Pivotal Events -- Full Version

By: Bob Hoye | Tue, Sep 12, 2006
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If you read the Pivotal Events excerpt on September 9, click here to read the balance of Pivotal Events.

Signs Of The Times:

"The Fed, which last month left interest rates unchanged for the first time in two years, is the main source of the current [stock market] optimism." - WSJ, September 5, 2006

This goes along with the glowing conclusions by David Wolf, an economist and strategist with Merrill Lynch. When the governor of the Bank of Canada did not change the administered rate earlier in August, the Financial Post headlined "Standing Pat Was the Right Call".

Strategist Wolf raved that the governor's non-move was "Looking Like a Genius".

Well, the way it worked in 2000 was that during the summer, as short rates were still rising, the consensus was very worried about the next increase in administered rates.

As we wrote then, throughout most of financial history rising rates mean that the boom is still on. The time to worry is when market rates of interest start down. Along with the usually concomitant turn to steepening of the yield curve, this indicates that demand for funds to speculate with is diminishing.

After all, inversion has always been driven by the urge to speculate.

So the consensus now is that the end of the Fed's or any lesser central bank's rate hikes is a mark of genius and is good for the stock market. This is nonsense and suggests that when an economist is elevated to the head of a central bank it gives new meaning to the concept of artificial intelligence.

First of all, at the climax of the biggest bubbles going back only to 1873, changes in administered rates by the senior central bank have followed the change in short-dated market rates of interest - usually by a few months.

For example, treasury bill rates turned down in September, 2000 and the Fed dropped the administered rate in the first week of 2001. In 1929, short rates started down in June, 1929 and the Fed raised the administered rate to 6% in early August. Then that extraordinary decline started.

The other irony is that academics ever since have argued that the hike caused the 1929 crash and the depression. In January, 2001 when the Nasdaq had lost over $3 trillion in market cap, op-ed pieces by different writers laid the blame on the Fed's last rate hike.

So this is how the behaviour pattern works. Fully astride the bull market, the consensus in real time celebrates the end of administered rate increases as a plus. Then, when the market is down substantially, the consensus then lays the blame on the last rate hike. Chagrin always seeks a scapegoat.

On this go around, the Fed is lauded for the last of 17 rate hikes of a ¼ point each and, as quoted above, the end of this has prompted "optimism" or, in the case of the Bank of Canada's non-move, "genius".

The next level of irony is that on the biggest booms the last rate hike has been followed by a severe contraction and the most relentless declines in short market rates, with the administered rate in close pursuit.

The Most Substantial Interest Rate Plunges In History

 July, 2000 6% 5133 1.12% 1109
 August, 1929 6% 381 1.5% 42
 November, 1873 9% 441 2% 157

As the stock market began to slide in September, 2000, some within the status quo crowd discovered that they had been had. The adamant faction found encouragement with the immediately circulated notion that the Fed would lower interest rates and that would reignite the boom.

James K. Glassman was using the WSJ's op-ed pages to promote his personal revelations that the Dow would soar to 35,000 and, in December of that fateful year, we concluded that "Market forces will permit the Fed to lower administered rates. That's frequently until the business and stock market contraction ends."

Of course, the theory was that a bubble was an event created and managed by policymakers and that it could readily be turned back on by a brilliantly timed rate cut.

Throughout all of recorded financial history, short-dated market rates of interest have increased during a boom and plunged during the consequent contraction. The senior central bank was able to materially change the administered rate in 1825 and the record is that at cyclical turns (either up or down), it lags the reversal in market rates of interest.

Beyond being merely ironical, the popular theory is a profound blunder. The first level is the unsupportable assumption that the senior central bank can and does make the major changes in interest rate direction - no, it follows.

The second level of folly can't even get the direction of major events right. Booms have never been reignited by declining rates, but contractions have always been accompanied by declining short rates for treasury bills, or equivalent, in the senior currency.

An explanation of how personal revelations about what markets ought to do has become official dogma and could be the subject of an essay entitled "Mother Nature Trumps Keynesian Whims Every Time".

In the meantime, 3-month dealer commercial paper rates reach a high of 5.44% on July 25 as the T-Bill rate reached 5.12%. So far, the lows have been this week's 5.29% and 4.96% respectively.

More importantly, treasury curve inversion (10s to 2s) reached -10 bps on August 28 and has steepened to 0 bps.

At previous cyclical peaks, and although only modest, this change has indicated that the contraction was inevitable.

Stock Market: Since early in the year, our theme has been that market forces were setting up a cyclical peak for the stock market.

One indicator was that the lesser exchanges had blown out in November and the collapse always fed into the senior exchange. The representative Dubai stock market crashed in February.

In the meantime, New York rallied up to what soon appeared as a cyclical peak in early May. The cyclical aspect was indicated by our long-time work on the gold/silver ratio.

In March, it looked like the precious metals would zoom to a climax, in which case the change in the ratio from going down to up would likely signal the top of that mania by three weeks and, in turn, this would soon be followed by the peak in base metal speculation. The latter is usually integral to the peak in the stock market as "every bull market has a copper roof".

As it turned out, the gold/silver ratio reversed on April 19, which indicated that the top would be in the week centred upon May 10. The key highs are tabled:

MAY 5 MAY 8 MAY 9 MAY 10 MAY 11
S&P Nasdaq London
DJIA Base Metals

The action since (nickel is exceptional) has the appearance of a cyclical top, with some of the key highs being tested now.

Lately the stock market is fitting a ChartWorks pattern that had to reach a certain upside momentum by August 11. This was a "make or break" requirement, so it didn't "make" it.

(Editor's Note: Following is the portion of Pivotal Events not published in the Sept 9 excerpt.)

The next stage of the pattern would require the DJIA reaching the upper standard deviation band in late August - early September. This was accomplished on September 1 and September 5, accompanied by the RSI(14) reaching an overbought reading.

On this pattern, the initial break measures to around 11,060, with 10,800 possible.

Confirmation that the top would likely be a cyclical peak was that our proprietary "Peak Momentum Indicator" registered on May 6. The last such reading anticipated the crash of LTCM and the bank stocks in 1998. (For more on LTCM, just Google it. It lost $4.6 billion in less than 4 months.)

This indicator measures speculation and it doesn't matter what it is in. It led the 1974 peak in commodities by 3 months as well as the peak in gold, silver, and crude oil in 1980.

By way of summary, the action in stocks, commodities, and residential real estate is indicative of a cyclical peak. The developing break in the stock market will provide more immediate confirmation.

Sector Comment: The behaviour of the big U.S. banks and financials this summer replicated the dangerous pattern of the summer of 1998. At the time, we described the pattern as the "Widows and Orphans Short" and this is the description now.

On that calamity, Citigroup crashed 60% and leap puts, which were 35 to 45 cents in the summer, reached $14.50 in early October.

On the near term, banks are within the overall market rebound likely to roll over this week. As noted last week, the mortgage sector, as represented by LEND, NEW, and WM, have failed.

Continue to sell the sector aggressively.


The Long Bond: Two weeks ago, the advice was to increase the selling of long-dated lower-grade bonds. This was repeated last week with the following added - "Given the measurable technical excesses, it seems appropriate to start selling high-grade long-dated corporates."

This was based upon where we are in the credit cycle as well as near-term technical excesses being reached. The LQD (ETF on corps) was close to a level that had ended rallies in the past.

We thought the rally would run into this week, but the high was set on Friday, from which it has slipped ½ a point. This could be partially due to the rally in base metals that began last week.

So let's look to continue selling and consider that Wednesday's slide in New York pricing of metals, energy, and grains will continue. This lifted bonds late in the afternoon and, with seasonals favourable over the near term, the high side of choppy action should be sold.

It is becoming more apparent that the rapid loss of liquidity we have been discussing is about to happen.

This could feed into long treasuries so investors could continue to get defensive.

Yield Curve: Last week's advice was to start putting on the "steepeners".

Developments this week suggest that curve steepening is very much on and will continue in its usual cyclically relentless style.

The initial inversion maxed in late February at -17 bps in May. The next inversion ran to -10 bps on August 28. At flat (0 bps) yesterday, the reversal is developing.

The inversion to last week is a big test of the earlier extreme and moving through +17 bps will lock in the trend. Given prevailing financial volatility, this could be choppy, but it has a high probability of happening.

The Dollar Index was expected to resume the uptrend as stocks and commodities roll over this week.

The intra-day low this week has been 84.7 and rising above 85.3 will be constructive in moving the chart out of a month-long wedge (85.5 today).

Above 86 will resume the uptrend. Fundamentals for this would include a global liquidity problem that could disrupt the Fed's chronic compulsion to depreciate the dollar.

With this, the Canadian dollar could consolidate the recent gains.


Energy Prices: As it was developing in the Spring, we identified the action in base metals as a cyclical peak.

This was also expected for energy prices as well, but closer to the usual seasonal high in late September - early October. This would, of course, be interrupted by weakness into late June.

However, the usual subsequent seasonal strength turned into a spike by the hot weather and hurricane "mania" that drove crude's price to 79 in mid-July. This drove natgas to 8.10.

The August 3 edition of Pivotal Events noted that the excess was a "weather" market from which prices would correct as the heat wave eased.

The August 12 edition of ChartWorks noted that the August rally was not exceeding the July highs and that more of a correction is possible. The August 24 edition of Pivotal Events concluded that it was appropriate to be underweighted the sector.

There has been very little by way of rallies to accomplish this.

However, crude is now approaching near-term oversold and, as noted last week, when a seasonal move has been, in this case, preempted by a mania that comes too early the price could get in line by rising to set the reversal.

The usual high is in late September - early October. We would not try a long trade, but would be a seller into whatever rally is offered.

Base Metal Prices were likely to rally with the stock market into this week.

Our index (less nickel) rallied from the last low of 650 on August 29 to 707 today. Up 8.8% in only 6 trading days is nice, but this compares to the rebound to 706 on July 12.

That was the test of the 779 high on May 11.

Senior companies such as BHP, Rio Tinto, and now PD have stalled out at rebounds below the highs achieved in May.

The Toronto index of mining stocks (SPTMN) soared on the merger-takeover hoopla until reaching 580 on August 21. Following the correction, the rebound has made it to 576, accompanied by some negative divergences.

One way of looking at this is that the senior companies are confirming that the May high for base metals (not including nickel) was the cyclical peak.

The action in the index of mining stocks was very much propelled by the mergers and the stall-out suggests that the takeover mania is fully discounted.

This was tied to the speculation raging in nickel, which drove the price to 34700 on August 24 when some wag observed that inventories in LME warehouses were down to only 6 hours of supply.

To put this in perspective, often when inventories get down to "only" 6 weeks of supply prices start to climb.

This is quite the opposite to the huge inventory figures being relentlessly reported in the 1980s slump. If memory serves, it was Simon Hunt who observed that the aluminum inventory was so big that it was the other manmade thing that could be seen from outer space.

Times change and nickel, which was the last gasper in the play, dropped 9.4% to 31450 and then bounced to 32245 on Tuesday. At 29550 yesterday, the initial low has been taken out.

It is likely that all base metal prices will plunge with the stock market and the classic indicator of a liquidity crisis has been a plunge in silver relative to gold.

Golds: Last week, we noted that gold's real price was at a cyclical low. Actually, at 180 it's a little lower than the 183 reached in October, 2000, from which the cyclical recovery ran to 255 in mid-2003.

The other point was that credit markets are beginning a change that in the past has prompted a massive increase in investment demand.

On the plus side for gold, the treasury yield curve continues its modest steepening trend. This has been accompanied by some widening of the spread between dealer commercial paper and treasury bill rates. This has yet to feed into longer maturities.

Another plus for gold is the noticeable weakening of the stock market. This will be enhanced as base metal prices fail and today's slip in New York copper could be the start.

So far, the real price, as represented by our gold/commodities index, has jumped from 180 on August 28 to yesterday's 198. This indicator of gold mining prosperity could come close to doubling over the next few years.

Last week's advice was "accumulation of gold and exploration stocks can be resumed, with senior stocks being accumulated on weakness".

Opportunity would likely occur as the latter decline with the general stock markets.

AUG./SEPTEMBER 31 1 5 6 7
High-Yield Spread 339 341 334 331 --
Treasury Curve - 5 - 4 0 - 1 - 2
Base Metal Prices 663 666 691 697 707
Dollar Index 85 84.9 85 85.1 85.5
Gold 625.9 624.4 638.5 633.5 617
Gold/Commodities 187 186 192 198 --



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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