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Marketmail

Tuesday, August 26, 2014

The Fed’s Reticence to Raise Rates Lifts Stocks to New Highs

By Louis Navellier

Last week, the Dow rose over 2% and the S&P rose 1.7% to reach a new all-time high on Thursday. The big news came from the Federal Reserve. First, on Wednesday, the Fed released the minutes of its last Federal Open Market Committee (FOMC) meeting, which revealed that some of the board’s hawks were worried about inflation, while the majority doves were more worried about problems in the labor market. As a result, the dovish FOMC consensus was that the Fed should keep key interest rates low for “some time.”

At the Kansas City Fed’s annual retreat in Jackson Hole, Wyoming, Fed Chairperson Janet Yellen said in her prepared remarks that we should not be fooled by the drop in the unemployment rate, since the labor market participation rate is so low. She said there is still a lot of “slack” in the labor market, so she asked Fed observers to be more patient regarding when the Fed will eventually raise key interest rates.

Meanwhile, international tensions continue to escalate. Russia moved artillery units inside Ukraine and is helping separatist forces fight Ukrainian forces. At the same time, ISIS forces photographed their brutal beheading of an American journalist. With the U.S. now dropping bombs on ISIS and helping Kurdish and Iraqi forces, the dollar has gained strength, particularly against the euro and the sagging Russian ruble. Ever since the strong second-quarter GDP report was announced, the U.S. dollar has been rising.

In this week’s Income Mail, Ivan Martchev will cover surprising developments in the oil markets and in the Fed funds futures, while Gary Alexander will take a look at recent Jackson Hole market rallies. I will cover the latest economic statistics going into the Labor Day break. Have a wonderful holiday weekend!

In This Issue

Income Mail:
More Red Flags from Commodities
by Ivan Martchev
Jackson Hole Moves the Fed Funds Futures

Growth Mail:
Last Week’s “Jackson Hole Rally” Delivered a New S&P High
by Gary Alexander
Will We See Another “Rocky Mountain High” after Jackson Hole, 2014?
Market Lessons from Old France & New Orleans on August 25 & 26 in History

Stat of the Week:
Housing Starts Surge 15.7% in July
by Louis Navellier
Euro-zone Growth is grinding to a Halt

Income Mail:

More Red Flags from Commodities

By Ivan Martchev

All the commentators looking for an oil price spike due to escalating geopolitical situations—including this reporter—must feel rather puzzled. ISIS fighters in Iraq have been protecting the energy infrastructure, so they might use it to fund their glorious caliphate. Ukraine has not yet blown up into a full scale intentional confrontation, but if one can judge by the way a white-painted convoy zipped in and out of Ukrainian territory and returned to Russia, one could conclude that the Russians are keeping the fighting in Luhansk and Donetsk going so that things develop according to their predetermined schedule. I think their theatrical troop withdrawal from the border in June was the bait that the Ukrainian military took in order to attack the rebels so that now we have a dire humanitarian situation that calls for Mr. Putin to intervene. The Ukrainian situation is starting to resemble Gaza, but with no end in sight.

Crude Oil Prices Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I am of the opinion that a bigger military confrontation is coming in Ukraine, which should have serious repercussions on government bonds (safe haven buying), commodities (weak), and currencies (weak for the euro and the unfortunate Ukrainian Hryvnia which is already collapsing, and stronger for the dollar).

The most important commodity of all—oil—is already showing the stress that this conflict has caused in Europe. Brent crude seems to be breaking below what traders call a symmetrical triangle consolidation. I know that every futures trader knows charts pretty well, both from a short- and long-term perspective, but here we appear to have been head-faked with the ISIS blitzkrieg in Iraq in June, where Brent crude tried to break out to the upside of this triangular consolidation. As ISIS has been rather careful with the energy infrastructure so far, Brent crude is weakening rather notably, breaking from that large triangular consolidation to the downside. Brent is the benchmark for crude in Europe, and the trade wars there are beginning to affect the fragile economic picture quite notably.

The Brent-WTI premium (red dotted line, right scale, above) is now vanishing as demand in Europe is notably weaker. To a degree, it was the fracking boom that caused the Brent-WTI premium to go as high as it did in 2011 as U.S. production skyrocketed, up more than 50% since 2008. It is no guarantee though that Brent will keep sliding as it may turn out to be a geopolitical weapon yet to be used in this escalating Ukrainian situation. The Russian counter-sanctions are causing pretty serious issues in smaller EU countries with large trade relationships with Russia, and crude oil and natural gas are more potent weapons yet to be used, particularly as winter approaches.

Commodity Research Bureau Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It is not only Brent that is weak. All commodities have weakened this summer, and major commodity indexes are near 52-week lows. A case in point is the Commodity Research Bureau index which has two reformulations—one where oil and energy are overweight (CRB, in black), and one where the 17 commodity futures included in the index are equally weighted (CCI, in red).

Over the past three years commodities have been gradually deflating. Non-energy commodities have actually been weaker as the CCI equally-weighted index shows. While energy and metals are highly economically-sensitive, agricultural commodities depend much more on the weather as food demand is quite inelastic. The big outlier is corn. The ethanol boom pushed corn prices to $8.50 a bushel a couple of years ago, yet December 2014 corn futures closed at $3.71 on Friday. Corn has seen two back-to-back bumper harvests (we’ll see the second one shortly) and the falling price reflects the swelling inventories.

This corn glut may hurt Deere (DE) sales over the short term. At one point during the corn boom, Deere was selling a lot of tractors with flat-screen TVs and built-in refrigerators and was probably on its way to offering massage chairs if corn prices stayed high. But the corn glut has boosted margins at Green Plains Renewable Energy (GPRE) which at present corn prices produces sugar that is the equivalent of 8-cents per pound. By comparison, Brazilian ethanol producers that use sugar cane instead of corn now start off their ethanol production with sugar at a price of 16-cents per pound. This could give GPRE an advantage in the present environment as its input costs are cheaper in the midst of the corn glut.

In that environment, I would be careful with companies that make their money on price comparisons, and I would look more carefully into companies that make their money on volume. The MLPs, some of which we revisited last week, are the classic volume investments that have limited exposure to the price of oil or natural gas. Long-term periods of depressed prices also affect volumes negatively, but we are nowhere near such a situation at the moment. The holdings of both Alerian MLP ETF (AMLP) and the Alerian Energy Infrastructure ETF (ENFR) are prime pools for research on investments geared toward the fracking boom. The other benefit to these domestically-oriented investments is the U.S. dollar, which has been getting firmer not only because the U.S. economy is outperforming many global economies, but because the Fed is getting ready to tighten while the ECB is doing the opposite.

Jackson Hole Moves the Fed Funds Futures

The Fed's Jackson Hole meeting last week moved the Fed funds futures marginally towards tightening. It does not look like much on a weekly chart, but it was a down week for the December 2015 Fed funds futures contract (see below). The latest weekly move, though, pales in comparison to the QE tapering panic from May 2013, when the Fed funds futures contract went into a nosedive, only to recover quickly after September 2013 as Bernanke, and the other Fed governors for that matter, went out of their way to explain that “tapering” is not “tightening,” with any moves on the Fed funds front coming much later.

Fed Funds 30 Day Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

At one point in September 2013, the December Fed funds futures contract was forecasting a Fed funds rate of 1.45% in December 2015 (calculated by 100 minus the ZQZ5 contract price of 98.55). If one wanted to trade the evolution of the tone of FOMC statements, one could do so freely in the Fed funds futures market. After the QE tapering swings in Fed funds futures in 2014, the ZQZ5 contract has gone into a relative sideways consolidation as traders digest economic data in the U.S. for clues on when the Fed fund rate is coming off its 0-25 bps target range, which in practice has spent most of the past five years in single basis point territory.

Harmonized Unemployment Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

During the annual Jackson Hole central bankers' get together last week, Janet Yellen and Mario Draghi delivered contrasting outlooks. In the U.S., the debate is whether “we should begin dialing back our extraordinary accommodation,” while the European central bankers on other hand “stand ready to adjust our policy stance further” in part due to market signals that inflation expectations in August have “exhibited significant declines at all horizons.” Such quotations carried by major news outlets represent pretty well rather divergent economic situations that the U.S. and the euro-zone are in. In 2009, both regions suffered 10% unemployment. Now, the unemployment rate here is 6.2% while in the euro-zone its 11.5%.

As this negative deposit rate business got introduced by the ECB, Draghi mentioned there was more coming if that unprecedented move did not help. Judging by the record lows in bund yields this month, I would say - more is going to be coming soon as such bund yields signify Japanese-style deflation. In this case, the deflationary threat is not only because of shrinking bank lending in Europe, but also because of disappearing trade flows due to sanctions on the Russian Federation starting in March and the recent counter-sanctions from the Russian Federation regarding the ban of all foods from EU-sanctioning countries. Those counter-sanctions seem to have produced quite the effect, as a large number of small EU members are already complaining that they hurt them more than sanctions hurt the Russian Federation.

I am not sure that the ECB can do anything to mediate a trade war created by politicians. The problem affecting trade flows in Europe can only be solved politically or militarily. Monetary policy is important, but a large, well-trained military can only be counterbalanced by a larger, better-trained military force.

Further quantitative easing with the ECB is only going to weaken the euro, which seems to have started a significant decline in July that has only accelerated in August. I thought the euro-zone crisis in 2011-2012 had the potential to drive EUR/USD to parity, but large counterbalancing forces with multiple QE programs in the U.S. and deleveraging of the banking system in Europe prevented that from happening. Now, with Europe in a precarious situation, euro-dollar parity is again in the cards, particularly as trade wars intensify and weaken the already weak euro-zone countries.

We can theorize that the purchasing power parity of the euro is about $1.15, but one thing currencies are known for is their ability to spectacularly overshoot their fair values. Where is the fair value of the Ukrainian Hryvnia, which is down 40% year-to-date and a whole 8% in August alone? It is going to be down quite a bit more if there is a full-scale Russian invasion as at that point Ukrainian tax revenues will collapse with the loss of Eastern territories and the country will likely default on its obligations.

Growth Mail:

Last Week’s “Jackson Hole Rally” Delivered a New S&P High

By Gary Alexander

“…if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate.”

—Janet Yellen at Jackson Hole, Wyoming, August 22, 2014

Jackson Hole, Wyoming has become an annual rallying point for the stock market over the last few years, and this year was no exception. It seems like the pre-Labor Day meeting in the Rockies has been just the medicine the market needs. Last Thursday, on the day that most of the world’s most important central bankers gathered at Jackson Hole, the S&P 500 shot up to a new all-time closing high of 1992.37.

The first conference sponsored by the Kansas City Fed was held in 1978 and it covered a specialized topic, “World Agricultural Trade,” since Kansas City is situated in America’s Breadbasket, near some of the world’s greatest farmland. The Chairman of the Federal Reserve in August 1978 was an ineffective political nominee, G. William Miller. At the time, America faced much bigger problems than farm trade, so President Carter nominated Paul Volcker to run the Fed in August 1979, right before the KC meeting.

After three years of Volcker’s tight-money anti-inflation medicine, he finally relented, easing the Fed Funds rates in July and August of 1982, fueling a market rally. To take a victory lap of sorts, he asked the Kansas City Fed to hold its meeting near a fishing hole in Jackson Hole, Wyoming – in the remote Northwestern corner of the Kansas City Fed’s district. Volcker’s fishing haven has become an annual getaway for the last 32 years, but it has only become a big focus for market watchers since the 2008 crisis.

Will We See Another “Rocky Mountain High” after Jackson Hole, 2014?

Since 2009, the market has responded favorably to whatever news comes out of Jackson Hole. Perhaps another reason for this pre-Labor Day rally is that the entire federal government has left Washington. The President is golfing in Martha’s Vineyard, Congress has adjourned, and the Fed has gone fishing. As Mark Twain once quipped, “No man's life, liberty, or property are safe while the legislature is in session.”

This year’s Jackson Hole event seemed to try hard to be non-controversial. The theme was Janet Yellen’s specialty, labor economics, particularly her dashboard of 19 sophisticated ways to measure jobs. There was no firm announcement about interest rates or further easing, but we can safely assume that QE3 will “taper” out fairly soon, ending the two-year QE3 program as of the October 29 FOMC meeting.

In the last few years, Federal Reserve Chairman Ben Bernanke has made monetary history at Jackson Hole. He often announced (or paved the way for) a major Fed policy change. Here’s a brief summary:

  • The 2010 Jackson Hole conference was held August 26-28. In his August 27 talk, Mr. Bernanke said the pace of economic growth had been “less vigorous” than the Fed was expecting and the pace of the U.S. job growth was “painfully” slow. He also acknowledged that the Fed was surprised by the “sharp deterioration” in the U.S. trade balance. His solution was to revive the Fed’s late-2008 “quantitative easing” (QE) scheme. The market loved QE2: The S&P rose from 1040 on the day of Bernanke’s Jackson Hole talk to 1363+ the following April – up 31%.
  • The 2011 Jackson Hole conference was held August 25-27, during an especially volatile month in market history. At Jackson Hole, Chairman Bernanke laid out the groundwork for another new Fed monetary strategy called “Operation Twist.” The detailed plan was not officially announced until September 21, but over the next month or so, various Fed governors hit the road to explain and defend their $400 billion operation to artificially flatten the yield curve. The stock market loved Operation Twist. The S&P 500 rose over 26% from August 2011 to April of 2012.
  • The 2012 Jackson Hole conference, held August 30 to September 1, laid the groundwork for QE3, which was officially launched on September 13. Bernanke’s Jackson Hole remarks were more frank than usual. First, he said that the stagnant job market was a “grave concern” to the Fed. He also called current economic growth “far from satisfactory” and “tepid.” Because of this slow growth, Bernanke said the Fed will “provide additional policy accommodation as needed.” This was a broad hint that more easing (dubbed QE3) would soon follow. The market seemed to love QE3, as the S&P 500 has risen by over 45% from its August 2012 lows.
  • The 2013 Jackson Hole conference was held August 22-24. By then, Chairman Bernanke was a lame duck, so he let his replacement (Janet Yellen) speak in his place. Strangely, she did not say much, except as part of a panel. Since the skies were smoky around Jackson Hole, due to all of the fires in Idaho, the inside joke was that Jackson Hole’s skies reflected the foggy future of the Fed, especially since Bernanke’s hints of “tapering” (uttered in May) were spooking the markets. In the end, tapering failed to faze the market, with the S&P 500 rising 22% in the last 12 months.

Here’s a basic summary of how the S&P 500 responded to the last five years of Jackson Hole meetings:

Post-Jackson-Hole Market Rallies, 2009-14
Data Source: Yahoo! Finance, using the S&P 500 closing price
Year August S&P 500 Low Next April’s High 8-9 Month Gain
2009-10 979.73 (August 17, 2009) 1217.28 (April 23, 2010) +24.25%
2010-11 1047.22 (August 26, 2010) 1363.61 (April 29, 2011) +30.21%
2011-12 1119.46 (August 8, 2011) 1419.04 (April 2, 2012) +26.76%
2012-13 1365.00 (August 2, 2012) 1597.57 (April 30, 2013) +17.04%
2013-14 1630.48 (August 28, 2013) 1890.90 (April 2, 2014) +15.97%
2014-15 1909.57 (August 7, 2014) (to come) (Average: 22.85%)

Could we see another 15% to 30% gain in the S&P 500 over the next eight months? A rapid rise from here could signal a danger point, but a modest 15% gain from August’s low could bring us to 2200 in April. A more relevant chart might be the strength of stocks in the last four months of the year since 2009:

Market Performance, September to December, 2009-13
Data source: Yahoo! Finance, using the S&P 500 closing price of the month
Year August 31 December 31 4-Month Gain
2009 1020.62 1115.10 +9.26%
2010 1049.33 1257.64 19.86%
2011 1218.99 1257.60 3.17%
2012 1406.58 1426.19 1.39%
2013 1632.97 1848.36 13.19%
  Average 4-Month Gain: +9.37%

The most relevant number in this table is the near 20% gain in 2010 – the last mid-term election year, when a switch in the composition of the House of Representatives led to a powerful year-end surge. A switch in the control of the Senate from Democrat to Republican could fuel a similar surge in late 2014.

My main point is “Don’t Fight the Fed.” Fed Chairperson Janet Yellen has said that “our goal is to help Main Street, not Wall Street,” but she has helped both. By keeping rates super-low, she has encouraged businesses to borrow money at low rates to buy back more of their shares. Low rates also make home mortgages and vehicle loans more affordable, reviving the housing and auto markets. Low rates also put a damper on the debt service portion of the federal budget – even though low rates punish income investors.

Since the financial crisis of 2008, most central bankers have bent over backward to be accommodating, fighting the remote possibility of a return of the deflationary 1930s. They have sort-of-succeeded, so far. Global growth is slow but steady, and inflation has not yet risen, despite all of this coordinated easing. From all her veiled hints, it appears Ms. Yellen will keep interest rates low for a considerable time after QE3 is all tapered out. That will likely be good news for corporate America… and for the stock market.

More Market History

Market Lessons from Old France & New Orleans on August 25 & 26 in History

August 25 is Saint Louis Day in France, in honor of King Louis IX, the only canonized King of France, who reigned from 1226 to 1270. This French holiday gained importance over the centuries: Joan of Arc (the Maid of Orleans) reached the outskirts of Paris in her campaign to liberate France on August 25, 1429. Then, shortly after the storming of the Bastille, the French Assembly decreed “the Declaration of the Rights of Man” on August 26, 1789. More recently, Allied troops liberated Paris on August 25, 1944.

But enough war history – let’s focus on market events on this date, both in Old France and New Orleans:

The French outpost of New Orleans was incorporated on August 25, 1718. Being a summer day, the local weather was likely hot and humid, but the visiting French “Cajuns” (from Acadia) ignored the bugs, the snakes, and the swamp (five feet under sea level) to name the new town for their beloved Duke of Orleans.

This discovery fueled a stock market mania in “Mississippi Company” shares in Paris. One year later, on August 24, 1719 (the eve of St. Louis’ Day), large and giddy crowds swarmed outside the office of the Scots-born French finance minister John Law to celebrate their new-found wealth. Thousands of new “millionaires” (a French term coined that year) gathered in the Jardin des Tuileries to enjoy fireworks and a holiday musical show. Alas, a barricade blocked their exit, and panic ensued. Hundreds suffered broken bones and 11 women were suffocated or trampled to death that night. Soon, the market in Mississippi stock suffered a similar fate, but that hot August night in Paris was a lot like Silicon Valley in 1999 and 2000. (If you replace the French gold-plated carriages with black BMWs, you can imagine the scene.)

The Mississippi Bubble faded fast, but investors failed to learn any lessons. Just one year later, a new market bubble captured the Paris stock market. French investors who unloaded their sinking shares in Mississippi River land in 1719 rushed to buy shares in a British stock, the South Seas Company. Shares traded as high as 1,050 British pounds by June 1720, but South Sea shares fell to 380 pounds by the end of August 1720. Investors who lost nearly everything in 1719 lost the rest in 1720. As the French say: plus la change, plus c’est la meme chose (the more things change, the more they stay the same).

Have any modern investors made the same mistake? The same kind of trend-followers who rushed from a Mississippi Bubble to a South Sea Bubble within one year rushed from NASDAQ tech stocks to real estate in the early 2000s. After real estate peaked, investors were lured into over-valued financial stocks. There have been many hot fad stocks since 2009, but wise investors continue to weigh the fundamentals.

Stat of the Week:

Housing Starts Surge 15.7% in July

By Louis Navellier

Last Tuesday, the Commerce Department announced that housing starts surged an astounding 15.7% in July to an annual rate of 1.09 million, up from a revised decline of 3.9% to an annual rate of 945,000 in June. Housing starts are notoriously volatile, but the news that July housing starts surged 44% in the Northeast, 29% in the South, and 18.6% in the West was encouraging. The Midwest reported a decline of almost 25%, but the overall housing market is improving, which is good news for GDP growth.

Also on Tuesday, the Labor Department reported that the Consumer Price Index (CPI) rose 0.1% in July. Excluding food and energy, the core CPI rose 0.1%, which was lower than economist expectations of a 0.2% rise. In the past 12 months, the CPI has reached the Fed’s 2% inflation threshold, but the Fed has told us that it is currently under no pressure to raise key interest rates. Perhaps that’s because the U.S. dollar is approaching a one-year high, which is helping put downward pressure on commodity prices.

Euro-zone Growth is grinding to a Halt

Outside of the U.S., there was plenty of evidence of slowing growth. On Wednesday, Markit reported that the euro-zone Purchasing Manager Index (PMI) slipped to 52.8 in August, down from 53.8 in July. Although any reading over 50 signals an expansion, euro-zone PMI job creation has dramatically slowed, which is chilling when you consider that the unemployment rate stands at a lofty 11.5% in the euro-zone.

Also on Wednesday, HSBC announced that its preliminary China PMI slipped to 50.3 in August, down from 51.7 in July. Even though the HSBC China PMI is typically below China’s official PMI, the fact that HSBC’s PMI is now at its lowest level in three months caused global bond yields to soften further.

In contrast, Markit reported on Thursday that its flash PMI for the U.S. surged to 58 in August, its highest level since April 2010, up from 55.8 in July, so the U.S. is once again leading global economic growth.



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