Markets Are Blissful as Trouble Mounts

by Anthony Mirhaydari | June 27, 2014 8:13 am

It seems the stock markets have hit the snooze button, because all the action seems to have gone to sleep. Stocks have pretty much gone nowhere this month after melting higher in late May, with the Dow Jones Industrial Average making not one but two attempts to breach the 17,000 level.

But all the price action has been relegated to a range between 16,980 and 16,700. In fact, the action has been so quiet that we recent saw one of the tightest two-day non-holiday trading ranges in market history. The last time this happened was back in 2004, and before that, you’d have to go all the way back to 1961 a get a similar period of market quiet.

Will it continue?

Historically, after a compression of volatility like this, the markets have tended to drift along for another week or two before suffering a correction that swiftly washes away the incremental gains. Stairs up. Elevator down.

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Certainly, there are many negative catalysts investors are dismissing right now.

• The sectarian violence is only getting worse in Iraq, with Sunni militants in the north encouraging Shias in Baghdad to lash out against local Sunni populations. A tripartite fracturing of that country seems increasingly likely now, putting oil export infrastructure at risk of terrorist attack.
• The situation in Eastern Ukraine continues to simmer as well, with reports of clashes between Kiev’s forces and pro-Russian separatists ongoing despite an apparent move toward a ceasefire agreement.
• Crude oil remains concerned, holding near $107 and $106 a barrel.
• Expectations of a big bounce back in economic growth and a solid Q2 earnings season are also fading somewhere.

Thursday’s report on consumer expenditures suggested that rising inflationary pressures and diminished savings are forcing households to retrench, resulting in the second consecutive monthly drop in real spending. Wall Street analysts were forced to known back their second-quarter GDP estimates in the wake of an abysmal 2.9% annualized drop in the economy in the first quarter — the 17th worst result in U.S. history.

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The market is already discounting ongoing trouble for retail sales with the Retail SPDR (XRT[3]) hitting resistance going back to the initial disappointment with Black Friday traffic in November. I’m also seeing sellers hit payment processors MasterCard (MA[4]) and Visa (V[5]). I’ve recommended put contracts in both names to my Edge Pro clients, which are carrying gains of nearly 50% and 30%, respectively, so far.

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As for earnings, corporate profitability is coming under pressure from a sizable drop in labor productivity. As a result, after-tax corporate profitability took a huge downturn last quarter, dropping on a scale that hasn’t been seen since the recession ended. Those elevated Q2 EPS estimates are going to have to come down.

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This is especially true given that bond-to-stocks wealth transfer is slowing down as companies like IBM (IBM[8]) can no longer simply borrow tons of cash in the bond market which to fund share repurchase programs and boost earnings per share by reducing the number of shares outstanding. That’s because this has gone on so long that debt levels are building up in a big way on corporate balance sheets. You can see this in the chart of corporate debt-to-GDP in the chart above.

All this will come back to bite when diminished profits make this new debt load harder and harder to carry. In other words, shifts in profitability and revenue are going to have a much larger impact on the bottom line now.

Finally, the true wildcard in all this is the course of monetary policy from the Federal Reserve going forward. The big takeaway from the last Fed meeting was that policymakers are trying their hardest to ignore bubbling inflationary pressures that would force them to raise short-term interest rates and start draining money from the financial system for the first time in 10 years.

But the longer they wait, the more inflationary pressures will build. A simple Taylor Rule analysis[9] — which is a yardstick to measure where interest rates should be based on inflation and the excess capacity in the economy — suggests interest rates should be near 2% instead of the 0% they’ve been at since 2008. The longer the Fed is behind the curve on this, the faster prices will rise.

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And while stocks are ignoring all this, the bond market has been sending a warning signal over the past few days with U.S. Treasury bonds — a safe-haven asset — blasting out of their June doldrums as yields decline. The fear is that we see “stagflation” — a combination of higher prices and a stagnant economy as consumers struggle.

With all this to consider, it’s no wonder options traders are looking for put option protection against a market decline. The CBOE Volatility Index — known as Wall Street’s “fear gauge,” or the VIX — tested its 50-day moving average for the first time since early May on Thursday.

So while stocks seem blissful on the surface, a look at the surroundings and the action deep within the market suggests trouble is building.

For now, I recommend a defensive approach with a focus on precious metals for inflation protection. Examples include mining stocks New Gold (NGD[11]) and NovaGold (NG[12]), which are up 16.4% and 19.7%, respectively, since they were added to the Edge Sample Portfolio[13] on June 5.

Learn more in the video below.

https://www.youtube.com/watch?v=jmV_FrBBr8A&feature=youtu.be

Anthony Mirhaydari is founder of the Edge[14] and Edge Pro[15] investment advisory newsletters, as well as Mirhaydari Capital Management[16], a registered investment advisory firm. As of this writing, Anthony had recommended put options against MA and V and common-stock longs in NGD and NG to his clients.

Source URL: https://investorplace.com/2014/06/markets-inflation-earnings/

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