Guiding You Through Uncharted Waters

Issue 2/19 for January 9, 2019

SPECIAL UPDATE

 

 

 

THE BIG SHIFT. FED REVERSES COURSE SO INVESTORS RESPOND, PRODUCING

A BREAK-AWAY MOMENTUM BUY SIGNAL.

 

What a difference a week makes! News about tariffs, trade talks with China, the U.S. government shutdown, Brexit and problems with Italian banks are just sideshows to the main events. The main events that effect almost everyone’s pocket books are oil prices and interest rates.

 

There is a well-known saying in investment circles – “Don’t fight the Fed.”

 

After series of booms and busts, the U.S. Federal Reserve was created in 1913 to try to moderate the ups and downs of the U.S. economy by manipulating interest rates and controlling the amount of money circulating in the economy.

Canada has the Bank of Canada, the UK has the Chancellor of the Exchequer and Europe has the European Central Bank, fulfilling the same roll. Politicians appoint wise, experienced men and women to these roles where the Chairpersons can then act with total independence going forward. While the people in these roles do their best to act in a way that results in steady economic growth with low inflation, manipulating the minds of consumers and business owners is no easy task. The fact that the U.S. experienced the Great Depression less than 20 years after the Fed was created confirms this.

 

President Trump appointed Jerome Powell to replace Janet Yellen on Monday February 5, 2018. The S&P 500 fell 4.1% that day when stock markets erupted with downside volatility that would last another 11 months. Why did this happen?

 

Since movements in U.S. interest rates also affect global currencies, the wideranging ramifications of actions by the Fed make the Fed Chairperson the most powerful person in the world. While we often think people in high, responsible

positions check their emotions at the door to act in a perfect, rational way. What I have observed shows that is not always the case. It would be hard for even the best of us to not feel the pride and over confidence that can go along with

becoming the most powerful person in the world. I believe pride and overconfidence, together with inexperience, caused Powell and the Fed to make a major blunder in late 2018.

 

By December 2018, the Fed had already increased interest rates by 0.25% eight times so some investors were not fighting the Fed by moving to the sidelines over the years. It can take six to twelve months for the negative effects of rising interest rates to impact the economy. The Fed needs to be firm and steady during normal economic and market volatility so Powell remained that way during most of 2018. He kept stating that the Fed was on a steady pace of increasing interest rates in 2018 and 2019 and kept removing money from the system to reduce the monetary stimulus that had been in place due to the Financial Crisis ten years ago.

 

The economy and markets depend on people’s confidence. By the fall of 2018, the negative impact of a 2% increase in interest rates together with a 200% rise in oil prices started to erode confidence. The disruption caused by tariffs and trade with China added to this, causing oil prices and stock prices to fall sharply in October and November.

 

There is one sign that is the most reliable indicator a recession is approaching – an inverted yield curve.

 

Normally short-term interest rates are lower than long-term interest rates. The Fed only controls very short-term interest rates. When the Fed believes the economy is so strong that there is a danger of rising inflation, they raise interest rates to cool the economy down. When the Fed raises short-term interest rates to the point that they are higher than longer-term interest rates (the U.S. 10 year government bond is used to represent long-term rates), the normal interest rate

relationship is upside down. This is called an inverted yield curve. Please see the example I created to show this below.

 

 

Banks provide the fuel for the economy. They borrow at cheaper short-term rates in order to profit by lending money at higher longer-term interest rates. When short-term rates are as high or higher than longer-term rates, it is not

profitable for banks to lend anymore. When this happens, banking profits fall and there is less fuel for the economy, which usually ends in an economic recession. Late last year, Fed official said it did not matter if the yield curve inverted this time since the reason long-term interest rates on 10 year bonds was so low was because the Fed was buying bonds to remove money from the economy. This was an absurd statement, since an inverted yield curve affects banks, and therefore the economy no matter what the cause is. Any student of the economy knows that an inverted yield curve is the main cause of a recession no matter how it comes about.

 

As stated earlier, the Fed should remain steady and not be swayed by the normal volatility with economic statistics and markets. However, when confidence has eroded to a certain point, it is vital for the Fed to step in with either

words or action to maintain stability. After oil prices and the shares of U.S. bank stocks had declined significantly in October and November, it was time for the Fed to step up and say that they were watching what was happening in the

economy and markets and would respond accordingly. It was important for Powell and others to say further interest rate increases and additional withdrawals of money from the economy was dependent not on a strategy that was on

autopilot, but dependent on daily economic and market data. They made a critical mistake in December by raising interest rates again and giving the impression that they were going to increase interest rates two more times in 2019, which would most certainly cause the yield curve to invert and therefore cause an economic slowdown, if not a recession. As markets continued to decline into the year-end, nothing changed, resulting in the worst December for U.S. stocks since the Depression in 1931.

 

Please see the chart below from the Federal Reserve Bank of St. Louis. On the upper left hand side you can see that the spread between the 2 year and 10 year bond was 2.5% in 2014. On the bottom right you can see the spread has narrowed dangerously close to inversion at only 0.15%.

 

 

By the end of 2018, Powell and Fed officials realized they had made a major blunder and needed to make it very clear to investors and consumers that they were willing to change whatever they were doing to restore confidence. They

needed to reassure those who understand how the economy and markets work that this was more important than following a pre-set plan. Powell had the opportunity to do this at a conference on January 4th. Here is an excerpt from a commentary about his talk from a New York Times article.

 

“But he was at pains to reassure investors unsettled by his confident tone at his last news conference in mid-December. He said that the Fed was watching for evidence of weakness, and that the health of the economy would ultimately determine the course of policy. The Fed predicted in December that it would raise rates twice in 2019, but Mr. Powell said the central bank was ready to change course ‘significantly’ if necessary.” (I have marked the sections in bold.)

 

While it was late, it is just what the investment community needed to hear to have confidence that the Fed was not hell-bent on driving the U.S. economy into recession. While there have been all sorts of market rebounds, the strength

beneath the surface of the markets over the last week has been historic.

 

One of the best ways to measure the strength of the markets is to look at the number of stocks advancing compared to those declining every day. When there are twice as many stocks rising compared to those that are falling, on average, for ten consecutive trading days, it is a rare sign that money is flowing into the stock markets like water over Niagara Falls. Few are aware of this. This occurred as of the market’s close on Wednesday, January 8th. The reliability of this indicator and the returns that follow are so impressive that I entitled Chapter 26 of my book, Mind, Money & Markets, that explained this indicator: “Reading Tomorrows Newspaper Today: 2-1 Advance/Decline Buy Signals.” Some call it a Break Away Momentum buy signal or Breadth Thrust buy signal. The reason why it so reliable is because it is based entirely on what people are doing with their money in the markets.

 

The chart from July 2016 on the next page from InvesTech shows when this indicator has issued buy signals since from 1950 to 2016. You can see there have only been 13 initial buy signals like this in the last 68 years. The red arrow shows

the last time this happened on July 12, 2016 right after the 7% correction following the Brexit vote. The gains for the following one, three, six, twelve and eighteen months were as follows: 1.5%, -0.5%, 5.5%, 13.5% and 29.5%. The

table at the bottom of the page shows the track record going back to 1962.

 

 

To some, it may seem strange for markets to reverse so quickly and suddenly from being in a sharp downtrend to a long, powerful uptrend. However, I tracked the buy signals this indicator gave in the midst of the severe 1982 recession and before the surge in 1987. There was close to a 20-year drought before this indicator issued a buy signal on March 23, 2009. In the depths of the 2008-2009 Financial Crisis, after many failed rallies and repeated action by the Fed, this is the headline I wrote for the Special Investment Update that day so I could inform all my clients about it. Do you remember how much fear there was at the time?

 

 

There were very few market experts who turned “pound the table” bullish so decisively and early in an advance that everyone now says has existed since March 9, 2009. For many months after, most experts were saying it was just

another rally in a bear market since quantitative easing was like giving more heroin to a drug addict. In spite of all the doubts and the severe crisis, this buy signal was precise and accurate. What happens in the markets does not always

make sense at the time. The cardinal rule of investing is to follow the trend. When there is clear evidence of a major longer-term trend change, investors need to adjust as well, even if we do not understand the reasons why at the time.

 

It is healthy for markets to have declines to eliminate excesses that have built up over previous years. This is what a bear market (a decline of 20% or more) does. However, a relatively unknown way to determine when the market has

declined enough for a positive reset is if it has reached an 18 month low. That happened in early 2016 and has happened again in late December 2018 as the S&P 500 fell down to levels reached in April 2017. Pessimism has also declined to levels last seen in early 2016, as shown in the chart from Investors Intelligence on the next page. Please see the black line showing there were recently more bears than bulls for the first time in years.

 

It is hard to imagine that some simple reassuring words from the Fed Chairperson can cause such a major shift in the mood of investors. However, I have observed that the most common factor that starts new uptrends is a reduction in interest rates or change by the Fed. In this case, being at “pains” to show how serious he was about being totally flexible did the trick. Hopefully he has learned from this needless mistake. It looks as though those who lost confidence in the Fed on February 5, 2018 have finally had it restored.

 

One of the most common traits of a bottoming process is for market averages to form a double bottom within 4% of the previous low, often within six to eight weeks of the first low. See all the examples in Chapter 24 of Mind, Money &

Markets. In a dilemma like this, we have to prioritize factors. From what I have observed, and what the track record shows, the 2-1 Advance/Decline buy signal supersedes any other factor.

 

During the 2009 Financial Crisis lows, the Canadian TSX and the NASDAQ traced out normal double bottoms, but the major market averages like the DJIA, S&P 500 and Russell 2000 did not. Yet, the March 9, 2009 turned out to be a low

that has never been seen again. This also supports that fact that this buy signal supersedes the necessity for a double bottom. Please see the chart of the 2009 low for the S&P 500 on the next page, showing that there was no double bottom.

 

 

In summary, we must be flexible, just like Jerome Powell needed to be flexible. We need to adjust to major shifts in trends and the data. Oil prices and interest rates are the key drivers of the markets and the economy. When we look

back, we can see that the investment community did not have confidence in Jerome Powell since the day he started in his new role on February 5, 2018. While it came too late, correcting a mistake late is better than never. Powell’s

comments last Friday restored confidence and unleashed a torrent of cash to come back into the markets.

 

The rare 2-1 Advance/Decline buy signal indicates the strength of this rally has been unusually strong and that the probability of very attractive returns in the next 12 months are as high as they get. In my opinion, it is as close as we will

ever get to be able to read tomorrow’s newspaper today. As a result, I have changed the photo on the front page to a green flag, which is the starting flag for a car race. History suggests a new longer-term uptrend has started and the

extreme downside volatility investors have experienced over the last 11 months is over. This indicator suggests it is time to increase equity exposure.

 

In the past, markets have often stabilized for a month or so after this buy signal before starting to rise again so there is usually time to add equity exposure. This is because the strong, steady buying uses up a lot of buying power to produce a rise and buy signal like this. Therefore, the rally can often pause for a few weeks, allowing more buying pressure to build.

I have been advocating a move into ETFs of the larger companies in the DJIA and S&P 500 since November 2017, which has turned out to be prudent. Now that markets should be strong again, I believe moving funds into ETF’s that own the U.S. mid-sized companies in the S&P 400 should work out well. Although most are not aware of it, history suggests what has happened in the last week will make 2019 a much better year than most were imagining. Now this is a really a Happy New Year!

 

Search and Rescue Update.

 

2018 was one of the slowest years for our SAR team since I joined in 2001 with only 35 calls. However, we had our first call of 2019 on Sunday night and it was an interesting one. The call came at 10:00 pm from the RCMP to help them look

for a family of five who were reported missing somewhere on the Harrison East service road since they had not arrived at home when expected.

 

As the team was heading out from the base, we received another call that there was an accident 2 km up the Harrison East service road with people trapped inside the vehicle. When we arrived, we discovered that as an RCMP officer was

heading up the gravel road looking for the missing people, he had a flat tire. While he was outside his SUV checking his tire, a vehicle passed him going the other way and then lost control and went over the bank, crashing into trees and the

bush 30 feet below. Thank goodness, the father and three children were not injured and were able to walk out after fireman used Jaws of Life to cut them out. The mother had to be carried out on a stretcher.

 

If the RCMP vehicle would not have been close enough to hear the other vehicle crash, it could have been hours until we would have found them down the bank. Even worse, if the vehicle would have continued along the road home and

went off the road where the road continues right beside Harrison Lake, they would have all disappeared into the cold, dark water and likely perished. I am thankful guardian angels were looking out for those children in this situation. In the

meantime, be safe out there. Have a great weekend!

 

Dave Harder, CIM, FCSI

Vice President and Portfolio Manager

RBC Dominion Securities

604-870-7126

Toll Free 1-866-928-4745

 

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