This week, once again, the market demonstrated that it is not driven by news. If it had been driven by news, it would have gone over a metaphorical cliff when it heard that the ex-mail-order-steak-salesman, who is now the president of the greatest country on Earth, had started a trade war with all of America’s closest defense allies. That’s right, he slapped tariffs on steel and aluminum coming from America’s closest friends and allies, on the pretense of national security, and the market ignored this stupid and dangerous financial mistake!

Does America not need the steel and aluminum that it buys from Canada? Has America been buying steel from Britain and the EU in order to be charitable? Is Canada, which is a partner in NORAD and NATO, a threat to the security of Americans? The Donald certainly thinks so. The steel and aluminum that will now cost American companies 25% and 10% more, respectively, cannot be replaced by domestic production overnight. That means that U.S manufacturers will become less competitive on the global stage, inflation will increase, and the Fed will be forced to raise rates faster than it has advertised, thereby, risking a rate inversion which invariably leads to recessions. But the market ignored it, proving that sentiment trumps fundamentals (pun is coincidental).

At a different point in the market, this same news event could have single-handedly turned a bull market into a bear — it is fundamentally obvious. However, what is obvious, is obviously wrong when it comes to the market. Which is why we do not use news events to extrapolate the market. We do not look for “causes”. Instead, we look for patterns in the historical record which “correlate” to future market movements.



Equities
Rate Differential and Unemployment
When the 10-year minus the 2-year Treasury rate inverts, it is a warning sign of an impending recession and accompanying bear market. This negative differential is a leading indicator which turns negative many months before the S&P 500 makes a top. A year ago, in May of 2017, the differential was at +0.96, and we noted that if the downward slope stayed constant, then the inversion was on track to happen in the last half of 2018 and a recession a further 12-to-18 months past that (chart below).

Six-months ago, in November of 2017, the differential was at +0.58 with a similar slope as before and with the same approximate inversion date of H2 of 2018.

Now, one-year later, the 10-year minus 2-year differential is at +0.42 and, again, if the slope is maintained, the inversion would take place later in 2018 or early 2019.

It should also be noted, that the unemployment rate continues to drop, and in the last two bull markets, the rate started to rise several months ahead of the market making a top. The fact that unemployment continues to drop, combined with the positive rate differential, makes it unlikely that we have already seen the highs of the present bull market.

Fed Funds Rate

The Federal Reserve kept rates zero-bound for the first seven years of the current bull market but has been slowly raising rates for two years now. It is a common belief that rising rates and bull markets don’t mix, but the facts prove otherwise. The last four rate-hiking cycles have taken place during bull markets. Rising rates do not cause bear markets, overly high rates cause bear markets. And what constitutes overly-high rates has been steadily decreasing since the 1980s (chart below).

The downward-sloping trend line implies that rates will top out between 2% and 3% early in 2019, if the Fed sticks to its advertised tightening schedule (blue oval in chart above). That timing roughly fits with the rate differential, which we discussed above, and would require at least two quarter-point rate hikes by the Fed. Again, a bear market is still some distance away.

GAAP Earnings
Six months ago, GAAP earnings were 104.02. Today, they are 5% higher at 109.88 (chart below). Bear markets do not start while earnings are increasing.

Industrial Production
Rising industrial production correlates strongly with bull markets. Rising industrial production does not start bear markets.

Technical Indicators
In the long-term (monthly) view (chart below):

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Investor Sentiment
Even local tops, not just major tops, correlate with the AAII bull-minus-bear investor sentiment differential; 57% of local tops have occurred when the differential was above 40%, while only 16% of tops occurred when the differential was less than 15%. In January, the differential peaked above 40% as the S&P 500 made a new high, but now is at only 8.5% despite the market recovering with higher-highs and higher-lows. There is still too much fear for this to be the start of a bear market.

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The NAAIM index 50 DMA, continues to flatten and align itself with the rising SPX (chart below).

The put-to-call ratio continues its bullish decent (chart below).

This week, we opened then, two days later, closed SPXL call options for a +71% gain on a 2% portfolio allocation.

Gold

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Rates have dropped (and partially recovered) below the upward-sloping channel line while gold rose to test the overhead resistance. The dollar could be forming a bullish reverse-head-and-shoulders pattern which, if completed, would put further pressure on gold (chart below).

The USD/JPY pair is over-bought according to the stochastic. This puts downward pressure on the currency pair and upward pressure on gold. Stochastics can stay elevated, but that has not been the case recently in the pair. This indicator puts a bullish-bias on gold (chart below).

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ANG Traders

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Forty years of private equity trading, and still learning.

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