Apologies for my absence most of last week. I had a family matter come up and was slammed with work on my FX desk all week.
Sunday Podcast link for those who want to follow each week’s market breakdown:
Fed member and President of the Federal Reserve Bank of Minneapolis Neel Kashkari appeared on an interview the other day in which he made some telling comments on the stock market action of recent weeks. Kashkari told the audience that he was disappointed to see the initial stock market rally directly following Jerome Powell’s early summer speech, and was much more relieved to see the market trade down after Powell’s clear indication regarding fighting inflation in the Jackson Hole speech. This highlights how much Fed speech and communication has become intertwined with stock market trading, and should be troublesome to all investors.
Forgetting for a moment whether the Fed is hoping for stock prices to go up or down, we should recognize that the Fed is pleased with recent stock market action, because it shows the Fed that investors remain confident in their willingness to fight inflation. We should also realize a big reason for high demand throughout the economy in the past decade has stemmed from the wealth effect driven directly from stock market returns and real estate appreciation. The last thing the Fed needs right now is to have a booming stock market, causing people to become more liberal in their spending from wealth effect behaviors. Stocks and commodity prices have also been positively correlated to a fair degree in the past year, and the Fed definitely does not want commodities prices back on the rise. This might come off as troublesome to a lot of people. After all, aren’t high stock market returns good for the country? The higher the stock market goes, the more business formation we can have, and the more people will be able to spend in the economy. Even people on Main Street have a huge chunk of equity in the stock market, either through a 401K or IRA, or even with individual investing accounts.
The fact of the matter is, the stock market is now tied to the economy and to Main Street more than ever before. When the stock market crashed in 1929, a lot of speculators lost money, but the typical person was not affected directly from the crash. Of course, a lot of people on Main Street were affected indirectly if they were unfortunate enough to have their money deposited in a financial institution that suffered losses, and thus lost customer deposits as a result. However, the average American didn’t really own stocks or have any stake on Wall Street directly prior to the development of 401Ks in the late 1970s. A big part of that was normalized interest rates which allowed for American savers to earn respectable yields on their savings to generate a retirement nest egg without having to take the risk of stepping into the stock market.
Not only is the wealth of average middle-class Americans tied to stock market appreciation much more than ever, but a lot of Americans are employed by publicly traded companies that are operating only from financing activity in selling stock to the public. The below chart from Statista shows the percentage of publicly traded businesses that were profitable at the time of their IPO onto public markets:
As you can see, the profitability of companies that were able to go public has declined drastically since the start of Quantitative Easing, and it is fairly obvious that this lack of profitability in public markets is a direct result from artificially low interest rates. Since money is cheap, a lot more financing and willingness for investing into more speculative business models has made it easier for un-proven businesses to raise capital. Since 72% of businesses that went public in 2021 were not profitable, 72% of the workforce for public companies derives their paychecks from investment capital as opposed to profits generated by businesses. Of course, some employees of non-productive businesses have their labor costs covered by revenues, but by in-large the majority of workforces for 72% of the stock market companies have their salaries funded by the sale of stock and the issuance of corporate debt. Thus, the entire Main Street population is highly dependent on stock market health which is tied to the health of the overall economy on a level never before seen in the US.
Circling back to the Fed, it should be no surprise that with the above holding true, they are more concerned about the health of the stock market than they are concerned with monitoring economic data. Some Fed members like Neel Kashkari will admit that, but others choose to deny it like Fed Chair Powell himself. The main concern from my end is that this has caused for the Fed to act in favor of the stock market in opposition to acting in favor of the health of Main Street. That is quite frankly why the Federal Reserve was so slow to react to the inflation threat when it first showed itself two years ago when the economy started to re-open. The Fed needed the stock market to recover from its Covid-19 lows, and they need it to hold up relatively well know, despite Kashkari’s comments that he does not want to see a rallying market.
What the Fed really needs is for the market to trade sideways for a meaningful amount of time. Many financial analysts would consider this to be a ‘soft landing,’ the term that has been popularized on Wall Street over the years. The Fed can’t have the market continue to trade down another 15-20% deeper into this bear market, because that will exacerbate lay-offs and really start to hurt the labor market, as well as consumer spending. But they also can’t have the market moving closer toward new all-time highs, because that would cause consumer spending to pickup again and allow businesses to continue to raise their prices, allowing inflation to continue to advance. The Fed is really looking for a ‘U-shaped recovery’ in the stock market, where we continue to trade at the 15-20% down levels we have been in, without seeing further contractions and without seeing new growth.
Of course this shouldn’t really have any implications on us as investors. The question becomes - Are we buying businesses, or are we trading the Fed?
Trading the Fed is actually quite simple. The expression ‘Don’t fight the Fed’ reigns supreme. The below chart from currentmarketvaluation.com shows the trading action in the S&P 500 vs. the growth of the Fed’s Balance Sheet through its expanding QE programs:
Quantitative Easing (QE) is simply the Fed injecting liquidity into the markets. When the Fed does QE, they are buying bonds which in turn lowers interest rates. The entire goal is to raise the risk-taking appetite of investors, along with getting business valuations to rise. As is indicated in the above chart, the Fed has achieved both of those factors in spades since the start of QE in the aftermath of the 2008 Financial Crisis. The term ‘Don’t fight the Fed’ stemmed from the Greenspan era of the Federal Reserve, which worked to stimulate the economy out of the 1987 stock market crash as well as the dotcom bust. Don’t fight the Fed, as it has applied to the past decade meant not to short stocks or get bearish on stock prices, despite any weak economic data coming out. After all, the Fed created its QE program with the purpose of allowing asset prices to rise to generate a wealth effect which would get the economy moving after the Financial Crisis. Not fighting the Fed in the past decade implied buying stocks and risk assets, for which investors were rewarded handsomely.
Well, if the goal is ‘Don’t fight the Fed,’ then the opposite should now hold true. The Fed is not doing QE anymore. They are starting to do the opposite in Quantitative Tightening. That would imply, as proven by the chart above that stock prices should come down as much as the removal of liquidity from the markets. As the Fed begins to sell more of its bond holdings onto the market, it will remove liquidity. The more courageous the Federal Reserve becomes in its bond-selling, the more the stock market SHOULD fall from here. If we are not fighting the Fed, that would imply we should be selling-short and not buying stocks. Of course that comes with the caveat I alluded to above - the Fed doesn’t want stocks going up right now, but they also don’t want a complete stock market crash. That is why I know they won’t be able to shrink their balance sheet substantially enough to remove the liquidity required to stomp out inflation. The risk for markets is the Fed goes slightly too far in its QT program, causing an unwanted fatal blow to the stock market and asset prices in general.
Thus, my best case scenario for markets here would be a U-shaped recovery. However, I think we have to head much lower from here. That is why my personal portfolio is 10% in SARK, shorting the ARKK innovation fund, which will suffer most in my view from liquidity being removed from the markets. After all, most of the businesses which comprise the ARKK fund are the companies mentioned above that have never generated profitability or proven their business models…they all rely on investor financing, and the appetite for investors to provide that financing will go away if the Fed moves to pull liquidity from the markets.
In fact, that lack of appetite to invest in speculative no-earnings businesses finally started to show itself for the first time last week, as noted in the below passage from Bloomberg:
As you can see below, this has already been one of the longer protracted bear markets in the past decade:
Unfortunately, the rip to newer highs is probably not coming. However, for the investors reading this who are not concerned about the next year and have a much more long-term investment mentality, kudos. I think it goes without saying that the long-term investors with long time horizons will always do best in the end. I try to make sure I always have the long-term vision in mind. Unfortunately for me, most of my work is involved in the day-to-day action of the markets. I love the game, don’t get me wrong. But it can be difficult to balance short-term thinking with long-term planning. I like to think my job in this newsletter is to provide clarity on both the short and long term, hence the name Thinking Long & Short.
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