June 5, 2016
JOBS REPORT SPOOKS MARKET
Last week US stock investors went for a roller-coaster ride as prices zigzagged sharply higher and lower. However, just like a roller coaster, they ended last week's ride at the same place they started.
Investors went on a roller-coaster ride of price swings last week, ultimately ending exactly
where they started with 0.00% gain in the S&P 500.
MARKET REMAINS AT A CRITICAL JUNCTURE
In the first section of last week's Value Alert newsletter, we displayed a chart which demonstrated that most major market indices, including the S&P 500 Index, the S&P 500 Equal Weight Index, the Nasdaq Composite, and the Russell 2000 Small-Capitalization Stock Index were all facing critical overhead resistance. As shown in Chart 1 below, those major market indices did not move much last week and all remain at that critical level for the second week in a row:
CHART 1: Market indices for the S&P500, S&P 500 Equal Weight, Nasdaq Composite, and Russell 2000 continue to face overhead resistance.
The S&P 500 index (top window, above) printed a return of 0.00% for the holiday-shortened week. In candlestick analysis, this result is displayed as a cross, or a '+' sign, which in technical parlance is called a 'doji.' Candlestick formations date their first use to Japanese rice trading in the 1700s, and a doji shows that prices went higher and lower during the week (or hour, day, month, etc.) but finished at the same level where they began.
A Doji is an indication that buying and selling market forces were balanced even though investors had a roller-coaster ride of price swings during the week. Following a rally, a doji candlestick formation is frequently a harbinger of a market reversal because it shows that bullish investors are unable to push prices higher, in this case through prior resistance levels. Conversely, when appearing at the bottom of a downward trend, it can foreshadow a reversal of prices higher.
Nearly the same result occurred in the three other indices displayed in Chart 1. The Russell 2000 small-capitalization index logged the largest gain at 1.19%. However, you can see that resistance held for the Russell 2000 as well as for each of the other indices.
Particularly for the S&P 500, prices have held below the 2100 level since last July-August 2015. The S&P 500 has been unable to close above this level for nearly a year and finished last week slightly below 2100 at 2099.13.
What happens in the coming weeks will be critical for the near-term future of the market. Stocks are facing far more challenges than just technical-based overhead resistance, which we will discuss below.
MAY'S SHOCKING JOBS REPORT
Investors were forced to reset their expectations dramatically following last Friday's jobs report. According to the Bureau of Labor Statistics (BLS), in May employers only hired 38,000 applicants; the fewest jobs added in more than five years.
Also, the BLS revised earlier data and said that employers added -59,000 fewer jobs in March and April than previously reported. The declining data brought the average monthly job growth over the last three months down to nearly half (116,000) of the more robust growth average of 219,000 per month over the last year. Declines in job growth are frequently a leading indicator of a recession, so this number calls for close attention in coming months. Hopefully, it is an outlier and vigorous increases in employment will resume in coming months.
Unfortunately, the BLS also reported that the unemployment rate fell to 4.7% because more than 450,000 Americans left the workforce. A record 94,708,000 Americans are currently not in the labor force, decreasing the labor-force participation rate to 62.6%.
Another thing that dropped following the jobs report was the odds of the Federal Reserve raising interest rates in June. The Federal Funds futures now gives a 0% chance that the Fed will raise rates later this month, even though Fed officials have protested all year that June was a "live" meeting for a potential rate increase. From the promise by the Fed last December of four rate increases for 2016, the odds are now that there will only be one or two. The question is when (of if) they will occur?
As shown in Chart 2 below, the free market mechanism has a way of providing that answer. Immediately after the jobs report was released, the Federal Funds Futures Market for the odds of a quarter-point rate increase in July dropped substantially from 64% to just 28%:
CHART 2: Federal Funds future's chance of a 0.25% rate increase in July plummeted on Friday. Source: Wall Street Journal
Since last December, IntelligentValue has maintained that there is zero chance of four rate increases this year, and we believe it is unlikely that there will be any rate increases in 2016. With all the headwinds facing central-bank policymakers, we believe it is more likely that the Fed will be lowering the rate back to zero and possibly instituting another round of quantitative easing or even negative interest rates as is already occurring in Japan and some parts of Europe.
PREDICTABLE ASSET CLASSES MOVING IN PREDICTABLE WAYS
With the surprisingly weak jobs report for May, the traditional asset classes that either rally or drop due to negative economic news moved in a predictable manner on Friday. First of all, and perhaps most importantly, when there is a weakness in US economic fundamentals, the value of the US dollar declines. Generally speaking, the value of the dollar is highly correlated to the strength of the US economy. Chart 3 below shows the US dollar dropping off sharply on Friday after climbing since the start of May:
3: US dollar dropped sharply last Friday following the dissapointing jobs report.
Many asset classes are affected by the value of the US dollar, with commodities probably ranking number one in that group. The upper window of Chart 4 below shows a 10-year history of the US dollar ($USD in green) and the PowerShares Commodity Index Tracking Fund (DBC in blue).
The lower window of Chart 4 shows the Correlation Coefficient between the US Dollar ($USD) and Commodities (DBC) in red. The Correlation Coefficient is positive when both securities move in the same direction, up or down. The Correlation Coefficient is negative when two securities move in opposite directions. It is clear that the correlation between these two asset classes is inverse since 98% of the history of the dollar/commodities, save for a few months surrounding the beginning of 2014, has been in negative territory (below zero in the lower window of the chart) for almost the entire period:
CHART 4: The US Dollar (green) and the PS Commodities Tracking Fund (blue) have been in negative correlation for the last decade.
If the decline in economic fundamentals and the value of the dollar continues, it will be a set-up for the purchase of commodity-based assets, ETFs, and stocks. This includes crude oil, gasoline, natural gas, and agricultural products such as orange juice, coffee, sugar, soybeans, oats, corn, wheat, and many others.
Also included in the commodities group are industrial and precious metals such as copper, gold, silver, palladium, etc. Foreign currencies such as the Yen, the Euro, Canadian dollar, Aussie dollar and others will also get a boost from a decline in the US dollar.
Another asset class that is advanced by a decline in the US economy are bonds and other safe-harbor assets. In fact, many bond ETFs skyrocketed on Friday.
IF ECONOMIC TROUBLES INTENSIFY, STOCKS WILL CRASH
If the US economic troubles increase and the US does enter into a recession, the asset class of equities will suffer the most. This has always been the case and shall forever be a given. In the last year, we have carefully documented what we believe has been a balanced view of the market, but most of the critical indicators are clearly negative. These indicators include the following (each could be a headline and article unto itself):
- Corporate Earnings Continue an Unabated Decline
- Rising Stock PE Ratios (second highest level since dot-com bubble)
- S&P 500 Sales Dropping Sharply
- Total Debt-To-Capitalization Ratio Signals Danger
- Real (inflation adjusted) Bond Rates Are Already Negative
- Russell 2000 (small company) Profits are Negative
- Business Inventories Rising While Business Sales Plummet
- Velocity of Money Now Slower Than Depression Era
In addition to these and many other negative economic performance indicators, this week we can also highlight our concerns about US Industrial Production...
INDUSTRIAL PRODUCTION DECLINING
According to Investopedia.com, "Industrial production figures are based on the monthly raw volume of goods produced by industrial firms such as factories, mines and electric utilities in the United States. Also included in the industrial production figures are the businesses of newspaper, periodical and book publishing, traditionally labeled as manufacturing.
The industrial production and related capacity utilization figures are considered coincident indicators, meaning that changes in the levels of these indicators usually reflect similar changes in overall economic activity, and therefore gross domestic product (GDP).
The industrial sector exhibits the most volatility in terms of nominal output during a business cycle peak to trough. As a result, significant changes here have been a historical forecaster of business cycle inflection points."
As shown in Chart 5 below, Industrial Production has been a very accurate coincident indicator for stock returns. The top window shows Industrial Production dating back to 1992; the middle window shows the S&P 500 index for the same period, and the bottom window shows the Correlation Coefficient for the two in green.
Conversely to Chart 4 above, this Correlation Coefficient (bottom window) is very positive, with periods of an almost perfect correlation (1.00) between the Industrial Production indicator and the S&P 500 Index. What is noteworthy in this chart is the fact that Industrial Production has been declining since the end of 2014. While Industrial Production has not (yet) dropped off a cliff as it did in 2008, the decline is not something that can be disregarded, either:
CHART 5: Industrial Production (top window) has been declining since late 2014 and has a nearly perfect correlation with stock prices.
Interestingly, Chart 5 shows that the S&P 500 remains near all-time highs even as Industrial Production continues to decline for more than a year.
Will stock prices soon buck the influence of Federal Reserve manipulation and catch up to all these negative indicators? It is an intimidating prospect to consider.
S&P 500 TREND CONTINUES HIGHER
Does the market have any bullish evidence going for it? From a technical standpoint, the answer is yes. In early March 2016, Chart 6 below shows the S&P 500 re-attained its Long Term Trend Channel that began seven years prior in March 2009. It dropped sharply below that Trend Channel to start the year, then moved sharply higher with a strong rally in February, and has been hovering just above the lower trend line ever since.
Another drop below the Long Term Trend Line could be the death-knell for this index, especially if the jobs report is beginning to signal a potential recession.
CHART 6: After dropping sharply below to start the year, the S&P 500 moved back above its upward Trend Channel in March 2016.
Zooming into the 2013-to-present timeframe gives a closer view of the S&P 500 Trend Channel. Chart 7 shows that the S&P index is only about 40 points above the Trend Channel, with a doji at the 2100 resistance level (red-dotted line). As we discussed previously, with strong resistance at the 2100 level, the S&P 500 is at a critical point. A drop from the 2100 level to below the trend channel may signal the beginning of a significant selloff:
CHART 7: Zooming in shows that the S&P 500 is about 40 points above the lower Trend Channel line but facing resistance at 2100.
OUR PLAN FOR THIS WEEK
One dark day does not a market calamity make. The very adverse jobs report released last Friday, in which only 38,000 individuals gained employment, is concerning. However, it could be an outlier. On the other hand, that dire report is confirming the highly unfavorable conditions we have documented in this issue as well as multiple prior editions of the Value Alert newsletter.
This week's plan is a repeat of last week's plan: "We will continue to keep our portfolios in cash at this time, but will be watching market charts carefully this week. If prices break through the resistance shown in Chart 1 above, we may be purchasing long positions. On the other hand, if the resistance holds and prices drop, we may be buying inverse ETFs or ETFs that rise during adverse economic conditions."
If you are considering cancelling your subscription to IntelligentValue, please first read our May 22 newsletter titled, "Don't Play the Loser's Game!" If you have questions about our approach, please feel free to contact us.
Best Wishes for Another Week of Intelligent Value Investing,
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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the subjects discussed, market environment, company or ETF SEC filings. Investors may wish to consult a qualified investment advisor. The information in this material was obtained from sources believed to be reliable, but were not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.