Today was a rough week for bonds and stocks, following a four-decade-high CPI print and the lowest Consumer Confidence reading … ever.
USD and gold were the top performing widely held assets. As we argued a year or two ago when the Fed was going nuts on monetary policy and the administration on fiscal policy, extremes beget extremes. We have a ways to go. In light of the “interesting” market action, it might be interesting to take a look at Synthetic Systems’ latest thoughts. Herewith is a fresh-off-the-presses run as of today’s market close.
This, by the way, is the “S” version referred to recently in Synthetic Systems Update, chosen because it takes only a few minutes to run. The “official” SS forecast remains the last quarterly run at the end of March, but this is interesting because it highlights where the greatest uncertainties lie and in which direction.
It’s also noteworthy not only for the outlook but for the record of market movement to date. This is the same for all versions of SS. Notice that despite first impressions, SS believes it has gotten the stock market just about right. Instead where it’s been wrong so far is in underestimating the magnitude of dollar strength. Dollars have risen sharply in value, with the result that it takes fewer of them to buy the same stuff. In short, while values have so far held up, prices have declined.
That may be about to change, however, if “quick” Systems has anything to say about it. The turning point for stocks and copper into bonds and gold has been softened or rounded and moved ahead by nearly a quarter. This is about the uncertainty limit of the existing SS version anyway, so it’s not entirely new, but this is its first explicit indication that the markets could be in transition as soon as … now.
29 thoughts on “Markets Update”
Thanks for this update Bill. Here is a post from EJ regarding his thoughts on the current situation; I hope you don’t mind me posting it in full here.
Soft Landing Prospects
Published on May 26, 2022
MV=PQ as M2, V, CPI and GDP
MV=PQ as M2, V, CPI and GDP
The pandemic produced the most intense economic disruption of any macro-economic event on record. Monetary and fiscal stimulus executed to rescue the economy then has left the economy with an inflation hangover during recovery, both CPI and asset price inflation.
The relationship between the money supply, velocity of money, economic growth, and inflation is well understood, as expressed in the equation MV=PQ, where M is the money supply, V is velocity of money, P is the price level, and Q is the quantity of economic output. In the charts above, M is expressed as M2, V as M2 Velocity, P as the CPI and Q by GDP.
Over time, the data show these relationships holding up well. The effect of asset price inflation and deflation on the macro-economy is less well understood. During periods of extended asset price inflation, the price level P tends to stay more elevated than the level and direction of M, V and Q would indicate. Conversely, during periods of rapid asset price deflation, the negative effect on GDP growth and inflation is pronounced.
Significant asset price inflation occurred since the summer of 2020. The NASDAQ increasing 128% from around 7,000 in August 2020 to 16,000 by the end of 2021. The correlation of asset prices and GDP growth is high, but the macro effects are difficult to quantify and causation is not directly measurable. Generally speaking, households are more inclined to spend when stock portfolios are growing rapidly and household balance sheets are flush, and less inclined to spend when portfolios and balance sheets are shrinking.
The macro effects of asset price inflation explains why the CPI continued to climb from Q3 2021 to Q1 2022 even as M2 and GDP fell over the same period, while V remained at an historically low level. This may also explain why the Fed waited so long to take action; either they were not taking asset price inflation into account while waiting for P to catch up with declines in Q and M, or they were concerned that sudden and extreme asset price deflation triggered by tightening in a period of low inflation could produce an unmanageable deflationary economic downturn. From a starting point of 8.3% CPI in April 2022, the Fed has some headroom room to manage a major economic contraction for a period without having to cut the discount rate, which at 1% today is already too low to be useful as a tool to stimulate the economy in a downturn.
If that’s the case, then rapid asset price deflation as we have seen since early April 2022 will slow the economy dramatically. We should see CPI begin to fall perhaps as soon as May, but certainly by June. In that case, it will appear that rate hikes are doing the job, although in reality the effect will be mostly indirect, via asset price deflation rather than directly by making credit more expensive.
If that happens, I expect asset markets to stabilize as falling inflation is interpreted as an indication that fewer rate hikes will be needed than are currently being priced into the equity and bond markets. However, US total stock market capitalization reached an historic peak of 232% of GDP at the end of 2021, exceeding the 185% level at the top of the previous NASDAQ bubble in 1999, after which it declined 44% to 78% in 2002. That period of asset price deflation induced a recession that lasted for three quarters starting in Q2 2021. The even more extreme proportion of market capitalization to GDP in the current instance suggests asset price declines from here may have an even more profoundly negative effect on the macro-economy than during the 2001 to 2002 period.
The Fed will need to be highly vigilant and reverse course early enough to prevent a positive feedback loop from developing as occurred from 2001 to 2002. In that time, as declining asset prices slowed the economy, the slowing economy reduced earnings potential, leading to further asset price declines. That self-reinforcing process brought the NASDAQ as far below trend as it had been above it at the top of the bubble, from 5,000 to 1,200, and the economy went into an extended recession. The NASDAQ did not recover to the previous 5,000 peak for another 13 years in 2015.
Some years after the event, Fed chairman Alan Greenspan stated that he had underestimated the macro effects of the NASDAQ correction and did not expect a recession to follow. The mortgage credit bubble collapse also produced a runaway downward loop, albeit centered in the debt versus equity markets. We can only hope that the Fed has learned from previous experience and is taking the macro effects of asset price deflation into account this time as the economy slows and inflation falls. If they are, then a soft landing is possible, with asset prices stabilizing, inflation leveling off at the Fed’s 2% to 3% target range, interest rates in the 1% to 2% real rate range, and the economy growing again from a new somewhat lower equilibrium. We’ll keep a close eye on it and update you on new developments.
The first url is a link to an image. It would be better if this was imbedded in the text; if you can fix this, that would be good.
Thanks, Peter. Especially since iTulip appears to be down for the count, Financology is now the de facto Finster’s Comments.
I suspect that posting another comment, before the first comment has been moderated, loses the current outstanding “Your comment is awaiting moderation”. I’m posting this third comment, as a test, to verify my understanding.
Thank you so much, Bill. This is so fascinating. And a little bit terrifying. We are in “interesting times” for sure.
I’m still wondering where energy fits in SS; how it’s going to behave in all this. Is it a commodity like copper? Or, since energy seems to be the most critical need in the world now (and for the forseeable future), so much so that sellers can name their price in gold if they want to, will it track more closely to gold?
Good questions, Shiny! Energy is too heterogeneous and noisy to track directly. It falls most closely to copper than any other … it tracks remarkably well over the longer term and less so over the short term. I use copper in SS for technical reasons … put succinctly it’s the “purest” of the industrial commodities. Also see my reply to JK below.
I think consumables like energy and food are different than industrial metals, and won’t necessarily follow the same trajectory. Otoh we know energy can drop a lot during an economic slowdown. on the third hand the loss of about 1mbbl/day of Russian output (net) and the now long-standing lack of capex in oil and gas should conspire to support oil and gas. gas is probably safer than oil as increasing exports of lng gradually arbitrage the relatively low cost of u.s. gas with the very high price of gas in Europe and Asia.
No argument there, JK. I use the term “industrial commodities” to distinguish from monetary commodities, the purest of which is gold. It’s not technically correct, but it avoids a lot of verbal clutter that could make the point even more obscure.
In the context of SS the benefit of copper is that it represents physical commodities as a class well, especially over the longer term. Gold is tracked separately because it just doesn’t trade with the rest … it marches to its own drummer.
Consumable commodities differ as you say fundamentally from nonconsumables. Their ability to be created and destroyed makes them noisier than elementary commodities that cannot (outside nuclear transmutation).
But probably the clearest demonstration of copper’s “purity” is visible in the charts. Notice the almost mirror-like negative correlation between copper and bonds. There is something more fundamental about copper than any other commodity save gold. As a practical matter, it just ‘works’ in SS. You may recall a point often made by Jeff Gundlach about the relationship between the copper-gold ratio and the ten year yield … this is a related issue.
I should probably find a better term than “industrial” commodities for the commodities class ex-gold. I don’t know … maybe “nonmonetary” commodities? But copper has been and is used as money, so that’s not technically correct either. Consider it an unsolved problem in the Financology lexicon.
As a practical matter, I know of no better way to track the whole mess than copper. It’s far from perfect in the short term but works pretty well in the longer term. Pending so-far-unimagined solutions, my suggestion for sophisticated investors would be to take the copper plot as the core commodity and apply their own knowledge about particular commodities to assess how their behavior might differ.
Bill, thanks for running and publishing the updated systems forecast. my confirmation bias is delighted since last night, after watching the umpteenth interview with David Rosenberg that I’ve consumed in the last month or so, I wrote to a couple of friends that I planned to buy some long dated treasuries and add to my gold position, as well as trimming my commodity positions a bit
I have to plead confirmation bias as well, lol. But it’s either that our biases are correct or pure chance that this new “quick” Systems version sees things our way. I did absolutely nothing to it to cause that outcome. There aren’t even any places to input my opinions. I would have to go to great lengths to bend the forecasts to my will. But I wouldn’t want to if I could. I count on it to be objective as a check on my opinions. If it were a mere “yes man” it wouldn’t be doing its job.
It’s actually in some disagreement with the current “official” version. This in itself could be useful as an indication of where the greatest uncertainty in the forecast lies. For the upcoming mid year update, I may publish more than one version just for this reason. Ultimately it may be up to readers to decide if that’s helpful or if they prefer to K.I.S.S. and just see one chart.
the difference between the new and the old versions of ss appears to be mostly in the timing of the turn into clearcut recession-typical markets [bond rates down/bond values up, stocks and industrial commodities down]. they are 1 quarter apart.
if anyone wants to hedge a long bond position, i suggest a look at pfix. i watched an interview with harley bassman [available at https://www.youtube.com/watch?v=7amehXFSNAI ] the creator of the move index [“the vix for bonds”] and a honcho at simplify funds which offers pfix, an etf.
pfix has a lot of convexity for upward movements in rates. i looked at it in the performance function of stockcharts.com, comparing it to tlt and edv, and it appears to be working quite well. bassman recommended a position 5% of the size of a 20-year bond position being hedged.
for me, buying some pfix will allow me to be comfortable with a larger bond position than i would otherwise tolerate emotionally.
Quick note … there are actually two new SS versions … I just ran this one because it takes a fraction of the time as the others. This chart isn’t really A/B comparable to the older version because of the different run date, but we did look at version comparisons recently.
Thanks for calling PFIX to our attention, JK. Interesting … I’m skeptical though. If I’m bullish bonds, why would I want to buy something to benefit from bearish action? I can’t get a clear picture in my head of where it fits in. Maybe in a taxable account where I have a big bond position I don’t want to sell for tax reasons? Otherwise why not just hold a less aggressive bond position? It kind of feels like one of those fuzzy quantum mechanical things where it’s here and there and in neither place at the same time. Sort of like what you might buy if you don’t know what you really want so you buy something you don’t know what it will really do.
My strategy FWIW has been to first move my bond allocation back up to neutral, then buy a little more each time they sell off. Right now I like the whole USD-UST duration spectrum – cash USD, GOVT, EDV, VGSH, VGIT, VGLT…
But I Don’t Like TIPS.
On the other hand, it certainly does seem to do well when bonds sell off. Very well.
Talk about immediate gratification. Any thoughts on this morning’s action? Stocks, copper, even oil … all being hit hard. Bonds and gold are down only a bit more mildly.
My impulse is to add to bonds and gold. I recently brought bonds back up to neutral but suspect this may be an opportunity to actually overweight. The case may be even stronger for gold, which I just added to positions this morning.
Welcome any perspectives…
Folks I think the point is near where the Fed option may transition from call to put. It wanted to throw some cold water on asset prices, but won’t stand idly by while the Treasury market freezes. It’s walking a bit of a tightrope because it doesn’t want to lose its credibility on inflation either, so I expect a more moderate tone on rate hikes while it simultaneously tries to assure markets that progress in inflation is in the pipeline.
And that would be justified. As I’ve argued ad nauseum, asset prices sit at the leading edge of inflation. And they have already cooled substantially. So long as the Fed doesn’t underwrite another surge, consumer prices will come off the boil.
Bill, my above comment from a moment ago was meant as a reply to you but I didn’t see the reply button until to late. Sorry!
Bill, you stated:
“Folks I think the point is near where the Fed option may transition from call to put”
by this statement are you saying that it is almost time for a new Fed Put to be in place, at the current lower level? I guess I’m confused. Either I’ve misunderstood what you mean by this statement or there is a disconnect between it ansd the latest run of the 10 minute version of S. Doesn’t the latest run of 10 min S show stocks declining until 11th March 2024?
Please clarify… Thanks, Peter
Fair point, Peter. And yes, please challenge me anytime you see something that’s doesn’t seem to add up.
Three points. First, I think the Fed may be more concerned about the bond market than the stock market. I’m not saying SS looks at it that way, but in fact it’s turning quite bullish on bonds. Second, even if the Fed were to take a more dovish turn, it wouldn’t necessarily turn the stock market around right away. Back in 2008 the Fed began to ease (and not just talk easy) even before 2008 – the first rate cut was in September 2007 – eighteen months before the stock market bottomed, and even before it topped. Third, SS doesn’t always agree with me. I have my opinions, but no way to input them into SS. As I said in an earlier reply to JK, that has value in itself. If my fundamental based view isn’t consistent with SS, then it’s certain one of us will be wrong. SS doesn’t think about the markets the way you and I do … it’s emotionless, objective and doesn’t even know what people are saying in the news.
Crude oil started and ended the day at $120 or thereabouts.
Inflation caused by printing too much money can can be tempered by the Fed’s tightening, but inflation caused by lack of resources can’t, unless they throw us into such a recession that it kills demand.
But energy demand is pretty inelastic. If they kill enough jobs, that that’ll reduce some demand. But those unemployed people still need to eat, still need to run the A/C and lights, still depend on diesel to grow their food and bring it to market. Everything is dependent on energy now, unless you grow your own food and shear your own sheep.
Forget about Peak Cheap Oil. Plain old Peak Oil is in the rearview mirror now. It’s going to be a continuing problem, made worse by sanctions. So what do they want us to do? Die in sufficient numbers that there will be sufficient oil and gas for the ones that remain? If it’s true that for every 1% rise in unemployment, 40,000 people die, then it looks that that’s that’s the plan. I’ve been looking at that crashing copper line for months now. In my ignorant opinion, the only thing that could cause such a collapse is a drastic recession.
But this stuff is way over my head. I never know what I don’t know. Heck, I can’t even understand how bonds work, so I probably shouldn’t even be talking here. Corrections are greatly appreciated.
Thank you Shiny! Very much welcome comments. I realize this isn’t the ideal discussion format, but it’s the best we can do until I can find time to install and manage a proper discussion board. It doesn’t sound like this is over your head, either … more like you have a pretty solid grasp of the picture.
It is a complex problem but breaking down complex problems and finding the underlying simplicity is what we’re all about here. We’re very fortunate to have people like you, JK, Peter (and even EJ by proxy) and our other commenters pitching in to make it happen.
You’re very generous, Bill.
I can get a sense of issues (some more than others) but I struggle with abstract concepts and even basic math. Thus I can never remember how bonds work. Plus, I always wonder what important thing I’m _not_ aware of that can turn into a GOTCHA!
So I’m seldom confident in my views and my timing is lousy. I’m probably depending on SS more than I should for timing, but it’s so good! Any failures are totally on me.
Thanks for your reply… Much appreciated as usual. Sometimes I get sidetracked with other issues, plus it’s our end of financial year right now, so a bit of housekeeping is required.
re: “the Fed put”
i believe yesterday the market was showing a probability of 96% that the fed would hike by 75bps. imho the fed can soften expectations [hint that there’s a put out there somewhere], maintain its inflation fighting bona fides, and calm the markets all at the same time just by doing what they said they were going to do all along: raise by 50bps.
In fact I’m hearing speculation on Bloomberg today of even a possible 100 bp tomorrow. Described as a “rip the bandaid off” approach … accompanied by a clear statement that no further action is planned and future changes will just depend on the data. Seems unlikely but it’s just what I advocated in recent weeks.
The bond market may be reacting excessively to a perception of 50 bp every meeting until doomsday … clearly unnecessary … and it’s plausible it could calm the market without inducing an explosive and counterproductive rally.
All the Fed needs to do right now is bring Fed funds into harmony with the rest of the yield curve.
Thanks Finster for your great analysis. It’s good to have a place to exchange ideas. I bought some gold today.
The problem with bonds, as I see it, is that interest rates, even now, are well below inflation. Is the call to own bonds just a call to own long-term Treasuries hoping to generate capital gains as long-term rates decline once the Fed starts QE up again?
Thanks, kbird. Your bond skepticism is understandable. Financial media routinely compare asset returns with consumer price inflation.
I believe it’s apples and oranges. Consumer price inflation isn’t on the investment menu. Investable assets live in a different world. You can only validly compare them with each other … and choose the best mix available for your risk and return objectives. There isn’t anything better than best.
This is accounted for in Synthetic Systems. It puts the asset classes on an equal footing … the plots are all total returns relative to each other. This takes into account both price changes and yields.
Alas inflation affects consumer prices and asset prices at different times. It sort of first gets stored up in assets and only later spills over into goods and services. This was recently explored in depth in The Big Takeaway.
What’s more, time frames between consumer price inflation and bond yield quotes don’t line up. Consumer price inflation is in the past … it’s typically reported over the last twelve months. Bond yields live in the future … they’re quoted as the yield you will receive if you hold the bond to maturity. Subtracting one from the other is logically invalid … like asking how many golf balls you will have if you start with ten tennis balls and subtract four footballs.
Some might object that you can invest in consumer price inflation … through TIPS (Treasury Inflation Protected Securities). We deconstructed that fantasy in I Don’t Like TIPS.
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