“Cease to resist, giving my goodbye
drive my car into the ocean
you’ll think I’m dead, but I sail away
on a wave of mutilation
I’ve kissed mermaids, rode the el Niño
walked the sand with the crustaceans
could find my way to Mariana
on a wave of mutilation,
wave of mutilation
wave of mutilation
wave of mutilation
Pixies - “Wave of Mutilation”
If you ever wanted a good reason to lose all faith in capitalism; now would seem an appropriate time. The conflict with Russia, China’s “about to burst any moment now” bubble, hyperinflation in developing markets, and scary charts illustrating U.S. margin debt and other concerning fundamental measures on the tip of the tongues of all of Wall Street all seem to point to a logical crossroads benefitting allocating away from equities. A 10% – 20% pullback looms large and is likely right around the corner. However, my technical research points to this being “just another bear trap.”
It’s difficult to write this “bullish” thesis knowing how hard I roll my eyes whenever I read “another bullish article about how we’re off to the races.” I sincerely disagree with that mindset. In fact, I think we’re experiencing somewhat of an anomaly in the current market; the bull market that goes up on anger, inequality, strife, and misery. Historically, Bull Markets have always been representative of a time of good or optimism. I can’t count how many times a day I hear someone mime “…in this economy” in normal conversation. What economy are they talking about? The one where their investment accounts go up on average 50 to 75 bips each week for five straight years? You poor babies! No, humans are locked in on the reality of the situation. They’ve told their children and grandchildren to follow their own formula for success, only to find them insulted, indebted, and economically paralyzed for doing so. And it’s none of their fault, just like it’s not this bull market’s fault that it’s accompanied by the appalling intangible economic realities we all know to be true; it’s the cycle, stupid.
For the life of quantitative easing, there’s been an unassisted belief that if inflation were to occur from central bank actions, that it would occur immediately. This is wrong. Just like a junkie mainlining a pop, it takes time for every capillary to become polluted in the alkaline. The first place it kicks in is always equity markets, then commodities, then bonds. For even hardened market pros, the illogical nature of current economic environment has made this a difficult pill to swallow; we want every hint at a trend change to materialize even when the cycles tell us we know better. There’s an order in place that must be respected. An order that can and will change, but must first do so prior to our anticipation of a replacement in its sequence.
Back in July, my friend Jeff Saut, Chief Equity Strategist of Raymond James featured an Elliot Wave study & case for a pullback I put together on the Russell 2000 in his “Monday Tack” research note sent out to High-Net-Worth and institutional clientele (and later to Minyanville). Admittedly, I’ve been a bit early to this whole 20% pullback thesis, but outside of timing – I do not think the premise is incorrect (I had anticipated the latest it would begin to be December 2013, so call it off by three months and counting). Here’s why; basic technical analysis calls for any “breakout” zone to be retested before an “impulsive” move higher. Further, my Elliot Wave Count of most major indices on a monthly basis states that we’re currently in a “Wave 3” up from the ’09 bottom. A 20% pullback from current levels would take us back to the breakout level on most major indices (some need more or less of a percentage) where a Wave 4 could end with the beginning of a monthly eW5 up. If this were to be the case, I can see the S&P 500 (SPX) retesting 1565 then topping out in 2015 near 2165. But, in the face of such dire headline risk, how could said rally be possible? It’s rotation, stupid.
Minyanville contributor and author of the TechStrat Report, Sean Udall, and I have spent countless hours challenging each other as to designing a roadmap of the markets ahead. Despite my disillusioned outlook (in contrast to Sean’s more bullish/optimistic view), we do not disagree (or argue) about what’s to come in the next 12+ months. Sean’s research lends to the possibility of a renaissance in the tech space, specifically in one hated name; Apple, Inc. (AAPL); more on that later. Mine, on the other hand, calls for an awakening in the sleeping dragon of commodities; a thesis Buzz contributor Brandon Perry, CFA & I have been contemplating for over a year as a sort of “bell” the top is near. The strange brew is oddly complimentary.
We’ve already seen Gold (GC) make a bullish turn higher since myself and the revered Jeff Cooper both hinted to a bottom in yellow late last year. On January 3rd, I put a price target of $1300 on Gold to subscribers of Minyanville’s Buzz & Banter and have since raised that level to $1480. Crude Oil (CL) is hanging naggingly near $100/barrel, Coffee (KC) is up 60% so far this year (another we pointed out on the Buzz in January), the list goes on and on. Commodities are on a roll. So, what about that commodity super cycle?
How this plays out in ACT III is more art than science, but here’s my playbook:
Whether we like it or not, some sort of catalyst is on the horizon that will likely take markets back to the breakout levels of 2012. This is probably enough to shake most out of high-beta and “less conservative” equity sectors. However, we have to remember that asset allocators are often restricted by “style class” meaning weightings to certain sectors & market caps. Hot-money tech picks are likely vulnerable to “flight to safety” inside their universe, of which names like Apple, Hewlett Packard (HPQ), and Microsoft (MSFT) stick out as the value in growth. This flight will likely catch many off guard as well.
Any sort of shock to equities is likely to add a further bid to fixed income, including high yield and munis. Allocations to “riskier” areas inside FI are merely a function of market structure; the Fed already owns most of the market and there’s a lack of collateral. Therefore, those who “need” to own bonds will be forced to buy whatever they can get their hands on in a “rush to quality.” Yields will continue to drop on US paper, possibly as low as 1.5% to 2% on the Ten Year Treasury. As yields drop, this should also encourage flow to utilities as these are often viewed as a sort of derivative Revenue Bond. And speaking of financials, there’s a bunch of TARP-era Warrants floating around forgotten with a very low probability expiring worthless next year…
Many of you may have read about how much of the Chinese economy is backed by receivables against hard commodity assets such as aluminum or copper. A further sizeable drop in the prices of these assets is feared to have the potential to derail the world economy, which is precisely why they will not go down much further. Today, as it stands, we’re not in the middle of a financial crisis a la 2008. The world is awash in liquidity. Before the world financial system allows itself to be pulled down the drain by its tail, it will through invisible hands and moral suasion, boost assets that endanger sovereign financial solvency. In today’s market, the cost/benefit of instituting a floor under asset prices is far easier to rig on the open market than is orchestrating Trillion Dollar bailouts funded by the dollars of taxpayers not yet born. Not saying it’s “rigged”, but inferring there could be a lot of incentive for certain players to do as they’re told; particularly when the person on the other end of the line is indicating unfavorable consequences for disobedience.
As the new bull market in commodities matures, this will benefit many downstream producers such as oil and gas refiners, et al. The case for $150/barrel crude is technically sound; companies such as Chevron (CVX) & Exxon Mobil (XOM) keep consistent LIFO margins despite input costs, meaning rising prices equal rising profits. The case for one more wave higher in the markets, a wave of mutilation, is a statistical, technical, and fundamental necessity before a new bear market is upon us.
In the middle of the maelstrom, this violent rotation could likely be enough to convince most that the final top is in place. There is no guarantee higher highs are on cue, particularly if we lose 1565 in the mosh pit of volatility. But, should the volatility subside and a short squeeze ignited, the greed will not be far behind. Inflation should actually begin to occur at this point, likely late 2014 or early 2015, possibly accompanied by a mild recession.
Central banks will not be happy until asset reflation back to near 2008 levels is observed in commodities, even at the expense of a further constrained consumer. It’s a fault in their models that economic health vis a vie healthy rising inflation is not occurring unless raw material prices are rising across the board, and when observed, it is considered a greater good than a temporarily burdened GDP. What they consistently miss is that loose monetary policy’s predominant effect on commodities is a shortening of frequency period between cycles (time between cycles lessened) while amplitude of frequency (price) remains mostly consistent in gross size of market cap (volume) divided by M3. Further, the major commodity cycle is never given sovereignty from monetary policy micromanagement. Rising commodity prices are relevant to the Fed only in the context that they confirm biases introduced through the lens of controlling monetary policy. In reality, these cause hypersensitive dislocations in the natural rhythm; hence, volatility. In reality, there are many factors at play outside of the human ego.
Should the commodity super cycle flex and significantly reflate commodities as anticipated, making a marked move higher as the taper winds down, it’s very possible sovereign bond yields may remain stubbornly low. At the end of every QE program of the last five years, the end of QE has brought lower yields, not higher as conventional wisdom often encourages. Higher “measured” inflation on the back of low sovereign bond yields could likely prove too much for the Federal Reserve. It’s at this point, likely in Q1 2015 that I anticipate a rate hike by the Fed. At first, this should exasperate the bull market in commodities. This will likely be the catalyst for several back-to-back rate hikes in a campaign to stymie rising prices. It’s at this point that a policy error seems guaranteed in my opinion.
That’s when you should start to worry.
About Duncan Parker: Duncan is a proprietary trader and former money manager. Duncan is a frequent contributor to Minyanville’s “Buzz & Banter”, where he focuses extensively on short to intermediate term technical setups in equities, futures, and forex. He also is a founding member of QAR, LLC/LP — an incubator hedge fund and research service concentrating on technical and quantitative market cycle analysis. Twitter: @MinyanDP
No position in any of the mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.