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Rough Road Back to Normal

For the past thirteen years, central banks around the world have tried to hold back 3000 years of history by suppressing interest rates.  Through their unique ability to create money out of thin air, they have embarked upon the greatest monetary stimulus of modern times.  Unfortunately, this has also created the greatest financial bubble of modern times.

The U.S. Federal Reserve and their global cohorts were, of course, inflating asset prices on purpose.  Having run out of room in 2008 to lower interest rates below zero percent, they pivoted to government’s age-old solution to money crises, which was to print more money.  This process, labelled with the euphemism “quantitative easing” or QE, sought to flood the banking system with cash in order to stimulate lending and also create a “wealth effect” to make people feel richer and thus make them more likely to spend.

The Fed, and investors, have for the last decade luxuriated in the complacency brought on by no apparent side effects from QE policies, which have increased the Fed’s balance sheet, a proxy for money supply, from about $1 trillion in 2008 to over $8.5 trillion today.  Investors have been conditioned to believe that the Fed will always “have their backs” and be ready to inject even more cash into the system with any hint of stock market decline.  This view has also prompted investors to gorge themselves on leverage (debt), encouraged by the virtually free money of the Fed’s policies.

The advent of inflation, the serious kind, has prompted a rethink of monetary policies of the last 13 years, and the Fed is now scrambling to scale back stimulus and move policy back to something resembling normality.  The road back to normal, though, is likely to be rough. Inflation is making a dramatic comeback and throwing Wall Street’s forecasts into disarray. 

Inflation is rising at almost every level, with the Consumer Price Index increasing by 7% over the last 12 months.  ShadowStat’s alternative inflation calculations, using 1990-based calculations, show inflation over 10% year-on-year.  No matter how you slice it, inflation has become a serious issue for financial markets.

Aside from Wall Street’s worries, current inflation is also worsening spending power.  Real wages, i.e., wages adjusted for inflation, are falling more than ever.  While wage growth has been modest for many years, today’s inflation is making it harder for families to make ends meet.  Increased labor strikes at John Deere and King Soopers (Kroger) are symptomatic of the pain workers are feeling, as are increased efforts to unionize at Starbucks and Amazon.  Inflationary psychology has taken hold as consumers adjust their behavior for the new environment.  The Fed, long the enabler for Wall Street, is now faced with a populist uprising on Main Street as inflation hits wallets hard.

The bumpy road investors face was made brutally clear in 2022’s first month, as stock prices had their deepest swoon since covid first hit.  The Fed made clear in late 2021 that it would be reducing their monthly bond purchases that have been the bedrock of QE policy.  To say that the markets are highly sensitive to these liquidity flows is an understatement, as it only took a few weeks for stocks to turn down after the Fed’s policy change began to sink in.  The major indexes are now following their lesser brethren down.  Since making marginal new highs in November, the S&P 500 is down 8.5% from its high, the NYSE is down 5.9%, and the NASDAQ 100, home to many of 2021’s market darlings, is down a whopping 12.5%.

We had cautioned in recent Market Outlooks that a combination of high leverage, overly bullish speculative sentiment, and rising interest rates brought on by increasing inflation had laid the groundwork for a risky market.  Panic is now replacing complacency as investors belatedly run to safe havens.

How should investors cope with this change of mood, and most importantly, market trends?

The first step is to realize that we are (barely) coming down from high extremes of valuation.  Valuations have been high by historical norms for quite a few years now, so it’s tempting to say they don’t matter anymore, but they probably do.  It takes many quarters, even years, for stock valuation measures to travel from expensive to fair value to “cheap.”  Thus, we should not be lulled by the inevitable Wall Street refrain that this is a buying opportunity because stocks have miraculously become great values in the past two months.  They haven’t, but declining prices are part of the process that gets us there.

Second, watch for changes to market leadership.  While garden-variety corrections rarely lead to changes in market leadership, broad, persistent declines (bear markets) often do.  Probably the biggest market divergence today is that between “growth” stocks and “value” stocks.  Growth stocks, exemplified by Apple, Amazon, Microsoft, and Google, have far outpaced value stocks since 2009, creating the greatest performance disparity between the two since the 1950s.

While it is too early for value to reclaim leadership from growth, the extreme divergence between the two argues for some reversion to the mean in their relationship.  Indeed, we are seeing new weakness in growth, and strength in value.  Investors can monitor this difference for signs of change.  Tracking the behavior of growth-focused ETFs versus value-oriented ETFs is a simple way to watch this unfold.  Readers can contact our office to get a list of representative ETFs, or a “relative strength” chart comparison of the two.

From a quantitative view, long-term indicators are urging caution.  The first of these is the NYSE advance/decline (a/d) line, plotted as a point-and-figure chart by Investors Intelligence (“II”).  The a/d line takes the number of advancing stocks minus declining stocks and adds that value (positive or negative) to a running cumulative total.  In bull markets more stocks go up than down in a day (or week) and so the chart rises, and the converse is true in a correction or bear market.  Currently, both the daily and weekly (shown) a/d lines are on a sell signals, indicating that downward price action predominates at the moment.  We respect the message from these charts, as they have provided timely signals as to market direction in the past.  Since there is no telling when buy signals will occur, we have to let the charts provide the “message from the markets” on their own schedule.

Next, we turn to our old friend, the NYSE Bullish %.  This measures the percentage of stocks on the NYSE that are on “buy” signals, using the point-and-figure method.  Like the a/d line, the NYSE Bullish % rises in a bull market, and falls during corrections as a declining percentage of stocks are able to hold on to buy signals.  Oversold low levels, and attractive buying levels, occur with the NYSE Bullish % below 30%.  Currently, it stands at 44.2% and looks to be headed lower.

Investors should be very, very disciplined about “buying the dip” as long as these two indicators are in a bearish mode, and resist the urge to try to predict when the correction will end.  There will be endless commentaries about market conditions, and many predictions that “the bottom” has been reached.

Remember that in any major decline, there are breathtaking rallies that look like they are marking the low.  The key to watch is whether the recently established pattern of lower lows-lower highs is in fact transitioning to a higher low-higher high pattern (looks like an “up” staircase).  Another clue to a bottom is that stocks stop going down even in the face of bad news.  Seeing as there is plenty of bad news to go around, there should be ample opportunity to see this phenomenon play out over the next few months.  However, with inflation becoming the Fed’s top priority, investors should expect higher interest rates ahead, and with them a rough ride as we are weaned off the extraordinary stimulus of the last decade.