Skynet Is In Total Control

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By: Kent Engelke | Capitol Securities

In my view, Skynet is in complete control of the markets. I believe momentum driven technology based trading is completely dictating market direction, direction that is devoid of any rational thought or fundamental analysis.

Some might challenge this view, but according to a recent SEC study, 50% of trading is the result of algorithmic trading and another 40% is the result of passive ETF/indexing.

I will adamantly argue the underlying fundamentals of the economy have and are changing, changes that are not yet reflected. The changes geopolitically are tectonic. Monetarily, the changes are fundamental with perhaps gargantuan implications in a technical driven market given the largest component of most valuation models are interest rates.

Commenting further about monetary policy, QE has been replaced by QT. Interest rates are heading higher and there is a distinct probability there could be 4 interest rate increases in 2018. Based upon fed funds futures, the markets still have not fully discounted two hikes. This is the inverse of 2008-2017.

The economy is on the verge of inflationary growth, the result of tax and regulatory reform, negative real interest rates and an increase in monetary velocity. There are few absolutes in life, but one of the almost absolutes is negative real interest rates greatly increases the odds of inflationary growth. The longer negative real interest rates exist, the greater probability of demand pull growth that could morph into cost push (wage) inflation.

It is the corollary of an inverted yield curve where an inverted yield curve has a 100% probability of a slowing economy. An inverted yield curve has preceded all recessions, but not every inversion creates a recession.

January’s PPI was similar to the CPI. The 0.4% increase in the core rate (ex food and energy) was double the expectations, partially the result of downward pressure on the dollar. It is all but assured these increases will soon feed into consumer prices. The 2.2% annual rate is at a six-year high.

Treasuries initially sold off on the data, almost breaching 3.0%, but then advanced on “technical driven trading as a large block trade in 10-year note futures was the catalyst to push the 10-year to session high prices,” quoting Bloomberg.

The biggest issue with technical based trading is that such trading does not reflect fundamental changes with the underlying structure. It assumes that yesterday’s environment will last forever. As these changes begin to be reflected, volatility will increase.

This too is not a radical statement. Barons wrote yesterday the volatility will not wane anytime in the near future given the underlying changes that have occurred macro economically and geopolitically.

Just as an aside, one factoid I think is interesting is that active managers have been selling the must owned technology issues, issues that led the recent three-day advance on technical based trading but as noted several times only 10% of the volume is the result of active management.

Last night, the foreign markets were up. London was up 0.71%, Paris was up 1.01% and Frankfurt was up 0.66%. China was closed for a holiday, Japan was up 1.19% and Hang Sang closed for a holiday. The Dow should open flat. The 10-year is up 4/32 to yield 2.89%.

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