Sometimes, my charts make me feel like Jekyll and Hyde.
The forces of macro liquidity tell us that the stock market (and the bond market too) are likely to top out and head into a bear market beginning in Q1 2018 or shortly thereafter. But this week the S&P 500 broke out above 2600. Technical cyclical analysis suggests that prices could be headed much higher.
So which is it? Are stocks the next Bitcoin? Or are we staring the bear in the teeth?
How can we reconcile these apparently conflicting views that are coming from the two prongs of my analytical work? Maybe… there really is no conflict. (Cue suspenseful music.)
Here’s what you need to know to take advantage of what this market is likely to hold in store for us in 2018.
The Market Is Set to Make New Highs Before The “Liquidity Drain” Begins
First, as you know if you’ve been following these reports at all, the forces of monetary policy and liquidity will be hostile to the markets in 2018. The Fed’s program, that it calls “normalization,” is designed to reduce the size of its balance sheet.
That program will literally take money out of the banking system and extinguish it. It means that the Fed’s Primary Dealers, who own and run the markets for their own benefit, not yours, will have less cash available to buy stocks and bonds.
At the same time, the supply of stocks and bonds will constantly increase. The US Treasury and other governments around the world will continue to issue bonds to finance their deficit spending. By the same token, corporations who have been buying back enough of their own stocks to keep the supply of stocks from growing, will do less of that. They might even start issuing stock on balance again to take advantage of these insanely high valuations.
In short, there will be less money around to buy stocks and bonds. But the supply of stocks and bonds will continue to increase, and with prices so historically high, issuers may even step up issuance. The bottom line is that the demand for all kinds of securities will shrink because there will be less money around. And supply will increase as issuers take advantage of high prices.
Assuming that the Law of Supply and Demand hasn’t been repealed, we can expect the trends of stock prices to reverse and turn lower next year. As the Fed ratchets up its draining operations to $50 billion per month in October 2018 and the ECB cuts its QE purchases beginning in January 2018, the forces of liquidity will become increasingly negative throughout 2018.
You can read more about how that will work here.
But this week we have seen a breakout in stocks and my technical analysis now projects that the long term price target on the S&P has risen to as high as 2800, from the forecast of 2600-2650 that I have had since June.
Here is a long term cycle chart of the SPX that I publish weekly in the Wall Street Examiner Pro Trader Market Updates. I could go into much greater detail about this chart, which is based on the work of JM Hurst in his 1970 book on cycle analysis…but in essence, if it holds above 2630, and it appears that it may, longer term projections now say that the SPX is going higher.
Now that we are seeing the market in the earlier projected range for a major top, should we act accordingly and aggressively increase the pace of our selling? Or should we pause and hold out for 2800?
There is certainly no reason to expect the Fed to detour from its new policy of destroying money rather than creating it. Yellen told us that the program to reduce the size of the Fed’s balance sheet is on autopilot. She also told us that there would have to be a “material adverse event” for the Fed to even begin to think of reversing the new policy. Furthermore, the first step in any reversal would be to lower the Fed Funds rate target before any consideration of reversing “normalization,” and returning to QE.
Then in the just-released Fed meeting minutes for October, the FOMC took that a step further. It absolutely codified that this policy is carved in stone. They even told us that they would no longer report it, and that any and all policy actions heretofore would be limited to the manipulation of interest rates. The Fed is determined to shrink its balance sheet and siphon money out of the banking system, come hell or high water.
In a similar vein, the ECB has announced that it will cut 30 billion euros a month from its QE purchases starting in January. The reports keep coming that Europe is doing better economically. It’s smoke and mirrors, but it is the propaganda narrative that European market managers are promoting. They appear hellbent on stopping their QE program in the next 6 months. So they make up a story that the economy is going gangbusters. Our reviews of European banking data says otherwise, but the name is of this game is managing perception, not reality.
The BoJ hasn’t taken those steps yet. It is still printing money hand over fist. But pundits who cover Japan and are connected to the financial hierarchy there, as well as some policymakers, are making noises that QE there will also come to an end in 2018.
There is every reason to believe, in fact it would be delusional to ignore the fact, that monetary policy has turned hostile to the stock market. It will take time for the most draconian stages of the new policy to be implemented and begin to impact market prices. But that time is growing shorter.
Tick tock. Are you willing to wait for the fuse to go off before you take protective action?
December May Be Your Last Chance to Ride the Wave
But what about that negative liquidity outlook?
Fear not. It’s coming. The Fed’s draining operations have barely started. The first tiny drains will only begin to hit the system in December. The more dramatic effect won’t come until it doubles the size of the drains in January and then increases them again in April, July, and October of next year. Even those impacts should have a 30-60 day lag from implantation. At the same time the ECB won’t cut its QE purchases in half until January.
For that reason this blowoff in stocks could easily continue through December. The speculative juices are flowing and we’ve seen evidence of the use of increased leverage in recent weeks. Interbank repo to finance securities borrowing has gone through the roof in the last couple of weeks. This is not a case of investors making value investments. It’s a raging speculative blowoff.
So the negative liquidity outlook and the technical picture of a market making new highs aren’t inconsistent at all. It’s merely a matter of timing. The liquidity is still flowing right now, but that will change next year, slowly at first, but with increasing intensity.
So yes, if you’re comfortable riding this wave, you can hold off on further liquidations of your stock portfolio until clear evidence that this euphoria has reversed. At that point, I would redouble my efforts to raise a cash cushion. My target is to reach 60-70% cash by the end of January, or the end of the first quarter at the latest. Your cash target could be more or less depending on your personal circumstances.
As a trader who is thinking of shorting the market, I would continue to hold off until clear evidence that the euphoria has broken. In the meantime, I’ll be looking for specific stocks or sectors that appear set up for swing trades to the short side. I’ll report a few of them here when the time looks right. So stay tuned for that.