My Trading Approach for the Divergences in Stocks

Last week I wrote about a number of markets, and I would like to recap a bit as a number of trades are setting up nicely. 

First, in silver, we got the expected corrective reaction off of the $32.50 level.  A number of weak longs got squeezed out of their positions, driving the price of silver down to $30.03.  I think that the market looks much healthier now, and it appears set to take out last weeks highs.  Gold is following a similar pattern, albeit with less volatility.  Overall, both look set to trade much higher over the coming weeks and months.

Underlying this move is an increasingly clear plan by the Fed and Treasury Department to slowly inflate the US out of its massive debt problem.  Financial conditions in the US keep getting looser and looser, and at the same time the authorities seem more and more intent on cutting interest rates as soon as possible, easing conditions still further.  In fact, per the Fed’s own financial condition index, we currently have the loosest financial conditions since November of 2021, when the 2-year US government bond was trading at 40 basis points!!  The idea of raising rates further to address the stubborn inflation is scarcely mentioned.  They scarcely want to even recognize the ongoing inflation problem, and they do this simply by noting that we might need to keep rates higher for longer.

Here you can see the remarkable disconnect between the absolute level of interest rates vis-a-vis the financially easy conditions in the market.  Interest rates have risen nearly 5%, but financial conditions are just as easy as they were before the rate hikes.

This scenario is being carefully managed by the authorities.  They want us to believe that we have restrictive policies in force, and that they are doing everything possible to squeeze the excess inflation out of the market so as to return the level of inflation to the long-established 2% annual target.  The reality, however, is very different.

We don’t need to examine the situation very deeply to understand why the authorities have been slowly creeping towards the decision to allow higher levels of monetary inflation.  With our government debt growing by about $1 trillion every 100 days, the US debt situation is clearly a very, very big elephant in the room, and the authorities can’t ignore it indefinitely. 

There are lots of ways to address excessive levels of debt, but the most obvious solutions are highly unpopular politically.  For example, the government could try something almost unimaginable and stop spending beyond its means and start running a surplus.  That would wreak havoc for the politicians, who love to buy the favor of their constituents with lots and lots of spending programs.  Even worse, the government could aggressively raise taxes to try to get their fiscal house in order.  Aside from being immensely unpopular, this sort of policy decision would put some very serious brakes on economic growth.  The government’s profligate spending has been a huge support for the economy, but at what long-term cost?  That accumulated debt becomes the burden of our future generations, and it seems not just irresponsible but even immoral to saddle our children and grandchildren with this sort of inheritance.

The path that the authorities are clearly taking is to try to stealthily inflate our way out of debt.  This is both dangerous and painful.  Sure, the US can keep borrowing more and more money and spending borrowed funds at a mind-boggling rate for the time being, but there will be a tipping point beyond which global investors will say, “Enough!  No more!! We are very nervous about whether you will be able to repay your debt with a sound currency, so you now need to pay us a much higher interest rate to take on the risk of lending to you.”  This could lead to an ugly snowball effect, with ever-higher borrowing costs and economic turmoil  This had led to collapse of many governments for many centuries.  It is more complicated with the US since the dollar is the world’s true reserve currency.  This means that people around the globe need dollars even if they don’t want them.  If BRICS is successful in building up an alternative to the dollar, then the day of reckoning for the US could come sooner than expected. 

As the US implicitly allows its targeted inflation rate to climb towards 3% -- and probably beyond -- the buying power, the true value of our money, halves in slightly more than 23 years.  This means that our current debt of nearly $35 trillion would be effectively halved during that time period.  That is to say, the actual value of that debt would be cut in half, as the prices of everything would double during this period.  Wealthy people, the people who have net savings and wealth that is stored in real assets, would flourish.  For everyone else, the inflation acts as an excruciating, demoralizing tax.

We are already seeing various “experts” tell us that there is nothing wrong with 3% inflation.  Paul Krugman, for example, the Nobel prize-winning economist, is calling for the Fed to formally raise its inflation target to 3%.  He is not alone in this call, and many more advisors and consultants to our government will communicate a similar message. For the people who are maintaining two or three jobs to try to cover the rising costs of life in the US, this would be a very painful outcome.  For the wealthy people, 3% inflation is hardly noticeable.  

The Fed’s choice to allow inflation to run at a 3%+ level while talking about a 2% target is precisely the sort of monetary double-speak to which we must pay very close attention. The authorities have basically broadcasted their intent, and in turn, it was very easy to forecast the recent surges in gold, silver, and copper.  With the Fed, the Treasury Department, and the government in general, we need to watch the behavior closely and ignore a lot of the words.  

The Fed could certainly take interest rates higher to finish squeezing the excess inflation out of the economy.  Yes, there is a lag effect on the economy and the rate of inflation from higher interest rates, but we have already gone past the point from which that lag should have taken effect.  The problem is that our economy is multi-faceted, and one size doesn’t fit all.  I have written previously about the deplorable state of commercial real estate in the US.  The vacancy rates are frighteningly high, and there are trillions of dollars of debt that needs to be refinanced over the next several years.  Refinancing huge amounts of debt at the current levels of interest rates would be crushing.  The knock-on effects in the banking system could prove to be very dangerous if the economy runs into any decent-sized headwinds.

In the housing market, many homeowners wisely locked in attractive borrowing rates when interest rates were much lower.  This is helping the economy somewhat, as the burden of higher interest rates is not hurting the entire market.  For borrowers with floating rate structures, however, the current level of rates is very painful.  The current level of interest rates is also creating a serious headwind for the overall housing market, as homeowners with attractive mortgage rates don’t want to sell their homes unless they can make cash purchases.

We also have a situation where the real job growth that is reported by the Bureau of Labor Statistics has distorted our perception of the actual level of strength in the job market. I have written about this at length in previous newsletters, so suffice it to say that the low level of unemployment in the US is misleading and overstating the actual level of tightness in the employment sector.  Coupled with the record high levels of credit card debt, the real risk to the economy in terms of future growth is almost certainly to the downside.  It would not be hard to see our economy slip into flat to negative growth quite quickly.

Would the Fed react?  They would react immediately, regardless of the inflation data.  They would prattle on about their dual mandate of maximum employment and price stability, but they would be thrilled to have an excuse to cut rates.  The Fed is empowered to take the necessary steps to keep inflation at a level that is conducive to a healthy economy, but the meaning of a “healthy economy” is hardly defined. 

In looking at the stock market, the thing that stands out most to me is the level of divergences across different sectors.  Sure, the Nasdaq, Dow Jones, and S&P500 have made multiple all-time highs recently, but the breadth of the rallies is concerning.  The retail sector, in particular, has been suffering, and the transportation sector has been flatlining.  The following chart of the Dow Jones Transportation Index hardly looks like a market that is on a bull run. 

Compared to the performance of the S&P500, it is easy to see that the strength of the S&P 500 has not translated to massive bull runs across the whole market.  

If one looks at the stock performance of many well-known retail names – Home Depot, Starbucks, Papa John’s Pizza, McDonalds, Lululemon, Delta, Southwest Air, Spirit, etc. – one can easily see that the old adage that “a rising tide lifts all ships” doesn’t apply here.  The stock market’s strength has been heavily concentrated in a limited number of stocks, with Nvidia being an astonishingly strong outlier.  

Going forward, I have no problem with the idea that the major indices will continue to grind higher, making further all-time highs.  In fact, I am not really expecting the market to have its final spike higher for another three to six months.  I can’t say that I agree with the fundamentals, but I am more than willing to hold onto long positions with trailing stop orders.  When a market moves into a bubble phase – which we are clearly in now –  allowing my profits to run by using trailing stop orders in typically the best strategy.  There is no direct relationship between the fundamentals and the technicals in that phase of a market, so I just hold onto the position until my trailing stop gets triggered, locking in the profit.

At the same time, I am also happy to have bearish option structures on a variety of individual stocks.  Some of the retail-focused stocks that I mentioned have been particularly weak, and I use the same basic strategy with many of them.  Once they are in the midst of a powerful downtrend, then I try to just hold onto the positions via trailing stop orders until they either hit my long-term target or they trigger my trailing stop order.  In fact, using the stop order is actually a great way to capture trends once they move into a type of irrational, bubble-like condition, when frenzied market conditions can make it nearly impossible to identity the ultimate target.  

In the currencies, I have been focusing my short-term trading on the Canadian dollar.  It is quite weak right now, and it has been trending quite nicely.  I still expect the euro, British pound, and Australian dollar to strengthen further against the Canadian dollar. The volatility of these moves is quite low, so I need to be particularly patient with these pairs.  Of course, I size positions in low volatility markets, accordingly, using larger notional positions to generate a similar risk exposure to the trades in stocks and certain commodities.  

The yen, for me, is not particularly interesting in the short-term right now.  Many speculators seem content to keep plowing into short yen exposures, capturing the interest rate differential between the two currencies.  What they have not noticed is that Japanese rates are slowly, but steadily rising, and this will ultimately help fuel one almighty reversal.  The authorities in Japan are very unhappy with the current level of the yen, and they are not far from taking serious steps to reverse the trend.  

The future move against the Swiss franc, in particular, will be astonishing. As you can see in the chart below, the Swiss franc is now at all-time highs against the yen, yet market participants are still piling into the trade.  I imagine they haven’t noticed that 10-year rates in Japan are now 30 basis higher than 10-year rates in Switzerland.  It is true that 3-month money in Switzerland is still about 1.5% higher than the 3-month rate in Japan, but I feel that the risk-reward of buying Swiss francs against the yen after the currency has rallied by nearly 70% in the past five years seems absolutely foolhardy.  The idea of not expecting a massive correction in the cross after the Swiss franc has rallied by over 200% against the yen since 2000 seems insane.   

We will certainly revisit this particular pair many times in future newsletters.

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

Andy Krieger