Last Week’s 10% Drop Was a Preview
After rumors that the stock market would rally as much as 50% this year by a “blow-off top,” last week the stock market suddenly reversed course and dropped 10%. In the past, the Federal Reserve would have injected liquidity into the banking system to minimize the downturn, but this time the Fed didn’t respond. After nearly nine years of Fed intervention in the stock market, investors are starting to see that perhaps the “central bank put” or belief that the Fed will prevent any major stock market drawdowns, is potentially gone. What is really going on is a battle between the “smart money,” or hedge funds, and the new Federal Reserve Chairman Jerome Powell.
Contrary to popular belief that stock prices rise based on earnings and profits, stock prices rise mostly due to liquidity. Liquidity is money, and the more money sloshing around the financial system, the higher stock prices will go – even when there is bad news. The largest form of liquidity comes from the Federal Reserve, by lowering the Federal Funds rate, and from direct liquidity injections such as Quantitative Easing. These easy money policies make Wall Street very happy because Wall Street investors make the most money during rising equity markets. These easy money policies don’t last indefinitely, and when the Fed starts to take the punch bowl away, Wall Street fights back.
Since Alan Greenspan was the Fed Chairman, the Fed has backed down every time Wall Street pushes back. The Fed has come to fear a falling stock market, as Federal tax receipts are closely linked to the stock market, and because the Fed believes that a falling stock market will trigger a recession. Over the past eighteen years Wall Street has figured out exactly what it will take to get the Fed to back down, but with Janet Yellen’s departure, the game has potentially changed.
With every incoming Fed Chairman, Wall Street attempts to manipulate them to find out just how far the new Chairman can be pushed before backing off their plans to tighten the money supply. It should come as no surprise that on Jerome Powell’s first day as the new Fed Chairman the stock market began to correct. Wall Street wanted to find out how quickly Powell would respond, but much to Wall Street’s surprise, he didn’t flinch.
Wall Street is a master at this game and they know the Fed’s pressure points. Under the guise of rampant inflation, Wall Street has been shorting the bond market to drive interest rates higher. At the same time, they’ve been telling the public that inflation is coming, and the public has responded by selling their bonds to buy more stocks. As the public sells their bonds, interest rates rise. It’s a circular loop—the public is causing inflation by selling their bonds!
Yet we are supposed to believe that tax cuts will lead to high inflation when there is little evidence to support that theory. Experts believe that the tax cuts will add $10-15 billion per month to the money supply. The Fed is selling $30 billion per month of bonds from their $4 trillion balance sheet, which is removing $30 billion per month from the month supply. The net result is that the money supply should continue to fall. Unless demand picks up, a falling money supply is deflationary. Meaning this push to drive interest rates up has little to do with inflation, but more to do with finding out if Powell will break and to encourage the public to buy more stocks.
We learned that a 10% drop in stock prices isn’t enough to garner the attention of Powell nor was it enough to get the public back buying stocks. Both are a huge problem for Wall Street who is desperate to get more money into stocks, so they can get out. I recently read that half of all American’s don’t own one share of stock, and as I have previously mentioned, 90% of the stock market is owned by 10% of our population. Meaning that if the money supply continues to contract it will cause asset prices, including stocks, to fall, which would quickly decrease the net worth of the top 10%. I can assure you, the top 10% aren’t interested in losing money.
This recent rout in bonds is a sign that the end of this stock market rally is much closer to the end than most people want to believe. Stock prices are first fueled by the Fed’s easy money policies that are implemented during recessions. As the Fed backs off their easy money policies, Wall Street needs to find a new source of fuel – the public. It’s at this point Wall Street’s propaganda machine moves into overdrive to entice the public to buy stocks. Once that source is tapped out, Wall Street goes after the bond market by trying to convince bond owners to sell to buy stocks. Once the bond market is tapped out, the public is tapped out and the Fed is tightening, then there’s nothing left to fuel the market. Eventually, gravity takes over and the stock market falls.
The stock market is like a rocket. Imagine a rocket sitting on the launch pad at Cape Canaveral ready to go. This is the stock market at the bottom of a recession. The Fed pumps money into the economy which is like rocket fuel. The Fed has to pump a large amount of money into the economy, just like the rocket needs an immense amount of thrust to lift off the ground. As the rocket moves off the launch pad and rises into the atmosphere, it doesn’t need quite as much thrust, but it still needs fuel. The economy is the same – the Fed continues to ease in order to drive the economy higher.
As the rocket flies higher it continues to need fuel to break out of the atmosphere, but should it run out of fuel or not have enough fuel, it will fail to break out of the atmosphere and plummet to the ground. That is exactly what happens to stock prices when liquidity leaves the market. The stock market will attempt to get liquidity from wherever it can, but once liquidity is gone, the markets begin to plummet as investors rush to cash out.
One of the last places Wall Street gets liquidity from is the bond market. American’s fear inflation and the mere mention of it will cause investors to dump their bonds to buy stocks. I find this odd because while stocks can be an inflation hedge, commodities are much better. As interest rates rise to offset inflation fears, rates reach a point where they won’t go any higher. It’s at these points where stocks tend to sell off, as we saw last week. Many believe this is the point where yields are high enough that risk investors are willing to buy bonds. That’s not quite it.
The reason interest rates stop rising in each cycle is because they reach a point where bondholders are unwilling to sell. Hedge funds, traders, and the retail public are all willing sellers. Pension funds, institutional money managers, central banks and sovereign wealth funds generally hold their bonds until maturity – they aren’t sellers. When interest rates have risen enough to flush out all of the willing sellers, then interest rates stop rising. It’s at that point where Wall Street realizes they aren’t going to get much more liquidity out of the bond market. That’s where we are today.
The Fed does have plans to normalize interest rates; specifically, the Federal Funds rate which dictates short-term interest rates. Long-term interest rates are set by the economy and not the Fed, contrary to popular belief. Prior to the early 1980’s, when the Fed raised the Federal Funds rate, long-term interest rates rose but starting in the mid-1980’s that correlation ended. Yet people believe that rising government deficits and debts are going to lead to higher interest rates. Over the past 35 years, interest rates have fallen despite rising government debts, which is evidence that higher debt levels are deflationary for the economy.
The reason Wall Street is pushing back on the Fed is because Wall Street has been borrowing and leveraging themselves to buy stocks during the past eight years. They have borrowed so much money that the amount of leverage underneath the stock market is twice what it was during the dot-com bubble (which was the largest stock bubble in history). Wall Street’s problem is they need more suckers to buy in at the peak so they can get out. Last week experts suggested that if money doesn’t start flowing back into stocks that Wall Street is going to have to start exiting their positions, which will get ugly quickly. Wall Street helped design many of these risk-parity or volatility-controlled products that have created a one-way street for investors.
These volatility-controlled products where designed specifically to drive investment dollars into equities, which is exactly what Wall Street wants. If that sounds remotely familiar, it’s because every major investment firm is investing in a similar fashion. There are trillions of dollars invested in these types of strategies, and as volatility rises they will be forced to sell stocks to buy bonds. Without the backing of the Fed to keep volatility low, Wall Street faces a nightmare scenario of having to get their money out without crashing the most over-leveraged stock market in the process. So, the next time you hear the financial media singing songs of a “blow-off top” or “buy the dip,” remember that it’s because they want you to buy so they can sell. Now you know why last week was a preview of what’s to come.
Q&A with Steve – Your Questions Answered
- Was the 10% correction just a pause in the market rally?
No – As I suggested a couple weeks back, the $20.2 billion of bonds that Janet Yellen unwound from the Fed’s balance sheet caused stocks to drop 10%. Many saw this as an opportunity to buy stocks because they believe the Bull market rally is going to continue.
As it turns out, the Fed bought $14 billion in bonds last week. The Fed bought back 68% of the bonds that Yellen sold off. The stock market rallied back 65% off its recent low. The two are highly correlated.
- Was this move a bailout by the new Fed Chairman Powell?
As my grandfather used to say, that is the $64,000 question. Based on what we know so far, Powell has not indicated he will support the stock market. Clearly, the actions by the Fed last week suggest that may not be the case.
Powell isn’t scheduled to speak until his first official meeting late next month. So far, nobody from the Fed has said a word about why their balance sheet increased last week.
What I do know is the Fed prefers to sell their balance sheet in the early or late part of the month. It is entirely possible that they bought the bonds they did as part of the regular management of their balance sheet – we just don’t know.
What we do know is that if the Powell-led Fed is going to continue what the Yellen-led Fed started, that the $14 billion of bonds they just bought will need to be sold in addition to another $20 billion of bonds by the end of the month.
If the stock market fell 10% from the unwinding of $20 billion in bonds, that tells us that selling off $34 billion of bonds will have a much bigger effect on stock prices.
- Were all asset classes affected by the drop in the Fed’s balance sheet?
Most asset classes fell along with stocks, so it’s too early to say where the safe havens are. Part of the problem is that investor sentiment towards stocks is practically euphoric, so until their spirit has been broken a bit, we won’t know when the safe haven assets will start to rally.
If there is another 10%+ correction in the weeks that come, I suspect we’ll have the answer to that question and potentially adjust our positioning.
It’s important to understand that the correlation between the stock market and the Fed’s balance sheet is very tight. Unfortunately, there’s no way to know what the Fed is or isn’t doing until a week after when the official data is reported.
- There will be a flight to safety?
Once investors know how the Powell-led Fed is going to respond to stock market volatility, then we will know how investors are likely to respond. If Powell lets the market slide, investors will flee to safety, which will just accelerate any moves down in the market.
- Are there any other takeaways we can learn from this?
Yes – The liquidity drain that I’ve been talking about is very real. The stock market didn’t retrace the entire move up in the Fed’s balance sheet. In the past, it would retrace it and rally from there. Friday’s price action suggests that higher interest rates are influencing the money supply, which affects asset prices.
- How do you trade this?
You almost don’t until you know how the Fed is or isn’t going to respond. I will be very interested to see the Fed’s balance sheet data over the next couple weeks and if any of the members of the Fed comment about the increase in their balance sheet.
- I saw that the retail sales data fell but the stock market rallied.
It is highly unusual that stocks rally on falling retail sales data. Liquidity drives markets and when there’s enough liquidity, markets can rally on bad news.
- Will rising consumer prices lead to stagflation?
Hard to say for sure, but we are seeing the early signs of prices rising faster than wages, which is stagflation. To put this in perspective, inflation is running at 2.9% annualized while retail sales have slid to a 2.2% annualized rate. Due to inflation, real average weekly earnings (weekly earnings less inflation) are at -0.3%. That’s what stagflation looks like.
- Won’t stagflation lead to higher long-term interest rates?
It can, but long-term interest rates are a function of demand. Less money in the system and less demand for goods leads to falling bond yields. We’re just not seeing it yet due to the euphoria surrounding the stock market.
- But consumers are doing well?
The data doesn’t confirm that. Personal loan delinquency rates just hit a four-year high. Auto loan delinquencies (90 days late) just broke over 4%. Credit card delinquencies are also over 4%. Last, student loan delinquencies are at 11%. If the economy was strong, we shouldn’t see rising delinquency rates.
- Won’t the tax cuts fix that?
The average worker is expected to see a monthly increase in their take-home pay by $131. I don’t see how that is going to fix the delinquency problem.
- What’s the word on the gold and silver miners?
As you may be aware, last week the mining stock fell below their key support level. They rebounded and then jumped on the injection of liquidity by the Fed and are sliding back down.
The plan remains to take baby steps in until the support levels have been confirmed, although I am very concerned about the Fed dropping $24 billion of bonds into the market. The miners fell right along with stocks and I’m not interested in riding through a double digit one-week loss.
In the next few days we’ll see if the market holds these levels or falls due to lack of liquidity.
Video Topic of the Week – Stagflation, the Fed, and Euphoria
Are we at the euphoria stage of the stock market? Signs suggest yes!
Chart of the Week – The Federal Reserve Balance Sheet
If you want to know why the market rallied this week, be sure to check out the chart pack this week!
Portfolio Shield™ Update
I’ve had a couple questions about this mysterious algorithm. It’s nothing too fancy, but it will be special if I can successfully adapt it to a wide range of securities. What it looks like is a trailing stop order.
A trailing stop can be added to new or existing trades that will sell a security if it drops a specified percentage off its high. If I place a trade for a security at $8 per share with a 5% trailing stop, as the price of the security rises, the trailing stop rises with it. Let’s say the security peaks at $10 and begins to fall. If it falls 25 cents, it won’t sell. But if it falls 50 cents to $9.50, then it will become a market order and sell the security.