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.

Two for the Bears

While Tuesday seems to have confirmed we put in a short term tradeable bottom in stocks, it does not mean ALL stocks. Remember what we invest in is not a stock market but rather a market of stocks. There is a big difference! It means some can (and do) move counter to the direction of the indexes (what most refer to as the stock market). Today’s blog post is about two companies that look to have topped and are set up for future downside

My first is Restaurant Brands International, QSR, which is a Canadian-based fast food company. While you may not have heard of them you have likely heard of their franchises, Tim Hortons, Popeye’s Louisiana Kitchen and Burger King.  As you can see in the weekly chart below, price has broken its red long-term uptrend line while creating bearish RSI momentum divergence (upper pane). For long term readers, the look should be familiar by now as this is stock has topped and begun to rollover, with price sitting below a falling 200-day moving average. A break below the green horizontal support points to a target of T1, an important level of past support some 12% below.

My next bearish “opportunity” is a company you have likely heard of before, Hilton Hotels (H). The daily chart of H shows another example of a stock that has temporarily topped. As you can see it made 3 (failed) attempts to get through that ~$81.5 level. Notice how on the first two attempts price fell to $75, found support and then went on to retest $81.5? But yesterday, that $75 support level failed to hold and price slice right through without a pause. Notice also how the first test of $81.5 created negative RSI momentum divergence warning of a correction or reversal? If the bulls cannot regain control, and I mean real soon, the pattern points to a target at T1 below. Notice also that same level is an open gap and where the 200-day moving average currently resides. This is a great example of a confluence of signals at or near the same level. When a confluence occurs it provides a much higher probability the target in question will be hit. Finally, if the stock has much more momentum to the downside and T1 does not hold, T2 is the next likely target for buyers to step in and stop the decline as it is acted as an important level in the past and it sits just below the other open gap in price.

Bad Catsup Update

About 6 months ago I wrote a post about the potential decline in Kraft Heinz stock (KHC) titled Bad Catsup.  Here is what the chart of Kraft looked like at the time of the post.

As you can see below, it is playing out as expected from the bearish rising wedge pattern as it has fallen by more than 20%. For those that shorted the stock on the break below the wedge, congratulations.  Don’t become complacent though, because the next few weeks/months may challenge your resolve. With price sitting below support level S2 and being very oversold (see RSI momentum in the upper pane), it would not surprise me to see a rally back up to the underside of S2 while the bears take a rest and the bulls try to take control driving prices higher. Any retest and failure to break higher is in line with the thesis of a much bigger decline ahead with S3 as a likely target, some 30% lower. A retest and hold above S2 is a signal that short-sellers should consider exiting the position and booking their profits.

Economic Demise Ahead?

There are some that believe a tightening yield curve is a harbinger of a bad economic times ahead, with a good possibility of the economy failing into a recession. If this were true, the chart below should be of concern as interest rates are in their tightest range in many years.

The fact is, the correlation between tightening rates and economic weakness is poor and provides little to no edge if used in making investment decisions. What does matter though, very compellingly, is when the yield curve inverts (short term rates are higher than long term rates), something we are in no danger of seeing happen anytime soon. Until that occurs (and it is worth monitoring because of its very high negative correlation to stocks), recent interest rate cks), recent interest rate activity is reflecting FED activity and forecasts, not economic demise.