The market seems to be frustrating both the bulls and the bears in the last few weeks. The bears found themselves caught overexposed in late September of last year. Just as it looked like the bottom was going to fall out after a choppy down market for the 1st eight months of 2022, share prices rallied sharply.
The price action of fast-growing and innovation stocks, represented by the ARKK ETF, caught investors’ hearts and minds in 2022. The ETF massively outperformed the S&P500 in 2020 and gave it all back in 2022. The big question remaining on the table is what’s next.
Interestingly, people are still “buying the dip” as they continue to buy the beleaguered ETF. One should never underestimate the commitment of an optimist. People are still putting new money to work in the stock market. According to an article on Yahoo Finance, they are doing so to the tune of $1.5 billion daily. Some of that money is making its way into ARKK, which still has $7.7 billion under management.
One of the items creating confusion is that the price action is not systemic. The DJIA is still in a very nice uptrend. It has only fallen from the upper end of the post-financial crisis trend channel. After participating in the bounce since October 2022, the index is approaching its all-time high again. If another leg is down, the DJIA could fall to about $27,500 (down 19%), and the secular bull market would still be intact.
One might ask why the DJIA would look relatively sanguine while tech stocks take it on the chin. The answer is straightforward. Foreign invesors prefer DJIA stocks. These are the big blue chips that everyone knows. Since the economy and investment environment are in the dumps, money is moving from Europe to the US. That money is going into Dow stocks.
The QQQs do not show identical resilience as the DJIA. A review of the chart above leads one to ask, “what bounce?” It has nearly moved off the low end of the trend channel. We are watching this ETF closely as we believe it holds the key to the future price action of risk assets. If it holds the lower trendline, the market is telling us to have a constructive view.
On the other hand, if it breaks the lower trend line, one might want to hide under their desk. The next level of support is down about 50%. Interestingly, this would only take the ETF back to the C19 lows.
The bond market is signaling the world has changed. Short-term interest rates have fallen for 40 years, and that trend ended this year. The only question is what form the rising rate environment takes. The consensus is that 1-year T-Bill interest rates will moderate again and fall to the 2 to 3% range. This is somewhere around the market consensus on inflation rates.
While people are piling money into the stock market, options traders are a somewhat more sober view. The VIX, which is a measure of price on 1-month options, is trending higher. It does not indicate panic, but the trend says that option sellers want a higher premium to compensate for risk, and options buyers are willing to pay it.
The budget deficit for 2022 was $1.4 trillion. This, by the way, was the deficit in 2009 when it looked like the world economy would implode. 2022 deficit is down from $3.1 trillion in 2020 and $2.8 Trillion in 2021. The Congressional Budget Office estimates it will be $2.2 trillion. Forget about the theater around the debt limit; it is clear from these numbers that the government has no intention of balancing its budget, much less paying down debt.
Needless to say that Russia will no longer buy US government debt. The Chinese government is methodically selling its securities. Both countries are accumulating gold with their reserves. So the private sector will have to fund the US government. We suspect that people will want a yield that is substantially above the inflation rate. The Fed will likely buy some of it to keep rates down.
One of the measures the Fed is taking to get the current and long-term potential inflation rate down is to sell securities from its portfolio. This reduces the amount of high-powered money in the economy and increases leverage in the financial system. Banks will have to slow or stop the growth in their loan portfolios to keep that leverage in check. Notice how fast the Fed is willing to buy assets and how slow it is to sell them off. It is easier to offer a free lunch today while demanding payment sometime in the future. We think this is a key figure to watch. Should the Fed stop selling assets or, heaven forbid, start buying them again, you will know they have given up on containing inflation.
The other indicator we think people should keep an eye on is home prices. They rand up 33% since the C19 buying panic, and we believe those purchases will be underwater in no time. Prices have already peaked due to higher interest rates. Higher interest rates reduce the intrinsic value of houses and equities, for that matter. So if interest rates continue to rise, more trouble slides ahead.
Higher interest rates have a compounding effect on the government’s budget. Interest payments have risen by 62% as the government has to roll over old debt at higher interest rates while the deficit still adds to the debt outstanding.
We are wondering how this resolves, but we can imagine two scenarios. 1) The government sucks all the savings out of the economy, making it more expensive for companies to finance their businesses. This will hit profits. Only the most capital-light companies will see their share prices rise. (e.g., software) 2) The Fed returns to its money-printing ways to suppress interest rates. This action will allow inflation to rise further. Companies with tangible hard assets will likely see their share prices rise in this scenario (e.g., metals & mining, oil & gas, manufacturing). We would put utilities in this category, but the government may cap prices so people can afford to pay their bill.)
These are just a few things to consider in the weeks and months ahead. With that, I will leave you with the following.
This is the budget of the Federal Government for 2021. Ask yourself what would you do to bring this back into balance. Now, think about what is politically palatable. So now ask the appropriate question. What will the politicians do? Given what you think the politicians will do, what will you do?
