Kids are back in school. Fall has officially arrived and with that spooky ghosts and goblins will be roaming our neighborhoods in search of tricks or treats. The markets are also in official trick or treat mode as well.
We know that August and September tend to be the worst months of the year, with October typically marking a culmination of negativity. This August and September (and maybe October too) are following history. Will this be the pause that refreshes the market, or will we have a pullback that is worse? Truth is, nobody really knows.
Of course, there are two ways of dealing with this as an investor. You can be a “strategic” investor (buy and hold) and ride the waves up and down. We would be the first to say that is a very viable option, IF you don’t get swept away with your emotions. Now we know based on behavioral economics that most people make emotional decisions with their money at the exact wrong time. We have watched people let their emotions get in the way of sound decision making, and that usually happens around the bottom of the market.
The other way of investing is “tactically.” Looking at the data and making adjustments in the portfolio to minimize volatility. Sometimes that’s easier said than done, such as those times our good friends at the Federal Reserve pull the rug on the market and do a 180. Will that happen this time? Only time will tell.
I would argue that the flexibility the FED has had over the last 15 years (resulting from little to no inflation) is largely gone and the playbook that worked over the last 15 years may not work this time around. Of course, the playbook was that anytime there was a pullback in the markets the FED would cut interest rates and throw money at the problem. This was called Quantitative Easing (QE1-2008, QE2-2010, QE3-2012, QE4-2020). We can see this in the FED balance sheet.
But wait, what is Quantitative Easing? Here’s a nice graphic.
That has definitely been the playbook. But the thing we didn’t have during those 15 years was inflation. See the next chart.
So, let’s explore what this change means. As you know, we have been saying that inflation would come down – and it has. And we think it will stay down in the 3%(ish) range going forward, with one BIG caveat. If the FED decides during the next economic slowdown to go back to the same playbook, we expect inflation to ramp up. Probably significantly.
Several months ago, we talked about the bullwhip effect. It’s possible that if they try to run the same play, inflation will get even worse than it did this time around. They have professed to want to get inflation down to that 2% target. Throwing massive amounts of money to revive a slowing economy would seem counterproductive to me. Would it work in the short run? Maybe. In the past we have quoted famed economist Milton Friedman. Here is his famous quote.
And to piggyback that quote, here’s another classic definition of inflation.
That can come in the form of too much money, but also in the form of low supply of goods. Or in the case of COVID, it was both – too much money and too little supply. A double whammy! Here’s a Harvard Business Review paper about it (click here) in case you want to read more.
I would argue that doing a QE5 would be a bad idea. Much like doing drugs will give you a short term high, that high always wears off and your feel worse than you did before.
And we see that short term high wearing off, as the Federal Reserve engages in QT (Quantitative Tightening), the opposite of QE, by raising interest rates and pulling money out of the system. As you know, we have been talking about that for a while. We recently mentioned that most excess savings had been used up by people. Here’s a quick chart.
This was published in a piece written by the San Franciso Federal Reserve back in May of this year. You can see as of this chart that there was still an excess of $500 billion in Pandemic savings. That money is likely used up now or will be shortly. We know that credit card balances have now topped $1 trillion. We would argue that QT is having its desired effect.
That leads us back to the original question. Is this just a pause in the market or something more? We know that every major bear market starts with a 5% pullback. But not every 5% pullback turns into a bear market. Here’s an interesting look at market cycles from our friends at SentimenTrader.
We are at stage 5 right now. The question is, “Will we go to stage 6 and turn around or go to stage 7?” Below are charts of the major markets. The small cap stocks (IWM) are below their 200-day average. Everything else so far is still above.
Our thought was the market would either broaden out or fail. Based on the small cap stocks, I would generally say the market has failed to broaden out so far. In addition, our Money Flow indicator has turned decisively negative and is about to go on a sell signal.
So, the one question I want to leave you with is this. If the market were to go into stage 7, how would you want to handle it? Strategic or Tactical? Let us know your thoughts on that. I hope you have a great week, and please let us know if you have any questions.