In following the markets, it is important to monitor the overall economic backdrop, the direction of interest rates, and the US Dollar. We can then focus on the industries and the leading companies within these industries to determine where best to invest.
At present, it isn't entirely clear whether we are, or are not, in a recession. The first two quarters of this year had negative GDP growth, which usually marks a recession. Now we have politicians debating the very definition of "recession." Whether we are in one or not, the Fed has been very verbal about its desire to tone down the growth of the economy without bringing it to a screeching halt.
It seems the Fed believes that inflation is caused by a difference between supply and demand. If this were the case, there would be two possible approaches: try to increase supply, or try to decrease demand. To increase supply, we would need productive investment. This would add to wealth and improve living standards. To decrease demand, we would reduce income and wealth, thereby lowering living standards.
Our policymakers have chosen/are choosing the latter and have delegated inflation fighting to the Fed. There is no discussion about how to increase supply. Higher interest rates reduce investment, and therefore, supply. The most glaring area might be in housing, where higher rates lead to reduced supply despite the widespread shortage. All told, this policy might make inflation worse rather than better.
These are the typical measures of inflation, yet it is beginning to appear that there is more fear about the economic slowdown than the fear of increased runaway inflation. The market at present seems to be measuring how interest rates will be handled by three major points:
- Short-term rates will continue to be raised by the Fed to continue to bleed off the excess cash sloshing around in the economy. This could continue beyond the economic slowdown that is sure to happen- maybe not recession across the board in all industries, but at least a slowdown.
- Longer-term interest rates appear close to topping out. This is the measure of economic prosperity, not a tool that can be affected by the Fed. This is what I am looking at to tell us when the money believes that rates have gone high enough and are prepared to top out. The US Dollar should confirm this as well.
- The election results on November 8th could give the markets some consistency. If there is a Republican takeover, it could be assumed that Biden and his constituency will not be able to continue their social programs to subsidize their voting constituency. As seen below, the voting expectations are starting to show a fairly large number of Republican changeovers in both the House and Senate.
The three points mentioned above are all sort of working in concert even though they may seem separate. This is very difficult for many to understand given the news flow, the political friction, and the international conflicts. If one can just remember that the short-term interest rates are the tool of the Fed to adjust the cost of money to businesses. If short rates go up then it costs more to do business, so business slows. Longer rates are a reflection of what investors feel is going on in the overall economy. If longer rates top out here and begin to turn back down, then it would imply that the action of the Fed is taking hold and doing what they are trying to do- slow down the economy and inflation.
The retail investor is feeling all of this and as a result, has run for the bomb shelter. Below is a clear picture of this:
On top of what the retail investor is thinking and doing, the large fund managers are also at an extreme. According to the Bank America Global Fund Manager Survey, they are currently not only below the allocation that they had in stocks at the COVID bottom, but they are also even below where they were in the Great Financial Crisis. This tends to be a situation where too many are on one side of the boat, and it could be time for the momentum to shift.
Given how extreme all markets are at present on the oversold side of the ledger, it would not be a surprise to see some level of movement back to a more balanced or moderate situation.
My third point above could be the catalyst to make this happen. I’m not making a political comment or judgment, but rather a statement of what the markets think about a political “stalemate.” This is a situation where there is not a lot that can be accomplished within the government if the executive branch cannot get anything passed by Congress and Senate due to party divides. This, strangely enough, is what the market loves. If nothing changes then the markets don’t have more unknowns to adapt to.
In closing, I’m going to attach once again the S&P 500 forward return table once price levels have reached the extremes they have. If this holds once again, it could be a nice Christmas on Wall Street.
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