A Leap Of Faith

7th December 2019

A Leap Of Faith

In the current environment full of bad economic news flow, geopolitical aberrations, and the news media hell-bent on flashing the same news everyday with a new twist because it needs to explain all the happenings in financial markets even if there is no good explanation, taking a contrarian stance has not been easy.

It requires a leap of faith, and a strong belief that something has changed in the approach and the only way around it might be to stay on the right side of the market. If logic had its way in 2017 and 2018 should have seen the nifty crash as hard as did so many stocks in the mid-and small cap universe. In fact many large caps like those in the automobile sector and Pharma sector were also beaten down over the last couple of years you can say that NBFCs stole the show while Pharma and auto were the sidekicks.

The truth is that the broad market has been through and 18 to 21 month bear market that has typically been sufficient for such a trend to end. The relative strength chart below shows how the MidCap under-performance has also fallen to the lower end of the channel and is in late stages of its downward trend. The Green Bull at the bottom reflects a positive divergence between the indicator that is making new lows even as Nifty is getting close to 12000.

The Midcap index itself is making a concerted effort to break out of the falling channel that it has been for two years. News of financial support to some of the banking stocks and announcements by the RBI today that it would not allow more non-banks to fail all align with this attempt to change the sentiment.

The implications of such a breakout in the Midcap index can be big if we consider the quarterly chart as shown below. The long consolidation phase that we have seen over the last two years would be only a 4th wave in its long progress from the 2009 low. While hard to believe it would imply a 5^th wave to new highs that can point to well above the 25,000 mark on the BSE midcap index if all goes well.

So what has really changed in the narrative that can allow for such a scenario to play out. After being right on the crash in the broad market on the back of the debt cycle identified by the Kondratieff winter theory, the first round of implications of an economic winter appear to have cleared out. The broad market started to look oversold and sentiment appeared to be at its most bearish since 2009. On some grounds like the RBI survey below it still is negative on sentiment.

In light of that no one was willing to bet on a turnaround in financial markets. In my September report the most optimistic scenario was an ending diagonal that would still drive the nifty back to 12,100 to 12,300 before resuming a larger bear market. The projection made below has been completed in the Sensex and Nifty 500 that have touched their respective trendlines. After a 3 wave rally this is an important market juncture where bulls are proven true if the move up continues or the worst lies ahead of us.

The chart below shows what followed, from its most extreme short position FIIs have covered their entire short position and are now marginally long on index futures. They have still not taken the leap of faith to the other side like they have done in the past before the major market tops. This leads me to believe that sentiment has a long way to change from bearish to bullish and then to extreme bullish before we get a final top in the market. Right now we have only gone from extreme bearish to even. You argue that if this is a bear market rally as above then they can start shorting again, but I will not count on it now after a 21 month bear market in Midcaps. So let the data show itself. If the market breaks higher Longs may go back to over 200000 contracts above the red line before the trend changes again.

In the meantime as the recovery took shape looking around it became apparent that the slowdown which is not just a domestic event but a global event was now being dealt with by the entire world by a new strategy which involved not just the central bank but the government itself. Over the last year central banks have already taken a step back from raising interest rates to lowering them and even going right back to quantitative easing. US Europe Japan and Australia have made announcements on the same. Many Asian countries and emerging markets have been cutting rates aggressively including China to stimulate the economy. Over a year back at the height of the slowdown a paper was floated talking about a new policy stance called MMT, or Modern Monetary Theory. Many have described it as a new form of what we already know as deficit financing with the use of fiscal stimulus. In short what was recommended is that government steps in to spend money and manage the rub off effect that may show up in the form of an overheating of the economy or inflation with the use of taxes. In other words with monetary policy failing to work to stimulate growth, and the unwillingness to prick the debt bubble by raising interest rates, the solution appears to be to use tax rates as a new policy tool to manage economic growth and overheating.

This in my mind tells me that the reason behind US cutting taxes aggressively after Trump’s election, and now a similar move by the BJP on being elected are trends in this direction.

I feel further vindicated on the stance after listening to the RBI policy today. I noted in my weekly podcast that many economists and research heads had recently started to talk about some kind of fiscal policy to stimulate growth. After years of talking about fiscal prudence this change in stance is a big step in mind-set because the next time around they will not be downgrading India when fiscal profligacy becomes policy. In fact they will lap it up as good policy in favor of future growth

It comes no surprise to me though I did not expect it, even as I did mention in all of my bearish reports last year that the only way we could stop the Indian economy from unwinding would be through fiscal measures. It is only fair then that a move in this direction should lead to a change in stance for a more bullish outcome for financial markets.

So what did the RBI say today? Here are some quotes from the policy statement,

‘’China decelerated further in Q3, reflecting weak industrial production and declining exports amidst trade tensions with the US. While retail sales edged lower in October, fiscal and monetary stimuli are expected to temper the slowdown.’’

‘’ In the Euro area, GDP growth remained stable in Q3 relative to the previous quarter on improved household consumption and government spending,’’

And while I was writing this news item popped up, Japan went ahead with one of its own

On India – RBI says

‘’it is also possible that the government may initiate counter cyclical measures to arrest the slowdown. The forthcoming union budget will provide further clarity on all these aspects. At this point it is of paramount importance that monetary and fiscal policy continue to work in coordination to achieve the best results in the national endeavor to revive growth’’

“the forward guidance itself indicates that there is space available for further monetary policy action”

On being asked if he was expecting government to announce some measures in Hindi translated -

“it would be wrong to say that the government will do nothing on the policy front going forward, so by converse to that, government will actually announce some measures”

Let me conclude by saying that we have not heard this kind of language coming from the central bank and it implies a big change in policy and narrative. The RBI also noted that inflation would remain muted apart from the short-term spikes all the way into July of next year which provides room for it to continue to cut rates down the line. RBI just wanted to pause on this trajectory to allow for existing cuts to take root, the union budget policy and fiscal measures to be announced, and data to confirm its inflation expectations. In light of that further rate cuts are expected down the line.

In terms of the global macro environment this is what it looks like. A deflationary world leading to lower commodity prices has pushed inflation levels to a low point allowing for lowering of interest rates all over again. The failure of interest rates to work in some parts of the world like Europe and more recently in India, has pushed the world to consider modern monetary theory [MMT] with direct comment intervention to spur growth. While measures in this direction are yet to show up the language among policymakers is becoming clearer that such action is likely pretty soon. Even in the US Donald Trump has not left any opportunity to point at the fed not doing enough on the interest rate front to not just counter growth but to weaken the dollar. What will all this result in?

THE RELFATION TRADE – RISK ON

1. A weak dollar environment reduces pressure on emerging markets with high debt loads, causing their currencies to get strong and allowing them to take pro-inflationary measures.

2. A falling dollar makes commodities and emerging markets attractive destination for investment allocation. Sometimes in this scenario emerging markets may outperform the US.

3. Even though interest rates are down risk on environment involves a shift in asset allocation away from debt towards equity causing bond yields to rise along with rising equity markets.

A week from now the US Fed will meet on interest rate policy and it would be interesting to see to what extent they succumb to Trump’s pressure to accelerate a weak dollar environment. Note I did not say lower rates, because there are many ways that can be taken towards the end objective of a weak dollar.

The existence of global overcapacity has allowed governments and central banks to take on the MMT route. Thus they can continue to pursue this policy as long as it does not cause high rates of inflation. Critics may argue that once the inflation genie is out it may be very hard to control. MMT theory believes that tax may be an effective tool in that environment. However, as investors and traders our interest lies in between. The time between now and the point where we go from overcapacity to excessive demand overheating and inflation may be several months. There lies opportunity

This is the primary reason why I think starting with the US stock markets a year ago, equities have started a recovery process that is now spreading to other parts of the world. In the interim there is a lot of noise around trade wars that impact sentiment more seriously than demand itself. If demand is strong it may simply shift to another place. For example if imports have to be made they can be at lower prices from places other than China. When aluminium tariffs were years for the first time a year ago during a one-month lag to their implementation, importers pre-booked orders creating short-term demand for the products. Raising tariffs thus puts upward pressure on prices that are deflating and adds to the government’s revenue in the form of tax collections. This sideshow has caused many gyrations in the market over the past year or two but the real reason behind the market recovery has been a change in interest rate policy from tightening to loosening and a return to QE, and hopes that fiscal stimulus will come in from various parts of the world economy.

This is a new world

CHARTS THAT MATTER

The Story above must be supported by charts and so now we explore the technical perspective on all the aspects one by one.

in my October long short report called “the reflation trade is on” I considered more bullish alternates in the wave count for nifty and bank nifty if the above developments take shape. So far we seem to be moving in that direction.

From a technical analysis stand point we would like the BSE midcap index and other Midcap indices to break out of the 2 year falling trendline or channel conclusively. Similarly on the nifty 500 index below you would like prices to go beyond the trendline of the last two highs and breakout of what could have looked like a triangle if prices headed down again. We are therefore at a critical juncture where a further advance in financial markets will confirm major long-term breakouts. A breakout would render the pattern below a diamond triangle a rare triangle pattern, and triangles are mostly 4th wave patterns.

After three consecutive bullish months the monthly momentum that was back to 0 for the nifty 500 has still not crossed back to buy mode but will do so if December closes positive. This would mean that the last two years was a 4th wave in most equity indices. We have then started a major fifth wave a final move into bubble territory for equities.

The chart below Sensex valuations that I discussed in the last report shows that Nifty has spent a lot of time near the 27 to 29 range where markets often peaked in the past. Any move higher would mean that large caps are going to extremely overvalued territory that may appear illogical to many market participants. On the other hand what will make these valuations justified will be a low interest rate regime. Equity markets value stocks based on the yield that they can generate and as interest rate expectations go down equity prices get marked up to offer a lower yield on your investment.

So while PE metrics can make a market look expensive when considered relative to yields they can appear cheap as shown on the chart below comparing Dividend yields to Bond yields for US stocks. Conversely rising bond yields can make a market look expensive and that is the only risk to such modelling.

This is what has kept US stocks elevated at all time high valuations for more than a decade. India seems to be going down that path as interest rates are being taken down to levels that we have not seen in decades. Transmission maybe an issue today but policy makers have not backed off. In light of these events the alternate wave counts that support a bullish outlook are as below for Nifty.

Another way we can count it is shown below. It would be to try to alight the Midcap index wave count considered at the start. 2010-2013 is not corrective but an impulse wave. I have for long maintained that it was a corrective period with non impulsive wave counts. But when you have many subdivisions it is possible to fit in an alternate so will leave this on the table as the next alternate. IN this case A channel to the highs goes very far to 20000. A trendline of the highs goes to 13800 which may feel more realistic at this moment.

Last month I also looked at the BSE Allcap Index On an arithmetic scale because it was possible to draw a perfect channel from the 2013 bottom with all touch points.

If a similar approach is taken with the nifty then as shown below wave 3 is slightly larger than wave 1, and if the fifth wave achieves equality when we go to 14,500.

GLOBAL MACRO

For all these crazy numbers to be achieved I believe the core thesis of the Reflation trade has to play out. So let me go over the macro factors that have to fall into place for this to happen. To start with let us not overlook that the Fed is not waiting for another crisis to resume its balance sheet expansion. By whatever name you might call it the expansion has already begun as seen in the following chart.

Donald Trump is not off the mark, asking for a weaker dollar in the face of expanding the currency supply in whatever form they may do so. He of course wants the fed to also lower rates at a much faster pace to get the dollar down. The dollar remember is the central force in today's world till the point where everyone gives up on it. It is still the main financing currency and therefore its direction determines which way all this excessive liquidity is flowing. When the dollar was in a bull market for the nine years starting 2008- 2017 US stock markets outperformed the rest of the world. In the interim countries that had larger dollar borrowings got into trouble, whether emerging or otherwise. This trend is very similar to what we saw in the late 1990s Greenspan era. Between 1998 to 2001 we saw the tech bubble reached its peak and then pop. The dollar index started It's bear market only after 2001. This time nobody is waiting for the existing bubble to pop for a change in monetary stance. So there are differences in the timing of how events are played out in the recent dollar bull market versus the last one. The pink circle shows the point where an EM dollar crisis occurred. The last time a second dollar wave popped the tech bubble. This time we are already in a dollar bear market.

Based on the long term cycles as discussed that a seven year bear market started from 2017. This is a seasonal pattern that is followed and repeated over and over again during the last few decades. Based on this 2017 to 2024 should be a dollar bear market.

On the Elliott wave setup we are now ending wave 2 up and starting wave three down. Wave to has retraced 70.7% of a one in a time extended pull back. Wave three could not only be equal to the first and go to 84 but even become an extended wave as is usually the case, then we end up at 76.

As the dollar falls it fuels interest in non dollar assets including real assets like commodities and Emerging market stocks. The CRB index of commodities that are highly weighed down by oil prices has Consolidated in a long triangle formation and Has broken out of the pattern to start a 3rd wave higher. I have marked the low as wave B because of the triangle formation however given the long-term decline in the dollar I will not rule out that it becomes  a 5 wave advance at a later stage. It still has upside and we have time to figure it out. In light of this metals are in the process of forming a bottom with lots of inter market divergences. Agro-commodities are also picking up pace. Slowly unnoticed we have momentum building up in many. This could then become a broad based rally in commodities. Yes I anticipated that in 2017 as well when only the metals did very well. But it is about time we get a broad based move during the third wave down for the dollar. 

 Just take a sneak peak at what this can mean for Oil or crude. For Long I have maintained that we will go to the top line of the highs now near 78$ at some point. But earlier I thought we would come down from there. Alternately a parallel channel allows us to go as far as 100$. Given the lows are inside the 66% retracement the case for a major move higher is something that you should not rule out. Oil is forming a strong base near 53$ and can take off anytime. What most people might find harder to appreciate is how the fundamental support this perspective. While oil prices have been suppressed you do a long drawn oversupply issue, it should be understood that the shale oil boom is based on a technology that has a drop-off effect in terms of its long-term production. The drop-off effect at some time in the future will lead to an oil shortage especially if demand picks up. The only long-term argument against demand is the introduction of electric vehicles a global scale. While this is a developing trend it is not yet being enforced by law which means that electric vehicles are an alternate will only become attractive after oil prices go up too much. It is at this crossroads that an opportunity for an oil spike actually exists. Till that point of time OPEC members will continue to negotiate output cuts to keep prices from falling too much. In short unless we break the $ 50 mark for oil we should be prepared to look at both 78 and 100 in the year or two ahead.

Is there is bearish for equities? For the nth time I will publish the same chart showing how long term relationship between oil and equities is played out. They have always remained highly correlated in the long term. Of course we have had oil shocks but those are temporary. Most price advances that occur over periods of time are driven by factors that are generally bullish for the underlying economy and stocks in general. Here is a link to charts I published on this ''Crude On The Edge''

Similarly after several gyrations copper prices have formed what looks like a triangle. And when triangles breakout on the upside in commodities you get explosive moves. Again this might come partly from the liquidity and asset allocation game of investing but fundamentally the long term case will build from the exponential demand that the move toward electric vehicles will create over time. I am highlighting these facts because they match what the charts are showing. The deflationary forces that were active in the commodities markets are abating, and a regime change is quietly taking place. Prices are losing downward momentum in building a base to move higher. The question then is only of size and magnitude.

The ADR Index has been edging higher pushing the weekly and monthly momentum back in to buy mode. This brings us to the second implication of a falling dollar. Rising prices and emerging markets. Remarking the entire structure since 2009 we may for now consider that this triangle structure is a long consolidation and some kind of upward move has started. The first level to question this would be the trendline of the highs of the pattern which is still much higher near 174. The Bank of New York ADR index is at 144. With new all time highs in Australia Canada Switzerland Taiwan this index does not fully reflect what is happening in some parts of the world. So till we hold the lows I am marking an impulsive move up as 1-2-3 and the 3rd wave just started.

To see what is happening you can simply look at the BRIC charts. Of them Brazil has been the leading indicator of a turnaround since the dollar started falling in 2017. The Bovespa has been in vertical bull market. Brazil broke out of a falling channel after six years in 2016. Since then it has been a non-stop move to new highs.

Russia completed a triangle formation and broke out of it in 2016 but did not move that far. Recently it has gone past the trendline of the highs since 2008 and can be said to be in a 3rd wave advance that will eventually end up at all time highs.

China has been the elephant in the room because each rally has been followed by a crash but not to new lows.The trendline of the lows from 1996 has held on the supports and we are trading very close to it. Despite some of the worst news in terms of slowdown of economic growth Shanghai composite did not break the 2018 bottom. This is classic Elliott wave psychology, when a market makes a higher bottom on news that is worse than it faced at the bottom itself. This is typical of a wave two low which we are seeing develop as of now. China has been the worst performing countries from the BRIC pack, However it should be due to pick up anytime now.

India tends to follow the US more closely and in that sense it did better than most others in the interim period between 2010 to 2018. The nifty managed to hold up in the midst of an economic winter and is now being aided by government support. A clear attempt to change sentiment and drive animal spirits can be seen in statements like the one made in the papers today below. This does not mean a debt cycle has ended but it may be put on a back-burner till the problem gets bigger. Nifty is very close to all-time highs and if all the above shows liquidity flowing into emerging markets then we will not be left behind unless domestic events go out of hand. Yes growth has slowed but fiscal policy this year in the form of tax cuts and more in the next budget as RBI anticipates can propel us back upward to some degree.

This creates a perfect storm for a Risk On trading environment which is best reflected in the chart below. The terminology 'Risk On' means when asset allocators gain a preference toward equities relative to bonds. This is reflected by falling bond prices and rising equity prices in an inverse correlation. The blue lines shows what is expected going forward between the Dow and US bonds.

The 30 year US bond yields in the near term completed a triangle formation at the bottom and bond yields are set to explode higher from here. As equities and commodities rise we will get some inflation back on the table, and higher rates will then appear justified. The 30 year bond yield is set to eventually go back to 3.4% and higher, from where it fell a year back. Will that cause a crisis? At some point yes but even a year back it did not till it did. so this trade off is one between growth and inflation. The stimulative actions of governments will get some growth back and some inflation. At that point we may afford higher rates. But not beyond a point. the exact inflection point cannot be known in advance but it does exist given that debt levels are the highest in the history of financial market data.

This next chart throws more light on these trends. Note how during every round of QE in the past bond yields go up. This chart from social media posts is pretty clear. And it makes sense. QE means money printing to buy bonds and debt. That money goes into asset inflation and some growth in the economy. So while bonds are being bought, investors become risk takers, or risk on, and buy equities while selling debt or bonds. So bond yields go up due to the bond selling even during QE, or should I say because of QE. So here we are with the FED expanding its balance sheet at a record pace and stocks are near all time highs and rising. Bonds are set to then fall as risk averse investors change sides. Yields will go up and it will not bother anyone till it does and that could be months away.

What will then be the impact on interest rates in India. On the one hand the RBI is an accommodative mode, on the other it has paused to watch future data points putting the onus of further growth partly on the government. This is not unusual as the world is moving towards coordinated action between central banks and governments. However if government spending has to step up for growth, it also means that governments need to borrow more and can drive up interest rates. This is probably why after the rate decision this week bond yields actually bumped up. When you look at the chart you will see that bond yields were actually at the bottom end of their 16 year range, developing a triangle pattern. We can argue whether this is a bullish or bearish triangle. Even if it is bearish triangle, Elliott wave wise we need to move up to the top end near 8.75% before heading lower again. A bullish triangle would be wave B of a corrective pattern and wave C could then head to levels closer to 11%.Either of these cases would occur over the next few years. In short if there is a clear shift away from lowering rates to higher government spending then we may be at the bottom as far as bond yields are concerned. Again the demand creation would likely afford slightly higher rates than where we are today. We may not yet be at the inflection point where rates become an issue and that point may be months away. I will stick with this wave count the recent low is break. If that happens then it might mean that the government has put the onus back on the central bank to stimulate by lowering rates.

Bond yield discussions also often end up With a discussion on the inverted yield curve, especially in light of the US stock market. You may often heard that such an inversion occurs 3 to 6 months prior to the recession. More recently many of also admitted that it is not the inversion but in actual trend reversal after an inversion that is associated with recessions. The reason behind the inversion however is always rising interest rates on the back of a strong economy. The risk on environment pushes short-term years up at a faster rate than long-term yields causing the version. There is no particular level though from where an inversion should reverse. As you can see on this chart in the year 2000 the inversion became far steeper before the trend changed. This is important. So while we may have been through one round of inversion there is nothing to rule out at another Round of steepening Can't happen in the future. In fact it is the more likely trend given the setups that I have discussed above. The new round of expansionary policy may lead to higher rates and a steeper inversion before the next recession. These are extremely long term charts and take their own time to play out.

Mega Trends

My long term view on gold has not changed. It bottomed out in late 2015 just as the dollar was about to top. We have started a long term third wave bull market from there. After forming a triangular structure the 1st wave completed at the recent high and we might be pulling back in wave 'II' even as the dollar is falling. This near-term weakness has more to do with an unwinding of the excessive long positions built up in the futures market and reflected in the commitment of traders report. Once there mining is complete we should start wave 'III' up to new highs. At larger degree a 3rd wave implies 3=1 going up to $ 8000 over the next several years. 

USDINR has been in a bull market since 2008. In 2018 started wave five of that move and broke out of the trading range above 69. While it is possible to say that the fifth wave ended truncated, it is too early to say so. The reason being that the fifth wave is very small and the recent pullback has corrective structures that do not indicate a very steep decline. Also consider that stimulative measures for the economy would involve currency devaluations of some kind hidden or otherwise. Technically a 61.8% retracement lies at 67.34 other worst-case scenario. The monthly averages near 68.10 and rising are a strong support zone. On the weekly charts 70 is itself is about. My sense is that we are in wave 2 of 5. The larger uptrend in USDINR will resume as and when there are corrective periods in equity markets, and thus on a long-term basis both might appear to be going up together. Right now USDINR may continue to consolidate in wave 2 before wave 3 starts.

In the October report I discussed that we metals index is a triangle ending at the recent lows. However I started covering metals under value wave investments in 2016 when the dollar top. In line with that it is also possible that the triangle pattern completed at that point of time. This is particularly true as far as stocks are concerned. Most metal stocks rallied impulsively in wave one long term, and were in wave two correction to September 2019. We have then started wave 3 higher. A 3rd wave can often be extended and I would think that is the more likely scenario year in which case 161.8% of wave one would go all the way to 30,000 for the BSE metals index. In that sense this would be among the best performing sectors for the coming months or years.

Lastly the gold bugs index [symbol-HUI] that reflects gold mining stocks should be of interest in light of the gold and silver bull market. This index is also pulling back in wave two down which once complete should see us go into a 3rd wave advance. It would be wave 3 of 3. There are many ways to participate in gold as discussed in previous reports. Remember December is a seasonal bottom in gold however we are still seeing weakness near term. The seasonality is not exacting but a general guideline which means that panic sell-off whether it ends this month or in the January might be a final decline for the precious metals. Among the options I have discussed are the government's gold bonds that are tax free if held for 7 years. Also PAYTM-Gold, That allows you to hold a physical gold in the government's MMTC Vaults. For playing gold mining stocks which are mostly listed in the US and other parts of the world gold fund like the DSP world gold fund, or Kotak Gold fund are interesting. More recently though I found that you can directly by gold mining stocks in the US with international brokers like Interactive Brokers that have opened office in India. I will try to work on wave counts for a list of them, have been looking at charts of the following symbols, PAAS, AG, SSRM, GOLD, AU, GOLD. I have written gold twice because one symbol is of Barrick Gold and the other of Gold Mining Inc. The reason to get interested gold and silver mining stocks Is that they tend to move at up to 3 times the base of the underlying precious metal. This means both greater risk and greater reward is proven right. These companies are either listed on the NASDAQ or the Canadian TSXV exchange.

CONCLUSIONS

Having achieved the September forecast I spent a lot more time explaining the risk on narrative that I took on in the October Long Short Report. The global macro environment is set up for a bullish trade in favor of commodities and emerging markets on the back of a falling dollar. Governments including ours are moving towards the use of fiscal policy to stimulate growth that can cause currency devaluations at the same time create optimism and push up asset prices. These factors play out with a lag and therefore markets will move ahead of actual news and events. The sentiment continues to be poor in financial markets and not at the extremes that you see at market tops. In valuation terms based on P/E ratios you may say that we are entering a hyper bubble. But simultaneously in the broad market there are stocks that are at the bottom end of valuations. We are starting a 5th wave long term a final move to new highs that will end at levels that will make no sense logically. We are at the start of a hyper bubble that will eventually be picked only by overheating of the economy where interest rates overshoot and prick the bubble. The opportunity in the meantime is on the long side of various asset markets for months to come.

For Nifty if the lows of 11800 hold the immediate implications are to head toward 13000 by the budget, as shown in the last chart below. This is my preferred scenario for now.