A Shift in Expectations

When discussing the outlook for so-called “risk assets”, i.e., mainly stocks and corporate bonds (particularly low-grade bonds) and their counterparts on the “safe haven” end of the spectrum (such as gold and government bonds with strong ratings), one has to consider different time frames and the indicators applicable to these time frames. Since Donald Trump’s election victory, there have been sizable moves in stocks, gold and treasury bonds, as the election result has strongly boosted certain market expectations.

 

 

The chart below compares three of the associated ETFs, namely SPY, TLT and GLD:

 

SPY, TLT and GLD – after the election, stocks rallied while treasuries and gold sold off. The main (but not only) driver of these moves were surging inflation expectations. Since mid December, treasuries and gold have quietly rallied though, in what seems to be widely considered a “technical bounce” one is usually advised to ignore (we won’t) – click to enlarge.

 

As we have mentioned late last year, US true money supply growth rates have accelerated sharply again. Since the stock market has concurrently broken out to new all time highs, its strength deserves some respect for now, despite the fact that valuations are extremely high. Our assessment is that there will likely be near term weakness, followed by medium term strength and ultimately a long term disaster. The “alarm bells” mentioned in the title of this post refer to the near term outlook.

In a recent article on post election seasonality (see “Regime Change – the Effect of Trump’s Victory on Stock Prices” for details) Dimitri Speck has pointed out that there is a case to be made for near term weakness based on the market’s average performance in post-election years. The question is now whether the current technical, sentiment and fundamental backdrop is conducive to market action that is in line with this statistical average.

Inflation expectations have trended higher through most of last year (note: we are referring to expectations regarding the future rate of change of CPI – they have nothing to do with monetary inflation). This is quite rational for a number of reasons. First of all, headline CPI is almost certain to rise due to last year’s rally in energy prices. This is due to a statistical artifact (the so-called base effect), the main characteristic of which is its inevitability.

 

5-year inflation  breakeven rates have been in an uptrend since early 2016, tracking the rally commodity prices. The trend has accelerated significantly since the US presidential election – click to enlarge.

 

Secondly, there is a strong and not exactly unreasonable suspicion that most of the economic policies favored by the Trump administration (at least some of which will presumably be backed by the Republican-controlled legislature) are  likely to push price inflation up. Higher government spending, tariff hikes, the possible deportation of cheap illegal workers, etc., are all deemed to lead to higher consumer prices.

Keep in mind in this context that the inter-temporal price distortions along the production structure triggered by the Fed’s loose monetary policy in recent years are fated to eventually shift and reverse anyway. Resources have been misallocated as too much has been invested in the higher stages of the economy’s capital structure relative to the lower stages. Eventually a bottleneck should emerge in terms of the demand for and supply of final goods, in conjunction with hitherto suppressed natural interest rates reasserting their influence on market rates.

The problem is that the real savings needed to support and maintain a lengthened production structure never existed – they were an illusion created by the printing press. The same holds for the decline in consumer demand implied by an increase in savings – it simply hasn’t happened (at least not to the extent indicated by market interest rates). The real funding for long term investment projects still needs to come from somewhere though.

It such investments are not supported by an increase in real savings, capital will be consumed. The falsification of economic calculation engendered by prices that have been distorted by credit expansion inter alia leads to the reporting of illusory accounting profits – later it turns out that capital maintenance has been lacking and the previously reported profits turn into very large losses (think about 2008/2009 as the most recent example of such an “unmasking”).  At some point the capital consumption will be reflected by a surge in market interest rates and a shift in prices. Many of Trump’s policy proposals (if implemented) are likely to hasten this process, ceteris paribus.

 

The ratio of capital goods to consumer goods production is a reflection of the policy-driven credit bubbles of recent decades. Currently the ratio is in a sideways channel at an extremely high level, as strong money supply growth and credit expansion have continued almost unabated since 2008. There is a natural limit to this trend though, provided the central bank does not opt for extreme inflation (we currently assume that it won’t, but this assessment may have to be changed in the future) – click to enlarge.

 

New Positioning Extremes

We can conclude from all this that the current positioning of speculators is at least partly justified, but their positions have become far too one-sided in the short term.  We have already shown a brief chart overview in mid December (see “The Exiling of Risk”), that illustrates the strong investor consensus that has emerged since the election and the enthusiasm with which short term traders have joined the bandwagon.

Recent developments in speculative positioning suggest that quite explosive counter-trend moves could be in store in the near term. We can once again report on new record highs in certain positioning data, which has almost become a tradition in this new era of unprecedented monetary policy extremism and the vast increase in systematic and fully automated trading. We never had occasion to use the terms “record high” and “record low” as often as in the past several years. This is an area in which some sort of “hyperinflation” is clearly underway.

This time it concerns speculative positioning in treasury futures. Below is a chart of the net hedger position (the inverse of the net speculative position) in 10-year treasury note futures. It actually serves as a proxy for the entire curve, as speculators have taken record net short positions across they entire maturity spectrum, with the exception of the 30 year bond. Even euro-dollar net speculative shorts are at a new record high of more than 2,444,000 contracts (equivalent to approx. 726,000 10 year treasury contracts). Mish has a report on the details here.

 

A new record high in the net hedger long position in 10 year treasury note futures and hence also in its inverse, the net speculative short position – click to enlarge.

 

Net speculator positions in treasury futures overall are currently equivalent to $100 billion in terms of cash treasuries. What makes this unprecedented case of speculators eagerly piling into the same trade especially interesting is the speed with which it happened and that they have decided to ignore the fact that the trade has actually stopped working a month ago.

Nearly every short position opened since mid December is under water by now, and yet, speculators keep enlarging these positions. But aren’t they correct in doing so? After all, it is a near-certainty that higher headline inflation rates will be reported in coming months. Moreover, even if the Trump administration only manages to implement a few of its policy proposals, upward pressure on price inflation will still result.

We believe the main problem with this is that it is simply too obvious. What everybody knows already is usually not really worth knowing. Once we see such extremes in positioning data, we should actually ask “what could go wrong with the obvious scenario”.

There are plenty of things that could go wrong – the possibilities include another crisis in the euro area (several critical elections are coming up),  problems in China’s currency and credit markets, a budding trade war, a surge in geopolitical upheaval, and so forth. Why all these so-called tail risks are so studiously ignored  all of a sudden is a bit of a mystery.

 

Real Interest Rates and Gold

A similar picture has emerged in the gold market: while speculators remain net long gold futures, their position has barely moved up from the one year low that was recently reached, despite the rally in gold prices. There are also other signs that sentiment on gold remains very cautious – so far the rebound seems to be met with plenty of disbelief, similar to what we can see in treasuries.

Readers may recall that near the recent correction lows in gold and gold stocks, some sentiment measures indiacted that bearish sentiment had reached rarely seen extremes (see our missive from late December: “Gold Ready to Spring Another Surprise” for details on this).

We will provide a more a more detailed update on the situation in the gold market in a separate post, but we want to show an update of one of the charts we discussed in the “fundamental drivers” section of the post mentioned above. As we have pointed out, the gold price at times leads changes in the trends of its fundamental macro-economic drivers.

The gold market is for instance highly sensitive to future changes in market liquidity and the reaction of central banks to such developments. At times this involves very long lead times. In the short term, the gold price appears the be sensing incipient trend changes in real yields. Gold has a very tight inverse correlation with 5 and 10 year TIPs yields, but often it is actually leading them slightly (sometimes by just a few days). This has just happened again as the updated chart of 5 year TIPs yields illustrates:

 

The short term trend in 5 year TIPs yields seems to have reversed again. They are no longer in positive territory, but have fallen back to zero – click to enlarge.

 

Stock Market Internals and Risk Appetite

The stock market itself actually still looks quite solid from a technical perspective – but not from a sentiment perspective. Confidence in a continued surge in stock prices has become way too pronounced, as sentimentrader’s “smart/ dumb money confidence spread” shows.

 

The smart/dumb money confidence spread has reached an extreme level again – which is actually diverging slightly from the one set in the summer months. Experience shows that such divergences often precede sizable corrections (if one studies the chart a bit, one can see several such instances actually – usually a higher low in the spread is put in place concurrently with a new high in stock prices or with stock prices retesting their previous highs). This spread is solely based on market data –  it includes no surveys – click to enlarge.

 

While there are small divergences evident in a few market internals as well, they are not yet pronounced enough to give cause for concern – but that could change very quickly. The last two sizable corrections were preceded by warning signs in several internals, but they were not particularly pronounced and one had to pay close attention to notice them in good time.

 

Market internals: a few small divergences with price are in evidence, but nothing major as of yet. The cumulative NYSE a/d line is still confirming the market’s strength, but one should keep a close eye on the “support shelf” consisting of the zero level in the NH/NL percentage spread – click to enlarge.

 

Someone once remarked to us that no bear market had ever begun while the cumulative NYSE a/d line still confirmed new price highs. That is actually not correct – while the a/d line and other internals usually do tend to diverge at major price peaks preceding bear markets, it does not always happen. A noteworthy exception occurred at the late 1937 market peak, which was confirmed by the a/d line, but was nevertheless followed by one of the fastest and steepest bear markets of the past century.

Below are two of the longer term indicators we follow. They usually have no bearing on the timing of short term market moves, but there have been a few recent developments worth mentioning. We already discussed the “Risk Appetite Index” in our mid December update. It remains at an extremely high level.

 

The sentimentrader “Risk Appetite Index”, a combination of the Citigroup Macro Risk Index, the Westpac Risk Aversion Index and the UBS G10 Carry Risk Index. Similar to the confidence spread shown further above, this index is solely based on market data and involves no surveys or other verbal or written expressions of opinions – click to enlarge.

 

What makes this so interesting is that after the person that was widely held to generate major “uncertainty” in the markets has become president of the US, market prices and positioning seem to indicate that certainty is greater than ever!

Zerohedge recently reported that the Goldman Sachs version of the risk appetite index has actually reached a new record high. The previous all time highs in this particular index were posted at the market peaks in 2000 and 2007, which are somewhat ominous precedents.

The mutual fund cash-to-asset ratio has finally also reached a new all time low of 3.1% at the end of 2016 (here we go again with the records!). It previously touched the former record low of 3.2% several times and has in the meantime ticked back up to that level. The persistently low level of this ratio in recent years represents the longest stretch of record or near record low readings in the history of the data (which begins in 1955).

 

Mutual fund cash-to-assets ratio: a new record low of 3.1% was recorded in December of 2016 – click to enlarge.

 

As mentioned above, this indicator is not useful for forecasting the timing of near term corrections. Similar to extremely high valuations, all it is telling us is that the market’s long term returns are likely to be very poor.

Lastly, the VIX –  a measure of the implied volatility of S&P 500 index options – also shows that complacency is quite pronounced at the moment. This is likely to be relevant for the market’s near term outlook, especially in view of the fact that speculators currently hold near record net short positions in VIX futures as well (129,000 contracts net as of the most recent CoT report– the record high posted in September 2016 was 138,000 contracts).

 

The VIX shows that investors are quite complacent – and it is accompanied by an extremely large net speculative short position in VIX futures as well, yet another vehicle that has broken a number of records in the past few years. Extremely low implied volatility as a rule tends to be followed by very high realized volatility – click to enlarge.

 

Conclusion

The recent extreme in net speculative short positions in treasury futures is a warning sign for risk assets – while it is per se not a bullish indicator for bonds, it makes treasury notes and bonds very vulnerable to a sizable upside correction. This is also confirmed by a decline in the five day average of the DSI (daily sentiment index of futures traders), which stood at only 9.8% bulls in early January.

Traders have so far largely ignored the quiet advance in treasuries and gold since mid December, which makes these rallies all the more intriguing. At the same time we see risk appetite indicators at or near record highs, while confidence regarding the trend in stock prices among the groups of traders most likely to be wrong is extremely high. Incidentally, the combined dollar-weighted net speculative long position in stock index futures is right at the upper end of its multi-year range as well.

While stock market internals are more or less still neutral at this stage, such extremely one-sided speculator positioning (recall also recent NAAIM survey data) should not be ignored. If any unexpected fundamental news should emerge that throw doubt on the beliefs so widely held by market participants of late, a sizable surge in market volatility is likely to ensue.

 

Charts by: SentimenTrader, StockCharts, St. Louis Federal Reserve Research

 

 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Coming Debt Reckoning
      Licking the Log American workers, as a whole, are facing a disagreeable disorder.  Their debt burdens are increasing.  Their incomes are stagnating.   There are many reasons why.  In truth, it would take several large volumes to chronicle all of them.  But when you get down to the ‘lick log’ of it all, the disorder stems from decades of technocratic intervention that have stripped away any semblance of a free functioning, self-correcting economy.   Happy...
  • How to Stick It to Your Banker, the Federal Reserve, and the Whole Doggone Fiat Money System
      Bernanke Redux Somehow, former Federal Reserve Chairman Ben Bernanke found time from his busy hedge fund advisory duties last week to tell his ex-employer how to do its job.  Namely, he recommended to his former cohorts at the Fed how much they should reduce the Fed’s balance sheet by.  In other words, he told them how to go about cleaning up his mess.   Praise the Lord! The Hero is back to tell us what to do! Why, oh why have you ever left, oh greatest central planner of all...
  • India: Why its Attempt to Go Digital Will Fail
      India Reverts to its Irrational, Tribal Normal (Part XIII) Over the three years in which Narendra Modi has been in power, his support base has continued to increase. Indian institutions — including the courts and the media — now toe his line. The President, otherwise a ceremonial rubber-stamp post, but the last obstacle keeping Modi from implementing a police state, comes up for re-election by a vote of the legislative houses in July 2017.  No one should be surprised if a Hindu...
  • The Triumph of Hope over Experience
      The Guessers Convocation On Wednesday the socialist central planning agency that has bedeviled the market economy for more than a century held one of its regular meetings.  Thereafter it informed us about its reading of the bird entrails via statement (one could call this a verbose form of groping in the dark).   Modern economic forecasting rituals.   A number of people have wondered why the Fed seems so uncommonly eager all of a sudden to keep hiking rates in spite...
  • What is the Buffet Indicator Saying About Gold?
      Chugging along in Nosebleed Territory Last Friday, both the S&P 500 and the Nasdaq composite indexes closed at record highs in the US, with the Dow Jones Industrial Average only a whisker away from its peak set in March. What has often been called the “most hated bull market in history” thus far continues  to chug along in defiance of its detractors.   Can current stock market valuations tell us something about the future trend in gold prices? Yes, they actually...
  • Moving Closer to the Precipice
      Money Supply and Credit Growth Continue to Falter The decline in the growth rate of the broad US money supply measure TMS-2 that started last November continues, but the momentum of the decline has slowed last month (TMS = “true money supply”).  The data were recently updated to the end of April, as of which the year-on-year growth rate of TMS-2 is clocking in at 6.05%, a slight decrease from the 6.12% growth rate recorded at the end of March. It remains the slowest y/y growth since...
  • The 21st Century Has Been a Big, Fat Flop
      Seeming Contradiction CACHI, ARGENTINA – Here at the Diary we have fun ridiculing the pretensions, absurdities, and hypocrisies of the ruling classes. But there is a serious side to it, too. Mockery makes us laugh. And laughing helps us wiggle free from the kudzu of fake news.   Is it real? Is it real? Is it real? Above you can see what the problem with reality is, or potentially is, in a 6-phase research undertaking that has landed its protagonist in a very disagreeable...
  • A Cloud Hangs Over the Oil Sector
      Endangered Recovery As we noted in a recent corporate debt update on occasion of the troubles Neiman-Marcus finds itself in (see “Cracks in Ponzi Finance Land”), problems are set to emerge among high-yield borrowers in the US retail sector this year. This happens just as similar problems among low-rated borrowers in the oil sector were mitigated by the rally in oil prices since early 2016. The recovery in the oil sector seems increasingly endangered though.   Too many oil...
  • Will Gold or Silver Pay the Higher Interest Rate?
      The Wrong Approach This question is no longer moot. As the world moves inexorably towards the use of metallic money, interest on gold and silver will return with it. This raises an important question. Which interest rate will be higher?   It’s instructive to explore a wrong, but popular, view. I call it the purchasing power paradigm. In this view, the value of money — its purchasing power —is 1/P (where P is the price level). Inflation is the rate of decline of...
  • Rising Oil Prices Don't Cause Inflation
      Correlation vs. Causation A very good visual correlation between the yearly percentage change in the consumer price index (CPI) and the yearly percentage change in the price of oil seems to provide support to the popular thinking that future changes in price inflation in the US are likely to be set by the yearly growth rate in the price of oil (see first chart below).   Gushing forth... a Union Oil Co. oil well sometime early in the 20th century   But is it valid to...
  • Silver Elevator Keeps Going Down – Precious Metals Supply and Demand
      Frexit Threat Macronized The dollar moved strongly, and is now over 25mg gold and 1.9g silver. This was a holiday-shortened week, due to the Early May bank holiday in the UK. The lateral entrant wakes up, preparing to march on, avenge the disinherited and let loose with fresh rounds of heavy philosophizing... we can't wait! [PT]   The big news as we write this, Macron beat Le Pen in the French election. We suppose this means markets can continue to do what they wanted...
  • Warnings from Mount Vesuvius
      When Mount Vesuvius Blew   “Injustice, swift, erect, and unconfin’d, Sweeps the wide earth, and tramples o’er mankind” – Homer, The Iliad   Everything was just the way it was supposed to be in Pompeii on August 24, 79 A.D.  The gods had bestowed wealth and abundance upon the inhabitants of this Roman trading town.  Things were near perfect.   Frescoes in the so-called “Villa of the Mysteries” in Pompeii, presumed to depict scenes from a...

Support Acting Man

Austrian Theory and Investment

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com