Selling Exhaustion Signs

The first day of decent selling…. but exhaustion signals appear.

Yesterday was the highest downside volume day since March 2012. It ended the longest streak of no >2% up or down day on the SP500 since May 2012. It was the 8th largest daily percentage move in the Vix of all time, at >30%.

Equity put/call hit an extreme in fear. Here is the indicator’s history:

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Source: Stockcharts

Now here is a zoom on those previous instances of prints >0.90:

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Typically they marked lows or were a precursor to a low within a few sessions.

Next is bullish percent as a ratio to total put/call. I’ve previously highlighted the divergence in this indicator with the market since January 2014. However, because it has been in decline, yesterday’s selling took it to the kind of deep level associated with previous bottoms.

30junn13I also previously highlighted the divergent breadth in stocks above the 50MA. Again, because it has been in decline, yesterday’s selling has now put it in a zone that could spell a bottom, particularly if we combine it with the reading on Tick. The most similar such pairing from recent times would have been last August’s low.

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The picture from stocks above the 200MA isn’t dissimilar.

30junn15Source: Charlie Bilello

Lastly, here is Vix to Vxv. It too has spiked to the kind of level associated with previous lows, with the exception of the 2011 falls.

30junn12Here is a zoom on recent incidences of this indicator spiking over 1:

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We can see that a bottom occurred within several sessions of Vix:Vxv coming off its spike high.

Drawing all these indicators together, odds are that we see a rally from a low within a few sessions. Thursday’s full moon would fit with this too. As per my note yesterday I entered short RUT and IBB early and took a chance. They and the Dow positions are all in profit but in light of the above indicator readings I will be looking to cut back again later this week, anticipating a lower low from here within the next several of days but then a rally back up in July, perhaps to the mid-July new moon.

 

 

 

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The Bubble Within The Bubble

Namely, the Biotech sector within the wider stock market.

Is the wider stock market in a bubble? Valuations in the 97th percentile, record extreme leverage, allocations second only to the dot.com bubble, all time record cluster of readings in sentiment, and more. Bubble deniers point to the context of ZIRP and QE as this time it’s different. Or they argue the froth we are seeing is of a new secular bull, with the stock market leading the economy. But ‘this time is different’ has rarely worked out historically and there have been many indicators acting like they did at the peak in 2000 or 2007, which I have published on the site in recent months. Here’s one:

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Source: Sentimentrader

That surge in unprofitable IPOs looks a lot like 2000, and whilst then it was particularly concentrated in dot.com companies, this time round there is a lot of Biotech.

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Source: Biospace

As we all know, into the dot.com peak of 2000, the mantra was that traditional valuations didn’t apply any more, and that stocks were ‘revalued’ on potential and expectations, justifying the crazy prices. Ultimately, traditonal valuation methods did still apply, and the pop was fairly unforgiving.

Today’s Biotech bubble is the same. Take a look at the constituents of the Nasdaq biotech index:

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Source: ZeroHedge

Just a handful of companies are making any money and the vast majority none or a loss.

Now look at how Biotech has outperformed the wider markets:

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And see how that run up in price has been solely multiple expansion, i.e. valuation rising hand in hand with price:

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Source: ZeroHedge

The price to sales ratio in Biotech is now over 10. Compare that to the SP500 which is around 1.8, which in itself is at the very top end of its historic range and close to the 2000 peak.

We can all see the parabolic, and we all know how parabolics end.

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IBB is the vehicle that mirrors the Nasdaq Biotech index.

I want to short Biotech. But we have to be careful with a parabolic because they can steepen further before collapsing. So do we know when the game is up? One is a technical breakdown. Here’s how the Shanghai Composite looks today:

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It broke mid-June. There was a divergence in strength leading into the peak, and there is such a divergence on the current Biotech chart.

The other clue is the wider market.

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Source: Stockcharts

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Source: John Kicklighter

The last couple of days delivered another telling bearish reversal. Those negative divergences are all still in tact. We await the news on Greece and whether some kind of deal announcement would pump the markets back up again in the short term. So whilst I’m looking for short entries on Biotech and Russell 2000, the timing has to be careful. Plus, it will be a little at first, then building up.  That building up may happen swiftly, as when Biotech breaks there are reasonable odds it will be quickly ugly.

If you have been long Biotech then sincere congratulations. It’s been the trade of the decade so far. But I would equally expect that short Biotech will be the trade of the next couple of years. It’s going to be about nimble and accurate timing and attacking. Will let you know when I enter.

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Comparison to 2000

The biggest stock market mania of all time peaked out in March 2000, which was the exact month the smoothed solar max of SC23 peaked. Solar cycle 24 appears to have made its smoothed peak in April 2014, into which we experienced another mania in equities.

Below we see put/call (smart to dumb money variants), allocations (Rydex, as a proxy for the wider market), valuation x2 (real SP500, and relative to bonds) and strength (TSI) all displaying similar behaviour to 2000. What’s interesting is the extremes reached in these indicators have hit levels very close to those reached in 2000, as designated by the horizontal arrows.

Screen Shot 2015-06-19 at 08.12.38 19junn4Source: Stockcharts

And we can add margin debt to GDP for one more:

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Source: Octafinance

In all the indicators, we see the intermittent 2007 stock market peak printed lower or milder. The difference? No solar max to drive speculation.

In short, various measures and indicators reveal a close mirror of 2000, both in behaviour and level. The question is whether those levels represent ceilings or whether we go on to see all new extremes. So back to the opening comment: 2000 was the biggest stock market mania of all time, and in various ways we are matching it. Wow, no? This is despite a demographic headwind (rather than tailwind into 2000) and despite a weak world economy (versus strong growth into 2000). Can we really go higher?

Timewise, equities are on borrowed time since the solar max of mid-2014. Although nominally they have not topped out, various measures under the hood (see previous posts) reveal a peak back then, and the divergences remain. The TSI divergence back at the SC23 peak lasted from mid-1998 to the top in 2000; the current TSI divergence began in mid-2013, making for a similar duration. Drawing it all together, I maintain the likelihood of a mid-2015 switch into an equities bear and I am staying on the attack.

 

Comparison to 1929

Hat tips to Mark, John Li and Chien Jen.

So what’s similar to 1929?

A stock market mania to extreme valuations.

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Source: D Short

A similar low intensity solar cycle.

17junn1Source: Chien Jen

Stock market breadth peaked very close to the smoothed solar maximum (May 1928 vs April 1928, Mar/Jul 2014 vs April 2014) whilst stock index prices didn’t peak until at least a year later.

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Source: RW Nelson17junn6Source: Stockcharts

Maybe stock prices are following a similar technical pattern.

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The timings within the year fairly closely match too. 1929 began with a range. The final push was June to Sept. Therefore, the onus is on the bulls here to push prices back up into the range and out, to prevent the breakdown from the current position.

Now what’s not similar.

Economic growth was stronger in the 1920s.

The fed funds rate was around 4-5% in 1928/9 versus zero now.

It was a demographic climax produced by peak immigration at the start of the century of the age bracket that would buy the stock market in the 1920s.

17junn20Leverage reached 12% of GDP by the peak, versus 3% now.

All things considered, I believe 1929 has more in common with 2000, which was a demographic climax following strong economic growth with fed funds rate similarly around 5%. Post 1929 we saw the Great Depression, post 2000 the Great Recession, then following both we experienced a valuations-led stock market mania into the next solar max set against easy money conditions. Hence 1937 is a better all round fit to now (see HERE for details).

However, what’s common with 1929 is important, specifically that breadth peaked out 16 months before prices, and that is was ultimately leverage that delivered the craziness into the peak. Here in 2015 margin debt is hitting new highs so maybe the game isn’t over yet.

There was always a question mark over why prices didn’t peak with the 1928 solar max but made the anomalous extension into 1929. However, now we can see that breadth peaked at the 1928 solar max, like it has at the mid-2014 solar max, so in both cases marking some kind of speculation peak. The majority of other solar maxima delivered peaks in both breadth and prices close to the sunspot peak. Assuming prices peak out within the next several months (and don’t keep going, new secular bull style) then we are again producing that kind of anomaly that we saw in 1929, namely a fairly long period of degrading internals whilst prices continue to levitate or rise. Why? It’s leverage. Saturation levels in sentiment, allocations and valuations have been in place since the start of 2014. Buybacks were significant for much of last year but now it is leverage which is left holding things up.

So what stopped it in 1929? Answer: nothing in particular. One day the market topped out without any notable trigger, like most tops. Ultimately it was a combination of the fuel for higher prices being spent, leverage at unsustainable levels, prices for stocks being fairly unpalatable, and the whole thing having become a ponzi scheme. Then I would argue that the twin downward pressures of post solar max and the geomagnetic seasonal lows of Sept/Oct produced the timing.

Which brings us to today. What’s to stop prices making a final major leg up like in June-Sept 1929? Nothing, if leverage can keep rising, and the appetite amongst participants is there. However, that ‘appetite’ is under threat due to our positioning post smoothed solar max and the seasonal downtrend from July to October.

Solar cycle 16 had a sting its tail with a final surge in sunspots from September to December 1929. As this rather fits with the declines than the final run up in prices, I don’t think it’s relevant as a cause of the last leg up.

I would summarise that stocks are on borrowed time since the solar max of mid-2014. Breadth, volatility (inverted) and various risk measures all peaked out then. Buybacks also peaked out around then, leaving leverage as the key driver. This kind of anomalous extension post solar max was only seen before in 1929. Given most things in the world are now ‘bigger, better, faster, more’ than back in the 1920s, what’s to stop us blowing that reference point out of the water with an even dizzier anomaly now? Well, I would argue that in the context of negative demographic trends we already have.

A common historic technical topping pattern looks like this.

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Bottom right is a chart from last year when it appeared to have formed into early 2014, but was a red herring. Drawing together several indices from around the world we could argue it is there again, with the primary distribution across last year and the final leg up in 2015.

17junn50Or we could argue the final leg needs to go higher yet, or has to happen yet on the main US indices. Not easy to call.

So if we stick to what we know, I suggest it’s this. Stocks are on borrowed time since mid-2014 as divergences continue to grow. The geomagnetic downtrend from July to October 2015 together with the post-solar-max downward pressure has a strong chance of killing the bull. The two things to watch are these. Can prices be bid back up into the 2015 range and out of the top? If so, a final leg up would gain weight. And can leverage keep rising? It needs to, if another leg up is to happen.

 

Is This ‘It’?

Why might it be?

The triple confluence peak of peak speculation: the new moon closest to the seasonal geomagnetic peak closest to the smoothed solar maximum: 27th June 2014. Many assets and indicators peaked then.

Screen Shot 2015-06-16 at 06.27.40Source: Stockcharts

Breadth bar cumulative advance declines peaked then too, with the latter having recently turned down.

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The global stock index has made a marginal new high since that point but the divergences in strength closely resemble previous major peaks.

16junn8The SP500 also shows a strength (and breadth) divergence that mirrors the 2011 major peak.

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The breadth in the Nasdaq measured two ways peaked out around the solar max of April 2014. There has been some improvement since but still divergent overall.

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Bullish percent / put call ratio shows one of the longest divergences, together with high yield to treasuries. Cyclicals vs defensives has repaired itself in 2015 but is overall flat for 18 months.

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NAAIM manager exposure shows a divergence similar to the run into the 2007 and 2011 peaks. It made ‘an attempt’ into the mid-2014 peak too, but as we know, the market managed to recover.

16junn4AAII bulls have also been making a divergence. Oddly though they have now reached the same level as March 2009, so that could be contrarian bullish. I’d just repeat that AAII sentiment survey has a poor predictive history hence I rarely post it.

16junn17AAII allocations – different to the above source – shows a bizarre rush to exit stocks. Don’t know what to make of that.

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Source: J Lyons

The Russell 2000 is one of the most bullish indices. But the same divergence is showing as the SP500 above.

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And it may be displaying that common pattern of historical major tops:

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In terms of its valuation, the latest p/e ex negative earnings is 22.38, which you can see versus history below.

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If we home in the Biotech sector, arguably the mania leader, we again see the same divergences as both above and prior peaks.

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In short, there are a whole host of negative divergences in strength, breadth, volatility, risk-off, sentiment and allocations for US and world stocks. The original set kicked off at the turn of 2013 into 2014, and have since been added to, with a concentration around the 27 June 2014 triple confluence peak.

I suggest there are only two ways to read it. Either all the supports for equities have been removed and they are about to tumble to ‘satisfy’ all those divergences. Or, stocks have held up despite all those divergences and so we now see breadth, strength, risk-on, etc, start to improve again, launching stocks higher. Needless to say, I side with the first option when we start to draw in valuations, allocations, leverage and other angles indicative of a major peak.

Today is the new moon at the seasonal geomagnetic mid-year peak. Either from this point or from the new moon of mid-July, stocks have the best chances of falling, with downward pressure into October.

30mays5In short, I’m on the attack, looking to build onto my short stocks positions (and long gold). I’m looking for an entry into the Russell 2000 as I believe it has the furthest to fall once equities break. I want to leave some allowance for a potential rally back up into the mid-July twin confluence peak, but until the evidence changes, the real peak was a year ago, putting equities on severely borrowed time and making yet another rally back up here doubtful.

The Dow, SP500 and NYSE all attempted a break out upwards from the 2015 range in May, which failed and now looks like a fakeout. The last chart here shows the NYSE in a rather textbook bearish formation: wedge, fakeout, breakdown, retest of wedge underside, repelled. That whole move has been building out since last July and now looks ripe for completion to the downside. I see this as another reason to be attacking here rather than waiting.

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The Conundrum Of Our Times Part 2

Let’s now draw in the solar cycle. Here are US equity valuations by Q ratio versus solar maxima over the last century. A relation becomes apparent with secular lows and highs.

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Source: D Short

We can see three that don’t fit so well. The 1929 stocks peak extended over a year beyond the SC16 peak, stocks sailed through the 1957 solar max and whilst the SC22 peak wasn’t so significant for US stocks it turned out the secular peak for the Nikkei.

Now for the three secular ‘lows’ on the above chart (SC15, 18 and 21) we can cross reference to long term commodity prices and see that they instead marked secular highs in hard assets. Similarly, the secular stocks highs of SC23 and SC20 maxima marked secular commodities lows.

15junn3Solar science reveals peaks in human excitement at solar maxima (e.g. clusters of war). In the financial markets this appears to translate as peaks in speculation (and in the economy in peak activity). Therefore, it appears that the asset in favour at the time is bid up to a secular peak and subsequent pop around the solar max (with the rare exception, as with any indicator or discipline). So what would make the favoured asset stocks rather than commodities or vice versa?

The evidence suggests it is demographics, namely that secular = demographic. The chart below reveals equity valuations tracking US demographics and gold moving in opposite directions. Therefore we see a secular peak in gold at the demographic low and a secular peak in stocks at the demographic high.

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The picture is enhanced when we discover that solar cycles influence birth rates, which may account for why demographic peaks often tie in with solar peaks.

The chart below shows how Japanese demographics peaked out first in the late 1980s, which explains why Japanese equities made their secular peak at the 1989 solar max whilst other major nation stock markets continued to advance under positive demographics.

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The current relevance of the chart is that the global demographic composite is definitively negative, and this is echoed in other demographic variants. Together they spell recessionary and deflationary pressures, which we are seeing in reality. But they also should be sinking equities and launching gold, which we are not (currently) seeing. More on that shortly.

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Solar cycles are long cycles, but armed with the above information we got the chance for a real time test with the SC24 max, which now appears to have been centred around April 2014 (smoothed max).

Two things were anomalous about the SC24 max. It was lower intensity (less sunspots overall) and it took longer to form (including a higher second peak).

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The average duration between solar maxima is 11 years 1 month, but the SC24 max didn’t form until 14 years 1 month after the SC23 max, which makes it an outlier. Is this relevant? Well, a major commodities peak occurred in April 2011, exactly 11 years 1 month after the SC23 max.

Tangent for a moment. Here is the influence of the lunar phase cycle on the markets: it makes for a fortnightly oscillation with distinct measurable returns over time.

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The most plausible explanation is the influence of nocturnal illumination levels on evolving humans. Yet, the influence is still present despite living under artificial lighting for several generations. Therefore it would appear to be hardcoded to some degree: we oscillate internally with the moon cycle, to some extent. Might the solar cycle also be to some degree hardcoded? If so, that could be a factor in the major speculative commodities peak (and associated major stocks low) in 2011, i.e. human excitement to some degree peaked into the anticipated/internalised solar max.

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Source: Stockcharts

The case for that increases if we look at ‘leveraged’ commodity silver. The same kind of parabolic blow off as in 1980 occurred.

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It would make the secular commodities bull 2000-2011 a mirror of the 1968-1980 bull, namely one solar cycle in length and set against a secular stocks bear, and both in keeping with demographic trends of the time. The implication would then be that commodities are now in a secular bear and stocks are in a new secular bull.

But let’s now look at the real experienced solar max of April 2014. From 2011 to 2014 stocks rallied strongly and since the start of 2013 displayed characteristics of a mania. A snapshot at April 2014 reveals many typical signs of a major market peak: extremes in valuation, sentiment, allocations and leverage; record negative earnings guidance and economic surprises all negative in the major nations; divergences in money flows and various risk-off measures; outperformance of defensive sectors and bonds; etc. At the time I gathered together 40 indicators all with different angles on a telltale top in stocks. Really, the evidence could not have been better for a speculative mania into the solar max.

However, as we passed through the real solar max, it was commodities that fell again, rather than stocks. An oil-heavy commodity index, used for emphasis, shown here:

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Source: Stockcharts

Indeed, by the end of March 2014 large speculators had amassed an all-time record long position in the CRB commodities index, suspiciously right at the solar max. So we have a potential case here for commodities to have effectively made a double secular peak between the ‘average’ and ‘real’ solar maxima.

But… things get more complicated when we look under the hood at equities. Stocks:dollar, stocks:bonds, volatility, breadth and various other measures not only resemble previous major peaks but occurred together very close to the real solar max.

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We are now waiting to see whether these will be repaired or whether nominal equity prices now fall in line. If the latter, then we have the evidence that speculation in equities peaked at the real solar max. At the same time, gold has been forming a technical bottom in recent months together supported by washout sentiment and allocation levels, which after a 4 year bear suggest it is ripe to break into a new bull. Which brings us back to demographic trends being aligned to stocks declining and gold rising: this angle on what happened would argue that the anomaly in hardcoded/real solar max produced a second speculative peak against demographic trends and in stocks, only for demographic trends to now reassert themselves (stocks complete the secular bear, as suggested in the last post, whilst gold goes to new highs).

As alluded to in the last post, the closest fit historically to the current time was the peak of 1937: a solar maximum and speculative peak against a backdrop of low rates and easy conditions. Equities peaked out at high valuation (see Q ratio chart at top of page for SC17), following a front-running of prices to an expected return to normal growth that didn’t materialise. If there was any doubt this isn’t being repeated today, take a look at how analysts continually expected bond yields to rise over the last several years. Reality (demographics) has persistently denied them.

15junn32Source: Mike Sankowski

In 1937, both equities and commodities rallied into the solar max of April and both topped out around then, falling sharply for the next 12 months with both deflation and recession occurring.

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Stocks didn’t make a real (inflation adjusted or valuation) bottom until 5 years later.

Which brings me back to the unfinished business in equities and the prediction by both demographics and valuations:

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In summary, from all the topping indicators in equities, stocks should now break into a bear market, tipping the fragile world economy fully into both deflation and recession. There should be a feedback looping between the two, taking stocks down to much more appropriate washout valuation levels, whilst crises breed crises again in the economy. As in 1937, it should kick off under easy monetary conditions, limiting the toolkit of central banks, but also as then, central banks will likely resort to unorthodox (and probably ruthless) tactics. Systemic breakdown is a real risk again, with debt levels greater than in the Great Recession (hat tip Sinuhet).

Screen Shot 2015-06-15 at 08.57.23

Source: McKinsey

Commodities (particularly industrial) should sink again too, but likely for shorter and shallower (in line with demographic pressures, as per 1937, and understanding their existing slide since 2011). However, I expect gold to break away and rally as real money. It’s not an easy call due to the limited history of gold free-floating and performing under deflationary conditions. But ultimately I maintain it is the anti-demographic ultimate safe haven, and should regain favour particularly as central banks are currently doing their best to corrupt the money mechanism with QE and ZIRP.

If I’m wrong? Well, this is where we get to the ultimate conundrum. If stocks are instead in a new secular bull (and commodities made their secular peak in 2011, doubled down in 2014) then the appropriate investments/trades are really the opposite of if they are on the cusp of a new devastating bear in an ongoing secular bear. Long stocks and short gold versus short stocks and long gold. I have been able to make cases for both in the last two posts, but I have also shown the flaws in both.

Ultimately it’s a game of probabilities. When all crunched together I see it as most likely that 40 topping indicators and an under-the-hood peak around the smoothed solar max of last year should produce an imminent meaningful correction in stocks unless those divergences start to be repaired. That would be the telling clue. Fitting with that I see gold’s technical basing as likely to produce a meaningful rally. From there I would expect to see serious troublespots emerging in the global economy (defaults, etc) and the meaningful correction in equities turn into a fully fledged bear. However, if the secular stocks bull scenario were to turn out true, then indicators should point to a recovery in equities before we hit such problems.

I have to end on a sobering note. If we do see a global bear market and recession here, then the damage will be immense. No capacity to reduce rates, QE proven to be a failure, record debt levels and increasing under deflation, and no demographic upturn in sight for some time. Accordingly, central bank response would have to get tough, such as penalising any saving, imposing capital flow controls or protectionism. The potential for civil unrest, war or systemic breakdown would increase. The outlook would be very uncertain but surely bleak for the majority of people for the period ahead. It would really be in mankind’s interest for the new secular stocks bull scenario to be true. However, both the debt and demographic problems that we now face can both be traced back to the second world war. They have been a long time growing and attempts to conceal or water down their impact cannot go on indefinitely. Printing money to buy your own debt is normally the end game, so it’s not realistic to expect ‘muddle through’ can keep going. It comes down to the complications of gauging how the end game plays out.

The Conundrum Of Our Times Part 1

This is a complex time to trade the financial markets. We are trying to forecast against a backdrop of prolonged ultra low rates, collective quantitative easing programmes, united demographic downtrends and extreme debt levels amongst all the major nations. It would be generally inaccurate to say those factors are unprecedented, but they are rare historically.

Debt to GDP levels, only like the Great Depression.

12junn1Source: Peter Peterson

Prolonged ultra low interest rates not seen for 50 years.

12junn2Source: Lance Roberts

Demographics – here we are in fact making history with middle-to-old ratios, as never before has the world had such an old cohort influencing developments.

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Quantitative easing: only seen in Japan the decade prior and in some form in 1930s US.

Plus, we can add that we haven’t seen such low levels of inflation for 30 years. Looking longer back in time we saw a greater spectrum of ‘flation.

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Source: DShort

We are seeing other historic extremes too. Aggregate stock market valuations only have the run into 2000 now for company.

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Source: DShort

Leverage to GDP is at the same record extreme of the 2000 and 2007 peaks.12junn5

Source: Lance Roberts

US household exposure to equities was only beaten by the run into 2000 in the last 50 years.

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Source: ShortSideOfLong

Fund manager allocations to global equities have been bumping up against equal record extremes.

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Source: Fat-Pitch

Sentiment towards equities has been record prolonged one-sided.

Screen Shot 2015-06-12 at 08.01.42

Source: Yardeni

Add these equity market indicators together and you get this kind of alert:

12junn12Source: Hussman

But now we need to add back in the environment, which is closest to the 1930s-40s. Or the last 20 years in Japan, which was the first to initiate ultra low rates and QE in the recent era, as it was the first major to go over the demographic cliff. How does this change things? Well, for example, we might look at valuations in the context of low inflation and argue they ought to go higher yet:

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Source: Richard Bernstein

Essentially, when we combine the economic/demographic environment with the financial market indicator extremes, we start to struggle for historical reference points, and therefore some kind of reliable probability calculation of where things are headed.

But there is more to add in to the mix. High frequency alto trading has become much more dominant than it ever was. Markets are globalised – and instant – like never before. Some central banks are buying equities. Plus there are two complex areas where there is a lack of full understanding: dark pools and derivatives. Dark pools are notorious for their lack of transparency, whilst the nominal amount of world derivatives now stands at over $700 trillion (around 10 times nominal world GDP) which is clearly a major threat, but to what degree isn’t truly understood.

Now what does market price action tell us? Bonds are in a 30 year bull market. Commodities are in a bear market since 2011. Equities are in a bull market since 2011 (or we might argue 2009). If we look at US equities adjusted for inflation we get this picture:

12junn15

So is the equity bull a new secular bull, as per the apparent breakout?

The problem is that various measures put that start of 2013 date as the beginning of the mania in stocks, such as money flow and divorce from fundamentals, and since then we have seen 2.5 years of multiple expansion (price not earnings). Another look at the valuations chart shows the contrast now to where previous secular bull markets in stocks began:

12junn17The path designated by the arrow is the better fit with demographics and would also be historically normal from these extremes of valuation, leverage, allocations and sentiment.

However, given conditions are relatively unprecedented and we are already seeing various indicators move out of historical ranges, we have to allow for something overall unprecedented. Perhaps we could argue that valuations will be disregarded as central banks expand their purchases and in so doing overcome the demographic headwind. However, if we assume they have stepped in as a new class of buyer, then why are leverage levels so high and going higher yet? The record leverage rather fits with the demographic trends and the shrinking volumes in the stock market, namely less buyers but on more credit. However, in turn, we could argue we might see leverage taken to a whole new level (as occurred in the 1990s), much higher than currently, under continued easy money conditions, before we see a collapse. Or we could see something that hasn’t happened before from these valuations, namely that the ‘earnings’ part of the p/e catches up with price and we see all round economic improvement whist stocks tread water instead of being resolved by a bear market.


Let me sum up. 1. Stock market price argues we are in a new secular bull. 2. Stock market indicators argue we are at a major peak, specifically a cyclical bull peak within an ongoing secular stocks bear. These two are incompatible. 3. The economic environment is closest to 1930s-40s US or the last 2 decades Japan, but when all factors are considered has no reliable historic precedent. This is unchartered territory.

If the equities bull is to continue then history will be made, either by central bank purchase expansion, leverage ratcheted much higher under low rates, valuations/sentiment/allocations being reduced from these levels without a bear market, or some other unprecedented development. If a bear market is at hand, then this would fit with demographics and stock market indicator history, but would have limited historical precedent in occurring whilst rates and inflation are low, such as the 1937 stock market peak.

Part 2 ahead.

 

Global Economy

The world economy is currently in trouble, showing both recessionary and deflationary coincident data:

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Source: Ned Davis10junn3Source: GaveKal

Given these, the resilience of equity markets has been pretty amazing, even more so as we are now a year post-solar maximum:

10junn12The last six months has been particularly weak economically, and normally historically stocks would have sold off leading into this, with stocks typically leading the economy.

In fact, under such extreme levels of valuation, allocations, leverage and sentiment, together with growth, ‘flation, and earnings all rolling over negative as well as the speculation peak of the solar maximum through, the case was extremely strong for 2014’s October sell-off to launch a fully-blown bear market. The weakening economy over the subsequent 6 months and the wealth-reduction effect of the declining stock market would then have fed off each other to create fairly significant devastation.

But it didn’t happen. Stocks were somehow saved. However, as pre previous posts, we see a lot of degradation in internals and cross-referenced data since mid last year, giving the potential for price action since then to be ‘last-gasps’. Below is the Dow Jones World stock index which reveals a similar higher high against weakening strength to the last 3 previous major tops.

10junn10Source: Stockcharts

Plus, we have seen a sell-off in recent weeks, making that higher high maybe a fake-out high. We still see saturation levels in valuations, allocations, sentiment and leverage and many negative divergences that all support the bear case.

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Source: Stockcharts

However, set against this, we have recently seen a turn up in leading indicators and what maybe a bottoming in coincident data.

Coincident:

10junn4Source: FT

Leading:

10junn2Source: Goldman Sachs

At the same time we have seen some money exiting bonds and inflation expectations recovering, suggesting some of the expected pick-up being priced in by market participants.

However, real money leading indicators predict this to be another non-sustained pick up in global growth, i.e. still not the move to sustainable strong growth that leads to central banks starting to raise rates. Rather, they predict the growth to peak by October this year and then give way to weakness again.

The key question, therefore, is whether equities can now rally again and keep the bull market going over the next few months against a backdrop of improving economic surprises. If so, then we would need to see stocks repairing this kind of bearish set-up of fake-out plus divergences:

10junn23

Source: Stockcharts

If stocks can do that, then an obvious reference point would then be 1929, with a potential Autumn/Fall peak, a similar length of time post-solar maximum, at similar extremes of valuation and leverage. Anything beyond that and there would be no further reference points. This really would be unchartered territory for world markets, whereby the ‘old rules’ no longer apply.

Here’s a look at China’s stock market. The divergence from GDP is extreme and as such valuations are now at a new record.

10junn6 10junn8Source: Sober Look

The rise in margin debt in China has rocketed. Leveraged-based stock rallies are ponzi-schemes, making for a risk of a major unwind at any point. The leverage situation around the world is similarly flagging that risk.

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Source: DShort

In summary, I believe this is where we find out what really moves the markets. My position on that: dumb forces. Demographics, solar cycles and simply running out of buyers. By the latter I refer to saturation in valuation, leverage, sentiment and allocations: everyone on one side of the boat and borrowed up to the max. We can see additional clues to the fuel drying up in divergences in breadth and other indicators.

June/July is the seasonal geomagnetic peak, so I don’t rule out the possibility of a short rally back up here in stocks. But unless all those under-the-hood July 2014 peaks are repaired, together with the bearish technical set-ups and negative divergences, then I expect leading indicators to be disregarded here, in the same way negative leading indicators were disregarded several months back. The fact that the market has risen against both positive and negative leading and coincident economic data the past 2 years is a clue that economic indicators aren’t the driver. So is central banks? I refer you back to the top two charts. After billions spent on QE and ultra suppressed rates, we still have a world economy on its knees.

The Influence Of The Solar Maximum

The smoothed solar maximum occurred mid-2014.

Screen Shot 2015-06-03 at 08.13.32

Source: Solen

Financial Conditions peaked mid-2014.

Screen Shot 2015-06-03 at 07.35.01Source: Bloomberg

World earnings peaked mid-2014.

Screen Shot 2015-06-03 at 08.12.29

Source: Schwab

US IPOs peaked then.

3junn2Source: Marketwatch

Buybacks peaked then.

Screen Shot 2015-06-03 at 08.23.52Source: Factset

US stocks:dollar, stocks:bonds, volatility (inverted) and breadth all peaked mid-2014.

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Source: Stockcharts

Junk bonds, commodities and FX all changed course then. European stock indices have since risen in nominal terms, but if we net out the Euro’s decline from the picture then they too peaked mid-2014.

3junn10Various economic data measures peaked out then.

3junn7

Source: Alhambra

This all fits with the theory of peak human excitement at the solar maximum, translating as peak speculation and risk-taking in the markets and peak activity in the economy. However, we need to continue to see further all-round degradation as the sun moves further away from its peak over the rest of 2015, and not least, we need to see the nominal falls in equities now come to pass.