Musings Report 26 6/28/14 2014 Investment Outlook

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For those who are new to the Musings reports: they are basically a glimpse into my notebook,the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books. As always, I hope the Musings spark new appraisals and insights. Thank you for supporting the site and for inviting me into your circle of correspondents.

A Note of Gratitude

I am very appreciative of your continuing financial support of my work. I often wonder if I'm providing enough value to you, my core group of supporters, and though I always strive to create value for you in some way, this week I'm covering some financial topics that may provide some potentially useful context for the year ahead.

2014 Investment Outlook

My gut feeling at the start of 2014 was that there would be no real clarity until late May at the earliest. Though I am rarely correct about anything in the market, this year has indeed been a chop-fest. Yes, the S&P 500 (SPX) gained 100 points this year, but most of that came in a few days in late May and early June; as of mid-May, the SPX was around 1,860, barely above the start of 2014 (around 1,845).

It's almost as if the market soared right when the conventional wisdom of "sell in May, go away" kicked in.

The resilience of participants' complacency and the overall Bull trend is widely regarded as a result of the Federal Reserve's Quantitative Easing. As we can see in this chart, the stock market has marched in almost lockstep with the Fed's balance sheet of assets purchased with newly created money:

The Fed is clearly playing for perfection with its tapering of QE: it has cut its monthly purchases of Treasury and mortgage bonds from $85 billion/month to $45 billion/month, and it announced a further cut to $35 billion/month. The idea is obvious: if we taper slowly and steadily enough, the market will maintain its high level even as as the financial stimulant is withdrawn.

Can any central bank fine-tune their exit from intervention? So far, the Fed is succeeding, but there are other factors other than the Fed's $35 billion/month in free money at work.

There is an equally strong correlation between corporate profits and the SPX: both have risen sharply since 2009.

So the question for the rest of 2014 is: as the Fed withdraws its stimulus, can corporate profits keep the market elevated? This chart suggests that profits have rolled over under the influence of numerous factors, including the global slowdown, stagnant real earnings for households and diminishing returns on zero-interest rates.

Many financial pundits are saying there can't be a downturn without a credit crunch/crisis, as some disolocation in the credit markets have presaged recent downturns. I am not so sure that any one correlation controls the market, be it the Fed balance sheet, corporate profits or the yen carry trade.

I suspect that looking for the same signals that triggered previous downturns is somewhat like fighting the last war: if the market was that predictable, we'd all be millionaires.

Of the many possibilities, one seems somewhat more likely than the rest. Please note that this is not a prediction or a recommendation: it is merely a description of one possible model. We will have to wait for the market to confirm or deny this technical model.

Given the extremes in corporate buybacks, complacency, subprime debt, the VIX and a host of other indicators, my sense is that the market is increasingly likely to deliver an "unexpected" decline that is sharp and short--that is, the dip is quickly bought because there is no credit crisis, the Fed is still providing stimulus, etc.

The market will likely rebound in a double top or M-top (as shown here), possibly hitting a new high with the SPX vaulting over 1,900. This chart highlights the M-top (or double-top with an overthrow, if you prefer) at the last top in 2007:

Here is the rest of the model: As profit conditions deteriorate, the Fed's $35 billion/month will prove insufficient to stabilize the $25 trillion stock market, and the market falls in a serious, sustained fashion, likely in the usual October time-frame.

Such a model would offer those who are still fully invested several opportunities to sell and preserve their capital and their gains.

The market could continue lofting higher in low-volume, low-volatility trading for months, but the evidence for a decline of some sort is stacking up. Some time after the expiration of July options (July 18) seems like a likely time frame for an initial short and sharp downturn. No one should bet on that occurring, but it's an eventuality to consider so if it does happen, we're prepared to act accordingly.

If a major low does occur in the 4th quarter of 2014 or the first quarter of 2015, it might (emphasis on might) offer an excellent buying opportunity for profitable companies and sectors.

Summary of the Blog This Past Week

The Stunted Tree Analogy: Nurturing, Neglect and Entrepreneurial Success 6/28/14

What's Behind the Rise in U.S. Industrial Production? 6/27/14

The Coming Global Generational Adjustment 6/26/14

The Happy Story of Boomers Retiring on Their Generational Wealth Is Wrong 6/25/14

The Fed's Hobson's Choice: End QE and Zero-Interest Rates or Destabilize the Dollar and the Treasury Market 6/24/14

The Generational Short Part 2: Who Will Boomers Sell Their Stocks To? 6/23/14

I think the Fed's Hobson's Choice is not widely appreciated, and those who grasp it will have a tradeable advantage in a complacent market that grants the Fed godlike powers.

Best Thing That Happened To Me This Week

Harvested green beans from our flourishing scarlet runner bean vines. Yes, we'll be sick of them in a month, but for now they're glorious.

Market Musings: Sentiment

There are a number of reasons to suspect the New Normal market is stretched; for example, bearish sentiment is low and bullish sentiment is at multi-year highs:

Bullish sentiment is at concurrent extremes:

Other conventional metrics of market activity such as corporate buybacks, mergers and acquisitions, issuance of junk bonds, margin debt, etc. are also at extremes.

A continuance of the New Normal requires these extremes to become even more extreme, with no blowback (unintended consequences) or snapback. How likely is it that extremes become more extreme? Bears have already been driven to near-extinction; there isn't much room left for complacency to increase.

If history is any guide, it is precisely when the herd feels confident that no downturn can occur that downturns occur--often for no real fundamental reason.

From Left Field

TWO ON SAN FRANCISCO:

Goodbye, for Now, San Francisco
“I was just standing in line behind two entrepreneurs that couldn’t be more than 19 years old and they were giving each other advice on how to fire people and run a company,” he said in a defeated tone.
Remember driving down the 101 freeway and looking at all the billboards? It seemed like every other advertisement was a recruiting pitch to young engineers. I got used to it, but my friends from out of town were baffled.

San Francisco Noir - the world of Sam Spade and Dashiell Hammett

Vintage Photos of Everyday Life in New York City from the 1890s -- quaint photos cannot capture the stench....

Herbert's Hippopotamus: Marcuse and Revolution in Paradise (50 min)
"This documentary examines the turbulent life in California of political philosopher Herbert Marcuse (1898-1979), author of One-Dimensional Man, Reason and Revolution and Eros and Civilization" -- Marcuse is largely forgotten now, but he was big in the 60s... I found his writing obtuse rather than illuminating....

Hunter S. Thompson on Finding Your Purpose -- interesting example of youthful seriousness, self-conscious and earnest in the same breath....

Mario Savio on the operation of the machine (1:48 min) -- one of the most famous extemporaneous speeches, for good reason:
"There is a time when the operation of the machine becomes so odious, makes you so sick at heart, that you can't take part; you can't even passively take part, and you've got to put your bodies upon the gears and upon the wheels, upon the levers, upon all the apparatus, and you've got to make it stop."

Bob Dylan and Susan Tedeschi Highway 61 Revisited (7:00) -- interesting combo, love the lyrics but need lyric sheet in front of you as Bob's diction is impossible to understand....

They Don’t Make ’Em Like They Used To: Inferior Products and Labor Drive Modern Construction -- multiple reasons for this, including boiled-frog acceptance of shoddiness as the New Normal....

New ACLU report takes a snapshot of police militarization in the United States -- SWAT teams need to lose some lawsuits in higher courts -- mostly they're busting down the doors of innocents in search of drugs....

Return to Vietnam Documentary film to explore role of ‘Donut Dollies’ in Vietnam War -- worth a Masters Degree in history...

Recruits' Ineligibility Tests the Military: More Than Two-Thirds of American Youth Wouldn't Qualify for Service, Pentagon Says -- what, no tats allowed on the the neck or face?
"Obesity, the single biggest reason for disqualifying new recruits, and other obstacles, such as poor educational attainment, led 90 retired military leaders in 2009 to form Mission: Readiness, a nonprofit aimed at raising awareness and seeking solutions. The group has lobbied state and federal officials to improve nutrition in schools and expand access to early education." Maybe the Deep State will get motivated to address some real problems in order to keep the Armed Forces functional....

One Tribe at a Time: A Strategy for Success in Afghanistan -- effective strategy and tactics ignored, too boring and time-consuming... the author was humiliated and marginalized for being correct.... our President prefers remote murder via drones to actual strategy....

"You can fail at something you don't want. So you might as well take a chance at something you do want." Jim Carrey

Thanks for reading--

charles