Dead Cat Alert
The stock market is currently bouncing in a decidedly 'deceased feline' fashion. A better late than never Santa rally, I guess, so enjoy it while you can. But the global economy is still reeling from last year's double barrelled attacks from a hostile FED and Trump's trade war. Investors are now left to clean up the detritus from the tsunami of economic downshifts that have been the result of tight money and diminished investor confidence. And by the way, the core problem that has to be addressed is domestic China policy, not trade or the FED.
China started its most recent downdraft shortly after President Xi's elevation to leader for life in Q1 last year. In a risky attempt to reign in bad debt problems created by unfettered shadow bank credit creation, Xi tightened fiscal and monetary policy. This was especially punitive to the massively indebted SOEs (State Owned Enterprises), with predictable results. The latest Chinese PMI reading has decelerated, dragging with it other economies like Germany, Brazil, India and Japan. The price of copper has confirmed this, sitting at two year lows (chart below).
State enterprises, dominated by infrastructure entities, are the achilles heel of world's largest command and control economy. Bloated by multiple attempts to prop up economic growth over the past decade, they are choking on debt. Meanwhile, the shift to a more consumer oriented economy has hampered demand for their products. China now has plenty of 'highways to nowhere', that lead to 'ghost cities' full of millions of unoccupied factories and housing units. Unsurprisingly, decrees from bureaucrats in Beijing were never going to create the most efficient allocation of scarce capital. The debt piper is now asking to be paid.
Chinese Lending Slowing
And for good measure, throw in Trump's China tariff power play, designed to reign in the nascent superpower, and voila, decelerating growth! Effectively, China is in a growth slowdown that shows no signs of bottoming.
To be fair, the policy makers in the Forbidden City have been softening the blow a bit with recent reserve requirement cuts and lending standard relaxations, but they are definitely pushing on a string in the short term. More bad news awaits.
With Apple's announcement of disappointing sales in China, corporate America's previously assumed immunity to the problems in China have now been revealed as the fraudulent musings of wishful-thinking MAGA isolationists.
An exasperated Jim Cramer wants to keep blaming Powell for the market decline. But unless my math is wrong, Apple, with a cash hoard in the hundreds of billions, should have benefitted from any rates hikes. Tim Cook has some 'splainin' to do.
The narrative of a FED engineered market correction has become a convenient scape-goating exercise for the lazy talking-heads to fill their hour long time slots.
And by the way, the FED was just doing its job! Unfortunately for the stock market, the job description for the FED is hopelessly out of synch with today's globally integrated economy. For an institution that is effectively the central banker to the world, they have a decidedly inappropriate mandate. Congress has charged them with the task of controlling U.S. domestic labour and inflation conditions, no more, no less. By being data dependant, but only using domestic data, Powell and company are blinded to the global forces of deceleration that have washed ashore recently.
Often the FED has been accused of driving in the rear-view mirror, using hard data that lags forward looking-asset markets. We can now add to that, a set of blinkers. Weak data from foreign economies has, until now, been conveniently ignored by the U.S. centric model-happy FED. The translation of widespread global weakness into the U.S. economy has been a lagging variable, especially given 2018's massive one-time tax-cut. But now, as evidenced by Apple, global weakness is now becoming visible to U.S. based multinationals, with damaging effect.
So with his data dependant, blinkered construct firmly in place, it will be increasingly hard for our economic jockey, Mr. Powell, to get the economic soft-landing horse into the barn.
You might say 'he's just doing what he's told'. But that's biggest problem I see. The futures markets have swiftly priced out any rate hikes for 2019. If Trump and XI pull off any kind of trade truce, that optimism will evaporate, putting a series rate hikes back on the table.
That is the biggest threat I see with a rally based on smoothly restored trade relations with China. Remember - "bad news is good news" not the other way around. I would rather see enough deterioration to actually prompt monetary easing. Europe is headed that way for sure after this morning's pathetic German IP numbers.
Bottom or Dead Cat Bounce?
Its one thing to construct a 'cease fire' on the China-U.S. tariff dispute, but quite another to develop a revamped framework of lasting economic co-operation. In the last week, building on the market lows engendered by the perceived dovish shift (inside thought: show me) in FED intentions, investors have now decided to bottom-fish the beat-up equity market. This has created 'V' shaped bottom in the charts. Although rare, such bottom patterns have occurred in the past. I can remember similar lows, as they came after the major bear markets such as experienced in 1982 and 2008. But these binary bottoms were created by sudden, massive reversals in monetary policy, marked by discount rate cuts of substantial proportions. No such outcome is likely here.
I don't believe we will see a fairy tale ending to the current crop of fundamentally intractable problems. I'm in a muddle-through mode after seeing the latest market technicals. The damage done in December in terms of breadth and volume will take multiple iterations to repair. The chart below shows a price and volume study for the NASDAQ ETF the QQQ. Notice how volume did not confirm the Sept - Oct new highs. To confirm a low of durable proportions, I would like to see the December low tested with a similarly unconfirmed volume reading. Failure at the downtrend line around $162-164 is a distinct possibility.
$QQQ - Price & Volume
A more likely outcome is a period of base-building as the competing forces of cheap valuation and decelerating fundamentals play out in a range-bound environment. Think: SPX between 2400 and 2600. Hedge strategies should be rewarding over this phase of this market. Defensives and Quality (defined by strong balance sheets) should dominate Cyclicals and Growth.
Bonds have done their job and yields should start to rise, especially due to massively increased Treasury issuance. Oversold commodities, especially oil, are bouncing on trade optimism, but I would not chase them. Agricultural products should benefit from any China trade deal. The ETF play on this is showing good net volume flows (CMF indicator - top panel) and should a good play. Grains are the low hanging fruit (yah I know the difference) for any commodity rally.
Invesco Agriculture Fund
Although we probably have seen the worst, a recovery in damaged sentiment and volatility measures will take time to back and fill, as repeated geopolitical threats and decelerating earnings estimates loom as problems still to confront to the pollyanna buyers of today.
Most importantly, my two favourite economists, Dr. Copper and Professor Yield Curve, are still signalling caution. They have been sage counsel over the past year and their track record has been impeccable. Too bad they aren't eligible for the Noble prize. I would take them over Schiller and Krugman any day.
Risk Model 2:5 - Risk Off
AAII Sentiment, Copper/Gold and Volatility are still the troublesome flies in the market ointment. Markets have bounced into a seasonally strong January, but remain poorly supported by fundamental improvement. Earnings 'confession' season is upon us and the weak top line sales environment that companies are facing is an earnings challenge, given increased labour compensation stemming from the full employment backdrop.
AAII may confirm the rally this Thursday, but it will be late to the party. I would like to see a consistent rising trend above a stable-to-rising 30 week moving average, indicative of broader investor confidence, before going all-in on risk. The chart below shows a capitulatory sentiment low has been marked, similar to the 2016 growth slow-down, but even that low was tested before a rising trend was established. Again... Dead Cat Alert!
AAIIBULL/BEAR RATIO vs 30 WMA
2014 2016 2018