Aha there you are readers, I couldn't see you, hidden behind all that steam rising from the cups of mulled wine. A warm welcome to the last letter for 2007 - did I hear cheers and whoops of delight? Well its to be expected I suppose, I have been a rather grizzly writer over the past 2 years and I know you would prefer to see a more positive outlook.
However, a positive outlook requires positive action to happen now that will help further ahead on the economic road. Alas, I am not seeing too much that gives me cause for hope.
I hope you found time to visit http://www.livecharts.co.uk/livewire/ and read the articles posted. As well as shorter articles covering topical subjects by myself you will find articles written by others too. Its well worth a visit.
As you know I try to peer into the future and divine what the economic outlook has in store for us. Readers had been well briefed about the credit crunch or as I see it the outright deflation of credit and it effects on the economy. Whilst I don't like to keep repeating the same theme, credit deflation is with us and will be around for some time to come. In this letter though I want to look at what the outcome of the current economic situation may do to stocks. I only rarely look at stock markets and try to see where they may be heading, not because I don't think its important but because there are plenty of other writers and systems out there who do just that, I prefer not to join a crowded play.
Edwin Coppock developed an indicator that helped to spot bull markets. Its a slow moving indicator and is usually late although, since 1996, it has become somewhat more timely. I think there is a very good reason for that. In 1995/6 Alan Greenspan changed his rate setting methodology, instead of following gold, he broke the link, allowing a period of steady rates in a more relaxed credit regime - enabled by the virtual abolishment of Bank reserve requirements.
The chart below shows that relationship and where it decoupled (with thanks to itulip.com and Aaron Krowne, the chart is part of a great article):
We can clearly see that he was attempting to rein in credit growth as he warned about "irrational exuberance" by keeping Fed Funds higher. As we now know the relaxation of reserve requirements had a much greater effect than he envisaged, probably due to his inability to see what the outcome of allowing unfettered credit creation and leverage would do, even with a Fed on an inflation fighting stance. Thus was born the beginning of the stock market surge in a newly revitalised Bull market, the building blocks for the housing boom and the acceleration of the credit derivative creation and application. I suspect the increase in the use of leverage and margin made the Coppock Indicator (CI) more sensitive to market conditions.
In decades to come, 1995/6 will be seen as a pivotal event, the enabling of what was to come. It was after this event that the CI became much more timely in showing Bull market conditions. Although the CI is a Bull indicator it can, if used carefully and by applying the new gold/Fed Funds relationship supply us with a longer term view of what may happen.
The next chart shows 2 things. The first is my dire attempt to display what I consider to be the best chart of the year. If only I was better at this graphics stuff eh? Ah well readers, you can't have everything..... The second is the chart itself. I have overlaid a chart of the Fed Fund Rates from 1986 to present with a monthly chart of the Dow from 1986 with its CI. Its clear to see the CI before 1996 did indeed lag and post '96 its a much better tool. Although the CI is used to indicate a bull market on a rise through zero it can be seen that in either half of the chart CI did give a lower high before stocks broke lower (marked by faint red lines). Whats more those lower highs were divergent when compared to the Dow which made higher highs.
Now before you run off and short every stock in the markets, remember, the CI wasn't designed for this use and the timescales involved increase the need for caution. Think of this more as a warning of a possible change of longer term trend, after all that's what I look for.
Lets look a little more at the CI before I discuss the Fed Funds Rate. Its use as a bull market indicator seems valid to me, it crossed up through the zero line twice, in late 1988 and 2003. By any count, that's not a bad indicator. Going long on those 2 dates would have been very profitable. When the day comes and the CI crosses zero to the upside again, I will be happy to look for good value long positions. Two other zero line crosses also appear, both to the downside. here is were I think the CI has changed. Notice the turn down in early 1988 would have to be judged as a failed signal, the Dow didn't retrace lower. In 2001 though the down signal was very useful especially when combined with the retest of the zero line and the turn back down. I suspect the difference between the the 2 signals was the way Fed Fund Rates were applied at the time.
The FFR in the late '80s was rising in an effort to control inflation (aha gold!) and even with the crash of '87 when rates dropped slightly, overall FFR continued to climb. As did stocks. There can be little argument that in modern times, rising FFR and rising stocks are not uncommon. For the long term, buying stocks when FFR is raised from a low is no bad thing. It also shows us that buying stocks when FFR is falling from a peak is a bad idea and since 1996, buying stocks with falling FFR and a divergence in the Dow/CI is not clever at all. Its noticeable too that if the CI is falling, even with FFR rising, stocks tend to tread water, a warning that conditions are not ripe for major stock gains. Its seen in the Dow returns in 1994, 1997-8, 2000 and 2004-5.
So, what are the Coppock, Fed Fund Rates and the Dow trying to tell us now? Firstly a rider. Although Fed Fund Rates are falling, other rates, especially LIBOR are not. We should keep this in mind. Firstly, we have a falling CI, with a divergent lower high when compared to the Dow. The Dow itself is beginning to resemble the 1999/2000 top, without a lower low as yet. Fed Funds are dropping and if consensus (a warning in itself) is correct, FFR will be much lower next year.
With the CI acting in a much more timely fashion, the minimum we can expect is for a flat return on stocks whilst FFR has ongoing cuts and the downward direction of the CI is maintained. A lower low on the Dow would make the flat return scenario seem less likely and open up expectations of a larger fall in 2008.
I do have one caveat to the above forecast. As can be seen in the next chart (below) Asset Backed Commercial Paper is still plunging but we can also see the beginning of an upturn in financial and non-financial Commercial Paper (CP).
Is liquidity beginning to return to the higher quality end of the market? Its probably too early to tell and the move higher could be connected with year end liquidity but a trend has to start somewhere. If CP has stabilized and issuance is increasing then confidence may begin to creep back into the markets.
I have no doubt it is connected to this:Term Auction Facility.
Finally, an old friend has been speaking, I refer of course to Alan Greenspan. (with thanks to Sarah for highlighting the article) A quick reminder of what I see ahead:
A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."In an interview on ABC's "This Week with George Stephanopoulos," Greenspan said low inflation was a major contributor to economic growth and prices must be held in check.
"We are beginning to get not stagflation, but the early symptoms of it," Greenspan said.
"Fundamentally, inflation must be suppressed," he added. "It's critically important that the Federal Reserve is allowed politically to do what it has to do to suppress the inflation rates that I see emerging, not immediately, but clearly over the intermediate and longer-term period."
That readers, is Alan Greenspan asking for rate rises. It makes sense if you think about what he did to the FFR / gold link. Remember, as the architect of this financial monster he has now to support it. As he sees it, rising rates and rising stocks go hand in hand. I still think he fails to see the effects that credit creation had in the making of bubbles. Even with a small increase in CP, credit is still being destroyed at a greater rate, confidence is still missing. I leave it to the reader to check where his remarks fit into the scenario.
The interview with Greenspan went on with this:
"Greenspan repeated his assessment that the probability of a U.S. recession had moved up toward 50 percent but noted that corporate America's debt levels were in good shape, which should help cushion the blow from tightening credit terms.
"The real story is, with the extraordinary credit problems we're confronting, why the probabilities (of recession) are not 60 percent or 70 percent," he said.
Maybe someone should remind him that only a few months ago, he thought the chances of recession were about 30%.
I hope you found this letter helpful and enjoyable. More importantly, I hope that you and your loved ones have a Christmas to remember for all the right reasons. Gifts and presents are nice but the warm glow from a smiling face is worth much more.
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