June 3, 2022
The last entry on this blog referred to a world of divergences, and they continue unabated. One of the most interesting of those is that the market appears to be putting in a (another?) bottom, just as the economy appears to be weakening.
For the nimble trader, there may be an opportunity to make a lot of money within this volatility, however it is likely the volatility will continue so caution is warranted.
In tracking markets, your author runs a number of market scans. One of them looks for companies that have declined significantly, and another looks for companies that have started to recover (in price) from those declines. The number of companies undergoing significant near term declines has been reduced dramatically in the past week or so, and a similar rise in the number that are experiencing a price recovery has been noted. In other words, the market is either taking a breather or healing.
There are many different, and very interesting aspects of this, and one of them is that the decline in the S&P 500 was halted just short of the 20% mark. Twenty percent is the official designation of a bear market. Not to fall into conspiracy conversations, but the large investment houses, hedge funds and so forth, the ‘big money’, may be trying to protect their portfolios from breaching a psychological barrier.
The divergence conversation gets more interesting because this little bump is being met with talk within the various news channels (CNBC, Marketwatch, etc.) about a turn in the market, time to get in and so forth. At the same time, some of the largest investment houses, governments, and companies (who make up the largest parts of the market) are warning of significant pain to come.
Who do you listen to? Well government almost always gets it wrong, but they are frequently too rosy; rarely are they too pessimistic. Talking heads on TV have a habit of ‘talking their book’ and reflecting what happened yesterday, so should be viewed with some caution. The big money also has a habit of talking their book, but often have such large stakes in the outcome of their work, that they might be worth listening to.
On Monday, the US Federal Reserve started shrinking their balance sheet. Prior to the COVID pandemic, the balance sheet had been reduced to about $3.8 trillion. During the next 28 months, the balance sheet exploded to about $9 trillion. This alone has accounted for a significant portion of the inflation that is hurting the average citizen around the world today. To repeat, on Monday, they started the process of unwinding that support for the economy, at about $95 Billion per month, it will take about five years to unwind two years of excess. The economy should expect a LOT of pain.
At the same time, central bankers around the world have made it clear that interest rates should be expected to rise and that fighting inflation is a top priority. For the past thirty years, every time there was a bump in the economy, the central banks were seen as a backstop to any serious problems. The ‘Greenspan put’ and ‘Helicopter Ben [Bernanke]’ made it clear that saving the economy was the focus of the Fed, while Janet Yellen who was not granted a memorable nickname, was often seen as a ‘dove’ who would protect jobs. The current chair, Jerome Powell, has been on both sides of the COVID crisis and so the market is a little wary about how things will play out. Currently Mr. Powell is talking tough.
All of that matters because the Federal Reserve is the most important central bank in the world (about 40% of all trade is conducted in US dollars, and the US economy represents about 24% of world GDP). At the same time, tough talk is coming out of the EU, rates have been raised in Canada, the UK, China and other nations as well.
Returning to divergences, there is a lot of talk in the past month about the workforce. With COVID causing a massive shift in office work and work from home, employers are having difficulty navigating a return to office. But there are signs that the declines in markets, the reduction in money supply and increases in costs are turning into real losses in the job market. Many of the former ‘new tech’ high flyers are starting to shrink and some service areas such as retail are looking shaky as costs rise. It is hard to imagine that spending will rise substantially, outside of food, shelter and transportation for most consumers, when the costs of these basic necessities is rising so rapidly. Again, a little bit of caution is warranted before investing.
Another significant divergence is the geopolitical uncertainty in too many places around the globe. From an external view, the US seems to be at war with itself, politically, socially and even with rights (Roe v. Wade) and guns. But in the rest of the world there are policy difficulties such as China’s ‘zero covid’ policy slowing their economy and hampering trade flows. Peru and Columbia are undergoing upheaval due to elections and rights issues. Sri Lanka has gone bankrupt and other countries such as Turkey are showing significant strain. Meanwhile Europe is undergoing economic and social strain due to war in Ukraine. And let’s not forget there is an actual war in Ukraine which is slowly destroying one of the most important countries in the world for the production of food and various manufactured goods.
Along these same lines there are risks to the world due to climate change which have no precedent. The world knows things are not ‘normal’, but studies don’t allow policy makers to justify significant changes to accommodate the associated risks and yet the changes are creeping up on civilization slowly. The tipping point will be catastrophic for many, even if the effects are local. Drought in India and California seem like good candidates to steal the headlines this year, but more traditional catastrophes may be just as damaging, such as hurricanes and forest fires.
In other words, the market has accommodated some risks, but probably doesn’t reflect the ongoing assault on normal that is increasing in frequency and intensity. An investment approach that acknowledges that the world has changed is probably appropriate, and if you don’t know how to do account for all that change, than simply standing aside with at least some of your assets is probably the best course of action.