- Stock markets started disconnecting from the economy in the first half of 2013.
- This served multiple purposes. Disguising policy failure is just one.
- Economic impact is obvious from the chart above.
- Markets now reflect 2 narratives that are in opposition.
- “Quad 4 Reality”. 12 market indicators reflect gathering deflation and falling growth.
- “Altered State”. 7 key signs of planned market manipulation.
- Markets in conflict will have to resolve inconsistencies.
- Enormous investment implications require a new solution.
- The Cycle Dynamic Portfolio.
In an attempt to disguise policy failure, an extraordinary attempt is being made to impose an “Altered State” on the markets with a narrative to back it up. However, fake it until you make it can only work if there is a chance of making it within a reasonable period of time, and it is hard to manipulate all the markets all the time.
What becomes obvious on closer examination is that markets are now reflecting two very different stories. Both these stories cannot be true at the same time. The reason they coexist at the current time results from the conflict between imposing an obsessive adherence to failing policies, and the real economic world.
The purpose of this note is to explain the contradictory nature of current markets and to reveal what is fake and what is real. The implications for investment strategy are enormous.
Long term economic trends should be obvious.
The long term economic trends should be overwhelmingly clear at this point to any impartial third party observer. Debts have kept rising, while real disposable incomes have been falling. This is not new. It has been happening for over 40 years now!
In truth current policy is not mainly economic any more, so much as it is a redistribution and control mechanism, which can only last while enough people support it, willingly or otherwise. That time is coming to an end. The inconsistencies and contradictions are becoming too obvious, as well as the destruction and inequities of the system.
Rising debt and falling real incomes is not a sustainable economic model. It requires ever lower interest rates to ease the burden of debt and ever increasing money printing to fill in for the lack of real capital and value generation. The process is exponential and is hitting its limits. For example, zero interest rates.
This is why the markets are becoming increasingly dysfunctional. The normal economic relationships and classical investment management strategies are no longer working as policy makers desperately attempt to keep the system going, by forcing a false narrative through the media and now increasingly into market prices.
Markets make opinions and in the short term it is possible to believe almost anything and a more optimistic outlook is obviously more attractive. However, at some point it becomes crucial to get the story straight, otherwise it is impossible to plan appropriately.
I believe this is where we are now. It is important to understand what the markets are saying, where the markets are reflecting economic reality, and where they are being purposefully distorted. Once this is understood it becomes increasingly important to adapt your investment plan to a methodology that can handle this complex set of circumstances.
Investment management is now uniquely challenged to adapt to current conditions. To create a new methodology that can not only handle current conditions but also avoid significant loses, while still providing the potential for gains.
A solution is provided below. But first what are the markets themselves telling us?
Altered State versus “Quad 4 Reality”
The starting point is to break the current markets into 2 sections. “Quad 4 reality” represents data and market relationships that are reflecting falling world growth and inflation, typically called Quadrant 4 of the economic cycle. Then there is an “Altered State” section where intervention is materially influencing market prices.
Quad 4 Reality:
- Commodities have crashed, especially oil.
- Many emerging markets have crashed. ILF (Latin American stock index) is at new 5 year lows.
- US high yield debt has crashed.
- S&P 500 core earnings are declining, with probably 2 years of consecutive declining core earnings.
- Big cap US stocks outperforming small caps. Narrowing performance is a weak growth signal.
- Deflation over the next 2 years is now priced in the US markets.
- Negative deposit rates and even bond yields have become a regular feature of European and Japanese markets.
- World growth continues to decline.
- The US yield curve is now as flat as it was back in 2008/09. Weak growth signal.
- Gold is strong relative to commodities. Weak growth signal.
- US housing market is flat at historically weak activity and price levels.
- Baltic dry index, a key global trade indicator is very weak.
- US equities at record valuations on all metrics that are predictive of future poor performance. This despite very poor underlying earnings.
- “S&P 500 profits are 86% higher than they would be without accounting fudges” Blackrock investment report.
- Big cap US stocks massive outperformance versus equities in the rest of the world to the point of inconsistency.
- Bank of Japan stating explicitly that it is printing money to buy equities. Acknowledged practice of central banks in addition to stated policy objective of boosting economic growth through the “Wealth Effect”.
- Silver has record demand for physical silver for 2 years running. Limited above ground inventory. Trading about 20% below average cost of production.
- Gold. Blatant and persistent downside price manipulation. No competition for US dollar permitted.
- Federal Reserve short term interest rate expectations are far above market levels and have been too high consistently for 6 years. Flawed model? Or setting unrealistic expectations?
In summary this collection of data strongly suggests that there has been a significant campaign to raise short term interest rate expectations, depress precious metals prices, and inflate US equity prices. Given the overwhelming evidence of the world economy entering an intense Quad 4 phase of the economic cycle, and all the factors mentioned above, these attempts are clearly diametrically opposed to the natural development of the markets.
As Jim grant recently said on CNBC, “The Fed has a 3rd Mandate …….. The Administration of American Equity Prices”. This mandate was internally decided. There is, of course, no congressional permission.
These distortions are very substantial and probably amount to at least a 30% overvaluation in the S&P500, and very substantial differences to the precious metals and interest rate markets. Furthermore, the impact of these interventions will accentuate the “Quad 4” phase of the economic cycle as the natural interest rate level has been distorted higher when the economy may have needed lower interest rates. In addition, they will likely lead to even more instability in the markets as the price corrections to natural levels could now be far more violent.
Far from stabilizing the markets and supporting the economy the Federal Reserve is achieving the opposite by its extraordinary interventions.
The manipulation of markets seems to have accelerated from around April 2013. At this time the gold price unexpected fell by an 8 sigma move down in just a few days without any significant news. Many other charts show clear breaks in normal relationships at that time. Since April 2013 investor’s results have been increasingly determined by administered Federal Reserve interventions.
To believe this is a game that can be played indefinitely, the following questions would need to be addressed. Will the Federal Reserve be able to continue this price administration forever? What are the limits to this? What are the targets? What signals will indicate a change in policy? What are the investment risks? There are no easy answers.
The only certainties left for most investors are the measurable elements of real economic cycles and relative strength. These characteristics remain realities no matter what manipulation takes place, so they provide both a near and long term solution.
That is why I have created the Cycle Dynamic Portfolio. This rests heavily on relative strength within the structure of economic cycles. This methodology provides a durable solution and significant advantages over most classical approaches to investment management, and an effective solution to the unusual investment circumstances of today.
Here is a detailed description of the Cycle Dynamic Portfolio.