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.


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.


Source: DShort

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


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.


Source: ShortSideOfLong

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


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:


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we combine the economic/demographic environment with the financial market indicator extremes, we start to struggle for historical reference points, and therefore some kind of reliable probability calculation of where things are headed.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


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.



The Bull Case And The Big Picture

Let’s distinguish between prospects for a stock market correction and prospects for a bear market, and start with the former.

There are multiple signals for an imminent stock market correction, such as sentiment and euphoria readings, put/call ratio, skew, distance from 200MA, divergence in stocks above MA. I’ve covered these, and more, in detail in recent posts. The history of each individual flag gives us a guide as to the timing and nature of a correction, but it’s just a guide. The risk, and the bull case, is that things go crazier yet: steeper parabolic under the excitement influence of the solar maximum. We see no decisive break in the markets yet and certain measures of breadth and sector participation are still supportive. Barring an external shock it can take time for perceptions to shift. If we try to anticipate buyer exhaustion, then current leverage, sentiment and investor credit are suggestive of ‘all in’, but we could still eek a little more out of each and propel higher yet.

My ‘balanced’ view. Multiple flags, with different angles on the market and with broadly reliable histories, are pointing to an imminent correction. Some of these indicators are at all-time record extremes, and the aggregation of both the warnings and the levels is a trader’s opportunity. Mean reversion always occurs, so a correction will come, but that could be ‘eventually’. If I were to play the long side, I would look for bullish momentum to resume, and play with stops for short term profits, knowing that under such one-way sentiment, high leverage, and technical levitation, the market is particularly vulnerable to a sudden fall or a lasting decline. If we take a purely statistical approach to the markets (you can find that in THIS post), and remove any big picture bias, then the risk-reward is on the short side, until we have seen a correction that relieves the current extremes. The data gives high confidence that short positions here will produce positive returns, if any drawdown en-route can be tolerated. If there is little leeway for drawdown long or short, then the prudent approach would be to sit aside whilst both prospects of steepening parabolic and steep drop or crash are in currently in play.

Now to the bigger picture, and the potential for a bear market.

Looking statistically again, valuations such as market cap to GDP and CAPE, corporate profit margins to GDP, levels of margin debt and investor credit, and bull market trend/gain history: they are all at top percentile readings that have historically ushered in bear markets. The bull case relies on ‘this time is different’, namely: valuations need adjusting as bond yields and cash are suppressed, margin debt can go some way higher yet due to low rate of borrowing or there will be an orderly transfer from leveraged buyers to new buyers, and the Fed is underpinning the stock market and trumping normal factors. It has always been dangerous to side with ‘new norms’ because mean reversion, until now, has always occurred.

The current extremes seen in sentiment and euphoria typically occur towards bull market peaks, but can on occasion be generated in young bull momentum. The case for a young bull is that certain stock indices, e.g. SP500, decisively broke above 2007 highs in a mirror of historic secular bear termination breakouts, and the economy is now finally picking up. Regarding the former, the break-out case doesn’t apply to other major global indices such as FTSE, Euro Stocks, Nikkei and Hang Seng, and regarding the latter, the pick up in the economy is tentative and may prove to be fleeting. Much of the data coming out currently is backward looking to October/November. Broad and narrow money measures suggest the pick up may be tipping over again. But, for now, data is generally positive and we could argue for the possiblity of positive feedback looping. Nonetheless, it is still a stretch to make a case for young equities bull momentum when valuations, leverage and bull market history collectively indicate we are at historic secular/cyclical topping levels. It would be unprecedented to see either a rapid catch up in the underlying (GDP, earnings, revenues) or significant collective further extension of valuations, leverage, and bull market trend/gain. Rather, the evidence suggests current euphoria and sentiment extremes are more typically those of a bull market ripe for termination.

So let’s now look at the macro picture and assess what kind of bear market we could be in for, because there are again two options.

The first option would be a bear market that is a pause in a new secular stocks bull, sufficient to remove the froth that has built up in sentiment, valuations and leverage. On the SP500, this could be a retrace to the 2000/2007 resistance breakout, which from current levels would be 20% down. A successful backtest and a new cyclical bull thereafter. The option second would be a deeper, longer bear market, which would be classed as continuation of a secular bear market from 2000. A case for the first option could be built on exponential technological evolution and collective central bank support (commitment to enduring low rates and stimulus as appropriate). A case for the second option could be built on demographics and debt. We then need to look for evidence as to in which camp the balance of power lies.

The economic recovery since the 2008 crisis has been historically weak in various areas, such as consumption, income, retail sales, job growth, productivity and private investment, and thus we still have ZIRP and QE 5 years on. I believe there are two reasons for this: demographics and debt. I have covered demographics in detail on this site – please do a site search if you are a new reader – and I can summarise that we see collective trends that suggest growth and consumption will remain weak for some years ahead. The bull case relies on growth and earnings picking up this year onwards to historically normal levels but this will be very difficult to achieve against the demographic backdrop. Over the longer term, a combination of pro-active immigration policies, greater global economic influence in positive-demographic countries such as India and Brazil, technological and societal shifts could potentially help alleviate the pressures, but we are looking at sustaining a secular bull market right now.

Turning to the debt issue, much of the world is suffering from all-time record debt: household, corporate and public. The problem with high and growing debt is that more and more has to be spent on servicing the debt, crowding out investment, and restricting other spending.  High debt has historically correlated with low growth and low productivity. Money invested in government bonds is not invested in productive capital. Below we see the growth in US debt:


Next we see US public debt as a percentage of GDP. To add to the wars labelled, the Vietnam war of the 60s-70s was also highly costly.

It is the combined costs of the wars that have led to the current predicament. War provides no economic benefit. There is a short term boost as certain industries boom and jobs are created, but ultimately it is highly costly, paid for in part by increasing taxation and by cutting other government spending, but mainly by increasing government borrowing. The build up of the debt led to the cutting of the gold standard, and since then debt has been on a one-way path. Compound debt can run away, unless revenues (GDP) can grow at a faster rate, or inflation is sufficiently high to shrink the debt, or, as a last resort, monetisation is undertaken (money printing to buy the debt). As growth has shrunk under the debt-overhang and both inflation and growth have been crimped by demographics, even more borrowing has been taken on to try to offset these factors, exacerbating the problem. Hence we are at that last resort of monetisation and no way back.

Here is the combined debt picture for US, UK, Eurozone and Japan:
10ja3China’s debt is ballooning too. All these countries are in demographic downtrends, and all are compromised by ballooning debt. This sets the scene for a particularly nasty global negative feedback looping (US demographics topped out around 2000, Europe around 2005 and China around 2010, therefore the collective pressure is now at its greatest). It is asking a lot of technology to deliver a range of paradigm shifts in the near future to somehow turn this around, particularly when corporate investment has been neglected. Meanwhile, conditions of zero rates and QE have failed to convince consumers and corporates to spend, borrow and invest, other than in asset bubbles. Thus it seems likely that debt and demographics will and are overwhelming policy and technological evolution, and the secular bear market will ultimately continue. However, I would of course accept that this position is to some degree theoretical whilst equities remain in a bull market and whilst economic reports are largely respectable.

The proof, of course, will come piece by piece in the economic data. Should equities hold up a while longer and central banks / governments get their balancing acts right, particularly China, then maybe a period of positive feedback looping can develop and extend. If a stocks bear erupts, as indicators alone suggest, then realistically this would sink the fragile economy as that wealth evaporates. A deflationary shock is also a possibility, as such events have occurred in the past when countries flirted with very low inflation.

Understand that I have not changed stance from my previous posts, but rather I’ve tried to keep it balanced in this post and see the bull case, as it’s important to challenge yourself. So yes, equities could potentially move higher in the near term. The onus is on the bears to take this down and until they do in a meaningful way then we are in a strong bull market. However, the weight of evidence for either an imminent correction or bear market is compelling. And yes, at the global macro level, things are currently reasonably benign and economic data generally not too troublesome, so my expectations regarding demographics and debt could potentially be proven to be less potent than I predict. However, again, it’s about the weighing up the evidence and I believe I side with the probability. I’m short, either for a correction or a bear, and will increase shorts on market clues.

Demographics: Bear Market, Global Recession And Deflation

Historically, demographic trends have correlated with secular bulls and bears in financial assets, economic growth/recession and inflation/deflation. Demographic forecasts are reliable because future trends were set in place with past swells and shrinkages in birth numbers. They would change if a country was subject to large scale death (war, pandemic, or similar) or the government henceforth adopted radical immigration policies. Demographics are particularly potent in countries that are relatively closed to migration, so understand that China has the smallest percentage of immigrants of any country (0.1% of the population), and Japan just 1.9% (compared to USA, UK and Germany all over 10%). My focus is on USA, China, Japan, Germany and UK, as collectively they make up 50% of world GDP. Know that whilst the European Union abolished barriers to movement within it, the demographics across all the member nations are uniformly poor.


Young labour force percentage of population (aged 15-40) and dependency ratios (inverted – old and young versus the working population) have both historically correlated with inflation/deflation. A swell of people entering the workforce works up price inflation through spending, whereas more people entering old age relative to the work force is disinflationary through saving and disinvestment (read more HERE).


Deflation1In the first chart above, we see the UK alone is currently in a small window of young labour force growth, whilst in the second chart China is just peaking out in dependency ratio (inverted). This is reflected in reality, with the UK currently registering the highest producer price inflation and China the highest consumer price inflation of the five. At this point in time, we generally see trends of disinflation. Demographics predict this will turn into outright deflation, and that deflation should be the norm for the next couple of decades (barring countries with inflationary demographics becoming much more dominant globally, such as India and Brazil).

7ja1 7ja3 7ja4


Due to globalisation and an increasingly open world economy, recessions around 2009, 2001, 1998, 1991 and 1982 have all been global in nature. Due to the US contributing 22% of world GDP, particular attention needs to be paid to indicators of future US growth, with China second.

Dependency ratios (inverted – old and young versus the working population) have historically correlated with economic growth / recession. That chart is presented in section 1. above. The picture for the next 2 decades is bleak.

Stepping aside from demographics for a moment, levels of debt have also been shown to assist or impede growth historically. Where public debt to GDP has exceeded 90%, economic growth has struggled. For 2014, Japan will be around 230%, UK and USA around 115% and Germany 85%.  China has the lowest ratio of public debt of the five, but its broader debt has been ballooning since 2008. Including corporate and household debt, China’s total debt to GDP has reached 218% of GDP (from around 130% in 2008).



Demographic trends in middle-to-young ratio (aged 35-49 / 20-34), middle-to-old ratio (35-49 / 60-69), percentage net investors (35-49 / all) and dependency ratios (charted in 1. above) have all been shown to have a correlation with stock market and real estate market performance historically, on a longer term secular level. There are young borrowers/spenders, middle-aged investors (partially investing for retirement) and old-ages disinvestors. If the middle group is growing relative to the others, then we have a growing demand for the stock market. Similarly, the old and the young don’t typically buy houses, so a swelling middle-aged group relative to the others is an environment for a housing boom, and vice versa (read more HERE).



BM3Using the weighted average composite as our overall guide looking out to mid-century, M/Y is flat whilst M/O and NI are down, suggesting long term ‘buy and hold’ may be a strategy doomed to the past, to be replaced by ‘short and hold’. Add in Dependency Ratios from 1. above and the picture worsens further. Within those overall trends there are positive windows for individual countries, for instance the USA sees M/Y, M/O and NI measures rising together between around 2025 and 2030, and the composites also suggest that period could be the backdrop to a cyclical bull. However, when the composite trends above from 1980-2000 are compared to what lies ahead of us now, the contrast is stark and suggests enduring downwards pressure on equities and real estate, in long secular bear markets.

The longer term fortunes of bonds have also historically correlated with demographic trends.

23jun16This CS graphic suggests yields will remain fairly low and contained, as demand for bonds will be maintained. However, through to 2020, the bias in yields, aside Japan, is overall upwards, suggesting net selling on balance. It is my view that gold, as the historic anti-demographic, is due to be the lead asset in the period ahead, as the collective trends above suggest deflation, recession, and net selling of equities, real estate and bonds.


A) Historic correlations in demographic trends and secular asset cycles, growth/recession and inflation/deflation. B) Unprecedented collective demographic downforces now in place, with evidence of impact in economic data. C) Downtrends in play for much of the first half of this century, suggesting tough times for the global economy and no safety in equities or real estate.

Europe has structural problems, a cautious central bank, and a relatively strong currency, mirroring 1990s Japan and making it the candidate for the first into deflation. China is closed to migration and thus trapped in a sharp demographic reversal, largely the result of its 1 child policy. Previous breakneck growth was built on exports, the market for which collapsed in recent years, leaving it with declining GDP and excess capacity. Stimulus response in 2008 was to invest in even more infrastructure, increasing the excess capacity issue. Non-public debt is ballooning whilst the authorities attempt to tighten, resulting in two cash crunches already this year, as well as high profile company bankruptcies. That makes China the candidate for delivering a 2008-style global crisis.

2014 For Equities

Dow is up more than 5% five consecutive years now. A sixth such year has not happened before in history. A 5-year bull trend only occurred once before, in the 1990s, and was followed by 3 down years. Russell 2k rallies of similar size and duration to 2013’s (excluding accelerations from major bear lows) are shown below. In each case all the gains were given back the following year.


Source: Fat-Pitch

2014 is the second year in the Presidential cycle, and is the weakest historically by returns, averaging flat. The logic for this is that is it a time for governments to deploy tougher, unpopular policies. The Investors Intelligence bull-bear ratio currently exceeding 40% also forecasts a flat return for the SP500 by the end of 2014, by averaging history, whilst the II bear percentage alone, around 15% the last 4 weeks, has historically produced returns of -5% to -20% over the next 6 months.

The Citigroup Panic/Euphoria Model, having crossed the Euphoria threshold, predicts an 83% chance of losses in 2014. Goldman’s analysis of performance following a year of 25% gains or more point to a median drawdown of 11% in the next 12 months.

Next is a chart highlighting a couple of previous occurrences similar to 2012 and 2013 where stock index rises were dominated by multiple expansion, not earnings growth.

22dece3Source: Fat-Pitch

In both instances the following two years saw better earnings growth. But notably the next two years were 1987, stock market crash, and 1999, at the end of which the Dow peaked, suggesting a common theme of pre-correction exuberance.

Both the following charts reveal that 10 year stock market returns are closely correlated to deviations from norms 10 years earlier. The first correlates average investor allocations and the second market cap to GDP. I have added the blue horiztonal line averages, revealing both are overvalued currently, but one more extreme than the other.


Source: Philosophical Economics22dece5Source: Hussman

The logic behind both is that mean reversion always occurs. The bigger the deviation build the bigger the subsequent normalisation, as ‘this time is different’ each time is disproven. For US markets currently, we see the second highest market cap to GDP valuation outside of 2000, the 4th highest Q ratio valuation and 4th highest CAPE valuation in history. In all the other such historic outliers, a bear market followed to correct the extreme, there was no orderly consolidation of prices whilst the underlying fundamentals accelerated to catch up. ‘This time is different’ thinking argues that because the Fed has suppressed cash and bond yields, equities have to be revalued higher, so this valuation outlier doesn’t count, and there will be an orderly normalisation of valuation as earnings and GDP will accelerate and yields rise slowly, without any crash in equities.

Interesting to discover that the rally in the 1990s was also at the time considered to be Fed-induced and prolonged. Also interesting to find out that the rally in 1980s, where price also accelerated beyond earnings, was achieved in the opposite environment to today where bond yields were record high and twice as high as equity yields at the time. So for no risk, investors could choose bonds at twice the yield, but still went big into equities as they were at historically cheap valuations and were bought up to mean reversion. Today, investors can choose equities at higher yield than bonds, but equities are conversely at historically expensive valuations. No ‘revaluation’ was required in the 80s, so maybe none is required today and equities will be sold down to mean reversion.

Spikes in margin debt and net investor credit balances to extremes have never previously been resolved in an orderly manner, always leading to bear markets or sharp corrections (as in 2011).

20dece4Source: STA Wealth

If ‘this time is different’ we would need to see an orderly reduction in leverage whilst lots of new buyers come to market. But recall through demographics, net investor populations are shrinking across USA, Europe and China, and this is reflected in declining trading volumes.

11dece3We therefore have a gradually thinning investor population, which adds weight to the likelihood of the current leverage excess spike being resolved in the usual historic manner, namely a deep correction or bear market.

However, in the near term, we could yet see more equities allocation and potentially even more leverage. How much higher could equities run before a bear market or a proper correction erupts? I say proper correction, because none of the pullbacks in 2013 have displayed the usual correction characteristics in terms of depth, duration, and flush-out or spike in breadth and vix. They have been shallow pullbacks, with keen buy-up. To this prolonged lack of correction we can add the deviation in distance above the 200MA of the major indices, the excessive bullish sentiment and the current divergences in breadth, and history is fairly compelling in suggesting high risk of a sharp correction. But again, the question is when, and from how much higher?

The 2007 top in US equities was marked by a steeper ascent in the last 12 months of the bull, but this is beaten in steepness by 2013’s rally. In fact, stocks have moved into a parabolic pattern:

20dece12Source: Sy Harding

Parabolic rises are typically resolved in a crash of similar steepness and depth. Comparisons to 1929 are valid if we consider the parabolic ascent, exuberance extremes in valuations, leverage and debt extremes, and a ‘this time is different’ mantra. Where 1929 differs is that it was the culmination of an economic boom with a demographic dividend. The current episode is neither.

History suggests a combination of internals degradation, buyer exhaustion and one or more ‘triggers’ are the likely terminators of a parabolic bull. We see breath divergence, but this should yet degrade further. In a normal topping process, there would be thinnest participation at the final push, but if this is a parabolic top, then we should see increasing divergence as we move higher. There is evidence of buyer exhaustion in sentiment and leverage extremes. We lack the trigger or triggers for the shift in perception. One potential trigger is the earnings season in January, as negative guidance is at a record extreme. A second is that the boost in GDP due to inventory build is likely to be reversed ahead as inventories give-then-take. A third potential trigger is if we see evidence that the current pick up in growth turns out to be a peak in growth rather than a new dawn.

22dece6Source: Moneymovesmarkets

The above chart is derived from OECD’s leading indicators and predicts a peak in industrial output between Dec and Feb.

The case that we are in a new secular bull market for equities relies on growth picking up in a meaningful way from here. For forward earnings calculations to be valid, GDP next year would have to average over 3% for the year and earnings growth come in around 10%. If global growth were to pick up, then we would likely see relative outperformance in emerging market equities and in commodities relative to developed market equities, as both are at relative cheapness to the latter and both are beneficiaries of a growth theme.

However, the history of demographics suggest a sustaining economic revival is unlikely to occur in the foreseeable future. Collective demographic trends in USA, Europe, other developed countries (aside Japan) and China are now both recessionary and deflationary, and we can see that in evidence below:


Source: dattaman


Source: Yardeni

The only G7 country in a positive inflationary trend is the only G7 country in a curent demographic tailwind window: Japan.

The demographic trends are pretty fixed on a medium term view, and historic evidence suggests that government / central bank intervention cannot force people to borrow or spend. Hence we see continued weakness in bank lending in Europe and the US, and real final sales of domestic product at previous recessionary levels.

5 years after the financial crisis, ZIRP is still in place across most of the developed world, and large QE programmes are still required in USA, UK and Japan. The global economy is fragile, and this puts it risk of rising bond yields and/or commodity price increases snuffing out any pick up in growth, as the former two tend to accompany the latter. The US cannot afford bond yields to rise much further because it would have a detrimental effect on interest sensitive sectors such as housing and autos (and also because of the servicing costs of its ballooning debt), whilst rising commodity prices, particularly energies, are input cost drags on all sectors.

To sum up, from a pure statistical perspective, removing any notion of the bigger picture, the probability for 2014 is at best a flat year for equities with a significant drawdown on the way, and at worst a significant down year. Stats are just a guide, but we see united predictions across a range of measures, drawn together at the top of the page.

However, when we look at similar episodes of stock market rises without earnings growth, similar outliers in stock market valuations to now (market cap to GDP, Q ratio, CAPE), similar historic spikes and extremes in margin debt, and similar extremes in bullish sentiment or euphoria as are currently in place, the same mirrors from history keep cropping up: 1929, 1987, 2000, 2007. Together, these signals point to something more historic and devastating at hand, and the ‘fundamentals’ for that occurring are provided by demographics. Yet the bullish momentum of the market and ‘this time is different’ thinking (Fed trumps all, equities need revaluing due to suppressed bonds and cash yields) are making for widespread complacency about (and dismissal of) the parallels.

Whilst we should not overly rely on any one indicator or discipline, it’s the collective case that gives me such conviction on the short side (disclosure: short stock indices). Now do me a favour and give me a convincing case below for why equities will rise in 2014.

New secular stocks bull market?

Did a new secular stocks bull market effectively begin in 2009 or 2011, with the recent breakouts above secular bear resistance making for a golden buy opportunity?

26nove16Source: Marketoracle

Or is a secular stocks bear still in progress and we are on the cusp of a major shorting opportunity, together with a GOLD buy opportunity?

26nove17Source: Marketoracle

26nove2Source: Approximity

The case for the stocks secular bull market would be that valuations washed out sufficiently from the peaks in 2000 to the lows in 2009, that central bank stimulus is doing enough to offset collective demographic down forces, and that exponential technological evolution will drive increasing profitability and economic growth from here. Here are a couple of charts I produced last year, pre demographic research, showing the secular bear p/e valuations progress, with the lower chart showing how I expected breakout in 2013 followed by retest of the breakout level in 2014, before secular bull momentum took hold.

26nove9 26nove10


That projection was based on historic patterns, and still seems reasonable to me, if this is a new secular stocks bull. 2013 has indeed seen the ‘pentagon’ breakout in the major global stock indices, and a successful retest of the nose of the pentagon in 2014 would reset some of the froth we have built up this year as well as giving technical validation to the new bull.

However, since my demographic research, and broader thoughts progress, I have been more convinced of secular bear continuation, and the megaphone projection above. The case for secular bear continuation includes unprecedented collective demographic downtrends and overvaluation of equities by other measures. Here are Doug Short’s 4 valuation measures all showing historic overvaluation extremes, excepting the 2000 outlier:

26nove18Source: Dshort

There is a case for a breakdown to -50% if historic patterns are to be maintained, before a secular bull could be considered. The doubt is if 2000 was not an outlier but the new norm, namely a racheting up of higher and lower valuations, perhaps as a result of technological evolution also ratcheting up. Alternatively, valuations may change in context – namely that in this current era, ZIRP and QE have killed the attractiveness of cash and bonds, and we are therefore in an era where stocks are relatively more appealing:

26nove1And commodities? Deflationary demographics may have terminated the secular commodities bull before expectations, i.e. without a collective final mania. Or commodities may yet perform as late cyclicals, making a final ascent into 2014 that tips the fragile global economy into recession. The commodities indices are still in large triangles, since 2011, and whilst they remain so, the latter remains possible.

If, however, deflationary demographics are working their way through the commodities complex, then, by my research, there still remains a place for precious metals to shine, as the anti-demographic asset. The third chart down above in this post shows the progress of the dow-gold ratio, and also suggests the two secular possibilities. One, that the rising long term channel shows a repricing in the ratio in favour of equities (due to tech evolution) which means higher bottoms for the ratio and higher tops, i.e. the 2008-2011 lows were sufficient. Or two, that the fiat capital era has produced ever increasing extreme swings, which suggests the ultimate low in the dow-gold ratio is still ahead and will be the lowest yet.

Of course this will all become clear with the fullness of time. If demographics overcome central bank actions and tip the world into deflation, recession or both, then I expect stocks to lose and gold to win. If central bank actions together with tech evolution are overcoming demographics, then we should see a gradual strengthening in economic growth and profitability which should mean stocks (continue to) win and gold loses. Somewhere inbetween would be the scenarios in which rising yields or an inflationary shock (speculative run in commodities) or both tip the world into recession, which could reset stocks to some degree but keep both secular options open.

Back to the near term, we continue to see signs of froth in equities as well as signs of a melt-up in progress. That makes it difficult as it suggests it not prudent to go long here, but the short opportunity that it is setting up could be yet, 5%, 10% higher or even higher. Depends how crazy things might get, and if this the solar maximum then that potential is there.

26nove11 26nove1226nove526nove7






Stocks, Gold, Money Supply and Debt

Here is a chart from Gary Tanashian through SlopeOfHope’s charting facility, which could be argued legitimises the current steep ascent in US stocks:

24nove1Parabolic money pump, steeply rising corporate profits, and therefore equities going vertical (on a long term view).

In fact the sharply rising monetary base is directly contributing to those rising corporate profits, as government spending (debt) has been the key driver of corporate profits since 2008:

24nove2Therefore, if the US Fed begins to withdraw stimulus, disappointment in corporate profits is likely, as the chart shows the traditional profits driver of private investment has collapsed and not recovered over the last few years. Once again, this fits with demographics, and we should therefore not expect private investment to ramp up significantly again any time soon. So it’s in the hands of the US government and Fed. Maintain or increase stimulus, corporate profits should keep rising; decrease or end stimulus, corporate profits should retreat.

Turning to the monetary base, equities are not the only correlated class. In fact, gold has had a tighter correlation, until 2013. Here 2000-2012:


Gold displayed a similar correlation with government debt, also until 2013.


Source: RockSituationReport24nove5

Source: SlopeCharts

The first shows the debt limit, which will be back on the agenda soon, and surely must keep rising, whilst they retain the need to stimulate, which they will due to demographics. The second shows debt as a percentage of GDP, which actually fell back a little in H1 2013 (my extension on the chart). The reason for that was better than expected economic growth and a trimming in certain areas of government spending. Total debt continues to rise at a historically rapid rate.

So are these correlations with gold broken, or is gold set to come back? One more chart shows that the US dollar and treasury yields have been largely inversely correlated with gold and the pair strengthening for much of 2013 has been a key factor in gold’s decline:

24nove6Source: SlopeCharts

In my opinion, gold’s relations with money supply and debt levels are logically sound, and both money supply and debt should continue to rise into the future under the demographic trends. I therefore I expect gold can restore its bull market if the US dollar and treasury yields tip again into sideways or declining trends. If the US economy strengthens and a little inflation is restored, then this is unlikely to happen and gold will remain in the doldrums. However, demographics and debt suggest the Fed will have to keep fighting to maintain growth and keep deflation at bay (taper disappointment, yields suppression, new measures to attempt to inflate), which could bring about such a reversal in fortunes.

I still expect equities can go a little more parabolic first, under a typical solar maximum speculation push. However the warning flags already in place of dumb/smart money, trading volumes, margin debt and trading credit balances, and overvaluations (e.g. Q ratio) suggest it is most likely limited in duration and size. I would go with something like this from trader Moe:

24nove7Source: Trader Moe

A further 10% gain in a rapid time, with a catalyst being collective major breakouts in the major global indices, to get to some crazy extreme indicator readings, and a subsequent termination. My first checkpoint is the start of December, because the 3rd is the new moon and as of the 4th geomagnetism is forecast to ramp up again. If equities can rally hard and fast into that point, with a spread of indicators flashing, then I would suggest that could be the earliest point for declines to set in (barring any external shocks). If, however, equities can rally through the seasonally strong Xmas period, and solar intensity stays high into the beginning of 2014, then the next checkpoint would be early January.


State Of The Markets

Starting with the equally-weighted commodities index versus the world equities index:

17nov11Source: Bloomberg

Commodities remain depressed but still within a large triangle. Last chance though here as the triangle compresses and they test horizontal support again. Their underperformance, based on supply and demand, is consistent with the demographic trends now in place in most of the major nations.

World equities broke out of their mid-year range, rendering the potential topping process redundant. That means equities need either to start over a multi-month topping process at some point ahead, or make a parabolic top instead. The increasing rate of gains, shown by the trend, suggests the latter could potentially occur (or be occurring), and this is supported by increasing evidence of a solar maximum taking place now:

17nov13Historic solar maximums have been correlated with speculative manias, such as Nasdaq 2000, Nikkei 1989, gold 1980 (last 3 solar maximums). I anticipated that commodities would be the speculative target for this solar max but there is reasonable evidence that such speculation froth is taking place in equities, as the next 5 charts show.

Firstly, Hussman’s long standing bearish call on the markets has to be taken with a pinch of salt, but the ‘bubble’ technical overlay shows what could be occurring:

17nov6Source: Hussman

Secondly, the steep wedging of both the SP500 and volatility indices is also indicative, and suggests both could be heading for a pop:

17nov5Source: Chris Kimble

Third, the situation for free cash in margin accounts together with margin debt levels reveals a dangerous extension, which is also suggestive of excessive speculation:

17nov3Source: Dshort

And fourth, a lack of hedging to go with that:

17nov2Source: Sentimentrader

Finally, fifth, the rally is now much more weighted into the hands of traditionally ‘dumb’ money rather than ‘smart’ money participants:

17nov1Source: Sentimentrader

On the flip side, we do not see significant deterioration in breadth nor rotation into defensives that would ordinarily warn of a top in the markets. The next 2 weeks are the positive lunar fornight so there is a reasonable chance that equities continue to rally through that period, and indeed could feasibly carry that through the traditionally strong Xmas period into the beginning of 2014. I believe the technical breakouts and steepening trends in stock indices together with the solar-inspired excitement could potentially make for a parabolic finale here. It’s a tough one to call because of the extremes already reached in some of the indicators above. Complacency is high and it has been a long time since a 10% correction. Stocks are also overvalued, historically, as the Q-ratio and CAPE reveal:


17nov8The 2000 outlier shows how much further overvalued stocks could feasibly yet become, but that anomaly aside we can see that by both measures warning signs are flashing. What could tip the market over? Rising rates (bond yields are back on the rise), an inflationary shock, or a deflationary shock. Normally, stocks would tip into a cyclical bear under excessive inflation. Right now we see the opposite. Take a look at the rate if disinflation in Europe:

17nov9Source: Yardeni

Add to this a crisis emerging again in emerging Europe, and I can see a case for the ECB taking to QE. If that were to occur, then maybe commodities can catch a bid again and make their speculative rally, under a brief but significant inflationary shock. Chris Carolan’s solunar model for crude oil paints the possibility that oil could come back here:


Source: Spiralcalendar

If the whole class cannot rise again, then precious metals alone could, under a deflationary shock, i.e. the world tips into a deflationary recession. This could occur with further commodity falls dragging global inflation rates yet lower. Emerging markets such as India and Brazil are in trouble again with low growth and high inflation, sinking currencies and debt problems. And leading indicators suggest global growth could be tipping over as of year end in the developed nations:

17nov10Source: Moneymovesmarkets

Under deflation, equities would normally fall hard and fast, to the lower ranges for CAPE and Q ratio above. That would likely mean sub 2009 lows in nominal terms. But under inflation, equities normally more slowly wind down to those valuation levels, and in nominal terms the damage is less severe. Under deflation the US dollar should rally, whereas under inflation the US dollar should break down. The US dollar was on the cusp of a major breakdown several weeks ago but has since rallied away from oversold and overbearish conditions, leaving both possibilities on the table, and its performance from here should be a key signal.

Right now, the deflationary outcome looks the most likely, which would make a short on the stock indices a very tasty trade. However, before that there is the potential for stocks to climb further, and possibly at an increasing trajectory. That makes for difficult timing. With the positive lunar fortnight right ahead, and momentum still with equities, I am expecting stocks can rally further in that period, barring any external shocks. But with various high danger levels already reached for this stocks bull, I am looking to build short here, not chase long. Regarding commodities, I continue to watch and wait, still long the complex, but not adding. I believe precious metals will come again, due to the unprecedented demographic downtrends, but am less sure about the broader complex due to the demographic impacts on demand. But let’s see – the moment of truth draws nearer – see below – and I don’t want to try to front-run or second-guess it. A speculative and final rally in commodities remains a possibility whilst the complex continues to consolidate up high. Yet if they cannot rally, and break down below the major support, I believe the global tipping into deflation will accelerate and kill equities in due course.

17nov14Source: Martin Pring

Demographics In Play

Demographics may be a long term theme but I believe it very much has relevance in trying to work out what’s next for the markets.

US demographics turned around 2000. Here we see US GDP changed trend around the same time, and with US demographics negative for this decade, that trend should continue. To be clear there are large oscillations within that but the overall pressure is down.

25sep20131Source: Scott Grannis

Here is my demographic (weighted) composite again for the main 5 economies of the world.


And here is real global GDP, which again matches the trends in global demographics (represented by the line overlaid):

25sep20132Source: TheNextRecession

In short, the demographic trend is recessionary, and I believe the global economy will at some point get the trigger or catalyst to tip into negative growth again, either through excessive bond yield rising tightening or through excessive commodity price rises, which would be a temporary inflationary shock. I say temporary as I previously also showed the relation between demographics and inflation/deflation which show the trend in place now is price deflationary:

“A swell of people aged 15-20 entering the workforce works up price inflation through spending, whereas more people entering old age relative to the work force is disinflationary through saving and disinvestment.”

The Fed is targeting 2.5% inflation, but the demographics say this is unlikely to be achieved. Also, GDP is going to remain weak and central banks are going to need to maintain intervention.

The latest US inflation rate came in at 1.5% annually. This is lower than most current treasury yields. The Fed wants inflation to be higher than yields in order to reduce its ballooning debt (by inflating away). Bond yields may still be historically low, but the demographic trends in place mean that inflation is low and growth is low. It wants to stop yields rising to 3% for fear that this level would be enough to tip a weak economy and to prevent it entering a deflationary trap where bond yields exceed inflation. Indeed the Fed’s Bullard has said that if inflation dropped to 1% annual he would want QE to be increased.

Which brings us to commodities. Can they rally? The demographics are largely against, as demand should erode and hard assets perform best in inflationary trends. On the flip side, the easy money conditions mean a loss of appetite for stocks could see money flows into commodities in a speculative momentum rally. History would suggest they probably can as late cyclicals, but history has not seen this collective demographic downtrend before between most of the major economies.

If I was to advise on a buy-and-hold portfolio for the next few years (I am not an advisor, don’t follow me etc) it would look something like this: long japan equities (positive demographics for stock market), short usa/europe/china equities (negative demographics), long gold (go-to asset as anti-demographic), short energy, short real estate, long cash with bias to asia currencies (all deflationary).

Russell Napier believes that there is trend-following in place in equities currently, but that eventually perception will turn to how QE and ZIRP have failed over 4 years to return the US to normal growth and stocks will turn bearish. I agree that this will happen and see developments ahead that can force it. If the US pulls back on government spending (debt ceiling 30 Sept) or stimulus then earnings should decrease (as per recent post) and yields should rise further, respectively. If commodities make a speculative rally they are likely to tip the weak economy over, and if they continue to decline in a deflationary trend then US inflation is likely to fall yet further beneath bond yields. In short, the Fed is in a trap, and it is a demographic trap, and a particularly potent trap because of the collective demographic downtrends amongst most developed countries, making for a downward global pressure. I don’t believe it can create sustained inflation or normal growth UNTIL demographic trends change. Collective demographics do start to improve once we get to the end of this decade, but over the next couple of years I believe there is really no way to avoid a global recession and harsh nominal stocks bear. Either yields, commodities, reduced goverment intervention or increased government intervention should tip a fragile economy over.

What does that mean for trading? Well, for me personally, I like to play an asset one way, siding with the longer term trend. If it goes against me nearer term, then I can use money management and averaging, with the conviction the longer term trend will ultimately drive it. So my anchoring would look something like that imaginary buy-and-hold portfolio I posted just above. Right now I am long energy (oil and gas commodities) which is a concern if deflationary trends dominate. However, solar cycles / historic topping order / easy money speculative conditions may yet deliver the decisive rally that I seek, so I’m going to carry on holding for now. With equities I am looking to build on the short side from the current position but am looking for more evidence of stocks topping. The technical action of the last few days has added weight to this, but we still don’t have ‘enough’ all round evidence. But this is trying to be as accurate as possible with timing, for the yearly trading P&L. I have sold my other longer term equity-related investments over the last couple of months and moved them to cash.

State Of The Markets

No collapse in the stock market, which makes the case stronger for a more regular multi-month topping process. It would be historically normal for equities to retest their May highs and even make a marginally new high, then complete a volatile trading range by around September time before falling in earnest.

Also historically normal would be if commodities outperform from here, with bonds having topped first, then stocks topping, and eventually commodities topping out, likely in 2014. The continued falls in bonds – and rise in yields – adds weight to bonds having topped – and yields bottomed – in 2012. Now are world equities in the process of making their top?:

7jul4Source: Bloomberg

The strong advance in crude oil of late has added more weight to commodities going on to outperform here, rather than the historically abnormal but deflationary case of commodities sinking. The combination of protest and unrest in Egypt together with speculation in crude oil are both historically normal for a solar maximum, so I am encouraged. Nonetheless, crude oil has yet to truly break out and some geopolitical dampening could pull it back:

7jul1Source: Stockcharts

If crude does continue to rise, then commodities as a whole should catch a bid, due to high historic correlation, with oil a a key input in the agri process and a key inflationary force, which brings us to gold. Gold has dropped around 30% from its 2011 high, which is similar to the percentage drop made in 2008. It has the potential to be making a bottom here with a higher low than in late June, and the longstanding overdue bounce based on extreme bearishness, but only if it can rise this coming week, which brings back to oil’s performance, plus also the US dollar.

The recent strength in the USD has taken the currency to back up to a key level. Below is the long term view and the potential for an important breakout:

7jul6Source: Rambus / Stockcharts

However, as per my demographic work, I believe leading indicators will weaken and gold will re-assert itself, and US stocks will top out here reducing demand for the dollar. Here is some evidence to support that view.

The latest global PMI combined services and manufacturing dropped to 51.4 from 52.9 and continues the overall weakening trend over the last few years. This is as I would expect under the combined deflationary demographics of USA, China and Europe since around 2010.

7jul7Source: Markit

The performance in corporate bonds suggests US housing may be about to turn down again also:

7jul5Source: Martin Pring

And margin debt continues to look an important pointer for the stock market. See below how a sharp run up in margin debt, a final parabolic rise, precedes the 2000 and 2007 tops in the SP500 by several months. We have seen a similar parabolic rise since mid-2012 to now and there is the possibility that margin debt peaked out in April which would suggest stocks should indeed be in a topping process now and over the next couple of months:

7jul8Source: Dshort

If stocks are topping out then normal clues would be found in negative divergences in stock market internals and leading indicators. For the former, we should look for breadth divergence once we see a retest of the highs. For the latter, we have the potential in the global PMI above, but also in this leading indicator of leading indicators, by RecessionAlert:


Source: RecessionAlert

I have enquired with them what this MBS indicator is, but have no reply. If anyone knows, please share. But it would fit with my demographic-deflationary expectations.

We also see a potential divergence in geomagnetism, if equities can now rally again to a retest of the highs:


The ideal combination by my work and research is for commodities to outperform again now into next year, and make a speculative peak near to the solar peak (the timing of the solar peak remains unknown, with the experts still diverging. Sunspots are currently back up over 100, which adds to the muddy trend), then deflationary demographics to mean the global economy fairly quickly tips into recession under that commodity price pressure, and then we should see the steep falls in nominal stocks. My alternative scenario is that the deflationary forces are too great and commodities in general sink with just gold, as the anti-demographic, eventually coming again alone.

In support of my primary scenario, the action in live cattle has been very much aligned with solar history, with what looks like a peak earlier this year:

7jul10Source: Tarassov

7jul11Source: TradingCharts

Now we need to see other commodities make a fresh rally to new highs, assuming a solar peak is still ahead.

This week we have the new moon on Monday and the end of the lunar positive period by Thursday. So I am ideally looking for equities to rise further in the next couple of days and make that retest of the highs or marginally higher high, then retracing again in the negative lunar period ahead, to further the technical look of a topping process. If we get that retest of the highs then I will be looking to sell equities longs and add short. But for further support I would like to see oil break out, commodities to rise en masse and the US dollar to be turned down with gold catching a bid at last. Let’s see how the action unfolds.