July 22, 2022
In the world of boating, the predictability of tides and the range of tidal motion are well known. Tables are produced; now apps can be pulled up with data; the rise and fall is well understood.
In the world of investment, the turning of the tide is completely obscure. Of course it is noticeable sometimes, but the complexity of modern finance means that what may seem obvious is not so clear. What’s worse, the liquidity that has been pumped into markets in the last twenty years has masked trends to such an extent that traditional methods can be unreliable.
Let me explain. One of the most prominent ways of making investment decisions is to use a trend following system. When prices start to rise you make an assumption that it is becoming safer to invest. When prices start to decline, you take the opposite approach. Moving averages are one way to do this. Here is a weekly chart of the last seven years for an oil company (Occidental Petroleum).
This particular company was chosen because it moves in relation to oil prices, not the economy. There is a distinctive rise and fall based on the price of the commodity (oil). If you were to sell when prices drop below the trendline (blue above), and buy when it moves above the trend line, an investor would have done better than just buying and holding over the long term. Note that this doesn’t always work however.
If one were to pick a company that might better reflect the economy, Wal-Mart or McDonalds might be better selections. They are used by millions of people on a daily basis from all walks of life, and so could be a good proxy for the economy. Let’s look at the charts for these two companies.
The notable feature here is that the consumer based companies have barely taken a breather. Almost all dips below the trendline have been for a just a few weeks. In many cases, the trend line never even turns down. A significant downturn in the moving average never occurs. Why would that happen? Shouldn’t there be a business cycle? Any business school on the planet taught business cycles as a core concept. The economy expands until business conditions stop being beneficial, then there is contraction, until the business conditions improve and growth starts again. The past 20 years has seen this cycle disappear and there are plenty of arguments that the business cycle has been tamed and we may just have constant growth.
There are many posts here arguing against that concept, but here is the chart to help understand why ‘normal’ downturns are not occurring any longer. The chart below shows the money supply being provided to the economy, in this case, M2. A notable feature is that the growth in the equities market is almost perfectly correlated to the growth in money supply.
Here is that chart of McDonalds again, with M2 plotted behind the share price.
Money supply has been driving the economy, but the supply of money has begun to run backwards. The Federal Reserve is starting to TIGHTEN monetary policy (increase interest rates) and remove money from the system (this is what M2 measures).
The effects can be seen quite clearly thus far in 2022 as equity prices and bond prices declined. Now commodity prices have been hammered back down, and the effects are showing up in real estate prices as well. All of the major asset classes are declining.
Is it safe yet? This morning Bank of America highlighted that Fund Flows, a measure of investor money moving into and out of investment funds, are still negative and pessimism is extremely negative. Here is the chart.
There is some evidence that the initial declines in the market were simply leveraged funds taking money off of the table. With so, so much money having been pumped into the financial system and no place for it to produce returns, that money was invested in financial markets (which are non-productive, but can be very enriching), and they went much higher with the constant purchasing of financial assets with every spare dollar.
When there is such bearishness, a contrarian could find some optimism and suggestions that things are about to get better are everywhere right now. In this case, it may be wise to remain cautious. If we go back to that chart of money flow, it is clear that every time, for the past twenty years, there is a hint of difficulty in the economy, the Federal Reserve increased the money supply in the economy. In 2011 when the Fed threatened to tighten monetary policy, the markets tanked. In 2018, when the markets thought tightening was coming, the markets tanked. For four decades, politicians have learned that a drop in equity prices was political suicide and so each time equity prices fell significantly, the Federal Reserve ended up INCREASING money supply, and the markets moved ever higher.
Here we are in 2022 and the bottom 90% of populations are no longer benefitting from that old thinking. In response, politicians are adjusting their focus. Over the past year, the Federal Reserve has warned markets, explained how they will and now they ARE taking money out of the system. And the market is tanking.
Are we done yet? No. It is clear that the Federal Reserve will take money out of the economy, for many years to come (they have been removing money from the system for just 53 days so far). Interest rates may stop rising, yet the higher (but historically low) rates that we have now will reduce spending by consumers and business for years to come. The taxes required to pay for these higher rates will need to be raised. There are yet more drags to the economy not even mentioned here as well. Still, the decline in money supply alone will reduce investment for years to come.
And investors are just starting to come to terms with the fact that the bounces in markets may be short lived. They may need more of their paycheck and perhaps some of that invested money to sustain their lifestyle. The list of reasons why equity prices may not march higher is a long list.
The tide on money supply is turning, slowly, and financial markets may have accommodated those changes appropriately. What may not be clear are the effects of that turn of tides on inflation, a reversal of the wealth affect and a delayed understanding by investors who have never experienced a significant economic downturn. The Federal Reserve does not appear to be well positioned to save the economy this time and even if they try, many of the forces acting against growth are out of their control in any case (i.e. globalism is being dismantled if not destroyed).
As Warren Buffet once said, “Only when the tide goes out do you discover who’s been swimming naked.” The tide has clearly turned, but this doesn’t look like low tide yet.