If China starts to sell a small portion of its holdings of US bonds and bills, US interest rates could go even higher. China has a very significant ‘ace in the hole’ and no one wants the country to play it. The only way China will play their ace is if they suddenly stop feeling they are richer than they think.
Bank of Nova Scotia says it best: “You’re richer than you think.” What does it mean to ‘think’ you’re rich? In our never-ending quest to buy-low-and-sell-high, we recognize that optimism accompanies stock market tops, and that ‘thinking you’re rich’ is a form of financial optimism. How would we measure it? How do we measure how rich we feel?
Economists label that feeling ‘the wealth effect’. The wealth effect is the widespread belief that we are richer than we actually are. In other words, Scotiabank is wrong. And what makes us feel so rich? Our homes are worth more than we thought and our investments are all up. And what do we do when we feel rich? We spend more money than when we felt poor. We take more financial risk than when we thought we were poor.
In developing judgment about the stock market, it is important for us to objectively observe optimism in others while we remain detached. It is important for us to take less financial risk when everyone else feels richer, and take more financial risk when others are fearful.
Next time you drive through the streets of your home town, check out the cars. Are there more new luxury cars now than a year or two ago? What is the percentage of shiny new cars to rusty old clunkers? Is the wealth effect manifesting in the streets of your neighbourhood?
Check new car sales growth for 2018: the fastest sales growth was achieved by the Toyota Prius. (This is ‘environmental effect’, not wealth effect.) Second prize goes to the Porsche 911. Definitely wealth effect! “I feel rich; I will buy a new Porsche.” Check it out next time you go for a drive: Is the wealth effect evident in your own neighbourhood? How about your own drive-way?
The wealth of markets
Let us review the financial markets: just how wealthy are we?
The US stock market has calmed down again. After the wild volatility of February and March, June’s sluggish action is boring and is lulling investors back to complacency. Mr. Trump has given us enough economic news to slam-dunk this sleepy market. People know that trade wars have begun, but the market is not going down. American investors don’t believe the news. They’re not worried. Somehow, they feel safe. Don’t get caught off guard! The long-term uptrend of the S&P500 ended five months ago in January of this year and the first down tick of the new long-term down trend was violent. When the next leg of the downtrend begins, it could be just as violent as the one in February.
The TSX Composite Index made a marginal new high in June and is lulling Canadian investors into complacency. Don’t be fooled.
At the 2007-8 stock market top, investors knew about US mortgage problems, but didn’t react. Finally, the events of the day overwhelmed them and the downtrend began in earnest. Today we have the same situation regarding global trade wars: we know it’s happening, but most are not yet taking defensive action. (Defensive action means selling your stocks or equity mutual funds.)
On the cusp of a downtrend
In summary, both the US and Canadian stock markets are in the early stage of long-term downtrends.
Long-term interest rates (measured by the yield of long-term treasury bonds) are in long-term up trends in both Canada and the United States. The upturn began approximately 2 years ago and has been confirmed by rising short-term interest rates in both countries.
The US dollar, measured against the basket of non-US currencies, is in a downtrend that began in December 2016. Notice the stability of currencies as this global trade war begins. The US dollar has risen modestly since April, at the very time the Americans fired the opening salvos in the Battle of the Embargoes. Apparently, currency traders/investors collectively believe embargoes and counter-embargoes are moderately good for the US dollar. This is a good lesson in market psychology: negative or surprising news doesn’t necessarily make the markets move. Later in the cycle, news of yet another trade tariff will send currency markets into a tizzy. At this stage, the ‘complacency’ stage, bad news is mostly ignored.
The Canadian Dollar vs. US Dollar is in a long term up trend and is just ending a short-term decline within that up trend.
Gold is an interesting economic situation. In trade wars and currency crises, gold usually rises because people see it a safe haven. But not this time. Even though a global trade war has begun, the price of gold vs. US dollar continues to drift lower. Gold’s up trend started in December of 2015 with a sharp rise to August 2016. Since then, gold has moved sideways in a series of zigzags, each zig being smaller than the last. This chart pattern is called a triangle and illustrates constantly decreasing volatility.
Investors are gradually losing interest in the precious metals. Classically, the way a triangle resolves is by ‘breaking out’ of the pattern in one direction or the other. When emotion (i.e. volatility) returns to the markets, if gold moved decisively UP, the long-term uptrend will be confirmed. If it breaks decisively DOWN, a long-term down trend will be in effect. Stay tuned.
Theoretical note: Market forecasters analyze this situation and try to predict the direction in which the breakout will occur. Trend followers (like me) wait for the breakout. Right now, many forecasters are predicting gold will go up because of the trade wars. Forecasters and traders who think like this are ‘bullish’. Market psychologists observe their news-based opinion and call it ‘optimism’. They maintain that gold will continue its short-term decline until that bullishness changes to bearishness. This illustrates how the cross currents of the markets interact. One group has a perfectly logical opinion—a second group has another perfectly logical opposing scenario. And a third group, the trend followers, waits to see how the situation resolves.
Energy prices. Oil has been in a long term up trend since Feb 2016, but natural gas has been in a down trend since June 2014. We expect both of these long-term price trends to continue.
Strategy. Buying and holding stocks or equity mutual funds for the long term is not a wise investment strategy at this time. It is time to reduce our exposure to risk. Remember what American advisor Richard Russell once said: “In a bear market, whoever sells first wins.”
Because interest rates are rising, invest in short-term bonds or GICs, not long term. But, if you still have a mortgage, abandon floating rate or short-term mortgages and choose the 5-year fixed rate mortgage.
Because the US Dollar is going down vs ‘the basket’ and the Loonie is going up vs. US Dollar, there is no clear currency advantage to participate in foreign investments.
Because gold is drifting sideways, we would not change our current precious metals investments until gold breaks out of the pattern mentioned earlier.
Energy stocks are a mixed bag: but the overall trend of the stock market is down. Resource stocks are for short-term traders only.
The wealth effect causes ordinary investors to take inappropriate action at exactly the wrong time in the economic cycle. But the most dramatic inappropriate action is at the international level. Mr. Trump, with his ‘bar-room brawler’ style of negotiating, is acting as if prosperity is a ‘given’. He assumes that America is prosperous and that he is negotiating from a position of strength.
But in his negotiations with China, he has forgotten one important fact: the Chinese are the world’s largest investors in US T-bills. America has been running a deficit for decades, and China is the main buyer of American debt. If China reacts to Mr. Trump’s tariffs and embargoes by slowing down their endless purchases of US debt, America might have to raise short-term interest rates to get their debt financed. And, if China stops buying US paper, interest rates could go significantly higher. And if China starts to sell a small portion of its holdings of US bonds and bills, American interest rates could go even higher. China has a very significant ‘ace in the hole’ and no one wants the country to play it. The only way China will play their ace is if they suddenly stop feeling they are richer than they think.
This is an edited version of an article that was originally published for subscribers in the July 2018/First Report of The MoneyLetter . You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter. 
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