Stocks fall, finally get the Fed message: Higher for much longer

Shareholders can act irrationally for quite a long time

The January rally went much higher than I thought possible. The Fed was still heading for higher interest rates, and was by no means going to “pivot”. The word pivot has been transmogrified several times, from cutting interest rates this year to stopping rate hikes, to the joy of 0.25% just a few more times this year. All these narratives have been far too optimistic. While I too can be accused of ingesting some of this Kool-aid, my imagination was that the economy can handle higher prices. That ZIRP was not only unnecessary, but keeping prices down to zero was actually harmful to the economy, making various assets “bubble” like Bitcoin for example. I thought that as long as rate hikes slowed so the economy could adjust, then a soft landing or even a complete avoidance of recession while defeating inflation is possible. I thought – mistakenly, it now appears that the Fed only used 2% inflation as an aspirational target. Once we fell to the 3% handle, there would be an urgency to tighten. Instead, two things have become apparent, 1) Inflation is nowhere near 3%, and 2) It is “sticky” and may not get there with a leisurely 0.25% increase. Loretta Meister has already hit 0.50% for March, we will see later this week when no less than 5 Fed officials make statements on Thursday and Friday. So will we get more restrictive comments to prepare the ground for faster tightening?? Will the Fed come out with guidance that interest rates will rise even by 0.25% and will continue through the end of the year and remain in place until 2025? Can any economy handle that kind of pressure? What I mean is that if it is expected at every FOMC meeting that there will be an increase in rates, that in itself is a barrier to economic growth. How does a bank price out a loan that they know can be 75 bps higher in interest in less than a year? Can the borrower handle such a business climate? Lending will only decrease, and will only be given to those businesses that need it least.

Louder and some say much louder, and longer

Greg Branch, founder and managing partner of Veritas Financial, said last week on CNBC that he expects 6.25% as the terminal Fed Funds Rate (FFR). Who is Greg Branch and why should we care what he thinks? Because way back, I think at the end of 2021, he predicted that the Fed was going to be super hawkish. I dished him out for being one of those perma-bears you always hear me complain about. I wish I had listened to him then. He has been right every step of the way, and now I will listen to him intently. I don’t think anyone else projects such a high level. Think he’s wrong? He and others who are clearly better at watching the Fed and interest rate hikes will at least push the range of terminal FFR to that level. No doubt stocks have not discounted that level.

PCE is coming and it could crash the market

Previous Core PCE — December ’22: 4.4 November ’22: 4.7 October ’22: 5.1 September ’22: 5.2

Below are the BEAs (Bureau of Economic Analysis) own definition in the report on core personal consumption expenditure.

“The PCE price index excluding food and energy, also known as the core PCE price index, is released as part of the monthly Personal Income and Expenditure report. The core index makes it easier to see the underlying inflation trend by excluding two categories – food and energy — where prices tend to fluctuate more dramatically and more frequently than other prices. The core PCE price index is closely monitored by the Federal Reserve as it conducts monetary policy.”

What is of particular interest to Jay Powell is the service charges. This indicates the labor costs, wages and benefits that Powell is very focused on. He believes that high employment is a path against inflation. The old wage-price spiral of the 70s all over again. I think this is bullshit, but Powell insists that the number of open jobs to the number of available workers pushes up consumer demand, and that pushes up inflation. It may just be a convenient excuse to just keep increasing until either the back of inflation is broken or the economy breaks. Right now, the last option is not a priority.

The interest rates in 2-Y and 10-Y have stopped until this last week

The real draw of the market was the tag team of 2-Y and 10-Y. To my eye, it was 10-Y that flew. However, the 10-year retreated from its multi-month high of 3.90%. The 2-Y continued to rise rapidly, coming within a whisper of a high that went back 15 years — It hit 4.718% and settled on a 4.617% yield, that’s a whopping 9 basis points for the week! The dollar played a no less important supporting role. The dollar rose to a 6-week high at the end of the week. Consider that as of last week, it was at a one-month low of 100.09. This week it almost went to 105. Is it any wonder that Thursday fell hard than Friday followed before recovering a bit before the end? The SPX and NDX were still moderately in the red with -.28% and -.58% respectively.

Where do we go from here?

I will not make any predictions about the schedule. If PCE Core, and especially service spending is bad, and Fedspeak at the end of this holiday-shortened week is hawkish talk of going back to a 0.50% rate hike, then I can totally see a drop to 3800. I’m not generally bearish , I’m not a super bull. I see no evidence right now that 2023 will reach the old high of last year, let alone make new highs. Also remember we have about 3 weeks after this one to worry about what the Fed does and says until their next FOMC meeting on the 21st-22nd. March. If a more aggressive tightening schedule is proposed before and during the meeting, we may go lower.

As it stands right now with the data I have to project forward, I wouldn’t say we’re entering another bear market. I think only the recovery expectations are going to be adjusted and the indices may start to rise again. Maybe they break even higher if we really see inflation move out of the 5-7% range and move towards 3%. I made the spread 7% for a reason and it’s not a typo. Larry Summers stated this weekend on Bloomberg TV that if you remove some numbers from the calculation, he comes up with a median inflation rate of 7%. He feels the Fed is between a rock and a hard place and is likely to plunge us into a recession, and rightfully so.

I don’t take that view, the consumer is still strong and there is a chance we will keep people employed, but if the number of additional openings per worker falls, Powell can only call it a victory before we fall into a recession. I don’t blame market participants for taking the opportunity to celebrate the resilience of the economy and bid up prices, but let’s face it, the average PE for a Nasdaq stock is 18. We are way overvalued. 3 weeks ago Tesla (TSLA) was a hundred dollars, this week it was inches below 220, and had a PE of over 55. There are many such names, I do not choose TSLA. Shares must discount higher interest rates. I know if I go through the litany of hedging and short positions that our community at Dual Mind Research perpetuates again, I think you’re going to be bored. I get tired of telling them. Check out my last two articles that go into detail about preparing for this downturn. Yes, I am about 3 weeks early again. I think from now on, if I’m brave (or stupid) enough to make a time-based prediction, please add 3 weeks to the goal. I will try to remember such a caveat. The market can remain irrational much longer than we think!

Okay, so what trades can I talk about?

I went through my entire long account and my trading account and I did not start any new long positions. So let me talk about one sector that I’m going to add to both my long-term and my trading account, which is energy. I will add my Devon (DVN) holdings, they had a bad quarter due to temporary circumstances. If you are a long-term investor, these are opportunities. I will definitely add to my EOG resources (EOG) and I have my eye on Apache (APA). If a little more comes in, I’ll add that position as well. I want to collect more Eli Lilly (LLY), for a split second it fell to $320 on Friday, but I wasn’t fast enough. Ideally I would love to get more under $320. I think the software hasn’t stopped going down, so I still haven’t picked up Palo Alto Networks (PANW), not because they excite me, but because they offer a comprehensive package, and I think they will expand market share because a CFO is more interested in ticking boxes than getting the best in each category. I added my Confluent (CFLT) via a call option. I really like the price action there. I’m waiting for my “Tech Titans” names to fall back to earth, but it might take a little longer towards mid-March. But if the indexes are going to fall hard this week and Amazon (AMZN) falls to $89, I would start putting back shares, same with Alphabet (GOOGL) but a little lower like $83. I haven’t set purchase prices for ServiceNow (NOW) Intuit (INTU), and Adobe (ADBE), but I want them to be 30 to 50 points lower. I might get lucky next month. I feel the same way about chips and chip equipment manufacturers. I think they’re going to come out of the chip glut this year and if they get knocked down enough I’d love to own that sector. Sorry, I don’t have any specific longs. I’m holding on to my shorts until next month, which will mean I’ll have to roll out a bunch of my puts until April to catch up on what happens at the next FOMC meeting.

I hope you all had a meaningful if not enjoyable President’s Day.