Crunch Time for The Markets

In the 94-year history of the S&P 500, there have been 99 corrections (not including this current episode) of 10% or more. So, usually about once a year, allocators must decide – buy the equity correction or take shelter from the coming storm. Historically, about half the time it gets worse and half the time you should have bought. In my early January column (A Return To Regular Order? (forbes.com)), I referred to 2022 as extremely tough for equities and that we were reducing exposure. So far, that’s been correct. Now, hold ‘em or fold ‘em?

For the particulars, we need to examine the Fed, the economic cycle, market valuation, and sentiment. Let’s go.

I seem to focus on the Fed in every decision. It’s because post the Great Financial Crisis (2008), through their zero-interest rates policies and overt money printing, they have come to dominate financial markets as they had never before done in their 100 prior years (ex-WW2, maybe). The venerable macro economist Stephany Pomboy (MacroMavens) has shown that the entire COVID economic recovery was nothing more than absurd levels of Federal spending monetized by Weimarian-Fed money printing. Now, both of those props are about to go in reverse. In fact, as of today, the rates market is expecting nearly 9 interest rate hikes by the Fed in 2022 and “Build Back Better” federal stimulus has joined the junk heap of slogans with” Transitory Inflation”.

But something else is changing as well. Many in the money management business, perhaps all who started their careers post 2008, believe there is an implicit “Fed put” to save the equity market. Maybe they think it is at 20% because of 2011 and 2019. But listen closely to the exchange between Senator Shelby (R, Alabama) and Fed Chair Powell at the latter’s recent Senate testimony. Shelby to Powell: “ So, you are prepared to do what it takes, without any reservation, to protect prices?”. Powell: “Yes”. With the Fed now predicting March inflation (reported mid-April) to be above February’s 7.9%, does that sound like there is a Fed equity put in play currently? The adage “Don’t Fight the Fed” is very much in force here.

One other thought for those sleeping soundly because of the Fed put. The Goldman Sachs Financial Conditions Index measures stress in the markets by examining short-term bond yields, long-term corporate yields, exchange rates, and the stock market. They have calculated it since 1981. Taking out 2021, we are currently at levels of the least financial stress ever. Here is another way to place this historically. Today’s financial conditions are easier than at the PEAK of the dot-com bubble. So, ask yourself, where is that Fed put if they observe no financial stress currently?

It’s not just the Fed, of course. Others say follow the economic cycle because “profits are the mother’s milk of stocks” (Larry Kudlow). If true, then I say find a safe place. Below is a list of malign cyclical weather patterns all hitting at once:

– Every time we have had a rise in oil prices this significant (since the 1960s), we have had a major economic slow down

– The US dollar strengthened by geo-political worries is bad for corporate profits

– The University of Michigan survey of consumers shows incredible pessimism at levels only seen post the collapse of Lehman in 2008 and during the odd-even gas shortage of ’79-80. Why so bad? Likely because disposable personal income on a REAL basis is the lowest ever at nearly -4% (yr/yr). And now, interest rates are rising quickly. These are not recipes for robust consumer spending.

– Wholesale inventories at up 19% yr/yr is the highest increase in 40 years: Message to factories- slow down production!

– Summing it up, the incredible MacroQuants at HedgeEye say we may be entering one of the most pronounced real GDP slowdowns ever. Don’t expect much earnings growth on a real basis in that environment.

Onto valuation which I have always said is a terrible timing tool but comes in handy as a depth finder in market declines. Why? Because once growth and momentum buyers vanish during a decline, the next group to buy are value investors and they look closely at – wait for it – valuation! Kudos to super-quant Darius Dale at 42 Macro for thinking about valuation on a REAL basis. Going back all the way to 1960, he takes the earning yield of the sS&P500 (inverse of P/E) and adjusts for inflation. Bulls cover your eyes. It’s the worst (most expensive) ever and portends a big potential drawdown.

If you’ve read this far then thank you. And many may say, yes, I’ve heard many of these things, but everyone tells me they are bearish. It’s all discounted they say. The best longer-term sentiment gauge we use is the Fed Flow of Funds data reported quarterly since 1945. Basically, it shows where the country is factually positioned among asset classes. Currently, that would be a maximum historical allocation to equities. People may express concern about equities, but they have never owned more equities as a percent of their portfolio than now. Moreover, on a shorter-term basis, somebody is still aggressively buying equity ETFs and equity mutual funds. At a bottom, they will likely be selling aggressively and repositioning away from equities. That’s what makes the well-worn path to a bottom.

So, I am not a fan of buying this equity correction; instead, I’m advocating minimum equity. That minimum level is age and risk dependent, but you should think about getting to it soon. Of course, there is a short-term upside if somehow Putin admits a mistake, exits Ukraine, and we all forget and forgive the already long list of atrocities. That still would not really change the Fed, the cycle, valuation and may make sentiment worse. I am fading all peace talk for now. Is there no place then to make money? I’m officially teasing another upcoming article on my oft-stated favorite asset – gold. Practically at an all-time high, I think there might be a lot more to go.