2022 is a year that most stock investors want to forget. Depending on the stock, prices peaked in December 2021 or January 2022, falling precipitously all year.
To our way of thinking, two forces move stock prices in probably equal measures—one point in valuation. Valuation is driven by the whole situation that describes the company’s competitive position and management’s skill in maneuvering the economic video game. Success or failure shows in profitability and growth (or anti-growth). These are the factors that the typical wall street analysts focus on as they try to direct investment capital. A big part of valuation is the discount rate. This is the rate investors demand to hold an asset. Interest rates are what caught analysts flat-footed this year. They underestimated inflation and the degree to which the Federal Reserve was suppressing interest rates by purchasing $120 to $150 billion in Treasures and mortgage-backed securities every month. As hard as it is to believe, the Fed bought virtually all the debt sold by the government in 2020 and 2021. Once the Fed stopped holding the balloon under the water, it popped up fast and furious, taking valuation and risk asset prices down with it.
For our new subscribers who may not have seen the video Mike & I did on interest rates and their contribution to the valuation problem, we recommend watching it. You will find a copy of that video here.
The second driver of stock prices is crown psychology. The crown moves from periods of optimism, which drives share prices up above fair value, and pessimism, which drives prices down below fair value. Emotions played an essential role in the recent bear market. But that effect started years before anyone thought a bear market was possible. The Fed did QE 1, 2, and Operation twist. Three programs with fancy names described nothing more than asset purchases and money printing. These assets purchased forced interest rates down and the price of assets purchased up to stupid levels. This happens because central banks are not the economic actors they only pretend to be. They are political actors, doing the dirty work of politicians who appoint them to their jobs. This is why the ECB will buy European government bonds with a negative yield to maturity. They do not care if they lose money. Their cost of capital is zero, and they cannot go bankrupt if they hold assets denominated in domestic currency.
This money printing helped produce exuberance in investors’ minds as they were more than willing to buy assets and then sell them to the local central banks at a higher price. But central banks cannot defy the laws of economics. Money printing leads to inflation; inflation causes investors to demand higher rates to buy depreciation assets. This demand caused the price of fixed-income instruments to fall. As bonds become more competitive with equities, the price of equities must fall to stay competitive. So here we are.
Most investors remained optimistic during the bear move. This caused them to “buy the dip,” a strategy that worked during the bull market. This causes several substantial bounces during the selloff. The DJIA is an index that reflects this phenomenon in spades.
Notice the big bounces after selloffs. This is a sign of two phenomena. (1) Retail investors look at the DJIA as a sign of market health and prices. Since they see this widely advertised index holding up, they interpret market action as a correction, not a bear market. But the DJIA is an elusive index because it holds the stocks foreign investors like to have when investing outside their home market.
Europe is in a full-blown implosion. People riot daily in virtually every European country as they cannot afford the energy prices. But riots are not limited to this phenomenon. Migrants are rioting, particularly in the UK and France, as they demand free food, housing, and medical care. These are not small riots. 10’s of thousands of people participate in these events. For reasons unknown to us, the Netherlands is trying to shut down 3000+ family farms because of their use of nitrogen fertilizer. When did this become a thing? These folks seek a safe haven, and the Dow Jones Industrial Average stocks are the place they run to as their savior. (Notice that the INDU is above their 50-week and 200-week moving averages. Most investors look at this as a sign of strength.)
On the other hand, the NASDAQ stocks are falling fast and furious. It is down 36% from the peak. Furthermore, the bounces are much weaker than those witnessed in the $INDUs. We think this tells a different story. The US economy moves forward on the back of tech and innovation. The rollover of the tech stocks tells us there is something bigger afoot.,
This gets us to the theme of this note. “Be Careful What You Ask For: You Just Might Get It.”
Everyone is looking for the “Fed Pivot.” This is that moment when the Fed decides they have raised interest rates enough to tame the inflation dragon, and they can stop raising interest rates at a minimum. The average wall street bloke thinks this moment will ultimately result in rate cuts. Under such a scenario, they think stock prices will rip again.
We think the investment community has it all wrong. When and if the day comes the Fed pivots; it is because the economy is falling off a cliff. By the time they figure out they tightened too much, just like they figured out too late, they loosened too much from 2010 to 2021 in general, and in 2020 and 2021, in particular, it will be too late. Stocks will be in freefall.
In short, we think that moment, the “Fed Pivot” will present a significant head fake. Investors will remain optimistic and confident just as share prices find a new low, perhaps a scary low.
