Over the past couple of weeks, I’ve gotten calls from people who seemed surprised my prediction for a rapid stock market decline has come true. Understanding our complex monetary system leads to one conclusion – our monetary system was designed to periodically fail. While my research doesn’t say when the system will reach its next failure point, it does indicate what will happen when our monetary system reaches its limits for its current business cycle. I don’t believe the recent drop in stock prices is over, but I do believe it could set up a short-term, low-risk opportunity to buy in.
The recent descent in stock prices follows on the heels of the tax cuts, whose monetary benefits are quickly fading from our economy. Stock prices rose following the Great Financial Crisis due to the monetary magic of three successive rounds of Quantitative Easing and, as the Fed unwinds their monetary magic, stock prices are finally starting to succumb to the lack of monetary support.
The Fed pumped the monetary base, or the total amount of currency in circulation plus the total amount of currency in bank reserves, through its Quantitative Easing programs. Asset prices, such as stocks and real estate, are highly sensitive to changes in the monetary base. When the monetary base rises, asset prices rise, and when the monetary base falls, so do asset prices.
When charting the monetary base against any one of the major stock indices, it is clear the two have a close relationship. Until the beginning of Quantitative Easing 3, the first two rounds flowed into the real economy as Federal tax receipts rose, in addition to asset prices which proves the newly printed currency did reach the average consumer. Quantitative Easing 3 flowed mostly into the hands of the wealthiest Americans, who used the currency to buy stocks.
When an investor purchases an investment, they need to know who they might sell it to in the future. Much to the surprise of the wealthiest, who initially planned to dump their stocks to the unsuspecting retail public, the Tax Cuts and Jobs Act of 2017 passed. Shortly after the tax bill became law, corporations began aggressively buying their own stock back. This new buyer of stocks, who is price insensitive, created a gateway for the wealthiest shareholders to dump their shares while the retail public continued to buy.
With fiscal and monetary stimuli being rapidly withdrawn from the financial system, asset prices have started falling. Based on a chart of the monetary base versus the S&P 500, the fair value of the S&P 500 is 1,800 or -25% from where it closed just before Christmas. The same chart with the Dow Jones Industrial Average shows its fair value at 16,500 or about -25% from where it closed just before Christmas.
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The relationship between stock prices and the monetary base is the big risk for equity prices. As long as the Fed is either raising the Federal Funds rate or unwinding their balance sheet, the monetary base will continue to fall. After the Fed’s December meeting, Chairman Powell said the balance sheet unwind is on autopilot, meaning the Fed doesn’t have any plans to stop or reduce the $50 billion per month of currency they are currently destroying.
The Smart Money, or investors with deep pockets and access to the most information possible, have been dumping stocks for more than a year. The Smart Money flow index discounts price moves in early trading and places most of its emphasis on the last 30 minutes of trading when the Smart Money tends to do the bulk of their buying or selling. Based on this index, the Smart Money has sold more stock in the past year than they did during the past two recessions.
Understanding how the Smart Money is positioned and what the Federal Reserve is doing helps identify where there may be opportunities in the future. The first issue to establish is whether the stock market is in a correction phase or truly entering a Bear market. Both decline in the first three months, which is then historically followed by a three-month rally. After the three-month rally is over, if stocks resume their decline, then we are in a Bear market.
It is also possible the stimulus from the tax cuts have already covered up the first leg down, as foreign stocks peaked back in February. Using history as a guide, the three-month decline started in early October, so any opportunity shouldn’t arrive until late January or early February 2019.
With economic growth tied to the performance of the stock market, it is possible the economy could enter a recession early next year. Should the economy enter a recession next year, then the safest move is to avoid equities and look for opportunities in other sectors as they become available. The best performing sectors during recessions are U.S. Treasury bonds, agricultural commodities, and physical metals.
A bottom in the stock market, even if in the short-term, will be determined by the Smart Money. Should the Smart Money return to buying stocks, then stock prices can bottom, as bottoms tend to form when retail investors run for the exit. In past Bear markets, retail investors waited until they were down 40% or more before selling. I don’t think retail investors will wait that long to sell this time around. Retail investors will probably sell somewhere close to where they last bought.
Most retail investors bought after the Presidential election when the S&P 500 was at 2,100. As the S&P 500 falls towards this level, or below, I expect retail investors will rush to sell. For the Smart Money to buy, they need to know whom will buy from them later. Without someone to dump their shares to, the Smart Money could choose to idly sit back and let stock prices fall.
Even though stock prices have fallen, retail investors remain very bullish about stock prices rising in the future. It is possible the Smart Money could create a strong rally, which would cause retail investors to come back into the market after it has risen again. Corporations have pledged to continue buying their stock back next year, but at a much smaller amount than this year.
In addition, institutional money managers and hedge-fund managers might also be enticed to buy stocks, as both have underperformed this past year, and may be willing to chase a rally. Last, but not least, are the computer models, which are moving into a short position. It wouldn’t take a big rally to trigger the computer models to start buying again.
Traders and speculators have been pointing out this past weekend that the stock market is “oversold” and is due for a huge relief rally. Oversold conditions occur when there has been more selling than buying, which suggests stock prices may have fallen below fair value in the short-term. While there are mathematical formulas to determine when a market is oversold, it is more of an emotional view.
With margin debt, or money borrowed to buy stocks, at the highest level in history by threefold, investors are desperate for stock prices to quickly rebound by any means possible. When investors borrow to buy stocks and prices start falling, selling into a falling market can lead to large losses. To avoid selling, investors will hedge their margined positions by shorting their leveraged positions. When the short positions are later removed, prices can quickly rise from an oversold condition.
When the stock market was rising after the Presidential election, and was in an overbought condition for months in a row, nobody showed any concern. Most investors don’t understand the monetary system or how the monetary base effects asset prices. Even if the stock market is oversold, it doesn’t mean stocks will rally. The last two recessions began with stocks prices rolling over from their peaks into an oversold condition.
Another issue causing stock prices to fall is liquidity, or the amount of money sloshing around in the financial conditions. Liquidity is currently at its lowest level in history, although data only goes back to about 2007. Liquidity is created by easy financial conditions, borrowing to buy stocks and rising stock prices. The opposite occurs when the financial conditions tighten, when margin debts are repaid and when stock prices fall, such as right now. During periods of low or no liquidity, stock prices fall until buyers are found.
Another metric I’m watching for as an entry point is volatility. Volatility has been rising as the Fed has been unwinding their balance sheet, but when volatility spikes, it tends to fall rather quickly. A spike in volatility that is contained, could further validate a short-term move back into equities. At the moment volatility hasn’t risen high enough to signal a short-term bottom, but it could in the weeks to come.
It is also possible global political leaders will back down from their differences for a while to create some positive news for stocks. A Bear market rally shouldn’t be discounted at this point but it shouldn’t be expected either. Until Smart Money starts buying again, stock prices are likely to continue falling.
This is the one organization who has the power to ignite a bullish sentiment – the Federal Reserve. The next Federal Open Market Committee (FOMC) meeting is in January. Historically the Fed doesn’t hold a press conference at their January meetings but staring in 2019, the Fed is going to hold a press conference after every meeting. While the Fed would not raise rates a month after raising rates, the Fed could use this press conference to calm investors by changing their forward guidance to a more dovish tone.
The Fed prefers to announce rate hikes at their March, June, September or December meetings, so the January meeting isn’t on the table unless the economic data indicates an overheating economy. The economic data won’t, since the recent forty-percent drop in oil prices since October will ease inflationary concerns. All Chair Powell has to say is the Fed is unlikely to hike in March if the data doesn’t warrant an increase and investors will breathe a sigh of relief.
It also won’t hurt if trade tensions ease, and combined with a dovish Fed, Wall Street will likely turn bullish. With the Bulls running back into the market, stocks will likely rally. It could also cause agricultural commodities and physical metals to shine, as the US dollar is likely to weaken. But what really has my attention at the moment for a short-term play are the oil and gas producers.
West Texas Intermediate (WTI) oil prices has dropped forty-percent since October and with it, the oil producer’s stocks have fallen over forty-percent from their October highs. What caught my attention is not the rapid drop in price or the global oversupply of oil, it’s the price level at which the oil producers Exchange Traded Fund (ETF) is trading. Over the past twenty years, this ETF has had two major bottoms—a few dollars below its current price. With oil sentiment at very low levels, investors are looking to exit this sector at a time when this sector could lead the next Bear market rally.
When looking for low-risk entry points, a twenty-year low is a good place to start. With any investment, an investor should have an idea of who they will eventually sell to before investing. Most investors will be led to believe this downturn in stock prices is due to the trade war with China and not due to the Federal Reserve tightening-monetary policy. It won’t take much for institutional money managers, hedge-fund managers, and the retail public to jump back on the oil bandwagon with renewed prospects of global growth and inflation.
Another aspect that makes me think there will be a Bear market rally is the financial media. After pumping the virtue of stocks for the past two years, the financial media has suddenly become bearish. The financial media has always been a tool of the Smart Money to get investors to do the opposite of what the Smart Money wants to do. When the Smart Money wants to buy, they convince everyone else to sell and vice versa. After convincing everyone to go “all in” on stocks, the financial media is changing their tune.
The key will be to buy in ahead of the computer models and retail investors, to create an exit buffer for when stocks eventually enter a Bear market. While there isn’t much information circulating on a daily basis about how these various computer models are positioned, on any given week someone will leak a bit of information out. Currently, many of the computer models are selling or short the market, which could make an entry point attractive, should there be an interim bottom.
Keep in mind the stock market is entering a Bear market cycle and while there is often a three-month rally following the first three-month move down, we aren’t in a Bull market anymore. No Bull market has ever started three years into a Federal Reserve monetary-tightening cycle. Typically two years into any monetary-tightening cycle the economy enters a recession.
With the stock market and economy rotating into the next Bear market, opportunities will be short and risk levels will rise. With the Fed committed to continuing to unwind their balance sheet and computer algorithms dominating most of the trading, be aware stock prices could fall further and faster than most expect. Bear markets create opportunities for those with cash to deploy, but it’s important to maintain some form of downside protection.
The biggest opportunity to buy stocks at a generational low will come for those with cash or highly liquid securities at the bottom of the next Bear market. Just make sure you are in a position to buy when that day comes!
Post Christmas Look at What is Driving the Markets (12/26/18 – 15 min)
Weekly Economic Update (12/28/18 – 28 min)