The Perfect conditions For a Bull Market

June 24, 2018

Weekly Summary

Mr. Market does not react in a consistent way to fundamentals, which is to say that it does not consistently react to economic data the way we logically think it should. Without consistency, there can be no prediction, and that is why we do not place much emphasis on fundamentals when assessing the direction of the market. While we keep an eye on the economy, we rely more on patterns in the market data that have some degree of consistent repetition through time. These patterns tend to be connected to irrational emotions that are so primitive and engrained in humans as to be imprinted in our DNA itself. That cannot be said about any economic system.

The markets that have the greatest potential for growth are those that have a healthy amount of skepticism (no extreme sentiment readings), while at the same time, fundamentals that are expanding. That is where we are today; middle-of-the-road sentiment, and an expanding business cycle.

GDP growth continues to expand, as the Atlanta Fed GDPNow model and the Blue Chip consensus both show in the chart below.

Even if the Fed’s very strong 4.7% GDP increase prediction ends up not being met, the average consensus of 3.5% GDP growth is still solid and healthy.

Since most (about 70%) of the economy is consumer driven, an important number to look at is the real disposable personal income (chart below).

The fact that the “rate of increase” itself is increasing is a strong signal of economic growth. Real disposable income was increasing at a rate of 0.2% at the start of 2017 and is now increasing 10x faster at 2.0%.

Industry sales (manufacturing and trade) continue to push higher, demonstrating on-going economic growth (chart below).

We could go on presenting evidence of strong economic fundamentals, but we do not think it is necessary. The point we are trying to make is that fundamentals cannot be relied-on to explain (or predict) market movements; the market has corrected, while the fundamentals are strong, and the market sentiment is one of skepticism (because of the correction). These are the perfect conditions for a bull market: a wall-of-worry that the market can use like a climbing-frame, and strong fundamentals to provide support.

The AAII sentiment survey showed some moderate shifting from bullish to bearish (chart below). This is not a significant change and shows that fearful skepticism is still present.

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The put-to-call ratio continues its bullish decline from the recent up-spike. The formation of a down-spike would indicate a local top in the S&P 500, but there is no sign of this at the moment (chart below).

The chart below shows the bear-to-bull asset allocation ratio, the bull asset level, and the bull and bear sentiment. A clearly bullish pattern continues to emerge.

The above sentiment analysis continues to support our view that we are still in a secular bull market.

The two charts below, show that the trading pattern in 2000 was similar to the pattern in today’s market (C3 and R4 in the charts below). If this pattern continues to replicate, then we should see new highs later this year.

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For most of the bull market, we have constantly heard how over-valued stocks are, but when we look at the yield from the S&P 500 minus the risk-free yield on a 6-month Treasury, we see that the resulting net yield, while recently turned negative, still remains higher than at any time during the 1995–2000 tech rally, and higher than during most of the 2003–2007 housing bubble. That does not sound like over-valuation to us. From this perspective, stocks could go much higher, even if dividends stay stagnant (chart below).

Interest rates from a Fed funds perspective are still 0.80% away from reaching the max Fed rate trend-line, and the various differentials along the curve continue to maintain slopes that point to inversions later this year or early next year. Since market tops tend to occur 6 to 12 months after inversions, a market top doesn’t become significantly probable until the Spring of 2019 (chart below).

Next to interest rates, the oil market is the most manipulated market on the planet since there is a cartel devoted to doing just that. The latter’s success, however, has always been “lumpy” since member compliance has not always been unanimous. This past week, the Saudis managed to get Iran to go along with an increase in production, but it was a half-hearted agreement that the market discounted for the most part; oil rallied.

Technically oil looks bullish, but there could be some resistance as oil has bumped up against the lower trend-line. If oil doesn’t follow-through into the rising price channel, then a drop down to $13.55 (38% Fibonacci) is likely. We will continue to hold our long USO position for now (chart below).

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Shop is displaying similar over-extended technical indicators as it did back in March (chart below). We continue to like this stock (several Canadian provinces will be using SHOP to market legal Cannabis), but we are waiting to see if the technical picture improves before getting back in.

The long-term technical picture for gold is still tilted toward weaker prices:

  • The RSI has broken below its trend-line.
  • Head-and-shoulders patterns continue to form.
  • MACD has made a bear cross-over.
  • Stochastic, while in over-sold territory, continues to drop.
  • The ADX bearish directional index (-DI) is increasing.

A closer look at the technical shows a similar picture. Last week we wrote “…if gold cannot manage to stay above $1274, then the next support does not come until the $1255 level.” $1274 was broken and gold came close to the $1255 support reaching as low as $1262. A bounce back up to test the $1274 level would not be unusual, but neither would a follow through down to the $1250-$1255 level (chart below).

The dollar failed to break above the 95 level, and long rates moved lower along with gold which caused the correlation with gold to turn positive on the 10-y and 30-y treasuries (chart below).

As strong as the correlation of gold with the dollar is, its correlation with the Euro is even stronger. Gold has been following the Euro lower for two months now (chart below).

Despite the USD/JPY moving sideways and the stochastic in over-bought territory, gold continued to drop (chart below).

Gold has dropped even though TIP (inflation expectations) has moved higher. The resulting negative correlation could reinforce the pattern of weak gold prices that tends to follow (chart below).

Finally, the commitment of gold futures traders report (COT) shows that the swap dealers kept their net-short position unchanged at -43K contracts, while the money managers reduced their already historically low net-long position down to +10k contracts. The swap dealer position implies lower prices to come, while the money managers’ position implies higher prices in the near future. Since the swap dealers are the experts in this market, we put the odds on lower gold prices at better than 50–50 (chart below).

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Forty years of private equity trading, and still learning.