"Ding, Ding"...Last Lap -- Natural Law, China and The Dollar by Paul Mylchreest

Equity & Cross Asset Strategy

24th May 2017

Paul Mylchreest

Tel: +44 20 7716 8257

Email: paul.mylchreest@admi [email protected] si.com

Equies: “Ding Ding”...Last Lap Natural Law, Law, China and the Dollar

We suspect that every strategist and acve fund manager has bet against this mega equity bull market at some point during the last eight years. Buy and hold/buy the dip have triumphed. In contrast, direconal changes in many so -called “fundamentals”, e.g. credit spreads, inaon/ deaon, Fed policy and earnings, have oen had limited predicve power. We could have delved even deeper into fundamental analysis, but quesoned whether that would add much value for acve porolio managers. Many are quesoning qu esoning the value of sellside research, and oen their own convicons, in very tough industry condions. There’s a case for the buyside and sellside to t o nd dierent analycal approaches at this point. With that mindset, we analysed repeang paerns of peak -to-peak and trough -to-trough cycles in the Dow Jones index. The interference of many individual cycles creates a complex waveform in aggregate. The analysis (for what it’s worth) suggested two things. Firstly, US equity prices have surprisingly behaved almost perfectly in terms of the trend since 2009, although we suspect that central bank policies signicantly exaggerated price movements to the upside. Secondly, the next cyclical peak for US equies could occur in i n the nal week of November 2017 (+/ - one month). 1 ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise the inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.

Equity & Cross Asset Strategy Paul Mylchreest

Email: [email protected] [email protected]

Tel: +44 20 7716 8257

So what, you might say, and we’d sympathise, s ympathise, as there’s nothing to be gained from guessing the end of bull markets. Nobody, including the strategist, would give them much more than a minimal chance of accuracy. What we found interesng, however, was corroborave evidence from two sources (with strong track records in cyclical ming) that Autumn/Winter 2017 should be a pivotal for global nancial markets. And we mean that in the challenging sense… The rst source is the Economic Condence Model (ECM), developed by Marn Armstrong, which correctly predicted, amongst other events, the emergence of the sub -prime crisis in early 2007, the LTCM/Russian debt crisis in 1998, the bursng of Japan’s credit bubble in in 1989 and the Great Crash of 1929. The most recent major peak in the ECM was 1 October 2015 and we speculate that China might be central to the underlying downtrend in this ECM cycle. The PBoC shocked sho cked nancial markets when it devalued the RMB several weeks earlier in i n August 2015. A key “node” in the ECM is 24 November 2017, which marks an intermediate peak in the ECM down cycle. Going back in me from this date at 30.1 year intervals gives us. 

October 1987 - we all know what happened that month. The ECM was in an up cycle and we saw global capital move out of equity markets into Japan, leading to the last lap l ap in Japan’s speculave equity and real estate bubble.



September 1957 – the ECM was in a down cycle. This date coincided closely with a Fed policy mistake when it raised rates to cool inaon in a slowing economy. Spreading out from the US, it led to the rst signicant global downturn aer World Worl d War II.



July 1927 – the ECM was w as in an up cycle. This date coincided with the secret central bankers’ meeng in New York, aer which the Fed cut rates and sparked the acceleraon of the speculave bubble which culminated in 1929.

So…the lesson from the ECM is that th at on, or around, 24 November 2017, we should see a signicant move in markets, or a policy change, which will be part of an even bigger nancial adjustment. With the ECM in a down cycle, the risk is obviously skewed in that direcon. The second source is the work of legendary Wall Street trader, W.D. Gann. There is lile doubt that Gann developed a phenomenally successful system based on cycles in nancial markets. Gann’s work has a cult following amongst scores of traders, many determined d etermined to decipher “The Tunnel Thru The Air”, the book in which he h e crypcally laid out his system.

2 ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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Gann publicly highlighted several of long -term cycles he used including 60 years, 30 years, 20 years and 10 years. Briey, if we take 2017 and go back 60 years, we get 1957. If we go back 30 years, we get 1987, another 30 years we w e get 1957 and another 30 years we get 1927. All three were pivotal years in the ECM as described above. If I f we go back 20 years, we get 1997 and the beginning of the emerging market debt crisis. If we go back 10 years, it takes us to the beginning of the Great Financial Crisis of 2007-08. Having done this analysis, you should see why we have a sense that there’s some kind of high risk “convergence” coming in Autumn/Winter 2017. It’s nigh on impossible to trace out the likely key events in the last lap in this bull market. Our best guess is that more leverage (e.g. margin debt) provides propellant, there is a renewed shi into dollar assets as China’s credit bubble begins to burst and expectaons of ghter Fed policy reverse as growth slows. ***************************

I wanna free fall out into nothin’ Financial markets are inherently cyclical and in the nal stages of a bull market, the consensus neglects this fact, choosing to believe an upbeat narrave varying with each bull market cycle. The Dow Jones is at “heady” levels and it says something when the crash of 1929, the horrendous bear market of 1974 and the crash of 1987 are almost invisible on the long -term chart.

Source: Bloomberg




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“Some skydive centers oer high altude jump training for experienced jumpers. Such jumps can approach approach 30,000 feet. During such jumps, skydivers must carry & use boled oxygen (‘bailout bole’) in freefall.”

www.fabulousrocketeers.com Almost everybody has tried to call the end of the current curr ent 8-year bull market on at least once occasion. Having heard this comment from two sources recently… “It could just go on and on…”

…we thought that we’d analyse the potenal circumstances and ming of what some of our recent analysis (see below) suggests might be the last lap in this mega -bull market. In 1999-2000, it was going to go on and on because convenonal valuaon metrics were irrelevant and we were entering a new paradigm. In 2007-08, the sub-prime problem was contained and hardly anybody was worried about repo or Eurodollar liquidity in the banking system. This me the narrave has become the importance of buying every dip because if anything bad starts happening, Yellen, Draghi, Kuroda et al, have our backs. Experience suggests that it works unl it doesn’t work and the only thing that maers now is the one thing that is almost impossible impossibl e to predict, ming. ming . There’s nothing to be gained for strategists in guessing when a bull market is going to end. Neither is there much to lose, since nobody (including the strategists) will assign any more than a minimal chance of being correct. Sll, it’s beer to have a view. During the last eight years, direconal changes in several so -called “fundamentals” (see below) haven’t been good predictors of equity performance, as many acve managers and strategists can tesfy. For a change, rather than delving even deeper into fundamentals, we decided it was me to look for answers elsewhere. We analysed repeang paerns of peak -to-peak and trough-totrough cycles in equity prices, from just over three months to more than 20 years. A cycle in one asset price – equies in this case – is the result of the t he interference of many cycles of varying frequencies and magnitudes. These individual cycles create a complex waveform in aggregate as shown in the chart below. It suggests (for what it’s worth) that the next cyclical peak in equies could occur in the fourth week of November 2017 (+/ - one month). month).




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Source: ADM ISI, Bloomberg

The correlaon is not perfect, but not too shabby either, and the trend is generally in line with the Dow Jones chart below.

Source: Bloomberg

Of course, the cycle predicted by our analysis could invert at some point, which happens about 10-15% of the me. Periodic inversions in specic variables are necessary from me to me to keep the “bigger picture” in harmony.




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In the case of equies, this would probably require an almost seamless transion to much higher rates of inaon, e.g. due to major conict or the devaluaon of key global currencies (notably the dollar). While we believe that the end game is high inaon in aon and a new Breon Woods (including the remonesaon of gold as part of an enhanced SDR), we are not expecng the transion to be smooth, or to take place in the next few months. Central banking convenon (omerta) demands that bubbles are never seen seen ahead of me. It doesn’t maer how many mes low interest rates and excessive credit creaon cause booms and busts…and we’ve gone to town in this cycle with ZIRP/NIRP/QE. Credit where credit is due (intended) and a global economy carrying US$215 trillion of brought forward consumpon (a.k.a. debt) is impressive…even for them. She’s a good girl, loves her mama…”

There’s no doubt that nancial markets have been temporarily re-engineered by the intervenon of central bankers. Unless they’ve been permanently re-engineered - which we doubt markets oscillate around a trend. The current divergence is stretched and may stretch further before the inevitable snap back. The legendary trader, W.D. Gann (1878 -1955), was famous for his asseron that he could plot a “tunnel thru the air” for prices in nancial markets. There is lile doubt that he created a phenomenally successful trading system based on cycles in nancial markets. He was monitored, for example, making 264 protable trades out of a total of 286 trades during 25 business days. Gann is a cult gure for scores of traders who try to emulate his system, oen spending years trying to decipher his book, “The Tunnel Thru The Air”, in which he crypcally outlined the system.




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In a course on “Forecasng by Time Cycles” Gann noted. "Time is the most important factor in determining market movements and by studying the past records of the averages or individual stocks you will be able to prove for yourself that history does repeat and that by knowing the past you can tell the future. There is a denite relaon between me and price. Now, by a study of the me periods and me cycles you will learn why tops and booms are found at certain mes…The most money is made when fast moves and extreme uctuaons occur at the end of major cycles."

Another invesng legend, Benjamin Graham (1894 -1976), wrote in his book “The Intelligent Investor” about the inherent cyclicality of markets. “The market is a pendulum that forever swings between unsustainable opmism and unjused pessimism.”

W.D. Gann again… "Every movement in the market is the result of a natural law and of a Cause which exists long before the Eect takes place and can be determined years in advance.”

Our conclusion is that, since si nce 2009, US equity prices have behaved almost perfectly, in terms t erms of the trend anyway, with what Gann would have termed “natural law”. law” . We were surprised. Central bankers have pulled o a paral takeover of nancial markets. However, it seems central bankers’ policies have conspired to increase the magnitude of price changes within the prevailing trend.




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“All the bad boys are standing in the shadows”

Commentators of all types like to aach narraves to explain market moves. In contrast, stock market oscillaons might be beer explained by cyclical cycli cal ming, rather than changes in one or more of the so -called “fundamentals.” Besides the near meltdown of the Euro system in 2011 -12, a few examples spring to mind in the current bull market. Valuaon On several valuaon measures, US equies have looked expensive for 2 -3 years, e.g. Shiller’s CAPE, Tobin’s Q, Price/Book, without terminang the current bull market. The price -to-sales rao has concerned us most, as it’s the least subjecve and/or prone to manipulaon. Here is the path we’ve trodden from chart legend, Ed Yardeni. Ya rdeni.

Source: Ed Yardeni




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Unfortunately, hing a valuaon of 1.8x price/sales, 2.0x price/sales or 2.2x price/sales won’t warn us in advance that we’re at a market top. Several other themes, which seemed to be driving the market, have come, gone…and somemes come back again. They also failed to signal the end of this bull market. Reaon US equies have arguably been a largely reaonary story for the last 2 -3 years, although there have been periods where where this theme has broken down. For example, July -September 2016 and signs of it happening again.


There was major breakdown in this correlaon during 2013 -2014 before it re -connected from the beginning of 2015.




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Credit spreads The S&P 500 was broadly tracking the narrowing in high yield spreads through to the beginning of 2015. Then that broke down and is now re r e-connecng.


ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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QE by the Fed We saw the market closely tracking the growth in the Fed’s balance sheet unl it broke free aer the 2016 elecon.


Earnings per share S&P 500 Adjusted EPS remain essenally unchanged from the laer part of 2014, while the S&P 500 is 25% higher. EPS have systemacally failed to meet year -ahead expectaons for several years during this muted economic recovery.

Source: Bloomberg ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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However… A more behavioural/psychological correlaon stands out for its longevity. The correlaon between the S&P 500 and the Conference Board’s index of consumer condence has been superior to valuaon, inaon expectaons, credit spreads, QE and EPS.


We checked the ming of the peak in consumer condence with peaks in the equity market in 2000 and 2007. Consumer condence peaked in January 2000, two months before the S&P 500 peaked and seven months before the second of the two S&P 500 tops which marked the beginning of the sharp sell-o. Consumer Condence is the red line.




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Source: Bloomberg

In 2007, consumer condence peaked in July, three months before the peak in the S&P 500 in October 2007.

Source: Bloomberg

Our working assumpon is that the Conference Board’s consumer condence index peaked at 124.90 in March 2017. On this basis, it is unlikely that the S&P 500 will connue to rise beyond the laer part of this year. This broadly ts with the scenario outlined above for a signicant correcon in US equies beginning in November 2017. ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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There are other sources of insight into market mark et cyclicality which point to late l ate 2017 as being high risk for equity investors. investors . We’ll briey menon two of them: 

The Economic Condence Model; and



Some Gann cycles.

1. Economic Condence Model (Marn Armstrong) We’ve taken another look into Marn Armstrong’s (formerly Princeton Economics) successful Economic Condence Model (ECM). Many of you will be familiar with Marn’s work from his blog. In summary, the ECM is an 8.6 year cycle which tracks the ow o w of global capital (the “hot money”) which leads to major booms and busts. The period 8.6 years is 3,141 3 ,141 (365.25 x 8.6) which is equivalent to Pi x 1,000 days. We recommend Marn’s paper “It’s Just Time”, wrien on an a n old fashioned typewriter, for a detailed understanding into his model. In the late 1990s, Armstrong could ll conference rooms with people listening on TV monitors in overow areas. In 1999, he was charged with commingling funds and spent 7 years in prison for civil contempt followed by 5 years resulng from a plea bargain. barg ain. Armstrong alleged that the charges were fabricated aer he refused to turn tu rn over his computer models to agencies of the US government. Whatever, the ECM’s record in recent decades is stellar. If we look at three recent peaks in the ECM in reverse chronological order. 

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The 2007.15 peak (24 February 2007) – 2007) – coincided with the HSBC prot warning on 8 February 2007, which marked the beginning of the sub -prime crisis. HSBC warned of rising default rates in its US mortgage business. HSBC had acquired Household Internaonal for US$9bn in 2003, which was its biggest ever acquision. The business was run to maximise volumes and focused on customers with low credit rangs taking out second mortgages. The 1998.55 peak (20 July 1998) 1998) – coincided with the approval of the US$22.6bn IMF/ World Bank rescue package for Russia on 13 July 1998. The Russian debt crisis (also known as the “Rouble crisis”) blew up a month later on 17 August 1998. Russia marked the crical stage of an emerging market debt crisis which began in Thailand in 1997. In the wake of the Russian crisis, LTCM was bailed out on 23 September 1998 to avoid a collapse in the nancial system.


Equity & Cross Asset Strategy Paul Mylchreest 


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The 1989.95 peak (13 December 1989) – 1989) – coincided with the peak in the Nikkei of 38,915.9 on 29 December 1989. This was a key moment in the bursng of Japan’s massive credit bubble which ushered in the naon’s “lost decade”, now nearly two decades. At its peak, Japanese property was worth about four mes the value of all the property in the US, even though Japan is the size of California.

We have reproduced a secon of Marn’s model in the chart below. You can see these three peaks along with the most recent peak of 2015.75, i.e. 1 October 2015.


We realised the power of this model when we checked back seven cycles (7 x 8.6 = 60.2 years) from the 1989.95 peak to 1929.75, i.e. 1 October 1929. The Great Crash began on 24 October, only three weeks later.




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While not infallible, we have established that the ECM has a strong track record. recor d. Two quesons come to mind. Is the ECM working in the current cycle which peaked on 2015.75, i.e. 1 October 2015? Aer all nothing “really bad” has has happened outside of Venezuela and Brazil. If it is working, which nancial markets/regions are central to the ECM’s current downcycle? We’ve discussed about these issues before and it’s sll not clear, although we have some new thoughts. Marn Armstrong speculated that 2015.75 was the peak in the government bond bubble. It’s possible…and thanks to QE, bond markets are undoubtedly in an unparalleled bubble. There was no sign of a peak in either developed or emerging market bonds around that date, or any other “bond-specic” event which we’ve idened. Did any major major event in nancial markets occur around 1 October 2015? The answer is yes. Five/six weeks earlier, during 11 -25 August 2015, China devalued the RMB versus the US dollar from 6.2097 to 6.4128, i.e. 3.3%. Coincidentally, the Naonal Day of the People’s Republic of China is 1 October. Maybe these are signicant, maybe not. It could be China.




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Whatever it is, we have a strong feeling that the dollar is going to play a central role and the dollar is central to what happens in China, a subject we’ve covered on many occasions. The speed and scale of the growth in China’s credit bubble is unprecedented and the danger of it bursng is increasing, as we summarise again below. Back to the ECM… Whether it’s China, government bonds or something else, there is a key node in Armstrong’s ECM which might come into play in late 2017. This is an intermediate high of 2017.9, i.e. 24 November 2017. 2017 . We’ve seen these intermediate highs in the ECM have very signicant eects on global nancial markets in the past, within bigger moves in global capital ows. ows . In the chart below, we’ve highlighted 2017.9 and 1987.8. The laer corresponds with 19 October 1987, which was the precise date of the 1987 market crash. cr ash.


In part, the 1987 crash saw capital (especially Japanese) moved out of US equies into other markets, especially Japan. Following the signing of the Plaza Accord on 22 September 1985, the US, Japan, West Germany, UK and France agreed to intervene in the currency markets to reduce the value of the dollar in relaon to the Yen and the Deutschemark.




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The situaon reached a head when US Treasury Secretary, James Baker, threatened to devalue the dollar further on the weekend before “Black Monday” if Germany didn’t reverse its interest rate rise. Following the crash, speculave capital owed into Japan, encouraged by expansionary policies aimed at overcoming the impact on Japan’s export -dependent economy from the strength of the Yen. We should point out that the 1987.8 node was in the “up” phase of the ECM and was a stepping stone to an even bigger bubble in Japan. This me we are in the “down” phase. Firstly, we need to make the assumpon that the 30.1 year period, i.e. 2017.9 – 1987.8, is a cycle of some signicance in global capital ows. ows . Starng in 1987.8 and going back 30.1 years gives us 1957.7, i.e. 12 September 1957. The chart below shows how the Dow saw a 20% decline between July -October 1957 (which arguably implies that themes – rather than actual events - recur in cycles).

Source: Bloomberg

There were a number of factors in play. The downturn began in the US with a recession during August 1957 – April 1958, which wasn’t helped by a u pandemic and the successful Russian launch of Sputnik (which terried many Americans from what we’ve read). The recession followed on from a rapid expansion of credit, both mortgage and consumer instalment credit (especially for autos), which put upward pressure on inaon, and businesses invesng heavily in plant and equipment.




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Falling equity market aside, here is a potenally signicant si gnicant point relang to our central bank friends… The Federal Reserve sought to curb the inaonary pressures, ignoring signs of a downswing during the Summer/Fall of 1957. It raised the discount rate from fro m 3.0% to 3.5% in August 1957, i.e. very close to the ECM date of 12 September 1957. That month, the Fed Chairman tesed to the Senate that inaon was the “most crical economic problem.” In mid -November, he was forced to reverse course and cut the discount rate by 0.5%. The 1957 crisis spread from the US, becoming the rst r st signicant downturn in the global industrial cycle since the Second World War. The focal point in global terms, ter ms, however, was South America. Low taxes and other incenves aracted huge foreign investment, especially into Brazil. The withdrawal of some American investors together with problems in servicing foreign debt as commodity prices fell and their currencies weakened led to panic and bank runs in Brazil in October 1958. The contagion spread to Argenna, Chile and Paraguay. This was picked up by the ECM which troughed in 1959.85, i.e. 6 November 1959.


You might also be wondering whether Brazil = China in this cycle.




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This avenue of enquiry was looking promising…so we went back in me another 30.1 years to 1927.6, i.e. 8 July 1927. 1927 . Hmmm, nothing pivotal happened in the Dow Jones around July 1927, as it connued moving upwards.

Source: Bloomberg

Wait a minute…

There was a massive event in July 1927 which facilitated the nal shi of global capital (especially from Britain) into US equies, culminated in the Great Crash of 1929. Remember, obviously, that we were in the up phase of the ECM on this occasion. This was, to quote Bytheway and Metzler in “Central Banks and Gold.” “the famous and elaborately orchestrated secret meeng of central bankers on Long Island, New York, in July 1927...This meeng also had an air of comic opera, as Norman and the others aempted to travel to New York in disguise (their names were not on the ship’s manifests and their luggage was unmarked) but were found out by news reporters.”




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Present at this meeng were the heads of the world’s four most powerful central banks, the Federal Reserve, Bank of England, Reichsbank and the Bank of France. Here are Messrs Schacht, Rist, Norman and Strong outside the NY Fed during their “secret meeng.”

Source: FRBNY

What transpired during the meengs, while not publicly disclosed, became apparent shortly aerwards. The European members of this cabal persuaded their American colleague to ease monetary policy, via lower rates and open market operaons, to ease the deaonary deaonar y pressures on the UK and France. The Fed cut the discount rate from 4.0% to 3.5% and instuted US$300m of open market operaons in which it bought Treasuries. This le the banking system with high levels of surplus cash (sounds only too familiar), much of which started to nd its way into the call loan market on the NYSE. The borrowers were stockbrokers and traders pledging stocks as collateral for loans for stock speculaon on margin. We all know what happened next…




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We have aached some thought -provoking exchanges from the House Stabilizaon Hearings in 1928 about the meeng in the Appendix. So… Armstrong’s ECM implies a possability that there will be an event – either a market event or policy event – which will facilitate the shi into the nal phase of the current 8.6 year cycle. cycle . Unfortunately, with the ECM in a down cycle, the risk is skewed in that direcon. direcon . Now let’s return to Gann for some supporng evidence about 2017 being pivotal.

2. Gann Cycles W.D. Gann argued that market trends (everything in fact) were cyclical and themes were r epeated in a series of specic cycles. "Mathemacal science, which is the only real science that the enre civilized world has agreed upon, furnishes unmistakable proof of history repeang itself and shows that the cycle theory, or harmonic analysis, is the only thing that we can rely upon to ascertain the future."

Gann’s enre philosophy and success was based on cycles and he oen made incredibly accurate intra-day calls on specic markets. He also highlighted several long -term cycles in his wrings which he believed were signicant. These included. 

60-year cycle;



30-year cycle;



20-year cycle; and



10-year cycle.

Similar to Armstrong, Gann seemed to think of cycles in a fractal structure of cycles within cycles. If we start with the 60-year cycle, cycle, Gann stated. “This is the greatest and most important cycle of all, which repeats every 60 -years or at the end of the third 20 -year cycle.”

If we go back 60 years from 2017, we come to 1957…a year which we highlighted above as being relevant according to a 30.1 year repeang repean g cycle within Marn Armstrong’s ECM.




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On the 20-year cycle Gann cycle Gann stated. “One of the most important Time Cycles is the 20 -year cycle or 240 months. Most stocks and the averages work closer to this cycle than to any other.”

Going back in me 20 years obviously takes us to 1997, which coincided with the beginning of the late-1990s Asian debt crisis, as we already noted, along with a sell -o in the Dow Jones in Winter. Moving on to the 10-year cycle, cycle, Gann had this to say. "The next important major cycle is the 10 -year cycle, which produces uctuaons of the same nature and extreme high or low every 10 years.”

This is another potenally relevant one for the current year. In 2007, 2007 , we obviously saw the emergence of the sub -prime crisis, Eurodollar illiquidity problems and the peak in the equity market cycle. Finally the 30-year cycle, cycle, about which Gann commented. "The next important major cycle is 30 years…extreme high or low prices in products of the earth at the end of each 30 -year cycle, and this makes Stocks high or low.”

Commodity prices were at very low levels in early 1987, but the year is obviously best remembered for the market crash in October, which we also discussed above. Back another 30 years yea rs gives 1957 and another 30 years gives us 1927. So we have a potenal links between the ECM and Gann cycles with regard rega rd to 2017, 1987, 1957 and 1927. This may or may not be signicant. Having established an alternave way of analysing the outlook for equies, let’s revert to some fundamentals.




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Mapping a potenal peak in Equies It’s nigh on impossible to trace out the likely key events in the last lap in this bull market. Having said that, our best guess is: 





Even more leverage, e.g. margin debt, providing propellant; Renewed shi into dollar -denominated assets as China’s credit bubble begins to burst; Reversal in expectaons of ghter Fed policy as growth slows .

Looking back at the nal stages of the last two “mega” equity bull markets, there is a good g ood chance of a nal surge in leverage in the normal pro -cyclical manner. Using 1996 as the baseline, NYSE margin debt has risen more than twice as fast as the S&P 500, another illustraon (as if we need it) of how leverage drives global economics and asset prices.


However, we were surprised to nd that one thing is sll missing – a nal surge in the growth of margin debt which was coincident with the 2000 and 2007 equity market peaks.




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The biggest risk to the global nancial system remains China. There are numerous risks to China’s credit bubble, but connued rate hikes by the Fed and a stronger dollar would add to the problems the PBoC is already facing. facing . Investors have been condioned into believing that the PBoC can manage any problems which might arise, even though the relave scale and speed of the build -up in the Chinese bubble is unprecedented. Moreover, bubbles always pop even though the consensus usually discounts that possibility. This is the nature of markets. Overnight SHIBOR rate, i.e. the cost of interbank funding in domesc Chinese money markets, has become increasingly volale with periodic plunges and rebounds since the beginning of the year. It probably reects shiing dynamics between acute liquidity needs of banks and subsequent PBoC infusions.




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Source: Bloomberg

The more stable 3 -month tenor has made a new high in this move.

Source: Bloomberg

The rising trend signies ghtening liquidity in the banking system IN SPITE OF fewer RMB deposits eeing the country in terms of capital oulow (see below). This has been overlooked. The PBoC is walking the proverbial ghtrope - reining back some of the extreme excesses of the credit bubble and promong the government’s GDP targets, which necessitates enlarging the same credit bubble. ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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Despite its protestaons of nancial prudence, the PBoC permied China’s biggest ever monthly credit infusion at the beginning of 2017, an exact repeat of 2016.


A warning sign is the recent inversion in the 5s10s yield curve on Chinese government bonds.


We expect that the PBoC’s ability to control outcomes will be progressively lost as more evidence of fraud and Ponzi -behaviour in China’s nancial sector comes to light.




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Mainstream news providers, like Bloomberg, have recently re cently published good pieces on the risks from China’s US$3.9 trillion WMP sector and the debt guarantee problem. pro blem. However, we’ve had huge news ow from the Trump Administraon, North Korea, French/UK elecons and few people are taking much noce. Given the rout in China’s government and corporate bond markets since Q4 2016, we nd it hard to believe that banks have not had to shoulder signicant losses to pay out “guaranteed” returns on WMPs. The 5 -year yield on AA corporate bonds, for example, has risen by over 200bp in about 6 months.

Source: Bloomberg

In April 2017, China’s largest private bank, Minsheng Banking Corp, admied to a RMB 3.0bn (US$437m) fraud when sold non -existent WMPs to customers. Earlier this month, we had a window into the Ponzi nature of some WMPs. One of China’s largest insurers, Foresea Life, warned of “mass defaults and social unrest” if the Chinese regulator failed to li the ban on its selling new WMPs. The company has about US$8.7bn of redempons in 2017. The company’s former Chairman, and one of the richest people in China, was banned from the industry for 10 years by the China Insurance Regulatory Commission. The debt guarantee problem is very opaque with large companies allowing smaller companies to borrow money by guaranteeing the former’s loans while keeping the guarantees guar antees o balance sheet. In some cases, it’s even more complex, e.g. the recent queson marks about the funding of one of China’s largest insurers, Anbang, by Caixin magazine.




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The PBoC faces a plethora of bank liquidity l iquidity and WMP challenges. However, its biggest challenge is probably the risk that it loses control of monetary policy . By pegging the RMB to the dollar, the PBoC has handed over direconal policy to the Fed… unless it oats the RMB, of course. While low-cost labour, outsourcing and investment/infrastructure spending were the best understood drivers of Chinese GDP growth and associated credit bubble, crical monetary supports were overlooked. 

Federal Reserve operang an easy monetary policy; and



The unconstrained ow of US dollar credit.

Pegging the RMB to the dollar was benecial to China when the Fed’s F ed’s policy was outright easy, or at least benign. It’s outright dangerous when the Fed is ghtening, especially when China’s debt/GDP rao has crossed 300% on some measures. It was noceable how the PBoC raised rates – albeit by a minimal 10bp – just hours aer the Fed’s latest rate hike in March 2017. Ironically, this was portrayed as voluntary - the PBoC acng prudently to discourage leverage – and most people accepted it. Despite recent dollar weakness against other major currencies, the RMB has only at lined.

Source: Bloomberg

It could have been considerably worse for the RMB without intense eorts by the Chinese authories to reduce capital oulows. While they have had some success, we’d note that RMB deposits, which have successfully migrated migrated to Hong Kong from the mainland, are connuing to ee. The chart below shows total RMB deposits in Hong Kong Banks. ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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Source: Bloomberg

With a slowdown in the oulow of RMB bank deposits from the mainland, however, the PBoC has beneted from a modest reprieve in the monstrous mons trous volume of money prinng it’s undertaken to save the Chinese banking system. system . The chart shows a small drop from US$1.3 trillion to just under US$1.2 trillion in the innocent sounding “Claims on other depository Instuons.”





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Having said that, renewed dollar strength and nding new ways to move RMBs out of China could put further pressure on China’s banking system and the RMB. As we’ve explained in excruciang detail during the last two years, there is a shortage of liquidity in oshore dollar (Eurodollar) funding markets. In other words, there is a lack of US dollar balance sheet (credit) oered by the global banking system. This reects greater risk aversion on the part of banks (especially US and other western banks) and increased regulaon, notably Basel III. Dollar funding problems have taken on greater signicance since the 2008 crisis with oshore dollar debt in excess of US$10 trillion, 70% increase. In aggregate, China has about US$2 trillion of US dollar debt, which is predominantly held by corporates. Unfortunately, a classic maturity mismatch has occurred, in addion to the currency mismatch. Non-US banks have lent dollars on a longer term te rm basis and need to rollover dollar funding on a short-term basis. Global dollar funding markets had become problemac at the end of 2016 – before the situaon suddenly improved. This can be seen in the cross currency basis swaps (CCBS), especially especiall y the Yen. Yen. In late 2016, we highlighted the extreme ghtness in dollar liquidity based on the weighted average CCBS of ve currencies against the dollar. This represents the cost of swapping these other currencies into dollars over and above the interest rate dierenals for a period of 3 months. In a benign environment, the CCBS should trade at zero and not be in negave territory.





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We were surprised by the sudden reversal in the CCBS and dollar weakness since the beginning of 2017 and were at a loss to explain it, especially given the shi in market expectaons towards greater Fed ghtening in Q1 2017. We need to acknowledge former Fed researcher and CS economist, Zoltan Pozsar, who has pointed to the unintended consequence on dollar funding of the US Treasury preparaons prepar aons for hing the debt ceiling. When the US Treasury increases its deposit account - Treasury General Account - at the Federal Reserve (by selling Treasury bills/bonds) or “Foreign Ocial” instuons tap the Fed’s reverse repo programme, dollar reserves are removed from the banking system. This process ghtens dollar liquidity. The reverse is also true which is relevant r elevant to us. In other words, when the US Treasury runs down its account with the Fed, liquidity in dollar funding markets improves . To avoid hing the debt ceiling, the US Treasury Treasur y began running down its account at the Federal Reserve in late 2016. From almost US$430bn, it fell to a low of US$38bn in mid -March 2017, a fall of almost US$400bn.


In reality, the US Government spent US$400bn which ended up in deposit accounts which were not simultaneously drained by sales of Treasury Bills. So…the system was ush with an addional US$400bn U S$400bn of dollar reserves. reserves . Swap spreads provided more evidence that bank balance sheets became slightly less constrained from late 2016. Swap spreads should not trade in negave territory as they imply that the US Treasury’s credit rang is inferior to major banks.




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The banking system has lacked the balance sheet (and the inclinaon) to arbitrage away the anomaly. The recent improvement in the negave 30 -year swap spread seems to be rolling over.


Another window on dollar liquidity and bank balance sheets… The chart below shows the roughly US$400bn rebound in excess reserves on the Fed’s balance sheet.





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As we’ve explained, the consensus view that these reserves sit quietly on the Fed’s balance sheet is incorrect. They are traded in the money markets from which they can have a broader impact on forex rates and asset prices in general. general . Given some of the sharp moves in CCBS, banks with spare dollars in late 2016/early 2017 could, for example, have earned 80 -90bp by swapping them with Yen -based dollar borrowers. It was hardly surprising, therefore, that some of the addional US$400bn of dollar funding found its way into the FX swap market. The reversal in the Yen CCBS since late 2016 has been something to behold.

Source: Bloomberg

When inverted, the Yen CCBS tracks the trend in the aggregated Foreign Ocial RRP and the Treasury General Account on the Fed’s balance sheet. In other words, the Yen CCBS became more negave as dollar bank reserves were drained dr ained from 2014 to late 2016. The paral normalisaon of the Yen CCBS in recent months has tracked the sudden improvement in dollar liquidity courtesy of the US Treasury.




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It raises an important queson now that the US government has negoated a budget deal through the end of the current scal year in September 2017. All other things being equal, if the Treasury replenishes, partly or fully, the Treasury General Account at the Fed (which it’s been doing), dollar liquidity should ghten again, which should drive a further upward move in the dollar index .

Source: Bloomberg




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This would have signicant knock -on implicaons for dollar funding markets, the dollar and China, to name but three. three . It should also be deaonary and G7 inaon should connue to rollover in the next few months. One way, or another, this gap is probably going to narrow.


As an aside – Fed ocials are increasingly talking about reducing the size of the Fed’s balance sheet later this year. Unfortunately, it seems that they are not taking account of the knock -on reducon in dollar liquidity if they proceed down this path. In the meanme, intensifying deaonary pressure from the dollar would be challenging with cracks appearing in the post -elecon reaon narrave… narrave … The recent peak in the 2s30s Treasury yield curve occurred only days aer Trump’s elecon victory while condence in the reaon narrave lasted well into 2017.




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Source: Bloomberg

The November 2013 peak in the 2s30s occurred three months before befor e the rst RMB devaluaon and the July 2015 peak occurred just before the t he second RMB devaluaon. Are we overdue? While the Trump reaon narrave suered a blow on Obamacare and the potenal knock -on hit to tax reform, we doubt that hope generated by Trump victory and the s condioning of investors that “the Fed has your back” will evaporate in weeks. The recent all -me high in equies is mirrored in the Conference Board’s US consumer condence survey, which exceeds the previous 2007 peak.





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That’s in spite of a labour force parcipaon rate which is 3% below 2007 and 4% below 2000.


In keeping with the high level of consumer opmism, there’s been a rebound in retail sales growth.


While it’s viewed as a reecon of underlying economic strength, it could also represent the last hurrah of the US consumer for this cycle.




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Retail sales growth was on a rising trend when the S&P 500 peaked in 2000 and 2007.


A signicant part of the retail sector faces dicult or, in some cases, insurmountable structural problems. Store closures and layos in malls and department stores have become commonplace. Below is the chart of Macy’s CDS since 2012.





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Within retail sales, autos have made an important contribuon to the post -crisis recovery. The seasonally adjusted annualised rate levelled o at 17.0 -18.0m units in 2015/16 and is in decline.

Source: Bloomberg

The boost from subprime auto loans and rising incenves is waning and not before me. However, cheap credit brought forward demand, leading auto companies to overesmate demand prospects. The inventory/sales rao is the highest since 1990 outside of the 2008 -09 recession (and above the recessions of the early 1990s and 2000s).

Source: Bloomberg




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Inventory chains, in general, are an issue that warrants close monitoring. Despite modest improvement, the inventory/sales rao in the wholesale part of the manufacturing chain (ex petroleum) is sll too high. The current level remains consistent with the last two recessions.


Within the credit stats, credit card (revolving credit) usage has been accelerang and we can’t help wondering whether this is one reason for the strength in retail r etail sales.


It may not be a posive sign as a pick -up in credit card usage was seen prior to the last two recessions. Consumers were guilty of over -opmism or pressure on incomes, or maybe a combinaon of the two. ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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Talking of pressure on consumer incomes… The last equity market peak in 2007 saw the outperformance of the S&P 500 Consumer Discreonary sector versus Consumer Staples top out about six months before the S&P S& P 500 top.


In 2000, the peak in the S&P 500 was coincident with the topping out of the S&P 500 Consumer Discreonary sector versus Consumer Staples.

Source: ADM ISI, Bloomberg ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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It looks like the relave performance of Consumer Discreonary versus Consumer Staples is in the process of topping out once again.


Shiing from consumers to businesses, opmism also prevails… Small business condence, according to the NFIB Small Business Opmism Index, is at its highest level for a decade, although it looks poised to roll over.


The NFIB index oen acts a leading indicator for the more closely watched ISM manufacturing index. ADM Investor Services Internaonal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered oce: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equies, CFDs, Futures, Opons, Derivaves and Foreign Exchange can uctuate in value, investors should therefore be aware that they may not realise t he inial amount invested, and indeed may incur addional liabilies. These Investments may entail above average nancial risk of loss, and investors should therefore carefully consider whether their nancial circumstances and investment experien ce permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Internaonal Limited 2014.



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Returning to one of our favourite indicators, the 2s30s yield curve… The long end is resisng the upward pressure to rates which the Fed is exerng at the short end. While all of the talk in recent months has been of the prospects for “reaon”, the steepening in our favourite 2s30s yield curve peaked on 10 November 2016, only two days aer Trump was elected. A gap has now opened up versus the ISM manufacturing index.


Our guess is that the gap gradually gr adually narrows as 2017 progresses due to weakness in the ISM.




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The lumber price is also a useful indicator to watch. A weakening trend in the manufacturing ISM is usually conrmed – and possibly led – by a decline in the lumber price.


The index of For Hire Trucking Tonnage has been oblivious to the post -elecon opmism, although we have seen rebounds from negave territory before, e.g. in 2013.





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Manufacturing and lumber, however, ignore the much larger service sector in the US economy. The chart below shows the historic correlaon between the 2s30s yield curve, shied twelve months forward, versus the combined manufacturing and non -manufacturing ISM in the rao 20%/80%.


The message of upcoming weakness across the US economy is unambiguous if the 2s30s curve is correct.

Song lyrics from Tom Pey’s “Free fallin’”




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Appendix Excerpts from the House Stabilizaon Hearings in 1928 :

GOVERNOR ADOLPH MILLER: The three largest central banks in Europe had sent representaves to this country. There were the Governor of the Bank of England, Mr. Hjalmar Schacht, and Professor Rist, Deputy Governor of the Bank of France. These gentlemen were in conference with ocials of the Federal Reserve Bank of New York. Aer a week or two, they appeared in Washington for the beer part of a day. MR. BEEDY: Was there some understanding arrived at between the representaves repre sentaves of these foreign banks and the Federal Reserve Board or the New York Federal Reserve Bank? GOVERNOR MILLER: Yes. MR. BEEDY: It was not reported formally? GOVERNOR MILLER: No. Later, there came a meeng of the Open-Market Policy Commiee, the investment policy commiee of the Federal Reserve System, by which and to which certain recommendaons were made. My recollecon is that about eighty million dollars’ worth of securies were purchased in August consistent con sistent with this plan. CHAIRMAN MCFADDEN: A change of policy on the part of our whole nancial system which has resulted in one of the most unusual situaons that has ever confronted this country nancially (the stock market speculaon boom). It seems to me that a maer of that importance should have been made a maer of record in Washington. GOVERNOR MILLER: I agree with you. MR. STEAGALL: The visit of these foreign bankers resulted re sulted in money being cheaper in New York? GOVERNOR MILLER: Yes, exactly. REPRESENTATIVE STRONG: The fact is that they came over here, they had a meeng, they banqueted, they talked, they got the Federal Reserve Board to lower lo wer the discount rate, and to make the purchases in the open market, and they got the gold. MR. STEAGALL: Is it true that acon stabilized the European currencies and upset ours? GOVERNOR MILLER: Yes, that was what it was intended to do.




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