Economic Demise Ahead?

There are some that believe a tightening yield curve is a harbinger of a bad economic times ahead, with a good possibility of the economy failing into a recession. If this were true, the chart below should be of concern as interest rates are in their tightest range in many years.

The fact is, the correlation between tightening rates and economic weakness is poor and provides little to no edge if used in making investment decisions. What does matter though, very compellingly, is when the yield curve inverts (short term rates are higher than long term rates), something we are in no danger of seeing happen anytime soon. Until that occurs (and it is worth monitoring because of its very high negative correlation to stocks), recent interest rate cks), recent interest rate activity is reflecting FED activity and forecasts, not economic demise.

Island Reversals

There are many recognizable patterns that prices develop in technical analysis but few are as important as island reversals (also known as an “abandoned baby” in Japanese candlestick lingo). An island reversal is a reversal pattern that forms with two gaps and price action in between the two gaps. These gaps tell us that the island reversal marks a sudden, and sharp, shift in direction. Even though they are relatively uncommon, island reversals are potent patterns that warrant our attention. The islands can be formed either at the top or bottom of a stock’s price movement, both indicate the prior trend is done and price has reversed.

The alignment of the gaps holds the key. First, note that a bullish island reversal forms with a gap down and then a gap up. A bearish island reversal forms with a gap up and then a gap down. These gaps overlap to create an island of price action, hence the term “island reversal”. The island is above the gaps on a bearish reversal, and above the gaps on the bearish reversal.

As you can see in the chart below of the Nasdaq 100 index, QQQ, it created a bearish island reversal on Monday when price gapped down below the gap created in the early March move higher. Why islands are important is because traders establishing long positions on the island (and maybe those who initiated on the rise into that island) are now trapped with losses. As such, if price were to move higher from here, closer towards the open gap, you would expect a large supply (sellers willing to sell) to quickly slow, stop, or reverse the advance as those late buyers exit their losing positions. You have often times heard me reference this as “resistance”.

The stock market is in a trading range and looking for a catalyst and there is an important FOMC meeting today, 3-21.  It is important because the Fed began increasing interest rates at the last meeting. Traders want an idea of how often and how much the Fed will raise rates this year. The meeting creates uncertainty, which is a hallmark of a trading range. And trading ranges need a catalyst to bust out. As such, the odds are that there will be a big move after the report. Unfortunately, the move can be up, down, or even in both directions. We will only know the answer after the fact. Either way, strap in as I expect some fireworks in the coming day(s) and to discover whether this island top reversal pattern will be an accurate predictor of the short to intermediate term future.

What You Want vs. What You Need

“The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” - John Maynard Keynes

 “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” ― Sam Ewing

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We all understand the destructive effects of inflation has over time but what happens when inflation is as low as it has been over the past 20 years? What you say, inflation has not been low? Your personal experiences says otherwise? Our Government’s Bureau of Labor Statistics (BLS) begs to differ. Prices on average over the past 20 years has been 55.6% which works out to be an annualized rate of ~2.02%. One of the lowest 20 year periods …. Ever. So who’s right?

 The problem as we uncover when peeling back the onion, is how the BLS calculates its numbers. To avoid going down that rat hole into a hornets nest, it’s safe to say that inflation is the sum of the prices of things that are rising and the rest that are rising more. Unfortunately, as it works out, the things that you want are rising while the things you need are the things that are rising more. This has never been so apparent than in the most recent 20-year data presented in the chart below.

 One scrutinizing the chart may point out that food and beverage prices (a need) have been rising at an “average” rate. The devil is in the details here too. Looking under the hood you will see the things that are healthier (unprocessed and natural foods) are rising at a much faster rate than things like fast food. Oh and while I do have some millennial readers, no, cellphone service is NOT a thing you need.

Too Far, Too Fast?

Turning the calendar to 2018 kicked off an exciting run in stocks as the market moved up almost 4% in 9 short trading days. In 8 of those 9 days the market closed higher and the one red day was down a whopping .1%. These euphoric-type moves can’t last forever especially when you consider how far price is from its 200 day moving average. Bullish RSI momentum has reached an extreme as it exceeded its all-time highs in the SP500, ever. When things become so stretched in one direction the markets need to rest and digest the moves, as such it would be normal and health to see a correction or a consolidation at a minimum.

Looking at the SP500 chart, you can see Tuesday gapped higher at the open and eventually closed below its open and down for the day and with large volume. This is clearly a distribution day. A day when the big money made some moves, locking in some profits. Anytime they speak, we need to listen. Keep in mind it was not just the SP500 that acted this was as almost all US and most foreign indexes followed suit.  Tuesdays’ action in stocks, while not surprising, was a warning shot to the possibility of a short term reversal. One could argue that “short term” price movement is only applicable to traders because investors have a much longer time horizon so there is no need to be concerned with them. This is a true statement but I find being prepared for any possible correction helpful to stay the longer-term course.

In an ordinary market, this gap higher and subsequent fizzle would be a huge red flag and a strong short signal. Unfortunately this is not an ordinary market and normal rules do not apply. We’ve seen poor price action over the last few months, but prices rebounded decisively within days, if not hours. Yesterday’s fizzle is still a significant concern as it usually is a sign of the start of a near-term dip. But without a bearish headline catalyst to drive fear into otherwise confident bulls, I don’t expect this selling to go very far or to dampen bulls’ conviction. If they refuse to sell, then it is much harder for a dip to take hold.  Complacency will eventually get us into trouble, but over the near-term confident owners keep supply tight by refusing to sell every bearish headline and any negative price-action. That said, at some point this unsustainable climb higher will falter. When that occurs is anyone’s guess. There is only so much money willing to chase these record highs even higher and yesterday’s daily reversal suggests we may be getting close to that point, at least over the near-term. One day does not make a trend so we will need to see what sort of follow through, if any, occurs over the next few trading days. If not, it yesterday’s action will just be another bump in the road.

Either way, I don’t trust this market, but because markets can be irrational for longer than we can expect and more importantly it keeps doing the right thing means we stick with it.

Will 2018 Bring the Return of Inflation?

The strength of the global economy is one reason why the stock market has started 2018 in a buoyant mood (with the Dow passing 25,000). At some point, in any expansion, businesses find it harder to recruit workers or get the materials they need; these bottlenecks cause wages and prices to rise. Central banks then start to tighten monetary policy, a process that can eventually turn the market (and the economy) down (recession). For years the US has been in a deflationary environment in spite of the FED’s ongoing attempts to do everything possible to create inflation but that looks like 2018 may signal a change.

Because commodities rise in an inflationary environment, following their price can be very profitable for investors in the back-end of the business cycle. The $CRB index is a basket of 19 liquid and highly diverse individual commodities is about the best proxy I have found which can help determine the direction of commodity prices. Taking a look at the chart of $CRB we see the index has been in a severe downtrend from 2014-2016 and after bottoming has consolidated sideways for 2 years. But it looks like it may soon change as it is attempting to breakout to the upside.  The consolidation is forming an inverse head and shoulders bottom pattern which projects, if it breaks out and confirms, to the 2015 highs, almost 30% higher.

I have learned the hard way that commodities are a fickle group and are not as reliable as stocks are when looking at charts and attempting to interpret what is next. As such I prefer to get additional confirmation before committing investment capital. What better confirmation than looking at the biggest market of all, bonds and see what, if anything, they are saying. You may be asking what do bonds have to do with commodities. The common thread is inflation so checking in on TIPS (Treasury inflation protected securities) makes a lot of sense.

In the chart of TIPS below you can see that they, like the $CRB index are knocking on the door looking as if they want to break out to the upside. The cup and handle continuation pattern that has formed points to a target move of 5% higher (don’t scoff, that’s a big move for bonds)

Whether we see inflation or not will only be known later in time. With both commodity prices and TIP bonds looking as if they want to go higher, is a signal the markets believe inflation may not be too far around the corner. As with all pattern breakouts, you should never invest unless the pattern triggers and confirms, which neither the $CRB or TIPS have yet done. Until then, it will pay to watch these two closely in the coming weeks/months for investment opportunities. 2018 may be shaping up to be a great year for inflation hedged investments