Central bankers always try to avoid their last big mistake. So every time there's the threat of a contraction in the economy, they'll over stimulate the economy, by printing too much money. The result will be a rising roller coaster of inflation, with each high and low being higher than the preceding one. - Milton Friedman, American Economist
The Ivory Hill RiskSIGNAL turned back red in the short-term, and the medium-long-term trend is still negative. We are hovering a little over 60% cash.
The S&P 500 has fallen 5% in less than a week after a failed test of the 200-day moving average amid overbought market conditions.
Strong and sustainable rallies are built on heavier trading volume. While volumes tend to be lower during the summer, trading volumes peaked during the June bottom. Since then, volume has steadily declined, even as the S&P 500 pulled back. Short sellers tend to jump in after three or four rallies on low trading volumes, which could bring the market down even further.
The whole point of a relief rally in a bear market is to make you think that the bottom has been reached. This is sometimes described as a sucker rally.
During the 2001 bear market, the Nasdaq had seven relief rallies of 20% or more. This was the FIRST relief rally of 17% or more during the bear market of 2022.
There are a lot of worries about the big picture, and there are a lot of bears on Wall Street. Nerves are high, and any setback makes people feel sick.
The Volatility Index (VIX) is back in the "chop zone," so you can expect strong moves up and down in the near future. Again, this is a very emotional market, and people look at any news with a lot of doubt. We haven't seen inflation this high in more than 40 years. Also, keep in mind that almost no money managers today were alive when inflation was this high for this long.
When inflation is high, bonds and stocks are positively correlated, making it hard for big Wall Street firms to run and hide. Most of the time, the correlation is negative when the environment is deflationary. One thing that makes the often-used 60/40 portfolio work is the negative correlation; it's not working this time and this is why I do not believe in buy-and-hold investing or asset allocation. If you were in a boiler plate portfolio like they use at the bigger firms, you would have had the opportunity to lose money both fast and slow.
Fed Chairman Powell's Jackson Hole Speech
Powell's speech in Jackson Hole was honest, direct, and crystal clear. The Fed will allow a recession or bear market if it means getting inflation under control.
To be more direct: the Fed is going to continue to aggressively hike rates, and the idea that the Fed is getting close to cutting rates is a fantasy.
Powell acknowledged that rates will need to be restrictive and this was a direct punch to the bullish idea of an imminent Fed pivot to cutting rates. Practically speaking, Powell stating rates will become restrictive means a fed funds rate above 3.5%, and that’s NOT priced into the market yet.
The short-to medium-term impact of Powell's speech was his commitment to kill inflation even if it means a "sustained period of below-trend growth and softness in the labor market, as these are the unfortunate costs of reducing inflation".
He is telling us to get ready for slowing economic growth and not to expect easing financial conditions anytime soon.
The bottom line is that the Fed is going to hike rates until they see a sustainable downward trend in inflation. They are going to intentionally break the economy. What most investors fail to understand is that in order for inflation to come down, the Fed literally has to break the economy. In order for that to happen, they must aggressively remove accommodation and hike rates to the point where it chokes off economic growth, just like it did in 1999/2000, 2005/2006, and 2018.
Read my post from October 27, 2021 "How Does This Stock Market Rally Ultimately End?"
Markets and Investment Positioning
Shortly after the June low, market watchers were buying into the Fed pivot narrative that was relatively correlated when oil and commodity prices were falling. Everyone thought inflation was declining since these two were the biggest drivers of inflation. This was textbook intermarket analysis, but the possible Fed pivot was driving the narrative. Market participants assumed the Fed would pivot and added more than 20% to the value of high-beta growth stocks.
That assumption is burning out as the Fed has screamed loud and clear that they are going to control inflation at any cost. You can see this starting to play out in inflation expectations.
Treasuries are echoing a similar narrative. Since the December FOMC meeting, when the central bank said that a new cycle of rate hikes was about to begin, Treasury yields have gone up sharply.
We are again seeing the all to familiar (and annoying) trend of stocks and bonds moving down together.
The bond market has only been trading on the inflation narrative but it is giving zero attention to the fact that the US economy is slowing quickly.
Retail sales were flat last month and have been trending lower
New home sales are down 40% (lowest level since 2016)
America's biggest corporations are issuing hiring freezes and layoffs
85% of small business are planning to implement a hiring freeze
78% of small business plan to lay off employees
Europe is facing a terrible energy crisis and the housing market is collapsing in China
10s2s yield spread is at -0.33, more inverted than the tech bubble. Another 13 point decline would match the 2008 inversions.
But yields keep moving up and up. This is most a sign of stagflation and way too much money getting pumped into the economy.
Remember hearing how much the Fed's balance sheet was going to be reduced? At its highest point in April, the total assets held by the Fed were a little bit less than $9 trillion. This amount is now $8.85 trillion. The Fed's balance sheet has barely been reduced. Even though rates are going up, there is still a huge amount of liquidity in the system.
If we were not in this inflation environment investors would have certainly been stacking up Treasuries by now. That is not the case. To be direct, there’s a good possibility rates go go higher and bonds prices come down before we start reversing. I expect the Fed to front-load rate hikes to tackle inflation as fast as possible. This will allow them to either continue hiking or pausing by the end of the year or earlier Q1 2023. We most likely won't see a sustainable rally in treasury bonds until the Fed stops hiking rates.
The US dollar is signaling a storm is coming. The greenback has been rallying throughout this year and is currently up 17% over the last 12 months. The dollar has only been this high two other times in history - the 1980s and tech bubble.
This could be the sign that a debt crisis is approaching. Effectively, foreign exchange (forex) traders are buying the up the dollar and only the dollar. Even though the U.S. economy isn't in the best shape, it's doing much better than most other economies.
China and Japan are collapsing.
Europe is buried in a what looks to be a very deep and prolonged recession.
Emerging markets will likely get hit the hardest.
Many countries borrow money in US dollars, and as the dollar gets stronger, it gets harder for those countries to pay back their debts. Russia, Zambia, Lebanon, and Sri Lanka have already defaulted on their debt. Ecuador and Egypt are on deck. There's a chance that it will spread to bigger economies like Pakistan, Argentina, and potentially Brazil. Then, developed markets could follow suit.
Based on history, sharp rallies in the dollar have been highly correlated with major negative economic events.
A 10% year-over-year increase in the dollar has historically signaled a major economic event is going to happen. Again, the dollar has risen 17%. The Dot-com bubble, 2008 Global Financial Crisis, and a few other debt/currency events all happened during anomalous US dollar rallies like we are seeing today.
Even though Treasuries are still trying to stabilize, we shouldn't ignored them. Long-term Treasuries are going to be a rollercoaster ride because the bond market is already more volatile than it has ever been in the past. Short-term and intermediate-term bonds are an idea to distort some of the volatility risk.
I expect the last four months of the year to be dramatically volatile while the Fed accelerates its QT and figures out when they will end the current rate hiking cycle. Even when that happens, you should still expect volatility because historically the market doesn't bottom for about a year after the Fed stops hiking. BUT when that happens we should see negative correlation between stocks and bonds and that will be the bullish case for US Treasuries.
For now we are going to sit on our cash and continue to make short-term adjustments as the market brings us opportunities.
And remember – the one fact pertaining to all conditions is that they will change.
Please reach out with your questions or comments.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President