It’s easy sometimes to get so caught up in the daily or weekly movement of markets that you forget to take step back and look at the bigger picture. Everyday we're inundated with data points from around the globe, gurus, news, blog posts and the most important central banker statements ever, or at least until tomorrow’s statements. With each passing year, it's getting easier and easier to miss the forest for the trees.
We're just a couple of weeks away from a month that may turn out to be historically significant. The market is expecting the US central bank to begin a rate hike cycle, while the ECB appears to be dead set on augmenting its current round of quantitative easing in several ways. First, the ECB is expected to step up the pace of its government bond-buying program by 20B Euros per month. Second, extend the time frame of those purchases beyond the current deadline of September 2016. Third, expand the universe of eligible assets it can purchase. And finally, they could possibly cut the current deposit rate by an additional 10 basis points, which would take it from an already -20 basis points to -30 basis points.
With a possibly historic month in front of us, it’s a good time to take a step back and assess where we stand. Most either look backward at lagging data or past performance to make decisions or try to forecast months in advance – both are fools' errands.
The goal is to better understand what's happening in the present – that's how you get a real edge over other market participants.
I’m a top down, macro guy, so my process starts with assimilating the fundamentals of the economy in question. Once I have built that foundational bias, I move on to examining the various asset classes that can be traded. And if it’s equities I’m interested in, I’ll dig down to the sector or industry level for trade ideas.
The Capital Economy
If you woke up today from a decade-long coma and looked at the US-based markets, you’d be inclined to think that things are going really well here.
The equity market has gone straight up and to the right for the last 7 years and it's just 4% off of its all-time high. A cross section of the fixed income markets also looks solid. Investment grade corporate are just 5% off all-time highs, long-dated Treasuries are 8% off their all-time highs and even junk bonds are just a touch over 10% off a recent highs.
All segments of the US fixed income markets have enjoyed prolonged rallies, with few setbacks. The US Dollar has been strong for the last 5 years and is currently sitting at the highest point in almost 13 years. The US capital markets appear to be firing on all cylinders.
The Fundamental Economy
But the fundamentals tell an entirely different story.
Since peaking, post-Crisis, in 2010, US GDP growth rate has been in a range between 3% and 1.5%, unable to gather any sustainable upside momentum; 3% growth has been a fierce level of resistance.
From a consumer perspective, things don’t look much better. The retail sales growth rate peaked in 2011 and has been in a downtrend ever since and is currently hovering at post-Crisis lows. Personal income growth has flat lined and personal spending has followed suit by falling to the low end of its 5 year range and is within spitting distance of being in outright contraction.
While none of this is startling, it shows the dichotomy between the picture that is painted from the capital markets and the one that is unveiled from a look at the fundamentals.
It's very clear that whatever the Fed did to get us out of the Crisis stopped having any impact on the US economy before 2012.
And the only thing that has been positively impacted by the actions of the Fed since then is the US capital markets. While the fundamentals in the US aren’t falling off a cliff, they are certainly not supportive of an array of US-based markets trading just off all-time highs. The Fed has successfully lifted all asset prices but the economy continues to sputter along.
Europe Shows A Different Side
A similar look at the Eurozone reveals a slightly different picture from the US, despite the fact that the ECB has been engaged in the same types of easing for the last seven years and unlike the Fed, continues to be so today.
Eurozone equities are currently 12% off of their post-Crisis highs but unlike the US equity market, they were never able to regain the pre-Crisis highs much less make new all-time highs. As a reference point, Eurozone equities are still 26% off their pre-Crisis highs.
The fixed income markets have behaved similarly to those in the US. Eurozone yields have been crushed in the last 7 years and most of the fixed income markets are trading just under recently attained all-time highs.
The US ended its latest round of easing in December 2013 and while the USD showed strength for the prior 2 years, it has gone parabolic since the end of easing. The ECB on the other hand has managed to trash its currency to the point that as of last week, the Euro is on the verge of giving up its 30-year uptrend line!
Eurozone GDP growth peaked in 2011 and although its gained some traction recently, growth hasn’t even touched 2% in over 5 years.
From a business activity perspective, most indicators peaked 4-5 years ago and have been trending downward. For instance, industrial production and both the manufacturing and service sectors all peaked 5 years ago and have been languishing ever since.
I chose to include a slightly different set of economic indicators for the Eurozone because it’s a different type of economy than that in the US. But similar to the US, if you look across a wide range of Eurozone indicators you see the same type of trend.
ECB policy has had very little impact on the economy since 2011. The ECB has managed to crush yields and burn its currency like a Salem Witch but it hasn’t been able to levitate its equity markets the way the Fed has and the Eurozone economy hasn’t benefited much in the last 5 years.
I’m not a member of the “build a bunker, buy all the ammo and canned food you can, put the rest of your net worth in gold bars and Bitcoin” club.
And I’m certainly not calling for a financial market calamity that will make the 2008 Financial Crisis look like a walk in the park. Although, I’m not ruling that out as a possibility.
But what I am saying is that over the long-term, markets move towards the underlying fundamentals, and the markets of the world’s larger economies are very disconnected from their underlying fundamentals.
While I acknowledge that markets can stay disconnected from fundamentals for long stretches of time, I also know that markets are cyclical and they don’t stay disconnected forever.
How To Play Today
Don't be in a hurry to run out and SHORT the US equity market because it's currently disconnected from the underlying fundamentals. That’s a sure way to go broke.
But a trade that has both fundamental and quantitative congruence is being SHORT the Euro.
I've been SHORT the Euro via the exchange traded fund Guggenheim Currency Shares Euro Trust (NYSE: FXE) since October 14.
The market is again giving you a nice opportunity to initiate a new SHORT if you haven’t already. The Euro has been consolidating right along its 30-year uptrend line and has carved out a clear trading range with $1.083 EUR as overhead resistance. If the EUR-USD were to close above that level, it would nullify a breakdown below that uptrend line. That makes $1.083 EUR a good risk price to initiate a SHORT trade.