Irregular Patterns and Price Action in the Markets

This past week, we have seen a number of markets moving strangely, demonstrating irregular patterns and price action. Stocks have continued to grind higher, notching multiple all-time highs in a weird, slow-motion, gravity-defying climb to ever more rarefied levels. At the same time, bond yields have continued to explode higher, pulling the dollar along for the ride as global investors have happily plowed into the dollar to earn the higher yields offered in dollar securities.

At first glance, these patterns are confusing as the normal correlations between interest rates and equities seem to have broken down.  One could have reasonably expected stocks to fall with interest rates screaming higher, but this has not happened. Why? What is driving this behavior?  Essentially, equity investors have put on their blinders, ignoring a variety of factors that would normally drive their behavior, choosing instead to focus on the stock market with a very selective perspective.  Specifically, they believe the Fed “put” on the stock market is in play, and they are acting accordingly with heavy buying.  They feel confident that the Fed will bail them out with a supportive policy shift every time the stock markets starts to dip.  So far, they are right.

As you can see from the chart above, the Fed’s own National Financial Conditions Index clearly demonstrates that monetary conditions in the US were already very loose when the Fed lowered rates in September.  A fifty-basis point cut in rates was absolutely not needed. Core inflation was still over 3%, so declaring a victory over inflation and aggressively moving to boost the softening labor market was at best premature, and at worst, a clear blunder. In fact, the Fed has continued their nearly perfect track record of being either too late, too early, or simply wrong by an order of magnitude.  More cynically, I can now formally label the Fed’s move last month as one of the greatest counter-indicators ever. It marked an important low in 10-year Treasury yields, with the yields having shot higher by 14% since the Fed’s announcement exactly one month ago. It also marked the lowest level for the year in dollar yen, which has shot up over ten yen since then.  In my view, a 3.3% annualized inflation rate is hardly something to celebrate.  Sure, it is much better than the cataclysmic inflation readings of 2021 and 2022, but this is hardly a victory.  Just ask the majority of the people in the country how they feel about their grocery bills or the cost of their insurance.  The problem is that the authorities are myopically fixated on promoting growth and doing everything possible to keep the equity markets moving higher.  The other problem is that the Fed’s power is essentially unchecked.  Journalists don’t even pretend to ask tough, pointed questions when they interview a Fed official.  They want to be invited back for the next press conference, so they consistently play nice with softball questions. 

In fact, despite a sharp downward drop in the number of available jobs over the past year, the US economy still appears to be chugging along at a decent pace.  The overall level of unemployment is still quite low by historical standards, although I fully expect a downward revision to last month’s strong jobs number. That would be the 12^th downward revision out of the prior 13 months.  The persistence of these revisions raises questions about possible untoward intentions on the part of certain government officials, but let’s leave that on the side for now and simply note that additional revisions are highly likely over the next several months.  Additionally, we know that many of the new jobs over the past year have been the jobs of people taking on second and third jobs to try to make ends meet, thereby overstating the true state of our jobs market.  Most importantly, we need to bear in mind that much of the economic growth we have seen since Covid, and even long before, has been heavily supported by the toxic combination of an immensely bloated Fed balance sheet and the US government’s untethered deficit spending.  So far this toxic combination has been able to mask some deep, underlying problems in the economy, but it is a highly dangerous mix, and it has potentially lethal implications.  Knowing that the US government will go to almost any length to avoid a crushing deflationary cycle, we can safely assume that our giant fiscal and monetary imbalances will very likely lead to an eventual resurgence in inflation over the coming years.  More borrowing and more spending will almost always be the preferred choice of the authorities to deal with problems as they arise.  Moreover, we can be sure that the relative purchasing power of our dollar will continue to decline over time.

 As you can easily see from the two charts above, the Fed’s balance sheet and the Federal debt levels have dramatically increased in tandem since The Great Recession.  This is not a coincidence.  Our government leaders have resorted to extreme measures to hold onto their power, which meant turning a blind eye to the risks of highly irresponsible economic policies…and in fact, embracing them.  It should not be a surprise to any of my readers that gold began a gigantic rally at the same time the Fed and the US Treasury embarked on their wild and crazy program of turbo-charging our economy through extreme monetary and fiscal measures.  You can also understand why over time I am expecting gold to continue its long-term rally, pausing periodically to allow for technical corrections when the market gets too exuberant.

It is patently obvious to most well-informed investors that the authorities are heavily focused on the performance of the stock market. Ninety percent of publicly traded stocks are owned by the wealthiest ten percent.  The wealthiest ten percent also happen to have an outsized influence on policy-makers due to their economic and political power.  In a perverse way, when people are celebrating the performance of the stock market, they are actually celebrating the ever-growing wealth disparity in our nation.  I think the chart below sums up this point very clearly. The related question that the authorities need to keep in mind is at what point will the suffering of the vast majority of people in our nation, who are struggling with serious life challenges due to the crushing costs of housing, food, energy, day care and other essentials, lead to potential widespread, social unrest.  This is potentially a precarious situation, and we should not pretend that the risks are remote and unlikely.  I maintain that the policy blunders of our leaders are creating a potentially lethal risk for our society that could lead to social instability the likes of which we have never seen.

The next several years will be critical to how this situation plays out.  We have a remarkably divided nation right now, and that is a bit frightening considering that the citizens here own over 500,000,000 firearms.  Historically, when things got too hot domestically, the US has resorted to a proven strategy of starting a war elsewhere in an effort to focus people’s attention away from the troubles at home.  It is not unlikely that one of the hotspots in the world today evolve into a bigger conflict, although that would absolutely be an awful development.  Otherwise, we can certainly count on increasing rhetoric about the real and present dangers posed to our great nation by Iran and China, and to a lesser extent, Russia.  This will set in motion further justification for yet more “emergency” defense spending, and ever-greater fiscal deficits.

All of our issues could be handled over time with responsible policy-making, but so far we have seen little of that from either party.  Both parties are complicit in our government’s reckless, uncontrolled spending, and the end result is that we are a nation with vast disparities in wealth, record unaffordability in housing, crushing price rises in most daily essentials, and an ever-decreasing number of families who can live comfortably with just one wage earner holding one job.  In terms of equity valuations, the current stock market is by many measures the most overvalued ever, and the risks for massive repricing are increasing with every tick higher in the markets.  I don’t want to sound depressing, but I find the talk about a soft landing and news about our wonderful economy unsettling.  I find it offensive that reporters refuse to ask the central bankers the tough questions that need to be answered, and I find it insulting that the leaders in Washington pretend to care about our nation’s long-term prosperity, knowing full well that they are mortgaging off the future of our youth.  

In just the past four years, the top 1% in our nation have added $13 trillion to their total net worth, while the rest of the nation increased their wealth by a mere $1.9 trillion.  This works out to an average increase of roughly $3.9 million in wealth for each of the one percenters in our country.  The other 327 million people have seen an average increase of about $5,800.  This dramatic disparity is actually far worse than it looks – and it looks very bad!  September credit delinquency expectations rose to their highest level since April 2020.  People are struggling, and the solutions are not easy.  Unfortunately, the power brokers in Washington are quite content with the status quo, so we shouldn’t expect any dramatic, near-term improvements for the supermajority of the population that is hurting.

Our government has been borrowing and spending money for many, many years as if we were in the depths of a deep recession, with massive levels of unemployment.  What are the leaders in Congress going to do when we actually have a serious economic downturn with unemployment screaming higher?  There will be a limit to the borrowing power of our government, and I would hate to see us test that limit any time soon.  At the same time, we can cynically wonder whether the Fed believes that they will reach their 2% inflation target by continuing to lower rates and ease monetary policy further?

In terms of the stock market, there are some technical indicators which are increasingly disturbing.  I am not necessarily of the view that we are ready to start the huge downside correction that I am expecting, but I feel strongly that a 10% to 15% correction could easily start before the end of the year.  What could cause this sell-off?  A host of things could act as a trigger, but the dramatic overvaluation of equities would be the underlying cause.  

The upcoming election could easily turn out to be a period rife with heightened volatility.  A very close presidential election could very well end in legal disputes, with the ultimate winner not being decided for a very long time.  Markets hate uncertainty, and that would certainly bring a lot of uncertainty.  I could easily point out many other possible triggers, but there is no need.  The unanimity of views about the market heading higher through year end tells me more than enough about where the risk lies.  The market is long, and they are getting longer.  There are stacks of stop losses piled up below the market, and at some point, those stops will get triggered.  The skew in SPX option volatility between calls and puts is very revealing, and it shows us that the market’s downside risk is dramatically higher than the upside risk.  

For many, many years I ran a trend-following program that was built upon some very basic logic.  Simply put, my analysis showed that roughly two thirds of the time, most markets are just chopping around going nowhere in particular.  The other one third of the time, the markets tend to have auto-correlative qualities, which means that they tend to trend.  There are many reasons for this behavior, but the reality is that buying tends to attract more buying, and conversely, selling tends to attract more selling.  In certain ways, this is a refutation of certain basic economic principles, but the fact is that we made money consistently, year after year, by following this strategy. 

In the current context, I would expect a sell-off in the markets to be self-reinforcing, with the down-move accelerating as more and more long positions are progressively forced to rebalance their positions and sell.  There would likely be other trades that coincide with this sell-off.  In particular, the yen’s recent corrective weakness against the dollar and the other currencies will likely reverse sharply.  In an ideal world, this move in the currencies would continue into December and then accelerate through the thin markets around Christmas. 

For those of you who have access to currency options, now is a good time to start building long yen exposures against a basket of currencies.  Volatilities have eased dramatically in the past month, so the risk-reward of owning calls on the yen has improved enormously.  My downside targets are quite extreme, but you don’t need to play for twelve-to-fifteen percent moves.  Rather, you can shorten your time horizon a bit and play for moves of five percent to seven percent.

In order to play the downside for a sharp correction in stocks, it is a bit trickier due to the heavy skew in S&P500 option volatility.  Simple put spreads will make money, but the returns won’t typically be very exciting – perhaps three or four to one.  As I don’t give specific financial advice in my newsletter, I need to shy away from being very specific.  I am happy, however, to work with individual clients on a consultancy basis to help them manage their exposures.  Otherwise, my partners are now organizing a trading fund for high-net-worth clients who want to diversify their return stream.  They are targeting about 2% a month on average, and so far, they have hit their targets.  I would also be happy to discuss this opportunity with you if you like.  For the more risk-seeking clients, my partners can run a more aggressive program targeting higher returns, but that program would also have a higher level of potential volatility in the return stream.  

Anyway, I am happy to discuss any of the above.  Feel free to contact me by email at akrieger@edenridgetrading.com

In the meanwhile, I want to wish you all the very best of luck with your trading.

Andy Krieger