Dear Bottarelli Research Reader,
I saw an interesting “throw-down” on Larry Kudlow’s cable show the other day, between Bentley University economist Scott Sumner and Euro Pacific Capital CEO Peter Schiff.
Normally, I don’t tolerate this sort of junk. I’ve actually been on CNBC, and I’ve found it to be a massive waste of everyone’s time. The advertisers are the only real winners. It’s all so irritating, I actually declined the last time they called (much to my publisher’s annoyance).
But when I saw the line-up on Kudlow’s show, I thought it might be worth tuning in for the debate. After all, Sumner is supposed to represent some kind of “new Keynesian economic school,” while Schiff is a famous champion of gold.
Kudlow asked both guests why there was no hyperinflation while the Fed keeps dumping trillions into the economy.
Sumner gave a kind of muddled explanation as to how this can happen when rates are super low, because the banks and Wall Street just trade the money back and forth so it never really enters the larger economy. He seemed to think this was a good thing – and pointed to rising home and stock prices as benefits of same.
Schiff answered that the Fed’s money creation was the text book definition of currency inflation. Rising prices are actually just a result. What’s more, Schiff warned, prices are rising, whether Washington confesses to it or not. “That’s why stocks and housing are up – it’s just the dollar shrinking!”
In the end, Larry Kudlow shut down Schiff and basically said he’d take the gains regardless of cost, so long as Washington didn’t tax him too hard.
As for us, we’ve long maintained that the economy and the asset market run on the following cycle…
- At the bottom, prices are cheap and jobs are scarce so Washington invents new money.
- This money accelerates the economy, and asset prices begin to rise.
- Eventually, there is too much cash chasing too few assets and prices exceed potential earnings and useful value – a “bubble.”
- At the top, Washington tries to withdraw excess cash via higher Fed and tax rates, and the asset bubble pops.
The question is not whether or not this happens, but whether or not we’re approaching the top where Washington taps off capital via taxes and rate increases.
To get a sense on this answer, let’s address the current situation…
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The Current Situation
What makes this whole discussion interesting is the fact that the Fed Open Market Committee is meeting again, and they’re trying to decide if it’s time to start hauling back on all that loose capital.
Both May and June’s FOMC meetings lead directly to broad market collapses, when Fed Chairman Ben Bernanke confessed that the committee must at least consider such a move (but had not set firm parameters for it yet).
We still don’t have a clear set of Dow Jones Industrials (DJIA) signals going into the meeting. The lower oscillators are still reading “Hold/Buy.” But as I write, price is already rolling over at last May’s highs in anticipation or more hints of “Fed Tapering.”
The American Enterprise Institute’s Kevin Hassett summed up Wall Street’s fears this way…
The economy is solid and “zombie inflation” is lurking outside, but hasn’t started knocking on the door yet. Friday’s jobs number could easily be above 200,000. Then I think the Fed is going to get very, very antsy. At that point, we’re going to have “Night of the Living Fed,” where they start tapering and everybody freaks out. I think that may well be September when it starts.
We see no reason for the market wait until September to respond as it did in May and June – with a drop back to Dow 15,000.
However, this time around, a strong drop will create a new long-term sign – a double top that could spell the end of the aging bull market.
We won’t know this for sure until price tests at the 38.2% retracement at 14,388. A bounce off this level would still count as extremely bullish.
The Telling Detail
But Peter Schiff pointed to two inflation-driven bubbles: stock prices and real estate prices.
We just learned this week that housing prices rose some 12.2% to a six-year high in May.
What’s more, April was revised upward to +1.73% month-over-month and +12.09% year-over-year (illustrated below).
But before you go popping the champagne corks, you might want to read this warning from Zillow senior economist Svenja Gudell…
Three straight months of national home value appreciation above 10 percent is not normal, not sustainable and, frankly, not very believable. As the overall housing market continues to improve, the impact of foreclosure re-sales on the Case-Shiller continues to be pronounced, as homes previously sold under duress trade again under more normal circumstances, leading to inflated and misleading markups in price… It’s increasingly critical that the average American homeowner not read numbers like today’s Case-Shiller results and assume their homes must also have appreciated at these levels over the past year, or will continue to appreciate at these levels going forward. In reality, typical home values have appreciated at roughly half this pace for the past several months, which is still very robust. Looking ahead, a combination of rising mortgage interest rates, flagging investor demand and more inventory entering the market will all help to moderate the pace of home value appreciation and stabilize the market.
And in fact, the pace of sales is already falling off sharply as rising mortgage prices tack on even more cost onto the real price of a newly purchased home.
According to the National Association of Realtors, pending home sales in the U.S. decreased 0.4% to 110.0 in June, after reaching a six-year-high in May.
NAR chief economist Lawrence Yun noted…
Mortgage interest rates began to rise in May, taking some of the momentum out of contract activity in June. The persistent lack of inventory also is contributing to lower contract signings.
How to Play It
We’ve already heard several homebuilders offer up their quarterly reports, and the follow-on action has been ugly across the board – even when profits were fair.
In fact, when we look to the chart for the S&P Homebuilders SPDR (XHB – NYSE), we see a menacing Head & Shoulders pattern building up, with an initial Left Shoulder in March, a higher Head topping out in May, and a lower Right Shoulder ending the string of higher highs in early July (illustrated below).
With a Head & Shoulders, the trick is to measure the gap between the Head and the Neckline, and then subtract that figure from the Neckline again. This formula generates a target for the XHB of $23.22, solidly between the 38.2% retracement marker at $24.77 and the 50% marker at $22.33. One way or another, we’re looking at a housing stock loss ranging between -15% and -24%.
Of course, we’re closely watching the trigger point for this formation, which would be a breakdown through the Neckline. In fact, we plan to begin offering subscribers their first speculative trades against this ominous formation in Saturday’s issue of Bottarelli Research LEAPS.
As always, the charts tell all.
Sincerely,
Adam Lass
Bottarelli Research Newsletter
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