Two by Four

I went to my local hardware store over the weekend to pick up some lumber to finish off a task I was doing in the backyard and was caught completely by surprise. Granted it has been a year or two since I last had any need to buy a 2x4 but WOW. Of course, I had to come home, jump on the computer and look at the chart of the of lumber. It’s all so clear now.

 As you can see in the chart below, the spot price of lumber has been in a steady uptrend since its intermediate term bottom in Sept of 2015. Since that time, it has risen almost 170% (~2.5 years) and the most recent touch of the trend line support it has risen parabolically.  We know what happens to parabolic rises (they eventually fall back to earth and typically much faster than they rose), we just don’t know when. 

From the chart, lumber looks as it has more upside. Buyers are in control (as is noticeable in the bottom volume pane) and the strength of its rise (RSI momentum in upper pane) is expanding with no divergence in place. Because lumber can be a good proxy for the strength of the economy, its price can provide an early warning sign for the possibility of a slowdown as such it is garners further scrutiny..

The Trouble with Stocks

It should be no surprise to investors that stocks have been struggling since the short term parabolic rise completed back in late January. The subsequent 12% correction followed by extremely choppy, sideways action is not at all unexpected and is unfortunately far from being complete.  Besides this being “normal” action after a double digit decline and an “easy-peasy” 2017 market, investors should look no further for additional explanation than what is happening in the bond market.

As you can see in the above chart of the 10-year treasury yield, it finally tagged the psychologically important 3% handle yesterday (although it actually closed a whisker below), a full 50 months since its last visit. Round numbers, whether they happen in stock indexes, bond yields or other investments are important as they act as magnets for potential future moves. The fact we hit that level yesterday is not a surprise as the setup unfolded in late January (I blogged about this possibility here). Breaking out of it box and moving higher could be a real impediment for the advancement of stocks. Stock investors need to keep a close eye on the bond market right here because as rates rise, eventually yields become attractive enough that  stock owners throw in the towel shunning the wild volatility involved with owning stocks and instead opting for a more steady, fixed return that bonds have historically provided. As more and more investors switch out of stocks and into bonds, stock prices tend to fall as sellers eventually outnumber buyers.

So Far So Good

The Advance Decline Line (ADL) is a breadth indicator that reflects participation. A broad-based advance shows underlying strength that lifts most boats. This is bullish. A narrow advance shows a relatively mixed market that is selective. Narrowness of participation in an advance (or decline) sets up the possibility of divergence signals. An advance with narrow participation is unlikely to keep up with the underlying index and a bearish divergence will form.

Simply, the ADL rises when there are more stocks rising in the index than are falling and vice versa. I find the usefulness of the ADL is if/when it diverges from price as it CAN provide early warnings of a potential reversal of the current trend (it helps find tops in rising markets and bottoms in falling markets). Below is a chart of the ADL and SP500 going back to 1965 and as you can see the ADL has done an excellent job of forewarning of an upcoming correction. Looking to the present market conditions ... so far so good as there is no divergence.

Keep in mind, the ADL is not perfect (no indicator is) and just because there is no divergence does not mean a correction is NOT ahead. Instead it is just another investor’s tool and when used in conjunction with everything else in the toolbox, using a weight of the evidence approach, it can help substantially keep investors on the right side of the market trend.

Morals or Money

For the most part I try to be agnostic to a specific investment for my own portfolio but attempt to be a bit more discriminating for clients. Don’t get me wrong, I am not devoid of investment morals but rather my driving force is to make money. Doing so allows me to use that money to promote and support the companies I believe in. Clearly, no one wants to invest in a “bad” company but the problem is there is no one definition of what a “bad” company is. For me, names like Monsanto and Wells Fargo are a few that are on my list of companies to avoid as they have a history of consistent “bad” behavior. I have learned over the years, everyone’s list of what is “bad” is different. The reason I bring this up is because the topic of this post is about a company that, for me, is on the edge of being “bad”. They are either evil, poorly managed or very, very unlucky. I am not sure which.

Regardless of where Pacific Gas and Electric falls, their chart (PCG), caught my attention. Because of a series of missteps (read ineptitude), their stock has fallen almost 50% since peaking in September of last year. It bottomed in early February while forming positive RSI momentum divergence, the sign of a potential bottom. Since that time price has pushed higher and broken out from a textbook, symmetrical inverse head and shoulders reversal pattern. The pattern’s upside target points to T1, a very close proximity to the falling 200 day moving average and ~20% above the pattern’s neckline (breakout level). Notice in the bottom pane of volume, the breakout was confirmed with an increase of more than 70% higher than its average and also provided a pocket pivot buy signal yesterday. In addition, it gapped higher at the open right in to the unfilled open gap (that will likely be filled) created on December 21-22. When looking at the entirety of the signals, they seem to be screaming “buy me” or better yet, trade me. Any purchase should be considered for now as a short term trade, a reversion to the mean opportunity. What tells me that? Price sits below a falling 200 day moving average. Until it is pointing north and price is situated comfortably above it, this is only a trade. That, of course, could all come to work itself out over time but for now, it should be viewed as only a short-intermediate term opportunity

No one should take the intent of any of my posts as recommendations or promotions to buy or sell a security they are nothing more than ideas to make money. Not only do I not know your risk tolerance but just as importantly, your moral tolerance.

The Fed is Behind but Still Screwing Up

With the markets still in a sideways, consolidative, sloppy, directionless chop, it’s becomes more difficult to identify ideas that aren’t following suit. During times like these I like to share the thoughts and views from other technicians. Not only does it provide a different perspective but also helps to keep investment biases in check. Regular readers know one of the people I respect and follow closely is Tom McClellan. Not only does Tom have a very unique and interesting approach to viewing the markets but his accuracy is very compelling. Today’s post, Tom’s latest hits home on a topic that has me very concerned about stocks continuing their climb higher over the intermediate term.

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 The Fed is Behind but Still Screwing Up

Make me Emperor for a day, and I would compel the FOMC to outsource interest rate policy to the bond market.  Why should we pay 12 experts, most with expensive Ivy League PhD degrees, to do what the bond market can do far more efficiently (and cheaply)?

This week’s chart compares the 2-year T-Note yield to the stated Fed Funds target rate.  The FOMC has actually said that the target rate is 1.5% to 1.75%, so I’m splitting the difference by calling it 1.625%.  What this chart shows is that first, the two interest rates are very strongly correlated over time, which is as one would expect.  But second and more importantly, the 2-year yield knows best what the Fed should do.  And the Fed screws up when it does not listen.

If the FOMC would just set the Fed Funds target to within a quarter point of wherever the 2-year T-Note yield is, we would have fewer and quieter bubbles, and also much less severe economic downturns.  For whatever reason, the FOMC members have not learned this lesson.  None of them, as far as I know, is a subscriber, which is their loss. 

The “Taylor Rule” for setting short term rates is an equation involving figures for GDP, inflation rate, and “potential output”, all of which are numbers which can be fudged by statisticians.  The “McClellan Rule” is much simpler: listen to the 2-year T-Note Yield, which the statisticians cannot monkey around with.  By this rule, the Fed is still being overly stimulative, by setting the Fed Funds target well below where it ought to be.  In other words, the Fed is being “too loose” with interest rate policy, according to this measure.

But complicating that equation is what else the Fed is doing, in terms of liquidating its holdings of Treasury debt and Mortgage Backed Securities (MBS).  During 3 separate rounds of “quantitative easing” or QE, the Fed got up to total holdings of $4.25 trillion.  At the most rapid rate of acquisition, the Fed was buying up $85 billion per month in 2014.

In 2017, the Fed announced it would be starting to unwind those holdings, slowly at first, but accelerating to a rate of $30 billion per month of “quantitative tightening” (or QT) now in Q2 of 2018, and supposedly going to a rate of $40 billion per month in Q3.  So while interest rate policy is still arguably stimulative, that effect is counteracted by what the Fed is doing in other ways, sucking liquidity out of the banking system with its QT.

The Fed was a little bit slow at first in keeping up with its stated rate of QT, but it is catching up now.  One could argue that the Fed is not really selling off these assets, and instead it is just allowing them to expire and not be renewed.  But it is still the case that several billion dollars of debt are having to be absorbed by the market place instead of by the Fed.  It is also true that the size of QE between 2009 and 2015 was small compared to the total amount of federal debt, but it was still important enough to lift the stock market in a huge way. 

Now the amounts of the QT unwinding are pretty small compared to the total debt, but they are having a similar effect of depressing the stock market, just as QE elevated it.  And this is where the modeling gets difficult - interest rate policy is stimulative, by the Fed Funds target rate being below the 2-year yield.  But at the same time the Fed is being repressive by sucking liquidity out of the banking system with QT.  I don’t know how to construct a “balance of forces equation” to depict how those two factors interact with each other, as this is pretty new territory for market history.

But I can say that when the Fed worked hard to reduce the size of its balance sheet in 2008, during the worst liquidity crisis in decades, the effect was pretty direct and pretty obvious.  The Fed blew up Bear Stearns and Lehman Brothers by sucking too much liquidity out of the banking system.

In a text note within this chart, I pose the rhetorical question of why the then-president of the NY Fed, Timothy Geithner, would orchestrate a huge reduction in the Fed’s holdings of Treasury debt during the worse liquidity crisis in years.  Part of the answer can be found in the historical observation that this bear market helped to assure the election of President Obama in November 2008.  And Mr. Obama very quickly appointed Timothy Geithner as his Treasury Secretary.  You can insert your own conspiracy theory here, since I don’t have subpoena authority to investigate contacts between the Obama campaign and the New York Fed in 2008. 

The point of that historical lesson which we should remember in the current moment is that having the Fed reduce the size of its balance sheet carries an enormously powerful effect on banking system liquidity.  My expectation is that by sometime later this summer, the FOMC is going to realize that its reduction of holdings of Treasuries and MBS is creating a big liquidity problem, and they will abandon or curtail those plans.  But it is going to require a lot of damage to the stock market to get them to realize what they need to do.  I expect that realization to hit them sometime around August 2018, and it should lead to a huge stock market rebound into year-end.  But it will be a rebound from a big selloff.