The US market uptrend broke this past January and signaled a market top that could lead to a 45% decline in the S&P 500 over the next three years. Market bubbles often trace out similar price patterns due to human nature’s predictable influence on trading. Man, a herd animal, historically succumbs to periods of mass greed and mass fear that are manifested in market bubbles and crashes, respectively.
The chart below shows the January break of the unsustainable 115% annualized rise of the S&P 500. The trendline broke due to the restrictive Federal Reserve policy, the Ukrainian invasion prospect and bubble equity valuations overpowering the market’s accelerating momentum which originated from the March 2020 COVID crash bottom.
While bursting bubbles often have counter-trend rallies, recency bias will persuade investors that the bull market remains intact. The three powerful bull markets of the S&P 500 to its current 4515 level from March 2020 — 2497.0, the longer term rise since March 2009 — 573.1, and the secular rise since September of 1982 — 122.4 will mislead investors into believing this bull market is not over. During the past four decades, declining interest rates have consistently bailed out the stock market. Unfortunately, this time is different. The Fed will not bail out overcommitted equity investors because the Fed has a serious inflation problem.
In the next few years, the investing public’s sheepish commitment to the S&P 500, the NASDAQ 100, and the 60/40 stock bond balanced portfolio model will disappoint retail and institutional investors alike because the markets must confront rising inflation and rising interest rates. January’s S&P 500 trendline break marks a new era for stocks where extreme overvaluations revert to the mean. This new era should resemble markets in the 1970s and the 1999-2008 period when energy prices soared, and stock indexes were dormant for a decade.
Jeremy Grantham’s January 14th “Let the Wild Rumpus Begin!” article compares today’s market to the epoch bubbles of the last century. We believe January’s clear break of the S&P 500 signals the commencement of a bear market. Grantham is one of three investment experts we respect who has correctly anticipated the market crashes of both 2000 and 2008. Nobel laureate Robert Shiller and Doubleline CEO Jeffrey Gundlach also called the 2000 and 2008 bubbles and their work is consistent with our bearish forecast.
Source: “Let the Wild Rumpus Begin” Jeremy Grantham, Advisor Perspectives, Robert Shiller.
Bear Market Repellant:
While this sounds terribly grim, there are sensible strategies for investors to embrace. The critical difference today versus most periods since 1982, is that the Federal Reserve is reversing its financial accommodation posture, interest rates are rising from extremely low rates, and inflation has reemerged. By NOT investing in what has worked in the recent past and investing in value-based strategies that benefit from rising inflation, rising commodity prices, and rising interest rates, a viable investment strategy can be positioned for this new inflationary environment.
Most importantly, a restrictive monetary policy and high inflation environment require that investors reduce duration risk. Investors should reduce duration (interest rate) risk in stock and bonds. High-flying stocks, especially those without earnings, are the longest duration equities. They should be sold. These popular bubble stocks’ valuations will collapse as the present value of their future cash flows will decline with higher interest rates. Stodgy operating companies trading at low multiples will outperform. This long-duration equity valuation collapse commenced over the last year and is in full gear. Tech stock superstar, Catherine Wood’s ARK Innovation ETF (ARKK) has declined over 55% from its high last February. Additionally, the number of NASDAQ stocks that have declined 50% is now approaching levels last seen following the 2000 and 2008 market peaks.
Throughout 2021, the market has been experiencing painful declines in MEME stocks, SPACs, tech story stocks like those owned by Catherine Wood’s Ark funds and nearly 1500 of the 3300 NASDAQ stocks which have declined 50% or more. This stealth bear market is blunting investors’ enthusiasm and starting to weigh on broader market psychology.
Inflation Commodity Hedging:
While commodities have underperformed the S&P 500 since 2009, rising inflation and commodity prices point to stocks that can benefit from these trends. Commodity stocks, commodities and companies with pricing power should now outperform the broad market. Global population growth and a lack of commodity capital investment over recent years will drive higher commodity prices in the years ahead. This is negative for the S&P 500, NASDAQ 100 and 60/40 stock-bond model, but positive for energy, minerals, and precious metals.
The chart below shows the ratio of the S&P 500 to the CRB index (SPGSCY/SPX). The chart reflects the outperformance of the CRB Commodity Index to the S&P 500 by 8-900% between 1999 and 2008. During this period, oil, as a proxy for commodities, rose from $12/bl to $175/bl while the S&P 500 suffered through the 2000 tech bubble and produced a nominal S&P 500 return. We see the last two years as confirmation of this trend reasserting itself in a similar fashion to the 1999-2008 period. Since March of 2020 oil prices and natural gas prices have broken out of long-term downtrends. Our clients who have owned natural gas stocks including Antero Resources Corporation, Antero Midstream Corporation, and Master Limited Partnerships have realized blistering total returns from sharp capital appreciation and high dividend/distributions.
We expect this trend will begin to reflexively self-reenforce while stocks weaken further, and inflation persisting.
Unfortunately, the Federal Reserve’s new Jackson Hole accommodation strategy has put the Federal Reserve in a badly lagging position to combat inflation. We won’t know until the second quarter whether inflation is peaking. After two decades of outsourcing manufacturing to China and technology innovation, these persistent deflationary forces have slowed. This makes the Fed’s inflation mandate more difficult.
We fear that complacent retired investors could be at risk. The Wall Street Journal reported this past week that this long bull market’s prospective demise could be particularly damaging to the savings of older investors. Data from Fidelity Investments’ 20.4 million (401k) show that investors between 60 to 69 hold about 67% or more in stocks. If our bearish forecast proves correct, these Fidelity (401k) investors and similar retirement programs could see a significant decline in their retirement assets. Unfortunately, retired individuals won’t have the time to recover potential losses from a protracted bear market. Bear market inflationary cycles can last several years. Historically, bear markets end after retail investors have sold and reduced their equity holdings. As philosopher George Santayana famously said, “those who cannot remember the past are condemned to repeat it”.
Geopolitical factors appear to be worsening. Russia’s threatened invasion of Ukraine is creating market instability not only for equity markets but commodities like natural gas and oil, in particular. China’s nettlesome threats against Taiwan represent another exogenous risk that the market might have to absorb.
Psychology and Feedback Loops:
Feedback loops are reinforcing phenomena. Rising stock markets induce stock buying, which then rewards investors with profits, which leads to further buying which lifts stock prices even further. This is a positive feedback loop. Bull markets are driven by positive feedback loops. When markets change direction, positive feedback loops turn into negative feedback loops.
The importance of the trend break is that now recent buyers are starting to lose money. Buyers of Catherine Wood’s top-performing ARK Innovation ETF (ARKK) are now losing money. Likewise, investors in highfliers like Peloton Interactive, Inc. (PTON), Netflix, Inc. (NFLX), Zoom Video Communication, Inc. (ZM), Teledoc Health, Inc. (TDOC), Roku, Inc. (ROKU), Coinbase Global, Inc. (COIN), have joined SPAC investors and buyers of MEME stocks AMC Entertainment Holdings, Inc. (AMC) and GameStop Corp. (GME) in losing money. People love to make money and when investing rewards investors with quick profits, their enthusiasm becomes infectious. Due to the stealth bear market of the last year, those enthusiastic investors are now confronting heavy losses and capitulating.
The break in the S&P 500 means that the largest companies in the United States are starting to break down. This negative feedback loop is driven by more than psychology and momentum. The Federal Reserve’s massive purchases of mortgages and US Treasuries artificially lowered interest rates. The Federal Reserve in an effort to revive the US economy from the Financial Crisis, the Great Recession and the COVID-19 Crash restored economic strength by lowering interest rates through purchases of US Treasuries and mortgages. These purchases will end in March after tapering concludes and the Fed will start raising rates, furthermore, shortly thereafter, the Fed will start to unwind its gargantuan $9 trillion balance sheet.
The chart below suggests that FAANG+ stocks will come under pressure as the Fed Balance sheet begins to shrink. Economic and monetary conservatives will argue that the balance sheet should drop back down to $2 trillion.
Historically, when the market turns, leaders of past bull markets decline the most. We are cautious on technology stocks and have begun successfully trading the inverse NASDAQ 100 ETF – (SQQQ).
We believe the secular bull market in stocks has ended. For the next seven years, we expect a period of flat or negative performance from broad-based indexes like the S&P 500, NASDAQ 100 (QQQ) and the popular 60% stock 40% bond balanced portfolio strategy that has provided four decades of risk mitigated attractive returns.
This new inflationary environment should resemble markets in the 1970s and the 1999-2008 period when energy prices soared, and stock indexes were dormant. By investing in value-based strategies that benefit from rising inflation, rising commodity prices, and rising interest rates, a viable investment strategy can be constructed.
We own and are buyers of energy securities including Master Limited Partnerships, natural gas and coal stocks. We own steel and precious stocks and select high-yielding ETFs with defensive characteristics. Lastly, we favor floating-rate ETFs and inverse ETFs to capitalize on market weakness in biotech, the NASDAQ, bonds, and the S&P 500.