August is another down month for financial assets. Price action is volatile, creating confusion in the minds of strategists and financial media.
Given the environment, this should not surprise those who have been around a long time, like Mike and me. Money printing by the Fed has three short-term effects. It pushes interest rates down and suppresses volatility. These two effects increase the price of risk assets (stocks, real estate, and junk bonds).
But market manipulation is a short to intermediate-term phenomenon. Eventually, the laws of economics tasks over. There is no such thing as a free lunch. There is a price for everything. The cost of money printing reveals itself as inflation. This phenomenon should be evident to anyone who has observed developing markets. The government in every developing economy thinks they can borrow, spend and print their way to prosperity. Then their currency collapses, and everyone wonders why.
The money printing hangover is where we are in the developing markets. The Fed has increased the quantity of high-power money by a factor of six since the end of the financial crisis. This is six times more money than the economy needs if price stability is the final objective. Not that they have lit the fire of inflation, they are looking for a bucket of water. We think they will find out they will need something substantially more significant.
As you can see in the charts above, the major market ETFs are in bear market mode. This is happening on the back of rising interest rates. The 10-year US treasury bond yields 3.2%, 1.95% more than it did a year ago. We have warned that rising rates would be the enemy of stock prices, and this process is taking place now.
So how much longer will we have to suffer this bear market? Unfortunately, the end is not in sight. The consumer price index has increased 8.5% over the last 12 months. We should not expect that rate to fall significantly until the Fed removes the excess money sloshing around the economy. They stopped printing money a few months ago, and we see the stress this is causing the financial markets. The Fed is set to let $95 billion of asset roll off its books per month. There is plenty of savings in the system to buy these assets, but the question is, at what price? The Fed is not a price-sensitive buyer of assets. Since its cost of capital is zero, it is guaranteed to make money on any asset it buys, provided they hold it to maturity.
Since we think people will want a real rate of return, we believe they will demand higher rates. So we think interest rates continue to move higher.
People are concerned about inflation in the short-term but not in the intermediate term. The chart above shows investor inflation expectation which is extracted from the prices of TIPS (Treasury Inflation-Protected Securities). It suggests people expect inflation of 6.2% over the next 12 months and 3.2% in three years. We think the intermediate-term estimate is way too optimistic.
There is a bit of doom and gloom concerning the overall economy. However, we do not think it is all that bad. Yes, we had a slowdown for a few quarters, but GDPNow is signaling the economy is doing okay. Not great, but okay.
It signals a 2.5% growth rate, and we would not be surprised if Q3 comes in at this level. This supports our bearish view of stocks, as odd as it may sound. So long as the economy keeps growing and inflation is far above the 10-year T-bond yield, the Fed will continue to shrink its balance sheet, which will lift rates. Rising rates will keep pressure on equity and real estate prices. In the end, we hope the air will slowly come out of the everything bubble, but we leave open the possibility of a dislocation that takes equity prices down hard.
This situation puts the fed in a very awkward position. If market prices meltdown, a recession is sure to follow. If inflation remains high, there will be little that can do to provide support. If the pivot, we could see short-term interest rates fall while long-term bond prices collapse. In that scenario, we will be in uncharted territory. It will be interesting to see how people react. Will they run for inflation hedges? Probably. But will a pivot support stock prices? Conventional wisdom says yes. But we are not so sure. We want to see what happens in real time before making definitive judgments.
In our last post, we predicted a bounce in share prices that would probably last a few days. Well, we were wrong. The DJIA rallied 350 points on the employment numbers, then at noon, stock prices peaked and then gave up the ghost. By the end of Friday’s session, the DJIA was trading 338 points lower.
This kind of price action is quite telling. It suggests there is more underlying weakness than the average investors might expect. This price action supports our bearish call.
The chart above highlights the price action of the S&P500 since the beginning of the year. It is decidedly down. It is best to be defensive and reduce exposure in markets like this. Active traders might want to focus on bearish bets, and we think the best strategy is to sell the blips.
We know that many of our subscribers are disappointed with our negative tilt. But we know that our first job is to help subscriber preserve their capital. The second is to help them grow it. We do this even though some subscribers drop us wishing/hoping for bullish support. We cannot change the mind of the market. All we can do is do our best to diagnose what is happening and help people ride the waves.
Finally, we would like to comment on Bitcoin. The selloff since the $69,000 top is more significant than we expected. That said, we think it has more to go. As equities selloff, we believe it will take bitcoin with it. Ultimately, we think it will find a bottom between $15,000 and $ 7,500. That implies a lot more pain to come. Investors can play this as they wish. The aggressive investors will get short here and cover (hopefully) at lower prices. We intend to sit on our hands and wait for what we think will be a bottom. Then sit back and wait for higher, much higher prices.
