My Secret Liquidity Weapon Pinpoints The One Short Trade for 2018

If you’ve been reading Sure Money for any length of time, you know all about the LAMPP indicator. The LAMPP measures the two most important sources and uses of macro liquidity for the US markets, which are the Fed and the US Treasury, and then feeds that information back to us as red or green signals. It is a great way to tell at a glance whether it is safe to be in the US stock market on the long side, or whether we should be out, or even short.

Over the past 11 years it has been flawless at calling the long term trend. It has also done a good job on most of the intermediate swings. But recently it had a misstep, calling for being out of the market during the late 2017 run. It’s not a perfect swing trading indicator. We wish it were so simple.

The truth is…the  LAMPP is only the beginning of the story…

I’m about to take you even deeper into my system and show you my proprietary liquidity weapon…the CLI.

And what it’s telling me about the coming bear market.

Up till now, the CLI has only been available to my Wall Street Examiner Pro Trader Macro Liquidity subscribers, but today, I’m taking you behind the scenes and showing you how it works. If you know what you’re looking for, you can use this information to fend off, and even profit from, the coming bear markets in stocks and bonds.

In this report, I will give you a vehicle that will allow you to do just that. A simple, one-decision trade. Just set it, and forget it.

Let’s get started…

My Secret Liquidity Weapon Tells Us…This Market Is Severely Overbought

First, let’s look at the liquidity picture.

The Fed normally supplies liquidity, but as we now know, what the Fed giveth, it can also taketh away. Taking away is what it’s now doing with its new, since October, automatic program of draining money from the banking system and the markets. The Fed calls it “normalization,” but we know better. Alarmed about runaway asset bubbles, the Fed is “pulling the punchbowl.”

The biggest user of liquidity is the US Treasury as it sucks up to a hundred billion bucks out of the financial sphere each month with new debt issuance. The fact that the Treasury now has to pay off some of the Fed’s holdings every month means that it will be selling even more debt than before. More supply means downward pressure on prices, upward on yields. That will have a spillover effect on stock prices.

Add to that the fact that the new tax cut law will cut revenue by $280 billion in fiscal 2019, according to the Joint Committee on Taxation of the US Congress.  So that will add even more debt to the pile. When the Treasury sells more debt, and the Fed is no longer a buyer, and is in fact indirectly adding to supply, that means that dealers and investors need to liquidate “stuff” to help absorb all the new paper. That “stuff” is existing bond and stock holdings. That’s why a bear market in bonds will also translate into a bear market in stocks.

As a result, I’ve foreseen a bearish scenario developing for the markets in 2018, and I’ve been warning you to gradually get the hell out, at least mostly, if not by the end of January, then by the end of the first quarter.

I’ve also projected that the market would top out in January in the mid 2700 to 2800 area on the S&P 500 on the basis of technical analysis.

I have seen nothing so far to deter me from any of my analytical conclusions, especially now that  the market has fulfilled the technical projections.  Why change the analysis now when the market has been doing EXACTLY as expected?

Years ago I created a composite indicator of these numerous liquidity measures…that I called, the Composite Liquidity Indicator (CLI). I have reported on this measure and its components to subscribers of the Wall Street Examiner Pro Trader Macro Liquidity services for the past dozen years. Since 2009, with a few brief exceptions when the Fed briefly pulled in its bullish horns, this indicator has kept me bullish on the markets. That’s because I rely heavily on Rule Number 1, “Don’t fight the Fed.” And the Fed was mostly bulling the market higher throughout the 2009-2017 era.

Macro liquidity is still trending higher but there was a slight downward blip in the last couple of weeks as the Fed went about its program of draining cash from the system.  We can see that in the CLI chart below.

 

Secret Ingredients: What’s In The CLIThe CLI combines five different measures of US systemic liquidity. Four of the five are domestic indicators, and one is a direct measure of foreign sources.

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.

 

In October the Fed began a program of shrinking its balance sheet that it calls “normalization.” The program actually drains funds from the banking system. The Fed is effectively “pulling the punchbowl” that has keep the market inebriated for the past 9 years.

The effects of  this program are minimal here in the early stages of the program. But the negative effects will begin to show up as the Fed increases the size of the monthly drains over the next year. Total liquidity will begin to turn flat, and eventually turn negative at some point in 2018. Stock prices should follow that curve.

The CLI has risen by 4.2% over the past year. But the Fed has begun withdrawing money from the financial system and those withdrawals will grow over the course of the next 9 months. That will slow macro liquidity growth. The Fed’s draining operations should have ripple effects throughout the worldwide liquidity pool that fuels stock and bond prices. By the time the Fed reaches its planned goal of $50 billion per month in drains from the system in October of this year, the CLI may even turn negative.

Stock prices have inflated by an astonishing 23.5% over the past year (to January 16), leading to an all time record overbought reading on the CLI. The recent upside extension of the market has even exceeded the degree to which the market was oversold versus liquidity at the February 2016 bottom. That leaves a lot of room for a decline.

When the market finally starts 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 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.

Back in February 2016, the market got extremely oversold versus the CLI. Today, it is just as extremely overbought. A violent reversal could be coming in the next few weeks.

A significant difference between the February 2016 oversold reading in the CLI and today’s overbought reading is that the 2016 move was counter trend.  Today, the overextension is in the direction of the trend. That can support overbought readings for an extended period while the liquidity trend is positive. We should not turn bearish just based on the market being overbought.

But here’s the key. The Fed has turned hostile to the markets, and its cohorts the ECB and BoJ, have become, if not outright hostile, a lot less friendly and circumspect. They too are starting to pull their punchbowls. When these big central banks reduce liquidity creation, it affects not just their home markets, but it especially affects Wall Street. Ultimately on the financial map, all roads lead to Wall Street.

The Fed’s Money Draining Program Will Leave Small Investors Holding the Bag

The Fed began withdrawing liquidity from the system in October. It started with tiny amounts and is gradually increasing them. The CLI will flatten and probably turn lower later this year. Today’s market overextension, therefore, represents an extreme level of risk. We don’t want to overstay our welcome on the long side. Any sign of market weakness should be viewed seriously as a sign that the phase of the bull market where you could simply buy the dips and hold on through the pullbacks, would be over.

The Fed’s draining program is the first effective tightening of monetary conditions since the temporary pause of QE1 in 2010.  This one will have much greater long term effects. As this program evolves it will become far more draconian and painful to the markets. The Fed will constantly reduce the amount of money in circulation, meaning that there will be less and less cash available over time to assist in the absorption of an ever increasing supply of Treasury debt. I don’t think anyone realizes what a lethal combination this will be.

The Fed’s money draining program is something new. Periods of shrinking macro liquidity are historically extremely rare. Long term historical data for the components of the CLI don’t go back far enough to show those rare periods prior to the 2007 to 2009 experience. But we know what happened then, a massive bear market that included a crash in September-October 2008.

The current bull market has persisted for 9 years, driven by massive increases in liquidity from central bank money printing. The ECB and BoJ will continue printing for a while longer but this month (January 2018) both sharply cut the amount of their QE. They are doing so just as the Fed increases the amounts it is actually pulling from the banking system.

The scuttlebutt among the cognoscenti now is that the ECB will turn off its printing presses and stop QE altogether later this year. The BoJ is expected to follow suit. It is likely that later this year the Fed will be draining and the BoJ and ECB will have stopped printing. That will be lethal for financial markets that have depended on central banks constantly absorbing supply.

Once central banks announce the intention to reverse policy, or put feelers out through their well placed henchmen among the Primary Dealers and in the media, it’s as good as a done deal.  By late this year, the Big Three central banks will be in a position that is extremely hostile to the markets and to small investors especially. The big guys will hedge themselves or even position to profit from a big, extended bear market.

Small investors will be left holding the bag. Wall Street will lead them to slaughter, just as it always does in every generation. This generation’s turn is coming. Now, it’s up to you whether to side with Wall Street’s bullish salespeople, or to take the side of prudence and caution.

I can’t manage your money, or force you to do something that you don’t want to do. But I will give you the facts and logic to the best of my ability, so that you can decide for yourself whether my recommendations make any sense or not, and whether to act on them or not. For now, with the market heading straight up every day, you may think that I sound like a crazy man shaking his fist at the moon. But sometimes those crazy men turn out to be prophetic because they are looking at the things that others don’t want you to see.

Obviously, it’s always easier to run with the crowd–safety in numbers. For a long time, that works. The consensus view can be correct for years. Until it isn’t. And that’s when it costs you the most money.

I believe we are on the threshold of just such a time.

The Fed has decided to restore the balance sheet to its historically normal position where there are virtually no excess reserves. The markets are likely to have a very bad accident before the balance sheet gets to that position of tight reserve balances. But that’s just the thing. It will take a bad accident to get the Fed to start easing again. Do you want to drive full speed into that accident? Or do you want to take another road, and not only avoid the accident, but profit from it?

The Fed is betting that it can manage a soft landing. It has made that bet every time it tightened in the past. Most of the time things didn’t go as the Fed had planned. There has never been a tightening that was as draconian as this one will be. The outcome is likely to be even less favorable than during past tightening periods.

That means if you don’t position yourself to profit, you’ll be pretty angry at yourself down the line.

The “Set It And Forget It” Short Liquidity Trade You’ve Been Waiting For

So what do we do about all that negative energy building up in the US markets in 2018? Is there a way to play the coming bear market that we can set it and forget it?

The answer is yes.

As a technical analyst I’m always looking for swing trading opportunities that can ultimately result in compounding of gains. Profits of 2-20% on trades of a month or so, may not sound sexy, but with the judicious use of margin those gains can be doubled. The effects of compounding then can work their magic over the course of a year. By using stocks and ETFs, as opposed to options, we need not worry about some trades that result in total losses setting the trading program back to zero. Compounding should keep things moving in a steadily positive direction. That’s the basis of my Daily Trades List in the Wall Street Examiner Pro Trader.

But most investors have neither the time nor the inclination to trade actively. What can you do to profit from the coming bear market? There’s a simple strategy that you can follow that will enable you to collect gains with just one trade. That trade is to short the REITS – Real Estate Investment Trusts. They will do very poorly in a tightening monetary environment, such as the one we are now in and are likely to be in for the next 12-24 months.

Liquidity analysis tells us that we are likely to be in a bearish environment for the next year or two as the central banks gradually tighten the monetary screws in an attempt to wring out the excessive speculation in the markets. The central banks always expect to be able to manage a soft landing. For reasons that I’ve delineated here and elsewhere, I don’t think they’ll be successful. But even if they are modestly so, interest rates and bond yields are all but certain to continue rising for the foreseeable future. That means bad news for the real estate business, especially commercial real estate, where valuations have soared to levels never before thought possible.

Now I’m a technical analyst, and I don’t pay much attention to investment fundamentals. They make a nice story if that’s what you need to support what the charts are showing, but in this case, I have an excuse for talking about fundamentals.

 

My Real Estate Appraiser Past Helps Me to Spot Bubbles…Before returning to technical and monetary analysis when I started The Wall Street Examiner in 2000, I spent 13 years as a commercial real estate appraiser and analyst in Palm Beach, Florida. I appraised numerous institutional Class A properties, as wells as a bunch of turkeys, throughout South Florida during the S&L and commercial real estate bubble of the 1980s. And I saw it all come crashing down in the 1990s.
Because I had always given the straight dope and had killed my share of insane deals on the way up, when the crash came, I found myself swamped with work from the FDIC and RTC (Resolution Trust Corporation), the agencies tasked with cleaning up the mess. I frequently saw properties that were worth no more than 20-35 cents on the dollar of what they had either been sold for or financed for on the way up. The assumptions that had been used to justify those high valuations were insane. The banking system virtually collapsed because of it.Then we did a repeat in the residential realm in 2004-06. From a crash low in 1992 to peak in 2006 took 14 years.  But that was after the S&L crisis culprits were held responsible. The Federal Government sent many of the leaders of that 1980s fraud to jail.

The more recent real estate crash  bottomed in 2011. It took only 5 years for things to get totally crazy again, because this time not a single perpetrator of the massive frauds that drove these bubbles was held accountable. In fact, the criminals are now running the entire system. Under the circumstances, who can guess what the fallout will be this time? But if the old time religion matters at all, the piper will be paid, and I can hear him coming from over the hills.

 

Why REITS Are The Perfect Trade for An Era of Monetary Tightening

Never during that 1980s period of insane speculation and overvaluation did I ever see anything along the lines of what we are seeing today.  Back then the lowest capitalization rates we saw for institutional quality property were around 7%. Today I have seen institutional office, industrial, and apartment real estate listings touting cap rates as low as 4%, 3%, 2%, and in the case of prime Manhattan real estate, even less than 2%.

Cap rates historically were always stable. I used to joke in the old days that “the cap rate is always 10, that is 10% for Class B, mom and pop investment property. Ordinarily, good quality institutional property would sell at around 8%.  But since the advent of securitization and REITization, the price of everything, including immovable real estate, has been tied to long term interest rates, i.e. bond yields. When the 10 Year Treasury sold at 1.5%, the Wall Street boyz could make a case that a nice office building on Broward Blvd. in Ft. Lauderdale should sell for around the same.

They used to say the same thing about retail, but we all know how that played, with our landscape pocked with dying mega malls and strip centers.  Retail REITS have been death to mom and pop investor portfolios. The Dow Jones Retail REIT index peaked in July of 2016 at 151. What were people smoking? It’s not like Amazon and its online ilk weren’t already killing the category. But there were buyers at the top. Sorry ones today. That index now stands at 105, losing a third of its value, with no end of this trend in sight.

Other REIT sectors haven’t gotten hit as badly yet, but they’re starting to leak. As bond yields rise, not only will the valuations of the owned properties fall, but the dividend yield will become less valuable. The market will demand higher yields on REITs, just as it will demand higher yields on bonds.

Making matters worse, many REITS are leveraged. Their borrowing costs will rise, cutting into their dividends. In some sectors, such as the red-headed stepchild retail sector, vacancies will rise, rents will fall and operating income will collapse and mortgages will be foreclosed.  These REITS are headed for the trash heap. They will be worthless.

As the risks in the REITS become apparent, risk premiums will increase. Investors will no longer be willing to settle for a dividend yield that is barely higher than the yield on the 10 year Treasury. They’ll want more, a lot more.  That will add more downward pressure on prices.

The REITS embody a potential perfect storm of what can go wrong in an environment of monetary tightening. They’re obviously not the only interest sensitive sector that will get pounded. But the case is there that they’ll do the worst. Many REITs will not survive.

The sector is screaming to be shorted. Let’s look at what happened to the REIT sector in the last tightening cycle from 2006 to 2007. It wasn’t pretty. This is the Dow Jones Equity REIT Index. On January 31, 2007 it stood at 356. By February 2009 it had plunged to a low of 82, a loss of 77%. And interest rates were actually falling sharply in the latter part of that crash. Once these cycles start down, they take on a life of their own. When unreality ends, reality bites hard and long.

So today, if you agree with the sector story, you can certainly short the Retail REITs. A case can be made that office space is in the process of becoming a white elephant as more and more workers telecommute. The office REITs haven’t rolled over yet, but they’ve made a nice double top on the chart. This could be the start of something there.

And what about the residential REITS? They’re the poster boys for Housing Bubble 2.0. They reached 6 times their value at the bottom of the last crash, and 2.5 times their peak level at the top of Housing Bubble 1.0. They look like they’re topping out too.

This Single REIT Recommendation Narrows It All Down…

Each case looks a bit different, but the end result should be the same, a bear market that decimates prices. So there’s no need to be a subsector picker. I would short the whole shebang. You can do that with an ETF, in this case, the RWR ETF, which is the SPDR Dow Jones REIT ETF.

This chart speaks for itself. The bull market ended in July of 2016. Since then the ETF has been in distribution. The big boys have been getting out for a year and a half as mom and pop investors desperate for yield pile in. Those who got in 18 months ago have gotten smoked to the tune of 14%. A 4% dividend yield won’t make up for that. And the stock hasn’t even broken down yet. That’s coming when the 10 year yield finally breaks out above 2.60 as the Fed continues to tighten the screws this year.

You can see the profit potential based on the 2007-2009 experience.  There are obviously no guarantees that the same thing will happen this time. But the case is there.

Rather than trying to pick several REITS that are likely to do poorly in an environment of tightening monetary conditions, you can sell short the RWR.  It can be sold on a rally back to the 94 area, or on a break of support at 87, or both. It will take a support break to get the ball rolling.

There’s some risk that I’m wrong of course. That would be the likely case should the ETF break out above 95. In that case, the short should be covered. I obviously consider that to have a low probability, but we must always be prepared for any eventuality.

If you are looking for a way to play the bearish liquidity environment of the next year or two, this is it. Short RWR. Set it and forget it. But stop in here regularly for updates on the situation. Nothing in the markets is carved in stone.

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