Dear subscribers,
This is update #2125 for Friday afternoon, September 25, 2015.
Typical of their historic pattern, gold and silver mining shares have been forming numerous higher lows in recent weeks, as energy-related commodities and equities have been slower to rebound while demonstrating more positive divergences, and emerging-market assets have been among the weakest global performers. This is similar to the behavior in the fourth quarter of 2008 and the first quarter of 2009, in which precious metals bottomed on or near the open on October 24, 2008, while many other commodity-related assets did likewise around November 20, 2008 and emerging markets reached their respective nadirs in January, February, or March 2009.
While gold and silver and the shares of their producers have likely begun to rally, some other commodities have been unusually depressed including platinum which reached a new 6-1/2-year bottom on Wednesday (September 23, 2015). Here is a chart showing the relative prices of platinum and gold during the past decade:
Oddly, while platinum had plummeted to 924.50 spot (925.80 U.S. dollars per troy ounce for the most active October 2015 futures contract), palladium was simultaneously surging. These two metals are closely related on the periodic table and can be substituted for each other in many industrial uses, so this sharp divergence highlights how the financial markets in the short run are driven almost entirely by emotions and chartists chasing trends rather than anything fundamental or logical. Numerous articles on this topic have invented explanations which attempt to sound intelligent, but which are totally meaningless. Nearly all of the analysts quoted in these articles are bearish toward slumping platinum and bullish toward surging palladium, even though taking the opposite side of this pairs trade is almost certainly a more sensible move regardless of what happens in the short run. Lots of hype about Volkswagen and diesel engines has fueled (sorry for the pun) some ridiculous speculation about the future behavior of these and related assets:
While many global investors have focused on the relatively irrelevant issue of exactly when the U.S. Federal Reserve will finally raise interest rates by a quarter percent, central banks in many countries have been cutting short-term rates sharply and thereby causing real rates (nominal rate minus the inflation rate) to become negative:
Besides Taiwan as is detailed above, Norway has done likewise:
I have been to many shows featuring mining companies and related industries for the past few decades. There were times when they would serve all kinds of food and drink at no charge to those who attended; during the last conference, they literally had only water and peanuts. Several well-known gold conferences including the U.S. Hard Assets Conference have shut down entirely. Here is a personal account of the Denver Gold Forum which ended on Wednesday:
Put options on GLD have recently become unpopular:
The financial media still don't understand why millennials haven't been buying houses. It is not primarily for the minor reasons cited in this article, but because millennials saw many family members, colleagues, friends, neighbors, and others get wiped out by the bear market for U.S. real estate in 2006-2011 and don't want to suffer a similar fate:
Marco Rubio has received a bit more press recently, and was even mentioned by Donald Trump:
I read all of Robert J. Shiller's most recent edition of Irrational Exuberance. It is not very entertaining and I fell asleep many times, but I also learned a lot while I was awake. He recognizes that U.S. financial assets and real estate are historically overvalued, and what is paradoxical is that these high prices have mostly spurred buying rather than selling:
In 2008, I was one of the few analysts to criticize Goldman Sachs' absurdly bullish crude oil forecast, and very few were similarly willing to contradict their recent wildly bearish outlook--but there is an important new exception:
The following comments about commodities and emerging markets are typical of how sectors are viewed when they are forming major bottoms:
This article contains some unusual graphics which illustrate the value of gold:
I have seen autumn in Alaska (although in September), while Inwood Park in Manhattan can be surprising--as is Van Cortlandt Park in the Bronx:
Today's first main topic is Presidential markets.
With the recent U.S. Presidential debates for Republicans, and with the Democrats set to initiate their series within a few weeks, it is worthwhile to examine how political changes in the United States will influence the financial markets--and, perhaps even more importantly, how the financial markets will affect the election for U.S. President to be held on November 8, 2016. Most people begin to think about this during the election year itself, but since the financial markets are an anticipating mechanism, it is worthwhile to look ahead a year early.
Since the end of the last recession in 2009, there have been dramatic price gains for U.S. equities and junk bonds at least until the past few months. U.S. housing prices continued their declines which had begun in 2005-2006 and which bottomed in 2010-2012, followed by a strong rebound which has led to new highs in some markets. At the same time, incomes and living conditions for average people have barely changed, although the job market has notably improved and wages have begun moderately accelerating during the past year. As a result, the average person perceives that "the rich" have enjoyed most of the changes in the worldwide economy in recent years. This has already been exerting a notable influence upon the kinds of topics which have been discussed during the Presidential debates and in other political forums, as candidates have tended to focus primarily on making the situation better for the average person. Marco Rubio, for example, has tapped into this concept with some effectiveness, which has been blunted primarily because of the overexcitement about Trump vs. Fiorina and the large number of candidates who remain in the race. No one is talking about helping the stock market to recover, which was the top issue in 2008 and was of moderate concern in 2012, because U.S. equity index valuations have become so high that they are likely reflecting a dangerous overpricing. Instead, the candidates who understand best what is going on in the financial markets are focusing on how they will help those who are near the median.
Other than Rand Paul, no one has been criticizing the Fed because the U.S. economy has been expanding for roughly 6-1/2 years. No one is worried about inflation, since deflation has been the major concern of the Fed and of most mainstream economists. I can clearly remember past decades when inflation was a major focus and sometimes the primary worry about the U.S. economy. The U.S. economic situation has been so positive that many candidates have ignored it completely, focusing on numerous other issues. In my opinion, this is a mistake, because in the end, voters are much more interested in economic and tax plans than in almost everything else. I think that Hillary Clinton has made a key mistake on this issue, in outlining her intention to require a graduated rate for long-term capital gains which will stretch out for as long as six years in order to enjoy the current discounted federal rate. Present law requires that an asset be held for one year and one day to enjoy this discount. I think this is a mistake; most voters are unaware of the proposal, while those who know about it tend to be sensitive to anything which is a tax increase. It is thus a no-win situation to adopt prior to the election. Below are the precise details of the proposal:
Were you aware of Clinton's ideas? If not, then you have a lot of company, because it hasn't received much press. I did mention it in a few updates. As the campaign intensifies later this year and especially in 2016, there will be a lot more focus on tax issues and especially upon proposed tax cuts. This would be consistent with prior U.S. Presidential campaigns, in which many such promises are made but very few new laws are legislated which follow through on these promises.
It is generally perceived that Republicans are more interested in a balanced budget, as is epitomized by the attitudes of the Tea Party, while Democrats are perceived as being accommodative to larger deficits. However, exactly the opposite is likely to be true in reality. With the current state of deadlock, with a U.S. Democratic President and Republican control of both the House of Representatives and the Senate, new legislation is very difficult to achieve. This has tended to keep the deficit, while still growing, from ballooning out of control in recent years. If there is a Republican President and Republicans maintain or even increase control of both chambers of Congress, then it will be far easier to enact any kind of legislation, including new spending. It may not be the kind of spending which Democrats favor, but it will almost surely end up widening the deficit significantly instead of narrowing it. On the other hand, if a Democrat wins and Republicans hang onto the House and Senate, then we will get a continuation of gridlock for at least another two or four years, which will tend to keep the deficit under some control. If you listen carefully to the few Republican candidates who actually talk about economic issues, you will hear almost nothing about a plan to balance the budget, because that is a way to become unpopular to many voters. The retirement age or the qualification age for Medicare should almost certainly be raised by one month per year for many years, but as Chris Christie discovered when he proposed this idea several months ago, it is extremely unpopular. In general, stating an unpleasant truth is not well received by most voters.
There is a historic tendency for voters to look forward to the resolution of any unknown situation, and for the anticipation of this resolution to keep U.S. equity prices from plummeting. Thus, it is very rare historically for the U.S. stock market to plummet prior to the U.S. Presidential election. It can definitely fall in an election year, as we experienced as recently as 2000 and 2008, but excitement over the anticipated outcome will likely prevent the worst part of any bear market from occurring until after the election. That of course is what had occurred during the bear markets of 2000-2002 and 2007-2009, in which the most severe losses occurred once the election was over. I still expect net losses for most U.S. equity indices in 2015 and larger losses in 2016, but the lion's share of the plunge will probably happen afterward which will especially mean the roughly one-year period after November 8, 2016. If the S&P 500 doesn't achieve a new high later in 2015 or in early 2016, then its peak on May 20, 2015 strongly suggests that a bear-market bottom will occur in 2017 rather than in any other year. My personal guess is for a nadir in October 2017, but of course many deviations from such a goal may occur between now and then. I am not referring to news events which will alter the outcome, but the pseudo-random fluctuations inherent in the financial markets which make it impossible to guess pricing or timing turning points in advance for any asset.
The Fed's biggest problem is that, even if it raises interest rates once, twice, or thrice during the next year or so, eventually it will be forced to slash rates during the next recession. When interest rates are high heading into a recession, as they usually are, then the Fed has plenty of room with which to maneuver. If rates are near one percent or lower, then that leaves a lot less flexibility. It is the difference between having a full tank of gasoline (petrol) at the beginning of an automobile race, versus being nearly empty with no chance to refuel. This is probably the biggest failing of the Fed's quantitative easing program, since in the next recession they will have very little ammunition to use. As investors realize the near powerlessness of the Fed, they will end up losing confidence in the U.S. economy just as investors in many countries near and south of the equator have lost confidence during the past 4-1/2 years. In many emerging markets, equity valuations reached lower levels this month than they were at their most depressed points in late 2008 and early 2009. We will likely experience a strong emerging-market rebound since these valuations are inconsistent with reasonably strong profit growth in those countries, but it serves as a warning--heeded by very few--that U.S. equities aren't immune from doing likewise two years from now.
The more that U.S. equity indices have fallen from their peak levels by the time of the next U.S. Presidential election, the more likely that the party in power will be voted out of office. Thus, a candidate like Marco Rubio will tend to be significantly supported by a bear market for the S&P 500 and the Nasdaq, whereas Hillary Clinton will tend to benefit from relatively stable U.S. stock and bond prices. Whether it makes sense or not, voters develop a powerful anti-incumbent streak during difficult economic times, with 2008 being a shining example. While I don't tend to agree with Donald Trump on most issues, he was absolutely right when he stated in the last debate that Abraham Lincoln would not have won re-election if the economy had collapsed during his tenure as badly as it had done in 2008. Of course there were numerous factors other than mismanagement by George W. Bush, but the voters were especially eager to throw out anyone connected with that administration. Two consecutive down years for U.S. stocks, which is probably the most likely outcome, will tend to heavily favor the Republicans in 2016. This is even more true if they can nominate a candidate who is perceived as being empathetic to the concerns of average people.
When considering the 2016 election this far in advance, it is too easy to assume that the general financial situation just over a year from now will be very similar to what it is today. It is likely that there could be some meaningful changes. Assume that interest rates have been climbing because of renewed inflationary fears, investors are wondering if the Fed may have to raise rates again, commodities and emerging markets have been rallying, many people are complaining about gasoline prices having soared once again, while U.S. stocks and bonds continue to grind lower without dramatically slumping. Perhaps even more importantly, assume that housing prices have been declining by modest percentages from their 2015 highs, as they have already been doing in a notable minority of neighborhoods in the United States. This will tend to hit the average person especially hard who has a mortgage, has most of their retirement money in 401(k) index funds, and who generally feels secure about the job market but uneasy about almost everything else in the economy. These people, who tend to be most likely to vote when they are most concerned, will be especially eager to hear a message with resonates with them.
By an interesting coincidence, the most overvalued U.S. housing markets tend to exist in Democratic strongholds, with the most absurd overvaluations in places like San Francisco. In contrast, the central part of the United States which reliably votes Republican has generally less overpriced real estate. If housing prices begin to decline in many of the Democratic-dominated areas, then it will make voters more willing to consider switching parties for the contest. Looking back at 2004, many people have puzzled over how George W. Bush was able to be re-elected; in my opinion, he was a shoe-in because the housing bubble was lifting prices--and thus people's net worth--for many traditionally Democratic voters who decided to stick with the status quo even though they may have disagreed with Bush and the Republicans on other policy issues. In the end, even if they have differing opinions on social issues, they tend to vote with their pocketbooks. This will make a Republican Presidential victory in 2016 even more likely.
The anticipation of a Republican victory, or even the increased possibility of one, will tend to lift the valuations of assets which are favorable toward less regulation, while likely disfavoring those which have benefited unusually from Obamacare or other programs which might not survive if the Republicans control the Presidency and both houses of Congress. In general, these assets will tend to anticipate rather than respond to the election, although there is often follow-through by those who wait until the results "just to be sure." So far, there has been almost no assets which are reflecting a likely Republican victory, so most of the price anticipation will occur during the upcoming 13-1/2 months with perhaps some follow-through into the end of 2016 and the beginning of 2017. In addition to likely rebounds for mining companies and others which would benefit from reduced regulation, the possibility of the end of gridlock and a surging U.S. national debt will probably be perceived eventually as being inherently negative for U.S. Treasuries.
If we briefly look farther ahead to the U.S. Presidential election in November 2020, then we will be in a situation where the U.S. economy had deteriorated badly during the first year of the next Presidential term, meaning 2017, followed by a recovery which begins in 2018 and accelerates in 2019-2020 just in time for voters to project the recent past into the indefinite future. As a result, whoever is elected in 2016 is likely to become unpopular but then to recover sufficiently to be re-elected. I think this will be true even if a Democrat ends up surprising me and becoming the next U.S. President. One potential pitfall for Republicans is that an acceleration of a recession in 2017, especially if the "real" economy doesn't recover, could be a significant gain by the party out of power in the House and Senate in 2018. So if the Republicans prevail in 2016, this would likely mean potentially large Democratic gains in 2018, perhaps resulting in reclaiming one or both branches of Congress to restore gridlock. This is actually a common result after two years of any new U.S. President.
There are many interesting issues which I didn't have time to discuss in today's topic, so I will probably revisit this subject again in a few months.
Take care and have a wonderful Shabbos and weekend. The next update will be on Sunday and I plan to include my asset allocation.
--Steve