For Friday, July 27, 2012, We Recommend Against Investing

We recommend selling your equity positions or hedging for a risk-neutral position.

Technical Comment:

The S&P 500 advance 1.7% on strong volume Thursday.  Volume was higher than both Wednesday and the 30-day moving average.  The S&P 500 would have to decline about 2% (-28 points) on Friday for our automated forecast to change to an uncertain trend.

Subjective Comment:

Thursday was a strong-volume up-day, and the index advance was impressive for a single day.  When the market advances so much on strong volume it has to be considered carefully.  The prevailing technical pattern has been weakness, so Thursday’s strong advance is in the opposite direction.  It takes several days to form a pattern, and that has not yet happened.  It should also be noted Thursday’s advance allowed the market to recover where it finished last week.  We will watch for the formation of any patterns, but so far this strong-volume up-day is not a reason to change your investments.  Technically the patterns still indicate market weakness ahead.  The likely reason for the strong advance on Thursday was spill-over effects from Europe.  The President of the European Central Bank, Mario Draghi, promised “to do whatever it takes to preserve the euro”.  Evidently market participants believed him and we think this is the reason for the pop up in the market.  If all Mr. Draghi and other central bankers do is talk while failing to act, then these up-days will be short lived and the downward trend will resume.  Never listen to a central banker.  Watch the monetary policy they implement for clues what the market will do.

We have downloaded the weekly US Money Supply data and the biweekly US Banking Reserves data and performed our analysis.  19 weeks ago (4 months) the US M2 (not seasonally adjusted) money supply growth rate slowed its expansion.  It had been growing over 7% annualized for the prior year and has been growing at a 2.6% straight-line annualized rate since.  We have reported the growth rate over the last 4 months to be as low as 0% and now as high as 2.6%.  The data set has week-to-week variability and this causes the straight-line curve fit to fluctuate.  The residual control chart for the data series remains unremarkable.  We also track the seasonally adjusted data series even though it is less reliable.  It can sometimes serve as an early indicator of a change.  The seasonally adjusted control chart has not produced an out-of-control condition yet, but there does appear to be an up-trend and the most recent data was less than 1 Billion Dollars below the upper control limit.  We have no signal that a change has occurred recently, but it has caught our interest to see what had been a near zero growth rate increase to 2.6% over the past several weeks along with a near spike above the upper control limit of the M2 (sa) residual chart.

We see two possibilities with the US money supply:

  • Growth has been 2.6% over the past 4 months and the recent acceleration is normal fluctuations
  • Growth collapsed to 0% 4 months ago, and 2 months ago it started to grow again around 11%

Statistically, the conclusion supported is normal fluctuations with a 2.6% growth rate.  Visually there is a possibility of an acceleration of the growth rate to 11% starting 2 months ago.  We will have to wait for the next weekly update to get a better evaluation of these 2 possibilities from the M2 data sets.

Turning to the US Banking Reserves data provides more of the picture.  What had been a declining trend in the Excess Reserves for almost the past half-year seems to have bottomed out 6 weeks ago.  We have no idea what direction Excess Reserves will go from here.  It is only noteworthy that the decline seems to have bottomed and possibly reversed.  This coincides with an up-tick in the Monetary Base (M0) over the same prior 6 weeks.  Required Reserves remain flat, so this means US Banks continue to originate new loans at the same rate old loans mature.  In other words there is no net new lending causing the money supply to expand.  This means the only source of the expanding money supply is the Federal Reserve itself, and this is coming from the daily open market operations used to fix the Federal Funds rate.  Over the past 6 to 7 months the Fed Funds rate has been creeping upward from 0.05% to around 0.15%.  This means the Fed had been draining excess reserves.  Now the Fed appears to have halted the drain of excess reserves and daily open market operations are keeping the Fed Funds rate around the 0.15% range.

We conclude from the changes in Banking Reserves and the Fed Funds rate that the Fed caused the M2 growth to collapse to 0% around 2 months ago in order to let the Fed Funds rate move up.  This had the effect of draining some excess reserves.  Now that the Fed Funds rate has stabilized around 0.15% it seems the Fed is no longer draining excess reserves and has allowed the money supply expansion to resume.  Since US Banks are not lending (on net), the source of the money supply growth is the Fed’s operation twist.  If this conclusion is correct, then US M2 money supply growth could have returned to near the same growth rate that had persisted for almost a year prior to 4 months ago, which was the 7% growth rate.  If true, the growth rate over the past 2 months could be between 7% to 11%.

Good Grief!

Austrian Business Cycle Theory (ABCT) provides the explanation of what to expect under these circumstances.  The US economy and stock market will not grow from here regardless if US M2 is growing at 2.6% or a more aggressive 7%.  At 2.6% the economy and stock market will eventually crash, and we guess sometime within the next 1 to 3 months.  At 7% the economy and stock market will not grow.  We’re not sure if a decline or sideways movement will occur, but 7% will not be enough to resume the bubble-boom.  At 11% it is possible mild to moderate growth could resume in the next 1 to 3 months, but only if 11% growth is sustained during this time.  With any of these circumstances we expect price inflation to impact consumers.  The higher the M2 growth rate, the worse price inflation will be.

We have no idea what is about to happen.  We have been very bearish for months based on the collapse in the money supply growth.  If the Fed has done a head fake and money supply growth has accelerated recently, then we have to admit we don’t know how things will play out from here.  ABCT provides the correct economic theory to forecast what will happen, but without a clear picture of the money supply growth rate there are too many economic factors occurring at the same time to predict what might occur.  We do see continued weakness in Asia and Europe, and that weakness will have spillover effects on the psychology of market participants.  Poor earnings from US corporations will also spook investors, and this is likely to be the case given current circumstances.  For now we advise holding and accumulating cash, avoiding US stocks and avoiding all bonds.  Hold your price inflation hedges for the long term.  This advice is unchanged from the past several months, but we are now suggesting two subtle changes for investors.  First, do additional research on price inflation hedges to determine what might be a good fit for your circumstances.  Second, carefully watch the market every day and the US money supply every Thursday.  If things are changing the new trends will present themselves very soon.  If things are not changing and US M2 is indeed growing around 2.6%, then we still expect a decline (crash) within the next 1 to 3 months.  Please continue to follow our daily updates and be prepared to make a change.  All things considered, we’re unlikely to change our advice until we get the next M2 update on Thursday, August 2nd.

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