Failure Analysis

The Fed has seemingly gone from 'the gang that couldn't shoot straight' to being American Snipers. After Chairman Jerome Powell's comments at the annual Jackson Hole monetary conference last Friday, stock prices resumed their bearish decline, abruptly ending the early 'pivot' dreams of the bulls. Sniper in chief, Minnesota Fed-head Neel Kaskhari, literally cheered the sudden drop in stock prices, declaring that he was "happy" with the reaction. That did not sit well with many investors, conditioned by years of Fed puts and easy money.

This abrupt and stunning reaction, in the face of widely telegraphed messaging, represents a level of Fed cred that many did not see coming. But the decline was unsurprising, given the hopium-fuelled rally that had preceded Powell's speech. I was of the opinion that markets were ahead of themselves in believing the inflation fight was over and Fed rate cuts were possible later next year. They fought the Fed and the Fed won.

But what if we have reached 'peak pessimism' and the bears are creating a monster 'crowded trade'?

We know there has been a build-up of cash in investor portfolios. Short positions in the Euro are at record levels as are those in dollar-yen. AAII sentiment, although in a recovery mode is still well below bull market levels. I can't find anyone who believes in the rally we have just seen or even considers a recovery in their forecast.

But a catalyst to spur the birth of such a new market cycle seems distant. Job growth of 300k and paltry earnings revisions of -5% are inconsistent with a bear market low. I would need to see outright job losses and earnings hits in the 15-20% range to believe we have created the preconditions for a durable low in the market. Whether we get there in the fall of 2022 or the spring of 2023 matters tactically but get there we must. This head-fake of the recent 'job-full recession' is unlikely to last much longer.

The immanent weak seasonally of the August-October timeframe is looming larger than ever now that the Fed is gunning for bulls. Weakness in forward-looking measures of inflation, commodity prices, in particular, are being confirmed by the transportation equivalent, the Baltic Dry Index. (chart below) The market has already signaled that goods inflation is again in full retreat. Unfortunately for those looking for a rally in stock prices, the Fed is focused on lagging indicators, primarily the unemployment rate, for their cue. They need a full surrender from the services sector before declaring victory and pivoting to easier policy.

Baltic Dry Index, Lumber

Stocks seem to have already reset to appropriate forward earnings multiple levels given the new higher interest rate environment. They now need to impound an earnings estimate that reflects a reduced demand side that is being sought by the Fed. It gives me no comfort that their lead spokesperson is an engineer by training, not a behavioral economist. Karshkari used to be a dovish outlier of the Fed. But he is more hawkish than anybody now. His previous stance was in response to the secular decline in inflation caused by the now spent forces of technology, globalization, and demographics. He was just using the trailing data to construct his policy, just as a mechanical engineer would use sensors to calibrate a machine. If he is indicative of the new consensus on the Fed, we may need to see them conduct a 'failure analysis' on the economy before they are satisfied with their work.

So while the Fed awaits a harder landing than the market expects, they may just get one sooner than they think. The energy emergency in Europe and the real estate collapse in China do not move the dial for a Fed preoccupied with domestic issues like gasoline prices and unemployment. But the supply side of the inflation 'problem' seems likely to be less problematic going forward. It is the weakening of demand that is now gathering steam. The semiconductor sector is the canary in the coal mine for me. The recent short-term breakdown is unnerving (chart below).

Don't blame me if I get tactically bullish again over the next few weeks. I'm looking forward to the next wave of 'bad news' on which to regain my confidence that the monetary tightening cycle is near its end. The low level of bond yields relative to inflation will be with us for a long time to come, especially if inflation drops quickly over the next few months. That will provide the valuation support for equities once we 'price-in' the earnings hits from the lagging service cost components. Remember, stocks do have growth and pricing power that nominal bonds can only dream of.

The legacy of Quantitative Easing and its related low real yields will take years to unravel. This is more like the early seventies than the later part of that decade. Yields stayed stubbornly low (relative to inflation) during those times due to institutionalized demand that was risk-based, not value-based. Only when the wage spiral of 1979-80 crescendoed did the Fed react with massive tightening. But that story is better left to the next monetary cycle for now.

A test of the lows is not necessary, especially with risk positioning and sentiment so bearish. The trading range scenario is still alive and well, despite the bearish broadsides from Powell & Co. The recent market chop should bring us a fall to remember. Don't 'fail' to buy this weakness.

Risk Model: 5/5 - Risk On

Well, this isn't much help, is it? The lagging nature of the data that underlies the model means that it will probably go negative this week unless the market somehow bounces. But even that may not be enough if the economic data ( as I expect) weakens and AAII and Copper/Gold drag the market down again. RSI is already dropping quickly and the 3-mo VXV is still on an upward trajectory. I don't like second-guessing the model but it actually hasn't been useful for a market with such choppy price action. It is meant to guide risk tolerance, not swing trade. But the current reading is instructive. I think it's saying that the bar for regaining the secular bull market has gotten very low. The bear market lows of June should hold if that is a valid interpretation.