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2) While the dollar works its way through its cycle top, gold will probably roll over and decline into a daily, and then an intermediate cycle low. The timing of gold’s next ICL will roughly coincide with the Intermediate peak in the USD.
4) Oil reached an oversold extreme not seen in 35 years. It is currently in the timing band for a daily cycle low. A sharp rally is due soon and will probably coincide with a stock market rally.
5) The counter trend rally in US Treasuries continues. The bull market in bonds that began in the early ’80s ended in 2016, but we don’t expect rapidly rising rates any time soon.
6) We are currently holding a cash reserve of 100%.
The Bear Roars
Last week stocks plunged to new lows for the year after Fed Chairman Powell made it clear that he intends to continue reducing the size of the Fed’s balance sheet. The public focuses on the target interest rate that the Fed sets for overnight bank loans, but it is the reduction of the balance sheet that the market is feeling. When the Fed reduces its balance sheet, money is pulled directly out of the economy. During the ’08 financial crisis, the Fed’s balance sheet more than tripled in size as it printed newly created money to buy mortgage-backed securities and US Treasuries. Heritage.org did a great job of showing a timeline of the events surrounding the Fed's actions in the graph below.
Like all loans, the Mortgage-backed securities and bonds eventually mature and become due. In order to maintain its massive balance sheet, the Fed would “roll” the old debt into new debt by using the proceeds from the former to purchase newly created debt. As the Fed's balance sheet expanded, the newly created money pushed up asset prices, including the stock market.
Now the opposite is taking place. The Fed is reducing the size of its balance sheet. When a debt instrument becomes due, it takes the payment, matches it with the bond, and the two cancel each other out. It disappears the same way any loan does once it is paid off, except when the Fed takes the money, it isn't recirculating it back into the economy as a commercial lender would. With fewer dollars chasing stocks, the prices continue to decline. When the balance sheet was expanding almost all asset classes rose in value. Now that it is shrinking, previously blown bubbles are deflating. A headline on CNBC put it best when it said: "Nothing worked for investors this year — nearly every major asset class is in the red for 2018."
But just looking at what the market indexes did for the calendar year doesn’t tell the whole story. People don't only buy stock on January first, and before the market turned down, it rallied hard. As it rallied, investors chased, paying up to get in on the action. You will remember we likened the bull market to that of a 113-year-old person. Once people reach a certain age, it simply cannot be ignored. Day after day, they may seem to defy the odds as they bound out of bed and go about their day. But time misses no one. Eventually, it catches up and the day comes when there is no more. Bull markets are much the same. They have a finite lifespan before they meet their demise and are replaced by a bear market. We never quite know the exact day in real time, but we can see the wrinkles and know that it pays to be cautious. Even though we still made a small trade here and there when the opportunity presented itself, we know that messing with a bull that is fighting for its life is a sure way to get gored, if you aren't careful.
For the US indexes, the bull came to a halt during the third quarter. Since then, the punishment has been swift and severe, with the Dow transports shedding over 30%, the small-cap Russell 2000 losing 25%, and the tech-heavy Nasdaq 100 down by over 20%. A correction becomes a bear market when it drops 20% or more from its high. By this definition, some indexes are clearly in bear market territory, while others like the Dow and SPX are just shy, down 17% and 18% respectively.
But even quoting the indexes doesn't paint the whole picture. To make matters worse, people tend to be trend followers. In other words, they buy what has already gone way up. If we look at some of the former high-fliers, we really see some carnage. For example, Netflix was a Wall Street darling that everyone loved to own. Since its peak in June, it has dropped over 40%. Others have lost more than half of their value just in the past couple of months. When January rolls around, and investors open their 401K statements, there could be even more selling as the trend followers that bought the top realize their mistake.
So far, we've just been talking about the stock market. But the economy is long overdue for a step back as well. Economies expand and contract, much like breathing. The current expansion is the second longest in US history. The average expansion since 1854 is 40 months, and the current expansion is now 114 months old. If we make it through 2019 without a recession, we will break the old record-long expansion of 120 months. So time tells us a recession is coming. What happens in recessions? Bear markets. The average stock market decline in a recession is 37%, so we aren't even close in terms of price yet. Even in bear markets, stocks go up and down, so we will still experience rallies along the way. But it appears the bull is on borrowed time and the bear has come out of hibernation.
Last week we explained that even though we were dubious that the bottom was in, the SPX 500 presented a 2B, and the reward to risk on a 2B is usually worth the trade even though it will sometimes result in a small loss. Sometimes a 2B produces a winning trade, and sometimes it is a loser—but the reward-to-risk ratio that they offer make them profitable over time. After waiting for a pullback to minimize risk, we traded the 2B and got stopped out. This week, the Nasdaq presented a 2B, which we attempted to trade via AMZN. Again, the bears proved victorious and pushed the prices back below support. With stocks now in free fall, we are back to a cash position waiting for the next indication of a market bottom, or a good position to get short.
Perhaps tellingly, despite the precipitous decline in stocks, the VIX—also known as the fear index—has yet to really make an outsized move to the upside. To be sure, it's current level at 30 isn't a low volatility environment, but it's also not spiking to highs, as is often seen when fear is taking over the markets. Fear equals panic selling, and we just aren't seeing that quite yet.
The weakness in the stock market caused capital to seek shelter in long-term bonds, pushing TLT above its 200-DMA and its downtrend line.
As short-term rates rise and the yield on long-term debt continues to decline, the yield curve comes ever closer to inverting. Although it has not inverted yet, it has a perfect record of predicting a recession when it does. As you can see from the shaded areas, the recession lags an inverted yield curve by several months. If this trend continues, then we would expect a recession in the second half of 2019 at the earliest.
On November 25, we said "As of Friday, gold is holding above its 20 and 50-DMA, and despite considerable dollar strength on Friday, it managed to hold up quite well. Given its resilience on Friday, chances are it may test resistance in the $1240-$1260 area before declining into its ICL." Last week we said there was a good chance the 200-DMA would be tested before the next ICL. With the benefit of hindsight, we get to see that gold accomplished both, and is currently sitting just above its 200-DMA.
The HUI index printed a 2B high and tested its 200-DMA. There remains some room for further upside, but a move into a cycle low is due. We made one attempt at shorting gold with DGLD when gold penetrated its 200-DMA and then reversed lower on Wednesday. Looking back at the trade, time and price both suggested it was worth an attempt. It was late in the daily cycle, late in the IC, and the down sloping 200-DMA was there to offer price resistance. In addition, the Fed maintained its hawkish stance, which typically would be interpreted as bearish for gold.
Thursday's rally was not expected. It is possible the market is losing faith in the Fed's ability to maintain control of the markets and is seeking safety in gold. There is a belief that the Fed has the market's back and will do what it can to keep the stock market from declining. When Powell showed willingness to raise rates in the face of a steep decline, it shook market confidence. If the investing public loses faith in the Fed's ability to maintain control, they could also lose faith in the dollar, and a falling dollar is bullish for gold.
In our November 25th issue we posted the chart below and said this: "Often during a severe decline, there will be what looks like a bottom, only to have the decline resume with a vengeance. The false bottom very often marks the halfway point, which in this case would suggest a low south of $50."
If we fast forward to today's chart, we can see that little rally in mid-Nov is starting to look like the halfway point. We are now in the timing band for a daily cycle low, and oil is deeply oversold. Simply put, a rally is due. Whether it will cooperate or not remains to be seen, but time and price suggest the next multi-dollar move should be to the upside, even if it is just a counter trend rally.
Last week we highlighted OIH as a potential buy once it shows signs of bottoming. On Friday, OIH broke below its 2001 low and closed at an all-time low. That means everybody who bought the ETF in the last seventeen years now has a capital loss. It's impressive how oversold something can get once it is out of favor. We will see if selling will abate once the calendar year is over and tax loss selling comes to an end.
We wish everyone the best during this holiday season. We will unplug from the markets during the coming week and spend time with family. There will not be a newsletter next weekend as we unwind and prepare for what is sure to be an interesting year ahead. We're looking forward to 2019, both for market opportunities, and for further adventures. We hope as the new year kicks off you are able to plan for, and achieve, the things that make you happy.
Wander With Us
This time of year also brings migrations in the Wanderer community. Cruisers finally shake off the last of hurricane season and head for warm weather and beautiful beaches. Overlanders/RVers meanwhile, are leaving the northern climes and mountains, chasing the sun south before they get snowed in.
Pat is calling Key West home for a couple of weeks while waiting for a weather window to cross the Gulf over to Mexico. The true beauty of trading for a living is never needing to hurry off to an office. Stuck in Key West longer than expected? Oh well, login from the top deck with a view.