For Friday, November 2, 2012, We Recommend Against Investing

Technical Comment:

The S&P 500 advanced 1.1% with volume above Wednesday and above the 30 day moving average volume.  The advance was sufficient to reverse our stop loss trigger and change our automated forecast back to a growth trend.  If the S&P 500 were to decline about 6 points (-0.4%) on Friday, our stop loss algorithm could again be triggered and flip our forecast back to an uncertain trend.

Subjective Comment:

US markets remain volatile and difficult to predict.  Our automated forecast is subject to frequent changes between a growth trend and uncertain trend when the S&P 500 bounces about with an overall sideways trend, as is currently the case.  We do not advise investing based on the change in our automated forecast, at least not yet.  Our pattern detection software continues to identify nothing in the daily market data worthy of comment.  Thursday was a strong-volume up-day.  Should such days continue that could become bullish and perhaps a pattern might form.

The US M2 money supply data, US banking reserve data and the daily Feds Funds rate data have been analyzed, and a curious situation is unfolding.  We will list observed facts and then provide interpretation:

  • US M2 (not seasonally adjusted) money supply continues to grow at an annualized rate around 8%
  • US M2 growth about a straight-line curve fit shows a cyclic pattern where every 4th week there is a dip followed by stronger growth for the next 3 weeks.  This has been consistent for the past 6 months with the exception of 2 weeks of a dip at the last quarter point.
  • 4 weeks ago, US Banking Required Reserves shot up and Excess Reserves dropped at the same time.
  • 2 weeks ago, US Banking Required Reserves fell back to where they had previously been, and Excess Reserves bounced back up to their prior point as well.
  • In the data just released, US Banking Required Reserves shot up again and this time Excess Reserves held steady.
  • For 98 days, from 7/18/12 through 10/23/12, the Fed Funds rate bounced about in a tight range of 0.13% to 0.16% with the exception of a weekend spent at 0.09%.  On 10/24/12 this overnight rate increased to 0.17% then returned to 0.16% for 4 days.  In the past 3 days it has moved back to 0.17% and on the last day of October the Fed Funds rate reached 0.18%.  The Fed Funds rate is fixed by the daily open market operations of the Federal Reserve.

The interpretation of these facts points to opposing forces trying to grow and shrink the US M2 money supply at the same time.  The US M2 growth rate remains where it has been for the past 6 months.  There is no statistical evidence of a change, but visually the pattern of a dip every 4 weeks shows the possibility of slightly stronger growth since the initiation of the new, unlimited Quantitative Easing program (QE3).  The dip for the data ending 10/22 was not as pronounced in the visual pattern.  This suggests a mild acceleration of the US M2 growth rate.

US Banking Reserves 4 weeks ago was the first data following the QE3 announcement, and it showed a sudden acceleration of bank lending by the sharp increase in Required Reserves combined with a drop in Excess Reserves.  When this occurred 4 weeks ago, we changed our investment recommendation under the assumption bank lending would accelerate in response to QE3.  2 weeks ago this data set appeared to completely undo what was seen 4 weeks ago.  Now Required Reserves have jumped up again, suggesting accelerated bank lending.  Excess Reserves remained unchanged.  This could be interpreted to imply US banks are using the new QE3 money to accelerate lending, but they are only doing so using QE3 funds and are not comfortable allowing their Excess Reserves to drop below $1.4 Trillion Dollars.  This would support an interpretation of an accelerating growth rate of the US M2 money supply.

The daily Fed Funds rate increases when the Fed decides to reduce or slow the growth of the Money Supply.  This is what is extremely odd.  The Fed launched unlimited QE3, which adds to the money supply.  At the same time they have begun to increase the Fed Funds rate, which removes money from the supply.  Since QE3 is pumping money into the supply by purchasing Mortgage Backed Securities, the housing market is going to begin another bubble-boom.  The increasing Fed Funds rate will have an off-setting effect for a short while, but eventually money will prove once again to be fungible as it works itself through the rest of the economy.  The Fed has announced a target for the Fed Funds rate of 0% to 0.25%, so they are limited in their use of open market operations in this curious effort to remove funds from the money supply while simultaneously creating new money to purchase Mortgage Backed Securities.  This situation will likely not last long, although it could continue for the rest of 2012.

Our synthesis of all this information leads us to conclude the US M2 money supply will accelerate its growth rate in the near future and the US housing market will experience another bubble-boom.  How quickly the M2 growth rate accelerates is unclear because of the opposing force of the rising Fed Funds rate.  US bank lending and the overall desire of everyone to hold dollars or spend them will determine how fast M2 accelerates.  With the US elections pending and the Eurozone debt crisis remaining unresolved there remains a lot of uncertainty.  For now we advise investments in price inflation hedges and avoid all bonds.  These recommendations are based on our expectations of accelerating price inflation as a direct result of the money supply growth.  As for investing in US equity markets, we recommend being prepared to invest but not doing so yet.  We think we are at the beginning of another bubble-boom for the US economy and stock markets, but we want to see validation in the data trends.  The opposing Fed actions of QE3 and increasing the Fed Funds rate gives us pause.