“It would be silly to expect every bear market to turn into the Great Depression. It would be equally wrong to expect that a fall from overvalued, to more fairly valued, couldn't badly overshoot on the downside.”
Seth Klarman, CEO of Baupost Group Hedge Fund
The Ivory Hill RiskSIGNAL is still firmly in the red and we are sitting on 70% cash.
For those of you not up to speed, our proprietary indicator, the Ivory Hill RiskSIGNAL went negative in January and we moved to 60-70% cash at that time. The trend is clearly down and fighting the trend is a great way to lose money.
The inflation report last week was hotter than expected at 9.1%. Is inflation priced into the markets? My answer is yes. BUT, what is not factored in yet is a recession. If we go into a recession markets will sell off harder and longer, and I don't think that is priced in to stocks yet. Every day that goes by, the historical narrative is pointing to a recession. We have heard Powell say the word soft landing a lot, but if we go into a recession, I don’t see any way that we have a soft landing, it looks mathematically impossible.
What investors need to watch is not the data, not an economist (who are always usually wrong), but the market trend. The trend tells us everything we need to know about how to trade/invest in any market environment. The Ivory Hill RiskSIGNAL is red, meaning the trend is down. We don't fight the trend as it’s a great way to lose money. We are sitting on a mountain of cash, from a cash/AUM percentage, probably more than just about any investment firm on Wall Street, and when the trend turns back up, we will start buying stocks at a fast pace. Until then, controlling emotions and being patient is the key to success.
Before we dive in, I wanted to address some questions I have been getting from clients. In my experience if one person is asking this, then there are more wondering the same thing.
"We are sitting on a lot of cash right now. Aren't we losing money with inflation at 40 year highs?"
Answer: You have to pick you poison here because cash is about the best investment out there right now. It's dropping at a lower pace than both the stock and bond market. Being neutral right now is a better place than intentionally losing money by fighting the trend.
At this point in time, I am more concerned about deflation rather than inflation. The pace of rising commodity prices are increasing the odds of a deflationary bust. The Fed is not raising rates fast enough so more inflation is actually deflationary. Put more simply, as inflation increases the more likely people are going to stop buying things and businesses will be forced to lower prices. Deflation can lead to an economic situation known as a liquidity trap. During times of deflation, goods and assets decrease in value, meaning that cash and other liquid assets become more valuable. Because of this, deflation exerts a disincentive towards investment and spending. In fact, during serious deflation, one of the best investments is a safe filled with cash or a bank account. So the very nature of deflation discourages investment in the stock market, and decreased demand for stocks can have a negative effect on the value of stocks.
"Where is the bottom and when will you start layering back into the market?"
Answer: We don't know where the bottom is. Nobody does. We are going to wait for the Ivory Hill RiskSIGNAL to turn positive because that will mean the intermediate to long-term trend has turned positive. When our indicator flips green, we have a 72% chance that the market is going higher. To be crystal clear, I guarantee you that we will not catch the bottom because our strategy is hype-focused on getting back in the market when the trend turns positive.
US inflation roared again to 9.1% from a year earlier. This is the highest inflation in more than four decades.
Yet despite all this actual bad news, the market appeared convinced last week that:
Inflation is peaking soon and this is the last report that will show material increases in inflation.
The looming intense slowdown likely awaiting the U.S economy will be bad enough to stop the Fed’s rate hike cycle.
The “terminal” rate of fed funds (where the Fed stops hiking rates) won’t rise above the current 3.5% expectation.
Put simply, the thesis for last week's recovery is that the looming economic slowdown won’t let the Fed hike rates any more than feared.
The 10Y/2Y Treasury yield spread is as negative today as it has been at any point over the past 20 years. That means investors should probably begin preparing for the high likelihood of recession in the not-so-distant future.
Treasuries, didn’t really show a negative reaction to the inflation number and instead moved higher following the release. Are investors starting to add Treasuries for safety again? The 10-year yield dropped almost 15 basis points on the week, so this could be a reaction to the perceived likelihood of recession as a result of the Fed raising into a slowing economy.
The start of earnings reports for Q2 were mixed and I continue to think this this could be a big source of volatility over the next month. With so many companies beginning to sound the alarm bells of hiring freezes and slowdowns, I have to think that where there’s smoke, there’s fire. Companies typically don't take this action unless they are under pressure from the market. I believe that the street is too optimistic about Q2 earnings, and further negative revisions to the forward guidance may be on the horizon.
Volatility has come down a fair amount over the past few weeks and calm could mean some more favorable short-term conditions. We still need to see a blowout in the VIX to confirm a bottom is near.
With Treasuries on the rise and the Ivory Hill RiskSIGNAL in the red, it’s definitely a time for caution. Interestingly, lumber continues its comeback and while it’s not signaling lower volatility conditions are here, it’s certainly heading in that direction.
Three Events that Need to Happen For a Confirmed Bottom
Key 1: Chinese Lockdowns Ease and Growth Recovers.
How we’ll know: China COVID cases drop, Chinese Purchasing Manager Index (PMI) rise back above 50 and the yuan moves back towards (and below) 6.50 to the dollar (currently around 6.75 to the dollar).
Update: The Chinese economy has largely reopened, but this week’s shutdown in Macau and mass testing in Shanghai and other regions show that “Zero COVID” remains partially in effect and as a result, the threat of lockdowns will continue to weigh on Chinese stocks and the outlook for the global economy.
More specifically, the June Chinese manufacturing PMI did rise above 50, barely to 50.2, and I’ll want to see another month or two above 50 before confidently believing that Chinese economic growth is sustainable. Meanwhile, the yuan remains near 6.75 and has not traded close to 6.50 level, where it was trading before the lockdowns started in April.
Bottom line, lock-downs have been eased compared to April/May, but the threat of new lockdowns clearly remains, and the Chinese economy is still not close to “typical” levels of growth and as a result it’s still a drag on global growth.
Key 2. Inflation Peaks and Declines and the Fed Eases Off the Hawkish Rhetoric.
CPI, the Core PCE Price Index and the price indices in the monthly PMIs begin to meaningfully decline. If CPI can get back down near 3%-5% towards the end of the summer (August) that will likely make the Fed back off the hawkish narrative, confirming “Peak Hawkishness” is upon us and helping to form a sustainable bottom.
Update: Obviously we’re not close on this yet. The June CPI printed above 9% and it’s essentially a 50/50 shot as to whether we get a 75-bps hike or a 100-bps hike. Yes, there are some hints of deflation in the future, specifically the University of Michigan 5-year inflation expectations declining to 2.8%, continued (small) drops in core CPI and core PPI, and a moderate drop in price indices in the Empire Manufacturing survey. But none of those are enough to convince markets that 1) Inflation has peaked or 2) Fed hawkishness has peaked.
Bottom line, until we get clear evidence (headline CPI) of a peak in inflation and peak Fed hawkishness, this market will have a hard time sustaining any rally, and a retest of the June lows can’t be ruled out if earnings disappoint over the next few weeks or economic data points roll over hard.
Key 3. Geopolitical Tensions Decline.
How we’ll know: Oil and other commodities will drop to prewar levels.
Update: Certain commodities like wheat and corn have declined to pre-invasion levels, as markets are hopeful that grain shipments from Ukraine will start again soon. But energy commodities, despite large drops, remain above pre-invasion levels (oil and natural gas). Additionally, the drops have been driven by fears of a global recession crimping demand and lack of export capacity in the U.S. (for natural gas), not on some geopolitical improvement.
Bottom line, while off the highs, commodity prices in general remain elevated and that’s a continued headwind on global growth.
In summary, stocks traded better than expected last week but that’s mostly because sellers priced in last week’s data via the June collapse. But that doesn’t mean the June lows are a bottom. For those levels to be a bottom, we need actual improvement in fundamentals, including 1) Sustainable economic reopening in China, 2) Concrete evidence (not just hope) of peak inflation/peak Fed Hawkishness and 3) Geopolitical improvement. Without those macro factors in place, this market will remain vulnerable to growth disappointments and earnings disappointments, as well as the possibility inflation takes longer to peak than expected and the Fed hikes more than expected.
In order for a sustainable bottom to form, we need the factors that “caused” this drop in stocks (Chinese slowdown, rising inflation, rising Fed hawkishness, geopolitical stress) to improve, and they have not. As such, we continue to warn about another 5%-10% “air pocket” in stocks looming and advocate defensive sector positioning.
And remember – the one fact pertaining to all conditions is that they will change.
Feel free to reach out to me and use me as a sounding board.
Best regards,
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Direct: 952.828.5336
Email: kurt@ivoryhill.com
-Written 07.17.2022