I’m not one to toot my own horn, but I do just want to observe that so far, the bear market that I believe began in January is proceeding right on schedule.
I pointed out in early February in the Wall Street Examiner Pro Trader that stock prices had inflated by an astonishing 24.9% over the 12 months ended January 17, leading to an all-time record overbought reading on the CLI (Composite Liquidity Indicator). That upside extension even exceeded the degree to which the market was oversold versus liquidity at the February 2016 bottom. We therefore knew then that the market was in an extreme buying panic – a mania – from September through most of January. I said then, “That leaves a lot of room for a decline.”
And as it turns out, I was right.
The early February market break was the start of it and we are probably now in the second phase of that decline and in the very earliest stages of the first leg of a major bear market. The inflation rate of stocks has already dropped from that shocking 24.9% in mid-January to just 10.4% annual change in the week ended March 23. I expect the 12 month rate of change to turn negative later in the year.
As I wrote in early February, “The level of overextension of stock prices from the liquidity trend reflects an extreme degree of risk of rapid deflation of the stock market bubble.” That overextension has barely begun to be corrected. The risks remain high.
Let’s take a look at my secret weapon, the CLI, and see what it’s telling us about our next steps.
The Flattening CLI Points to A Bear Market (And An Escape to Cash)
The CLI now combines four different measures of US systemic liquidity. There were 5, but the Fed stopped reporting a measure of bank trading. Three of the remaining four are domestic indicators, and one is a direct measure of foreign central bank activity in the US market.
The domestic indicators also are partially impacted by foreign inflows to and outflows from the US system. The Composite Liquidity Indicator (CLI) thereby attempts to capture every macro source that would have an impact on the US stock market.
The most important component is a measure of the cash flowing from the Fed to the Primary Dealers. Other components include a measure of bank deposit growth, and several measures of commercial bank trading and investment activities. Finally, I include a measure of direct foreign central bank purchases of US securities. Each of these is assigned a weighting based on its apparent relative importance in correlating the index with stock prices over the base period 2009-2012.
The CLI has risen by 5.3% over the past year. The Fed has been withdrawing money from the financial system since October. It started with tiny drains but has begun increasing their size by the schedule the Fed published in September. Those withdrawals will grow over the course of the next 6 months. That will slow macro liquidity growth.
The Fed allows Treasuries and MBS to roll off its balance sheet under the program it calls normalization. The Treasury must sell additional bills, notes and bonds to pay off the maturing holdings that the Fed is redeeming. Investors and dealers use existing cash to buy the bonds. The Treasury then pays off the Fed’s maturing bonds. That money thereby leaves the banking system for good. Or at least until the Fed starts printing money again (QE) which is a long way off.
Now that the market has started down, I would expect it to correct at least to the 39 week moving average of the CLI, which is now near 2400 on the S&P 500 on the combined chart of the CLI and SPX. I expect a bear market to develop, and ultimately for the SPX to become deeply oversold versus the CLI before a bottom is reached.
Macroliquidity is still trending higher but the trend is flattening as the Fed withdraws money from the banking system and extinguishes it. That means that there is less and less money available to absorb new securities issuance, particularly US Treasuries, which are now coming to market at a breathtaking pace that will continue all year and beyond as the tax cuts and spending increases send the deficit soaring.
The effects of those operations have begun to be expressed in the market and we are still in the early stages of the program. The negative effects will increase as the Fed increases the size of the drains over the next 6 months. Total liquidity will turn flat and eventually turn negative probably around October or soon after. Stock prices should follow that curve.
The Fed’s draining operations should have ripple effects throughout the worldwide liquidity pool that fuels stock and bond prices. The CLI should turn negative by October, when the Fed reaches $50 billion per month in drains from the system. It could happen earlier, but should at least happen by then.
Therefore I continue to recommend a cash position of 60-70% of your total portfolio (more or less, depending on your circumstances). When I started to make that recommendation back in September I suggested that a systematic program of regular sales of small amounts of stock would be the best tactic, with the goal of reaching that cash level by the end of January. That was fortuitous, because of course the market broke at the end of January into the second week of February.
Again, I’m just pointing out that we’re on the right track.
For those who came late to the idea of raising cash, I suggested that your selling program should be complete by the end of March, but I allowed for an extension until May because the market typically rallies from mid-April to mid-May thanks to the Treasury paying down debt. But I would not delay beyond that. The market scenario is playing out according to Hoyle, and I believe that it will continue to get worse.
Given that, I would not be averse to continuing to raise cash to the 80-100% level by mid-May.