HUGE INSIGHTS: The Big Picture - Issue #13
HUGE INSIGHTS: The Big Picture - Issue #13
Please enjoy this monthly newsletter with our compliments. To get full access to our Idea Generator Lab content, which includes our top stock or ETF idea each week, become a dues-paying member for just $10 a month by clicking here.
Monetary Policy and Price Stability
Last week, Fed Chairman Jerome Powell delivered an 8-minute speech at the Kansas City Federal Reserve Bank's annual monetary policy symposium in Jackson Hole, which shook the world of finance to its core. While most on Wall Street had been expecting Powell to outline how the Fed would pivot from their current hawkish position to one with more dovish overtones, the Fed chair did quite the opposite.
“Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy,” said Chair Powell. “Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all. The burdens of high inflation fall heaviest on those who are least able to bear them," continued the Fed Chairman. Then he delivered the haymaker: “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
That last statement was particularly surprising to the bulls who, heretofore, were still fantasizing about a rate cut before year-end. Indeed, the rumors of an imminent Fed pivot were greatly exaggerated. So, what comes next? Well, it appears that expectations have since shifted toward the view that the Fed will hike by another 75 bps on September 21st. According to CME Group's FedWatch Tool, the market is now ascribing a 56% probability to that outcome. Just one month ago, those odds were hovering at 26% -- and lest we forget, the Fed will also shrink its balance sheet by $95B this month.
Many have been asking how could the Fed have gotten it so wrong with inflation. The answer is that the Fed is no better at predicting the future than anyone else is. In fact, they might be worse at it. Why? Because their dual mandate of stable prices and full employment keeps their focus on two of the most lagging series in all of macro economic analysis: 1) The Consumer Price Index; and 2) The Unemployment Rate.
The Fed knows this. That's why they also pay close attention to the yield on the 2-year Treasury note. It's no coincidence that just as the 2-year Treasury yield edged above 3.5% -- a 15-year high, Cleveland Federal Reserve Bank President Loretta Mester, a voting member of the FOMC, publicly announced that she sees the Fed funds benchmark rate rising above 4.0% by early next year. She also said that she does not expect to Fed to cut rates in 2023. If she's right, then we would point out that once the 2-year Treasury yield resolves above 3.75%, there is no meaningful chart resistance below 5.0%, then 6.0%.
To take this part of the discussion to its logical conclusion, it's also worth mentioning that New York Federal Reserve Bank President John Williams, Powell's right hand man -- and also a voting member of the FOMC, was quoted in the Wall Street Journal last Tuesday saying that he does not expect the Fed to succeed in subduing inflation until "real rates" turn positive. In layman's terms, that means that the Fed funds rate must be greater than the inflation rate. To put that into perspective, the current Fed funds rate is 2.5%. The current annualized CPI inflation rate is 8.5%. So, the current "real" Fed funds rate is negative 6.0%. If my math is correct, even if the Fed raises rates by another 75 bps on September 21st, they're still a good 300 bps behind the curve. The modest uptick in the August unemployment rate to 3.7% doesn't change that fact.
Implications for the Economy and Valuations
Last month, we detailed the case for an economic recession in the US. This month, it's obvious that things have gotten even worse. All of the hawkish commentary from senior Fed officials is finding its way into the real economy. Mortgage rates (gold) have rallied back to their recent June highs. This comes on the heels of a collapse in new home sales in July, which were down 12.6% versus June, and down 29.0% y/y. Existing homes sales have tanked as well, down 20.2% y/y in July. There has been a rash of canceled purchase agreements as rising rates have put substantial pressure on the Housing Affordability Index (blue), which is now plumbing the lowest levels of the last 30 years. Importantly, the housing industry accounts for about 18.0% of GDP in an average year.
The median home price had vaulted by 36% from around $322K in 2Q20 to about $440K by 2Q22. That increase was almost entirely driven by zero interest rate policy (ZIRP) in the US following the COVID-19 pandemic and subsequent economic shut-down. The return to normal interest rate policy will not be without its own set of victims, as those who bought at the highs will soon find out. There is an inverse relationship between asset valuations and interest rates and the housing market is just now starting to get the message.
The stock market, on the other hand, has been in the process of systematically rationalizing valuations for the better part of the last year, but apparently got sidetracked between mid-June and mid-August, when it somehow got the idea that the Fed might not have the guts to take on inflation. It seems that Chairman Powell's Jackson Hole speech has since put that notion to rest. The market now appears to be getting back to the business of rationalizing valuations again -- separating the wheat from the chaff so to speak.
Although, there is one possible exception to that last statement. The top 10 S&P 500 stocks by market cap, which collectively represent 29% of the index, "seem" to be impervious to rising rates. It's as if some investors feel that because these ten stocks represent the best companies in the world, they are in some way the new safe harbor trade. And as such, investors are willing to pay any price just to have a perceived "safe place" to store their capital. This, despite the fact that the collective Q2 results of this group of stocks fell well-short of that of the market.
But in fact, these top 10 are not impervious to the impact of rising rates. And while they may well be among the best companies in the world -- the wheat, rather than the chaff, they too are also baring the brunt of rising rates. Consider that just two weeks ago, this same group traded at a WAVG forward P/E ratio of 37.9x and a WAVG trailing P/S ratio of 7.7x. While they've since retrenched 7% from their mid-August highs, the group still trades at a forward P/E ratio that is twice that of the market, and a P/S ratio that is three times that of the market -- assuming, of course, that the bloated street consensus EPS estimates actually come to fruition! While earnings estimates have come down modestly from their most exuberant levels of the year, there is far more room to fall should the worst case scenario play out for rates.
The Stock Market Cycle: Where are We Now?
There is no doubt in our minds that the peak of the blow-off phase of the market is behind us. MEME stocks, Cryptocurrency, EVs, ARKK, Disruptive Growth IPOs, SPACs, the list goes on and on -- and all of it was made possible by ZIRP. But where are we now in the market cycle, and how did we get there?
As subscribers to our ALPHA INSIGHTS investment strategy and advisory service will know, on January 1st we wrote that 2022 was a “Shmita year,” the final year of the 7-year cycle, and that as such, we expected large drawdown into the mid-Autumn months. On January 23rd, we concluded that the market had probably topped for the year. On February 27th, we called for a significant bear market rally on the heels of the February sell-off. On April 10th, we said that the market had reached another “tipping point.” On May 20th, we stated that this was “not the buying opportunity of a lifetime.” On June 26th we wrote, “The S&P 500 found interim support around the 200-week EMA and a new countertrend bounce is likely to carry into resistance around the SPX 4000-4250 range.” On August 7th we said that the bear market rally appeared mature and could terminate in the subsequent weeks. On August 16th, the S&P 500 peaked at SPX 4325, slightly exceeding the upper boundary of our expected target range.
All that being said, the decline into the June lows lacked any of the historically recognizable features of "capitulation," let alone "despair." How could it? There have been no net outflows from equities. In fact, according to B of A Global Research, household holdings of equities are at an all-time record high! No, in our opinion, the market had only experienced a period of "denial" leading into the June low. Then, deeply oversold short-term breadth statistics led investors into the "bull trap" phase. By the August 16th high, it had reached the “return to normal” point in the cycle. The market has since rolled-over hard down. Indeed, the collective realization by investors during that 8-minute speech by Chairman Powell last week was that the situation is anything but "normal."
We have since retraced a Fibonacci 61.8% of the bear market rally from the June 17th low to the August 16th high. The bullish "re-test" crowd knows that once the decline exceeds that level, the odds begin to shift dramatically in favor of a lower low. And once the market makes a lower low, that is when "fear" will begin to overwhelm market participants. Fear is what has been missing from this entire bear market decline from the January 4th high. The Volatility index hasn't posted a reading above 40% in more than two years. But we suspect that it will in the not-too-distant future. There are two indicators that suggest this outcome: 1) the VIX is now trading above 24%, which in the past has acted as a sort of boiling point for volatility; and 2) The VIX has begun to trend above its 21-DMA, which has historically preceded past VIX spikes.
If we are right about a volatility spike, then it will most likely occur as the S&P 500 makes a new lower low. This leads us to the point of this entire discussion: The “what” that comes next. The chart below shows the price action of the Dow Jones Industrial Average (DJIA) throughout the the year 1987. We are not showing this chart because we're predicting a crash. We're showing this chart because it is the best illustration of how quickly things can change. 1987 was also a year in which the Fed, then led by newly appointed Chairman Alan Greenspan, embarked upon a tightening cycle to address concerns over rising inflation. The Fed funds rate rose from a low 6.0% in June to a high 8.375% in September. Then, like water turning from a liquid state to a gaseous state at 212 degrees Fahrenheit, the temperament of the stock market abruptly changed.
But, unlike physics, we don't know at what level the Fed funds rate could have this effect on the stock market again. Because, unlike physics, economics is a dismal science. What we do know is that the set-up is very similar, albeit at a much larger scale this time. You see, going from 6.0% to 8.375% in four months, a 238 bps increase, is similar to three 75 bps rate hikes in absolute terms. But in relative terms, the 1987 rate hikes equated to an increase of just 40% in total. The situation today effectively triples the benchmark rate over the same four month period. Now, looking at the the 3-year weekly chart of the S&P 500 below and comparing it to the 1-year daily chart of the DJIA in 1987 above, one can see how the price action of the two are similar, but at different degrees of trend. So, while the market may be poised to follow the same path as the DJIA in 1987, it doesn't necessarily imply a crash. It also doesn't rule it out.
Market Analysis and Elliott Wave Forecast
We've been considering two plausible scenarios in which, 1) the market makes a new lower low; or 2) the market does not make a lower low. We illustrate them below using the Elliott Wave principle in order to present a road map of where the market may be headed.
The first scenario projects a fairly grim outlook for the stock market. We're calling this our "Preferred Count," not because we're rooting for this to happen, but because the probabilities favor this outcome. Under this rubric, the January 4th high market the end of a cycle wave V advance off the 2009 low, and by extension, a supercycle wave (III) advance off the 1932 low. As such, a corrective wave form of supercycle degree is now underway. The corrective wave form should trace out an A-B-C zigzag pattern [5-3-5] to begin, which could evolve into any one of eleven different potential patterns or combinations over time. But for now we're focused on cycle wave A down [(1)-(2)-(3)-(4)-(5)].
The 24.5% January-June decline counts best as primary wave (1) of cycle wave A down. Thus, the 18.9% June-August countertrend advance counts as primary wave (2) up. If this count is correct so far, then the decline since August 16th represent the early sub-divisions of primary wave (3) down. Here's what we know about third waves, based upon the work of R. N. Elliott. Wave three always travels beyond the end of wave one. Third waves are usually the longest wave within the five wave motive wave progression, but are never the shortest. And wave three is always the most powerful wave of the progression, and often sub-divides in an identifiable manner.
If primary wave (3) down is now operative, then it syncs-up near perfectly with the 1987 analog. We calculate that primary wave (3) down could carry the index to at least SPX 2750 before a primary degree wave (4) countertrend advance begins. Although, ultimately, we expect that cycle wave A down will likely take the index to approximately SPX 2250 before it terminates. This would retrace 61.8% of the cycle wave V advance off the 2009 low, and allow the index to test its rising 200-month MA.
The second scenario is less grim. We'll call this our "Alternate Count." This count is only relevant if the S&P somehow manages to avoid making a new lower low. We'll also know that our preferred count (as detailed above) has been negated if the S&P exceeds the August 16th high. Under this rubric, we must assume that the January 4th high was only the top of intermediate wave 3 of primary wave (5) of the cycle wave V advance off the 2009 low. As such, the January-June decline was most likely minor wave a down of intermediate wave 4, which is tracing out a lateral consolidation pattern, commonly an a-b-c-d-e triangle pattern [3-3-3-3-3].
If this count were to prove operative, then the advance off the June 17th low is most likely a part of minor wave b of intermediate wave 4 of primary wave (5) of cycle wave V. Here's what we know about fourth waves, based upon the work of R. N. Elliott. Fourth waves are corrective wave forms within a motive wave progression. Corrective wave forms tend to alternate between the second and fourth wave. If the second wave traces out a zigzag, the the fourth wave is likely to support a flat wave or triangle wave form. Triangles always precede the final move of a wave progression.
If cycle wave V of (III) has not yet terminated, and the market is instead tracing out intermediate wave 4 of primary wave (5), then the 1987 analog is off the table. Based upon the time and depth of minor wave a down, we calculate that wave 4 could take many months -- possibly more than a year to complete, before a move to new highs should be expected. This is a low probability outcome by our analysis, but it would frustrate both the bulls and the bears.
Conclusion
An interesting alternative to the unpleasant set of outcomes discussed above can be found in the 2-year Treasury note, which is now yielding around 3.4%. While currently below the CPI inflation rate, its return is twice the dividend yield of the S&P 500, and 20 bps above the 10-year Treasury note. In addition, unlike the stock market, you're guaranteed the return of your principle at maturity. We view the current investment environment as one where investors will do best by seeking out investments that emphasize capital preservation.
Judging from the strength in the US Dollar index (USD), we are not alone in our thinking. Indeed, the USD has long been considered the go-to safe haven asset among investors worldwide. With short-term foreign sovereign yields still barely positive on average, we suspect foreign investors and carry-traders alike are salivating at the sight of the 2-year US Treasury yield trading near a 15-year high.
That's all for this issue of HUGE INSIGHTS: The Big Picture. Next month we plan to address the coming global energy crisis.
Disclaimer
All information and data contained on this site and in reports, analytics, etc. produced by Jeffrey W. Huge (the “author”) is for informational purposes only. The author makes no representations as to accuracy, completeness, suitability, or validity, of any information. The author will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.
External links are often provided within the author’s newsletter for the convenience of the reader. The author will not be responsible for any material that is found at the end of these external links.
The author is NOT registered as a securities broker dealer or investment adviser with either the U.S. Securities and Exchange Commission or with any other state or federal securities regulatory authority.
The content of the author’s newsletter should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. The author may hold positions or other interests in securities mentioned, including positions inconsistent with the views expressed.
The user bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional before making any investment decisions.
Past performance is no guarantee of future results.