I've been mentioning how Fed officials have been pissing on the market rally and so low and behold, Jay Powell the big dick, whips it out and pissed on it too during his Jackson Hole speech Friday. He had quite the hawkish tone downplaying the notion of any kind of pause in rate hikes. He used the word "pain" to describe what was in store and was rather dismissive of the recent rollover in inflation pressure. At last year's speech Powel was making the case about how inflation was transitory and therefore justifying keeping rates at 0. He eventually capitulated and gave up on the transitory thesis.. Now he's at the opposite end of the spectrum. He's worried about inflation staying persistent and is justifying further rate hikes despite the fact that forward and current readings of inflation pressures have clearly rolled over. I'm betting Powell will end up eating his words again. I believe Powell was correct about inflation being transitory, but he underestimated its duration. Granted, the Chinese lockdowns and Ukraine invasion inflamed inflation pressures and could not have been predicted, but Powel caved into the narrative that the Fed had to do something to fight inflation which was due to factors that are not related to low interest rates. The main thing rate hikes do is kill housing which in turn can lead to decrease in the pace of aggregate consumption. People were given free money in the pandemic while supply of many goods & services got stifled. That's what caused inflation to soar. That was the case for transitory which is valid. The free money is now gone but supply side issues lingered. We need to address these factors directly as best as possible. But you know what, I think it's good that the housing market cooled off as it was on an unsustainable path and I believe the rate hikes were justified for that purpose, but not to fight the inflation problems. Now that housing has notably cooled down, the rate hikes should stop right now. They have done their job and further hikes raises the risks of going too far creating unnecessary damage. Aside from creating a housing induced recession, rate hikes can actually exacerbate inflation as the cost of credit businesses have to incur gets passed on to consumers to some degree. It also makes financing investments to increase production of goods and services more expensive and therefore more prohibited which again actually exacerbates inflation. But I digress. We have to play the cards that are dealt and realize that the markets and powers that be don't give a rat's ass about what you think and the way things should be. If you have good reason to believe that the market will eventually see things your way, then that's another story; place your bets accordingly, but don't whine and complain if things don't turn out your way. This is how most of the dogmatic permabears operate.
I had mentioned in my previous post that I had ST concerns about the market given the emergence of some froth i.e. cracks in the wall of worry. When you have such conditions, it doesn't take much for the market to have the type of decline we've seen since. I suspect that Friday's decline could start to rebuild that wall of worry. Coming into Friday NAAIM long exposure had already dropped to 55% and so it's probably even lower now. Near the peak of the rally in mid August Fund flows turned positive again after being negative for 5-6 weeks. I suspect that too will reverse course. Put/call ratios have spiked back up. The current reading of 1.22 as I type this is historically quite high. If the bull case is to play out, we will have a period of consolidation. That could either entail sideways action or a retest of the lows. We have September on deck, the historically worst month of the year.
One thing that's quite troubling is the soaring electricity costs in Europe which is squarely the result of Russia turning off the taps. Again, how does interest rate hikes address this cause of inflation? It actually creates more costs for consumers in the form of higher interest payments on debts. It's a game of chicken right now between Russia and Europe. I think it's fair to say that this war has been a disaster for Russia. Putin could not have expected it to go on for this long and for this degree of backlash from the global community. Their largest ally China, has its own issues too. How much longer can Russia maintain its current level of military persistence in Ukraine while being cut off from most of the world? At this point, Putin has gone all in. He's not going to back down until either Russia wins or he gets overthrown/killed. This is the other wildcard in the market. Imagine we wake up one day to hear news of a Russian coup. That's going to create the mother of all rallies in equities and decline in fossil fuel prices. On the flip side, if there's a collapse in the unity of the European countries to resist Putin that too could perversely have the same results in the short term but the fracturing of the West would be a long term negative. If the latter would take place I suspect it would have to be a point where there's more pain then what we are seeing right now in Europe. In North America, the situation is not nearly as dire. We are largely energy and food self-sufficient. The US could ban exports of oil if they chose to but that would be cruel.
With all of these cross-currents out there how does one position him/herself in the market? For one to believe that a bullish resolution will take place, it requires quite a leap of faith that somehow things will get resolved or won't turn out to be as bad as feared. One of the benefits of posting to this blog is that it allows me to look back at previous times of turmoil to see what I was observing and how I was feeling. I was looking back at posts in 2011 whereby the market had been dealing with European bank and sovereign debt woes. Emerging markets were also struggling quite notably. At the depths of the lows it looked ugly and hopeless. Then like now, calls for a recession were loud but somehow things turned out to be OK. The bottoming process took about 4 months. This is not to suggest that things will turn out to be OK or that if we did hit a low the bottoming process will take about 4 months. My point here is that when the market is near a major low things are bad and look like they will get worse, but that's also the point where expectations are very low and there's a lot of defensive positioning which sets the stage for either a major rally or new bull market rally on just a marginal improvement in fundamentals. If the fundamentals haven't turned up enough, we tend to get a major rally which will get given back to a certain degree as more time is needed before a new bull run is launched (base building). In the 2002-2003 bottom it look 8 months of base building and triple bottom the first one being in July 2002, second one October 2002 and the last one in March 2003. The 2008 bear market low also had a series of lows spanning 5 months but they were lower lows. The COVID low was a V bottom with no retest. Every market low is different which is why you should pay little attention of market analogs.
Let me say what's bothering me about the market from a market action perceptive, some of which is repetitive from prior weeks. The action in the meme and crypto space for one. These sectors are the epicenter of the speculative behavior of 2021 and I would much rather see them become a wasteland rather than still moving in tandem with the market to a high degree. The latest decline has washed away some of the recent froth but the connection is still there. Government bond yields have been rising and tech has lost its leadership which probably is a result of the former.
In my opinion here's how to best generally operate in this type of market environment unless you're a ST trader. If you see compelling buys, accumulate positions on weakness when there's clear signs of extreme pessimism leaving enough powder dry so that you will be able to be a strong holder should the market continue to go against you. Be willing to commit say 50-60% of your position this way or which ever exposure you can handle. Then commit the rest once there has been clearer evidence that the tide has turned. For me, that means 6 months without having made a new low. Using an all or nothing approach, especially chasing the market on strength, and then placing a stop is a sure fire way to get whipsawed as I'm sure most people are.
If I had to guess, I would say that we are going to have a choppy market for the next few months. While it's always difficult to make ST calls due to uncertainty, right now it's especially difficult given the many cross-currents which makes for a treacherous ST environment from either side of the market. Be patient and pick your spots. Keep an eye for extremes in sentiment to fine tune entry/exist points. With expectations reset due to the Powel non-pivot, it's tough to envision the market getting any escape velocity on any rally attempts unless we start seeing further drop in inflation pressures without it being accompanied by serious economic weakness. Some weakness would probably tolerated but not to the point which results in a vicious cycle of big earnings misses and layoffs i.e. a true recession. Admittedly, that's a tall order to ask. Bottom line is that if corporate earnings don't fall off a cliff, the market will be able to muddle through until the market sniffs an end game for the rate hikes. That could entail a sideways chop with a possible retest of the lows. I don't need to reiterate the bear case as it's self evident but that's what bulls like Ken Fisher will say is the reason to be bullish - by now the market has priced in these worries. Well, we shall soon see if that's true won't we?
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