Season’s greetings. This has not been a typical holiday season for investors. December is normally the strongest month for stocks. This one is on track for one of the worst in over a decade. There is very little that’s normal about today. The Bear Market price action has completely tossed seasonality aside. Despite the trade truce and the growth of Corporate America and the US economy, this Market is all about the Fed. It’s really always been all about the Fed.
The Bull Market was born in 2009 as the Fed basically backstopped the financial system from complete collapse. Its series of quantitative easing programs increased the money supply and injected substantial liquidity into the system. Interest rates fell, sending money into higher-risk assets, namely stocks. It worked. For 9+ years the US Stock Market made a historic run, outdistancing all others around the world. Sure, there were corrective periods along the way. That’s part of the deal and it’s a healthy process. Those corrections addressed the excesses and created a buying opportunity for the resumption of the Bullish uptrend. That has not been the case this time. At least not yet. Every oversold bounce since October has been sold. At first, the rally would last a couple of weeks. Then it switched to a couple of days. This week, rallies were only a matter of hours before being knocked back down. All eyes are on next week’s Fed meeting, and anxiety has rarely been this high about it.
You might have heard that the yield curve inverted. As a reminder, the yield curve is the line that plots the various rates of interest from the overnight rate that the Fed presides over to the 30-Year Treasury yield. The 2-Year and 10-Year yields are the ones that probably get the most attention. There was an inversion in one part of the curve. The yield between the 3-Year and 5-Year Treasury inverted this week, which means the 3-Year Yield was higher than the 5-Year. Conventionally, that runs counter to logic because who would lend money for 2 additional years for lower compensation? It shows that something else is going on.
Historically, an inverted yield curve has often led to a recession within 18 months’ time. That is a long leading indicator. It hasn’t been perfect. But the point is clear. The caution flags have been waved. But the fact is, the yield curve has been flattening ever since the Fed hinted at tapering back in 2013, which triggered a huge sell-off, now known as the “Taper Tantrum.” The Fed has been raising the front end of the curve, while low to zero percent interest rates overseas have kept the back-end artificially low. The result has been a flat curve, despite the strong earnings and economic growth, which has confused the system.
The biggest issue in our mind is the Fed’s quantitative tightening program underway. It is the process of unwinding the quantitative easing. In 2007, the Fed had less than $900 Billion on its balance sheet. 10 years later, it had ballooned to $4.5 Trillion. The process of unwinding has been well telegraphed, but its impact was unknown. It’s the right thing to do. The problem is, this has never been done before. The Fed has let nearly $500 Billion roll off its balance sheet in over a year, mostly in the form of $50 Billion per month. They haven’t sold securities. They just didn’t reinvest the proceeds from maturities, which has taken money out of the money supply. This has reduced liquidity which has exacerbated volatility. We have also started to see some stress in the credit markets, something that was missing prior. High-quality bonds are doing what they’re supposed to be doing. Lower quality bonds had been acting like high quality. They haven’t of late. The Dollar continues to rise as well, which is a continued warning sign. We take our cues from the Bond Market.
The herd has been selling. $46 Billion was sold this week, the largest outflows on record from stocks. There was a rush into cash as money market funds attracted over $81 Billion, also the largest inflow on record. Investor sentiment reflects the fear, with Bulls down to 20.9%, the lowest level since March of 2016 and has slipped to just 1/3 of the 60% cycle high for Bullish sentiment reached in January of this year. No surprise, that was at the then all-time highs. Bears are now up to a whopping 48.9%. These are all traditional contrarian signs of capitulation and bottom formation. Buying when others are fearful has been a winning strategy this whole cycle. The dilemma is, the selling hasn’t stopped. This one feels different. We are starting to see lower lows and lower highs. It feels awful. Now keep in mind, the S&P and DOW are down on the year but are still up 300% in this cycle.
We are focused on protecting those gains.
This sell-off is not about trade. It’s not about politics nor is it about the Mueller investigation… but they are certainly not helping. The issue is the Fed and liquidity in the money supply. Earnings and economic growth have been stellar this year. But the rate of growth is decelerating, and it seems to be falling faster than thought. Fed Chair Jerome Powell has the meeting of his life next week. Our sense is another rate hike comes. It has to. Even though the probabilities have shrunk from nearly 100% in September down to 74.9% today, Powell runs the risk of looking weak and reactive to the barrage of criticism from the President as well as sending the message to the Market that things are even worse than thought. If a rate hike is followed with clear commentary acknowledging things have changed and the Fed intends to pause its tightening policy for the time being, we think a year-end rally finally comes. But if its business as usual and more hikes are signaled for 2019, this sell-off will continue.
We have ramped up our defensive positioning by raising cash with sales and have built up our hedges, which increase in value when the Stock Market declines. Rallies have been sold. We’ve been selling Calls too. We’ve also been buying Bonds which have provided a nice cushion of late. 2600 on the S&P is a very important level, which was danced around all week. It closed almost to the penny there on Friday. The volatility will continue next week. That we can be sure. We are prepared for whatever comes our way.
Have a nice weekend. We’re on it. We’ll be back, dark and early on Monday.