"Ding, Ding"... Last Lap - Natural Law, China and The Dollar by Paul Mylchreest

Equity & Cross Asset Strategy 24th May 2017
Paul Mylchreest Email: paul.mylchreest@admisi.com Tel: +44 20 7716 8257
Equities: Ding Ding...Last Lap

Natural Law, China and the Dollar
We suspect that every strategist and active fund manager has bet against this mega equity bull
market at some point during the last eight years. Buy and hold/buy the dip have triumphed. In
contrast, directional changes in many so-called fundamentals, e.g. credit spreads, inflation/
deflation, Fed policy and earnings, have often had limited predictive power.
We could have delved even deeper into fundamental analysis, but questioned whether that
would add much value for active portfolio managers. Many are questioning the value of
sellside research, and often their own convictions, in very tough industry conditions.
Theres a case for the buyside and sellside to find different analytical approaches at this point.
With that mindset, we analysed repeating patterns of peak-to-peak and trough-to-trough
cycles in the Dow Jones index. The interference of many individual cycles creates a complex
waveform in aggregate.
The analysis (for what its worth) suggested two things. Firstly, US equity prices have surpris-
ingly behaved almost perfectly in terms of the trend since 2009, although we suspect that cen-
tral bank policies significantly exaggerated price movements to the upside. Secondly, the next
cyclical peak for US equities could occur in the final week of November 2017 (+/- one month).
1
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Company. Risk Warning: Investments in Equities, CFDs, Futures, Options, Derivatives and Foreign Exchange can fluctuate in val ue, investors should therefore be aware that they may not realise the initial amount invested, and indeed may incur additional li abilities. These Investments may entail above average financial risk of
loss, and investors should therefore carefully consider whether their financial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United
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Equity & Cross Asset Strategy
So what, you might say, and wed sympathise, as theres nothing to be gained from guessing
the end of bull markets. Nobody, including the strategist, would give them much more than a
minimal chance of accuracy. What we found interesting, however, was corroborative evi-
dence from two sources (with strong track records in cyclical timing) that Autumn/Winter
2017 should be a pivotal for global financial markets. And we mean that in the challenging
sense
The first source is the Economic Confidence Model (ECM), developed by Martin Armstrong,
which correctly predicted, amongst other events, the emergence of the sub-prime crisis in
early 2007, the LTCM/Russian debt crisis in 1998, the bursting of Japans credit bubble in
1989 and the Great Crash of 1929.
The most recent major peak in the ECM was 1 October 2015 and we speculate that China
might be central to the underlying downtrend in this ECM cycle. The PBoC shocked financial
markets when it devalued the RMB several weeks earlier in August 2015.
A key node in the ECM is 24 November 2017, which marks an intermediate peak in the ECM
down cycle. Going back in time from this date at 30.1 year intervals gives us.
October 1987 - we all know what happened that month. The ECM was in an up cycle and
we saw global capital move out of equity markets into Japan, leading to the last lap in
Japans speculative equity and real estate bubble.
September 1957 the ECM was in a down cycle. This date coincided closely with a Fed
policy mistake when it raised rates to cool inflation in a slowing economy. Spreading out
from the US, it led to the first significant global downturn after World War II.
July 1927 the ECM was in an up cycle. This date coincided with the secret central bank-
ers meeting in New York, after which the Fed cut rates and sparked the acceleration of
the speculative bubble which culminated in 1929.
Sothe lesson from the ECM is that on, or around, 24 November 2017, we should see a sig-
nificant move in markets, or a policy change, which will be part of an even bigger financial
adjustment. With the ECM in a down cycle, the risk is obviously skewed in that direction.
The second source is the work of legendary Wall Street trader, W.D. Gann. There is little
doubt that Gann developed a phenomenally successful system based on cycles in financial
markets. Ganns work has a cult following amongst scores of traders, many determined to
decipher The Tunnel Thru The Air, the book in which he cryptically laid out his system.
2
ADM Investor Services International Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered office: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland
Company. Risk Warning: Investments in Equities, CFDs, Futures, Options, Derivatives and Foreign Exchange can fluctuate in value, investors should therefore be aware that they may not realise the initial amount invested, and indeed may incur additional liabilities. These Investments may entail above average financial
risk of loss, and investors should therefore carefully consider whether their financial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints
either in the United Kingdom or elsewhere. 2014 ADM Investor Services International Limited 2014.
Gann publicly highlighted several of long-term cycles he used including 60 years, 30 years, 20
years and 10 years. Briefly, if we take 2017 and go back 60 years, we get 1957. If we go back
30 years, we get 1987, another 30 years we get 1957 and another 30 years we get 1927. All
three were pivotal years in the ECM as described above. If we go back 20 years, we get 1997
and the beginning of the emerging market debt crisis. If we go back 10 years, it takes us to
the beginning of the Great Financial Crisis of 2007-08.
Having done this analysis, you should see why we have a sense that theres some kind of
high risk convergence coming in Autumn/Winter 2017.
Its nigh on impossible to trace out the likely key events in the last lap in this bull market. Our
best guess is that more leverage (e.g. margin debt) provides propellant, there is a renewed
shift into dollar assets as Chinas credit bubble begins to burst and expectations of tighter
Fed policy reverse as growth slows.
***************************
I wanna free fall out into nothin
Financial markets are inherently cyclical and in the final stages of a bull market, the consensus
neglects this fact, choosing to believe an upbeat narrative varying with each bull market cycle.
The Dow Jones is at heady levels and it says something when the crash of 1929, the horren-
dous bear market of 1974 and the crash of 1987 are almost invisible on the long-term chart.
Source: Bloomberg
3
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gen (bailout bottle) in freefall.
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Almost everybody has tried to call the end of the current 8-year bull market on at least once
occasion. Having heard this comment from two sources recently
It could just go on and on
we thought that wed analyse the potential circumstances and timing of what some of our
recent analysis (see below) suggests might be the last lap in this mega-bull market.
In 1999-2000, it was going to go on and on because conventional valuation metrics were irrele-
vant and we were entering a new paradigm. In 2007-08, the sub-prime problem was contained
and hardly anybody was worried about repo or Eurodollar liquidity in the banking system.
This time the narrative has become the importance of buying every dip because if anything bad
starts happening, Yellen, Draghi, Kuroda et al, have our backs.
Experience suggests that it works until it doesnt work and the only thing that matters now is
the one thing that is almost impossible to predict, timing.
Theres nothing to be gained for strategists in guessing when a bull market is going to end. Nei-
ther is there much to lose, since nobody (including the strategists) will assign any more than a
minimal chance of being correct. Still, its better to have a view.
During the last eight years, directional changes in several so-called fundamentals (see below)
havent been good predictors of equity performance, as many active managers and strategists
can testify.
For a change, rather than delving even deeper into fundamentals, we decided it was time to
look for answers elsewhere. We analysed repeating patterns of peak-to-peak and trough-to-
trough cycles in equity prices, from just over three months to more than 20 years.
A cycle in one asset price equities in this case is the result of the interference of many cy-
cles of varying frequencies and magnitudes. These individual cycles create a complex wave-
form in aggregate as shown in the chart below. It suggests (for what its worth) that the next
cyclical peak in equities could occur in the fourth week of November 2017 (+/- one month).
4
Source: ADM ISI, Bloomberg
The correlation is not perfect, but not too shabby either, and the trend is generally in line with
the Dow Jones chart below.
Source: Bloomberg
Of course, the cycle predicted by our analysis could invert at some point, which happens
about 10-15% of the time. Periodic inversions in specific variables are necessary from time to
time to keep the bigger picture in harmony.
5
In the case of equities, this would probably require an almost seamless transition to much high-
er rates of inflation, e.g. due to major conflict or the devaluation of key global currencies
(notably the dollar). While we believe that the end game is high inflation and a new Bretton
Woods (including the remonetisation of gold as part of an enhanced SDR), we are not ex-
pecting the transition to be smooth, or to take place in the next few months.
Central banking convention (omerta) demands that bubbles are never seen ahead of time. It
doesnt matter how many times low interest rates and excessive credit creation cause booms
and bustsand weve gone to town in this cycle with ZIRP/NIRP/QE. Credit where credit is due
(intended) and a global economy carrying US$215 trillion of brought forward consumption
(a.k.a. debt) is impressiveeven for them.
Shes a good girl, loves her mama
Theres no doubt that financial markets have been temporarily re-engineered by the interven-
tion of central bankers. Unless theyve been permanently re-engineered - which we doubt -
markets oscillate around a trend. The current divergence is stretched and may stretch further
before the inevitable snap back.
The legendary trader, W.D. Gann (1878-1955), was famous for his assertion that he could plot a
tunnel thru the air for prices in financial markets. There is little doubt that he created a phe-
nomenally successful trading system based on cycles in financial markets. He was monitored,
for example, making 264 profitable trades out of a total of 286 trades during 25 business days.
Gann is a cult figure for scores of traders who try to emulate his system, often spending years
trying to decipher his book, The Tunnel Thru The Air, in which he cryptically outlined the sys-
tem.
6
In a course on Forecasting by Time Cycles Gann noted.

"Time is the most important factor in determining market movements and by studying the past
records of the averages or individual stocks you will be able to prove for yourself that history
does repeat and that by knowing the past you can tell the future. There is a definite relation be-
tween time and price. Now, by a study of the time periods and time cycles you will learn why
tops and bottoms are found at certain timesThe most money is made when fast moves and
extreme fluctuations occur at the end of major cycles."
Another investing legend, Benjamin Graham (1894-1976), wrote in his book The Intelligent In-
vestor about the inherent cyclicality of markets.
The market is a pendulum that forever swings between unsustainable optimism and unjustified
pessimism.
W.D. Gann again
"Every movement in the market is the result of a natural law and of a Cause which exists long
before the Effect takes place and can be determined years in advance.
Our conclusion is that, since 2009, US equity prices have behaved almost perfectly, in terms
of the trend anyway, with what Gann would have termed natural law.
We were surprised.
Central bankers have pulled off a partial takeover of financial markets. However, it seems cen-
tral bankers policies have conspired to increase the magnitude of price changes within the pre-
vailing trend.
7
All the bad boys are standing in the shadows
Commentators of all types like to attach narratives to explain market moves. In contrast,
stock market oscillations might be better explained by cyclical timing, rather than changes in
one or more of the so-called fundamentals.
Besides the near meltdown of the Euro system in 2011-12, a few examples spring to mind in
the current bull market.
Valuation
On several valuation measures, US equities have looked expensive for 2-3 years, e.g. Shillers
CAPE, Tobins Q, Price/Book, without terminating the current bull market. The price-to-sales
ratio has concerned us most, as its the least subjective and/or prone to manipulation. Here is
the path weve trodden from chart legend, Ed Yardeni.
Source: Ed Yardeni
8
Unfortunately, hitting a valuation of 1.8x price/sales, 2.0x price/sales or 2.2x price/sales wont
warn us in advance that were at a market top.
Several other themes, which seemed to be driving the market, have come, goneand some-
times come back again. They also failed to signal the end of this bull market.
Reflation
US equities have arguably been a largely reflationary story for the last 2-3 years, although there
have been periods where this theme has broken down. For example, July-September 2016 and
signs of it happening again.
There was major breakdown in this correlation during 2013-2014 before it re-connected from
the beginning of 2015.
9
Credit spreads
The S&P 500 was broadly tracking the narrowing in high yield spreads through to the beginning
of 2015. Then that broke down and is now re-connecting.
QE by the Fed
We saw the market closely tracking the growth in the Feds balance sheet until it broke free
after the 2016 election.
Earnings per share

S&P 500 Adjusted EPS remain essentially unchanged from the latter part of 2014, while the S&P
500 is 25% higher. EPS have systematically failed to meet year-ahead expectations for several
years during this muted economic recovery.
Source: Bloomberg
However
A more behavioural/psychological correlation stands out for its longevity.
The correlation between the S&P 500 and the Conference Boards index of consumer confi-
dence has been superior to valuation, inflation expectations, credit spreads, QE and EPS.
We checked the timing of the peak in consumer confidence with peaks in the equity market in
2000 and 2007.
Consumer confidence peaked in January 2000, two months before the S&P 500 peaked and
seven months before the second of the two S&P 500 tops which marked the beginning of the
sharp sell-off. Consumer Confidence is the red line.
Source: Bloomberg
In 2007, consumer confidence peaked in July, three months before the peak in the S&P 500 in
October 2007.
Source: Bloomberg
Our working assumption is that the Conference Boards consumer confidence index peaked at
124.90 in March 2017. On this basis, it is unlikely that the S&P 500 will continue to rise beyond
the latter part of this year. This broadly fits with the scenario outlined above for a significant
correction in US equities beginning in November 2017.
There are other sources of insight into market cyclicality which point to late 2017 as being
high risk for equity investors.
Well briefly mention two of them:
The Economic Confidence Model; and
Some Gann cycles.
1. Economic Confidence Model (Martin Armstrong)

Weve taken another look into Martin Armstrongs (formerly Princeton Economics) successful
Economic Confidence Model (ECM). Many of you will be familiar with Martins work from his
blog.
In summary, the ECM is an 8.6 year cycle which tracks the flow of global capital (the hot mon-
ey) which leads to major booms and busts. The period 8.6 years is 3,141 (365.25 x 8.6) which is
equivalent to Pi x 1,000 days. We recommend Martins paper Its Just Time, written on an old
fashioned typewriter, for a detailed understanding into his model.
In the late 1990s, Armstrong could fill conference rooms with people listening on TV monitors
in overflow areas. In 1999, he was charged with commingling funds and spent 7 years in prison
for civil contempt followed by 5 years resulting from a plea bargain. Armstrong alleged that the
charges were fabricated after he refused to turn over his computer models to agencies of the
US government.
Whatever, the ECMs record in recent decades is stellar.
If we look at three recent peaks in the ECM in reverse chronological order.
The 2007.15 peak (24 February 2007) coincided with the HSBC profit warning on 8 Feb-
ruary 2007, which marked the beginning of the sub-prime crisis. HSBC warned of rising de-
fault rates in its US mortgage business. HSBC had acquired Household International for
US$9bn in 2003, which was its biggest ever acquisition. The business was run to maximise
volumes and focused on customers with low credit ratings taking out second mortgages.
The 1998.55 peak (20 July 1998) coincided with the approval of the US$22.6bn IMF/
World Bank rescue package for Russia on 13 July 1998. The Russian debt crisis (also known
as the Rouble crisis) blew up a month later on 17 August 1998. Russia marked the criti-
cal stage of an emerging market debt crisis which began in Thailand in 1997. In the wake
of the Russian crisis, LTCM was bailed out on 23 September 1998 to avoid a collapse in the
financial system.
The 1989.95 peak (13 December 1989) coincided with the peak in the Nikkei of 38,915.9
on 29 December 1989. This was a key moment in the bursting of Japans massive credit
bubble which ushered in the nations lost decade, now nearly two decades. At its peak,
Japanese property was worth about four times the value of all the property in the US,
even though Japan is the size of California.
We have reproduced a section of Martins model in the chart below. You can see these three
peaks along with the most recent peak of 2015.75, i.e. 1 October 2015.
We realised the power of this model when we checked back seven cycles (7 x 8.6 = 60.2 years)
from the 1989.95 peak to 1929.75, i.e. 1 October 1929. The Great Crash began on 24 October,
only three weeks later.
While not infallible, we have established that the ECM has a strong track record.
Two questions come to mind.
Is the ECM working in the current cycle which peaked on 2015.75, i.e. 1 October 2015?
After all nothing really bad has happened outside of Venezuela and Brazil.
If it is working, which financial markets/regions are central to the ECMs current downcycle?
Weve discussed about these issues before and its still not clear, although we have some new
thoughts.
Martin Armstrong speculated that 2015.75 was the peak in the government bond bubble. Its
possibleand thanks to QE, bond markets are undoubtedly in an unparalleled bubble. There
was no sign of a peak in either developed or emerging market bonds around that date, or any
other bond-specific event which weve identified.
Did any major event in financial markets occur around 1 October 2015?
The answer is yes. Five/six weeks earlier, during 11-25 August 2015, China devalued the RMB
versus the US dollar from 6.2097 to 6.4128, i.e. 3.3%. Coincidentally, the National Day of the
Peoples Republic of China is 1 October.
Maybe these are significant, maybe not.

It could be China.
Whatever it is, we have a strong feeling that the dollar is going to play a central role and the
dollar is central to what happens in China, a subject weve covered on many occasions.
The speed and scale of the growth in Chinas credit bubble is unprecedented and the danger of
it bursting is increasing, as we summarise again below.
Back to the ECM
Whether its China, government bonds or something else, there is a key node in Armstrongs
ECM which might come into play in late 2017. This is an intermediate high of 2017.9, i.e. 24
November 2017.
Weve seen these intermediate highs in the ECM have very significant effects on global finan-
cial markets in the past, within bigger moves in global capital flows.
In the chart below, weve highlighted 2017.9 and 1987.8. The latter corresponds with 19 Octo-
ber 1987, which was the precise date of the 1987 market crash.
In part, the 1987 crash saw capital (especially Japanese) moved out of US equities into other
markets, especially Japan. Following the signing of the Plaza Accord on 22 September 1985, the
US, Japan, West Germany, UK and France agreed to intervene in the currency markets to re-
duce the value of the dollar in relation to the Yen and the Deutschemark.
The situation reached a head when US Treasury Secretary, James Baker, threatened to devalue
the dollar further on the weekend before Black Monday if Germany didnt reverse its interest
rate rise. Following the crash, speculative capital flowed into Japan, encouraged by expansion-
ary policies aimed at overcoming the impact on Japans export-dependent economy from the
strength of the Yen.
We should point out that the 1987.8 node was in the up phase of the ECM and was a step-
ping stone to an even bigger bubble in Japan. This time we are in the down phase.
Firstly, we need to make the assumption that the 30.1 year period, i.e. 2017.9 1987.8, is a
cycle of some significance in global capital flows.
Starting in 1987.8 and going back 30.1 years gives us 1957.7, i.e. 12 September 1957. The chart
below shows how the Dow saw a 20% decline between July-October 1957 (which arguably im-
plies that themes rather than actual events - recur in cycles).
Source: Bloomberg
There were a number of factors in play. The downturn began in the US with a recession during
August 1957 April 1958, which wasnt helped by a flu pandemic and the successful Russian
launch of Sputnik (which terrified many Americans from what weve read).
The recession followed on from a rapid expansion of credit, both mortgage and consumer in-
stalment credit (especially for autos), which put upward pressure on inflation, and businesses
investing heavily in plant and equipment.
Falling equity market aside, here is a potentially significant point relating to our central bank
friends
The Federal Reserve sought to curb the inflationary pressures, ignoring signs of a downswing
during the Summer/Fall of 1957. It raised the discount rate from 3.0% to 3.5% in August 1957,
i.e. very close to the ECM date of 12 September 1957. That month, the Fed Chairman testified
to the Senate that inflation was the most critical economic problem. In mid-November, he
was forced to reverse course and cut the discount rate by 0.5%.
The 1957 crisis spread from the US, becoming the first significant downturn in the global indus-
trial cycle since the Second World War. The focal point in global terms, however, was South
America.
Low taxes and other incentives attracted huge foreign investment, especially into Brazil. The
withdrawal of some American investors together with problems in servicing foreign debt as
commodity prices fell and their currencies weakened led to panic and bank runs in Brazil in Oc-
tober 1958. The contagion spread to Argentina, Chile and Paraguay.
This was picked up by the ECM which troughed in 1959.85, i.e. 6 November 1959.
You might also be wondering whether Brazil = China in this cycle.
This avenue of enquiry was looking promisingso we went back in time another 30.1 years to
1927.6, i.e. 8 July 1927.
Hmmm, nothing pivotal happened in the Dow Jones around July 1927, as it continued moving
upwards.
Source: Bloomberg
Wait a minute
There was a massive event in July 1927 which facilitated the final shift of global capital
(especially from Britain) into US equities, culminated in the Great Crash of 1929. Remember,
obviously, that we were in the up phase of the ECM on this occasion.
This was, to quote Bytheway and Metzler in Central Banks and Gold.
the famous and elaborately orchestrated secret meeting of central bankers on Long Island,
New York, in July 1927...This meeting also had an air of comic opera, as Norman and the others
attempted to travel to New York in disguise (their names were not on the ships manifests and
their luggage was unmarked) but were found out by news reporters.
Present at this meeting were the heads of the worlds four most powerful central banks, the
Federal Reserve, Bank of England, Reichsbank and the Bank of France. Here are Messrs
Schacht, Rist, Norman and Strong outside the NY Fed during their secret meeting.
Source: FRBNY
What transpired during the meetings, while not publicly disclosed, became apparent shortly
afterwards. The European members of this cabal persuaded their American colleague to ease
monetary policy, via lower rates and open market operations, to ease the deflationary pres-
sures on the UK and France.
The Fed cut the discount rate from 4.0% to 3.5% and instituted US$300m of open market oper-
ations in which it bought Treasuries. This left the banking system with high levels of surplus
cash (sounds only too familiar), much of which started to find its way into the call loan market
on the NYSE. The borrowers were stockbrokers and traders pledging stocks as collateral for
loans for stock speculation on margin.
We all know what happened next
We have attached some thought-provoking exchanges from the House Stabilization Hearings in
1928 about the meeting in the Appendix.
So
Armstrongs ECM implies a possability that there will be an event either a market event or
policy event which will facilitate the shift into the final phase of the current 8.6 year cycle.
Unfortunately, with the ECM in a down cycle, the risk is skewed in that direction.
Now lets return to Gann for some supporting evidence about 2017 being pivotal.
2. Gann Cycles
W.D. Gann argued that market trends (everything in fact) were cyclical and themes were re-
peated in a series of specific cycles.
"Mathematical science, which is the only real science that the entire civilized world has agreed
upon, furnishes unmistakable proof of history repeating itself and shows that the cycle theory,
or harmonic analysis, is the only thing that we can rely upon to ascertain the future."
Ganns entire philosophy and success was based on cycles and he often made incredibly accu-
rate intra-day calls on specific markets. He also highlighted several long-term cycles in his
writings which he believed were significant. These included.
60-year cycle;
30-year cycle;
20-year cycle; and
10-year cycle.
Similar to Armstrong, Gann seemed to think of cycles in a fractal structure of cycles within cy-
cles.
If we start with the 60-year cycle, Gann stated.
This is the greatest and most important cycle of all, which repeats every 60-years or at the end
of the third 20-year cycle.
If we go back 60 years from 2017, we come to 1957a year which we highlighted above as be-
ing relevant according to a 30.1 year repeating cycle within Martin Armstrongs ECM.
On the 20-year cycle Gann stated.
One of the most important Time Cycles is the 20-year cycle or 240 months. Most stocks and
the averages work closer to this cycle than to any other.
Going back in time 20 years obviously takes us to 1997, which coincided with the beginning of
the late-1990s Asian debt crisis, as we already noted, along with a sell-off in the Dow Jones in
Winter.
Moving on to the 10-year cycle, Gann had this to say.
"The next important major cycle is the 10-year cycle, which produces fluctuations of the same
nature and extreme high or low every 10 years.
This is another potentially relevant one for the current year. In 2007, we obviously saw the
emergence of the sub-prime crisis, Eurodollar illiquidity problems and the peak in the equity
market cycle.
Finally the 30-year cycle, about which Gann commented.
"The next important major cycle is 30 yearsextreme high or low prices in products of the earth
at the end of each 30-year cycle, and this makes Stocks high or low.
Commodity prices were at very low levels in early 1987, but the year is obviously best remem-
bered for the market crash in October, which we also discussed above. Back another 30 years
gives 1957 and another 30 years gives us 1927.
So we have a potential links between the ECM and Gann cycles with regard to 2017, 1987,
1957 and 1927. This may or may not be significant.
Having established an alternative way of analysing the outlook for equities, lets revert to some
fundamentals.
Mapping a potential peak in Equities

Its nigh on impossible to trace out the likely key events in the last lap in this bull market. Hav-
ing said that, our best guess is:
Even more leverage, e.g. margin debt, providing propellant;
Renewed shift into dollar-denominated assets as Chinas credit bubble begins to burst;
Reversal in expectations of tighter Fed policy as growth slows.
Looking back at the final stages of the last two mega equity bull markets, there is a good
chance of a final surge in leverage in the normal pro-cyclical manner.
Using 1996 as the baseline, NYSE margin debt has risen more than twice as fast as the S&P 500,
another illustration (as if we need it) of how leverage drives global economics and asset prices.
However, we were surprised to find that one thing is still missing a final surge in the growth
of margin debt which was coincident with the 2000 and 2007 equity market peaks.
The biggest risk to the global financial system remains China.
There are numerous risks to Chinas credit bubble, but continued rate hikes by the Fed and a
stronger dollar would add to the problems the PBoC is already facing.
Investors have been conditioned into believing that the PBoC can manage any problems which
might arise, even though the relative scale and speed of the build-up in the Chinese bubble is
unprecedented. Moreover, bubbles always pop even though the consensus usually discounts
that possibility. This is the nature of markets.
Overnight SHIBOR rate, i.e. the cost of interbank funding in domestic Chinese money markets,
has become increasingly volatile with periodic plunges and rebounds since the beginning of the
year. It probably reflects shifting dynamics between acute liquidity needs of banks and subse-
quent PBoC infusions.
Source: Bloomberg
The more stable 3-month tenor has made a new high in this move.
Source: Bloomberg
The rising trend signifies tightening liquidity in the banking system IN SPITE OF fewer RMB de-
posits fleeing the country in terms of capital outflow (see below). This has been overlooked.
The PBoC is walking the proverbial tightrope - reining back some of the extreme excesses of
the credit bubble and promoting the governments GDP targets, which necessitates enlarging
the same credit bubble.
Despite its protestations of financial prudence, the PBoC permitted Chinas biggest ever month-
ly credit infusion at the beginning of 2017, an exact repeat of 2016.
A warning sign is the recent inversion in the 5s10s yield curve on Chinese government bonds.
We expect that the PBoCs ability to control outcomes will be progressively lost as more evi-
dence of fraud and Ponzi-behaviour in Chinas financial sector comes to light.
Mainstream news providers, like Bloomberg, have recently published good pieces on the risks
from Chinas US$3.9 trillion WMP sector and the debt guarantee problem. However, weve had
huge news flow from the Trump Administration, North Korea, French/UK elections and few
people are taking much notice.
Given the rout in Chinas government and corporate bond markets since Q4 2016, we find it
hard to believe that banks have not had to shoulder significant losses to pay out guaranteed
returns on WMPs. The 5-year yield on AA corporate bonds, for example, has risen by over
200bp in about 6 months.
Source: Bloomberg
In April 2017, Chinas largest private bank, Minsheng Banking Corp, admitted to a RMB 3.0bn
(US$437m) fraud when sold non-existent WMPs to customers. Earlier this month, we had a
window into the Ponzi nature of some WMPs. One of Chinas largest insurers, Foresea Life,
warned of mass defaults and social unrest if the Chinese regulator failed to lift the ban on its
selling new WMPs. The company has about US$8.7bn of redemptions in 2017. The companys
former Chairman, and one of the richest people in China, was banned from the industry for 10
years by the China Insurance Regulatory Commission.
The debt guarantee problem is very opaque with large companies allowing smaller companies
to borrow money by guaranteeing the formers loans while keeping the guarantees off balance
sheet. In some cases, its even more complex, e.g. the recent question marks about the funding
of one of Chinas largest insurers, Anbang, by Caixin magazine.
The PBoC faces a plethora of bank liquidity and WMP challenges. However, its biggest chal-
lenge is probably the risk that it loses control of monetary policy.
By pegging the RMB to the dollar, the PBoC has handed over directional policy to the Fed
unless it floats the RMB, of course.
While low-cost labour, outsourcing and investment/infrastructure spending were the best un-
derstood drivers of Chinese GDP growth and associated credit bubble, critical monetary sup-
ports were overlooked.
Federal Reserve operating an easy monetary policy; and
The unconstrained flow of US dollar credit.
Pegging the RMB to the dollar was beneficial to China when the Feds policy was outright easy,
or at least benign. Its outright dangerous when the Fed is tightening, especially when Chinas
debt/GDP ratio has crossed 300% on some measures.
It was noticeable how the PBoC raised rates albeit by a minimal 10bp just hours after the
Feds latest rate hike in March 2017. Ironically, this was portrayed as voluntary - the PBoC acting
prudently to discourage leverage and most people accepted it. Despite recent dollar weakness
against other major currencies, the RMB has only flat lined.
Source: Bloomberg
It could have been considerably worse for the RMB without intense efforts by the Chinese au-
thorities to reduce capital outflows. While they have had some success, wed note that RMB de-
posits, which have successfully migrated to Hong Kong from the mainland, are continuing to
flee. The chart below shows total RMB deposits in Hong Kong Banks.
Source: Bloomberg
With a slowdown in the outflow of RMB bank deposits from the mainland, however, the
PBoC has benefited from a modest reprieve in the monstrous volume of money printing its
undertaken to save the Chinese banking system.
The chart shows a small drop from US$1.3 trillion to just under US$1.2 trillion in the innocent
sounding Claims on other depository Institutions.
Having said that, renewed dollar strength and finding new ways to move RMBs out of China
could put further pressure on Chinas banking system and the RMB.
As weve explained in excruciating detail during the last two years, there is a shortage of liquidi-
ty in offshore dollar (Eurodollar) funding markets. In other words, there is a lack of US dollar
balance sheet (credit) offered by the global banking system. This reflects greater risk aversion
on the part of banks (especially US and other western banks) and increased regulation, notably
Basel III.
Dollar funding problems have taken on greater significance since the 2008 crisis with offshore
dollar debt in excess of US$10 trillion, 70% increase. In aggregate, China has about US$2 trillion
of US dollar debt, which is predominantly held by corporates.
Unfortunately, a classic maturity mismatch has occurred, in addition to the currency mismatch.
Non-US banks have lent dollars on a longer term basis and need to rollover dollar funding on a
short-term basis.
Global dollar funding markets had become problematic at the end of 2016 before the situa-
tion suddenly improved. This can be seen in the cross currency basis swaps (CCBS), especially
the Yen.
In late 2016, we highlighted the extreme tightness in dollar liquidity based on the weighted av-
erage CCBS of five currencies against the dollar. This represents the cost of swapping these oth-
er currencies into dollars over and above the interest rate differentials for a period of 3 months.
In a benign environment, the CCBS should trade at zero and not be in negative territory.
We were surprised by the sudden reversal in the CCBS and dollar weakness since the beginning
of 2017 and were at a loss to explain it, especially given the shift in market expectations to-
wards greater Fed tightening in Q1 2017.
We need to acknowledge former Fed researcher and CS economist, Zoltan Pozsar, who has
pointed to the unintended consequence on dollar funding of the US Treasury preparations for
hitting the debt ceiling. When the US Treasury increases its deposit account - Treasury General
Account - at the Federal Reserve (by selling Treasury bills/bonds) or Foreign Official institu-
tions tap the Feds reverse repo programme, dollar reserves are removed from the banking sys-
tem. This process tightens dollar liquidity.
The reverse is also true which is relevant to us. In other words, when the US Treasury runs
down its account with the Fed, liquidity in dollar funding markets improves.
To avoid hitting the debt ceiling, the US Treasury began running down its account at the Federal
Reserve in late 2016. From almost US$430bn, it fell to a low of US$38bn in mid-March 2017, a
fall of almost US$400bn.
In reality, the US Government spent US$400bn which ended up in deposit accounts which were
not simultaneously drained by sales of Treasury Bills.
Sothe system was flush with an additional US$400bn of dollar reserves.
Swap spreads provided more evidence that bank balance sheets became slightly less con-
strained from late 2016. Swap spreads should not trade in negative territory as they imply that
the US Treasurys credit rating is inferior to major banks.
The banking system has lacked the balance sheet (and the inclination) to arbitrage away the
anomaly. The recent improvement in the negative 30-year swap spread seems to be rolling
over.
Another window on dollar liquidity and bank balance sheets
The chart below shows the roughly US$400bn rebound in excess reserves on the Feds balance
sheet.
As weve explained, the consensus view that these reserves sit quietly on the Feds balance
sheet is incorrect. They are traded in the money markets from which they can have a broader
impact on forex rates and asset prices in general.
Given some of the sharp moves in CCBS, banks with spare dollars in late 2016/early 2017 could,
for example, have earned 80-90bp by swapping them with Yen-based dollar borrowers. It was
hardly surprising, therefore, that some of the additional US$400bn of dollar funding found its
way into the FX swap market.
The reversal in the Yen CCBS since late 2016 has been something to behold.
Source: Bloomberg
When inverted, the Yen CCBS tracks the trend in the aggregated Foreign Official RRP and the
Treasury General Account on the Feds balance sheet. In other words, the Yen CCBS became
more negative as dollar bank reserves were drained from 2014 to late 2016.
The partial normalisation of the Yen CCBS in recent months has tracked the sudden improve-
ment in dollar liquidity courtesy of the US Treasury.
It raises an important question now that the US government has negotiated a budget deal
through the end of the current fiscal year in September 2017.
All other things being equal, if the Treasury replenishes, partly or fully, the Treasury General
Account at the Fed (which its been doing), dollar liquidity should tighten again, which should
drive a further upward move in the dollar index.
Source: Bloomberg
This would have significant knock-on implications for dollar funding markets, the dollar and
China, to name but three.
It should also be deflationary and G7 inflation should continue to rollover in the next few
months. One way, or another, this gap is probably going to narrow.
As an aside Fed officials are increasingly talking about reducing the size of the Feds balance
sheet later this year. Unfortunately, it seems that they are not taking account of the knock-on
reduction in dollar liquidity if they proceed down this path.
In the meantime, intensifying deflationary pressure from the dollar would be challenging
with cracks appearing in the post-election reflation narrative
The recent peak in the 2s30s Treasury yield curve occurred only days after Trumps election vic-
tory while confidence in the reflation narrative lasted well into 2017.
Source: Bloomberg
The November 2013 peak in the 2s30s occurred three months before the first RMB devaluation
and the July 2015 peak occurred just before the second RMB devaluation. Are we overdue?
While the Trump reflation narrative suffered a blow on Obamacare and the potential knock-on
hit to tax reform, we doubt that hope generated by Trump victory and the s conditioning of in-
vestors that the Fed has your back will evaporate in weeks. The recent all-time high in equi-
ties is mirrored in the Conference Boards US consumer confidence survey, which exceeds the
previous 2007 peak.
Thats in spite of a labour force participation rate which is 3% below 2007 and 4% below 2000.
In keeping with the high level of consumer optimism, theres been a rebound in retail sales
growth.
While its viewed as a reflection of underlying economic strength, it could also represent the
last hurrah of the US consumer for this cycle.
Retail sales growth was on a rising trend when the S&P 500 peaked in 2000 and 2007.
A significant part of the retail sector faces difficult or, in some cases, insurmountable structural
problems. Store closures and layoffs in malls and department stores have become common-
place. Below is the chart of Macys CDS since 2012.
Within retail sales, autos have made an important contribution to the post-crisis recovery. The
seasonally adjusted annualised rate levelled off at 17.0-18.0m units in 2015/16 and is in decline.
Source: Bloomberg
The boost from subprime auto loans and rising incentives is waning and not before time. How-
ever, cheap credit brought forward demand, leading auto companies to overestimate demand
prospects. The inventory/sales ratio is the highest since 1990 outside of the 2008-09 recession
(and above the recessions of the early 1990s and 2000s).
Source: Bloomberg
Inventory chains, in general, are an issue that warrants close monitoring. Despite modest im-
provement, the inventory/sales ratio in the wholesale part of the manufacturing chain (ex-
petroleum) is still too high. The current level remains consistent with the last two recessions.
Within the credit stats, credit card (revolving credit) usage has been accelerating and we cant
help wondering whether this is one reason for the strength in retail sales.
It may not be a positive sign as a pick-up in credit card usage was seen prior to the last two re-
cessions. Consumers were guilty of over-optimism or pressure on incomes, or maybe a combi-
nation of the two.
Talking of pressure on consumer incomes

The last equity market peak in 2007 saw the outperformance of the S&P 500 Consumer Discre-
tionary sector versus Consumer Staples top out about six months before the S&P 500 top.
In 2000, the peak in the S&P 500 was coincident with the topping out of the S&P 500 Consumer
Discretionary sector versus Consumer Staples.
It looks like the relative performance of Consumer Discretionary versus Consumer Staples is in
the process of topping out once again.
Shifting from consumers to businesses, optimism also prevails

Small business confidence, according to the NFIB Small Business Optimism Index, is at its high-
est level for a decade, although it looks poised to roll over.
The NFIB index often acts a leading indicator for the more closely watched ISM manufacturing
index.
Returning to one of our favourite indicators, the 2s30s yield curve

The long end is resisting the upward pressure to rates which the Fed is exerting at the short
end. While all of the talk in recent months has been of the prospects for reflation, the steep-
ening in our favourite 2s30s yield curve peaked on 10 November 2016, only two days after
Trump was elected. A gap has now opened up versus the ISM manufacturing index.
Our guess is that the gap gradually narrows as 2017 progresses due to weakness in the ISM.
The lumber price is also a useful indicator to watch.

A weakening trend in the manufacturing ISM is usually confirmed and possibly led by a de-
cline in the lumber price.
The index of For Hire Trucking Tonnage has been oblivious to the post-election optimism, alt-
hough we have seen rebounds from negative territory before, e.g. in 2013.
Manufacturing and lumber, however, ignore the much larger service sector in the US economy.
The chart below shows the historic correlation between the 2s30s yield curve, shifted twelve
months forward, versus the combined manufacturing and non-manufacturing ISM in the ratio
20%/80%.
The message of upcoming weakness across the US economy is unambiguous if the 2s30s curve
is correct.
Song lyrics from Tom Pettys Free fallin
Appendix
Excerpts from the House Stabilization Hearings in 1928:
GOVERNOR ADOLPH MILLER: The three largest central banks in Europe had sent representa-
tives to this country. There were the Governor of the Bank of England, Mr. Hjalmar Schacht,
and Professor Rist, Deputy Governor of the Bank of France. These gentlemen were in confer-
ence with officials of the Federal Reserve Bank of New York. After a week or two, they ap-
peared in Washington for the better part of a day.
MR. BEEDY: Was there some understanding arrived at between the representatives of these
foreign banks and the Federal Reserve Board or the New York Federal Reserve Bank?
GOVERNOR MILLER: Yes.
MR. BEEDY: It was not reported formally?
GOVERNOR MILLER: No. Later, there came a meeting of the Open-Market Policy Committee,
the investment policy committee of the Federal Reserve System, by which and to which certain
recommendations were made. My recollection is that about eighty million dollars worth of se-
curities were purchased in August consistent with this plan.
CHAIRMAN MCFADDEN: A change of policy on the part of our whole financial system which has
resulted in one of the most unusual situations that has ever confronted this country financially
(the stock market speculation boom). It seems to me that a matter of that importance should
have been made a matter of record in Washington.
GOVERNOR MILLER: I agree with you.
MR. STEAGALL: The visit of these foreign bankers resulted in money being cheaper in New
York?
GOVERNOR MILLER: Yes, exactly.
REPRESENTATIVE STRONG: The fact is that they came over here, they had a meeting, they ban-
queted, they talked, they got the Federal Reserve Board to lower the discount rate, and to
make the purchases in the open market, and they got the gold.
MR. STEAGALL: Is it true that action stabilized the European currencies and upset ours?
GOVERNOR MILLER: Yes, that was what it was intended to do.
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"Ding, Ding"... Last Lap - Natural Law, China and The Dollar by Paul Mylchreest

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Equity & Cross Asset Strategy 24th May 2017

Paul Mylchreest Email: paul.mylchreest@admisi.com Tel: +44 20 7716 8257

Equities: Ding Ding...Last Lap

I wanna free fall out into nothin

Source: ADM ISI, Bloomberg

In a course on Forecasting by Time Cycles Gann noted.

All the bad boys are standing in the shadows

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Earnings per share

Source: ADM ISI, Bloomberg

Well briefly mention two of them:

The Economic Confidence Model; and

Some Gann cycles.

1. Economic Confidence Model (Martin Armstrong)

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Maybe these are significant, maybe not.

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

You might also be wondering whether Brazil = China in this cycle.

20-year cycle; and

If we start with the 60-year cycle, Gann stated.

On the 20-year cycle Gann stated.

Moving on to the 10-year cycle, Gann had this to say.

Finally the 30-year cycle, about which Gann commented.

Mapping a potential peak in Equities

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

The biggest risk to the global financial system remains China.

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

The unconstrained flow of US dollar credit.

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Sothe system was flush with an additional US$400bn of dollar reserves.

Source: ADM ISI, Bloomberg

Another window on dollar liquidity and bank balance sheets

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Talking of pressure on consumer incomes

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Shifting from consumers to businesses, optimism also prevails

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg

Returning to one of our favourite indicators, the 2s30s yield curve

Source: ADM ISI, Bloomberg

The lumber price is also a useful indicator to watch.

Source: ADM ISI, Bloomberg

Source: ADM ISI, Bloomberg