for the upcoming week beginning May 2, 2016
With Market Questions and Answers
They say a picture is worth a thousand words. As I contemplated what was top of mind for me this week, my thoughts kept coming back to the relative value of the US dollar and the performance of the US economy. Our economic growth is lackluster in many areas and, as the world’s largest economy, this is depressing global growth. The world needs us to grow at a much faster pace to drive demand, trade and economic expansion across the developed and emerging territories. Because of our lack of growth and the timing of the financial market turbulence in January and February of this year, a rather significant change occurred in February that I believe will be discussed in history books. Before I get ahead of myself from a narrative perspective, let me give you those thousand word pictures with some brief explanations, and then I will add my thoughts as to what happened in February and what it may mean going forward.
First up is a picture of the U.S. Dollar, and please know I do not have an editor so what you see is my handiwork at chart preparation (making fun of my skills here is perfectly acceptable).
This Friday, April 29, 2016, the dollar fell slightly below the 2015 low as it closed at 93.02. If this decline continues there is a lack of support until we get to 88.55. Ask yourself why is the US Dollar weakening?
Next up is the U.S. data on exports and imports.
The level of Imports into the United States and Exports from the United States have been relatively flat over the past 18 months. US demand has been stagnant, and WW demand lacks momentum, particularly given the expensive nature of US goods arising from the strength of the US dollar since 2014.
The next set of pictures reflect a lackluster historic view of various US performance metrics on our Business Sales and Inventories, Factories, Housing, Autos, and inflation (or lack thereof).
The low level of sales per dollar of inventory at 70.88% reflects a dramatic decline over the past few years in a manner similar to the recessionary periods we experienced in 2001/02 and 2008/09. Excess inventories lead to cutbacks and deflationary pricing.
In this environment what are our factories telling us?
They are telling us that inventories reached levels that far exceeded new orders and shipments, and as a result our factories have cut back and reduced their output as a percentage of capacity. We have been clearly running at sub-optimal rates for a period of close to two years, and have been on a downward trajectory for quite some time as we have become more of a service economy. There is still much factory based inventories to be worked off, and we need an increase in demand to show up in New Factory Orders to bring about a more historically balanced set of relationships here.
Some of the fundamental economic results within the United States can be seen by the demand for New Homes and Automobiles. This demand typically arose from expanding incomes. Unfortunately, the average US Household income level has not increased since the year 2000. As a result, borrowing stepped in to enable demand creation. We all know the degree to which we over-leveraged to obtain New Homes and Cars, but that only went so far. We are now at a stage where to enable new demand we need rising incomes. The data on New Home Starts and Domestic Autos is as follows:
While we have improved from the 2008/09 recessionary lows, we are still meaningfully below the historic levels of a robust economic environment, and in some sense we appear to be plateauing without any further catalyst to drive incremental new demand.
Finally, let’s look at inflation vs deflation. In the United States I prefer to look at the inputs at the Producer level and therefore track the Producer Price Index vs the Consumer Price Index.
Clearly over the past two years’ prices have been falling. This corresponds with the strength in the dollar over that period as buyers seek price discounts in a world where foreign exchange is unfavorable and where global demand is lackluster.
After digesting the information above, as well as many other factors, the thought process that has evolved for me and which I am choosing to share here sees a parallel with the Plaza Accord that took place in 1985. At that time the world economic leaders met in New York to agree on a coordinated plan to drive the US Dollar lower versus other currencies. Remember, we had recently exited a significant recession of the early 1980s. The actions taken at the New York Plaza Hotel in 1985 led to a multi-year economic boom.
Putting that history into the context of today, we have seen years of lackluster growth since the Great Recession of 2008/09. As a result, is it possible that the world leaders have decided to take an “old” bold step that may be needed to address today’s global malaise and lack of economic strength/leadership from the world’s largest economy? The United States heretofore has been unable to drive global demand because it has been impaired by the strength of the dollar. And now it is interesting to see the recent weakness of the US Dollar which just happens to follow the G-20 Finance Minister meetings that were held on February 26/27, 2016 in Shanghai, China (US Dollar was at 98.09 on 2/26/16 and is now at 93.02). Since that date the US Dollar has weakened considerably. Foreign Central Banks have pulled back from their own easing actions (think of the Bank of Japan doing nothing last week, and the European Central Bank taking no further action as well), while the US Fed chose to stay in a holding pattern rather than raise interest rates in the US that would increase the gap between global rates and the US rates of return. If this is a coordinated approach, it is not likely short-term in nature and to that end a careful eye on the movement of the dollar will be very important. The global benefit of a weaker US currency to the Emerging markets, the support of prices in the commodity area (the rise in the price of oil without any OPEC actions is curious, yes?), and the stimulative nature to US Multi-Nationals’ foreign operations and of U.S. exporters are all outcomes of a sustained lower dollar. If right, we may just see a meaningful rise in future economic activity and in prices to defeat deflation.
This is a very dicey position to be in at the moment, for market internals and sentiment have been very positive while fundamentally the market is expensive based on current revenues, earnings and cash flows. Conflicting messages are everywhere and many traders are scratching their heads trying to make heads or tails from the varying price movements of the different asset classes. Putting capital at risk is this environment must be done prudently, so be very careful and do not try and be a hero in these swirling waters.
The thoughts reflected above did not drive my market activity during this past week, but they are now front and center in my mind. For the week I traded around the Thursday and Friday declines by getting smaller, then larger, then smaller again in the Futures Market, and in some specific cases I chose to buy small positions in equities that were punished during the week (think Apple, Twitter etc). The end result was a modest weekly gain.
The Connolly portfolio and the market performance for the Year-to-Date period ending on April 29, 2016 is as follows:
YTD Connolly portfolio gain as of April 29, 2016 equals +7.05%
S&P 500 Index YTD gain as of April 29, 2016 equals +1.05%
NASDAQ Index YTD loss as of April 29, 2016 equals -4.63%
The Connolly Portfolio composition as of April 29, 2016 is as follows:
• Cash 50.3%
• Equities 33.0%
• Gold 15.2%
• Fixed Income 1.5%
Forecast for the week: I anticipate that the market weakness of this past Thursday and Friday will continue into the upcoming week. There are multiple dynamics at play ranging from continued first quarter earnings’ releases, geographic economic releases, political and territorial tensions that abound, and an investing climate that feels as though it is moving from “resilience” to uncertainty. The market does not like uncertainty. Accordingly, I will maintain a modestly hedged position and will look to take advantage of market declines.
However, given my earlier comments during the first section of this weekly report, I will be very attuned to data and price movements that could see me move either bullishly or more bearishly. Fundamentally, I still believe the market should price lower, but if my sense of optimism around a coordinated currency agreement gains traction, then my long-side buying could accelerate. No need to rush here, but be aware of the multitude of dynamics at play and the volatility that may become very real as the market wrestles with incomplete information.
Finally, given the time I committed to preparing the economic discussion above, I will not detail the Market questions and answers this week. The summary of what that data would convey is that the market remains expensive, but less so given this past week’s late sell-off, and that the market internals continue to express optimism and support for a move higher in the indexes. Current quarter earnings’ releases are showing a continuation of lower performance and that is problematic. But, there is always light at the end of the tunnel and we need to be ready to see it early enough to be positioned to enjoy returns that add to our own sense of financial security. Be well, and as always, have a great week!