The Waiting Game

The Waiting Game

October 05, 2021

Investors have become preoccupied with Federal Reserve monetary policy with regard to the anticipated tapering of the Quantitative Easing bond-buying program, along with continuing concerns about the virus and the variant. With the emergence of vaccines, boosters, and now the new Molnupiravir pill, there is continued hope that the pandemic can be brought under control if a high percentage of the population becomes virus resistant. Currently, vaccination rates remain under 20%, yet the incidence of new cases and deaths seem to be declining. Stock market history clearly shows that the primary bear market risk faced by investors is a recession. This is due to the fact that an economic contraction results in declining earnings, lower dividend growth, and an increase in bankruptcies. I take a watchful stance on these points and make a weekly attempt to point out to readers what is going on in the media and the mouths of the public, yet at the same time go over interest rates/bonds, the general stock market, currencies, and places considered flights to safety — namely precious metals and alt-currencies. My discipline and analysis of the key factors that provide the basis for economic expansion are then monitored to see if there is really anything sinister going on under the hood of the markets and the economy. 

Bob Brinker, the author of the monthly newsletter, The Marketimer, does a masterful job of analyzing what he feels are the five central components to the measurement of the economy. Namely, monetary policy, interest rates, inflation, the rate of growth, and valuation. He believes that if these begin to show negative trends, a bear market could be on the way. I will go into detail on these later, but at present, the economy seems to be continuing in a positive direction. At the same time, in the short run, there can be things out of the blue that could be construed as "mini" black swans and as such could add to the short-term weakness and volatilities that are being experienced. I see these as the following:

  • With the emergence of the Evergrande "cockroach," could China be the source of the next crisis? As Xi Jinping views capitalism as a threat to his power, there has been a strange and somewhat consistent number of missing billionaires and a strange number of limits put on China's growing internet companies. It is clear that Xi wants a closed society, much like the 1960's Soviet Union. It wouldn't be surprising if China simply didn't have tradable financial markets in ten years. 
  • The bond market was telegraphing higher rates and possibly higher inflation last week. Friday and this Monday this was tamed to some extent, but if measures of inflation continue — no matter how transitory it may be — this could prove difficult for the markets to digest, given rates have been so low for so long. 
  • The most recent one that is really becoming quite surprising to me (as it is a very negative comment on the internal structure of our high-level Federal Reserve members) is the unethical trading histories of our Fed Governors. Last weekend it was reported that Vice Chair Clarida traded millions of dollars of positions in securities on February 27, 2020, one day before Chairman Powell made his emergency statement on the effects of COVID and the possibilities of policy changes in a worsening pandemic. The day before? Come now ladies and gentlemen, this is just too much of a coincidence. Kaplan is leaving early for his trades and Rosengren decided he would rather have a kidney transplant than face the scrutiny of his trades. Perhaps Clarida will find some organ he needs transplanted — maybe a new conscience? 
  • The Forbes article on the possibility of the Chinese taking over the crippled semiconductor industry in Taiwan, which is responsible for 92% of the world's capacity of manufacturing sub-10 nanometer chips. This appears quite impossible to me given that chip design. 50% of the chip process is owned by US-based companies, the fabs (which are in Taiwan) are only 24% of the value, and the equipment used for the fabrication is dominated by the US. The reason why this is such an issue is that chips are used in almost everything 
  • Per Freightos, the average container cost from China to West Coast is up 393% year over year, while days to deliver climbed 83% to 73 days. Somebody has got to eat this increase!

Since the end of August, I have been writing about the negatives affecting the markets. It has appeared that they are possibly getting close to running their course and we are getting close to a point where a resumption of the advance could be in front of us. So, what am I seeing that is telling me that we could be getting close?

  • Amazing news from a large US Pharmaceutical company that it has developed an antiviral pill cutting the risk of hospitalization, or death, by nearly 50%. Isn't science amazing?!
  • In an interview last Thursday, Cathie Wood, of ARK Investment Management, said she believes that "inflation will not only subside in the coming months, but that deflation should be more of a worry." She pointed to recent earnings reports from some larger retailers and speculated that the consumer would pull back before "continuing to pay more and more for everything." And if this occurs, interest rates might decline, and growth reasserts itself. This was my point in last week's missive about the lack of inventory due to the 73 freighters off the coast of San Pedro and Long Beach. This has caused a lack of inventory and as a result the ability of retailers to raise prices due to a lack of inventories. 
  • In July indicators were peaking in breadth readings of the markets. These now appear to be resetting to attractive levels. So much so that Ari Wald, Oppenheimer Technical Analyst, actually raised his 6-month target for the S&P 500 (the end of the first quarter of 2022) to 4,800. Based on the 4,300 close on October 4th, that is an almost 12% increase. 
  • Even though the decline in the Nasdaq 100 was a lower low this week, the VIX (volatility index) readings are a higher low, this tends to signal decreased acceleration to the downside. 
  • The percentage of NYSE companies above their 200-day moving average peaked in December of last year at 89% and has been on a steady decline. It is now back down to 50%, its lowest reading since November of last year, just prior to the 2020-year-end rally. 

I wanted to end with Bob Brinker's five central components of the economy:

  • Tight Money: FOMC held its September meeting on the 21st and 22nd of September and held its Fed Funds rate at its historically low range of 0% - .25%. This, along with continued bond-buying, shows no intention of rate increases and tight money. 
  • Rising Rates: Powell made it clear that tapering the bond purchasing was very different from raising rates. It doesn't appear that this is even a consideration until late summer or autumn of 2022. 
  • High Inflation: This I find to be the most important. Inflation appears to be in the form of three different scenarios. (1) transitory, (2) transitory, but stubborn, (3) entrenched. The current transitory inflation appears to be ready to run its course, but the gridlock due to supply-chain dislocations is causing inflation to stick around longer than would normally be the case. When this gets solved, rates should drop back to around the 2% level. 
  • Rapid Growth: This is primarily measured by labor growth and productivity growth. Nothing has changed materially here. Our US birth rates remain at historically low levels, and the labor force is only growing at 0.2% annually. The pandemic has created an increase in productivity as companies have been forced to invest in labor-saving technology as a result of dealing with a lack of qualified workers. If these two persist, GDP growth remains in check, prices stabilize, and slow and consistent growth should continue. 
  • Overvaluation: If earnings continue to rise and the PE ratio of the S&P 500 remains in the area of 21-22 while rates stay low, the markets are not in an overvalued state. We should be able to get a better idea of how earnings are going to end the year when we begin getting earnings reports on October 13th. If they telegraph rising earnings being able to continue, rising earnings should pull up prices. If the catalyst of a decrease in the virus is thrown on top of this, consumption, manufacturing, and distribution could increase, and prices would have the opportunity to rise.

I know I went into the various reasons why the markets might take a breather the last few weeks, but still, it is not fun. I don't like to weather declines, but I am OK with structural consistency. Where we go from here is really anybody's guess, but hopefully we are at the tail end of a market digestion, and we can get prepared for a much-wanted year-end rally. As it appears, aside from the US equity markets, there doesn't seem to be a lot of places where upside can be expected. If the stars align and the dam doesn't break, hopefully we can look forward to higher prices in the next few months.






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