Andy Krieger's Thoughts on the Market - 15 January 2024

It has been an interesting start to the year, with lots of seemingly stochastic price action in multiple markets. Let’s try to make sense of what has occurred so far, and let’s try to figure out where we are heading from here.

I have always felt that it is best to tread carefully during the first two weeks of the year. Many bankers are on holiday, and trading conditions are light – and therefore, distorted. This is particularly the case after strong trending moves took place at the end of the prior year, as was the case in 2023. It was this basic principle that helped me determine that the markets were set for short-term reversals in the beginning of January. Speculative traders had pushed the markets into extreme overbought and oversold conditions at year-end to in order to capitalize on the trends and earn some extra year-end incentive fees. Early January is when they typically would want to reduce their exposures and realize some profits. The logic of this simple observation works nearly every time, and it worked out perfectly this year.

What is unusual about this year is that essentially every major trend that was developing in December went into reversal mode at the start of this year. Whether we were looking at stock market strength, the sell-off in U.S. yields, or the general weakness in the dollar, every market reversed in early January. In many of these markets, these short-term corrections were sharp, but short-lived.

Things have been a bit different in the currencies, where the dollar’s recovery against the Japanese yen and the Aussie dollar, in particular, has continued. Is this surprising? Not really. Let me explain. I like to think about currencies being akin to supertankers which need a long time and a few kilometers to stop, let alone change direction. The forex markets are so massive that typically it takes huge capital flows to push them into notable trends. The inertia that gets built up is significant; it typically takes some time for these markets to stop and then reverse. The daily moves in the currencies go as fast as the other markets or go as far, but once they are in motion, they tend to carry on for a while. The easiest way to identify this phenomenon is to look at the level of market volatility in the major currency pairs, which is typically 10% or lower, often quite a bit lower.

Compared to major stocks such as Tesla and Meta, the currencies are outright lethargic. Tesla options regularly trade at volatility levels close to 50%, while Meta options typically trade at a volatility of roughly 40%. This is very instructive, as it means that on a typical day, these stocks will move about five times as much as the typical currency pair. Everything gets turbo-charged when it comes to trading most individual stocks.

Even stock indices, which are theoretically very calm relative to the individual stocks, have volatility levels that are quite a bit higher than individual currency pairs. The same holds for gold, which people often think is pretty stable. Individual commodities are more akin to individual stocks, except even wilder in some cases. As you will see in the oil chart from the Federal Reserve of St. Louis, crude oil trades on average close to a 40% volatility level. When you play in that market, you need to adjust your risk profile and market expectations accordingly. Prices will simply fluctuate a LOT more, and the markets will react very quickly.

The current levels of volatility in the currencies are pretty much in line with long-term average levels. Historically, when these levels drop about 30% below the long-term average, then the market is coiling for some wild times. Conversely, when the volatilities start trading about 30% above the long-term average, then it is time to start looking for some consolidation. These are general guidelines, but with a bit of fine-tuning, I find them far more effective than any technical indicator, and I have experimented with pretty much every possible technical indicator.

I have traded trend-following systems and mean-reversion systems, using a wide range of technical indicators. I have hired NASA scientists and mathematicians and had them work side-by-side with Elliott Wave and cycle analysts. My systems all made money over time, and I am wide open to pretty much any sort of methodology to capture Alpha from the markets, but I have never found a better way to approach the markets and take risk in the markets than through the clever use of options.

These are all things that we will cover in my classes, but just to hammer home the point, volatility levels have a big impact on general market analysis. They will also drive different types of trading strategies.

Going forward, we are at some interesting juxtapositions in the markets. Inflationary pressures have softened towards the 3% level, as we forecasted last year, but things are likely to get a bit sticky between here and the Fed’s 2% target level. The job market is still tight, and consumers are still spending. There are, however, some serious economic headwinds lurking in the background. For example, the full impact of the Fed’s huge interest rate hikes has not been fully absorbed by the economy yet.

Mortgage rates are very high, and the housing market is somewhat paralyzed. Cash buyers are happy to proceed with their acquisitions, but a lot of inventory has been yanked off the market because buyers are priced out of the market due to extremely high borrowing costs.

Banks have become more restrictive with their lending and delinquency rates are rising sharply. This is coming at a tough time in the commercial real estate market as roughly one trillion ($1,000,000,000,000.00) of refinancings need to be executed over the next eighteen months. Consumers are still spending, but more and more of this spending is funded with credit card debt rather than with surplus earnings. Perhaps an anecdotal point to consider might be the strange fact that over 100 members of Congress have to sleep in their offices due to their inability to make ends meet on their base salaries of $174,000 per year. Their base pay hasn’t changed since 2009, and they make less than the typical mid-level executive at major private sector firms. These people play a critical role in the functioning of our government, our security, and our economy, yet the painful impact of inflation has not left them unscathed. They have residences in their home states where they are elected, and they cannot afford the extra rent required to have a small apartment in D.C. Clearly, there is something very wrong with this picture!

In addition to these things, there are some additional critical factors that we need to consider when we look at the macro picture. In particular, I like to look at levels of money supply in the US economy. Monetarists have fallen out of favor since the 1980’s, and although many of them forecasted the inflationary surge that we had several years ago, they really missed the mark last year with their widespread forecasts of imminent recessions. There is currently a rare phenomenon that we need to consider, however, and it really has my attention. For the first time since the Great Depression – yes, for the first time in ninety years – M2 money supply in the US has been dropping sharply.

According to the research I have done, this has only occurred four times previously in the past 154 years, and each time this has occurred, the economy has sunk into a deflationary tailspin. Since the middle of 2022, M2 is down over 4%, which might not sound like a big deal, but in the context of sharply higher prices since that time, it means that there is simply not enough money sloshing around in the system to cover a lot of purchases. Put more simplistically, this means that a lot of families and businesses will need to delay purchases and investments. It is a perfect recipe for an economic slowdown.

Moreover, once the slowdown starts, it could very well snowball because the Fed is still struggling to reduce its absolutely massive balance sheet. Imagine where our economy would be if the Fed hadn’t gone wild since the Great Recession of 2008. They have ballooned their assets by Seven Trillion USD ($7,000,000,000,000.00) in the past 15 years, and by Four Trillion USD ($4,000,000,000,000.00) in just the past 3 ¼ years! Talk about kicking the can down the road and leaving the problem for the next guy!! This is a classic example of that strategy. The chart below really sums it up perfectly.

Consider what would happen if suddenly unemployment were to start rising sharply and a sharp recession were to start. The Fed’s standard response would be to start cutting rates aggressively, but with inflation well above the Fed’s target rate, would that really be a sensible response? Inflation could easily start to rear its ugly ahead again. Then we could be looking at the worst scenario possible for our equity markets, stagflation.

Against this rather unappealing backdrop, we have another looming issue, which is the massive federal deficit. Federal deficit spending has provided a huge boost to the economy, but at some point, that debt can come back to haunt us. So far, investors have been willing to step in and fund this ever-growing bucket of debt. But what happens when investors suddenly say, “no more? We have more than enough of this paper already.” Funding costs for the U.S. federal debt would shoot higher and things would get really ugly. I seriously hope that doesn’t occur anytime soon, as we would then be facing a very, very rough economic future. Sharply rising borrowing costs for the government’s deficit-spending would squeeze out private spending, the economy would get slammed, and the dollar would crash. It would be a vicious circle, the de facto doomsday scenario for the U.S. Do I expect this to occur? Hopefully not anytime soon, but it is not out of the question.

Going forward, in a shorter time horizon, how do I see things playing out? Well, first of all, I think that the market is way too optimistic about short-term Fed interest rate cuts. The Fed needs to tread carefully here, and they will not start slashing rates as soon as many hope. Will they cut rates a few times this year? Almost certainly, but I don’t see them moving as soon and as aggressively as the market has priced in unless we start getting some very weak economic data.

This means that bonds probably shift into a range trade for a while, with the yield gently dropping lower as the range shifts to lower levels. A lot of Fed easing is already priced into current levels of the bond yields. In a future write-up, I will address the Fed’s “data dependent” methodology, but I will leave that for another day.

Stocks have recovered from their sharp sell-off early in 2024, but I feel that the new all-time highs will struggle to be sustained. The market is pricing in a Goldilocks scenario with modest growth, good earnings, softer interest rates, and no major geopolitical crises to manage. My bet is that this scenario is way too optimistic. While I can see some aggressive speculative buying pushing the markets a touch higher still, I believe that the risk is asymmetrically skewed lower. Too many good things have to occur for this to play out so pleasantly. Could it turn into a very sharp reversal and subsequent bear market? Absolutely! There is plenty of time to play for this move, however, I am happy to sit and wait for some clearer signals that it is time.

In the currencies, I persist in my view that the dollar is overall headed lower against the yen. I see the recovery since the end-of-December dollar lows around 140.24 as a much needed and sensible technical recovery. I would like to see just a little bit more dollar bullishness in the market, at which point I would expect the next down leg to start. In the big picture, I see this rally as the correction of the initial down move from 151.91. How far can the rally go before reversing? Technically, it can go almost all the way back to the high, but I expect strong selling to emerge from 147.50 all the way up to 151.00. The move down after this correction is done should be quite strong, possibly reaching the 128.50 level – which seems like a long way from here. Hmmm. Actually, it is a long way from here, but that area happens to be a level that has a lot of energy from prior lows between 127.25 and 129.75. 128.50 is conveniently the midpoint of that band. There are some other technical reasons I have chosen that level, and I like it when multiple types of analysis all point to the same level.

The dollar will likely come under renewed attack against nearly all the major currencies once this corrective cycle is complete. The euro, Swiss franc, British pound, Aussie dollar, and Canadian dollar should all have strong rallies versus the US dollar, but I expect the pound and the Canadian dollar to be laggards. I would expect the yen to outperform all the others on the crosses, and it should be easier to carry the cross positions than the short dollars once the moves are underway, as the volatility in the crosses should be a bit lower.

In the commodities, Natural Gas will likely fail in its rally to take out the prior highs at $3.63. The only certainty in Natural Gas is that it will move around – a LOT!! Gold will probably continue to consolidate for a while before resuming its bull market. Crude oil – I remain undecided. It is trying to find a base, but the price action is messy and unconvincing. Coffee is interesting because of its monstrous rally last fall. After a 41% rally, I would expect some more corrective action. That means we can probably see another leg lower, but I don’t feel like taking that trade.

So, we should get ready for some wild action in many markets. This volatility is likely to continue for a long time, and it could very well accelerate. Wishing you the best of luck.

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