HUGE INSIGHTS: The Big Picture - Issue #15
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Investors are now facing a three ring circus of risks. On the geopolitical front, there are the twin pillars of doom: Russia and China. But to a lesser extent, concerns have been building over recent actions by Iran and North Korea. On the political front, there are the midterm elections next week, which some say will seal the fate of our democracy. Finally, in the center ring, there is the U.S. economy, the Fed, and corporate earnings.
With the 60/40 portfolio on track to post its worst annual performance of the past 100 years -- down more than 30% today vs. its average annual return of 9%, these risk factors appear poised to continue their influence on the future direction of markets, and ultimately the financial health and security of all investors -- worldwide.
The Economy, the Fed, and Corporate Earnings
It's been our view that the economy, and by extension, the stock and bond markets, are suffering from the initial effects of a dramatic shift in monetary policy from easing to tightening. This policy shift was brought about in reaction to extreme inflation data that reached levels heretofore not witnessed since the early 1980s.
These extremes in the inflation data are the direct result of three factors: 1) massive fiscal stimulus endorsed by both political parties; 2) massive monetary stimulus implemented by central bankers around the globe; and 3) the inability of the global economy to re-start, and smoothly ramp-up supply chains, infrastructure, and logistics in synchronicity with demand, as the global economy staged a staggered recovery from the depths of a pandemic-induced shut-down and global recession. Caveat: This last reason was also partly due to the outbreak of war in Eastern Europe.
On Wednesday, November 2nd, the FOMC announced the decision to raise their benchmark funds rate by another 75 basis points to 4.0%, the highest level since November 2007. This was not a surprise, as the move was well telegraphed by Fed Chairman Powell and other Fed governors in speeches throughout the month of October. However, the WSJ's chief economic correspondent, Nick Timiraos, playfully referred to by some as the 'Fed Whisperer,' published an article on October 21st that gave credibility to a view that the central bank was poised to 'pivot' away from their aggressive tightening stance and pause following just one more 50 bps rate hike in December. This inspired a sharp, incremental rally in the S&P 500, pushing the index up a total of 12% from the October 13th low into the November 1st recovery high.
But the markets found the Fed Chairman's post-meeting speech to be far less inspiring, resulting in a brutal sell-off that took the major stock averages down by 5% into the lows of the week, and left the 10-year bond yield just basis points below its recent high of 4.3%. Indeed, the Fed Chairman was explicit in his statement, declaring, "overtightening may be a less costly option than doing too little." This made it clear that the central bank would not allow its resolve to be questioned with respect to taming inflation. And why would it? As illustrated in the chart above, the Fed's preferred inflation gauge -- the Core PCE -- just rose to an annualized rate of 5.1% in the month of September, up from 4.9% in August, leaving it more than 100 bps above the current Fed funds rate. By this measure, core inflation is still expanding, and remains alive and well.
Powell's speech essentially indicated that the Fed would continue to raise their benchmark rate until real rates were positive (i.e. above the core inflation rate). Then, he intimated that they intended to hold them there throughout 2023, or until it was clear that inflation had reached the central bank's 2.0% target level. The so-called 'Dot Plot' above confirms that the Fed intends to raise rates by at least another 50 basis points in December, and by as much as an additional 50 basis points in 2023. This stiff headwind could pose a serious problem for the economy next year, not to mention the stock market. And all of this assumes that inflation doesn't surprise again on the upside.
To be clear, the Fed Chairman stated at the Jackson Hole economic symposium in August that the central bank was prepared to take the economy into recession if necessary in order to quash inflation. Economists that have been more concerned about the risks of high inflation over the risks of slow growth have been comparing the current circumstance to that of the 1970s. If they are correct, then to examine the 1974 historical policy analog would seem germane to understanding the forward 12-month outlook in our view.
We've been cautioning investors that a Fed pivot should not be mistaken to mean that the economy and stock market are poised for some kind of sharp sustained recovery. The Fed has a long history of overshooting the mark on both the upside and the downside. While it's now clear to all that they overshot the mark on the downside following the COVID crisis, it should not be ignored that the Fed has told us that they are now willing to overshoot it on the upside. Indeed, in 1974, the pivot came long-after the Fed had gone too far, and the economy was already deep into a recession. Then, the stock market continued to decline by an additional 30% over the subsequent six months following the Fed's pivot.
In fact, the stock market has historically declined by an average of -28.3% over the subsequent 14 months following the Fed’s initial policy pivot. With so many bulls now basing their constructive views on 1) a peak in the inflation data; and 2) the imminent shift in monetary policy by Fed officials back toward easing, it might be worth the effort, for those convinced that the two will result in an immediate new bull market advance, to actually review the historical record.
The silver lining to all of this doom and gloom, has so far been the seeming ability of corporate earnings to continue to grow. But, have they? According to FactSet Research, 3Q22 S&P op-EPS are still expected to grow by 2.2%. That's not bad, despite being less than the 2.7% growth that analysts were forecasting just a month ago. Yet, seven of the eleven S&P sectors are actually expected to report a y/y decline during the quarter, led by Communications Services, Financials, and Materials. Paradoxically, ex-Energy, 3Q22 S&P op-EPS would be expected to post a y/y decline of -5.6%!
This brings us back to the caveat mentioned above -- related to the third reason for this year's extreme inflation data. Energy producers have been coining money this year as the elevated price range of the underlying commodities in the oil patch have allowed even the most marginal producers to turn a profit. Politicians like to complain that big oil companies always put profits ahead of consumers, and make veiled threats of a windfall profit-tax, but at the end of the day, production is nearly back to pre-COVID levels, and it will likely hit a new all-time high before year-end. Energy prices will remain a key swing factor for the economy and corporate earnings in both Q4, and 2023.
Politics and the Midterm Elections
We don't have too much to opine about here. The clown car in the cartoon above pretty much says it all. But based upon the latest polling data, there is good reason to believe that the Republicans will sweep the House, and could pick-up a seat or two in the Senate.
If, however, the Democrats can hold the Senate, it would split the Congress and create a condition of gridlock in Washington for the next two years. Nate Silver at FiveThirtyEight calls the race for control of the Senate a dead heat.
Perhaps more important to the state of the republic, than which political party controls which body of Congress, is which candidate wins the outcome of the many federal, state and local races around the country. There are reportedly over 300 candidates seeking public office in next week's midterm election that are self-avowed 2020 election deniers. Democracy is fragile, and the republic of the United States of America is currently on unstable ground. Some have gone as far as to call it a 'cold civil war.' An internally divided nation is a weak nation. Our adversaries know this, and they seek to divide and conquer.
Whether your baseball cap is colored red or blue, remember this -- we are all Americans. Perform your civic duty -- vote. Then treat your fellow Americans with respect and dignity, regardless of their political ideology. United we stand, divided we fall.
Geopolitical Risks Are Rising
The Chinese Communist Party (CCP) re-elected Xi Jinping to an unprecedented third-term as their nation's President. But the real story lay in the details. Not only was Xi given another 5-years at the helm of the most populous country in the world, he was also given new authority to amend the party's constitution, and appoint new leadership to the politburo made up of hard-line loyalists to back him. His coupé-de-gras was made complete when Xi's predecessor, Hu Jintao -- a reformer with a 'soft approach' to Taiwan, was suddenly and inexplicably ordered to leave the session, and was then physically escorted out of the CCP congressional chamber.
Xi's rhetoric at the meeting of the CCP congress last month included statements related to the use of force over Taiwan -- if attempts for a peaceful reunification proved unsuccessful. This language received thunderous applause, leading many top western military officials to warn that the CCP was accelerating China's plans to push ahead with a presumed planned military move against Taiwan as early as year-end.
Meanwhile, Russian President Vladimir Putin has softened his rhetoric over the use of nuclear weapons in Ukraine, yet there are worries that a possible 'false flag' attack is being planned by the Russian usurper. The claim by Putin that Ukraine was allegedly building a so-called 'dirty bomb' to be used against Russian troops on Ukrainian soil, has been found likely to be a cover story designed so that the Russians could use said weapon themselves against the Ukrainians, and then cast the blame on their enemy. UN nuclear inspectors have found no credible evidence to support Putin's claim.
As noted, a key variable in the global inflation picture is the price of crude oil. The current administration has gone all out to suppress oil prices in the U.S., but with limited success. Eventually, they will be forced to cease the drawdown of the nation's Strategic Petroleum Reserve (SPR). When they do, we may also find that the supply/demand function could potentially be impacted by a wide variety of exogenous events including, but not limited to, China reversing their zero-COVID policy, Russia turning down the heat on Europe, or even the possibility of another outbreak of war in the Middle East -- this time between Saudi Arabia and Iran.
And lest we forget, our old friend Kim Jong-un is back in the news again. All, or any of these geopolitical and domestic policy factors could serve to exacerbate the world's economic problems. Those factors amount to something of a wild card in the deck as things playout toward their logical conclusions. They could either improve or worsen from here. Most believe that they will improve, but as we've written before, during bear markets, surprises tend to occur on the negative side of the ledger, so don't count on that.
Market Analysis and Outlook
As discussed in our past newsletters, it has been our long-standing view that the January 4th peak in the S&P 500 index most likely marked the end of cycle wave V, and by extension, the end of a supercycle wave (III) advance. If so, then a fourth wave correction at supercycle degree of trend is now likely operative. Under this rubric, primary wave (1) down, of cycle wave A down, terminated on June 17th at SPX 3637. Thus, primary wave (2) up, the countertrend advance that followed, then terminated on August 16th at SPX 4325.
If this view is correct, then primary wave (3) down is still tracing out its early subdivisions. So far, this entire sequence is only part of an impulsive five wave decline that should eventually carry the index to approximately SPX 2250 before cycle wave A down terminates. Once complete, cycle wave B up -- a countertrend advance at the same degree of trend -- should then retrace between one-third and two-thirds of the entire expected cycle wave A decline, before cycle wave C down ensues to carry the index to new lows.
As such, it is far too early in the process to begin worrying about catching the wave B countertrend advance. At this stage of the game, we are only interested in identifying the key subdivisions of primary wave (3) down. So far, we believe that the October 13th low counts best as marking the bottom of intermediate wave 1 down, of primary wave 3 down. If correct, then the November 1st high likely either marked, or is very close to marking the top of intermediate wave 2 up.
Once price breaks below the October 13th low it will confirm that intermediate wave 3 down, of primary wave (3) down is well-underway. Third waves are the most powerful and dramatic of the impulse sequence. Elliott had this to say about them, "They are wonders to behold." Based upon a variety of technical measures and common wave relationships, we estimate that primary wave (3) down should terminate between SPX 2750-2400. By this count, price cannot exceed SPX 4325. If it does, then our preferred count will be invalidated, and we will need to reassess the situation.
As stated above, it's our view that the S&P 500 index has experienced a countertrend advance off the October 13th low. We define it as countertrend for two reasons: 1) because the advance follows a prior impulsive wave form (five waves) in the opposite direction, at the same degree of trend; and 2) because the identifiable highs and lows at one lesser degree of trend are overlapping, which is a violation of Elliott's rules pertaining to motive waves.
As such, from a short-term perspective, we think that there are two acceptable ways to count the price action since the October 13th low that satisfy all of Elliott's rules and guidelines. The first assumes that the countertrend advance -- a double zigzag [(w)-(x)-(y)] in Elliott Wave parlance, topped on November 1st at SPX 3911 -- a 50% retracement of the intermediate wave 1 decline from the primary wave (2) high on August 16th. We've labeled that as the top of intermediate wave 2 up, of primary wave (3) down. The subsequent five wave impulsive decline at one lesser degree of trend gives us enough confidence in this interpretation to refer to it as our preferred short-term count.
Our alternate short-term count below illustrates the other acceptable way to label the price action over the same period. This count assumes that the November 1st high marked only the top minor wave (w) up, of intermediate wave 2 up. The subsequent decline must then be an (x) wave. This should be followed by a further advance to a modest higher high to mark the intermediate wave 2 top. If this interpretation proves to be correct, then we suspect it will carry to the Fibonacci 61.8% retracement of the preceding intermediate wave 1 decline, as illustrated below.
The most common question that receive from our institutional clients is this: "What would it take to turn you bullish?" The answer to that question is three-fold. First, the S&P 500 would have to trade above the August 16th high of SPX 4325. That's the 'make or break' level for our preferred Elliott Wave count at primary degree of trend. Second, our long-term trend following model below would need to trigger a buy signal. This would occur if the faster exponential moving average (green), were to cross above the slower simple moving average (red), on a weekly closing basis.
Finally, our long-term momentum model would need to turn up on a monthly closing basis. By our calculations, based upon October's month-end reading, the S&P 500 would need to close above SPX 4500 on November 30th in order for the model line to register an uptick. That level declines rapidly once the calendar crosses into 2023, and the oldest price data falls out of the calculation. A hat trick, including all three of the signals, would move us decidedly into the bull camp. At present, however, we are not at all close to seeing even one of the signals triggered.
Conclusion
Given this rather grimm outlook, what's an investor to do? As we've been advocating for many months now, during a bear market it is wise for investors to allocate the majority of their capital (80-90%) to short-term, Treasury securities at the 1-3 year part of the yield curve, where they can now earn up to 4.7% on their money, risk-free. In our view, this investment allocation offers the best combination of safety, liquidity, and income, while the broad equity markets decline. The other 10-20% of an investor's capital should be held in an FDIC insured interest bearing cash account, ready to be allocated to trading opportunities as they present themselves. There are always trading opportunities!
For those who have difficulties finding such trading opportunities in a timely manner, or for those who simply have an interest in seeing regular idea flow, our ALPHA INSIGHTS: Idea Generator Lab publication, is available to newsletter members for just $10/month. The publication highlights our top actionable trade idea each week, and is delivered to your inbox every Wednesday afternoon between 12:00-1:00 pm CST via e-mail. That's four ideas a month for $10 -- each costing less than the price of a cup of coffee at Starbucks! Is that worth it? You tell us.
Our third-party verified performance, as of the close of business on November 4th, is presented below. It details our total returns vs. the S&P 500 since inception (11/15/21), along with our win/loss ratio, our average gain per winning trade, and our average loss per losing trade. In our experience, the secret to making money in the stock market is this: let your winners run, and cut our losers short. Famed hedge fund speculator George Soros probably put it best when he said, "It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."
Of the 40 trade ideas that we've presented over the past year, only around 1 in 3 have paid off. But, when we're right, we've made over three times as much as we've lost when we're wrong. That formula has allow us to post a +24% positive absolute return on total capital deployed over that time, and a +43.5% positive relative return vs. the S&P 500 index, which has declined by about -19.5% during the same period.
Below is a recent example of a trade idea presented to our members just a couple of weeks ago. We identified a mid-cap company, based in Milwaukee, WI by the name of Badger Meter, Inc. (BMI) that has the leading market share position in the automatic water meter reading business. Their product provides their main customers (municipalities) with a major source of cost savings and productivity improvement. The stock recently posted a new all-time record high after posting strong quarterly results, to resolve above a year-long, classic patterned base formation of the inverted "Head & Shoulders" variety. After first rallying by 30%, the stock has just pulled back to trend support.
We see this as a low risk entry point for swing traders with a 1-3 month time horizon to capitalize on the next possible wave of the advance, which could carry the stock up to our published target price of $145 -- a potential 33% gain. An initial stop-loss set at $102 would establish a very attractive 5:1 positive risk skew, and limit downside risk to less than $7/share, or 6.3% of capital deployed based upon Friday's closing price of $108.91. For this trade idea, we would suggest limiting your position size to less that 5% of trading capital, or about 1% of total portfolio capital (assuming that 80% of the portfolio is allocated to short-term Treasury securities).
If you like this type of idea flow -- one top actionable trade idea, once a week -- then maybe you should consider trying our membership option below. There's no long-term commitment or contracts. If it's not for you, then it's not for you -- cancel anytime.
To get full access to our ALPHA INSIGHTS: Idea Generator Lab publication, which includes our top stock or ETF idea each week, become a dues-paying member for just $10 a month by clicking here.
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.
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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.
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Past performance is no guarantee of future results.