Monday, December 28, 2009

Asset Classes and Capital Flow – The Wheels on the Bus Go ‘Round & ‘Round…

That is to say that the wheels of commerce go ‘round & ‘round as long as there is enough “lubrication” to keep the wheels from falling off! Obviously we had some pretty dry wheel bearings last year and during the first quarter of this year, so how are we really looking now? Perhaps everyone is feeling a little bit too comfortable which is usually when the unseen stress makes itself known:

For the purpose of this discussion, there are five primary asset classes:

1. DEBT – all types; personal, corporate, municipal, Treasury notes and bonds.

2. CURRENCIES – The U.S. Dollar interacts with all the other currencies of the world. Almost all dollars are “credit dollars,” meaning that they were brought into existence with interest bearing debt behind it. Most currencies of the world are like this.

3. EQUITY – This is stock in corporations.

4. REAL ESTATE – The earth itself and things attached to it, both developed (residential & commercial), and undeveloped.

5. COMMODITIES – things of the earth, such as gold, silver, oil, grain, aluminum, copper, uranium, etc.

This can be thought of like this, where money flows from one asset class to another in any and all directions:

Or, since money is needed for all transactions, you can place currency at the middle of the hub and this may help you visualize that all assets are first exchanged for money. Money can then move to another major asset class, wherever the holder believes it will be treated best:

But if only it were that easy, the truth is that all asset classes are now interwoven with and surrounded by derivatives of all types that comprise the shadow banking world. This world is fuzzy. It produces leverage and affects our money supply in ways that are not easily measured, much less controlled:

When understanding how capital flows from one asset class to another we must keep in mind some basic rules:

1. All money in our current system is backed by interest bearing debt (actual coins being the only exception). This means that for new money to come into existence, debt must increase.

2. All debt gets repaid WITH INTEREST in ONE WAY OR THE OTHER! This is to say that if one attempts to wiggle out of paying their debts via default or by simply printing more dollars to devalue their currency, then the entire population will pay the debt back, it’ll just be in a different way. For example, when the government prints, the currency is devalued and everybody in society must work more hours to pay for their goods and services. The amount of extra work, no surprise, will approximately equal the debt plus interest.

3. The ultimate purpose of money is to exchange labor. Thus, do not be fooled by financial engineering and how complex our money system has become. Nothing has really changed, the laws of nature still apply – it is the financial engineers and conspirators in government who are being fooled, not you!

4. Too much debt cannot be cured by creating more debt.

5. There are only two ways to get rid of debt. Pay it off per the contract (with interest), or default.

6. Since our money is backed by debt, when debt is defaulted the supply of money goes down.

7. Debt equals leverage.

8. In order to deleverage, you must first convert assets into currency which can then be used to pay back debt. This is the reason the dollar goes up during times of deleveraging – it is in high demand to pay back debt. Once debt is paid back, the supply of money goes down. This is deflation and it’s a spiral that the Central Bankers cannot stand as their own profits go down. To combat this they will do anything to create more money and thus more debt (they designed this system so that they can profit). What they have done is to expand the effective fractional reserve ability. When that was maxed, they resorted to more leverage via derivatives and zero interest rates.

9. Once a person, a business, or a government has pulled forward in time all future income beyond reasonable lending limits, then more debt cannot be forced into that entity without producing a future default. This condition is known as “debt saturation.”

10. Once overall debt saturation nears, as more debt is added, unemployment must rise.

11. Stress in one asset class will cause money to flow into other asset classes, OR it can also flow out of one currency and into another where it then finds an asset class in the new location (international capital flow or flight).

So, keeping in mind all of “Nate’s Rules” above, I began examining the charts with an eye on the way in which capital is flowing from one asset group to another. And naturally, since we’re nearing the end of a year, I began to look back a year, or even longer, to see what I would see…

I find that breaking the charts into each asset group makes this exercise easier to follow; I hope it works the same for you. Might as well begin by looking at the hub of it all, our debt backed money, the dollar!


Artwork by AZ Rainman

Interesting, but when we look back one year at the dollar, we find that the dollar, despite being very disparaged, has now only lost 2.5% in the past year!

Meanwhile, note that the SPX has gained 27% in the past year, despite falling 25% between December and March! Now, that sounds terrific, but let’s note right up front that the S&P 500 is still down 28.4% from its late ’07 peak and has LOST 19.2% in the past DECADE! And that’s WITH substitution bias, meaning that companies that have failed were replaced! Could you have bought the dips and made money? Did you? Uh, huh, that’s what I thought.

But it is interesting that the dollar was down considerably earlier in the year and is now nearly back to even for that period. In general, you would consider a true bull market to be occurring if both the dollar and stocks advance together. However, in this instance, that is not occurring, the only reason the dollar has any relative strength at all is due to the weakness in other currencies which it is measured against. On that I note that gold has risen 25% in the past year, just underperforming the SPX by a whisker. This shows that money is currently flowing into commodities and in the short term into stocks.

The dollar spent a good portion of the year since March forming a descending wedge, the exact opposite of the rising wedge formed in the indices. Just a couple weeks ago the dollar clearly broke up and out of its wedge:

The dollar has been fueling a carry trade with people borrowing inexpensive dollars at low interest here and shipping them overseas where they earned a higher return. But when those dollars go up in value it hurts that carry trade, thus you would expect that equities would suffer as the dollar rose, but so far that has not happened. Will it?

Much of the strength of the recent dollar move has come at the expense of the Euro. Below is a chart showing the EUR/USD cross and how it formed a rising wedge and has now broken back beneath it. Normally you would expect the target on such a wedge to be the base of the wedge:

In this case I can see the Euro falling into the 1.30ish range, and the dollar rising up into the 80 to 82 area. This will not, believe it or not, trip bullish targets on the dollar point and figure chart. The dollar is still in a structural downtrend and the P&F is targeting 63:

While I’m speaking of Point and Figure charts, I want to note that with the recent move above the sideways range that equities have been in that almost all the index charts now have new bullish targets. Again, I think it foolish to argue with these charts, they are very good at spotting broken support and resistance levels, but they are certainly not perfect and often miss major turning points. They can also be whipsawed with throwovers and throwunders.

Keeping in tune with money at the center of our asset wheel, let’s address what is happening to our money supply. Remember that since our money (excluding coins) is backed by debt, as our debt goes, so goes our money. I’ve been showing everyone how total bank credit, consumer credit, and commercial paper are all still very negative, that is being offset by the government which is ramping debt just as fast as they can.

The above chart is the Total Public Debt change from one year ago – nearly $2 trillion that they confess to. That compares to the $600 billion on the previous chart drop in consumer credit and total loans and leases. However, when you add in drops in commercial paper and other modern forms of “money,” you will find that much of that government debt creation is offset.

How? By shrinkage in the shadow banking world of derivatives for one… Again, I point out that although the OCC was talking of rising derivatives in the 2nd quarter, in fact total derivatives were falling as it was the change to allowing investment “banks” like Goldman to become “commercial banks” thereby getting their derivatives counted and giving them access to TARP/ bonus payment funds. When looking at the largest banks like JPMorgan, however, you will see huge shrinkage in their derivative portfolios. This is a decrease of leverage and the multiplication of their credit dollars thus was falling.

Recently released, below is the Treasury’s 3rd quarter OCC report on derivates at commercial banks. Make sure to read the executive summary at the top of the first page. Now that the transition to commercial banks has ended, we can compare apples to apples again in the 2nd and 3rd quarters and here we will find shrinkage in some areas and growth in others:

Here is a snapshot of the quarter 1, 2009 report showing the top 5 banks. Note that Goldman Sachs is NOT on this list and look at JPMorgan’s $90 TRILLION in derivatives, or 64 times the amount of claimed assets:

Next is quarter 2, 2009, when the transition amounts were first reported. Note that although the total derivatives jumped in size, there is a new heavy on the list in Goldman with $40 TRILLION in notional derivatives a whopping 340 times their stated assets. Now note what happened to JPM… they fell from the previous $90 trillion down to “only” $80 trillion – this represents a deleveraging down from 64 times assets to 48 times assets (now remarked to fantasy).

And that brings us to quarter 3, 2009, where we find that JPM gave up another Trillion, GS gained nearly a couple Trillion, and BAC also gained, pushing the grand total of the top 5 up a little. Remember though, that this period was supposedly a GDP growth period and did not see the deleveraging that occurred earlier. That we can see is confirmed here:

So, the shadow banking world was shrinking dramatically and is now apparently growing slightly. What you see in the OCC report, however, does not represent nearly the total amount of derivatives, no, no! It only represents those that are required to be reported to the OCC by commercial banks. Think about all the derivatives that are out there in the hands of retirement funds and municipalities! Huge. I would contend that the world of derivatives acts as a leverage multiplier, ADDING risk into the money system. The money supply charts are basically meaningless unless you take into account the world of derivatives.

Since our money system is backed by debt, then debt is the flip side of our money.


Artwork by AZ Rainman

It used to be, in a time long ago, that debt was a relatively simply thing. No longer! Now there are debts of all types, and the financial engineer whizzes have CONSPIRED with people in the marketing business to get you all lathered up to take on more and more debt! Yeeehaw! Now every nook and cranny of the globe, all our citizens (word to be used to replace “consumer”), our businesses, our corporations, and our government on all levels are saturated with debt.

As all this debt has piled higher and higher, each economic upswing produces more of it and our government is cheering the banks on! Got to keep that credit flowing! Ain’t America great? Then on the downswings government is there to provide stimulus after stimulus, got to keep that credit flowing, let’s lower interest rates! And on each down cycle since 1980 interest rates have gone lower, and lower, and lower, and then ZERO!

See, the government is the only one that, even though they have reached debt saturation, is foolish and crazy enough to keep piling on debt. No one else is that stupid!

And here we are. Short term debt costs zero and so we pile on more and more, got to get that credit flowing, oh thank god the credit’s flowing!

But what happens now? Now that all levels of the economy are saturated with debt and we’re adding more instead of clearing it out, what happens at the bottom of the next cycle? Can interest rates go below zero? No, we resort to monetizing as we have already done – that would be producing money without debt. Actually a smarter game when you realize that if we just printed money at least we wouldn’t owe the central bankers interest on all that we borrow! But the trick, of course, is keeping the QUANTITY of money under control. Something that has never succeeded for long under any system attempted by any country – in the history of man! Not even when the money was backed by gold!

This is what the people calling for imminent hyperinflation see. They see the quantity of money out of control, and for good reason. Our system, because it’s backed by debt would be DEFLATIONARY as interest payments eat away our money… except that the central bankers can’t allow that or their profits fall, so their game is to create never ending growth with larger and larger interests payments and fees, always more fees, that go directly to them. But of course that game ENDS when incomes can no longer support the DEBT. That is where we are now. The only debt that is truly growing is governmental – it will be the last debt to rise, but like all exponential growth, it too will eventually collapse.

Is that beginning now, or is a pullback in government debt about to begin? Could be, it’s the same thing that happened during the Great Depression – stocks fell, they bounced, then corporate debt became more expensive, followed by government debt becoming more expensive.

How is this for a little bit of common sense… if total debt is rising, but the total output of goods and services is falling, then what does that say about the effectiveness of pumping more debt into the system? Well, that’s exactly the situation we now find ourselves. Annual GDP, as trumped up as it is, is still negative, and yet total credit, thanks to government debt, is still growing. This means that debt is no longer effective at producing growth, one of the sure fire signs of total debt saturation.

I’ve shown you this chart before, showing debt contribution to growth. You can clearly see that as we’ve gotten closer to saturation that putting debt into the system gets less and less effective. The trend line was saying that it would be the year 2015 when one dollar of new debt would add ZERO towards GDP.

Well, according to Christopher Rupe, a poster on Ticker Forum who tracks this information by the quarter and charts it, during the third quarter one dollar of debt produced NEGATIVE 15 cents worth of goods and services! We are already PAST ZERO HOUR. Hard to imagine, but adding debt now subtracts from the economy more than it offers - that's debt saturation! He gets his data straight from the Treasury and BEA, plugs it into his spreadsheet and viola, out comes a product that is of utmost importance, one that your government fails to track or report:

Remember, MUST GET CREDIT FLOWING! What happens during the next downturn?

Now let’s turn to the charts to examine the Treasury note and bond markets. The spread between the two year and ten year has NEVER been wider. This is a result of the interest rates on the long end rising, bond prices falling, while on the short end money continues to pour in behind Bernanke’s QE keeping short term rates effectively at zero. This MUST CONTINUE OR ELSE! The reason is simple – the government, banks, hedge funds, and others have been borrowing their money short term – some lending long, a very dangerous situation should interest rates rise. Are interest rates going to rise? YES, of course they are! I told you that last January (Bond Market Hide & Seek – A Domed House & 3 Peaks...) where I pointed out that interest rates have declined ever since they peaked in 1980 and have reached zero. There is only one way they can go from zero:

Here is a chart with the entire history of modern day interest rates on it – 3 months to 30 years:

I would love to put the SPX on that chart, but can’t. What I would like to show is the parabolic rise in stocks during the same time period of this chart. While rates were rising into 1980, stocks were going up. This became rapid after 1971 when Nixon was forced to remove us from the gold standard entirely (the third time the quantity of paper to gold was changed since 1913). So, when rates were rising, stocks (as measured by the index) went up, and then when rates began to fall, stocks were still going up! Proof that rates simply do not dictate the action in stocks. Martin Armstrong contends that money will flow from bonds and to stocks as rates begin to rise again. That is one explanation for why stocks are rising now. Let’s examine that. Below is a chart showing the past 3 years of the US Bond Fund (30 year bonds), and it has an SPX overlay:

What you clearly see is that indeed, over the past 3 years that as bonds rose, stocks fell, and then as bonds fell stocks rose. So, we’re seeing that bonds could continue to fall, does that mean that money will continue to flow from bonds and into stocks? I think NOT, at least not for too long.

The reason is simple. Prior to 1980 debt saturation had not occurred. It has now, as it did during the late 20’s, but is more than twice as bad now as then. What happens when the economy is debt saturated is that higher rates require more and more money to service debt and thus REAL economic growth cannot take place until the debt is cleared! Adding more debt will not help, it will HURT. So, do not be surprised when the flow of money ceases to look as clean as it does on the chart above. Remember too, that BONDS ARE DEBT! These charts are charting government bonds, or government DEBT that’s for sale. As money flows out of bonds, rates rise, and thus our government’s cost to carry debt will also rise. They have been borrowing short, and other rates are tied into these rates.

Below is a 2.5 year chart of the USB fund showing a nasty looking Head & Shoulders. A break below the red neckline would produce much higher mortgage rates:

In that bond market article I wrote in January, I showed that TLT, the 20 year bond fund, had created a parabolic shaped curve and a classic topping formation, and top it did! TLT collapsed, as all parabolic shaped curves do, then fell into a rising channel formation at the base of its prior rise. Just recently TLT broke down from that pattern and appears destined to break a head and shoulders neckline:

Here is a one year version of the chart. The neckline is represented by the double blue lines and if it’s drawn in the correct location (it may be lower) then it has already been broken. The target on a break below the neckline is about 62, WAY down there, and much higher interest rates.

And now I’m not the only one seeing higher rates ahead, here’s what Morgan Stanley’s analyst has to say about the 10 year rate:

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

But what most analysts see is an “improving” economy and the inevitable rising rates that follow. Not this time. This time it is all about debt saturation and the risk associated thereto.

Since Greenlaw is talking about the ten year, let’s examine TNX, the 10 year treasury fund. Below is a logarithmic 40 year chart of the TNX. Again, you will see a peak in the year 1980 followed by a run down in yield to 2%. Note the long term downtrend line now at about 4.7%:

If what I now see is correct, that line will be broken in the months ahead, here’s why… Below is a 5 year weekly chart of the TNX. We just broke from a small inverted Head & Shoulders pattern that had a target of 4.0%. We’re well on our way there and you can see that 4% breaks the next neckline of a much larger Inverted Head & Shoulders pattern:

Should that pattern complete, the target is 5.8%. Now go back up to the 40 year chart and you will see that 5.8% cleanly breaks the long term downtrend line. Here is a 2 year close up of the H&S pattern:

Guess what, the TNX CANNOT effectively go lower than 2%! Why? Because the Effective Federal Funds rate can’t go below zero and then the Discount rate is added on, and so forth… here is the hierarchy of rates in our current system:

In the United States, the Federal Reserve sets basic rates, called the Federal funds rate. This is the starting point for interest rates; they only go up from there. The hierarchy of rates is as follows (sample rates are for example only):

1. Nominal Rate: This is the target rate set by the Federal Reserve Board of Governors, of which Mr. Ben Bernanke is the current Chairman. He also heads the committee that actually sets nominal interest rates, the Federal Open Market Committee (FOMC). The twelve members of the FOMC meet eight times each year to set rates. The FOMC issues bonds and attempts to maintain their target rate, while working with the U.S. Treasury who is responsible for setting policies regarding the exchange value of the dollar.

2. Federal Funds Rate: This is the interest rate that depository institutions lend federal funds at the Federal Reserve to other institutions overnight.
Discount Rate: This is the interest rate that banks are charged to borrow short term funds directly from the central bank.

3. Prime Rate: This is the interest rate charged by lenders to borrowers who they consider most creditworthy. The prime rate is approximately three percent (3%) above the federal funds rate. For example, if the federal funds rate is 5%, then the prime rate would be 8% (a more normal type of rate).

The longer the duration of debt, the more risk filled it is considered and the higher the rate of interest. The shorter the term of debt, the less risky and thus lower interest rates.

Still on the TNX, below is a 3 month daily chart. Note that rates have been climbing up the upper Bollinger band and just produced a hammer today. That’s a potential reversal indicator but needs to be confirmed by tomorrow’s action. Equities are way overbought here (hammer on the RUT), so I will not be surprised to see directions reverse, at least in the short term, but again, it needs to be confirmed and we have ONLY $175 BILLION in debt issuance this week alone:

Now let’s look at very short term rates via the IRX. Rates on this chart are at zero, the only other times they have been this low was during the Great Depression, last year during the height of the financial crisis, and NOW:

Again, you can see the waves… up then down to a lower low. What happens at the bottom of the next cycle? Oh yeah. SPLAT!

Now let’s follow the money as it flows from debt and into Stocks…


Let’s start by looking at a one year logarithmic chart of the DOW. Clearly a rising wedge that was broken on this chart, a flat pattern and a potential breakout last week on extremely thin volume. The divergence between stock price and volume here is HISTORIC in size.

Below is the same chart simply with the log button checked. This is the only index that still has not broken this wedge, but again, this is only on a non logarithmic chart:

Again, the flag break on equities means a run up to about SPX 1,200 is what everyone is expecting. Very risk filled if you ask me.

I didn’t leave the studies on, but there is a clear divergence in the daily and weekly RSI. The weekly MACD is rolling over, a clear sign of tops. Today there were 404 new highs, yet another indicator that a significant top is near.

Next is a one year chart of the Transports. They broke their rising wedge and now prices are climbing along the bottom rising trend line:

The XLF has yet to break the 38.2% retrace and has yet to get near breaking its November high:

The put call ratio hit the territory where turns can happen today. Note that that total put/call ratio has only been lower twice in the past 3 years, once was near the top in ’07:

The VIX broke down below 20 last week and produced a new target of only 14. That would correspond with the bullish targets on the equity P&F charts, but this is a place where I am VERY weary. Watch the VIX to see if it gets back above 20, it moved a little higher today:

Back to the flow of capital, money doesn’t just have to flow from bonds to stocks. It can also flow right on out of the country. In fact, I think a great deal of our capital has been doing so. Money and Markets produced a chart today showing some of the overseas markets and how they are doing compared to the DOW this past year. Again, this is a sign of capital flow:

Now here’s something else that concerns me. When I look at the NYSE and Nasdaq Advance/Decline lines compared to their respective indices, the divergences are EXTREME, but even more troubling is that they diverge against one another, in different directions!

Here’s what I mean… below is the Nasdaq A/D line (in red/black) verses the Nasdaq price (black). Huge divergence that is larger than during the declines of last year! This shows a complete lack of breadth, in other words only a very few tech stocks are responsible for running prices to bubble heights:

The NYSE is the opposite! The A/D line is at the other extreme, now HIGHER than the ’07 high! And very divergent from the rise in price. This coincides with the extreme number of new highs and very few new lows, again numbers seen at extremes, and this is NOT a bottom!

That leaves two asset classes to discuss, but this is getting very lengthy already, so let’s just summarize. Real estate is obviously still correcting. NAR and others are doing their best to pump up the data, but that will fail miserably as the option ARM resets begin to kick in strongly next year. This will hit higher priced homes hardest and you may begin to see some true bottoming on the low end stuff. The banks will continue to struggle with this and with Commercial Real estate. Money is obviously still flowing out from real estate and I believe will do so for some time to come.

Commodities have been on the opposite end, they have been receiving capital flows over the past decade while equities have been losing. Oil is priced very high right now compared to real demand. Gold is expensive but obviously can go higher should our government continue on their credit pushing ways.

I think it is important to see and view all the major asset classes and watch the money flow between them. The most clear short term trend is that as bonds go down, stocks go up. Again, that is a trend that I do not expect will continue, the difference being DEBT saturation and the ability of incomes to support more interest payments with higher rates of interest.

Yes, it’s true… exponential growth leads to parabolic up moves. When they become too steep, prices tend to crash down the back side, the fall being steeper than the ascent. This is found throughout nature, here’s proof, LOL.