In case that wasn’t clear … nooooo!!! I like to follow Bloomberg, CNBC and other business news sources. Not because they offer much in the way of market insight, but to see what the “mainstream” narrative is. Twenty-something experts are not always wrong, but when they are, it usually means opportunity. That has been the case for a few months. Let me try to frame the mainstream story:

Inflation has risen sharply because of Covid, Ukraine, and consequent “supply chain disruptions” etcetera. The US Fed and other central banks are diligently fighting this exogenously caused inflation by raising interest rates and shrinking their balance sheets. This has caused stock prices to fall. But as inflation readings have gradually fallen over the last few months, this brings us closer to the time when the Fed can stop raising rates, lifting the lid on stock prices, and unleashing a new bull market.

I really like this narrative. It’s just sooo wrong. On multiple fronts. When the crowd is really wrong, it creates powerful outperformance opportunities.

Just one of those fronts is the assumption that there’s a lid keeping US stocks down. Free of outside influences, they would be much higher. Nothing could be further from the truth. US stocks have been levitated for years by unusual, unnaturally low interest rate policy and money printing. That support is gone. So left to their own devices, free of outside influences, they would fall.

Another is the fantasy that consumer price inflation is an anomalous aberration that can promptly normalize without asset prices coming down. Financology has discussed this ad nauseum so it need not be belabored here. All prices – asset and consumer – are subject to the same inflation, just not at the same time. Asset prices first, consumer prices later. There is no planet on which stocks can rise by double digit percentages in perpetuity without consumer prices eventually following suit. We’ve reached the end of that road for this cycle. So there is likewise no planet on which consumer price inflation will come under control while stocks shoot higher.

The Fed will stop hiking, and probably start cutting, before too much longer. But only if stock prices go lower first. That will finally break consumer price inflation. The Fed has glommed onto this asset price relationship, so it’s not just abstract Financology theory. But the Fed itself hasn’t got it all right either, because it appears to think it has lots of time to finish its hiking mission. The bond market begs to differ. I’ll have to go along with the bond market on this one.

The third shaky leg of this rickety stool is that once the Fed begins to cut rates, stocks will soar. Eager dip buyers should recall, however, that the Fed cut rates all the way though the last two major bear markets. In the 2008 debacle, for example, the first rate cut came before the bear market even started. That happened in September 2007 … stocks peaked in October.

The opportunity that appears to present itself now is that the stock market is still in the early phases of correcting its misunderstanding. As it does, prices decline. But it still hasn’t given up on the flawed narrative we outlined earlier; it still has a ways to go. This of course doesn’t mean there won’t be bear market rallies – every bear market has them – but unless you’re a nimble trader, they’re a high risk game. Realistically, someone who is far below their target equity allocation could add a bit on dips like these, but this is not the time to be backing up the truck. For most of us, the opportunity is to resist the impulse to BTFD.

8 thoughts on “BTFD?

  1. jk says:

    the fed can’t wait on unemployment – the demographics are wrong. there might be a credit event with a threat of contagion- credit suisse perhaps?

    the real inevitable problem assuming something singular doesn’t happen first is illiquidity in what is always characterized as “the deepest, most liquid market in the world: the Treasury market. deficits are large and sticky, foreign cbs are sellers, not buyers, there aren’t many petrodollars to recycle, the fed is a net seller and in fact the fed itself is running a deficit. interest on the debt is skyrocketing. there are games to be played with reverse repo and the tga, but ultimately the fed will have to be the buyer of last resort. I doubt we’ll get to 2% inflation by then. and it’s not clear to me what interest rates will look like in such a situation.

    1. Finster says:

      Right; employment is about the last domino in a long line. They talk about it partly because they want to frame their decision making in terms of their statutory mandate, even if other imperatives are driving their actual decision making.

      The aim here though isn’t to dissect Fed policy but to highlight gross flaws in the mainstream stock market narrative. The Fed comes in because of the sharp contrast between its projections of rates and the bond market’s. They say they’re going to hike more and then hold at a terminal rate for a long time. The bond market thinks they’ll be cutting long before they project. I think the bond market’s right. You?

      And whenever they do start to cut, does that mean stocks will kick off a new bull market?

    2. Finster says:

      “I doubt we’ll get to 2% inflation by then. and it’s not clear to me what interest rates will look like in such a situation.”

      I doubt it matters as much as policymakers let on. They talk in more qualitative terms like “substantial progress” etc. Talk about inflation and employment lets them frame their policy in terms of statutory mandates, but that doesn’t describe the whole of their thinking.

      I think their talk about “financial conditions” gets closer to what they’re really thinking about. Their proximate target is asset prices, specifically stocks. Know how they’ve spent decades developing the Fed put? The new Big Thing is the Fed call.

      It’s not irrational. Asset prices lead consumer prices. Recall 2008. In the middle of that year inflation had become a problem. Oil hit $147 a barrel. By the end of October stocks were in full-on crash mode. By the end of December oil was in the 20s – 30s, and we were getting negative month-over-month CPI prints.

      This doesn’t mean the Fed put is dead; just that the strike price is a lot lower. Short of putting an exact number on it, if stocks go down far enough or fast enough that it starts to look scary, it will be triggered. That would would serve to tell them the balance of risks has plainly shifted and as a shorthand criterion that enough progress on “inflation” is in the bag, regardless of any arbitrary CPI or PCE figure, and long before statutory mandates about prices and employment provide clear guidance.

      Hence this post. The Fed has been telling us this for months and the stock market and financial media haven’t wanted to hear it. They’re just now catching on.

  2. Finster says:

    Let’s make this as simple as possible (but hopefully not simpler;-): The Fed is targeting the stock market. There’s a Fed call at roughly S&P 4000 and a put at roughly S&P 3000. Forget everything you know about the size of hikes, terminal rates, balance sheet tightening … if the Fed stops asset price inflation consumer price inflation will take care of itself.

    Is this an oversimplification? Sure. But you will have a much better working understanding of what the Fed is doing by just looking at this than you would by twisting yourself into pretzels with detailed analysis of “services inflation” versus “goods inflation”, the size of each rate hike, “terminal rate” targets, employment data, supply chains and all the other minutiae the financial media obsess over.

  3. jk says:

    historically the fed starts cutting well before a bear market bottom in stocks. e.g. the fed started cutting rates in jan 2001. the stock market bottomed in oct 2002.

    what will cause the fed to stop hiking and to eventually start cutting rates and re-instituting qe will be something bad for the economy. equities will fall for some time after the fed halts and then pivots.

    the only equities i hold are some precious metals miners. my own positions, fwiw, are 29% cash, 19% private multi-family real estate partnerships, 16% a short durations tips ladder from 2024-2028, 15% precious metals and miners, 13% tlt and edv, 3.5% george noble’s new etf-symbol “nope” – a mostly bearish hedge-fund like instrument [currently short stuff like ark, coinbase, draftkings, robinhood, peleton, tesla, and long much smaller positions in a scattering of stocks. i think it’s significantly net short but i don’t have the numbers.]

    nope is very volatile, so i don’t think i’d want a larger position. harley bassman is always saying that position sizing is more important than entry price.

    1. Finster says:

      JK: “historically the fed starts cutting well before a bear market bottom in stocks. e.g. the fed started cutting rates in jan 2001. the stock market bottomed in oct 2002.”

      Absolutely … this is one reason the mainstream narrative is so absurd. My post cites the example of 2008, when the Fed started cutting even before the bear market began. Possibly in an example of recency bias – or better yet, bias in favor of anything that supports the bullish narrative – they could look to the infamous 2018 “pivot”. Powell cost himself a load of credibility in that cave and it could easily be making his job harder today.

      But this has little in common with 2018. CPI data were benign then. Both 2000-2002 and 2007-2009 are better analogues. We have a tech bubble bursting now not unlike the dotcom bubble associated with the first bear and a consumer price inflation scare not unlike the second.

      I’d only quibble on speculation that it won’t be economic data that prompt a real change in direction, but financial markets. Say stock market declines (per my last comment). This would finally give the Fed the tightening financial conditions it’s been pursuing, whereupon it can at long last declare mission accomplished.

      But there’s no fine tuning that. The stock market could easily overshoot, and likely continue down even after the Fed begins slashing rates. Then the risk becomes another over-easing cycle that begets another over-tightening cycle, that begets … well, the Fed will have to look deeper at its own irrational dogma (penultimate paragraph) to fix that.