Edition #144
Economy vs. Prior Tightening Cycles, Stocks Panic, Crypto Market Cap Update
Economy:
As the financial markets continue to digest the significance and potential impact of the Federal Reserve’s tapering and tightening schedule, I continue to hunt for data that will help set and manage expectations. It appears most of the commentary around this topic has been focused specifically on how financial markets and asset prices will respond, which is an interesting shift relative to prior tightening cycles.
For one, I think this might indicate that markets & investors fully recognize the impact that monetary policy has on asset prices. I provided an excellent framework that I use in my 2022 market outlook:
“One of my favorite quotes about investing is: “Don’t fight the Federal Reserve”. While it may seem elementary to use the Fed’s expected monetary policy actions as the guiding principle for my market outlook, it’s proved to be extremely effective. The rules of this framework are simple:
• Remain overweight U.S. equities and dollar-denominated assets in periods of monetary stimulus and expansion of M2.
• Shift towards caution as the Federal Reserve reduces their rate of asset purchases and begins to transition into a period of monetary tightening (stagnant/contracting M2).
• De-risk during periods of blatant monetary tightening, reducing exposure to tech and emphasizing strong cash flows, profitability, dividends, and share buybacks. Note that de-risk doesn’t mean to sell everything, but simply to shift allocations.”
Let’s evaluate how closely the stock market has followed this framework:
The Federal Reserve announced an emergency rate cut from 2.5% to 0.00% and historic levels of monetary stimulus on Sunday, March 15, 2020 (Category #1). On November 3, 2021, the Fed officially announced the start of tapering, intending to reduce asset purchases by $15Bn/month (Category #2).
• From 3/16/2020 - 11/3/2021, when the framework says to be overweight U.S. equities, the S&P 500 gained +85.7%.
• Since 11/3/2021, when the framework encourages a shift towards caution, the S&P 500 has fallen -5.6%.
So far, so good…
A second reason why there’s less focus on the economic impact is that the market recognizes the urgency to combat inflation. The Federal Reserve’s dual mandate is extremely clear, and all eyes are focused on the half pertaining to inflation while the labor market continues to steadily improve. The relentless acceleration of inflation has called into question whether or not the Fed will be forced to raise rates even faster than they’ve communicated in recent months. The market continues to ponder how the broader economy will be impacted by an accelerated shift in monetary policy; however, I provided some general thoughts back in October 2021 when I raised some red flags about the situation. In Edition #112, I provided the following:
“A concern that I’m starting to have is that the Federal Reserve is preparing to tighten monetary policy into a weakening expansion. While the tapering process will still provide liquidity, it will be a deceleration in the amount of monetary stimulus. The tone of the Fed & other central banks regarding inflation has continued to shift dramatically. At the beginning of the year, they didn’t expect inflation, then it became a transitory spike, then that inflation COULD be more sticky, and now that it’s persistent.
I don’t necessarily fear stagflation, but it’s clear that those who have been calling for stagflation are feeling vindicated in this moment. The annualized Q3 GDP growth was +2.0% vs. the GDP price index rising +5.7% (and a 12-month inflation rate exceeding +5.3% for every month in Q3 2021). Powell & Fed officials have stated that their monetary policy strategy is effective in stimulating demand, but doesn’t improve supply-chain dynamics. The bottlenecks are expected to persist for the majority of 2022 or beyond. This will impact inflation.
LAGARDE SAYS IF SUPPLY BOTTLENECKS LAST LONGER, FEED THROUGH TO WAGES, PRICE PRESSURES COULD BE MORE PERSISTENTIf the Fed sees improvements in the labor market & has already met their inflation requirements to raise rates, what happens if/when inflation is more persistent & sticky? They’ll consider raising more aggressively. If not, the market will do it on its own with rising Treasury yields (as we’ve been seeing). This is not doom & gloom, but a substantiated concern of a more restrictive monetary policy in the face of a potentially slowing economy, global supply-chain bottlenecks, and inflation that has proven to not be transitory (yet). There’s a lot of pressure on the Fed right now.”
At the time I provided this commentary, the most recent CPI data was for September 2021, with a 12-month inflation rate of +5.3%. At the present moment, the most recent data for December 2021 showed a 12-month inflation rate of +7.0%. The concerns I highlighted about “raising more aggressively” have now become mainstream over the last several weeks, and all eyes are shifting towards the Q4 2021 GDP data that will be released this upcoming week.
As we prepare for the impacts of the Fed’s actions, it’s vital to understand where the economy is today relative to the beginning of the prior tightening cycles. The table below from Brent Donnelly provides some fantastic data on this:
There are a few things in particular that I wanted to highlight:
Relative to the other periods on this table, this is the only time where the 10-year real rate is negative. At the start of the year, the 10-year Treasury par real yield curve rate was -0.97% and has already risen quickly to -0.59% as of 1/21/22.
The current level of unemployment claims is lower than any other period on this list. The other six periods on this table had an average level of unemployment claims equal to 331 million vs. the current amount of 231M.
The current unemployment rate is significantly lower than any other period on this list. The other six periods on this table had an average unemployment rate of 6.5% vs. the current rate of 3.9%.
The Job Openings and Labor Turnover Survey is a relatively new data point, but the current level of 10.5M is larger than the combined amount from the prior two tightening cycles.
The 12-month change in the core CPI, which excludes changes in food & energy prices, is the highest since the rate hike cycle from 1976.
Finally, the debt/GDP ratio is completely skewed, but has consistently accelerated since the 1970’s. At a current level of 141%, one might think the U.S. government actually WANTS inflation in order to depreciate the value of what it needs to pay back in the future.
Stock Market:
Amidst expectations for a rate hike cycle that will be higher and faster than originally anticipated, the market is in the process of re-pricing risk and putting downward pressure on valuations. After experiencing a valuation expansion for at least eighteen months, long-term investors should rejoice at the opportunity to reengage at these prices.
Since the Russell 2000 peaked on 11/8/2021, here are the returns of the major indexes through the market close on 1/21/2022:
• Dow Jones Industrial Average ($DJX): -6.3%
• S&P 500 ($SPX): -6.7%
• Nasdaq-100 ($NDX): -12%
• Russell 2000 ($RUT): -19.2%
I pulled extremely insightful data about the S&P 500 from a stock-screening exercise:
341 out of 500 stocks are trading below their 50-day moving average.
252 stocks are trading below their 200-day moving average.
147 stocks are at least -15% below their respective 50-day highs.
150 stocks are at least -20% below their respective 52-week highs.
5 stocks hit new 52-week highs during Friday’s session.
24 stocks hit new 52-week lows.
27 stocks have a year-to-date performance worse than -20%.
Unequivocally, the underlying trend within the S&P 500 is to the downside. Despite this fact, the index as a whole is “only” down -8.7% from the ATH’s it hit at the start of the year.
On Thursday, markets had a wild day. What started as an optimistic morning finished in chaos, as the Nasdaq-100 reversed a +1.4% gain into a -1.1% loss. This was a historic intraday shift, as explained by Bespoke, a market research firm:
Liz Ann Sonders, the Chief Investment Strategist at Charles Schwab, shared interesting data to highlight the significance of this monthly drawdown so far:
With the majority of stocks facing downside pressure, I can’t argue that short-term momentum is pointing to further downside. How much further and for how long? I don’t know. All I do know is that long-term investors have been rewarded for patience, maintaining composure, and buying great companies at discounted prices.
Cryptocurrency:
In Edition #138, published on January 8th, I shared some analysis on the total market cap of cryptocurrencies alongside the following chart:
“From my perspective, I am staying optimistic until we see a decisive breakdown below the September 2021 lows, shown by the white levels. If the total crypto market cap is able to remain above this level, around $1.8Tn, I will remain optimistic about this current cycle. If we break below it, I will likely reduce my price targets for this cycle. If there is slippage below $1.8Tn, I believe the possibility of reaching $1.2Tn will increase substantially, although I don’t believe it would be the probable outcome. For me, this $1.8Tn level is the line in the sand for bulls & bears.”
Since that post, the total market cap of crypto has fallen from $1.95Tn to a current level of $1.6Tn. Based on the current market dynamics, here is the updated chart:
As I said, the September lows of $1.8Tn was the line in the sand for bulls & bears. Based on current market sentiment, it feels as if a decline to $1.2Tn is almost a certainty, which would represent an additional decline of -25%. This means a retest of the May-July 2021 lows is officially on the table. While the past few months have been extremely unpleasant, particularly over the past few weeks, my prior analysis allowed me to prepare mentally for this scenario. I have yet to sell or reduce any of my crypto exposure, and still have an ample cash position I am waiting to allocate.
In November, I expressed strong conviction that Bitcoin would reach a level of $135k-$290k this bull cycle. On December 4th, I shared my thoughts on Twitter and said that “I’ll reduce my bullishness on this cycle if we get a weekly close below $40k (lows from September post-El Salvador adoption).”
Now that we’ve officially closed below $40k, currently sitting at a price of $35.2k, I am officially lowering my forecast. I still need to work through the analysis to determine what price range is feasible this cycle, but I do believe the cycle is still intact. I still remain bullish. Over the course of my analysis with crypto over the years, I’ve continued to be reminded that it takes the path of most pain. In March & April 2021, it felt like a certainty that Bitcoin & other cryptocurrencies would extend to new highs and enter the exponential phase of the cycle. The opposite happened & $BTC was cut in half. In June & July 2021, the consensus was that crypto would continue to plummet and that the bull market was over. Bitcoin rallied from $29k to $69k over the subsequent months.
In November, the market sentiment was exuberant and we’ve once again crashed by -50% from those new ATH’s. It appears that market sentiment has fully shifted once again to extreme fear and negativity. It’s possible that crypto will continue to decline while market sentiment remains negative. The contrarian pattern gives me some degree of positivity, but I will continue to remain flexible with incoming data, charts, and fundamentals.
Price is what you pay, value is what you get.
Talk soon,
Caleb Franzen