HUGE INSIGHTS: The Big Picture - Issue #14
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From Inflation to Deflation
Cathie Wood, the founder of ARK Invest, and her flagship fund the ARK Innovation ETF (ARKK), have seen something of a fall from grace over the past year. ARKK made its all-time record high in February 2021 and was the posterchild for the new growth stock bull market. But, as we pen this note, the fund has since declined by approximately 75% over the subsequent 20 months. We mention Cathie because she was recently on CNBC defending her thesis on the "favorable trends" in disruptive technology.
We respect what Cathie has accomplished, but we think that both her rise, and her fall were largely circumstantial. And while we disagree with almost every aspect of her investment strategy, she did say something the other day that caught our attention. The specific point was this, and I paraphrase: "We believe that the biggest risk to the global economy is not inflation, but deflation!" Indeed, we hold a similar opinion.
Using 110-years of detrended quarterly data taken from the most cyclical price series that we have tested -- the Dow Jones Transportation Average, our Economic Cycle Model (ECM) illustrates a clear sinewave that has captured the structural ebb and flow of U.S. economic activity fairly accurately over the last century. The past troughs of this cycle measure a Fibonacci 34-years apart. The cycle appears to follow a repetitive path that results in approximately 17-years of feast and 17-years of famine — effectively, an inflation/deflation cycle. The cycle was scheduled to top in 2022, and it very likely did.
From our lens, the entire economic advance since the great financial crisis (GFC) has been a function of the liquidity derived from an ever expanding Fed balance sheet and an effective zero interest rate policy. That came to an end earlier this year as the Fed reversed a policy that has effectively been embedded into the fabric of the U.S. economy -- if not the American culture, for the better part of the last two decades. What was an inflationary tailwind for economic growth, is now a deflationary headwind. If our ECM is correct, and with history as our guide, Fed policy may remain a deflationary headwind until the cycle bottoms next in 2039.
In addition, there is another secular trend that also supports the notion of a new deflationary decline in economic activity. The number annual net live births in the U.S. has collapsed over the past 15-years. A decline in population growth has historically translated into a decline in economic growth over time.
Recession...What Recession?
Economic growth in the U.S. collapsed in the first half of the year -- posting two consecutive quarters of contracting real economic output, causing some (including us) to question whether or not the economy had entered a recession. Final Q1 real GDP was -1.6%, while final Q2 real GDP came in at -0.6%. Yet, much to our surprise, Q3 appears on track to buck that trend. The Atlanta Fed's GDPNow model attempts to estimate quarterly GDP through an evolving process of netting out new economic data releases and properly weighing their impact on growth in real-time. The model's estimate for Q3 real GDP growth is currently +2.9%. There are a lot of additional data inputs that will affect this model between now and October 27th, when the BEA officially releases their advance estimate of Q3 GDP, but if this growth trajectory can be sustained, then it would be a welcome sign that nominal growth remains steadfast despite historically extreme inflation levels. If not, then a continued environment of persistently high inflation and weakening economic growth is a textbook formula for stagflation.
To be sure, the nation's nine Federal Reserve Board banks have each developed their own independent calculations to measure that all important variable -- core inflation. While the FOMC has a tendency to focus on the core personal consumption expenditure (PCE) as its baseline -- a measure that exceeded the market's expectations when last reported (ticking up 0.6% during the month of August) -- current y/y measures of core inflation across the board now grossly exceed the Fed's 2% target rate by an average of 403 bps. Recall that core inflation excludes volatile food and energy prices, but OPEC's decision to cut oil production by 2 million bbl./day will not help the Fed achieve their goal.
Yet, many economists, strategists, and financial media pundits have been vocal advocates of the notion that inflation has peaked. If they're right, then we say, “Beware!” Every inflation peak since 1960 has been accompanied by, or followed by a recession. If inflation were to have already peaked for the cycle, then it would represent the largest absolute change on record, and the third largest percentage change following the 1974 and 1981 peaks. Prior to the GFC, the recessions that followed the 1974 and 1981 inflation peaks were considered to be the most severe since the great depression.
The Fed's tool box is very limited. The ability to control short-term interest rates is a hammer. And if the only tool they have is a hammer, then every problem looks like a nail to them. In this case, the nail is aggregate demand. The Fed is using their hammer to pound it down by raising interest rates aggressively. Today, the 10-year Treasury yield is 3.88%. That rate exceeded 8% in 1974, and fell just short of 16% in 1981 before the Fed was able to break the back of inflation -- and with it aggregate demand, sending the U.S. economy into two of the worst recessions in modern history.
The Fed Will Hike Until Something Breaks
A certain nutty professor from a well-regarded business school has found internet fame by going off on tirades over the Fed's past monetary policy experiments. Good for him, but what's done is done. It is far more important to understand what the Fed is doing now, than it is to understand why they are doing it. And what the Fed is doing now is raising their benchmark policy rate at the fastest pace in the last 40 years. The textbooks all say that it takes 6-12 months for short-term rate increases to funnel through to the real economy. The problem with the textbooks is that they are all based upon the study of empirical evidence. As we can see in the chart below, there really isn't any precedent to go by for "this cycle."
As the debate rages on over whether the Fed will choose to increase rates by another 50 bps or 75 bps at the November FOMC meeting, we see a more concerning issue at hand -- the accelerated pace of policy response. What is concerning about the pace of policy response is that so far we've only seen the initial effects of the first two rate hikes (a total of 75 bps). When the next three 75 bps rate hikes -- implemented between June and September, ultimately funnel into the real economy, it's likely to have the effect on GDP of hitting an economic brick wall. In addition, there are always unexpected consequences with rapid policy change. Warren Buffett once famously wrote, "You never know who's swimming naked until the tide goes out." The Bank of England found out the hard way that their national pension plan was skinny dipping. The UK's $1.8 Trillion defined benefit plan was leveraging its fixed-income portfolio and trading interest rate swaps against it (the so-called "Liability Driven Investment" strategy). When the margin clerks started calling, the central bank was forced to pivot from tightening, to easing monetary policy in order to back-stop the entire system.
The fragility of the European banking system should not be underestimated. The CEOs of at least two major European investment banks including Credit Suisse and Deutsche Bank spent the better part of the last week trying to calm investor fears over the resulting weakness in their respective balance sheets following aggressive rate hikes from central banks around the globe. This is not "nothing." Just have a look at the MOVE index above. The MOVE index basically measures the cost to hedge against an outsized rise in Treasury yields. It is to the bond market what the VIX index is to the stock market. The MOVE index closed at a recent high of 158.99 on September 28th. The last time it got anywhere near that level was during the COVID panic in March 2020. The time before that was during the GFC in November 2008 when it closed at 214. To quote Harley Bassman, the creator of the MOVE index, "A level near 150 occurs when the Fed has lost control."
Some Seismic Shifts in the Markets
It's our observation that the bear market in equities began in near synchronicity with the breakout of the 10-year Treasury yield above its 40-year structural downtrend line. The subsequent bullish inflection above chart resistance at 3.25% -- the 2018 high, has since resolved a range consolidation, which projects a measured move to approximately 6.00%. While we concede that the reaction high of 3.99% could remain a point of resistance should yields decide to consolidate their advance, as long as they hold sustainably above the 2018 high, we would continue to expect higher highs to follow.
The U.S. Dollar index (DXY) is another candidate for a sustained structural trend reversal, albeit one that has been in the making for nearly a decade. An eight-year range consolidation was resolved to the upside this year, again in synchronicity with the breakout in T-Note yields. While many pundits have railed against the dollar's strength this year (+17.25% YTD through Q3) -- blaming it for all that ails the world, the fact of the matter is this: The U.S. Dollar index has been in a new structural bull market since its GFC lows. Its structural momentum actually bottomed back in 1988! Our work suggests that the DXY has further upside potential to at least 120 before the next important wave of consolidation ensues.
Yet, WTI Crude, which normally trades with a natural inverse correlation to the U.S. Dollar, remains up double-digits for the year. This, in the face of a 30% drawdown of the nation's Strategic Petroleum Reserve (SPR) -- an effort by politicians to hold prices at bay before an election. Why? Because U.S. energy policy has deemphasized domestic production in favor of foreign energy dependence, and an investment focus on renewable energy. We consider this decision to be ill-timed at best, and a policy error at worst. The Russian invasion of Ukraine has no doubt exaggerated the effects of this policy. Nevertheless, it is what it is. Our work supports the notion that WTI Crude has likely seen its structural lows. It remains another candidate for a structural trend reversal.
In case you haven't figured out where we are going with this discussion, allow us to get to the punchline. All of these macro trend reversals appear structural in nature. If so, they are a kin to shifting tectonic plates beneath the surface of the earth. Once they are in motion, they cannot be reversed -- and all are in motion. In addition, the Fed began the process of of shrinking its balance sheet (QT) in June. The plan is to drain $95 billion/month in liquidity from the system. According to Chicago Fed President Charles Evans, an alternate voting member of the FOMC, "the [Fed's] balance sheet will be completely reduced within three years." Given the strong correlation between stock prices and the Fed's balance during its historically accomodative monetary policy phase (QE), the reversal of that policy is not expected to prove supportive to equity markets.
Importantly, these trend changes represent major headwinds for the U.S. economy, and by extension, U.S. equity markets. And lest we forget, when the U.S. sneezes, the rest of the world catches cold. Rising rates and QT will result in slowing GDP growth at best, and a severe recession at worst. A strong and rising U.S. Dollar will hamper exports and negatively impact the earnings of multinational U.S. corporations. And high and rising oil prices will act like a tax on disposable incomes and weigh heavily on U.S. consumer spending. So, given these structural impediments to growth, what are the long-term implications for the stock market?
In our view, given the seismic shifts evident in the global macro data described above, it would be nothing short of foolish not to at least consider the possibility, however small it might be, that something more significant than a garden-variety, cyclical bear market may be underway.
Using the Elliott Wave principle as our model -- a framework that utilizes concepts from both behavioral economics and fractal geometry to identify self-similar price patterns within the market in an attempt to map the impulsive and corrective wave forms that determine the directional path of the market at every degree of trend -- we have evaluated the price data of the S&P 500 and its predecessor index going back to its foundation in 1926, and also analyzed the DJIA price data to fill in the blanks during the preceding 30 years. Based solely on the U.S. public market price data available, we have concluded that the U.S. stock market likely peaked at the largest degree of trend in observed history. In our opinion, the 90-year advance in the S&P 500 that began in April 1932 and terminated in January 2022 counts best as wave (III) within a five wave impulsive motive wave [(I)-(II)-(III)-(IV)-(V)] at supercycle degree of trend.
If our analysis is correct, then the bear market decline thus far only represents the very early subdivisions of cycle wave A down, of a supercycle wave (IV) corrective wave form, which could potentially carry prices to the lower boundary of the parallel trend channel before completion -- as illustrated in the chart above.
We are not the only analysts on the street that are entertaining the possibility of a more perilous future for equity prices. Robert Prechter of Elliott Wave International, has been postulating the notion of a grand supercycle top for years. It encompasses price data that extends back to the 18th century London Stock Exchange, and assumes the market to be trading at one larger degree of trend than the supercycle degree top that we've proposed. That hypothesis, originally put forth by R.N. Elliott himself, is predicated upon the idea that fractal geometry has no known limits, and as such, we should extend our understanding of market psychology and price patterns as far back into history as reasonably possible in order to best forecast these repeating patterns into the future.
While we don't disagree with this view philosophically, we prefer to deal with the tangible realities within our grasp and leave educated speculations of this nature to the academics like Bob and his team. Suffice it to say, the outcome in either case is nearly identical, they both lead to fourth wave declines; it's simply a matter of how one labels the degree of trend. And in both cases, the degree of trend is outside the purview of most market analysts, portfolio managers, and investors.
It is human nature to rely upon our experiences and recent history in order to form judgements about the future. Yet, we can't help but laugh when we hear serious people base their conclusions upon "data going back to 1957," or upon "post-WWII history." That limited sample of data leaves out the most extreme experiences of the last century. In our opinion, analysts will remain blind to the forest through the trees, until they expand their range of thought to include that which is unimaginable to the consensus on Wall Street.
Geopolitical Risks are Nearing a Boiling Point
Many investors have inquired as what might be the catalyst for such an extreme reaction in stock prices and economic activity. We don't know for certain, and we don't wish to sound alarmist, but just open any newspaper.
We've commented in these pages before that we think it is entirely plausible that China and Russia are working together to undermine the West in order to achieve their own independent foreign policy objectives -- and that China likely supported Russia's invasion of Ukraine in order to observe NATO's reaction. Since May, Chinese banks have been taking steps to insulate themselves from any adverse repercussions from sanctions should the reaction befall China. In addition, China has been building up their own SPR, while quietly stockpiling a two-year supply of grain. They have roughly 20% of the world's population, but they're currently hoarding over 70% of the world's corn, 60% of the world's rice, and 50% of the world's wheat supply. These are the actions of a country preparing for war.
In a last ditch effort to save face in Ukraine, following what appears to be an illegitimate referendum, Russia has annexed four regions of the occupied country and is now threatening to use nuclear weapons to defend against any future incursion into what they are now referring to as "their homeland." Meanwhile, China has made numerous verbal rebukes of recent U.S. diplomatic visits to Taiwan, while increasing military exercises in the South China Sea and raising the number of forces stationed at their military base on man-made Woody Island. It was also reported that the Taiwanese Air Force recently shot-down a Chinese drone that had entered into its airspace.
A military move by China against Taiwan is not a far-fetched idea. China has maintained that Taiwan is part of People's Republic of China (PRC) since it's separation from the Chinese Communist Party (CCP) in 1946. Henry Kissinger negotiated the current U.S. policy toward Taiwan with China during the Nixon administration in 1972, "one country, two systems." But there is now a precedent for the unauthorized annexation of Taiwan -- Hong Kong. While it was intended that Hong Kong would eventually be folded back into the Chinese government's control after a 50-year period as a special administrative region following the handover from the UK to the PRC in 1997, the CCP jumped the gun in 2020 and seized the former British colonial city-state, breaking dozens of international laws in the process, and without consequence.
But why would the CCP want to reign in Taiwan today? Hasn't business as usual been profitable for both governments? The CCP has a 100-year plan, and they are patient. But they also understand strategy very well -- and Taiwan is the center of the global economic chess board. It is well-known that Taiwan is responsible for 70% of the world's semiconductor production -- and 92% of the most advanced semiconductors. The U.S. has made it very difficult for China to acquire the the necessary equipment to manufacture their own advanced semiconductor chips. The world's economic growth is dependent upon a steady, available supply of semiconductor chips. He who controls the supply of semiconductors controls the world.
Our Stock Market Forecast
The world in which live has changed. It may be helpful to study history in order to understand how and why, but it's most important is to understand what has changed. Today's circumstances are not comparable to the GFC; they are similar, but still not directly comparable to the 1970s; and despite the President's latest remark, we don't think that they are comparable to the Cuban Missile Crisis. But they might be comparable to the early 1930s.
Why the early 1930s? Because that's the last time that the world experienced an economic and market reaction to a supercycle degree trend reversal. While it's impossible to know the future, or predict exactly how the the stock market will behave, we can attempt to analyze the market's price action in real-time using the Elliott Wave principle to create a high probability forecast of where prices are likely move in terms of both direction and magnitude.
S&P 500: 13-Year Monthly View
Our preferred Elliott Wave count at cycle degree of trend supports the conclusion that the S&P 500 is in the early subdivisions of primary wave (3) down, of cycle wave A down, within a supercycle wave (IV) correction. A break below SPX 3584 would confirm that view, suggesting that prices are potentially poised for a third wave decline at three degrees of trend.
Third waves are usually the most powerful and dynamic wave within the impulsive wave progression. They have a tendency to subdivide and extend, concomitant with strong momentum. The point of peak momentum usually occurs at the midpoint and have been observed in combination with continuation gaps, volume expansions, and extraordinary breadth. R.N. Elliott had this to say about third waves: "They are wonders to behold."
S&P 500: 3-Year Weekly View
Using several orthodox measures we have identified the range between SPX 2750-2400 as the optimal target area for primary wave (3) down to reach its terminal point. The timing of this decline could occur before the election on November 8th (see the September issue for details related to the midterm election cycle). Once complete, it will be followed by a primary wave (4) countertrend advance, which based upon Elliott’s guideline of alternation, should prove to be a shallow, lateral consolidation — it should not exceed the primary wave (1) low in order for the current count to remain valid. Ultimately, we expect cycle wave A down to terminate with a final fifth wave plunge to around SPX 2250, a level which coincides closely with the Fibonacci 61.8% retracement of cycle wave V -- the 13-year advance off the March 2009 low, along with the 200-month SMA, and a previous fourth wave extreme at one lesser degree of trend.
We are often asked, "what would make you change your mind?" The answer is simple. If prices exceed SPX 4326, the August 16th high, then our current count is wrong and something else is happening. We have an alternate count, but it also does not present a bullish outcome. We will share that count if and when it becomes relevant. For now, we are quite confident in our preferred count.
Let's consider for a moment, the four core asset classes from which we have to choose -- Stocks, Bonds, Real Estate, and Commodities -- from a valuation perspective relative to history. U.S. property valuations are at their highest level of the past 40-years, trading at 3 standard deviations above their mean. U.S. equity valuations have come down from their peaks, but equities still trade at >1 standard deviation above their 40-year mean. Commodities are trading in-line with their 40-year mean valuation. Yet, U.S. Treasuries alone are the only one of these four asset classes that now trades at a discount to their long-term average. This doesn't mean that they can’t get cheaper, but at present, they represent the best value in the capital markets.
Conclusion
It is our view that investors will be best served in the current environment by holding the majority of their assets in cash equivalents and the highest quality short-duration fixed income securities. We consider 1-3 year Treasuries to offer the best combination of safety, liquidity, and income. Those who wish to add a capital appreciation leg to that stool, might consider a bar-bell strategy in which they hold an equally-weighted position in short duration Treasuries and long duration Treasuries. If the stock market follows the path that we have projected, then it is possible that institutional investors will reallocate a larger portion of their assets to the long end of the yield curve resulting in a potential rally in long duration Treasury bonds.
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