“As goes January, so goes the year.” —The Stock Trader’s Almanac, 1972
Written Jan 31, 2022
On this last day of January 2022, the equity market convincingly added to its spectacular reversal up in the previous trading session. Depending on which major index you look at, the equity market recouped between 38% and 50% of its loss this month in just two days. Happy days are here again, so it seems.
For the month, the S&P 500 still closed down -5.85% (compared to -4.75% in Jan, 2008), the Nasdaq did worse at -10.06% (compared to -8.42% in Jan, 2008), and smallcaps closed down -10.68% (compared to -5.6% in Jan, 2008). The Dow was least damaged at -3.99% (compared to -3.55% in Jan, 2008). So despite two fabulous recovery days, this January still did worse than the same month in 2008, and we all know what happened the rest of that year. Are happy days really returning for the rest of 2022?
Let’s start with some known facts: Official inflation rate is now around 7% (actual rate is almost certainly higher), and the Federal Reserve said it will taper its rate of money printing to zero (i.e. ending its 14-year long Quantitative Easing program) by March, 2022, at which time it will start the first in a series of Fed Funds (i.e. overnight lending) Rate hikes.
As my previous articles repeatedly point out, the equity market is a gigantic bubble 14 years in the making (as the result of the Fed’s policy response to the 2008 global credit crisis), and has been propped up solely by ever larger amounts of money printed. Is it any wonder that the bubble is deflating now, — the last two trading sessions notwithstanding, — in anticipation that in just a short two months, the helium-pump will be removed?
Warren Buffet famously said “When the tide goes out, you’ll see who’s been swimming naked”. Well, the tide has barely started to go out and we already see Cathie Wood naked. And if Robin Hood already showed signs of stress in high tide, what do you think will happen the rest of this year as the tide goes further out? Watch the Millennials’ losses pile up as this year wears on.
What is Quantitative Easing anyway? Simply, the Federal Reserve prints money out of thin air and gives it to (thus “liquefies”) the commercial banks in exchange for U.S. Treasury bonds on their books. In other words, the Fed has been buying Treasuries with money printed out of thin air. This buying is what enabled the Fed to keep interest rates artificially low at near zero per its Zero Interest Rate Policy (i.e. the Fed’s “programmed” demand drives up the prices, therefore drives down the rates, of Treasuries). The reverse will happen when this “programmed” demand ceases: Rates go up as prices of Treasuries go down with demand. This is already evident in the 5-year, 10-year, and 20-year Treasury rates. In other words, the long end is already repricing itself (bond holders sell in anticipation of negative return, thus driving up rates); we don’t have to wait for the Fed to raise the stinkin’ overnight Fed Funds Rate in March (i.e. that is just a lot of B.S.)!
When bond prices go down, portfolios with bond holdings lose value. Since most institutional portfolios are structured for “risk parity” (i.e. 60% in stocks and 40% in bonds), they are being “double whammy’d” now. Both their stock and bond holdings are tanking. What would you do as a portfolio manager? You sell both before further loss! The vicious self-reinforcing market down-cycle has thus begun. The “Fed Put” (i.e. the “Fed has your back” with endless money printing) regime has ended. Perhaps those still operating in the 14-year long BTFD (Buy The F’ing Dip) mode, — no doubt responsible for the fabulous two-day rally, — just haven’t read the memo carefully?
Rising interest rates dampen “credit impulse” (i.e. discourage bank lending), particularly when shorter term interest rates rise faster than longer term interest rates (the so called “flattened or inverted yield curve”). This in turn slows economic growth and operating income shrinks for a lot of businesses, forcing layoffs. As well, capital flow to unprofitable Unicorn startups will dwindle, forcing them to reduce burn-rate by layoffs. Rising unemployment further reduces consumption and economic growth. Thus the vicious self-reinforcing economic down-cycle has also begun. At long last, the physical economy and financial markets are re-coupling (but not in a good way!), after 14 years of decoupling from ceaseless asset inflation in the financial markets as the result of the Fed’s money creation in ever-larger amounts (see 2022: The year FinTech comes of age?)
Meanwhile, the country (nay, the entire planet) is up to its eyeballs in debt! The global credit crisis in 2008 was caused by excessive (and bad) debt. Debt to GDP then was 68%. We never fixed that excessive debt problem. Instead, the Fed papered over it by creating massively more debt. Debt to GDP is now a whopping 130%! A lot of this debt has to be continually rolled-over (i.e. refinanced). What happens when interest rates rise? Debt becomes more expensive to “service” (from higher interest payments). And new debt will be more expensive than old debt. Debtors will increasingly face liquidity and solvency issues. Debt default will in turn become creditors’ problem (i.e. banks will face liquidity and solvency problems).
And so began 2022 — a year of impending financial market crash and economic slowdown, with a monumental debt overhang while inflation persists. Sure, demand destruction from economic slowdown will dampen inflation somewhat. But supply chain problems still persist, preventing meaningful abatement of inflation. Not only are containers still backed up in major ports around the world, production in China is further disrupted by Omicron lock-downs (remember, the Chinese “zero Covid policy” means even if one person is found infected, a big part of a populous city gets locked down), the Olympic games, and (month-long) Chinese New Year holidays. Then there is ammonia shortage which affects the entire agriculture industry. There is natural gas shortage in Europe. There is coal shortage for China. And we haven’t even started to ponder what the slow motion collapse of China’s real estate sector (a la Evergrande) will do to its ginormous local government debt bomb (a lot of which is U.S. dollar denominated) and how that may spill over to the rest of the world.
Say official inflation improves from 7% to 5%. And the Fed hikes the Fed Funds Rate to a full 1% from zero by year-end. Real rate will still be negative 4%. So the Fed is still incentivizing borrowing and spending rather than saving and investing, — which fuels inflation. Its rhetoric of fighting inflation by (sufficiently) raising interest rates rings hugely hollow. And it knows that. Its fiddling continues, except this time, Rome will be burning — for the rest of this year of “the perfect storm”. My bet is, once again the Stock Trader’s Almanac will be proven right: “As goes January, so goes the year”.
That all said, there is one wild card, — the U.S. Dollar may continue to strengthen with rising interest rates. If so, offshore dollar denominated debt will unwind. Repatriated U.S. dollars will seek a home in U.S. securities, thus providing a floor and preventing collapse. That is not my bet (U.S. Dollar Index just tested 40-year down trend-line and turned back down). But we’ll see.
