In Front of the Bulldozer

High prices and calm markets breed conditions for intense future volatility.  Well, we're getting a sneak preview of future volatility as you got a 2% selloff in the closing 2 hours of the trading day, something you haven't seen for a long time.  Some people will blame 0DTE options for the move, but its the complacency that's been building up that sets the market up for these cascade moves lower. Moves like this actually reduce the overbought conditions quickly and flatten out the uptrend, making them more sustainable in the intermediate term. 

For trend followers in 2024, it has been heaven.  For countertrend traders, it has been hell.   Valuations are getting unhinged from the realities of higher discount rates.  Yields are going higher along with stocks. 

Will we go back to the old normal of yields in the 4-6% range like you saw pre 2008?  It depends on fiscal policy.  If the government ignores the deficit and keeps growing the the deficit to GDP ratio to even higher numbers, then you will.  We could be back to a higher plateau for Treasury yields along with higher, sticky inflation.  Fundamentally, the U.S. is becoming a more closed society, with the population wanting less immigration, while wanting more government handouts and low taxes.  This leads to ever growing budget deficits, as politicians will always do what is popular.  Fiscal stimulus and low taxes are popular.   These loose fiscal policies will continue.  In the long run, the large fiscal deficits and the lack of supply growth for labor will lead to higher yields.

With Trump likely to win the White House in November, you get a scenario where a Republican president and a Republican or Democrat Congress produces big budget deficits.  The only combination which has proven to lower budget deficits in the past is a Democrat president and a Republic controlled Congress, and that looks extremely unlikely in 2024.  So more fiscal pump to come in the years ahead.  

But this isn't really an edge.  It's consensus.  Almost everything I read and hear is that the US is entering an era of fiscal dominance, where monetary policy has little effect on the economy compared to fiscal policy.  Now almost everyone thinks recession is unlikely because of the big budget deficits.  But I question whether big budget deficits lead to sustained economic growth.  Just taking a look at the big budget deficits in Japan and the low growth there over the past 30 years, public sector borrowing can crowd out private investment and lending.  You have actually seen some of that in 2023 with bank lending flattening out to no growth, which is unusual in a non-recession.

Lately, the market has run with the fiscal profligacy and government debt fueled boom thesis by selling Treasuries and buying stocks and commodities.  The Project Argentina end game is the right long term thesis, but is it the right short to intermediate term thesis?  The US dollar is still the reserve currency, and its not going to be easy to move to another form of money for global trade.  For example, hard money like gold or even bitcoin are too supply constrained and not what central banks want as the main form of money.  The politicians would never let it happen and would lose too much power in the process.  For now, the Fed still has some inflation credibility by keeping rates high for the moment.

The market is fixated on sticky inflation, and a belief that the US economy is strong, and that the Fed is too dovish.  Thus the rush into commodities and stocks. Looking at the price action, this belief appears almost fully priced into the market.  There is almost no talk about a hard landing or the lagged effect of 5.25% of rate hikes.  You heard that constantly in 2023, when recession was a big concern.  Now, with the real economy slower than it was last year, you have more optimism on growth.  But as I've mentioned previously, Wall St. overestimates the wealth effect from higher stock prices.  There aren't many out there selling stocks at high prices to consume more goods and services.  Those with the largest equity allocations are mostly the wealthy, and their propensity to consume more based on higher stock prices is low.

You have a bifurcated economy, with the rich doing well, and the poor and middle class not so well.  Inequality helps to keep the inflation somewhat under control, since the poor and middle class have the highest propensity to consume their income.  A less prosperous lower 50% is a brake on inflation.  And wage income is growing slower than inflation, despite the BLS making up the inflation numbers to make it appear lower than it actually is.   

This explains the dichotomy of a surging stock market but a low approval rating for Biden.  Most people aren't doing well, no matter how much Wall St. touts the US economy as being strong.  The Wall St. economy is strong, not the real economy.  The real economy is mediocre at best, and growth is overstated since inflation is understated.  

This week, we've finally got a pullback that lasts more than 2 days.  The market selloff started 4 days ago and is now down more than 2% from the highs.  That doesn't sound like a lot, but we haven't had a 2%+, 4+ day pullback in the market since early January.  Its been 3 months since we've seen this type of price action.  That 4 day pullback was a spring board to a huge rally in the 1st quarter.  I don't expect this pullback to lead to a rally anything like that with the market so much more extended.  

But when you haven't had a 2% pullback in such a long time, that pullback is usually bought up quickly and you go right back to the previous highs or close to the highs within weeks.  That is my base case for the current market, and I've actually done the unthinkable and bought this dip in SPX for a trade, expecting higher prices in the weeks ahead.  This a purely tactical trade, and not recommended for long term investors/traders.  Still believe the market will have a much deeper pullback in the coming months, although we may go a bit higher before that happens.  I continue to see many investors who are looking for a pullback and who have gotten nervous this week because of either higher yields or higher oil prices.  I don't expect either of those trends to continue for much longer.  Its the geopolitical bid that's squeezed oil higher recently, and geopolitics is almost always a fade.