It’s a bear market

The S&P 500 broke primary support at 4170 to confirm a bear market. A Trend Index peak at zero warns of strong selling pressure.

S&P 500

The Nasdaq 100 similarly broke support at 13K, confirming the bear market.

Nasdaq 100

Dow Jones Industrial Average, already in a primary down-trend, confirmed the bear market with a break below 32.5K.

Dow Jones Industrial Average

The Transportation Average lags slightly, testing primary support at 14.5K. Follow-through below 14K would be the final nail in the coffin.

Dow Jones Transportation Average

A plunging Freightwaves National Truckload Index warns that we should not have long to wait.

Freightwaves Truckload Index

Conclusion

All major US stock market indices now warn of a bear market. Weak retracement, to test new resistance levels, should not be confused with a buy-the-dip opportunity.

S&P 500

Stocks: Winter is coming

GDP grew by a solid 10.64% for the 12 months ended March ’22 but that is in nominal terms.

GDP

GDP for the quarter slowed to 1.58%, while real GDP fell to -0.36%. Not only is growth slowing but inflation is taking a bigger bite.

GDP & Real GDP

The implicit price deflator climbed to 1.94% for the quarter — almost 8.0% when annualized.

GDP Implicit Price Deflator

Growth is expected to decline further as long-term interest rates rise.

10-Year Treasury Yield & Moody's Baa Corporate Bond Yield

Conventional monetary policy would be for the Fed to hike the funds rate (gray below) above CPI (red). But, with CPI at 8.56% for the 12 months to March and FFR at 0.20%, the Fed may be tempted to try unconventional methods to ease inflationary pressures.

Fed Funds Rate & CPI

That includes shrinking its $9 trillion balance sheet (QT).

During the pandemic, the Fed purchased almost $5 trillion of securities. The resulting shortage of Treasuries and mortgage-backed securities (MBS) caused long-terms yields to fall and a migration of investors to equities in search of yield.

The Fed is expected to commence QT in May at the rate of $95 billion per month — $60 billion in Treasuries and $35 billion in MBS — after a phase-in over the first three months. Long-term Treasury yields are likely to rise even faster, accompanied by a reverse flow from equities into bonds.

S&P 500 & Fed Total Assets

S&P 500 breach of support at 4200, signaling a bear market, would anticipate this.

Conclusion

Fed rate hikes combined with QT are expected to drive long-term interest rates higher and cause an outflow from equities into bonds.

A bear market (Winter) is coming.

S&P 500 rallies as Fed tightens

Stocks rallied, with the S&P 500 recovering above thew former primary support level at 4300. Follow-through above 4400 would be a short-term bull signal.

S&P 500

Markets were lifted by reports of progress on a Russia-Ukraine peace agreement — although that is unlikely to affect sanctions on Russia this year — while the Fed went ahead with “the most publicized quarter point rate hike in world history” according to Julian Brigden at MI2 Partners.

FOMC

The Federal Reserve on Wednesday approved its first interest rate increase in more than three years, an incremental salvo to address spiraling inflation without torpedoing economic growth. After keeping its benchmark interest rate anchored near zero since the beginning of the Covid pandemic, the policymaking Federal Open Market Committee (FOMC) said it will raise rates by a quarter percentage point, or 25 basis points….. Fed officials indicated the rate increases will come with slower economic growth this year. Along with the rate hikes, the committee also penciled in increases at each of the six remaining meetings this year, pointing to a consensus funds rate of 1.9% by year’s end. (CNBC)

Rate hikes are likely to continue at every meeting until the economy slows or the Fed breaks something — which is quite likely. To say the plumbing of the global financial system is complicated would be an understatement and we are already seeing reports of yield curves misbehaving (a negative yield curve warns of recession).

Federal Reserve policymakers have made “excellent progress” on their plan for reducing the central bank’s nearly $9 trillion balance sheet, and could finalize details at their next policy meeting in May, Fed Chair Jerome Powell said on Wednesday. Overall, he said, the plan will look “familiar” to when the Fed last reduced bond holdings between 2017 and 2019, “but it will be faster than the last time, and of course it’s much sooner in the cycle than last time.” (Reuters)

The last time the Fed tried to shrink its balance sheet, between 2017 and 2019, it caused repo rates (SOFR) to explode in September 2019. The Fed was panicked into lending in the repo market and restarting QE, ending their QT experiment.

SOFR

QT

Equities are unlikely to be fazed by initial rate hikes but markets are highly sensitive to liquidity. A decline in the Fed’s balance sheet would be mirrored by a fall in M2 money supply.

M2 Money Supply/GDP & Fed Total Assets/GDP

And a similar decline in stocks.

S&P 500 & Fed Total Assets

Ukraine & Russia

Unfortunately, Ukrainian and French officials poured cold water on prospects of an early ceasefire.

Annmarie Horden

Neil Ellis

Samuel Ramani

Conclusion

Financial markets were correct not be alarmed by the prospect of Fed rate hikes. The real interest rate remains deeply negative. But commencement of quantitative tightening (QT) in May is likely to drain liquidity, causing stocks to decline.

Relief over prospects of a Russia-Ukraine ceasefire and/or any reductions in sanctions is premature.

The bear market is likely to continue.

No soft landing

10-Year Treasury yields have climbed in response to the December FOMC minutes which suggest a faster taper of QE purchases and faster rate hikes. Breakout above 1.75% would offer a medium-term target of 2.3% (projecting the trough of 1.2% above resistance at 1.75%).

10-Year Treasury Yield

The Dollar Index retreated below short-term support at 96, warning of a correction despite rising LT yields.

Dollar Index

Do the latest FOMC minutes mean that the Fed is serious about fighting inflation? The short answer: NO. If they were serious, they would not taper but halt Treasury and MBS purchases. Instead of discussing rate hikes later in the year, they would hike rates now. The Fed are trying to slow the economy by talking rather than doing — and will be largely ignored until they slam on the brakes.

Average hourly earnings growth — 5.8% for the 2021 calendar year — is likely to remain high.

Hourly Wage Rate

A widening labor shortage — with job openings exceeding total unemployment by more than 4 million — is likely to drive wages even higher, eating into profit margins.

Job Openings & Unemployment

The S&P 500 continues to climb without any significant corrections over the past 18 months.

S&P 500

Rising earnings have lowered the expected December 2020 PE ratio (of highest trailing earnings) for the S&P 500 to a still-high 24.56.

S&P 500/Highest Trailing Earnings (PEmax)

But wide profit margins from supply chain shortages are unsustainable in the long-term and are likely to reverse, creating a headwind for stocks.

Warren Buffett’s long-term indicator of market value avoids fluctuating profit margins by comparing market cap to GDP as a surrogate for LT earnings. The ratio is at an extreme 2.7 (Q3 2020), having doubled since the Fed stated to expand its balance sheet (QE) after the 2008 global financial crisis.

Market Cap/GDP

Stock prices only adjust to fundamental values in the long-term. In the short-term, prices are driven by ebbs and flows of liquidity.

We are still witnessing a spectacular rise in the M2 money stock in relation to GDP, caused by Fed QE. The rise is only likely to halt when the taper ends in March 2022 — but there is no date yet set for quantitative tightening (QT) which would reverse the flow.

M2/GDP

Gold continues to range between $1725 and $1830 per ounce with no sign of a breakout.

Spot Gold

Conclusion

Expect a turbulent year ahead, driven by the pandemic, geopolitics, and Fed monetary policy. Rising inflation continues to be a major threat and we maintain our overweight positions in Gold and defensive stocks. A soft landing is unlikely — the Fed could easily lose control  — and we are underweight highly-priced growth stocks and cyclicals, while avoiding bonds completely.

S&P 500: Small caps diverge

The S&P 500 ($INX) remains bullish, with Trend Index holding above zero for over a year indicating tremendous buying pressure.

S&P 500

Narrow breadth is our main concern, with the Russell 2000 small caps ETF (IWM) diverging from the S&P 500 ($INX).

S&P 500 & Russell 2000 Small Caps

Conclusion

The market is growing risk-averse as the Fed starts to taper. But financial markets are still awash with cash.

M2/GDP

Buying is likely to be concentrated in the heavyweights.

Apple (AAPL), Alphabet (GOOGL), Amazon (AMZN), Meta Platforms (FB), and Microsoft (MSFT)

Small caps could possibly accelerate into a down-trend but reversal of large cap indices is unlikely with so much liquidity.

Tech heavyweights pause for breath

Good progress has been made combating the pandemic but daily COVID cases seem to be struggling to break through a floor between 50 and 60 thousand. The vaccine roll-out is ahead of schedule but people need to stop listening to idiots like Rand Paul — who went to the Senate gym while infected — and listen to the Chief Medical Adviser whose advice is to wear a mask.

Daily US COVID Cases

Stocks have paused after the recent run up in Treasury yields. When both stocks and bonds are being sold, there is nowhere to hide.

The Nasdaq 100 is testing support at 12000. At this stage the correction looks mild, with declining Trend Index remaining above zero, but breach of 12000 would signal a test of the Sep 2020 low.

Nasdaq 100

The S&P 500 is performing better but Volatility troughs above 1.0% still warn of elevated risk.

S&P 500 & Twiggs Volatility 21-Day

The big five tech stocks are a mixed bag. Alphabet (GOOGL) and Facebook (FB) show strength. Microsft (MSFT) looks stable, while Mazon (AMZN) and Apple (AAPL) are trending lower.

AAPL, AMZN, GOOGL, FB, MSFT

When leaders no longer lead normally signals the final stage of a bull market. The chart below shows the Russell 2000 small caps ETF (IWM) clearly outperforming the large cap Nasdaq (QQQ) and S&P 500 (IVV) indices with all the tech heavyweights.

IVV, IWM, QQQ

@Schuldensuehner

The steeper yield curve benefits banks, who profit from the wider net interest margin. Major banks have climbed 60% to 80% over the past six months, with Goldman Sachs (GS) leading and Bank of America (BAC) the laggard.

Major Banks

Consumer durables sectors are, again, a mixed bag. Household Goods (HG) is flat, Apparel Retail (RA) is climbing steadily, while Automobiles (AU) is down sharply — mainly because of Tesla (TSLA).

Consumer Durables

Though light vehicle sales were down a million units in February.

Light Vehicle Sales

And heavy truck sales were down 4,000 units compared to January.

Heavy Truck Sales

Prospects for the tire industry are improving. Goodyear (GT) retraced to test its new support level after breaking out above its high from late 2019. Respect would confirm another advance.

Goodyear Tyre Co. (GT)

Conclusion

The recovery is going to be a long hard slog with frequent setbacks. Banks are doing nicely but stocks generally are over-priced and ripe for a major adjustment. There are signs that this is the final stage of the bull market and market risk is elevated.

S&P 500 fueled by the Fed

The S&P 500 continues, unwavering, in a strong up-trend.

S&P 500

But compare the growth in the S&P 500 index relative to growth in the money supply (M2). In relative terms, the S&P 500 appreciated only 29%, or 2.6% p.a., over the past decade. Most of the stellar performance over the past 10 years can be attributed to the Fed’s expansionary monetary policy.

S&P 500/M2 Money Supply

Dollar Index

The Dollar Index continues to test support at 90. A Trend Index peak below zero warns of strong selling pressure. Breach of support is likely and would signal another primary decline.

Dollar Index

The Chinese Yuan, however, has halted in its appreciation against the Dollar. Trend Index peak below the 7-week MA warns of secondary selling pressure. Breach of support at 15.4 US cents would warn of a correction.

CNYUSD

Conclusion

The S&P 500 is likely to continue rising for as long as the Fed expands the money supply. The Dollar, however, is expected to weaken for the same reason.

Global stock market correction

Strong red candles across major market indices warn of a global correction.

Breach of 3650 on the S&P 500 would warn of a test of the strong band of support between 3250 and 3400. Bearish divergence on Twiggs Money Flow continues to warn of long-term selling pressure.

S&P 500

The European Stoxx 600 threatens a similar secondary correction with a test of support at 375.

DJ Euro Stoxx 600

The Footsie is testing support between 6300 and 6500, while Money Flow reversal below zero warns of strong selling pressure. Breach of 6300 is likely and would indicate a strong correction, with primary support at 5500.

FTSE 100

The reaction on China’s Shanghai Composite is of similar weight to the S&P and STOXX. Breach of medium-term support at 3400 would warn of a test of primary support at 3200.

Shanghai Composite

The reaction on Japan’s Nikkei 225 appears secondary and likely to test the rising trendline at 26000.

Nikkei 225

The Seoul Composite is similar, with a rising trendline at 2700.

Seoul Composite

Selling on India’s Nifty 50 is heavier, flagged by a sharp fall in Money Flow over the past three weeks. Support at the rising trendline is unlikely to hold — which would mean a test of support at 12500.

Nifty 50

Conclusion

The correction across global stock markets appears secondary at this stage and likely to test medium-term support levels. Selling is heaviest on the FTSE 100 and India’s Nifty 50. These are the canary in the coal mine and should be monitored for unusual activity. Further falls on strong volume would indicate that sellers are overwhelming support.

Can the Fed keep a lid on inflation?

Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.

CNBC VideoClick to play

Both are right, just in different time frames.

Putting the cart before the horse

The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.

CPI & GDP

Money supply and interest rates

Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.

Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.

S&P 500

In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.

Housing: Building Starts & Permits

Wealth effect

Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.

High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.

Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.

The role of the Fed

Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:

“…..to take away the punch bowl just as the party gets going.”

In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.

The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.

Federal government debt is currently above 120% of GDP.

Federal Debt/GDP

GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.

With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.

Conclusion

Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.

S&P 500 bubble risk

S&P 500 valuations are higher than the 1929 (Black Friday) Wall Street crash and the October 1987 (Black Monday) crash. The Dotcom bubble is the only time in the last 120 years that the ratio between Price and highest trailing earnings (PEmax) was higher.

S&P 500 PE of Highest Trailing Earnings (PEmax)

PEmax eliminates distortions in the price/earnings multiple caused by sharp falls in earnings during recessions. The current multiple of 26.93 compares the index at December 31, 2020 to highest trailing earnings of 139.47 (for the 12 months ended December 2019) rather than expected earnings of 95.22 for the 12 months ended December 2020. Highest trailing earnings in such a case are a far better reflection of future earnings potential than more recent results.

Payback model

Using our payback valuation model, we arrive at a fair value estimate of 2331 for the S&P 500 based on:

  • highest trailing earnings of 139.47;
  • a long-term growth rate of 5% (the highest nominal GDP growth achieved in recent years was 6.0% in Q2 2018); and
  • a payback period of 12 years — normally only used for stable companies with a strong defensive market position.

The LT growth rate required to match the current index value (3851) is 12.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was in double-digits.

Nominal GDP & Inflation (CPI)

Conclusion

Stock prices are in a bubble of epic proportions. Risk of a major collapse remains elevated.