The Market Beat Goes On, What to Expect, and Impact of China Yuan IMF Reserve Status

by Victor Sperandeo with the Curmudgeon

Disclaimer:

As usual, all opinions expressed herein are those of Victor Sperandeo. The Curmudgeon is more shell shocked than ever from the widening disconnect between stock prices and the real economy, which we've called attention to over the years.

Market Recap:

The equity markets have been up four weeks in a row with no real change in economic fundamentals. The NDX (NASDAQ Composite) and QQQ (NASDAQ 100) are on the verge of making new all- time highs. On Friday, Microsoft vaulted to a 15-year high, while Amazon and Google’s parent company Alphabet also closed sharply higher. Global central bank liquidity moves also helped the rally.

Investors welcomed an interest rate cut by China’s central bank - the sixth interest-rate cut in the past year. Rates on China savings deposits were deregulated to permit savers to earn more interest income. A day earlier, Mario Draghi, the head of the European Central Bank hinted that the bank might extend its $1.2 trillion bond purchase program or take other measures to stimulate the Euro-zone’s economy.

What to watch in the Weeks Ahead:

On October 27^th and 28^th the Federal Reserve Open Market Committee (FOMC) meets again, but no press conference will follow their meeting. The predictions from Fed members are mixed as to whether the FOMC will raise short term interest rates. My belief is they won't, because the economy is weak worldwide, and in the U.S. as well. Even if they do a 25bps (¼ of 1%) rate increase is worthless except psychologically. Therefore, if the Fed raises rates it really means nothing for the real economy. More likely, the Fed will stand pat and say "we will go very slowly” or “we'll re-evaluate potential rate increases in light of future economic data."
On October 29th we'll get the first estimate of 3rd quarter GDP with consensus estimates of +1.9%. Curmudgeon Notes:

1. Marketwatch expects +2.1% vs the previous estimate of 3.9%.

2. The October 26th Barron's page 17 states: "The initial report on 3rd Quarter GDP iis likely to show a sharp slowdown in growth from the second quarter." Consensus estimate is +1.7% vs prior estimate of +3.9%.

The U.S. federal debt limit/ ceiling will be up for debate in early November. With (Neo-Conservative) Paul Ryan most likely to be the new Speaker of the House of Representatives, it will be extended. Nothing new here.
Also in early November, we will see if the IMF gives China’s Yuan/Renminbi reserve status (AKA Special Drawing Rights or SDRs). The additional critical points to this status are "when" will it become "effective” and the "quantity" it will be given (e.g.10% or 13%)? The higher the better for China. That would means banks can buy China stocks and use them as reserves. More details in the corresponding section below.

Central Banks Are the Biggest Players in Global Financial Markets (Curmudgeon):

According to a June 2015 paper by Michael Hartnett, Chief Market Strategist at BofA- Merrill Lynch Global Research:

Central banks now own over $22 trillion of financial assets, a figure that exceeds the annual GDP of US & Japan
Central banks have cut interest rates 577 times since Lehman, a rate cut once every three 3 trading days
Central bank financial repression created $6 trillion of negatively-yielding global government bonds earlier this year
45% of all government bonds in the world currently yield <1% (that’s $17.4 trillion of bond issues outstanding)
US corporate high grade bond issuance as a % of GDP has doubled to almost 30% since the introduction of ZIRP
US small cap 5-year rolling returns hit 30-year highs (28%) in recent quarters
The US equity bull market is now in the 3rd longest ever
83% of global equity markets are currently supported by zero rate policies

In an October 23^rd interview with Consuelo Mack, Mr. Hartnett explains what key transformational trends he sees mean for the global economy and investors. Hartnett said that 55% of all the world's government bonds are yielding 1.0% or less! He thinks that remarkably low interest rates- now at 5,000 year lows, will persist for several more years.

Implications for Bearish Stock Traders:

Central bank dominance of the markets is why playing the short side should only be a "trade" (not an investment) when continuing downside momentum occurs. That's because rallies can go against your shorts in a big way. The August 19^th - 24^th sell-off went straight down on consecutive days, culminated by a 1000 point down DJI opening on August 24th.

In retrospect, that was a classic selling climax buy signal for short term traders. After the disappointing September jobs report on October 2^nd, the market opened down 1.5% but reversed to close up by ~ 1%. If you're brave enough to be a short seller, look for a similar down open and sharp reversal to cover your shorts in the future.

U.S. $ Rallies on Surprise Earnings Beating Estimates (Victor):

The dollar index ($DXC) rallied +2.44% on Oct 22^nd and 23th. In seven trading days, it moved from below 94 to 97.05 as of Friday's close.

The recent up move in the US $ was largely due to several surprise corporate earnings reports which handily beat estimates. The assumption now is that interest rates might be increased because of stronger than expected corporate earnings.

For example, Amazon earned +17 cents per share, while the consensus forecast was -0.1 cent per share - AMZN stock closed at $561.61 on Thursday and rose to $599.03 on Friday. Other stocks like Microsoft and McDonalds also reported earnings which strongly beat lower estimates and the shorts got beaten like dogs. This is yet another reason why short "investing" is a very difficult business.

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Curmudgeon Note: Companies have been “managing earnings” for years with intentionally lower forward guidance which their reported quarterly earnings almost always beat. That trend is getting a whole lot stronger in this weak global economy.

On October 23^rd, Factset said that “of the 173 companies that have reported earnings to date for Q3 2015, 77% have reported earnings above the mean estimate. The percentage of companies reporting EPS above the mean EPS estimate is well above both the 1-year (74%) average and the 5-year (72%) average...For Q3 2015, the blended earnings decline is -3.8%. If the index reports a decline in earnings for Q3, it will mark the first back-to-back quarters of earnings declines since 2009.”

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The $DXC's future will likely be determined by the trend of U.S. interest rates. One increase (whenever it comes) is not a trend. After the Fed raises rates (if they ever do, while Obama is in office) the $DXC will decline as that news will have been discounted while the U.S. economy remains weak.

Central Planning Benefiting Financial Assets – Not the Economy!

Political Power is making the markets stay up, without any concern for "we the people," who would benefit from a stronger economy. Virtually all the controlling interests of government are on the side of the wealthy who own stocks. No one seems to care about senior citizens living off their dwindling savings, savers in general, or the middle class (which is becoming an endangered species).

The poor suffer, but get subsides without work, so they couldn't care less about ZIRP or rounds of QE. The main beneficiaries of the current policies (ZIRP/easy money and no fiscal policy to encourage economic growth) are wealthy individuals and corporations whose stock rises in value. This is central planning at its worst. Without political change nothing will stop this policy. The bottom line: expect more of the same unless the leaders in Washington DC get thrown out of office and are replaced by non-establishment types, like a Ben Carson or Donald Trump, who would shake up the system.

Impact of IMF Reserve Status for the Yuan/Renminbi:

It's quite likely that China's leader Xi Jinping made a secret deal with President Obama when he visited Washington in late September. That deal was for the U.S. to support China's IMF request for reserve currency status in exchange for stopping the Chinese government hack attacks on U.S. government and companies.

The result of Yuan reserve status will be at least $1 trillion to flow into China stocks, according to an article by Bloomberg's Andrew Mayeda.

“Once the Chinese yuan becomes part of the SDR, central-bank reserve managers and institutional investors will automatically want to accumulate yuan-denominated assets,” Hua Jingdong, vice president and treasurer at IFC, said in an interview in Lima earlier this month during the IMF and World Bank annual meetings. “It will be strategically important for China to welcome all kinds of issuers to become regular issuers in China’s onshore market.”

My view is that Yuan Reserve currency status will help global economies only marginally, via the" wealth effect," but it will be great for equity markets. As such, global equities will continue to rise, in part because this is not fully discounted and not all of the news is known.

Outlook for Commodities and Bonds:

China buys (in general) 50% of the world commodities. So commodities will continue to rally from the DJ UBS Commodity Index low on August 24^th at 479.06 (Friday's close was 496.99 +3.74%). Gold and silver should also rally from their long bottoming process.

The bond market now trades opposite equities (that was NOT always the case), so I think bonds will remain in a trading range, and is currently at the top of the range so is headed south.

Conclusions:

I remain long term bearish on the market and the economy, but refuse to play the hara-kiri short game, and watch the government manipulate the economy and stocks higher with their “talk the talk.” They don't want to allow a decline because a recession is death to their jobs (especially the Fed Chairperson) and to the people in power. Thereby, when you have a printing press, unlimited borrowing power, and use it without concern for the future, it's a no win hand to short against. Unless one or more events occur which the Fed can't control!

It may be wise to consider the wisdom of Albert Einstein – the creator of the Theory of Relativity:

"We cannot solve our problems with the same thinking we used when we created them.”

OBVIOUSLY, Fed Chairwoman Janet Yellen has never thought about that!

Good luck and till next time…

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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