Category: Financial Analysis

Even though the larger cyclical growth trend is slowing, we are seeing unexpected signs of a temporary and unexpected bounce in growth. With inflation likely peaking, the FED beginning to walk back the most hawkish path of rate hikes this year, we could set up a much needed rally in high beta stocks from historically oversold conditions. This also lines up with our technical analysis work, all of which we discuss below.

We do plan to use any move in high beta stocks from here to further de-risk and raise another round of cash. We raised cash in December/early January, and have used that cash to layer into the companies that we want to own for longer than 1-2 years. On a short to intermediate-term time frame, we believe the upside risk from current oversold levels is higher than the downside risk. On an intermediate to long-term time frame, the risk will likely be more to the downside until the 4th cyclical slowdown within the larger secular bull market runs its course. Regardless, we believe the odds that the end of this great secular bull market is quite low.

The type of bear markets that go deep and last for years happen in conjunction with recessions. With the Yield Curve NOT inverted, nor giving any sign of an inversion in the near future, the current consensus odds of a recession are close to zero. Instead, what we are likely experiencing is the 4th deflationary shock in an ongoing secular bull market. We experienced these shocks in 2011, 2015, 2019/2020, and now 2022. these shocks are emotional and sharp but tend to recover quickly with a renewed reflationary impulse. Nobody can give you an exact guarantee, however, this is the outlook we are using for our current portfolio positioning. If something changes, we will let you know.

Inflation vs. Equities

Historically, rate hikes cause a knee-jerk reaction by markets rotating assets over the short term; however, we tend to see sharp snapbacks to new highs once that rotation subsides. Rising rates imply a strong economy.  As growth and inflation rise together with the Fed Funds Rate, we tend to see strong moves in the stock market.

For example, in December of 2015, the Fed raised rates for the first time since 2006. This created a short-term top as the S&P 500 fell 11%. Within 8 months the market was back at ATHs. From there the FED raised rates aggressively, as inflation, growth and the markets began to advance together on one of the best years within the secular bull market that started in 2009.

Today, we seem to be getting a similar reaction, yet at a more aggressive velocity. So, what happened? The short answer is that the FED has never waited this long to raise rates. Their “transitory” inflation stunt last year, coupled with inflation targets in the second half of 2021 that were also wildly detached from reality, placed them between a rock and a hard place.

On one hand, now that inflation is elevated, we are seeing the results of this reality filter through the economy. For example, real hourly wage growth is at an annualized pace of 12%, which is very inflationary. Yet, this growth in wages is still not enough to keep up with the annualized CPI print, causing real wage growth to be negative. Another example is that Real GDP grew at a 6.9% annual rate in Q4. Even with this excellent Q4 beat, real GDP for 2021 was only 1.6% (growth minus inflation), which was slower growth than the pre-COVID trend.

On the other hand, we have the U.S. Equity Market, which is dependent on an ongoing infusion of liquidity to maintain support. Though there is some room to deflate current prices in equities, letting the market crash for a sustained period is also not a viable option. Unlike in prior decades, the pivot towards manipulating a “Wealth Effect” in 2009 through FED policy, coupled with the near-universal adoption of 401Ks, over a decade of mostly 0% savings rates forcing money out of savings, and Wall Street’s infiltration of public and private retirement funds, has fundamentally tied the stock market to the economy.

The FED is now faced with allowing inflation to further erode growth, which is affecting middle to low-income households or attempting to deflate the stock market by focusing on curbing inflation. Going into Jan of 2022, we got the answer to that very difficult question, which was further backed by the recent FOMC Q&A. The market was expecting 1-2 rate hikes going into 2022 with a targeted roll off of QE to be in June-July. They then announced that 4 rate hikes were needed and an end to QE in March. This sudden increase of actions caused a panic out of risk assets and into energy, financials and various defensive assets, which is still playing out.

On top of a rushed tapering announcement, we have further evidence building that the cyclical growth in the global economy is peaking. So, unlike 2017 where inflation growth and rates rose together, we have the FED rushing to raise rates with growth and likely inflation peaking. Once again, this is unchartered territory, as the FED has never waited this long to act, which is creating uncertainty that is showing up in market volatility.

Like many, we did not expect such a sharp selloff so early into 2022. I do believe the market has moved too far too fast, which is common with market sentiment. This has set up the pricing in the worst-case scenario, and created oversold conditions that noticeably outpaced March of 2020. With sentiment at extremes, we only need the slightest upward surprise to trigger a reverse rally, which I believe the bond market is signaling.

How Bonds Relates to Tech and Why This Matters

Tech growth is considered a long-duration asset. When a stock has no current cashflow or earnings, yet is showing strong top-line growth with a large runway to expand, you are in essence buying a stake in the future cashflow of that business. These cashflows are far out in the future but are assumed to be very large. They are then discounted back to the present-value. Thus, a small change in the discount rate on the long duration cashflows has a material impact on current valuations.

As inflation rises, the costs associated with these company’s day-to-day businesses becomes more expensive. Furthermore, if they require on-going debts to fuel growth until profitable, the cost of borrowing goes up with an increase in yields. This forces the stockholder’s future stake on the company’s profitability to get repriced.

Equity investors are focused primarily on a company’s fundamentals and price action. Bond traders, on the other hand, are focused predominantly on economic growth and inflation. This is what drives the bond market, except for one key factor – FED policy. Because the Federal Reserve controls the Fed Funds Rate, which is the target yield set by the FOMC for commercial banks’ lending excess reserves overnight, this action filters out across the yield curve, having a greater effect on yields the closer you are to the Fed Funds Rate.

In other words, the closer a bond’s duration is to the front end of the curve, the less it is affected by growth and inflation expectations, and the more it is controlled by FED policy. As we move farther out on the yield curve, FED policy has less of an effect on bond buying. Instead, growth and inflation expectations drive these yields. This is important to understand when discussing what’s going on in the greater macro environment.

If growth and inflation expectations are driving long-duration yields, what does this mean for the recent upward moves in the 10-year yields across the world (Ex-China)?

With the CPI at 7% and the 10-year yielding 1.75%, the real yields on the 10-year are currently -6.25%. Inflation is obviously affecting the 10 year yield. However, with evidence that inflation is peaking, which will likely rollover in a decelerating economy, as well as evidence of one-time events not moving into 2022, the 10-year is likely also picking up on an unexpected and temporary growth surge.

Inflation

In 2022, the only major assets and sectors that are up are Energy, Oil, Commodities and the Dollar. In fact, the energy sector is the only sector that is up YTD, showing 17% gains in one month. Inflation fears are high and the expectation is that the 10-year yield is destined to reach 2.5%, and likely never see sub-2% again. All of this could happen, but I do not believe this is what’s causing the 10-year yield to make a higher high. Here are some points that show inflation may be peaking soon.

• Our model measures the Rate of Change in both Inflation and Economic Growth. This matters because even though we are seeing a high reading of 7% in the CPI, the rate of change is slowing.

Note how Nov-21 marked a lower high in inflation’s rate of change than May-21. As we entered December, inflation is slowing and trending towards deceleration.

• The recent CPI number showed a slowing down of both food and energy, which is a trend that will likely continue to further fuel the deceleration in inflation into 2022. With energy showing a noticeable topping pattern, a drawdown will bring inflation numbers down further.

The advance is oil prices is showing a strong divergence within the RSI, suggesting the upward advance in oil is due for a pullback. This would relieve the inflation pressures on the economy, pushing yields down and potentially being a temporary catalyst for long-duration assets.

• Last Friday, we also saw the FED’s preferred method for gauging inflation, PCE, was up 5.8% on a YoY basis, while the core PCE was up 4.9% on a YoY basis. These are high numbers, which have been fully priced into stocks, yet they were well below the worst case scenarios. Moving into February and March inflation metrics will have higher comps to clear on a YoY basis, which should provide a cushion. As long as we continue to see CPI and PCE either come in-line or surprise to the downside in 2023, we should see buyers step back into the risk market.
• From recent earning calls the one theme that is universal is the ongoing supply chain disruption, which is certainly contributing to the inflation we are seeing throughout the global economy. Interestingly, the continued trend in recent PMI reports as well as the Empire State MoM delivery Times Index are showing that purchasers are reporting quicker delivery times, which suggests that we have reached peak supply chain issues, and should see a further resolution in 2022.

• The supply chain disruptions have forced businesses to build up their inventory, which has also contributed. The excellent Real GDP Print in Q4 was largely due to this inventory buildup, as businesses have reacted to the supply chain issues in 2021. This increase in inventory will not be repeated going into 2022 due to signals of a recovering supply chain and a cyclical slowdown in global growth.

All of the above data points suggest inflation should start to ease. This was further backed up by recent statements from Mathias Cormann, the secretary general of the OECD. Corman claimed that inflation should start to ease as global central banks update their policies to pre-pandemic levels.

Furthermore, the bond market is also suggesting an inflation slowdown, which is running counter to the popular narrative that inflation is only going to get worse. If inflation was going to remain elevated and continue upwards as a secular trend, we would likely see more of a reaction the further out on the yield curve we move, as well as a continued upward move to the 10-year yield.

Instead, with the 10 year making new highs and holding below the 2% line, the 30-year, which is looking more at longer cyclical trend in growth and inflation is still in a noticeable downtrend.

In other words, the bond market is not buying that the inflation (as well as growth) will continue its upward trend on a longer-term time frame. Instead, the 10-year could be signaling a temporary reprieve, which is not fully being priced into the equity market, and the 30-year is signaling that if this manifests, it will not be sustainable before the bigger cyclical slowdown resumes.

Growth

The below model measures various growth metrics within the U.S. economy that tend to be leading indicators for the market. This is important because cyclical growth affects the far end of the yield curve. Visually, you can see how the economy was slowing down going into the COVID crash, and how it appears to have peaked in Q4 of 2021.

 This is confirmed with recent data worth pointing out:

• Industrial production came in at -0.1% on a MoM basis, which compares to the historical average of 0.74%. This was well below the expectation of a 0.3% increase.
• Retail sales also came in at well below expectations of -0.1% with a -1.9% MoM reading.
• New Orders missed expectations.
• The same can be said with manufacturing and business activity. The Manufacturing PMI came in an 11 month low, also surprising to the downside as it dipped below its 1-year moving average. The last time this happened was in September of 2018.

• PMI in Services came in relatively strong; however, we needed more growth in this area of the U.S. economy to offset the decline in manufacturing.
• This was further backed up with the recent ADP employment survey showing the economy lost 301,000 jobs in January, which was well below the expectation of an increase of 200,000. This was the first decline for ADP employment since December of 2020, and it was led by services.

 

Economic Conditions and Consumer Sentiment

Economic conditions, as measured by the US Current Economic Conditions Index, are at a similar measurement as March 2020, while consumer sentiment actually was lower in December than at the March low in 2020.

The reason for this is that though average hourly wage growth is up between 5.1% and 4.7% on a YoY basis over the last 2 months, real wage growth, when factored in for inflation, is down between -1.75% and -2.4%. As you can see in the above table, real wage growth has been negative since April of 2021, which has certainly been one of the main drivers for the deceleration in consumer sentiment that is filtering into economic growth.

Why is consumer sentiment so important? There are a few simple factors that when present, have preceded deflationary shocks to the stock market and economy. Consumer sentiment is one of them.

Going back to 1987 there is a clear correlation between consumer sentiment and stock market events. As consumer sentiment diverges from the stock market’s uptrend, what tends to follow is large correction or bear market. Today, we are seeing consumer sentiment hit levels that we last saw in 2011, which is something investors should be aware of.

The reason for this correlation is quite simple. If consumers feel good about their financials, they tend to spend more money on discretionary items. What tends to affect this sentiment, aside from a rare black swan event, is that inflation rises faster than wages. As consumers feel their real wages decline, they tend to spend less on discretionary items, and in periods of heightened inflation, consumers tend to take out debt to cover living expenses, which is what we have been seeing in the last half of 2021.

It’s important to know where we are in the business cycle for both short and long term investors. The larger cyclical trend is certainly suggesting that we have reached peak growth or close to it. However, recent data is providing some green shoots that the consumer is starting to feel better about the economy.

• The Conference Board released their monthly Consumer Confidence index and report in January. Even though it fell to 113.8 from 115.2 in December, it was above the expected decline to 111. They acknowledge that the surprise was that even though inflation is high, and real hourly wages are down, the average consumer is still planning to buy homes and large ticket items including cars over the next 6 months.
• This positive upside surprise was even further backed by Visa and American Express’s recent earnings call. AMEX said that card members’ spending was at an all-time high. They also confirmed that consumer travel and leisure spending is finally above pre-pandemic highs. They further claimed that they believe travel and leisure spending will continue to boost their revenues through 2022.
• UPS recently reported a strong beat on both the top and bottom line. Their top-line growth showed a 11.5% YoY increase, which they claim was the result of strong e-commerce demand. They further raised their guidance for 2022. UPS further noted that they have raised their prices do to supply chain disruption, and the consumer has shown a willingness to pay these higher prices.
• Two Federal Reserve chairs came out this week easing the probability of the most hawkish FED response in 2022, which has been priced into the equity market. The Federal Reserve Bank of Philadelphia President Patrick Harker expressed that the supply chains have a lot do with inflation pressures. He believes that 50 bp hike in March is not necessary. This approach was also expressed by the Atlanta President as well as the San Francisco President, supporting a more tempered approach to rate hikes in 2022.

With sentiment at rock bottom levels, this potential temporary return to growth, and likely peaking of inflation, which the bond market could be signaling, would be the catalyst that leads to a short to intermediate-term reprieve from the larger cyclical slowdown taking place. If this scenario manifests, and/or we see the FED continue to let up on the most aggressive plot program for 2022, we expect to see a bid in risk assets.

Is Tech Growth Over?

What will happen to long-duration assets and high beta when the larger global growth slowdown resumes, and if/when inflation continues its deceleration into 2022? Right now, many tech innovators are showing strong forward growth and even raising guidance into 2022, yet their stock is down anywhere between 30-70%. With growth assets left for dead, this would be the ideal environment to see a multi-week to multi-month relief rally that could last throughout the remainder of Q1 2022.

This is also lining up with our broad market Technical Analysis in the S&P 500

The above scenario lines up with the macro thesis outlined. It would suggest a multi-week/multi-month rally to ATHs within the broader market. This is supported by extreme sentiment readings. For example, the S&P 500 recently hit 22 on the daily RSI, a level only seen 5 times in the last 20 years, and each time showing positive returns 6 months from that reading.

On a micro view, it appears that the current bounce is still within the range of being a 4th wave within a 5 wave decline. Considering that the current c wave down is only showing a distinct 3 waves down, I wouldn't be surprised to see the market trend down into a lower 5th wave to complete the correction that started 9 weeks ago. If we do get another low into the Feb 3-11 time factor, I would consider this strong evidence that the above thesis is in play. 

On the other hand, if the market moves above 4585-4600, that will complicate the above scenario on a technical basis. I would not like to see us trend up into the February time factor after only giving us 3 waves down. My current count, for reference, has us in the final leg lower now, but we would need to see one more leg to retest the lows, at minimum. If we do not see this, It would mean that we have likely only experienced the first leg down, the current bounce is a b wave, with a c wave to follow to new lows. We will simply need to see what the coming week gives us.

If we do rally to new highs, once this rally finishes, we will likely see a larger deflationary correction in both price and time. So, any rally that we get would be an opportunity to de-risk as we head further into 2022. Note the larger degree (4) wave in our future (shown above). this lines up with the slow move into the deflation/stagflation macro quadrant.

Keep in mind, as inflation and economic growth start their decline, it is only a matter of time before stocks get the message in a meaningful way. Because this Deflation/Stagflation cycle is looming over any short-term economic boost, it is likely only some indexes and some sectors will make new highs while others make lower highs. This is common with risk assets. They tend to lead us into slowdowns and lead us out, which appears to be the case, so far.

For example, one of our favorite microtrends in play, which is only in its middle innings, is Cloud. The best proxy for this trend is CLOU, which is an ETF of cloud pure-plays (shown below).

One thing that is undeniable is that the excess sentiment from 2020 in high tech began to correct in February of 2021. As the broad market moved forward, cloud, which is arguably the strongest microtrend in tech right now, is providing us with a very distinct corrective pattern outlined in blue. This would suggest that this flush-out in January could setup the next large degree uptrend.

Even with this potential on the table, I’m leaning more towards the red path. This suggests that the high beta tech world is experiencing its first leg down in a larger degree 2nd wave drawdown. Like we see with high beta, they tend to lead us into and out of larger declines. So, as SPX and the DOW would potentially make a new high, continuing their uptrend, high beta would be in a b wave. Thus, we would see high beta bottom first, and begin its new uptrend as the broader market likely makes one more lower low.

Conclusion

Regardless of what plays out, we believe that valuations in key names are oversold and setting up for a decent comeback. As long-term investors in tech trends, managing sentiment is crucial. Though cloud is growing and well within the middle innings of adoption economically, the sentiment regarding the stocks that are setup to benefit from this growth experience wide and emotional swings. Just like we saw an exuberance stretching sentiment in one direction in 2020/Q1 of 2021, we are now seeing the reverse effect, which we believe is setting up great buying opportunities amongst specific names for long-term investors willing to ride out any further volatility, which is likely.

We do believe the market shifted into a risk-off investing environment in Nov/Dec of 2021 due to the realization of peak growth and the projections of peak inflation soon after. However, the consumer is starting to perk up, appearing to accept the new norm of heightened inflation. This, coupled with the real possibility of a post-pandemic economy and heightened inflation, is causing long-duration assets to get sold, which is affecting tech growth. When coupled with the oversold conditions in tech growth, the macro environment could be setting up for a recovery rally that could last well into 2022. However, we see any renewed uptrend as an opportunity to de-risk, and raise some cash until the global growth story bottoms and begins a new cycle.