A Sleeping Giant Awakens

Jay Powell has finally had his Road to Damascus moment.  He’s catching up to where these pages were months ago.  In the press conference following Wednesday’s FOMC announcement, he acknowledged inflation is a serious problem not to be dismissed.  

He’s still dragging his feet on rate policy … the notion that rates can’t move until QE is over is a figment of Fed dogma.  As we pointed out in Monetary Mythology, it’s based on an ad hoc assumption that QE is just an extension of rate policy out the curve.

This unfounded assumption has consequences.  Real interest rates 5%-10% below zero is an economic emergency.  But … and this is key … rates have started to move, just a bit, but every journey starts with a step. The Treasury market, not the fed funds target, is what really matters, and rates have already begun to creep up in the one-two year area of the yield curve.

It’s also just plain silly to keep any mortgage purchases going at all … never justified to begin with, they became redundant – worse, counterproductive – a year and a half ago. But at least now they’re being trimmed.

Sure, we could do better. I’d rather see movement first on rates and mortgages, but maybe be less aggressive on the Treasury taper, adjusting as needed to buffer unnecessary volatility.  But at least the Fed is opening its eyes … as they say, the first step in solving a problem is admitting there is a problem.

What does it mean for financial markets? Fed tightening, or becoming less loose, typically leads to lower asset prices, or less pressure higher.  But this comes at a time of extraordinarily high asset prices.  The markets, bond and stock, are now in a similar position to Wile E Coyote after he’s run off the edge of a cliff and hasn’t yet looked down.

They could be correcting this hyperinflated state already, or they could stay that way for a while.  Synthetic Systems says it could be as long at the second half of next year before they look down and realize there’s nothing below but a lot of thin air.  Watch for the next update around the beginning of the new year.

8 thoughts on “A Sleeping Giant Awakens

  1. Peter Fife says:

    Hi Finster,

    You may have mentioned this elsewhere, but how do you use your Synthetic Systems, from an investment perspective. I am of the understanding that you use technical analysis, as well.

    So, I would like to understand how you integrate both of these? Do you use SS for a longer time frame perspective and TA for a shorter time frame.


    1. Bill Terrell says:

      The way I think about Synthetic Systems it’s that it’s like traditional technical analysis, in the sense that it doesn’t attempt to evaluate fundamentals. Of course it differs in that TA doesn’t generate forecasts. It also at once evaluates multiple asset classes, showing their expected relative performance.

      It can be used a variety ways. Let me put in context how I use it. First, my basic target allocations are based on the market portfolio adjusted by my view of the long term fundamentals, including valuations. Valuations are the best predictors of investment performance over time frames of several years or more. At the opposite end of the spectrum, valuations have almost no impact on short term performance (less than a quarter) where news and sentiment reign. This is where traditional technical analysis is most useful, although even then randomness is so great that it’s a hit and miss proposition.

      Synthetic Systems lives in the twilight zone between. It’s at its best over times frames from a couple quarters to a couple years. I use it as an overlay to my basic allocations, when to over or under weight asset classes. For instance if my allocation to stocks based on my objectives and long term outlook is X%, I add or subtract a few percentage points if SS is notably bullish or bearish. I have an algorithm that adjusts my target allocations quantitatively based on numerical outputs from SS, but it’s just as easy to look at the charts and assess based on your time frame.

      This is also where the simultaneous multi asset class view is especially helpful. It doesn’t do you much good to hear an analyst tell you to stay out X, because that still leaves you with the question of what to be in. As we’ve observed before, as long as you have assets, there’s no such thing as investing in nothing. Some have for example have been saying US stocks are a bad investment for years. They may well have been right, but for most of those years, however bad stocks may have been, being in cash has been worse!

      More than anything else though, it’s been good for getting an overall feel for what to expect over the next couple of years or so. As early as 2017 SS clearly foresaw the inflationary environment of 2020-2021. We discussed it on iTulip. On the other hand, it did not foresee the deflationary crash that occurred in the first quarter of 2020 … from SS point of view, the coronavirus crash was a true black swan. Notably though, the markets did quickly return to the trajectory SS had outlined. You can look at SS as showing you what the markets ‘ought’ to do absent external impulses.

  2. Llanlad2 says:

    Cheers Bill.
    Wishing you and yours a Merry Christmas and what looks an interesting New Year.
    And thanks once again for this blog.

  3. Peter Fife says:

    Thanks Bill, I just read your reply. I appreciate you taking the time to provide an in depth answer to my question.

    I think it’s fair enough to claim that coronavirus was a true black swan, although EJ tweeted about the next crisis in the system was about to occur on the 28th Feb 2020.

    So, in December 2007, when EJ posted “It’s Time To Short the S&P 500”, on iTulip, you made a comment along the lines “Thanks for the heads up”. Was SS predicting the 2008 crash? And, based on EJ’s article, did you get completely out of stocks?

    Clearly, if you don’t want to answer these questions, that’s perfectly fine.

    1. Bill Terrell says:

      Perfectly valid questions, Peter. I only meant the corona crisis was a true black swan as far as Synthetic Systems was concerned. SS doesn’t attempt fundamental analysis like EJ does. It’s not intended to compete with it, but rather to complement it. It’s pure math … sophisticated and advanced, but has no insight or imagination.

      It also doesn’t work over time frames less than around a quarter or more than four years. It more or less fits in between traditional technical analysis and fundamental analysis (including valuations). In its area of validity, including simultaneous detailed forecasts for five asset classes, I know of no better market forecasting system. But it is far from perfect and certainly is no substitute for EJ!

      Synthetic Systems did not foresee the 2008 crash. Again, it’s not intended to be used by itself. It’s also been improved in the fourteen years since 2008. In particular there was a major overhaul in early 2014 and another significant refinement in 2018. SS also studies the markets over time and learns from their behavior.

      I conceived the first crude version in 1994. It turned out to be about as good as a tossing coins and it took several failures and revisions over a couple of decades before it started to get traction.

      I didn’t get completely out of stocks on EJ’s prescient warning in December 2007, but did lighten up considerably. Like most investors, my portfolio took a significant hit in October 2008 when both stocks and commodities collapsed. That was moderated somewhat due not to SS but another tool, the FDI, which tracks and records (but does not attempt to predict) the rate of inflation/deflation. Recall my post nine days before the Lehman Bros collapse warning that deflation had arrived.

      That post was 4, 3, 2, 1 … Deflation! on September 6, 2008.

  4. Peter Fife says:

    Hi Bill,

    Once again, thanks for taking the time to reply, and also for your open and candid response. It provides good insight into SS, how it works and, from your perspective, its accuracy.

    Just curious about the fact that your portfolio took a significant hit in October 2008; was that because you didn’t know how good EJ was at that time, and hence took his “Time to short the S & P 500” warning less seriously than you should have.

    Once again, just pass on any question/s I may ask if you don’t want to answer. As stated, I ask the previous question out of curiosity, as I am a very curious person, and like to know both how things work as well as how people think.

    1. Bill Terrell says:

      The fall 2008 losses had more to do with the overall market than confidence in EJ. EJ established his credibility and then some with his December 2007 call. It was probably the single most striking market call I’ve ever seen. By the end of January it was abundantly obvious he had nailed it.

      It was a combination of two factors. First, some inattention due other distractions; I was getting a band going in the second half of 2008 and it was consuming most of my mind space. A close friend was having a baby and I was her only local support. The other was my diversification discipline. As a general policy I never go to zero in any major asset class. I discuss this on my Investing Basics page as well as in recent posts here. Further most of my investments were in a taxable account which limits making large frequent adjustments to allocations.

      Nevertheless I had repositioned both on EJ’s original warning and further on my identification of the onset of deflation per my September 6 post. Many investors didn’t even survive 2008. One investor friend was convinced the only grave consideration was inflation, and in fall 2008 was still up to his neck in junior mining stocks. Others were leveraged, ie short cash. EJ’s insights, as well as my own, allowed me to survive what might otherwise been financially fatal.

      In the bigger picture, also remember that due to the surging value of cash, the nominal market declines exaggerated the real losses. The surge in the value of the dollar isn’t acknowledged in nominal prices, and a cash position actually rose in value. If anything my portfolio was hurt more by dragging my feet in getting more fully reinvested after the March 2009 bottom. Neither EJ nor I were convinced it was over, as you can see from a review of our iTulip postings at the time.

      Regarding Synthetic Systems, please take a look at some of my recent posts where I discuss its interpretation in more depth.