In previous blog posts (e.g. HERE) I explained the limitations of sentiment as a market timing tool. Since the public is invariably wrong at price extremes, it certainly can be helpful to track the public’s sentiment and use it as a contrary indicator. However, whereas price extremes always coincide with sentiment extremes, sentiment extremes often don’t coincide with price extremes. This is especially the case during long-term bull markets, when sentiment is capable of staying very optimistic for years. It’s therefore best to think of a sentiment extreme as a necessary, but not a sufficient, condition for a price extreme.

With regard to US stock market sentiment there was an optimistic extreme in January of this year. This is evidenced by the TSI Index of Bullish Sentiment (TIBS) hitting a 20-year high at that time. Refer to the following weekly chart for details. Note that TIBS is a weighted average of four sentiment surveys (Investors Intelligence, Market Vane, Consensus-inc and American Association of Individual Investors), the 5-day moving average of the equity put/call ratio and the 5-day moving average of the VIX.

What is the probability that January’s optimistic extreme coincided with the top of the equity bull market?

The answer is: quite low. While sentiment was consistent with a major top and valuations, on average, were definitely high enough to usher in a major top, an end to the long-term upward trend was not signaled by several important indicators. For example, there would normally be a pronounced widening of credit spreads at or before a bull market top, but credit spreads remain near their narrowest levels of the past 10 years. For another example, there is likely to be a reversal in the yield curve from flattening to steepening at or prior to a bull market top, but at the end of last week the US yield curve was at its ‘flattest’ in more than 10 years. For a third example, there has been more strength in market internals over the past two months than there normally would be if we were dealing with the early stage of a bear market.

So, despite the rampant optimism evident in January-2018, the decline that followed the January peak probably will turn out to be a bull-market correction.

Among the list of stock selection and trading ideas maintained at the TSI web site there was, until the week before last, a Tesla (TSLA) put option position. The position was exited — and a large profit recorded — after the stock’s recent plunge from well above $300 to the $250s. However, this stock could present multiple opportunities over the coming 12 months to profit on the dark (bearish) side as it makes its way along the path to zero. TSLA could become the short that keeps on giving.

In fact, the fast rebound from the 2nd April low in the mid-$240s to the 9th April high of $309.50 may have already created the next such opportunity. The reason is that the rebound appears to have ended near the top of the former major support at $300-$310, the implication being that the stock has completed a successful test of its breakdown.

The company is clearly in trouble. It is hemorrhaging cash and running out of money, it is suffering production problems, it has possibly engaged in fraudulent accounting and is under investigation, and it will soon be faced with much greater competition from companies that are far more adept at vehicle manufacturing. And yet, it still sports an extremely high market valuation.

TSLA bears will have to remain on guard, though, because Elon “the carnival barker” Musk is still capable of whipping up enthusiasm.

[This blog post is an excerpt from a TSI commentary published on 27th March 2018]

The policies of the Trump Administration are being influenced by the view that international trade is a zero sum game, where whoever receives the most money is the winner at the expense of whoever receives the most goods. Under this line of thinking, which sometimes goes under the name “mercantilism”, policies are beneficial if they increase the amount of money coming into the country relative to the amount of money going out of the country. As discussed below, it’s the wrong way to look at the world.

Another way of framing the mercantilist position is that the winner is the one who ends up with the larger amount of the medium of exchange and the loser is the one who ends up with the larger amount of real wealth. For reasons we’ll get into in a moment there are actually no winners and losers, but if it were true that one side was getting the better deal then surely it would be the one that ended up with the most real wealth; especially these days, when the medium of exchange is created out of nothing by the banking system.

Also, it’s important to understand that countries don’t trade with each other. For example, the US doesn’t trade with China. What we mean is that a country is not an economic entity that buys and sells. Instead, individuals in one country trade with individuals in another country and in each transaction both sides believe that they are benefiting (otherwise the transaction wouldn’t happen). While it is technically possible to lump together all the transactions undertaken by the individuals in one region and arrive at the conclusion that ‘we’ have a trade deficit or ‘we’ have a trade surplus, in the real world there is no ‘we’ when it comes to trade.

Unfortunately, however, governments pay attention to the meaningless lumping-together of millions of individual transactions, and if the result happens to be what is commonly called a deficit then the government will often conclude that it should place obstacles in the way of many transactions. You may think that you are benefiting from a deal with a foreign seller, but according to the government you are creating a problem for the collective ‘we’ and must be hindered or stopped.

The Trump Administration is in the spotlight at the moment for having undertaken three sets of protectionist measures over just the past two months. There were the tariffs on imported washing machines and solar panels announced in January, the tariffs on imported steel and aluminium announced at the beginning of March and the as-yet-unspecified tariffs on $60B of Chinese imports announced last week. However, the US government does not have a monopoly on counter-productive mercantilism. Far from it! The same sort of ‘reasoning’ that has informed the trade-related missteps of the US government over the past two months is informing the actions of most governments around the world.

For example, other governments are threatening to impose their own tariffs in response to the US tariffs, which is something they would not do unless they wrongly believed that such restrictions could benefit their own economies. For another example, the large quantity of US$-denominated reserves collectively held by central banks around the world has almost nothing to do with the US$ being the official reserve currency and almost everything to do with exchange-rate management designed, using terribly flawed logic, to gain an international trade advantage. Refer to the May-2015 post at the TSI Blog for more colour on this issue.

There is nothing that any one government can do directly to change the wrongheaded protectionist ways of other governments. The best that any single government can do is to not become part of the problem. The ideal situation is that no side erects barriers to international trade, but the second-best situation for any one country is that its own government opts not to erect barriers. Just because some other government decides to impose economic sanctions on its own citizens doesn’t mean that your government is justified in doing the same.

[This blog post is an excerpt from a recent TSI commentary]

The year-over-year rate of growth in the US True Money Supply (TMS) was around 11.5% in October of 2016 (the month before the US Presidential election) and is now only 2.4%, which is near a 20-year low. Refer to the following monthly chart for details. In terms of effects on the financial markets and the economy, up until recently the US monetary inflation slowdown was largely offset by continuing rapid monetary inflation elsewhere, most notably in Europe. However, the tightening of US monetary conditions has started to have noticeable effects and these effects should become more pronounced as the year progresses.

The tightening of monetary conditions eventually will expose the mal-investments of the last several years, which, in turn, will result in a severe recession, but the most obvious effect to date is the increase in interest rates across the entire curve. The upward acceleration in interest rates over the past six months has more than one driver, but it probably wouldn’t have happened if money had remained as plentiful as it was two years ago.

It would be a mistake to think that the tightening has been engineered by the Fed. The reality is that the Fed has done very little to date.

The Fed has made several 0.25% increases in its targeted interest rates, but the main effect of these rate hikes is to increase the amount of money the Fed pays to the commercial banks in the form of interest on reserves (IOR). It doesn’t matter how you spin it, injecting more money into banks ain’t monetary tightening!

The Fed’s actual efforts on the monetary loosening/tightening front over the past 5 years are encapsulated by the following weekly chart of Reserve Bank Credit (RBC). This chart shows that there was a rapid rise in RBC during 2013-2014 that ended with the completion of QE in October-2014. For the next three years RBC essentially flat-lined, which is what should be expected given that the Fed was neither quantitatively easing nor quantitatively tightening during this period. In October-2017 the Fed introduced its Quantitative Tightening (QT) program. To date, this program has resulted in only a small reduction in RBC, but the plan is for the pace of the QT to ramp up.

Strangely, the most senior members of the Fed appear to believe that their baby-step rate hikes constitute genuine tightening and that the contraction of the central bank’s balance sheet is neither here nor there. The reality is the opposite.

So, the Fed is not responsible for the large decline in the US monetary inflation rate and the resultant tightening of monetary conditions that has occurred to date.

The responsibility for the tightening actually lies with the commercial banks. As illustrated by the next chart, the year-over-year rate of growth in commercial bank credit was slightly above 8% at around the time of the Presidential election in late-2016 and is now about 3%.

We won’t be surprised if a steepening yield curve prompts commercial banks to collectively increase their pace of credit creation over the next two quarters, but with the Fed set to quicken the pace of its QT the US monetary inflation rate probably will remain low by the standards of the past two decades. At the same time, the ECB will be taking actions that reduce the monetary inflation rate in the euro-zone. This could lead to stock and bond market volatility during the second half of this year that dwarfs what we’ve witnessed over the past two months.