Correction continues….could this lead to a 2007-09 collapse?  Here are a few more indicators that should concern us…..

Our analysis clearly shows that the risk of a severe correction could begin the second half 2014 or in 2015.  We have provided a number of clear overviews as to why the world macro situation poses major problems.  You can add to it that many cycles roll over now and into 2015.  Fundamentals are slowly eroding and have primarily held up due to share buybacks, multiple expansion and cost cutting.  We have been looking for more organic growth and are not seeing it.  This is disconcerting for expensive markets.  The risks are high and we have said that the final and primary trigger will be technicals.  Well they are starting to fall in place from a bearish perspective.  Precious metals continue to weaken and should continue.   The Euro is weak, with a short term bounce expected but downtrend should continue.  The more aggressive market, the Russell 2000 has broken through key support levels and moving averages with the death cross occurring.  Back in 2007 we saw a divergence as the Russell started to break down prior to the more senior indexes, just like today…….

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Lets have a look at two key charts that reflect how dangerous the situation could become based on history and today’s reality….

First, here is a chart that reflects the similarity of the period we are in today versus the last major economic and stock market collapse of the Great Depression.  There are two major components in the chart that are disconcerting:

1.  the velocity of money has collapsed to the lowest level ever.  It currently is a 4.36, a collapse from pre-financial crisis levels.  The last time it was this low was in 1940 when the level was 5.91.  At this time the markets ended a rally and saw a further 41% correction on the DJIA.  The velocity of money is the number of times one dollar is spent to buy goods and services per unit of time.  As of today, money is not turning over…it is dieing.  An economy needs the frequency of money to increase to see GDP growth.  The only reason we have not seen a collapse is the other side of the coin, the increase in the monetary based driven by the Federal Reserve, other world central banks and world governments.

2.  The second line of the chart is just that, the monetary base as a percentage of nominal GDP.  Once again, it has set a record at 22.92%.  The previous high was also in 1940 as velocity collapsed back then.  The level then was 16.92%.  This reflects how dramatic the increase in monetary base is……so much money has entered the banks and economy but the money is not flowing through the economy.  This is a dangerous phenomenon.  There are two major risks include the risk of hyper inflation as if velocity picks up combined with such a high monetary base, hyper inflation is a real possibility, but not our first choice.  We believe that deflation will take hold as monetary base will have to shrink and if velocity does not pick up, the risks of deflation are real.  Given the monetary base is at such a lofty all time high level, we cannot look for much more growth, with the reality of contraction in the monetary base probable.  Velocity will not pick up if banks, businesses and individuals do not become more confident.  Some sentiment indicatiors show that confidence has not increased but it has not been translated into improved velocity of money.  Instead it continues to collapse year after year since the financial crash of 2008.   Both indicators pose huge risks to the US economy and stock market as well as the rest of the world.

 

The second chart here reflects that many investors are at significant risk without even knowing it.  The amount of low quality debt that has been issued over recent years is at record levels.  Investors have been buying into high yield funds like crazy in search for yield. The problem is that many are not aware of the risk that such investments pose.  We have seen the spread of high yield bonds to US treasuries go from a record low of 3.4% to 4.4%.  This may not sound significant but the move is probably the beginning of a much bigger increase in the spread.  Remember as the spread increases, this means that the increase in high yield corporate bonds is going up and therefore their prices decreasing.  A realistic target short term could be the peak seen in late 2011 at 9%.  That is more than double the current spread and would lead to significant capital losses on lower quality corporate bonds…..and many high yield bond funds.

Here is a shorter term perspective on velocity of money and how it has totally collapsed since 2007 and for that matter since 2000.  One of the reasons that is rarely discussed is demographics. Aging baby boomers who drove velocity of money up to 2000 are now doing the opposite..they are saving and paying down debt, forcing velocity to collapse.  Beyond that, the younger generation are not getting jobs out of university/college and if they are, many of the jobs are low paying positions. They are needed to help velocity of money pick up, but the structural failures we are seeing are not allowing it.

If we get back to levels seen in the last fiscal collapse in 2008-09 of over 20%, the loss of capital of numerous corporate bonds of lower quality. This will create capital losses on many bonds of more than 50% with many defaults anticipated. Of course this will only occur with another banking or fiscal collapse but reality given all the risks in the world today, we cannot ignore this possibility.  Investing is about probabilities and as time passes and things do not improve like the Federal Reserve and US and world governments expected, the risks increase.

B of A Merrill Lynch US High Yield Master II Option Adjusted Spread

Do these indicators guarantee a market and economic collapse….of course not.  But this is just more evidence that we have to be on our toes and allow technicals to dictate our next moves as risks continue to increase.  Right now the technicals are neutral to negative.  Once they become outright negative, it will be very prudent to get out of harms way and protect your capital.  Many tools we track reflect his possibility, which we use as a backdrop, but until the market does break through key levels of resistance, we will not panic.  Smart investing is disciplined and non-emotional.  Do not get caught up on positive hype as that can kill net worth.

One last interesting chart to look at is the total private and public debt as a percentage of GDP (numbers are similar in Canada and much of the developed world).  As you can see, total debt has exploded up, especially since 1980 when the ratio was around 170%.  Now the ratio is more than double that level at about 350% and rising in many areas again.   What you saw during the Great Depression was a cleansing of debt which led to the next great growth phase of 1945 to 2000.  Clearly, we live in very overleveraged times, which is dangerous and at some stage will have to be clawed back.  Can one only imagine what will happend to the eocnomy if debt as a percentage of GDP even fell to  230%, the level in 1990 or the average for the period of 182%….it would be a deflationary depression.  You can add onto this debt the monstrous unfunded liabilities of many governments (US is believed to be over $100 trillion) and the reality is the world is broke.

These are more warning signals that should not be ignored. Markets are correcting and slicing through major support levels and moving averages.  As of yet, they have not crashed through our long term investor signal, but intermediate and short-term investors should be out…….