Andy Krieger's Thoughts on the Market - 9 August 2023

The past few years have given us a fascinating lesson in just how wrong the “experts” can be when it comes to forecasting. The remarkable call from Jerome Powell that inflation in 2021 would be “transitory” was just one of many noteworthy misses.

Last year, almost every Wall Street analyst got the stock market totally wrong, with the sell-off in equities taking them by surprise. This year, the analysts have again gotten things wrong as the stock market has surged higher, completely shattering their pessimistic forecasts.

The forecasts have been wrong in other areas as well. The “inevitable” recession hasn’t manifested, as consumers have totally stunned the forecasters with their resilience. Growth in the economy has continued to surprise, and there is now a growing consensus that we are headed for a soft landing – a sort of fairy tale ending to a tumultuous period.

The authorities in many nations for many centuries have been searching for the magic formula to somehow delay recessions and prevent hard economic landings, but markets and economies are cyclical, and these cycles have their own way of playing out. Sure, the authorities can intervene and try to forestall a large negative downturn in the economy, but they are just kicking the proverbial can down the road, leaving the problem for the next guy who is in charge.

Eventually, the structural issues dominate the efforts of the authorities, and we are faced with one massive economic shock or another. The longer the reckoning is delayed, the greater the shock. The Great Recession was a perfect example of this, as was the 84% meltdown in the Nasdaq back in 2000. Bubbles finally pop and the markets do their job of cleaning out the gross imbalances. There has always been this day of reckoning, and in time it can’t be avoided.

The U.S. economy, the largest and most powerful economy in the world, has been the paradigm of this attempt by authorities to avoid taking the bitter medicine and addressing its economic problems. Consider, for example, that the Federal deficit in 2000 was $5.7 trillion. In 2020 it had ballooned to $23.22 trillion. In just the past three years, this debt level has exploded to $32.8 trillion. During this same twenty-three-year period, the Fed’s balance sheet has shot up from less than $1 trillion to roughly $9 trillion. These are mind-boggling numbers.

These dual increases in Federal spending and central bank monetizing are bound to have a serious effect on the economy and the purchasing power of the dollar. A significant portion of these huge increases have been used to try to cover up underlying problems. The US GDP in 2000 was about $10.5 trillion. The economy, twenty-three years later, had grown to about $25.5 trillion. While this is great on the one hand, it has come at a great cost. In 2000, the debt to GDP ratio for the US was about 44%. It now stands at 120%. It is clear to even the casual observer that a good chunk of the US economic growth over the past 23 years has been fueled by gigantic government spending coupled with aggressive monetary stimulus. It was only a matter of time before this combination led to a sharp spike in inflation.

The underlying weakness in the economy and the overall disinflationary cycle were offset by this dual economic stimulation. One obvious effect has been the devaluation of the dollar in terms of its buying power. This is most evident when we look at the cost of basic goods and services over a long time. Housing, education, food, and fuel are just a few examples of goods and services whose prices have skyrocketed over time. Now that the extended disinflationary cycle has largely come to an end, we need to reassess where we head from here.

Please bear in mind that If we have learned anything from the recent failures of “experts” to forecast economic trends and markets accurately, it is that the consensus view may be right for a while, but rarely is it right for long. Let’s put on our cynical hats for a little while and think about what sort of economic scenario would inflict the maximum amount of pain to the maximum number of people. This is precisely the sort of thought process that I have used in analyzing economic trends and markets for the past 40 years. In general, this analysis will get it right, but timing is a critical component that needs to be factored into the equation.

Since the Wall Street analysts are now shifting their views towards a Goldilocks scenario of the Fed hitting their 2% inflation target without a hard landing in the economy, we should take the opposite position and try to figure out what can go wrong to spoil this happy picture. Clearly, it is naïve to think that inflation will just keep sliding down comfortably to 2% with no disruptions along the way. The labor market has been remarkably resilient despite the Fed hiking interest rates by 5% in a little over a year, confounding nearly every economist who called the onset of a recession as practically inevitable. Unemployment is at its lowest level in roughly sixty years, and the labor market is so tight that employers have lost their leverage in wage negotiations.

Wage pressures are still very high, growing at an annualized 4.4% growth rate. This is a serious impediment to the Fed achieving its goal painlessly. Although we have seen a sharp drop in inflation over the past eighteen months, further progress is unlikely to be so easy. Remember, the primary fuel driving the economy has been the consumer, and a tight labor market with significant wage pressures will lead to continued strong consumption and further price pressures and inflation.

We need to expect inflation to get very sticky as we head towards 3%. One factor that would change this scenario would be a sharp downturn in the economy and a sharp rise in the unemployment rate. As you will see, there are enough negative factors lurking in the background that this sharp downturn is more than a distinct possibility.

We have recently had a very sharp rise in the price of crude oil, but we are only slowly starting to see the impact of the recent price increases. Our economy is heavily reliant on cheap fuel and energy, and these added costs will filter into the prices of nearly all consumer products. Rising fuel costs coupled with stubborn wage pressures from a very tight labor market are among the worst things the Fed could confront. The chances are high that a very tight labor market and rising fuel costs are enough to stoke the flames of inflation. Getting inflation below 3% is going to be a tough job, and it will take time – and probably require some economic hardship along the way.

Coupled with the enormous increases in debt servicing costs for the US due to the combination of exploding levels of Federal debt and sharply higher interest rates, some serious crowding out by the Federal Government is inevitable. The funding of our government debt is tricky enough without the divisive infighting in Congress, and there is a growing risk that the annual game of chicken played by Congress could lead to a disastrous default on US Government debt. Think of this unholy dance as a catastrophe of our own making.

This was the main reason behind the recent downgrading of US credit to AA+, and the risk of something truly ugly happening in the near future is exacerbated by the ever-growing nominal levels of debt and the ever-rising costs to service that debt. The crowding out effect could easily lead to a sharp slowdown in the economy as the private sector is forced to compete with the government for funding. Moreover, this competition for money could lead to a reduction in available credit for the private sector. Remember, it is the combination of the availability of credit and the absolute level of interest rates which has the biggest impact on consumer spending. The availability of ample credit is at least as important as the level of interest rates.

It is not hard to imagine a scenario in which 30-year interest rates rise sharply from current levels, perhaps heading back to 5.3%, a level last seen in 2008 right before the stock markets had their meltdown. This would have a chilling effect on the residential housing market as the cost of mortgages would price most new homebuyers out of the market. It would also have a severe dampening effect on resales, as people would tend to stay in their existing homes rather than face the burden of a sharply monthly mortgage payment associated with a new mortgage on a different house.

This could lead to the awkward combination of sticky inflation and an economy which starts to sharply slow. There are some other factors which could also lead to economic problems. Payments for student loans, which were largely on a moratorium for the past three years are now starting up again. This will definitely have an adverse impact on some consumers. Likewise, but to a lesser extent, the end of the moratorium on evictions due to the nonpayment of rents will also hit a small segment of the economy.

In the background, we have the ongoing issues at many banks which Moody’s Investment Services is now warning us about. In particular, they are considering credit downgrades of many banks. I wrote about this in priors updates, so this recent announcement should come as no surprise to any of my readers. This is the sort of development which could lead to at least some disruption in the availability of credit.

I could carry on with many other warnings about potential negative shocks, but in isolation they won’t help us trade and make money. Therefore, we need to look at the overall conditions in the markets today. First, do I think that stocks are dramatically overvalued? Yes, absolutely. Do I think they could become still more overvalued? Yes, but I think the rallies of 2023 are running out of steam.

The massive, short covering which drove the initial surge in the equity markets is certainly done. The next layer of buying from the asset managers who were heavily underweight in stocks is also done. The layer of buying from speculators and investors who were tormented by the fear of missing out is also done. The final layer of buying from speculators who largely adhere to trend-following and momentum strategies is also done. Simply put, barring some shockingly good news or unexpected happy developments, the next significant swing lower could be close at hand. The market is long and becoming increasingly vulnerable.

It is too early to fine-tune the entry for a major short, but there are definitely some major warning signals. Some of the early leaders in the stock market’s rally, such as Tesla and Apple, have flashed sell signals in my trading model, and many more stocks have shifted from long to neutral. On an individual basis, I am happy to play for an aggressive downside move through some limited-risk option strategies, but it is still a bit early for me to short the entire market.

In the currencies, I have recently been quite busy. There are some interesting plays setting up that could develop into major trends. There is currently a lot of demand for the Swiss Franc and Euro, but primarily against the Australian dollar and New Zealand dollar. These trades have performed nicely over the past several weeks, but I think they might have further room to go. The Aussie and Kiwi are under heavy pressure now as inflationary pressures in their countries finally seem to be abating. This is leading to some heavy selling of these currencies as they are set to become less attractive on a relative yield basis. The Canadian dollar is also under heavy selling pressure. Euro/CAD, one of my favorite pairs to trade, corrected nicely back to the 1.4300 level from 1.5100, where it found good support, and I think that overall the cross pair is getting set for a move to challenge and take out the prior highs at 1.5100. It is possible it needs to consolidate for a while longer, but the overall direction seems clear.

The Swiss franc has also been strengthening against the Canadian dollar, and it looks like it is getting ready to test and probably take out the all-time low against the Canadian dollar around the .6475 level. A move like that could trigger further waves of selling, but it is important that we watch the action around that level over the coming days. Historically, when the Swiss franc breaks major levels against other currencies, it tends to re-test those levels several times before accelerating further in the direction of the break.

A trickier currency right now is the Japanese yen. I still think that the next major move in the yen will be higher against most other currencies, but it is not quite ready. Once the yen starts its next major trending cycle, it is likely to last a long time and strengthen much more than people expect. Once a yen trend gets entrenched, I tend to only trade in the direction of the trend, waiting for pullbacks to re-enter positions after taking profits, or otherwise waiting for levels to add. This move will present many great trading opportunities along the way, so we should be patient and wait for clear signs that the trend has started. Then we simply need to decide which part of the trend to participate in.

In commodities, I remain short gold and long natural gas. I also remain bullish on crude oil, as I think there is at least one more sharp rally to follow. Being long natural gas was a strange trade that was based on probabilities as much as anything else. It had collapsed so far that I figured that even a “tiny” bounce would yield a 50% bounce. We have now rallied almost 40% so I am going to take profits on half the position. Gold is still correcting lower… more of a grind than a sharp move, but I will remain patient for a little while longer.

I am excited about what I see as fantastic trading opportunities over the coming weeks and months. Wishing you all the best of luck.