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 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.

Coiling

BVN, a Peruvian mining company came back from the dead in January of 2016. After bottoming at $3.27 it rallied almost 400% in 8 short months. As you would expect after such an enormous run, it needed to take a rest, consolidating sideways for the last 17 months, allowing those wanting to sell the opportunity to do xo. But after this long sideways journey, the selling is waning, price has formed a cup and handle continuation pattern and is coiling above its rising 200 day moving average. A confirmed breakout above the pattern’s neckline points to a target in the $22-3$23 range, some 40% higher.

Risk management is easily controlled as it would make no sense to hold on to the position if it closed below the prior low of 14.13. If you really wanted to give it more room, a break of the 200 day moving average would be my final exit point. Either way, the risk-reward ratio is well above the desired 3:1 target and as such provides a compelling opportunity.

February 2018 Charts on the Move Video

February welcomed back volatility and our first double digit decline in many, many months. February also marked the end of the intermediate term parabolic blowoff and points to further consolidation in the coming months as I discuss in my latest video

https://youtu.be/aec4QquCfUk

Is This the Reason for the High Divorce Rate?

This the Reason for the High Divorce Rate?

Do you think, based upon the Economists data below, if the tradition of the man giving his bride-to-be an engagement ring changed to giving stock certificates would materially decrease the divorce rate? At least they would be starting off on better financial footing (said with tongue planted firmly in cheek)