HUGE INSIGHTS: The Big Picture - Issue #9
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The Economic Cycle
The month of June will likely provide investors with several additional clues as to where we are in the current market cycle, if not the economic cycle. The May NFP report is due out on Friday, 6/3, and the next CPI report is due out the following Friday, 6/10. If the employment report is too strong and the inflation report is too hot, then the bears will cheer and the market will no doubt resume its trend lower. But if job growth falls short, and the inflation data cools, then the bulls will cheer and the rally will likely carry the market higher until reality sets in.
The reality of which we speak is the fact that GDP growth has weakened substantially (1Q22 GDP was -1.5%), and concomitantly, so have earnings. According to S&P Global, actual 1Q22 operating earnings are down 12.5% sequentially from 4Q21, putting y/y EPS growth at just 4.7% (w/ 97.1% of companies reporting) -- well-below the street consensus forecast of 9.2% for the same period. This is clear to anyone who has been tracking the quarterly results posted by the likes of APPL, AMZN, FB, GOOGL, NVDA, WMT, TGT, WFC, C, NKE, and DIS, just to name a few.
Yet, the street is estimating $228 in S&P operating EPS for 2022, and $249 for 2023, suggesting 9.3% and 9.2% full-year EPS growth for this year and next. This means that analysts on Wall Street are currently ignoring the reality of high inflation and slowing GDP growth, and simply pushing the first quarter earnings miss into future quarters. We doubt actual earnings will come close to those estimates as GDP growth appears poised to weaken further in the second quarter, and with it, 2Q22 earnings.
Indeed, our working hypothesis, based upon tightening monetary policy conditions, persistently high inflation, lagging wage growth, elevated inventory levels due to overordering in the back-half of 2021, and a total collapse in mortgage applications and new housing starts, is that the US economy likely entered a recession in the first quarter of this year. Whether or not this recession turns out to be a deep or shallow affair remains to be seen. However, as illustrated in the chart above, our long-term Economic Cycle Model was expected to reach a structural peak within the year. The model is already rolling over, and with history as our guide, if a structural peak has been reached, then the next structural bottom is not due until 2039.
Quantitative Tightening
To be sure, the Fed has made it clear that they are not fooling around anymore when it comes to inflation. While the Core PCE did tick down to 4.9% in April, from 5.2% in March, the Fed's most closely watched inflation gauge is still 290 bps above their target rate of 2.0%. Fed Chairman Powell stated at the May FOMC meeting that the central bank expects to raise its funds rate by 50 bps in June, and by another 50 bps at the July meeting, before pausing. Moreover, the Fed also outlined its plan to reduce its bloated balance sheet starting this month by $402.5B before year-end, and by another $1.14T next year, and annually thereafter. This is not be good news for the stock market.
As can be seen in the chart below, there was an unusually tight correlation between the advance in the S&P 500 and the growth in the Fed's balance sheet since March 2020. As the Fed begins to withdraw liquidity from the market, the potential exists for that correlation to remain just as tight in the opposite direction. We suspect that the decline in stock prices so far this year, to some extent, has been in anticipation of this change in monetary policy.
Valuation Comparison
A new structural bear phase in equities likely began this year. If our analysis proves correct, then the January high in the S&P 500 index may remain the high for some time to come. So, where are we in this process? In a word, early.
While the S&P 500 index declined by 20.9% over 105 trading days from its January 4th intraday peak to its May 20th intraday trough, that may only represent the first ripple in this decline. Yet, many pundits in the financial media have been arguing that the May low was the bottom -- the end of the bear market. The problem with this notion, as we've discussed in these pages before, is that the bear phase of a market cycle is not governed by some arbitrary percentage change in the price of an index. It's a process. And that process takes time to play out. The amount of time is determined by the degree of trend from which the bear phase begins. In other words, it is initial conditions dependent. Oftentimes, the degree of trend can be identified based upon the common denominator of valuation. Typically, the larger the degree of trend, the higher the valuation.
As illustrated in the chart below, we've indicated the valuation multiple at significant prior peaks and troughs. They are significant because once surpassed, they have never been seen again. The valuation methodology used is based upon the well-known Shiller CAPE ratio, which normalizes margins and adjusts all data for inflation. Over the past century, these key market bottoms in the S&P 500 were marked by mid-single digit to low-teens CAPE ratios. The only exception was the March 2020 low, which was marked by a CAPE ratio of 19.8x. The epic market peaks, on the other hand, were marked by CAPE ratios that ranged from the low-30s to the mid-40s.
So, if the May 20th low truly marked the end of the bear market, and consequently a significant market bottom, one which will never be seen again -- a veritable "buying opportunity of a lifetime," then why is it that the valuation multiple at that low -- a CAPR ratio of 31.0x -- is more representative of an epic market peak, such as that seen in 1929, than a historic low, like those witnessed in 1987 or 2009? We suspect that its because the May 20th low was not a historic market low. Indeed, we suspect that it was merely an interim low in an ongoing structural bear phase in equites. Potentially, one at such a large degree of trend that there may not be any recent precedent from which to draw any reasonable comparison.
A Bear Market Roadmap
Our work concludes that the January 4th all-time record high marked a cycle degree top in the stock market, and possibly a supercycle degree top. The reason that we need to qualify the supercycle top is because no one has actually ever seen one before. But, by using the Elliott Wave principle, a fractal hierarchy of self-similar wave patterns, which vacillate between motive wave forms (1-2-3-4-5), and corrective wave forms (a-b-c or w-x-y), we can identify a scenario whereby the current corrective wave form, which must be of at least cycle degree, could be part of a larger corrective wave form of supercycle degree. The chart below illustrates three different degrees of trend over the past century: Primary degree (1-5); Cycle degree I-V; and Supercycle degree (I-IV). If our hypothesis proves correct, then cycle wave A down of supercycle wave (IV) down is now operative.
Zooming in on cycle wave V up -- the 13-year advance off the March 2009 low, as illustrated in the next chart below -- we can conclude that the depth of the five month decline we've experienced thus far in 2022 is insufficient to be considered a cycle degree corrective wave form. An orthodox corrective wave form must retrace between one-third and two-thirds of the previous advance at the same degree of trend. More commonly, these corrective retracements tend to coalesce around three key Fibonacci ratios: 38.2%; 50.0%; and most commonly, 61.8%. As such, to be considered a valid cycle degree correction, the decline in the S&P 500 should eventually carry to at least SPX 3232, and potentially as low as SPX 2252.
The most common pattern for a corrective wave form is three waves (a-b-c) that create a zigzag of sorts, whereby wave "a" and wave "c" are of equal length and are bisected by wave "b", which also forms a smaller degree zigzag pattern. But if the (a-b-c) correction that we have outlined is itself just cycle wave A, of supercycle degree corrective wave (IV), then the potential exists for a structural bear phase to extend for years or even decades, as occurred from 1966 to 1982. The fundamental basis for this expected price action extends from human psychology and social behavior, and has been well-documented over the years by the study of behavioral economics.
What Might Be the Catalyst for Such an Event?
It is impossible to know for certain, but one possibility that we have been considering is that of a new world war. Not necessarily a nuclear war, as most would fear, but a new cold war that erupts into brief, small-scale hot wars, such as that being waged against Ukraine by Russia. The spoils of such a new world war will be economic dominance. So the motives of the participants should not be underestimated.
What is clear at this point, is who the key players are: The West, led by the United States, the East, led by Russia, and most importantly, China. It might even be possible that China is collaborating with Russia to undermine the West in order to achieve its own nationalist foreign policy objectives. Indeed, Chinese President Xi Jinping met with Russian President Vladimir Putin on February 4th, just weeks before the invasion of Ukraine commenced-- an invasion that likely was years in the planning. Based upon the actions that have followed in China, Xi may have blessed the planned Russian invasion in order to observe how the West would respond. Kyle Bass does a nice job explaining it in the Tweet storm below:
Moreover, it is quite clear that China does not want to be interfered with economically should the same fate befall Xi's government. And why might they be worried about that? It's no secret that Xi wishes to bring Taiwan back into fold of China, much the same way he did with Hong Kong in 2020. The key difference is that Hong Kong was always part of China. China's stated constitutional principle regarding Hong Kong was, "One country, two systems." Taiwan is a completely separate sovereign nation. But China is not about to let that stop them. Don't forget, China has completely militarized three man-made islands in the South China Sea. These bases could be staging areas for a land-based assault on Taiwan if push comes to shove.
Why else would China be stockpiling a two year supply of grain including 70% of the world's corn, 60% of the world's rice, and half the world's wheat? It has been widely speculated that China is also in negotiations to absorb up to 3 million barrels/day of excess crude oil production from Russia in order to shore-up their own strategic petroleum reserves. Taiwan now accounts for 92% of the world's most advanced semiconductor manufacturing capacity. Dozens-to-hundreds of semiconductors are now required for all electronic devices and myriad types of complex machinery manufactured around the world, including aircraft, ships, tanks, weapons systems, and laser guided munitions. He who controls the supply of semiconductors, controls the world.
Conclusion
Inflation is just a symptom. The problems are much larger. Don't be fooled by short-term changes in investor sentiment. They can act as fuel for a bear market rally, but they do not forestall the inevitable. There were six such countertrend advances that exceeded 7% during the 2000-02 cyclical bear market, three of which exceeded 20%. During the 2008-09 cyclical bear market, there were five that exceeded 7%, three of those exceeded 12%, and one came in above 24%. Remember, when a market declines by 50%, it needs to double just for you to breakeven.
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