Bear Market Update and New Investor Psychology

by Victor Sperandeo with the Curmudgeon




Curmudgeon Notes:


This is the second of a two-part article examining the Fed’s impact on the markets and Victor’s view that the Fed is responsible for the recent stock market selloff.   Part 1 can be read here.


The opinions expressed herein are those of Victor Sperandeo.  The Curmudgeon remains silent on those points. 


Importantly, Victor and I caution readers NOT to trade stocks considering the huge intra-day volatility and that their competition would be computers who trade with each other. Those high-powered computers are much faster than any human could enter a buy or sell order - long or short.  Stick with whatever investment program you have and don’t think you can make a quick buck either on the long or short side of the market.


Also, we don't recommend any alternative investments which have done incredibly horrible this year.  This can best be seen by examining the dismal total returns of the AQR alternative open end (act 40) mutual funds, which have the largest total assets of any alternative fund company.   That’s incredibly disappointing because I specialized in alternative investments starting in 1984 with managed futures.


Economy vs the Stock Market (Victor with Curmudgeon Notes and data points):


U.S. stock market cheerleaders constantly repeat that "U.S. economic fundamentals are strong” and therefore the stock market should be fine.  Of course, but the economic data are LAGGING INDICATORS, while the stock market is looking six to 12 months out.  


-->Hence, a strong economy that is weakening is no reason to be bullish


NEVER in history have stocks gone up, when the economy has begun to weaken and might be going into a recession in the next year.   


Conversely, the market has declined without the economy going into recession. But that is because the market doesn’t predict “only recessions,” but adjusts to potential problems of all kinds, including war.  Here are a few examples:


1.  In 1962, President John F. Kennedy threatened steel companies because steel prices were increasing. The Dow dropped 26% in 3 months, as this was seen as Socialism at the time. 


2.  In 1966, President Johnson’s inflation created by his "guns and butter" policies [1].  Also, the Fed raised rates and tightened credit [2] from December 1965 to November 1966 and the market (S&P 500) dropped by -12.2% over 12 months, according to Deutsche Bank. The Fed changed its mind and started easing in December 1966 and the stock market rallied.  No recession occurred during that time.



Note 1.  President Lyndon B. Johnson wanted to continue New Deal programs and expand welfare with his own Great Society programs; he was also involved in Cold War arms race and sending troops and material in the Vietnam War. Those wars put strains on the economy and hampered Johnson's Great Society programs.


Note 2.  In the summer of 1966 a policy of monetary restraint led to conditions popularly called the Credit Crunch of 1966. The most publicized features of this period were: 

(1) the development in August of an alleged near liquidity crisis in the bond markets and 

(2) a record decrease in savings inflows into non-bank financial intermediaries and the resulting reduced rate of residential construction.  


The Fed actively used Regulation Q ceiling rates on time deposits as a means to restrict the banks’ ability to extend credit, for the first time in 1966.  Reflecting the heavy demand for credit in the first eight months of that year, market interest rates rose to new peaks for the post World War II period. The weekly average of yields on Aaa-rated corporate bonds rose 64 basis points by the end of August. Yields on long-term Government bonds and state and local securities and yields on short- and intermediate-term securities, also rose markedly over the first eight months of 1966.



3.  In October 1987 (over the October 17-18th weekend), U.S Treasury Secretary James Baker threatened Germany with a dollar devaluation.  According to author Eric Singer, Baker said: "If you don't lower rates, we're going to lower the dollar and you're going to have export problems."


Days later, after the October 19th stock market crash, Baker recanted on this threat and there was no economic recession. 


As noted by the above examples, the U.S. equity markets may decline for many different reasons when perceived or real problems may occur, but they then adjust quickly when the problems are corrected. The economy basically declines because of a decline in earnings coupled WITH a recession (two consecutive quarters of declining GDP). 


One of the greatest Dow Theory proponents -William Peter Hamilton- so accurately stated ..."When coming events cast their shadows before, those shadows fall on the New York Stock Exchange.” 

Now for Fundamentals (Victor with Curmudgeon Notes):

The Fed decided to show its muscle to the world by raising rates, penciling in two rate hikes for 2019 and continuing to reduce its (bloated) balance sheet.  Powell et al. would not be swayed by several WSJ editorials, President Trump’s plea not to raise rates. 


“It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!” Trump wrote last Monday in a Twitter post (i.e. a tweet).                                                                                      

I believe the evidence shows this latest Fed rate increase was done on purely political grounds. 


The Curmudgeon Notes that inflation is moderating as per November's Personal Consumption Expenditure (PCE) price index report, published December 21st by the BEA.  The PCE is the Fed's favorite inflation metric.  It was up 0.06% month-over-month (MoM - from October to November 2018) and is up 1.84% year-over-year (YoY). The latest Core PCE index (less Food and Energy) came in at 0.15% MoM and 1.88% YoY Core PCE are now both below the Fed's 2% target rate.



Victor's conclusion is that the Fed is targeting high GDP growth without inflation accelerating or meeting their 2% target.  Here are a few supporting data points:


·       The 12-month rate of headline inflation that includes energy prices fell to1.8%, the lowest reading since January.

·       Oil is down over 40% from its 10/3/18 high.

·       U.S. dollar index is near a 52-week high and has been rallying since May 2018.

·       All Commodity indexes have made new lows (as stated in yesterday's Curmudgeon post - Superior Long-Term Indicators Say U.S. Stocks are in 2nd Leg of a Bear Market).

·       The 10-year break even inflation rate (CPI) using the 10 year T Note and 10 year Treasury Inflation Protected Security (TIPS) [3.] has been declining steadily since its 10/9/2018 high of 2.17%.  As of December 19th (latest reading available) it is at 1.8%.  Check out the graph of the 10 year break even rate for different time periods at the St. Louis Fed website.


Note 3.  The principal of TIPS is adjusted to reflect the change in the Consumer Price Index (CPI), and the interest payment is then calculated using the adjusted value of the bond. This payment increases with inflation, but it would decrease in the rare case of deflation (i.e. falling prices). The amount of principal an investor receives is their original investment plus any upward adjustment.  In other words, TIPS principal rises with the CPI, while the coupon rate represents the investor’s “real return,” or return above inflation as measured by the CPI.


The inflation premium can be calculated by comparing the difference in yields on a Treasury Note/Bond and a Treasury Inflation-Protected Security (TIPS) of similar maturity. The result indicates the amount of protection investors require, which in turn tells us what inflation expectations may be. The simple equation is:

Treasury Yield - TIPS Yield = Expected Inflation


For example, if the five-year Treasury has a yield of 3 percent and the five-year TIPS has a yield of 1 percent, then inflation expectations for the next five years are roughly 2 percent per year. Similarly, using two- or ten-year issues would tell us the expectation for those periods. This difference is often referred to as the “break even” inflation rate.  



What is the Fed Thinking?  (Victor)


The changes and misses by the FED are due to Keynesian models, as they do not weigh supply side tax cuts or lower regulations in their policy decisions.  IMHO, THEY HAVE BEEN DEAD WRONG.


The Fed's reduced economic growth forecast for 2019 is coupled with the Fed reducing their holdings of U.S. Treasury and mortgage debt by $50 billion a month.  That's ~ $600 billion a year for several years of balance sheet reduction. Add to that the decrease of the monetary base (-11%) this year and only a +4% increase in M2 (from the St Louis Fed tables and charts).


With all of that you have a virtual guaranteed beheading of the economy.


Therefore, the Fed intends to stop the growth in the economy, and thereby derail Trump's 2020 re-election. What Mueller and his 17 Ninjas could not do yet, Powell did last Wednesday!                                                                         


The bear market is here.  With the politics against economic growth, pushed forward by the Fed, one should expect a 2008 like stock market decline followed by a recession. Powell is smiling as he can’t be fired without cause!  


Update - Investor Sentiment Changes to “get me out now, at any price” (Victor with Curmudgeon data points): 

Today (December 24, 2018), many facts about the psychology of the markets tell a tail.  First and foremost was the news that Secretary of the Treasury Steven Mnuchin would host a conference call with the plunge protection team (PPT) which is officially called the Working Group on Financial Markets.  The PPT was created in March 1988 to prevent a severe stock market decline - like the October 19, 1987 crash.  The group met during the 2008 financial crisis

The Curmudgeon and I suspect the PTT intervened by buying stock index futures and/or ETFs on October 3, 2011 and February 11 and 12, 2016 to stop stock market declines that were approaching 20%.  We talked and emailed each other those days.  Despite no economic or financial news or catalysts, there were strong rallies at the end of the day.  For example, on February 11, 2016 the S&P 500 hit a low of 1,810.10 but closed on February 12th at 1,864.78 which was the day’s print high!  The volume on three stock index ETFs (SPY, QQQ, IWM) increased tremendously on those up days.

One would assume the “investors” would wait for a rally (caused by PPT intervention or a counter trend bounce) to sell stocks.  But instead we’ve had a literal crescendo of selling.   There have been no rallies from the 2nd trading day of December till the close of 12l24/18.

Apparently, the mental state of those holding stocks is “get me out now.”  Look at the daily charts and you will see non-stop selling as there haven’t been any rallies. The pressure to sell is constant.

Is the Fed too tight? Powell does not say or seem to care.  Evidently, the market believes the fed won’t let sell is the word.

Worse and critical is even if the PPT buys and creates a strong rally for a day or two, it will likely be sold unless the Fed fundamentally changes their tune, i.e. cancel the two rate increases planned for 2019, and pause QT (don’t reduce the Fed balance sheet).

End Quote:

These words from William Peter Hamilton say it best:                                                                                                               

“In the mind of the demagogue, Wall Street (AKA Donald Trump in this case) can never be forgiven for being right when he (e.g. Powell) is wrong.”

Good luck and till next time…

The Curmudgeon

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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