Welcome to 2017. According to Wall Street it will be a fairly straightforward affair of a continued bull market with little corrective risk along the way. They may be correct of course as artificial liquidity by global central banks continues to flow at record levels and the incoming Trump administration has promised more free money in form of tax cuts and a very large infrastructure bill which may reflect positively in earnings. This may all be enough to keep the bull market on its trajectory for seemingly guaranteed gains. A virtually risk free market if you will. I have outlined my variant concerns in detail in my 2016 Market Review and if you haven’t read it yet I strongly encourage you to do so as the data outlines a potentially very different risk equation than currently projected:
Indeed it is our view that markets are in the final innings of a historically extended bull market and it is our firm expectation that 2017 will offer quite a different ride than 2016 in terms of volatility and ultimate market direction.
How the year will play out frankly much depends on the interplay of market technicals, the cost of carry, the coming AI and automation revolution in context of the current business cycle and, finally, the Trump administration’s ability to deliver on the promises that markets have priced in.
Let’s start with the upside since this is the status quo at the moment.
Last April I posted this chart in The Big Move which outlined a potential price expansion target into 2458 on the $SPX in case of a break higher out of the price consolidation range:
Ironically this price target is right in the middle of the range of current Wall Street consensus. To be clear I’m not calling for this target, but I’m outlining what the technical risk range may be.
Additionally back in September I talked about bearish wedge patterns that potentially extended into 2017:
These patterns continue to exist and they are very pronounced on a number of indices.
Also, to be clear: None of these patterns require markets to follow them to the apex conclusion. However we are looking for pattern resolution some time in 2017. The apex structure leaves the door open that an eventual peak could arise in 2017, but then it’s likely over and markets will finally set up for a proper corrective move that may or may not end up in a bear market.
Why “finally a proper corrective move”?
Well, for one, we haven’t had a 20% correction in forever it seems and, if I may ask, where are the signs of any serious correction in recent years?
From what I can tell the last correction of any serious sort was in 2011 almost 6 years ago when QE1 was ended. Call it the central bank effect if you will. But this lack of any serious correction also highlights the technical risk that an eventual correction will be much steeper than anyone can imagine at this stage.
A basic fib analysis using the current highs suggests a base correction of just to the .382 fib could yield a potential corrective move of 20%-27%:
It seems unfathomable in the current environment of volatility compression, but it is precisely this volatility compression that is laying the groundwork for future risk expansion.
The current rounding bottom pattern on the $VXO highlights that moves toward the red and green zones are coming in 2017:
Indeed looking at recent market history we can observe that the $VIX has been engaging in a distinct pattern of lower highs, a pattern that suggests not a continuation into infinity, but rather a coming breakout above the current trend line:
In this context it may be worth noting that the general market rhythm over the last several years has produced retraces to the weekly 25 MA or below following rallies to new highs in particular. A corollary breakout in volatility may then challenge price gains.
Also note the emergence of a potential megaphone pattern in recent months opening the door to a revisit of the lower trend line of the megaphone pattern.
What could bring about such an expansion in volatility? Frankly plenty of factors which are seemingly not priced into markets at the moment:
A. The coming increase in the cost of carry including margin compression. Never before in modern times has the world transitioned from such a low rate basis with so much added government, corporate and private debt into a rising rate environment. You want inflation in this context? Be careful what you wish for. We know credit card balances are at all time highs, we know government and corporate debt is at all time highs. Rising rates will impact interest payment obligations everywhere in society. To pretend that it doesn’t is a mistake in my view and a sustained break above this multi decade trend of lower rates will set markets on a course of the undiscovered country:
While there is evidence of panic buying and fear of missing out capitulation buying we note this is occurring on negatively divergent money flows at a time when people are positioned all long in markets:
People are getting bullish and euphoric at all time highs. Granted central banks have managed to win the battle in 2016. In April, in The Big Move, I called it “a fight for control between the historic precedence of earnings and technicals and a very much divergent development in money supply, one of the key drivers behind stock prices since the financial crisis.”
And clearly so far the money supply game has trumped everything fundamental and has permitted to let unlimited debt expansion to remain consequence free. Just relentless:
As many of you may recall last year the lower dollar was cited as a favorable tail wind for earnings.
This week the dollar hit its highest level since 2002:
Now we are told a rising dollar is bullish too. Upcoming earnings reports shall shed some light on the issue as companies will let us know what the impact is on their overseas earnings and exports.
As of late we have seen a booming of Libor rates globally. Here’s China and we can note the US hitting 1% for the first time since 2009:
Now one can rightfully argue and say, well historically it’s still low:
But in a world entirely dependent on low rates and record debt levels what does a trend change suggest? To me this remains a powder keg of mathematically assured destruction.
My supposition for 2017 and beyond is that this entire construct cannot maintain itself in a rising rate/reduced QE environment as the cost of carry increases and that markets will feel its impact at some stage.
B. The coming AI and automation evolution. To pretend there will never be a recession again is complete folly in my mind. Of course there will be and despite all the sudden happy talk following the election the data continues to point toward major risk in that department:
The trends in industrial production and manufacturing is already teetering dangerously close to a recession bounces not withstanding. Like it or not this remains a tight margin world. And companies that can achieve efficiencies and scale will succeed and the one that don’t will die. Nothing tells this story clearer than retail with $AMZN crowing over the bodies of retailers that haven’t been able to adapt to this new world.
And from what I am seeing: AI and automation capabilities will be so impressive and effective they will wreak complete havoc on entire employment industries. Anyone involved in a manually repetitive job is at risk. Robots will do it more efficiently. Anyone involved in a customer interaction position in a call center or service environment is at risk. AI bots will be capable of handling it. Fleet/trucking drivers? They are coming for your jobs. Headline writers in media organizations? You are already getting canned and replaced by algorithms that can do the job even more quickly than you can absorb the information. Hell, traders have already disappeared at banks and PhDs in advanced mathematics have developed sophisticated trading algorithms. None of this is hyperbole, this should not come as a surprise to anyone. It’s in process now and will accelerate during the next recession and my personal concern is that this next recession will be so deep and ugly that it will permanently kill off what’s left of the American dream. The job replacement cycle will be deeper than ever before.
One guy already knows this:
“When most people think about automation, they usually have in mind only the simple replacement of labor or improving workers’ speed or productivity, not the more extensive disruption caused by process reengineering,” Kaplan writes. Process reëngineering means that, no matter how much the warehouse business expands, it’s not going to hire more humans, because they’ll just get in the way. It’s worth noting that in 2012 Amazon acquired a robotics company, called Kiva, for three-quarters of a billion dollars. The company’s squat orange bots look like microwave ovens with a grudge. They zip around on the ground, retrieving whole racks’ worth of merchandise. Amazon now deploys at least thirty thousand of them in its fulfillment centers. Speaking of the next wave of automation, Amazon’s chairman, Jeff Bezos, said recently, “It’s probably hard to overstate how big of an impact it’s going to have on society over the next twenty years.”
It’s coming and I sense it will change the unspoken social contract in ways we can’t yet fully understand.
This technological shift is deflationary. It has been and will continue to be so and even much more radical during the next recession.
But because it is already so pervasive central banks and governments keep pumping artificial liquidity every single day of the week.
Here we are at all time human history highs in markets with unemployment supposedly so fantastically low and yet every day massive amounts of money are still being pumped into the system.
The first technological revolution of outsourcing permitted the relocation of jobs to other countries where labor was cheap. But now they can replace even that cheap labor completely and it’s not coming back and it’s already happening:
And this is just the beginning of it.
No I worry deeply about the implications of the next recession in the context of massive debt and increasing technological capabilities. Corporations will do what they have to to survive and they will cut and replace jobs left and right.
What’s the impact on society? My sense is it will be dramatic and none of us can have a clear view on how this will play out. But clearly the White House is aware and concerned about it.
I am not trying to be pessimistic on purpose here, but I am trying to be extremely real about what’s really going on and not the permanent happy talk we see everywhere.
The next recession is coming, it’s not a matter of if not when.
What will prompt a turn toward a recession? Most likely a change in confidence and the inability of the economy to push the unemployment rate any lower. After all, once unemployment bottoms out and rates rise typically is when we see a turn toward a recession.
The fact remains that 100% of all 2 term presidencies were followed by a recession. I frankly have my concerns about the promises versus the delivery of a Trump presidency. The math of the promises make zero sense to me and my suspicion is that either the promises are untenable or, if pushed through, then we run $1 trillion+ deficits. I’ve discussed the math issues in Empty Promises. I seriously doubt they can avoid copping up to this unless they start a war somewhere or not submit an actual budget. So something has to give on this front which brings me to the next point:
C. Political reality versus fantasy. As you know the election of Donald Trump has been justified to push valuations massively higher specifically in the banks.
I sense I have no choice but to account for political risk impact on markets as we have an incoming president that can potentially move individual stocks and markets simply by tweeting with his persona being so unprecedented in world politics. And continue tweeting he will, so it’s hard to avoid.
And I know some of you will not agree with me as everyone will have their own political views which is fine, but I will give you my interpretation of what I am seeing and you can of course take it as you wish. And to be clear: I thought both candidates were wrong for what the country needed as neither seemed to have a plan to address the structural issues facing the country.
Here’s what I am seeing: Donald Trump’s entire history is about self promotion. A 70 year old man is not changing his tune overnight and he may not be able to. He is a promoter who plays to people’s fantasies. Don’t take my word for it. From his book the art of the deal:
“I play to people’s fantasies. People may not always think big themselves, but they can still get very excited by those who do,” he writes on page 58. “That’s why a little hyperbole never hurts. People want to believe that something is the biggest and the greatest and the most spectacular.”
This playbook has served him well and he knows he can keep this game up for a long time as many people are slow to catch up. In his words:
“Ronald Reagan is another example. He is so smooth and so effective a performer that he completely won over the American people,” Trump wrote. “Only now, nearly seven years later, are people beginning to question whether there’s anything beneath that smile.”
Markets have priced in perfection based on promises and there seems little upside to going beyond perfection, rather there seems much more downside on future disappointment. And from my perspective pricing in perfection with overly bullish positioning in context of larger bearish market patterns highlights the big structural risk set-up for this market.
As I pointed out in December:
Donald Trump has led markets to believe he can deliver on all the things that he promises. Given the math issues I’ve outlined this seems like a very tall order and one that is likely to disappoint. Additionally Mr. Trump has raised the specter of trade tariffs, and a confrontational course with North Korea among other things. How these tweets relate to any actionable policies remains to be seen, but none of this has been factored into any sort of risk assessment by markets at this moment.
All I can say is that Mr. Trump’s multi-year twitter stream is a record of drama. He seems to thrive on drama and conflict. If his presidency ends up reflecting similar attributes then markets may be in for a harsh realignment on the political front.
From my perspective the totality of the factors outlined above can’t be reconciled with a $VIX trading with a 10-12 handle. After January 20, 2017 we will move from a phase of fantasy to reality. What, specifically, will Congress pass in terms of legislation and laws? And what will their impact be? What specific agreements will a Trump presidency actually accomplish or tear apart and what will foreign relations be about? What military action will he engage in if any? Note President Obama had authorized bombing in 7 countries without any Congressional declarations of war. That’s the type of executive power presidents have now. And now Trump has it as of January 20. Will there be a trade war/tariffs?
All of these are unknowns suggesting great uncertainty ahead. We will find out in time how compatible this will all be in regards to earnings, confidence, jobs and productivity.
If it all turns out wonderful and Trump will usher in an a new era of prosperity with an expanding middle class then great, I’m all for it. But that is supposition at this stage.
In my view the world is entering a completely new phase in its history. And the course of the journey will be greatly influenced by the interplay of debt, demographics, technology and politics. It will not be as smooth a ride as advertised. It will be as complex as we have seen and stretch our analytical capabilities.
From a risk assessment perspective our view is that the next big move will be 20%-25% lower not 20%-25% higher. Technical upside risk suggests another 5-8% upside potential per the technical assessments outlined in 2016 and supported by ongoing record liquidity injections and stimulus. However an eventual break of the long term technical structures continues to suggest 20-27% downside risk and, in case of an actual recession unfolding in the next year or two, a move significantly lower in the years ahead if a bear market arises given the massive global debt overhang.
But principally I presume the following to happen in 2017 at minimum:
We will eventually see another run at the daily 50MA and 200MAs and the weekly, monthly and quarterly MAs. What happens then in conjunction with the $VIX will then drive further price development. Sub 12 into 10 $VIX readings offer an opportunity to sell strength and large technical disconnects on either side of the spectrum offer opportunities to swing trade in the opposite direction. Any break below the weekly 50 and 100 MAs on the $SPX sets up potentially for a break of the large technical wedge pattern and a larger scale correction.
There never is certainty in forecasting, but unless markets are truly now a risk free proposition let me suggest that at some point there will be a red candle again on the chart below, and if so, it’s setting up to be a whopper:
Either way our outlook envisions a vast expansion of volatility into 2017 and beyond and we look forward to positioning for these big moves as they will offer large swing trade opportunities. If you care to join us for the journey you are welcome to sign up for the Daily Market Brief.