Going into February of 2021, we warned of a selloff based on weakening momentum trending into an important broad market time factor. We used this opportunity to raise some cash and even had a proactive hedge on QQQ at the time. This shift helped us remain competitive with the pros in the growth markets, as did our proactive move out of crypto (and back in again). Even when the growth selloff intensified into late Q1, many were calling for the end of the bull market, as we used that opportunity to add to some quality companies that were getting beaten up. Like many, we underestimated the difficulty in the high beta market, showing mixed results in our additions to high conviction/long-term plays, but we continued to hold the broader thesis that the bull market is not over, as we do today. I do believe we will see a return to 2020-style growth investing before this great bull market is over, but I also believe that we will get a chance to grab shares of targeted companies at lower prices first.
That being said, what I do want to point out is the difference between February 2021 and today. The economic environment tends to lend itself towards high beta being in favor or out of favor. Coming out of the 2020 bear market, we saw a large acceleration of economic growth with low inflation – ie, the perfect environment for our world. As inflation picked up in mid Q1 of 2021, growth investing became more difficult. We still saw numerous winners in this field coming out of the February/March selloff, so a more discerning filter really paid off. The reason for this is that we saw inflation and growth accelerating up at the same time. However, today's dip in growth assets and rotation into more deflation protection assets is signaling something different, in my opinion. I believe looking at the growth trends in the macro-environment will help clarify what that is…
First up, we'll look at our economic heat map.
Note the difference between February of 2021 and today. In February, inflation was starting to pick up but wasn't a major concern (according to the bond market). Also, note how we were in the early stages of accelerated growth in the US economy. Now, compare that to today – growth is starting to slow as our models expect the rate of change in this deceleration to start turning soft red in mid-late Q1. With inflation in the red as well, we also are expecting this slowdown to lead to inflation slowing down as well. We are seeing signs of this slowdown globally with China leading the way. Much like we saw a global growth push in 2017, the macro environment is suggesting a global growth slowdown into 2022.
Our quadrant analysis, which measures the Rate of Change of both growth and inflation in the US, is supporting this thesis.
The October data is being uploaded soon, but it will have the Oct. numbers closer to the bottom right quadrant – inflation/stagflation. This is a risk-off macro environment where high beta struggles, and we see a flight to real estate, utilities, staples, long-duration bonds, and very liquid mega-cap growth companies (exactly what has been working over the last month). We do believe this quadrant will take us into the lower left quadrant (deflation) in 2022.
With this in mind, think of the FED's position. They waited too long to raise rates so are under the gun to rush this process in order to have ammo to fight the next deep correction. So, with growth slowing, inflation peaking, and the FED in a rush to tighten conditions for the next reflation attempt, probabilities suggest that risk assets will continue to struggle until a floor is found in the economic slow-down.
But, don't take our word for it, just look what the bond market is saying.
Remember, long-duration yields are controlled by market expectations of growth and inflation (not the FED). As long-duration yields go down, it's signaling the same slow down our models are showing. The spread between the 10-year yield (not affected by FED policy) and 2-year yield (highly affected by Fed policy) has seen the sharpest flattening since 1994.
Interestingly, this also lines up with our Elliott Wave analysis. I have always been amazed at how using Fibonacci/golden ratio analysis on charts tends to predict future outcomes. Anyone that has been with us for a while knows that we've been talking about 2022 being a tough year based on this analysis alone. We now have a combined macro analysis, coupled with inflation and FED policy catching up to what Elliott Wave was predicting over a year ago.
Trends move in 5 waves in the direction of the predominant trend. this is true in all markets and on all time frames. Since March of 2020, the predominant trend is up. We have a clean 1st and 2nd wave in place (in red). In order to complete the minimum targets for the 3rd wave, we need the current trend to move us into the SPX 4900-5200 region. This will lead to the larger 4th wave, which we expect to be between a 10%-15% drawdown in early/mid-2022. We also have two important broad market time factors coming up – Dec 27-Jan 3 and one in late January (I'll narrow down the focus as we approach this). Almost every chart I map is showing the same inflection points.
These time factors are marking inflection points and how the market trends into them will be crucial. Interestingly, they are also lining up with what our models are suggesting – an acceleration of the global economic slowdown in late Q1 (remember, markets are looking into the future, so expect a top prior to the data coming out). Furthermore, if we look at inter-market signals, a similar warning is still present.
Our risk-on and economically sensitive sectors are diverging from the broad market. When we see this pattern, only one of 2 things will happen: (1) either the broad market is leading the risk-on sectors; (2) the risk-on sectors are leading the broad markets. With the preponderance of evidence discussed, we believe 2 is more likely as we push into early 2022.
Why This is Not the End of the Great Bull Market
In one word – liquidity. I've talked about this for several weeks, in various ways. Last week we showed the strange phenomenon that money market funds and the S&P 500 are both close to ATHs, which is one of many examples of the excess liquidity in the markets. This week, we will focus on how the flood of liquidity in the economy is affecting the banking system.
I, for one, do believe the central banking system will go down in history as a monumental failure. However, you have to play the market you are dealt – not the one that you want or think makes more sense. Many pundits have stubbornly ignored this reality, and as a result, missed out on one of the greatest bull markets in US history. That being said, this is a FED-driven, liquidity-fueled bull market, and the drastic actions taken by the FED (and global central banks) during the COVID crash last year is why we are continuing to push higher today.
In 2008, we saw a gradual tightening that ultimately put in motion the GFC. During this time we saw the first run on banks (and money markets) since the turn of the century. The fear was sudden and caused banks to shut the borrowing window for even qualified companies to refinance their debts. As a result, defaults intensified, and only exacerbated the problem. This liquidity/credit crunch was the primary driver behind the pain experienced in the GFC.
Compared to 2007/2008, last year the FED flooded the economy with excess liquidity that was needed by struggling companies to stay afloat. In other words, they guaranteed that a credit crunch would not happen. this lead to the bizarro world of monthly economic data that literally went off the charts in a negative way, while the stock market kept powering higher. As a result, it's hard to look at the current landscape and see any hint of a liquidity crunch. In fact, the opposite seems to be true.
Liquidity in Banks
We tend to see the beginning stages of a liquidity crunch in overnight markets. In other words, if a bank needs additional liquidity to meet their normal business demands, they will borrow this cash from other banks in the overnight markets. If these private banks see trouble on the horizon they tend to not want to participate in overnight loans, pushing the overnight borrowing rate up, and thus making liquidity even harder to come by. This lack of overnight liquidity begins to filter into the banking system and ultimately down into the economy. To combat this free-market phenomenon, the FED created the repurchase agreement program (Repos) to be the lender of last result. In other words, when no private bank wants to take on the counter-party risk of another bank needing cash to operate, the FED steps in.
Prior to the economic slowdowns, we tend to see the FED's repo program tick up, signaling that private banks are not willing to loan into the overnight markets.
Note how these repo agreements preceded major market events. It's a signal that liquidity is drying up, and this removal of liquidity from the market by the banking system is what ultimately crashes the markets.
Now, let's overlay this metric with inflation expectations (10 yr. breakeven rate) as well as economic growth (PMI – manufacturing).
Note how inflation peaked as did economic growth going into these liquidity crunches. What preceded was sharp bear markets in both instances. Now, note the 2011 and 2015 deep correction periods. We had a deceleration in both economic growth and inflation (much like we're projecting going into 2022), but there was no liquidity crunch. The result was either a sharp and quick selloff (2011), or a correction that was more in time than price (2015) before the bull market resumed. It's important to see that we are not in a similar liquidity crunch today. In fact, the opposite seems to be happening.
The FED also has a program designed to address this opposite problem banks can face, and it's called reverse-repo agreements (Reverse-Repos). Banks operate under strict regulations, one of which addresses the maximum amount of cash/credit they are allowed to hold relative to assets. If a bank is close to that limit, it will lend this excess liquidity to other banks for a small overnight rate. However, what happens when most banks are flushed with cash and cannot accept anymore? The FED steps in to be the buyer of last result, exchanging cash for bonds at a minuscule rate.
Today, the reverse repo operation is at record highs.
In other words, the FED is "borrowing" excess cash from banks on a nightly basis. This is what too much liquidity in the banking system looks like. Now, factor in that the FED is STILL adding ~$60 Billion of QE per month on top of the chart above!
So, like 2019 and 2008, the economy is starting to slow as inflation is likely about to peak. However, unlike 2008 and 2019 there is tons of liquidity in the system that has to go somewhere, and with the CPI running at 6.8% and likely to move into the 7% region, money markets and bonds are not very attractive. For this single, yet crucial reason, I see 2022's volatility to be more like 2011/2015 – an extended road bump in a much larger bull market, which we want to prepare our readers for.
Remember, the FED and global governments need inflation. It is literally the only way out of the massive debt obligations taken on by governments, aside from a default. the same problem was seen in the post-war 1940's – large increase in money supply as inflation ran hot for over a decade. This allowed the US government to get out from under their war debts, while the stock market went on a multi-decade bull market. This, I believe, is what the FED is trying to do today – get everyone used to higher inflation, so that the US has a shot of unwinding its debt. So, creating a market crash would not be conducive to this end.
Our Game Plan for 2022 and Beyond
Going back to our Elliott Wave analysis, if we are completing the 4th wave of the larger 3rd wave, that means that we have the final 5th wave to go. If everything moves as planned, which is always a BIG if, we will bottom into late December, and rally hard into the late January time factor, which is targeting the 4900 regions, at a minimum. We also know that we are in a stagflation/inflation style macro environment, which tends to favor mega-cap growth names. The type of mega-cap growth that is working right now is FAANG and semis. Since our recent entries in NVDA and AMD, we are sitting on 60% gains in just under 2 months, as LRCX and MRVL were almost at ATHs while the rest of tech sold off hard. You are seeing where the money is flowing in real-time. We plan to continue to ride this momentum as the SPX makes its minor 5th wave push, focusing on a potential MSFT play and continued adds to our semis.
Regarding high beta, we are trending down into the first-time factor, which, as previously stated, I'm expecting to be a low. This should kick off the final minor 5th wave push. Also, even though we are focusing on mega-caps and semis, I do not think risk assets are being completely left for dead on this push, as of now.
The options market is not as bearish on risk assets now as the popular narrative/Twitter suggests. Note how ARKK is showing negative implied volatility on a 30-day basis based on their recent realized volatility. When this pattern is present at market/asset highs, it's a big warning. However, when we see this closer to market/asset lows, it's a signal that the options market believes the volatility in this asset is likely to reverse.
So, over the short term, our plan is to continue to rotate into lower beta positions, ride any momentum of our higher beta plays (CFLT, VYGVF, ASAN, AFRM, etc), and then build cash along the way.
Over the longer-term time frame, we plan to have a reasonable cash position to accumulate shares of great companies for when the economic environment clears up and the bull market resumes. Our targeted themes will continue to be semis, as Beth's long-term thesis is starting to really pick up, as well as Cloud. As growth slows and rates move higher, borrowing costs will be affected as will revenue streams. In a slow-growth environment, we tend to see companies address margins in a much more aggressive fashion. We saw this in 2020 regarding cloud. The cloud migration intensified because companies saw that cutting costly IT infrastructure budgets and moving to cloud systems both reduced overhead and made their business more efficient. We believe the same will happen in the current environment.
Arguably, the most cost-effective microtrend is the work-from-home trend. This allows companies to reduce COL allowances as well as expensive real estate. This trend is here to stay, and we are only in the early stages. For this reason, we like plays like ASAN, ZM, MNDY, etc. Regarding Zoom, it showed a 94% enterprise growth on top of triple-digit comps. Yet, the market continuously beats it down as a consumer play that peaked during COVID. This is a mistake and allows for a great chance to buy a quality company at low relative valuations. Though we did not expect the market to beat it down this much, we do believe a relative floor is under Zoom based on its current price to forward growth projections.
Look for ideas like this as we move into 2022. If/when we start approaching any bottom from the coming correction we will shift our focus to more high beat/speculative plays. But, for now, defense is warranted for anyone looking to not be shocked by 2022. As always, we developed a thesis based on incoming data. If that data changes, so will our thesis and pivot. We are not looking to be right, only make money. Markets are fluid, and thus require the need for pivots If anything changes, you will be the first to know.
Also, it's important to not overreact and sell everything or buy everything in an emotional rush. Instead, we prefer to tilt our portfolio into a defensive/offensive posture. We will target 10-15% cash if our plan for a bounce manifests.