The US Bull market in stocks is alive although not entirely well. Heavy investment holdings by long term investors remain warranted, yet various measures of valuation combined with declining earnings and margin debt are warnings signs to be vigilant for in 2015. Shorter term indicators we often highlight here have been muted or neutral thus far in 2015. While long term indicators lack precision of timing to discern when high is too high and with the short term indicators temporarily nebulous, we will highlight today an interesting proxy for the stock market that may yield clues for what to expect next.
The Japanese Yen has an important relationship with US stocks. Why? The Yen has long been a favored “carry trade” currency. That is investors will arbitrage higher US vs lower Japanese interest rates and Sell Yen and Buy US Dollars & Dollar assets. As shown here the value of the Yen moves inversely to US stocks, thus new lows in the Yen tend to coincide with new highs in US stock indices. Predict the Yen and you will have a crystal ball for US stock indices!
The chart above doesn’t yield a clear prediction about the Yen, but it does confirm our correlation. Despite the new record highs in US stock averages the past couple of weeks, both stocks indexes and the Japanese Yen have been linked together in trading ranges since early December. A more decisive breakout of the Yen in coming weeks will signal a more decisive move in the US stock market. Currently the Yen is testing new lows and stocks as expected are testing new highs.
Let’s look at Big money using the Commitment of Traders report.
Leveraged Funds (green line) and other Large Speculators move their investments in sync with prices and peaks in the Yen occur when Leveraged Funds have covered enough of their short positions. Despite the large Yen depreciation this past year we can see that the current Yen trading range has encouraged these Funds to reduce risk and move to levels that are more aligned with Tops than Bottoms. Certainly the Yen could rally while Large Specs move to modest net long holdings from modest shorts today, but for now the odds favor a lower Yen resolution.
The above chart shows a portion of the previous sharp downtrend and current sideways pattern. Typically the angle of incidence heading into a congestion pattern is the angle of resolution from the trading range. Again the odds favor an eventual break lower in the Yen and higher in stocks. Basis the March Yen futures pricing the parameters to watch for a breakout in either direction are bound by 8663 on the upside and 8219 on the low end.
We are certainly mindful that long term the Yen looks very oversold and US stocks are at the high end of historic valuations other than the late 1990’s tech bubble. The Crestmont Price to Earnings ratio (P/E) below is based upon inflation adjusted forward estimated GDP divided by 10 year earnings average with filters.
Another long term perspective looks at the market price of all stocks in relation to their total replacement cost using the Q ratio (dshort.com).
Our long term valuation concern is tempered for now due to the unique period we are in where Central Governments around the globe have adopted a monetary scheme to backstop all bad bets until the economy is self sustaining with normal growth rates and inflation. With Trillions of free reserves allowing assets to inflate in a world weighed down by massive debt deflation induced austerity, we see this tug of war continuing until risk taking and rapid growth are more evident. Normally we would see Yield curves tightening if not inverting where short term rates rise above long term rates. In this low inflation and temporary deflationary environment, we are a long way from credit tightening concerns and overheating economies. Sure stocks seem to be overheating at times, but that can continue longer than our wallets can continue betting against the over priced uptrend.
Treasury Yields are very positive slopping and would appear more so if not for shorter term yields being struck at zero thanks to deflation and the Federal Reserve. This is a healthy chart. When inflation is a concern and banks need to tighten credit to cool the economy you can bet the left side of this chart will rise quickly.
Oil deflation over the past 8 months and the currently stable prices in recent weeks are supporting factors for now. Oil is unlikely to rise significantly for a long time given the supply and demand fundamentals. Last month we revealed that a massive reduction in Natural Gas drilling rigs had virtually no correlation with falling production medium term as Natural Gas supplies increased since the 2008 crash despite over 80% of the rigs being idled. The same is occurring today with Oil.
While Oil prices “could” fall again to new lows under $40, we are in a seasonal period of strength as refineries have idled for summer blends and demand will begin to pick up in March. Should prices remain under the mid 50’s into April then beware of a renewed push lower in energy as this historic supply glut of Oil injects fear into energy markets again soon. Any new lows in Oil will temporarily hurt US stocks and potentially boost the Yen. The parameters to watch for US Oil (WTI) are 45 to 55.
Finally we will note further evidence of deflation with our recent short term upside trade closed out today for the rising US Dollar at 96.61. With deflated Oil and massive Central Bank Bond buying by Europe and Japan kicking off next week it’s hard to be anything but Bullish longer term on the US $ with US interest rates rising ever higher relative to other countries.
Tech stocks have broken to the upside while Blue Chip stocks as represented by the Dow and the SP 500 Index are still clinging to their 3 month trading ranges, perhaps awaiting the Japanese Yen and Oil to break out and tip the scales. The Bull market is still alive and may continue for several years, however before year end 2015 the odds of a 20%+ correction big enough to scare investors and create Bear Market headlines is likely.
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