For Monday, August 13, 2012, We Recommend Against Investing

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

Technical Comment:

The S&P 500 advanced 0.22% on Friday with volume below Thursday and below the 30-day moving average volume.  The S&P 500 would have to decline about 2% (-28 points) on Monday to change our forecast to an uncertain trend.

Subjective Comment:

Friday’s light-volume advance in US markets remains unimpressive.  Our pattern detection algorithms spotted a growth pattern back on August 3rd, but since then we have not seen the strong-volume growth that typically follows such patterns.  The detection algorithms are very good at finding daily patterns similar to those preceding historic periods of market growth and decline.  This technique is not foolproof, but it works more often than it fails.  By combining pattern recognition with analysis of the US money supply we are able to produce our subjective investment recommendation.  We discussed the 09AUG2010 US money supply data in our prior post and encourage you to read it.

To better understand the US money supply trends, we looked at the biweekly Excess Reserves (not seasonally adjusted) data and the daily Fed Funds rate data.  US Bank lending appears to remain flat, although there was some variability that contributed to the changing growth rates of the US money supply.  Bank loans fell from February through June as demonstrated by Required Reserves falling during this period.  From June to the most recent data available, bank loans increased slightly but are overall very flat since the beginning of the year.  The variability appears to be the theme for Required Reserves going back to November.  Aside from the variability, US Banks are not increasing the money supply via fractional reserve lending, although the variability appears to have combined with changes in the Fed Funds rate.

The Fed Funds rate is the rate US Banks charge each other for overnight loans.  The Federal Reserve price-fixes the Fed Funds rate based on monetary policy decisions by the Federal Reserve’s Open Market Committee (FOMC).  The FOMC policy has been for quite some time to target a Fed Funds rate of 0% to 0.25%, which many commentators call “ZIRP” for Zero Interest Rate Policy.  Any changes within this range are unannounced policy changes by the FOMC.  From last August through early January the Fed Funds rate averaged 0.08%.  From January through April the Fed Funds rate crept up slowly to 0.16%.  These are small numbers, but the Fed Funds rate did in fact double during the first 4 months of the year.  This coincides with the period of ZERO growth in the US M2 (nsa) money supply.  At the same time Bank Loans declined gradually during these 4 months.  This means the cause of the money supply growth rate collapse to 0% was the doubling of the Fed Funds rate during this time period with a little help from shrinking bank loans.  Remember, the Fed Funds rate is the “price” of money, and for the rate (price) to go up, the commodity (money supply) had to become scarcer.  Bank Lending was variable and ended lower, which put some downward pressure on the money supply at the same time, but the key driver, was the Fed Funds rate moving from 0.08% to 0.16%.

Starting at the beginning of May, the Fed Funds rate has been holding steady at an average of 0.16% with minor variability until mid-July.  This coincides with Required Reserves growing again, meaning US Banks expanded their lending a bit at the same time the FOMC decided to stop increasing the Fed Funds rate and hold it steady (price fix) at 0.16%.  This required the Fed to expand the money supply again at the same time US Banks also expanded it a bit.  This is why we conclude the US M2 money supply growth rate for the first quarter was 0% and then 6.2% annualized during the second quarter.

The most recent data for Required Reserves and the Fed Funds rate are very interesting:

  • The two weeks from 7/25 to 8/8/12 saw Required Reserves move up almost $4 Billion.  This is normal variability right now but needs to be watched as it appears to be a new trend.
  • On 7/19 the Fed Funds rate dropped to 0.13% from the average of 0.16%.  Through 8/8/12 the Fed Funds rate has averaged 0.138% after having been at 0.16% for just over 3 months.

A drop in the Fed Funds rate at the same time as growing Required Reserves means both the Fed and US Banks are acting to grow the US M2 (nsa) money supply.  If this continues, we should see the M2 data continue to grow.  We have no idea why the Fed and US Banks are taking these actions.  There could be a cause, it might be concerns about the Eurozone and China, or it could be random.  What is not random is the impact this will have on the US economy and stock market.

The US M2 growth rate has slowed down.  It has not yet resumed growing fast enough to avoid the crash that must come after an initial acceleration.  At a growth of 6.2% annualized the crash could be delayed longer than a 0% growth rate.  The US economy and markets will continue to stagnate as long as US M2 growth is at or below 7.5%.  How long until a major decline will begin has become very difficult to guess as there are too many variables for anyone to figure this out.  The US national elections and pending fiscal challenges of Federal, State and local governments all will impact the decision making of market actors, as will economic events in the Eurozone and China.  We are certain US markets will not grow from here given these circumstances.  For this reason, we recommend wealth preservation strategies for your investments.  Avoid all bonds.  Instead we recommend holding and accumulating cash.  Price inflation hedges are an option right now but be sure to do additional research before investing in any commodities.

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