy Grail”. And what is the “Holy Grail”, you might ask? It has come to mean that magic chart that will tell all what will happen to the market and when, without missing the boat, as has happened so many times in the past. With geopolitical sabers sheathed once more, the attention now shifts back to the favored pastime – guessing the future.

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Financial headlines are replete with fresh articles about the normal fare: Where is inflation; Does Steve Bannon’s departure from Trump’s White House staff signal the end of economic nationalism in the U.S.; How will trade with China be affected going forward; What will the Fed do in September; Is the bond bubble really ready to burst; Is volatility about to reappear with a flourish; Will the Almighty Dollar become almighty again; and, of course, the fan favorite – Is there a single chart that really discloses at this point in time where markets will surely trend over the near term?

If anyone really did discover this “Holy Grail” of technical expertise and it was correct in its prognostications, then we would never hear the end of it, especially from the analyst that uncovered this jewel hidden away in chart-dom. There have been so many of these “miracle drugs” put forth in the past several years that it is almost time to declare that the wolf will never appear at our door or the sky will never fall, but wait. As the saying goes, even a broken watch tells the correct time twice a day, so, perhaps, one of these adventuresome analysts will get it right, even if it is for the wrong reasons.

With those words as a brief introduction, here are a few tidbits from the world of crystal ball gazing. Will one of these charts be the winner of public praise, at least for a momentary moment in time? Time will tell, but for the time being, enjoy the banter to follow, or batten down the hatches, or buy market positions in a frenzy – your choice.

Can GDP growth rates really take off when interest rates are in the toilet?

GDP year over year growth

This first chart submission may have annotations that are difficult to read, but the conclusion is self-evident: From 1954 until the present, there has been a direct correlation between 10-Year Treasury Rates and Nominal GDP Growth Rates. If you remember your early economics classes, “Nominal” means unadjusted for inflation, the opposite of “Real” GDP growth rates, which reflect if economic engines are truly moving forward and not in reverse. Nominal GDP Growth Rates dipped deeply into negative territory during the Great Recession, and, although they have recovered somewhat on a “real” basis, they have leveled out at roughly the 2% plateau.

The Trump administration has promised skyrocketing rates of growth, if you were drawn in by his ebullient campaign rhetoric, the fundamental driving force behind the “Trump Re-flation“ market rally and trade. Words are one thing, and results are obviously another. Time is of the essence, but the GOP-controlled Congress has been unable to move any legislation forward that could materially change the handwriting on the wall – in the absence of concrete policy changes, market valuations must come down. If GDP growth is dependent on trending interest rates, then the problem is even more pronounced on a global basis, as depicted in the following 2016 diagram:

10 year note yields

Can an average workingman today really afford to invest in the S&P 500?

BofA Wages and SnP

This next submission comes to us from a determined analyst buried in the bowels of Bank of America. One can only ponder at the amount of work necessary to portray the data points in the above chart, but make no mistake about it, the forthright conclusion is evident with only a brief glance – stocks today are very overvalued. Demand drives prices in the northerly direction, but mass participation by the public at large is a prerequisite if high valuations are to be maintained.

The chart may only go back to 1964, but, compared to hourly wages, stock values are at historical highs. This index rose during the prosperity of the nineties, only to fall back when the Internet-driven bubble burst at the seams. A recovery in the index never got off the ground before the next recession hit, but here we are, once again at an historical high. Stocks have appreciated, while wages have stagnated since the millennium crossover. The stark reality is that this correlation will not correct itself until prices fall or wages increase dramatically, a possibility that begs credulity.

Are index funds in over abundance and how will they cope going forward?

Benchmarks ETFs

The rise of exchange-traded funds (ETFs) and their look-alikes, the so-called index funds of the day, has been a success story for decades. When money managers failed to better even the broadest of these funds, the rush was on for low-cost vehicles that offered both ease of access/exit and diversification benefits, as well. As the graph illustrates, ETFs have mushroomed from a few hundred to over 5,000 in just six years, while stocks “have fallen 42%”, due primarily to merger activity and cheap money policy from central banks. At some point, something has got to give.

When a correlation breaks down big time, is it also time to re-think your strategy?

The S&P 500 Index may be making new highs and trending favorably, but the same cannot be said about the entire market of public offerings. Not a day goes by without some mention of how smaller-cap stocks are in retreat: “Sometimes bigger really is better. So far this year, the S&P 500, which tracks the performance of large U.S. stocks, has surged 8.5 percent. But the small-cap-tracking Russell 2000 is now very slightly lower year to date, after sliding 5.5 percent in the past month to give back all of its 2017 gains.”

Are participants in the S&P 500 somehow different? Not necessarily so, it seems when you look at the following chart:

200 day stock movers

The letter “X” may mark the spot, but in this representation, according to John Mauldin’s synopsis of John Hussman’s technical creation, the “X” reveals “a major disconnect.” The percentage of U.S. stocks trending above their 200-Day moving average has been in major decline since last February, dropping from 72% to around 53%. Even as the index moves steadily higher, the number of bullishly trending stocks has dropped considerably. On the other hand, it’s still above 50%, so we can’t yet say most stocks are losing momentum.” Something akin to sector rotation may now be in order.

Bannon may have departed, but is economic war with China a real possibility?

Recent news headlines proclaimed that Steve Bannon, the protagonist for trade isolationist thinking and economic nationalism, had departed Trump’s White House staff. Financial markets rejoiced. Bannon had said, “To me, the economic war with China is everything. And we have to be maniacally focused on that. If we continue to lose it, we’re five years away, I think, ten years at the most, of hitting an inflection point from which we’ll never be able to recover.”

Bannon obviously did not check the trade data before commenting so rashly. While our trade imbalance with China might be huge by any measure, it has actually been declining, according to the data below:

US China Trade

Yes, we have helped to create a wealthy class in China, but those individuals have been buying products from us, as well. Exports currently have a healthy margin over imports, but international trade is not really this simplistic. There are also issues with intellectual property, subsidizing failing companies, and technology exchange, but at the end of the day, “most economists would argue that the U.S. and China have a complex symbiotic economic relationship that is mutually beneficial.”

What are the other primary themes that prevail in today’s financial commentary?

Oddly enough, there has not been a cacophony of recession forecasts dominating the latest storylines. Well-respected models are not signaling that a recession is imminent, but 2018 will be another story. Several recent articles in the months past have touted the “R” word, but the narrative soon lost its audience, when supportive data was lacking. For the time being, the latest news has focused on the following three areas:


  • What will the Fed do in September? – The next Federal Open Market Committee takes place on September 19 and 20. The Fed is currently on two “normalization” tracks. Analysts expect no changes in interest rates, but also that the Fed will commence its balance sheet reduction program. They foresee the $4.5 trillion balloon slowly dropping by 50%, as events permit. Reserves will be a good thing, giving the Fed leeway for tough times ahead;
  • Are we sitting on the surface of a bond bubble ready to burst? – As the first chart in this article demonstrated, Nominal GDP drives bond yields, which have been in a downward trend for 35 years. When bond yields go down, bond values appreciate. Investors that were savvy enough to recognize this trend have been rewarded handsomely over the years, yet naysayers claim a “bond bubble” exists. If Nominal GDP remains at historic low levels, then fear of a bond bubble may be misplaced;
  • Will the Almighty Dollar return in a vengeance and wreak havoc? – When the direction of the market is uncertain, all eyes tend to turn to the USD for insights. The U.S. Dollar index had vaulted from 80 to well past 100 in the short span of two years, but from 2015, it has been locked in a range about a mean of 96 (93.5 today). The “EUR/USD” currency pair is, perhaps, a better indicator of future possibilities. The Euro has appreciated from 1.05 in March to 1.18, but has been trapped in a tight range for August. The political situation in Europe has improved, while the opposite is true in the States, but will it stay this way?

Concluding Remarks

What a difference a week makes. Last week, we were on the brink of nuclear war. This week, cooler heads have prevailed, at least on the surface, and analysts have returned to doing what they prefer doing – guessing at what the future might bring. Trump continues to be disruptive, divisive, and unpredictable on both domestic and global stages, while other economies seem to be on the mend, recovering to a degree.

As always, however, conditions could change in one short heartbeat. Consequently, remain vigilant, and stay prepared!

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Tom Cleveland
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