We have reached the midyear point of 2022, and bullish investors are not happy. The bears, on the other hand, are doing just fine. The question on everyone’s mind is, what’s next?
We have been decidedly bearish here at theOptionsEdge.Com. Our primary thesis is that the Federal Government made a monumental policy mistake by shutting down the economy and passing our money to anyone with a heartbeat. That maneuver stopped the production of goods and services and forced people to stay home. With little to do but therapeutic shopping, people bought everything in sight. This activity caused a depletion of products in the supply chain, which is the primary cause of the shortages we have seen worldwide. Shutting down the economy killed tax revenues, so the government paid for its misguided policy by taking on a historic amount of debt.
The chart above shows the amount of public debt outstanding issued by the US Federal Government. Any reasonable review of this chart shows that the government has given up on fiscal discipline. The federal government has liabilities it cannot pay, so they borrow to fill the budget gap because the people will not tolerate higher taxes. This situation tells us that we are near the end game where the government will have to default on its promises. To be clear, this is not something we want to see, but there are laws of economics, and the government is violating them in mass.
If the US were operating under a gold standard as the founders demanded in the Constitution, interest rates would have skyrocketed by all this borrowing. Over the past few years, the government scooped up all the savings and then some. As you can see from the chart below, people typically save about $1 trillion a year. But what about those savings spikes in 2020 and 2021?
These are savings manufactured by the Fed. The Fed printed about $5 trillion since 2020. That money has ended up as personal savings. Some people who received free money from the government saved it. Others sold goods and services, making a healthy profit. Those folks put it in savings as well.
Commercial banks printed up a lot of credit during this period as well, increasing the money supply. Most of what they created went into savings as well.
Money printing by the Federal Reserve allowed the Federal Government to spend without restraint as it suppressed interest rates. It did this by putting money into the private sector, which it lent to the Federal Government. The Federal Deserve does great harm when it prints money. 1) It takes away the immediate consequence of bad economic policy. That pushed the cost to a later date, and generations that have no say in the matter. 2) We end up paying for it with inflation. The bill has come due, and payment is going to be excruciating.
The CPI is now running at 8.5% on an annual basis. The US has not seen this level of inflation since the 70 and 80s. The 70s was a time of great economic hardship for everyone. People lost jobs and had trouble paying bills as prices ran away. Investors had a terrible time as well. The return on stocks for the entire decade of the 1970s was essentially zero. Savers saw their purchasing power fall by over 50%.
Like it or not, inflation is here to stay for years to come. The math is relatively simple. The quantity of high-powered money went from $1 trillion in 2008 to $9 trillion in 2022. The Fed has put enough money in the system to cause prices to rise by a factor of 9 (i.e., hyperinflation). Why has this not happened? The answer is simple. People still have faith in the Fed and the government. So they are willing to save and hold on to cash. Should the day come when people lose confidence, they will dump cash, causing prices to spike higher. At this point, this thesis is not our expected scenario. Prices have already increased by 33% since 2008. We think prices will rise at a 10+% per year unless and until the Fed starts selling assets. They say they will begin doing so this month. But we do not see it in the number yet. With asset prices selling off, we have our doubts they really will.
Inflation is running so hot now, and interest rates have nowhere to go but up. However, the 70s courted 40+ years ago, and a huge portion of the current population has never seen real inflation before. (It is common in emerging markets.) As a result, their expectations are anchored in the past. This is why we see inflation expectations in the 3+% range for the short-term and 2.5% in the long-term.
These numbers are laughable low. While fixed-income investors are starting to earn a higher yield as interest rates rise, they are still way too low, which means stock and real estate prices are too high. If you have not watched our discussion of interest rates and stock valuation, we encourage you to do so now. It will be as enlightening as it is frightening.
Our ideas on the causes of inflation are not unique to us. If fact, our thoughts are build on the work of the late great Milton Friedman, who developed the Monetary Theory of the Economy. The following is a video that is about four decades old but more relevant than ever. We suggest you watch it from start to finish.
Year to date, the Dow Jones Industrial Average was the best performer. It was down only 14.42%. The NASDAQ Composite Index was down the most at 28.87%. This should not come as a surprise as the NASDAQ has a heavier weight in growth and tech stocks, so it has a higher beta. That means it goes up more in a bull market and down more in a bear market. The S&P500 and S&P 600 Small Cap Index fell 19.74% and 18.78%, respectively.
Take a look a the return on the 30 US Government bonds. It was down 14.22%. The 30-year bond has the volatility of equities, but you do not get the growth. The 30-year bonds currently yield 3.11%. We are confident of very few things in this world. But we are convinced that in 30 years, the purchasing power of 30-year government bonds will be close to zero. We view them as certificates of confiscation.
Drilling down into the various economic sectors, Energy, that is, Oil & Gas stocks, performed very well, up 33.51%. Utilities came in a distant second at up 1.86%. This should not come as a surprise. Utilities are highly regulated, so the government tells them what they can charge for electric power. Since their revenues are stable, they tend to be bond surrogates, so their prices are sensitive to interest rates. That said, regulators typically allow inflation adjustments, so they tend to do better than bonds in the long run. The biggest loser is the consumer discretionary stocks. They are down 31.25%. Most everything else got taken to the woodshed as well.
A bear market has begun and has more to go, a lot more to go. The big question is how will equity price fair in the short term. We think there is a good chance the equity prices will keep falling, but it is also a good chance that equity prices get a bounce before the next leg down.
There are several reasons why we think lower prices are in the future. (1) Interest rates are going higher. (2) Companies are starting to cut revenue and earnings estimates. (3) Oil prices will remain high and will likely go even higher. (4) There is no panic among investors.
Here is a recent list of layoffs that have been announced since February of this year. We have not seen an update since late May, but we keep an eye out for it. Meta’s Zuckerberg stated that his company is facing the most challenging economic backdrop in its history. Since the company started, many people who work at Meta probably do not belong there. He went on to say that he would hope people would self-select and resign.
From a technical perspective, we investors are not paying up to hedge their longs just yet. The Fed’s money printing has inflated stock prices and has taught everyone to “hold for the long term” and “buy the dip.” Indexing has replaced stock-picking for the first time. We think it will prove to be a dangerous strategy. Yes, one removes individual company risk, which is endemic to active management, but it is the only way to make money in a bear market.
In Markets like these, we think it makes sense to use option to limit risk. We also suggest people trade small. Never take a position that make you want to check the market multiple times a day. Diversify your portions as well. While it is considered a bad idea by censuses think, do not be afraid to hold cash and wait for opportunities that peak to you. Only invest in what you understand. Be comfortable with the risks your take. Investing is a marathon and not a sprint.
We like to remind our readers that investing involves risk and that it is possible for one to lose most or all their investment when trading options (or any investment for that matter). Be sure to trade within the limits of your capital. Limit the size of your trades to an amount that will not harm you should they result in a loss.
Here at The Options Edge, our primary focus is to educate and help our readers make better decisions. We design trade suggestions to give real-time examples of how we think about the investment process. Our goal is to help investors develop a process that works for them, given their unique circumstances and risk tolerances. In time, we hope they find an approach that works for them.
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Photo by August de Richelieu
