Offsides

For those of you who would prefer to listen:

The Market got caught offsides this week. It happens often when trying to anticipate something that doesn’t pan out. It’s actually the case with most any competitive environment. People looking for an advantage tend to jump the gun, as they say. It certainly occurs in sports. Aggressive activity almost always finds someone caught offsides at some point. 

The Dow and S&P saw a sharp sell-off to close out the week after the Fed dug in on its higher-for-longer interest rate campaign. The Fed seems to be ignoring the economic slowdown upon us. The Stock Market had been rallying of late in anticipation of a Fed pause early in the new year. The Bond Market still thinks it happens. In fact, the Bond Market thinks the Fed will not only pause, but cut rates in ’23 because recession seems all but inevitable. The yield on the 10-Year keeps sliding in December, currently below 3.5%, sending bond prices higher. The Yield Curve remains inverted, and the 30-Year yield is nearly identical to the 10-Year and much lower than the front-end of the curve. That’s always a sign of trouble ahead. It’s just never clear when. The Bond Market keeps signaling the Fed is making a mistake. The Fed is making a soft landing harder to happen. The Bond Market is usually right. 

Economic data keeps slowing. Both the Philadelphia Fed Manufacturing Index and Empire State Manufacturing Survey saw a contraction. These are important indicators of the health of the Economy. Companies are slowing. So are consumers. The Holiday Season saw a big burst of buying in October, but it didn’t last. Retail sales were weaker-than-expected in November, indicating the strong start didn’t keep the momentum. The retail report, which includes spending at stores, online and at restaurants, fell 0.6% last month. It was only expected to shrink by 0.2%. The spending slowdown is accelerating. 

High prices are less to blame now. Inflation’s rise has slowed. Of course, it’s still on the high side. The Consumer Price Index (CPI) cooled off again in November. It fell for a fifth straight month. CPI came in at a pace of 7.1% year-over-year. That’s the lowest pace for 2022. Inflation has fallen from a peak of 9.1% reached back in June. Fed Chair Powell’s “most important” inflation metric, which is the core services CPI, cooled to just 0.1% month-over-month. Though still high, inflation is going firmly in the right direction, which the Market has been celebrating. 

It’s really important to point out that these inflationary pressures have changed drastically over the course of the year. Supply chains have loosened substantially around the globe. Remember the backup of cargo ships in Long Beach? It is long gone. In fact, shipping rates from China to the West Coast have fallen 90% from last year. Energy prices have declined substantially too. West Texas crude actually went below $70 last week, erasing all of the 2022 gains. In fact, both Oil and Wheat prices are below their levels before Russia invaded Ukraine. That has translated to lower prices at the grocery store and the pump. That’s a big deal for American consumers, as food and gas prices act like a phantom tax, sucking money away from other areas in the economic system. 

Stocks surged Tuesday morning in response to the slowing inflation. But the rally failed to hold. The Bulls jumped the gun. They got ahead of themselves. They were caught offsides. The S&P hit an important resistance level of 4100 then it reversed, erasing nearly all of those morning gains. 4100 acted like a brick wall, denying the rally. That’s effectively where the 2022 downtrend line exists. The Dow gave up an 800-point gain and actually turned red twice before closing slightly in the green on the day. The Stock Market has demonstrated a series of lower highs. For this Bear Market to end, a decisive break through 4100 with breadth, thrust and momentum higher is required. It certainly is not happening yet. 

Despite all the evidence of peak inflation, the Fed increased the overnight rate by a Β½ point to the 4.25%-4.50% range on Wednesday. This was a downshift from the 3/4 -point hikes at its previous four meetings. That was expected and would normally have been a reason for the Market to rally. The Fed didn’t stop there though. The central bank raised what’s called the “dot plot” higher, by surprise, which caught the Bulls completely offsides. The Fed projection now sees the federal funds target range rising to 5.1% next year. That’s a level last seen in 2007. The Fed said it would be 4.6% back in its September projection. This was an unwelcome surprise. Higher for longer is the new mantra and the Market doesn’t like it. That’s what sent stocks south this week.

Interest rates are the price of money. It’s gotten really expensive this year, after being essentially free for a while. Free money encouraged investment and growth during the depths of the Covid crisis. But keeping rates that low for longer enabled irresponsible and reckless behavior, which led to asset bubbles. The Fed has now jacked up its key overnight rate by 4.25 percentage points in less than a year, from the near-zero level that had stayed in place over 2020 and 2021. For consumers, rising interest rates make it more expensive to take out a mortgage, carry a balance on credit cards, or get a loan to buy a car. For businesses, it increases the cost of bank loans and for raising capital in the Bond Market. The Fed has increased the price of money to slow spending and cut asset prices. It’s worked. It’s time they re-visit how well it’s worked to make sure they don’t overdo it. 

Back to the Market: Friday was a Quad Witching Day. That occurs 4 times per year with the simultaneous expiration of Market Index Futures, Stock Futures, Market Index Options and Stock Options at the end of every quarter. This event always leads to higher trading volumes and increased volatility. This Quad Witch had $4 Trillion in options contracts that expired. That’s a really big number. Friday was the busiest session for options traders this year. You could see and feel the volatile price action all day.

The Fed was clearly the highlight, or perhaps lowlight, of the week and the last big Market event of the year. News flow is expected to slow as investors settle in for the Holidays. Volume will thin out significantly, which generally creates an upward seasonal bias into year’s end. The S&P has been locked in the middle of a five-week range between 3,800 and 4,100. This week hit both the high-end and low-end of the range in just 72 hours’ time. That range seems likely to hold until January. We shall soon see.

France and Argentina meet Sunday for the World Cup title. 1.5 Billion people are expected to watch this championship game across the globe. That’s nearly 20% of all humans on Earth. The stakes are high. Competition will be fierce. Regardless of the outcome, it’s a virtual lock that someone will get caught offsides during the match. It’s how it goes. We’ll see if it ends up being a factor in the final outcome. 

Unlike sports, the Market doesn’t have an end point. It’s basically built for eternity. Getting caught offsides as an investor just means a turnover. The Bears took the ball from the Bulls again this week. It’s happened in every Bear Market rally this year. Defense has been the theme in 2022. Defense has been Bedell Frazier’s playbook. Our goal is to minimize turnovers and intercept opportunities when presented. 

Have a nice weekend. We’ll be back, dark and early on Monday. 

Mike

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