The Most Accurate Market Indicator?16 min read

Dear Readers,

For sure a recession is coming, they say.

In fact, just a month ago, more than 30 percent of the world’s business leaders were expecting an economic slowdown this year – a stark contrast to last year’s five percent.

Even Ray Dalio, founder of the world’s largest hedge fund, said in January he was worried that “greater political and social antagonism” could accelerate the arrival of “the next downturn.”

He warned that there isn’t much the government can do to prevent an ugly fallout and that he saw “significant risks” of a recession (a 70% chance) before the US 2020 elections.

Yet the markets soared.

So much so that just last week, Dalio changed his tune – cutting the risk for a recession before the next U.S. Presidential election in half to 35%.

How can so many of the world’s smartest investors and business executives have been so wrong?

Meanwhile, here at the Equedia Letter, we predicted quite the opposite.

Getting it Right: The Most Accurate Stock Market Indicator?

Despite a bear-market territory drop in last year’s fourth quarter – a drop not seen in nearly a decade – I said, via “How to Invest 2019”:

“…I would never suggest being completely in or out, of any market. By taking the cues from 2018 into 2019, I believe there is still ample room to profit.

…Outside of the complexities in March and Q2 (Europe, trade war, government) history is somewhat in our favour when it comes to stock market performance.

Stocks are not only cheaper now than they have been in the last ten years from a P/E ratio perspective, but the S&P 500 has only declined in back-to-back years four times since 1929.

…In other words, what may appear shaky at first could turn into prime trading opportunities if we’re cashed up.”

And boy did the trading opportunities present themselves.

In just 46 days since the lows of Christmas Eve, the overall stock market has soared.

Both the Dow and the S&P 500 have climbed 20%, while the Nasdaq has climbed a whopping 25%.

So how did we get it right again during a time when some of the best in the business were calling for the opposite?

The answer lies in one simple strategy – one that has proven correct for us time and time again over the last decade.

Follow the Leader

To understand this, let’s go back to what I wrote in July 2017:

“First and foremost, you must understand that the dynamics of the global economy are controlled by financial instruments – be it stocks, derivatives, currencies, bonds, debt, etc.

These instruments have their purpose, but their roots inevitably converge back to one simple concept…

The Concept of Money

Money, in the simplest term, is the concept of a medium that can be exchanged for goods and services and a store of value or wealth.

Ultimately, money can be many things depending on the parties involved in the exchange.

For example, money can be gold, silver, or coins, and it can be pieces of paper we call bank notes; that’s because you can almost universally exchange any of these things into something else.

In our modern era, currency has become the primary form of money.

Currency is a system of money that’s in general use in a particular country; its value is based on supply and demand, just like anything else. Generally, this supply and demand is based on the issuing countries’ respective economic (GDP, balance of trade, etc.) and financial strength (assets, interest rates, debt, money supply, etc.).

Ultimately, money is the root of our global economy, while currency is the primary form of money.

Once we take that at face value, then it becomes much easier to understand not just what is going on, but what is about to happen.

Who Controls the Money?

“I care not what puppet is placed upon the throne of England to rule the Empire on which the sun never sets. The man who controls Britain’s money supply controls the British Empire, and I control the British money supply.”

~Nathan Rothschild

Ah, the famous quote from Nathan Rothschild. Whether this quote was actually written or spoken by Nathan Rothschild is irrelevant.

What’s relevant is that the quote is, in fact, very true.

Whoever controls the money supply controls the economy in which that currency resides.

But in our modern era of globalization, whoever controls the money supply of the world’s most widely used currency can actually control the entire global economy.

And which entity controls the money supply of the world’s most used currency?

The World’s Most Powerful Entity

The Federal Reserve, or the Fed, controls the money supply in the United States which is home to the US dollar – the most widely used and accepted form of money in the world.

And as we know, since 2008, the monetary base, or the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks, has more than quadrupled.

Let’s not forget that debt, stocks, bonds, and many other financial instruments can be money as well.

That means the overall true money supply has grown even more.

This is the Fed’s way of inflating the economy by increasing the money supply.

As I mentioned in past letters, the Federal Reserve is responsible for managing monetary policy. This means they manipulate interest rates to obtain a desired inflation target.

In addition to managing monetary policy, the Fed also oversees all the banks in the US and provides financial services to depository institutions such as banks, credit unions, and savings and loans – a bank to the banks, so to speak.

This is important because the Fed’s actions are what dictates what happens to the global economy.

Throughout history, the Fed has inflated and deflated the economy by lowering and raising interest rates, as well as increasing and decreasing the money supply.

History shows us when the Fed lowers interest rates and increases the money supply, the economy booms; when the Fed raises interest rates and decreases the money supply, the economy shrinks.

…leading up to the Great Depression in 1929, the U.S. economy was booming, and stocks were soaring – very much like today (on paper, anyway).

To reign in the exuberance, the Fed decided to raise interest rates and contract the money supply (by their own words, to limit speculation in the securities market).

The Fed’s actions resulted in the worst economic depression in U.S. history.

If you think that 1929 was an anomaly that only occurred because currency was backed by gold, think again…

Finding Balance: Inflate and Deflate

In 1971, United States President Richard Nixon removed the direct international convertibility of the United States dollar to gold.

In other words, the US dollar became a fiat currency backed by nothing more than a promise from the government. Should the government fail, the currency would likely become worthless.

As a result of the Nixon Shock, inflation took off as the value of the US dollar sank.

In March 1972, the Fed began to hike interest rates to combat the falling dollar. They were aggressive in their actions and hiked rates 21 times over the course of the next year in order to tame the runaway inflation taking place.

But their actions had serious consequences.

What followed was the first major recession of the early 1970s.

The Fed continued to hike rates up until 1974 when it finally decided to shift course and reflate the economy by lowering rates later that year.

By lowering rates, the Fed put an end to the stagnation/recession of the early 1970s.

But the Fed simply cannot keep rates low for long…

A couple of years later, the Fed hiked rates again starting in December 1976. This, of course, led to yet another small recession in 1980. To combat this again, the Fed lowered rates.

Over the next few years, the Fed went back and forth hiking and lowering rates until it reached a peak interest rate level of 20 percent.

These rate hikes once again put the US into a major recession – one that became known as the second-worst recession since the Great Depression, second only to the Great Recession of 2008.

Unsurprisingly, to combat the recession that resulted from the rate hikes, the Fed slashed rates by nearly 50 percent from the 20 percent in June 1981 down to 10.8 percent in November 1982.

Because of the dramatic rate hikes of the 70s and early 80s, the Fed slowed their rates hikes in the late 80s, raising rates just over 3 percentage points over the course of 22 months.

Eventually, the rate hikes took effect which led to the Black Monday stock crash of October 1987. And again, prompted the Fed to – you guessed it – lower rates.

Over the next few years, the Fed continued to slowly lower rates to stimulate the economy.

When the economy picked up steam, the Fed hiked rates yet again.

Between 1995 and 2000, the world was taken by storm by a unique economic occurrence – the consumerization of the Internet, which paved the way for the dotcom bubble.

When the bubble burst in 2001, it wiped out trillions of dollars. As a result, the Fed was once again forced to ease and lower interest rates over the following years.

This led to the market exuberance which caused the housing bubble of 2008.

As you can see, it’s a rather simple cycle.

The Fed inflates and deflates, and inflates and deflates…”

In other words, if you want to predict the near-term outcome of the market, just follow the Fed.

And that’s precisely what we have been doing.

Predicting Market flows

In October 2018, I suggested some short-term pain was coming as a result of the Fed’s actions.

Via The Ultimate Debt Transfer:

“Where we are in the market cycle can be summed up in a Letter I wrote three years ago, titled, “The Ultimate Bailout Plan: The Fed’s True Plan:

“Eventually, the Fed will have to begin winding down its assets, which means there will be a lot of bonds to soak up.

Foreign liquidity won’t be able to soak up all that has been printed. That means money will have to come from somewhere else. And that somewhere – I believe – is from the stock market.

If the stock market continues to climb, it will create more liquidity for bonds.

Why? Because the stock market will eventually correct at some point, and when it does, investors will seek the safety of bonds; thus, soaking up much of the bonds held by the Fed.

The higher the stock market climbs, the more money is available for bonds on the way down.

This is the Fed’s true plan.”

A year ago, the Fed began unwinding its US$4 trillion of Treasury bonds and mortgage-backed securities, liquidating tens of billions of dollars each month.

In fact, what began at just $10 billion per month in Q4 2017, soon became $20 billion per month…then $30 billion…then $40 billion…and is now on track to hit $50 billion per month.

Take a look:

Now recall what I wrote in July:

“With a Federal budget expected to exceed US$1 trillion starting in 2019, the US will have to sell more Treasury securities. A lot more.

And it will have to do it during a time when the Fed is also unwinding the US bonds it has on its balance sheet.”

And how has that played out?

Via CNBC:

“…All that debt piling up in the government’s coffers is going to require the Treasury Department to get more creative in figuring out how to finance it.

As a result, the department said Wednesday (Aug 1, 2018) it needs to sell an additional $30 billion worth of bonds in the second quarter and is adding a two-month note to the offering of debt securities. That compares to a $27 billion increase for the first quarter.

In its quarterly refunding statement, the Treasury said it will be adding another $1 billion a month to each of the auctions for two-, three- and five-year notes over the next three months.

On top of that, it will increase the auction size for the seven- and 10-year notes and the 30-year bond by $1 billion for the August sales.”

In other words, while the Fed unloads its balance sheet to the tune of $50 billion a month, the US is steadily increasing its issuance of new bonds to accommodate its growing deficit.

And what happens when so many bonds hit the market at once?

Raise Those Rates

When so many bonds hit the market, the inevitable outcome is a rise in overall interest rates.

Via my Letter from March 2018, The Ides of March:

“With the abundance of US bond supply expected to hit the market, better bond terms will likely be required in order to compete for capital – especially since yields are still near all-time lows.

That means yields will eventually have to go up.

In Layman, interest rates will have to rise.”

Here’s a look at the Fed Funds Rate since the Fed began unwinding:

And what happens as interest rates rise?

Via my Letter from April 2018, How Tariffs Really Affect the Market:

“…if interest rates rise, capital will shift from the equity markets over to the bond market.”

And that’s precisely what is happening.

Via CNBC:

“…Investors poured just over $19 billion into bond funds for August, compared with a net withdrawal of $1.4 billion for U.S. stock-focused funds, according to data this week (September 2018) from Morningstar.

…Over the past year, flows in mutual funds and exchange-traded funds combined have told a disparate story – $293.2 billion has gone into bonds, while just $4.5 billion has found its way into U.S. equities.”

In other words, the Fed’s transfer of debt to the people is working.

In fact, US Households are now the biggest buyers of Treasuries – by a long shot.

Via Business Insider:

“Treasury demand from US households dwarfed that of the next-highest category, RoW (rest of world).

‘Households remained the largest buyer of Treasuries for the second quarter in a row, and they have purchased 46% of the net Treasury supply so far this year,’ MS said.”

Which is why I suggested in July:

“It wouldn’t be a bad idea to start looking at ETFs that take advantage of a rise in bond yields.

Since bond prices drop as yield rises, ETFs that “short” bond prices will benefit if that scenario plays out.

Some of them include the Proshares Short 20 Plus Year Treasury (TBF) which uses no leverage, the Proshares UltraShort Lehman 20 Plus Year Treasury (TBT) which uses double leverage, and the Direxion Daily 20 Plus Year Bear 3 Shares (TMV) which uses triple leverage.”

Here’s how the TBF has performed:

And if you took the additional risk through the triple-leverage TMV, you’d be up over 22% in less than three months, and up to nearly 28% if you cashed out at the top of the chart:

I suspect that we’ll continue to see further US equities outflows and more bond inflows to support the exodus of bonds from the Fed’s balance sheet.

In other words, the world’s richest and most powerful entity, the Federal Reserve, is now in deleveraging mode – that is where we are in the market cycle.

The question for the market now is how far and how fast the Fed will go in both unloading its balance sheet while raising rates to accommodate that unwind.”

Following that Letter, the market experienced a sharp correction – just as we expected.

In the following quarter, stocks fell a whopping 20% – entering bear market territory.

It was then the Fed decided to once again intervene by telling the market that it won’t raise rates much further; stating it is not on a preset hiking path and could adjust its plans as needed.

It was also then that we predicted a December rate hike, but that support was likely coming and that a rally would ensue because the Fed needed it to:

Via The Countdown Has Begun:

“…the Fed needs more time to unwind the massive balance sheet it accumulated since 2008.

The Fed needs this rally to go on a little longer.

…if the stock market falls too quickly, there simply won’t be enough money to buy the bonds the Fed needs to unwind.

So it’s no wonder Fed Chairman Jerome Powell told us last week (November) that he not only sees the Fed’s benchmark interest rate to be near a neutral level but also that the Fed’s policymaking arm is not on a preset hiking path and could adjust its plans as needed.

And while that means we will likely still see some minor rate hikes in the near future, it also tells us that the Fed Chair’s carefully crafted words mean the Fed needs more time.

I suspect we could still see a rate hike in December – especially if the market rallies next week on the trade war ceasefire. This may slow momentum in the market, but bring support nonetheless.”

Following that Letter, the Fed did raise rates one more time in December – as we predicted – which led to the market low on Christmas Eve.

A week later, I wrote there is still ample room to profit as a result of the Fed’s guidance.

And the market soared.

No Going Back

There’s no doubt the U.S. economy is beginning to slow. Retail is slipping, and consumer confidence has dropped.

So it should come as no surprise that the Fed – with pressures from politicians – is once again here to intervene.

In the Minutes of the January Federal Open Market Committee (FOMC) meeting, the Fed said it will end its balance sheet reduction program – Quantitative Tightening (QT) – much earlier than had been previously expected.

In fact, perhaps as soon as this year – nearly a full year ahead of its original schedule and expectations.

Then, last week, in the Fed’s semi-annual testimony to Congress, Fed Chair Jerome Powell not only once again highlighted the fact that the Fed is nearing the end of its balance sheet reduction process, but said that the Fed “can’t go back to that very small balance sheet,” because shrinking would drain the reserves demanded by banks.

Not only did he say that the Fed expects to end QT “later this year,” he even said that many key details had already been worked out:

“My guess is we’ll be announcing something fairly soon.” – Jerome Powell, Fed Chair

It’s no wonder Goldman Sachs believes the Fed will end QT by the end of the third quarter.

It’s even possible the Fed could even announce a set-date for the end of QT by the next FOMC Meeting scheduled for March 19-20.

Perspective into Action

If the Fed ends QT and doesn’t raise rates, we could see continued growth in both Treasury purchases and stocks.

Recall earlier that when the Fed unleashes the supply of its balance sheet, the demand for treasuries decreases, which in turn leads to a rise in rates to make those bonds more attractive.

But now that the Fed is expected to stop unwinding its balance sheet, the demand for Treasuries should eventually go up – which leads to stabilizing interest rates as higher bond yields are no longer required to drive demand.

I suspect that bond yields will drop slightly from here.

That means the shift from stocks to bonds could slow, as investors look to riskier assets to beat inflation – bringing support to the stock market.

Furthermore, if the Fed is no longer decreasing the money supply by selling bonds, overall liquidity improves which could lead Emerging Market central banks to resume adding to their foreign reserves – most notably US dollars, which would then be used to accumulate sovereign bonds – such as US Treasuries.

All during a time when the US needs it most. Brilliant.

But that’s not all.

Demand for Treasuries to Grow?

In January, we were bombarded with headlines like this:

“Weakest Treasuries Demand Since 2008 Sends Bond-Market Warning”

Via Bloomberg:

“As the U.S. government kicks off its debt sales this year, here’s one potentially worrisome sign for traders to keep in mind: the steep decline in demand at its bond auctions.”

However, based on what I just wrote, I suspect we’ll see stronger investor demand for US treasuries as soon as tomorrow, if not already.

Furthermore, we know that the Fed wants a balance sheet primarily comprised of Treasuries, and not mortgage-backed securities (MBS).

In the January FOMC Minutes, the Fed indicated that participants agreed that “it would be appropriate once asset redemptions end to reinvest most, if not all, principal payments received from agency MBS in Treasury securities.”

That means the Fed will likely use the money from its MBS redemptions (at an appropriate time) and reinvest it in Treasuries.

This scenario would be extremely bullish for Treasuries.

The Congressional Budget Office (CBO) projects that, assuming no changes in current law, the federal debt will exceed 90 percent of GDP by 2027.

In other words, the supply of Treasuries is expected to keep increasing.

If the demand for Treasuries slows while the supply continues to grow, bond prices will go down, and bond yields will go up.

But now that the Fed is likely to intervene, we should expect the opposite.

Conclusion

No matter the variables, it is truly incredible just how much direct influence the Fed has on the stock market, and thus the economy.

Those who are close to the Fed, or those who follow the Fed closely, are often one step ahead of the market.

For example, while most hedge funds were facing a surge of redemptions late last year, and thus selling stocks, the world’s biggest wealth fund was aggressively and quietly buying them.

Via Bloomberg:

“Norway’s $1 trillion sovereign wealth fund bought a net $22 billion in equities at the end of 2018 and continued to make “significant” purchases at the start of this year to take advantage of a market rout as it builds its global holdings.”

I suspect the managers of Norway’s sovereign wealth fund knew what the Fed was going to do.

But that’s not all.

Even the world’s largest hedge fund was doing the same.

While Ray Dalio was telling the world that he saw “significant risks,” his Bridgewater fund didn’t seem to think so.

In December, Bridgewater more than doubled its holdings of iShares Core S&P 500 ETF, an ETF that tracks the S&P 500, and increased its exposure to financials.

Why would any fund double their holdings if they saw significant risks?

In other words, don’t believe what everyone tells you – instead, follow the Fed.

Seek the truth,

Ivan Lo

The Equedia Letter

Equedia.com and Equedia Network Corporation are not registered as investment advisers, broker-dealers or other securities professionals with any financial or securities regulatory authority. Remember, past performance is not indicative of future performance. This article also contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from the forward-looking statements made in this article. Just because many of the companies in our previous Equedia Reports have done well, doesn’t mean they all will.

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