I have kept an open mind over the past few months as to whether the July-September decline in US equities was the first leg of a new cyclical bear market or a correction within an on-going cyclical bull market. There were hints that it was the former, but there was nothing definitive in the indicators I follow and the price action was consistent with either possibility. The jury is still out, although there has been a probability shift over the past couple of weeks. Before I discuss this shift I’ll do a quick recap for the benefit of blog readers who aren’t TSI subscribers.

During the first half of July this year I thought that there was almost no chance of the US stock market experiencing a bona fide crash over the ensuing few months, but — for reasons outlined in TSI commentaries at the time — I thought there was a good chance of the S&P500 Index (SPX) falling by 10%-20% from a July peak to a bottom by mid-October and that a put-option position was a reasonable way to trade this likely outcome. Then, when there was a discontinuity at the start of the US trading session on Monday 24th August with prices gapping sharply lower across the board, I sent an email to TSI subscribers saying that all bearish positions should be exited immediately. My view was that the 24th August mini-panic would be followed by a multi-week rebound and then a decline to test the low by mid-October, but regardless of what the future held in store the 24th August price action created a very obvious profit-taking opportunity for anyone who was betting on lower prices.

Subsequent price action could aptly be described as noncommittal. There was a successful test of the 24th August low in late-September followed by a strong rebound to a high in early-November, none of which was surprising. Also, this price action didn’t provide any important new clues, because I considered a successful test of the August low followed by a rebound to at least the 200-day MA to be likely regardless of whether we were dealing with a bull-market correction or the early stages of a new bear market.

I’ll now deal with the probability shift mentioned in the first paragraph.

Although I was keeping an open mind regarding the nature of the July-September downturn, if someone had held a gun to my head a few weeks ago and forced me to pick a side I would have chosen the ‘new bear market’ scenario. That is no longer the case.

The jury is still out and for practical investing/speculating purposes there is no need to pick a side, but the probabilities have recently shifted in favour of the ‘bull market correction’ scenario. Displayed below is a chart that illustrates one of the reasons for this probability shift. It is a monthly chart of the S&P500 Index (SPX) with a 20-month moving-average (MA).

This chart shows that once a bear market got underway in 2000 and 2007 and the SPX had achieved a monthly close below its 20-month MA, it did not achieve a monthly close above this MA until the bear market was over. However, in 2011 and again this year, a monthly close below the 20-month MA was quickly reversed.

If a cyclical bear market was in progress then the SPX should have weakened enough in November to give another monthly close below its 20-month MA, but it didn’t. Instead, it managed a second consecutive monthly close above this MA. This is a meaningful divergence from the price action in the early stages of the preceding two cyclical bear markets and is more consistent with the bull-market correction scenario.

There is other evidence to support the ‘bull market correction’ scenario, but, as I said, the evidence is not yet conclusive. In fact, in a TSI commentary scheduled for tomorrow I’m going to show two important indicators that support the ‘equity bear market’ scenario. Moreover, the bull market is ‘long in the tooth’, valuations are high and earnings growth (on a market-wide basis) is non-existent, so even if the long-term bullish trend is still in progress there’s a high risk that it will end sometime next year.

The following charts from www.sharelynx.com are referenced in an email that will soon be sent to TSI subscribers.

This post is a slightly-modified excerpt from a recent TSI commentary.

In the US, the commercial banks can create money and the Fed can create money. A chart showing the change in the US money supply therefore won’t directly tell us if the Fed was a creator of new money during the period covered by the chart. However, unlike the commercial banks, when the Fed monetises debt it boosts bank reserves as well as the money supply, which means that we can quickly identify the periods during which the Fed was a direct creator of new money by looking at a chart of the total quantity of US bank reserves. Such a chart is displayed below.

With reference to this chart, notice the huge rises in bank reserves during the periods labeled “QE1″, “QE2″ and “QE3″. These are the times when the Fed was directly creating new money. The downward/sideways drifts in bank reserves prior to the start of “QE1″, between the QE programs and since the end of “QE3″ are times when the Fed was not directly creating new money. The US money supply still increased during these ‘non-QE’ periods, but it increased due to the actions of commercial banks rather than the direct intervention of the Fed.

To put the 2008-2015 period into perspective, here is a chart showing the total quantity of US bank reserves going back to 1959. Notice that for decades prior to 2008, total bank reserves hovered just above zero. There was a lot of monetary inflation during this period, but almost none of it was due to the direct creation of money by the Fed.

As an aside, if you compare the above chart of bank reserves with a chart of commercial bank credit you will see that over the past few decades there has been no relationship between bank reserves and the quantity of money loaned into existence by US commercial banks. That’s why, as I wrote in a recent blog post (https://tsi-blog.com/2015/10/the-zero-reserve-banking-system/), it’s more realistic to think of the US as now having a zero-reserve banking system as opposed to a fractional-reserve banking system. Bank reserves are a throw-back to an earlier monetary system, when gold was held in reserve and receipts for gold circulated within the economy. It makes no sense to have dollars backed by dollars, especially since the quantity of dollars held in reserve in no way determines/limits the quantity of dollars loaned into existence or held in bank deposits.

An extraordinary situation can start to seem ordinary if it persists for long enough, so the main point I wanted to reiterate with the help of the above charts is that the past several years constitute a massive and unprecedented departure from the Fed’s traditional mode of operation. An implication is that the Fed’s next monetary tightening program, which may or may not tentatively begin with a tiny rate hike in December, will not look like any previous monetary tightening program. The “uncharted waters” cliche is now very appropriate.

If you listen to the top central bankers of the world talk for long enough you will come away with the impression that central banks are attempting to give us “price inflation”, as if rising prices were beneficial. However, nobody wants to pay more for stuff. In fact, rational people prefer to pay less, not more. Therefore, when central banks claim to be giving us “price inflation” what they are really doing is stealing the “price deflation” from which we would otherwise benefit.

We are told that a general expectation of rising prices is important, because if people start expecting prices to be lower in the future then they will curtail their spending in the present. This, apparently, will lead to an economically-disastrous downward spiral in which the general expectation of lower prices leads to reduced spending and reduced spending leads to even lower prices.

The economic ‘logic’ contained in the idea that expectations of higher prices are needed to promote present-day spending explains why companies like Apple can never sell anything. After all, who in their right mind would buy an Apple product today when they can be sure that a better product will be available at a lower price by this time next year?

And just imagine how bad it would be if prices trended lower throughout the entire economy the way they do in the computing and mobile communications industries. There would be almost no spending anywhere! That operation to save your life that you have scheduled for next week could be postponed until healthcare charges have declined to much lower levels. And all of the eating you were planning on doing over the next few months could be delayed indefinitely in anticipation of more attractive food prices. And there would never be a good reason to buy a house or a car because each year you did without these things, the more of a bargain they would become and the better off you would be for not having bought earlier.

Also, try to imagine how bad it must have been before there were central banks to guarantee a continuous rise in the general price level. If expectations of rising prices are needed to promote spending and growth, then in pre-central-bank days, when money often increased in purchasing-power from one year to the next, there must have been almost no spending anywhere in the economy. That is, there must have been relentless economic contraction. Thankfully, we now have people like Ben Bernanke, Janet Yellen, Mario Draghi and Haruhiko Kuroda to save us from such a predicament.

The point that hopefully hasn’t been totally obscured by my sarcasm is that central bankers are thieves. They are stealing our deflation. It isn’t fair to compare them with common burglars, though, because common burglars don’t claim to be doing you a favour while they make off with your valuables.