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Fed Hike Too Little, Too Late - Beware Of 2016!
BY GREG TOLPIGIN - 18/12/2015 | VIEW MORE ARTICLES BY GREG TOLPIGIN

After calling for an early Xmas rally to come in October following the August correction, we have been highlighting the extensive risks that have been building across financial markets. Some of these risks have been apparent all year long – such as our long-held view that a GFC-style collapse emerging in junk bonds and emerging markets – but now, we see more and more reasons for investors to turn cautious and in reality, bearish.

The start of every calendar year asks economists and strategists to pick where markets will be at the end of the next year. To me it’s a useless projection that almost always nobody gets right. The key is that such projections don’t tell us the path to get to any of these year-end targets. There could easily be a huge correction mid-year before rallying late in the year to hit these designated targets or a huge rally at the start of the year before entering a bear market to end at the same targets or anything in between.

I instead focus on what is happening now and where the risks now are to markets and in which direction these risks are building, positive or negative. After all, running a proprietary desk our sole aim is to make as much money as possible, with extreme consistency – almost everyday.

Regular readers will know that I have been highlighting these underlying risks but there is clear evidence of these changing tides across a variety of sectors, indices and asset classes. I spent the past week review all my strategy reports and analysis from 2002 which displays immense resemblance to the current period and also to 2011. Keeping notes and analytical work is a key component of understanding and identifying why cycles repeat and what drives markets. Before embarking on these similarities let’s look at several markets that show the bull market for equity markets is complete and investors need to be wary of what 2016 unfolds.

We have shown emerging markets and junk bonds in recent weeks and months so I won’t cover old ground. Suffice to say that my negative and dire projections continue to unfold so I am so far on the right path to understanding what environment we will be tackling over the next 12 months.

First below is the Dow Jones Transport Index which has built a clear top formation is on the verge of breaking lower. This a weekly 10-year chart and after more than doubling since the 2011 lows and gaining 400% from the 2008 lows the trend has turned lower. Not only is the price action negative but the key moving averages (10,21 and 30) are also declining with the prices remaining below the averages. This is the exact reverse to 2013 and 2014 where prices remained above the moving averages. The bull market in transports is complete and now reversed. And according to Dow Theory this is a leading reflection of economic activity and a barometer to the health of overall market.

Similar circumstances are present for the retail sector as well. Below is a retail sector ETF and again a top formation is on the verge of completion with clear price action that is below the moving averages that themselves are also clearly drifting lower. These moving averages now act as clear resistance, an about face on the huge support they provided from 2011 onwards. Outside auto sales, retail has been very patchy and inconsistent. Multi-year trendline support is also on the verge of breaking too.

The home builders are also topping out in similar fashion to the transports and retail – but with a lag. The performance of individual home builders has been quite negative despite a booming housing industry. Below we show several key home builders that have been in long-term decline or on the verge of entering downtrends – again not a pretty picture and certainly not one that shows a robust economy.

Lennar

Pulte Corp

The so called beneficiaries of an improving economy and higher interest rates – the banks – are not leading the market higher. They are still caught in their long-term multi-year ranges. Not an indication of great times ahead. Bank of America which is the most leveraged to rising rates is still at late 2013 levels. No breakout and higher trend here.

Now let’s look at some of the major indices around the world. Most major top formations are characterized by similar price action. We showed how using previous periods in market behaviour can be very powerful when we compared 2011 to the August sell off which correctly predicted an almighty short-covering rally was to come in October. Major top formations are characterized by a lengthy rolling top which a short sharp decline. There is usually a secondary “bounce back” that either retests the highs or at the very least the original break down point. This bounce back – like the one we just had – sucks 95% of participants into believing the dip was a buy. It cements bulls into staying long, causes bears to cover shorts (again) and exhausts their ongoing negativity.

We had this occur at the top in 2007, 2002, 2000, 1937, and in 2011. Below I show a weekly chart of the S&P 500 and this bearish top formation is clearly visible. We can also see a similar pattern in 2011. Most of 2011 was spent consolidating, before a drop into June broke supports – shown at point 1. A quick rebound back to the highs in July – point 2, and then the big fall in August – point 3. From here equities are at risk of declining but the question is will it be slow and orderly like 2002 or will it be rapid, almost a crash? I currently favour orderly.

To emphasize similarities in market peaks below is a comparison of 1937 to 2015.

So finally we have had the Federal Reserve raise rates. Almost everyone I speak to highlights that equities typically perform well during the early part of rate rising cycle. Yes that is true – I did the research 18 months ago when the Fed began tapering which indicated there would be no sell off or collapse like many predicted. Even when QE officially ended in October 2014, the tantrum was small. New highs were seen a month later.

So why is now different, when history shows that when the Fed starts a tightening cycle we typically see equity markets perform strongly for 6-12 months. And here is the key to understanding how global markets work and being aware of where risks exist.

This cycle is unlike any other, with the exception of Japan’s 20-year long zero rate and QE policy. My road map of 2013 that highlighted why the S&P 500 would embark on one of the biggest bull market rallies of modern times was based around two things main factors – the goals of the Federal Reserve and the relative value of equities as an asset class. The goal of the Federal Reserve in embarking on QE was simply to lift asset prices (equities, real estate and basically anything) as high as possible. Push investors further out the risk curve so asset prices get so high that the companies and investors begin to spend this paper wealth in the real economy. Effectively there is little else that can be done. And so the past few years has been a textbook case of engineered asset price inflation. Without the Federal Reserve spending $4 trillion dollars (along with other global central banks adding to this total) where would equity prices be? US corporations this year will have spent near over $600 billion buying back stock while directors have been net sellers.

The consequences of this global central bank policy has been to create another bubble. Investors across the globe who were burned by buying Mortgage Backed Securities in 2003 to 2008 invested in products they knew very little about and turned out to be high risk sub-prime mortgages. Investors in Exchange Traded Funds (and unitized funds) are in similar positions where high-yield bond exposures are to companies that have little ability to pay back their debt and these funds have no way of exiting because liquidity for these junk bonds has dried up. So as I noted this week junk bonds have collapsed and funds have ceased allowing redemptions. There is $1.2 trillion of this junk rolling around in the system and of that oil companies account for $200-300 billion with an oil price that is a third of what it was 18 months ago.

Equity markets globally have boomed as investors have been channeled away from cash/Government bonds and into equities. Zero interest rates lifts equity valuations everywhere no matter the sector. Corporates have cut staff and operational costs, helping drive an increase in profits but not revenue. Using cheap money they have engaged in buybacks to help lift earnings per share but very little cash has been used on capital expenditure to grow organically.

This is all great for a while and we have seen the results in the rally of the past 5 years which has been characterized by extremely low volatility. The exact reflection of an engineered rally not a real one.

The consequences are that eventually these engineered conditions need to be reversed. Emerging market inflows have turned to outflows. Equity market volatility needs to increase. The debt that has shifted from corporations during the GFC has become public debt leaving Governments with few avenues to help drive real economic growth. Investors that were forced to find higher returns in riskier assets (like junk bonds) will incur steep losses.

Due to all of the above the US economy – arguable the best performing in the Western World – is not rosy. Manufacturing data as reflected in the ISM numbers is the lowest in 4 years – and contracting. Industrial production has weakened to the lowest in 3 years. This type of data since 1948 has predicted most US recessions. Even the Blackrock strategist indicated that the level of company defaults currently occurring is associated with an upcoming recession, however doesn’t believe that will occur as this time its “different”. I hear that statement at the peak of every cycle!

Finally, Janet Yellen was forced to comment on the Citigroup forecast of a 65% chance of a US recession next year stating that it was not something the Fed is expecting. What is the target for the most bearish analysts on Wall St for the S&P 500 at the end of 2016? 2200. Yes, most bearish is 2200, 10% above current levels. Economists are expecting 3 to 4 Fed rate hikes next year and that’s what the Fed indicated is its expectation. Everyone seems very complacent and comfortable. I can promise right now it won’t be 4. How long did it take to raise one time and with each subsequent rate hike it becomes more difficult and has a greater impact on the economy.

I think they will struggle to raise a second time and if they do it will only make the bearish case stronger. Watch the economic data weaken rapidly in 2016 and the risks are the Fed makes the same mistake the European Central Bank did in April 2011 – raised rates when the economy couldn’t handle it and 4 months later a crisis appeared.

I have spent a lengthy time explaining the bear case for 2016 and the immense risks that are building in markets. As a trader that only gets paid through profits it is important I get these things right and execute the trade correctly as well. I need to manage risks and be able to extract profits in market condition which is unlike analysts, economists and strategists. I feel immense complacency over 2016 and that world will “chug along”. Markets are telling us otherwise.



View More Articles By Greg Tolpigin

Greg is the Head of Proprietary Trading at Gleneagle Securities and has over 20 years of experience as proprietary trader and high level strategist for the major investment banks including Citigroup, Bankers Trust and Macquarie Bank. He has been involved across all asset classes including commodities, bonds, currencies and equities right across the globe.

After a 10-year career within the comforts of the large investment banks and research firms he branched out on his own to form his own proprietary trading firm successfully building the business into a multi-million dollar trading operation that turned over a billion dollars a year. This same team now runs the proprietary trading desk at Global Prime, risking their own money in line with the firm's and client's capital.

Greg has appeared on CNBC, Channel 9 - Business Sunday programme, a guest columnist for the Australian Financial Review, a regular author for Personal Investor, Wealth Creator and Shares magazine and is the former Treasurer of the Australian Technical Analysts Association.



 

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