Table of Contents:

1) The Fed is telling us that they’re that it will take more than just a further slowdown in growth to cause them to shift their policy.

2) It will take more than a weaker economy to push inflation down to an acceptable level.

3) Deep corrections and bear markets don’t bottom at 16x-17x earnings.

4) The MACD charts on the SPX & NDX still look encouraging (but they have to rally more immediately).

5) Don’t look for pre-pandemic levels to give much support for the market or economy.

6) Another “lower-low” in the chip stocks. That’ not good at all.

7) What is the rally in the Treasury market really mean for stocks?

8) China’s stock market needs a breather near-term, but it does look quite good.

9) The 200-week moving average is critical support for the STOXX Europe 600 Index.

10) Summary of our current stance.

1) There is little question that the focus for investors is starting to shift a big from concerns over inflation…to the concerns about slowing growth. The problem in our minds is that too many investors don’t realize that a significant slowdown in growth is not going to force the Fed to shift their policy away from their current policy. They’ve told us that their number one fight is against inflation…even at the expense of growth. Too many investors don’t want to believe them…and that’s a mistake.

It is amazing to us that so many people think the Fed will change their policy in a meaningful way if the economy slows further. The Fed has been emphatic about telling us that they will do whatever it takes to fight inflation…even if its at the expense of the economy. In other words, unless we see some major stress in the financial system (the fixed income markets…like it did in late 2018), they’re going to do what Paul Volcker’s Fed did 40 years ago.

Nobody wants to believe Chairman Powell and the rest of the Fed when they say that they are willing to cause problems in the economy and the stock market to tame inflation. The Fed has told us that letting inflation get out of control now will make things much worse for the economy and the stock market…than it will if they continue to hurt them both to the degree they are right now. In other words, the Fed is picking the lesser of two evils…and yet nobody wants to believe them when they tell us this.

Don’t get us wrong, we understand why people don’t have a massive amount of belief in what the Fed says. Let’s face it, early in the year, they said that their tightening policy would not cause a lot of stress in the markets and would not have an outsized impact on growth. That was ridiculous. They’ve always knows in would cause a lot of pain. However, we DO understand that they have to fudge those opinions early on…or they would become self-fulfilling prophecies. (That, in turn, would cause the impact of their tightening policy to take place much more quickly…and that would make it much harder to control.)

However, when it comes to how they would act, the Fed has been VERY forthright. They spent much of the 4th quarter telling us that they were going to taper back on their QE program much more quickly…that they’d raise rates much more rapidly (and to higher levels)…and they told us that they’d shrink their balance sheet much sooner than anybody was thinking…..Then, in December, they confirmed all of these changes…and sure enough, they went ahead and did EXACTLY what they said they were going to do!

Today, we have Chairman Powell say on several occasions that they are committed “to doing whatever it takes to tame inflation”…and he has explicitly said that they will do this if even if it causes the economy to slow. On top of this, NY Fed President Williams said this past week that “Rates need to move much higher”…and Cleveland Fed President Mester said, that the Fed is “Just at the beginning of raising U.S. interest rates.” Finally, as we highlighted last week, former NY Fed President Dudley said that the Fed is “More focused on pushing down inflation than supporting economic activity” and, “The focus on price stability will be relentless.” (Anybody who thinks Dudley is making comments like this willy-nilly is kidding themselves.)

Too much of Wall Street ignored history when the Fed told us all what they were going to do back in late 2021. It should have been evident that when the Fed starts tightening when the market is extremely overvalued and extremely leveraged, it always causes the stock market to see a deep correction or a bear market. Now, many on the Street are ignoring the fact that the vast majority of today’s inflation problem is due to supply issues, not demand issues. Therefore, the slowing economy will not help tame the inflation problem anywhere near as quickly or as meaningfully as many pundits are thinking right now.

In other words, too many people on Wall Street are ignoring history once again. When inflation is supply induced and thus creates stagflation (like it did in the 1970s)…and it stays high for a very long period of time. Therefore, the Fed will have to tighten in a more aggressive fashion (and for longer) than most people think (just like they did in the late 70’s and early 80s).

The Fed told us what they were going to do in December of last year…and they did it…and the markets reacted the same way they have in the past. The Fed is telling us something else right now…and it sure looks like they’re going to follow through with it. The results should follow history once again. Again, the Fed has been “EMPHATIC” in saying that they’ll fight inflation at the expense of growth if need be.

Of course, they WILL be FORCED to change their policy if the financial system starts to see some very serious stress. However, if THAT happens, most risk assets will have fallen A LOT MORE than they have already BEFORE the Fed shifts gears. So, be careful what you wish for.

Thankfully, this process will create some unbelievable opportunities down the road. It’s just a matter of navigating this process in the kind of way that will allow us to take advantage of the opportunity once it finally presents itself……Yes, the Fed has “fibbed” a little bit when they’ve said some things in the last year, but they’ve been quite honest when it comes to telling us what they’re actually going to do. Right now, the Fed is telling us that they’re that it will take more than just a further slowdown in growth to cause them to shift their policy.

Therefore, we believe that those who think that the Fed will not have the stomach to keep on tightening if the economy weakens…but inflation stays high…are wrong. (Inflation will very likely come down, but we strongly believe that it will stabilize at a level that is quite high…too high to get the Fed to reverse policy……We’d also highlight that the fact that the Fed Funds Futures are pointing to a rate CUT next year mean absolutely nothing. Experience tells us that the FFF’s are only accurate for the very next meeting. When you look out further than the upcoming meeting, they are frequently worthless.)

In other words, the people who think the Fed will change their policy much more quickly than the Fed is saying right now fall into one of two categories. The first one is the people who think their tightening policy will change because something will “break” over the next several months. This is quite possible, but if that happens, the stock market will fall a lot further…so it’s not a reason to be bullish right now. The second group is based on the hope that the Fed is bluffing and that they’re just trying to talk inflation down. However, when inflation is supply driven like it is now, it’s all but impossible to jawbone it lower. Jawboning might be able to scare people into lowering their demand for goods and services, but it does not increase supply of things like wheat, soybeans, corn, crude oil or natural gas. We think the Fed knows this…and thus we also thing that they are not bluffing….…….Hope is not a good investment strategy…and neither is fighting the Fed.

2) We are NOT saying that the economy is not weakening…or that it will not weaken in a significant manner. We’re merely saying that it won’t be enough for the Fed to reverse their policy unless we move to the brink of another possible crisis. Therefore, we still believe that the economy is headed for a recession (which we’re probably already in). So, we haven’t changed our tune on that front.

It is becoming more and more evident that the significant slowdown in the economy that we’ve been calling for since the 4th quarter of last year is coming to fruition…and that the recession we’ve been calling for since Q1 of this year is very likely as well. We got confirmation last week that Q1 growth was negative…and we now have the estimate for Q2 growth from the Atlanta Fed’s GDPNow reading looking for negative growth in Q2 as well. (It’s now -2.1%...down from their previous reading of +1.0%.) On top of this, we have record low numbers in consumer confidence…decades low numbers in business confidence…seven months of declining real wages…a big drop in searches on the travel websites…a big drop in restaurant reservations on Open Table…a slowdown in housing…lowered guidance from retailers like TGT, WMT, RH, BBBY, etc….and a recent plethora of upcoming layoffs from several big U.S. companies.

The weakness we’re seeing in these, and other areas means the economy is weakening in a significant way…and very likely headed for a recession. As we will discuss in the next bullet point, this will cause earnings estimates for 2022 (and likely 2023) to come down in a meaningful way. However, before we dive into that issue, we want to discuss what this further economic weakness mean for inflation…and for how the Fed handles the situation going forward.

The fact that we are seeing so many signs of weakness…and further weakness to come…DOES mean that we should indeed see a decline in inflation at some point in the second half. As demand drops, the prices of some (maybe even many) products and services WILL fall. However, in the areas that are seen as essential for everyday life (food and energy), demand is not going to fall as much as it is in other areas. (They’re ESSENTIAL, so people will pay what every they have to for them.)

One of those essential items, energy, will very likely remain high even if the economy slows considerably. Due to the lack of capital investment in fossil fuels (and thus the lowered capabilities to increase supply of most energy sources)…and (especially) the war of attrition in Ukraine…a drop in most energy prices to pre-pandemic levels is very unlikely. In fact, we’ll be lucky to see a minor decline from current levels.

The same is true for many agricultural prices that is so important for food prices. (Yes, wheat is down 30% since mid-May, but it’s still more than 40% above its pre-pandemic levels of early 2020. It’s also becoming quite oversold, so it could rebound at any time.) There are some signs about barge traffic in the Black Sea is getting better…and they are using land sources (rail/truck) to get ag supplies flowing better. However, those flows are still going to remain very constricted. When you add the fact crop that will come to market soon had to use extremely high fertilizer prices to produce the crop…it’s quite evident that food inflation is going to be a problem for some time.

In other words, just like it was in the 1970s, a drop in demand is not going to cause inflation to come down enough to alleviate the growing strains on the consumer (64% of whom live paycheck to paycheck). This is especially true if the oversold charts on wheat, corn, crude oil and natural gas mean that we’ll get another bounce in these prices before long.

The war of attrition in Ukraine means that we won’t get much relief in food prices to help the average American. This war…along with the inability to really increase energy production in any significant way…means the average American won’t get help on that front any time soon either. This means overall prices will remain high…even though demand will continue to fall. Put another way, we are now in a period of stagflation…one that will last for more than just a few months…and stagflation is not good for most risk assets.

3) We have been saying for many, many months that we thought the stock market had only priced-in the change in Fed policy (and the revaluation of risk assets that had to go with it)…and that the next shoe to drop was going to be the repricing of economic and earnings growth. That theme has finally become a very popular one. As investors come to grips with lower earnings, the stock market should fall further in the months ahead.

Late last week, Michael Burry of “The Big Short” fame tweeted out that he thought we’re probably just halfway through the bear market. That might be a bit aggressive, but we did find it interesting that he said that the first half of the decline was driven by market compression…and the second half will be driven by earnings compression.

Of course, this is EXACTLY what we have been saying for many months…and have repeated ad nauseam in recent weeks. We have been saying that the decline we’ve experienced in the stock market so far has not priced-in a recession. It has merely priced-in the fact that the stock market now has had to fall back to valuation levels that are more inline with historic levels (when massive central bank liquidity was not pushing them artificially higher). NOW, we have been saying, the market is going to have to contend with the fact that the “E” part of the “P/E ratio” is going to have to come down…which means the market is going to have to fall a lot further than it already has before it reaches “fair value.”

Not only has Mr. Burry come to this conclusion, but it has become something that a lot of investors are now thinking about as we move into the 2nd half of the year. However, just because we are no longer in the significant minority when it comes to thinking earnings estimates will have to come down, it does not mean that it’s already priced into the stock market!

At the risk of being repetitive, we’d like to continue to highlight the numbers we have been reciting for quite a while. If the stock market is going to return to the valuation levels that existed before the Fed’s massive QE programs of the past dozen years (and rise in interest rates we’ve seen), it’s going to have to fall to the 15x/16x forward earnings to reach “fair value.” Therefore, even if earnings estimate don’t come down, the S&P is going to have to drop to the 3800 level. If, however, those estimates do decline…from say a 10% gain to just a 5% gain…that takes the S&P down to about 3,350. If it turns out earnings are going to be flat for this year (which we think is highly likely), that takes the SPX down to (or below) 3,200.

Of course, if earnings estimates come down in a significant way (and move into negative territory)…and they start to fall for 2023 as well (neither of which is out of the question)…the 3,000 level comes into play. On top of all this, history tells us that when an expensive and overleveraged market rolls-over, it almost always never stops at fairly valued. Instead, it almost always falls to undervalued before it bottoms. Therefore, the odds that a drop into the low 3,000’s takes place for the S&P 500 are much higher than most people think today.

There is little question that sentiment is quite bearish today, so the bulls DO have something they can hang their hats on right now. We’d also note that sentiment in the crypto market is about as bad as it gets. With such low sentiment…and the fact that Bitcoin has become quite oversold on its weekly RSI chart, it could see a bounce quite soon. Given the strong correlation that we have seen during most of this year between the two, a bounce in Bitcoin could give us a short-term rally. However, the line of least resistance on an intermediate-term basis (multi-week) and longer-term basis (multi-month) is lower.

4) The stock market did not see a big quarter-end rally last week, but it still ended the week in much better shape than it was looking Thursday morning. This left the MACD charts on both the S&P 500 and NDX 100 looking pretty good. Therefore, even though we’re very cautious on the market right now, it could still give us a further bounce off its mid-June lows.

Last weekend, we highlighted how both the MACD charts on both the S&P 500 Index and the NDX Nasdaq 100 Index had seen positive crosses. Therefore, if they continued to rally this past week…and those “crosses” became more meaningful ones…it would be quite positive on a short-term basis for the stock market. Well, they both sold off quickly last week…and things looked particularly dicey on Thursday morning. However, the market was able to pullout of its nose dive…and rally back very strongly on the last day of the quarter. It was also able to shake-off some weakness on Friday morning…to rally nicely on the day before the long weekend as well. These bounces turned a loss of over 4% on the week into a decline of “only” 2.2%. (The bounce off the lows on Thursday morning left the NDX with a 4.3% loss…instead of a 6.5% loss it was staring at in the first hour of trading on Thursday.)

More importantly, it left the positive crosses on the MACD charts for these two indices intact. However, these “crosses” are still very minor ones. We got a couple of those in both indices in February and March…and they turned out to be head fakes…and they both continued lower in a significant way in those late-winter months. Therefore, we’re going to have to see some strong upside follow-through from the late-week rally next week, or it will raise the odds that we’ll get the same kind of head fake we got a couple of months ago.

When you combine these MACD charts…with some of the sentiment readings we’ve seen recently…and there are still reasons to think that the market could see some more upside movement in early July.

Don’t get us wrong, we’re not saying that the technical picture for these indices are suddenly looking good if you look at them on an intermediate/longer-term basis. They both continue to make “lower-highs/lower-lows” on a very regular basis, so it’s only their short-term potential that could give them a bit more of a boost in the days ahead. In fact, it will take a rally above the early June highs (of 3911 on the SPX and 12,900 on the NDX) to shift our intermediate-term opinion.

As we all know, bear market rallies can last for several weeks sometimes…and there’s little question that we’ve seen some wild moves this year (including late last week). Thus, anything is possible. As we have always said, if somebody is will to pay well over $100 million dollars for some paint splatter by Jackson Pollack, ANYTHING is possible!!!

(Although my all-time favorite was the work…“Near opposites”…that I saw at the Guggenheim once. I was in my early 20s and the display was one that showed a giant off-white mural next to a giant purple one…on perpendicular walls. Nothing else in the room. There were two people gazing at it in amazement, but I only lasted about 10 seconds on that one………When we decided to move to another floor about 45 minutes later, we went past that display once again…and the same two people were still staring at it. I went over to them and said, “Are you kidding me?”….just before my then-girlfriend quickly yanked me away.……I liked A LOT of what I saw that day, but that one was ridiculous.) 😊

5) Earlier, we used the “pre-pandemic level” as a gauge for inflation prices. Others use it as a gauge for the economy and the stock market. However, in the pre-pandemic timeframe of early 2020, the economy and markets were pushed to artificially high levels. Therefore, the fact that many commodity prices are still so much higher than those levels is even more concerning. It also means that we should not look for the early 2020 level of the S&P to provide a lot of support for the stock market.

The term, “pre-pandemic levels” is one that we all hear quite often. In fact, we used it earlier…when we said that the food and energy commodity prices are still a lot higher than they were in early 2020 just before the pandemic wreaked havoc on the world. The problem is that those pre-pandemic levels are not good ones to use as a starting point for analysis. The market (and thus the economy) were artificially higher in late 2019 and early 2020 by another Fed QE plan.

Back in September of 2019, the repo market began to freeze up. (There were a lot of rumors about why it started to freeze up…like problems at Deutsche Bank. However, we never found out the specific reason this mini-crisis took place, but it DID take place.) As we all known, the repo market is critical in the everyday running of the global financial system, so the Fed acted quickly with another QE program. This new injection of liquidity helped the S&P 500 rally over 17% from September of that year into early 2020. It’s no surprise that this program coincided with a more than 10% rise in the CRB Commodity Index and a 20% rise in WTI crude oil.

This artificial stimulus took the S&P 500 index up to more than 20x its forward earnings. This was higher than any time we had seen since the dotcom bubble of the late-1990s/early-2000s. Therefore, you can see that if the stock market falls towards those pre-pandemic highs, it will not take the S&P down to a fairly value level. Of course, the earnings on the S&P 500 will very likely be higher in 2022 than they were in 2019. Thus, the market will very likely be cheaper than 20x earnings if/when it falls toward the pre-pandemic levels of about 3400. However, just because it will be less expensive than early 2020, it WON’T be cheap if the earnings forecasts for 2022 & 2023 start to come down like we expect them to. Therefore, we are do not expect that “old resistance” level to become “new support” as we move through the year.

Similarly, the boost that commodities saw from the Fed’s 2019 QE program took them to artificial levels as well. Therefore, the fact that the food & energy prices are still WELL ABOVE those early 2020 highs shows just how bad the inflation picture has become this year.

What we’re saying is that it’s going to take a herculean effort to tame inflation…and when the dust settles, the stock market could easily be standing at a level that is well below the pre-pandemic levels we saw in 2020.

6) It was already a rough week for the chip stocks last week, but when Micron (MU) reported their earnings Thursday night, it kicked the stool out from under the SMH semiconductor ETF. Some of the individual names are getting oversold, but the SMH has not reached that level yet. Therefore, the new “lower-low” in this key leadership group is another item for the bearish side of the bull/bear ledger right now.

In one of our “Morning Comments” last week, we said that the chip stocks could/should be quite important for how the market acts between now and the meat of earnings season in July. Well, the SMH semiconductor ETF rolled-over in a significant fashion midweek last week…and continued lower for the rest of the week.

The decline started with a 4% drop from the intraday highs on Tuesday and left the SMH 2.5% below Monday’s close. It also gave the SMH an “outside-down” day. (A higher-high than the previous day’s high…lower-low than its previous day’s low…and a close below the previous day’s intraday low.) These “outside days” can frequently signal a reversal in the near-term…and it sure played out that way the rest of last week. The SMH finished the week with a loss of over 9%. More importantly, it gave the ETF another “lower-low” in a series of “lower-highs/lower-lows” since the beginning of the year.

We’d also note that SMH looked to be headed for a positive cross on its MACD chart early last week, but it rolled back over with the onslaught of selling in the group as we moved through the week. Needless to say, this is not a good development for the stock market. The chip stocks are either a leading indictor for the broad stock market or a coincident indicator. It is not a lagging indicator. Therefore, it is much more likely that the S&P will follow the SMH lower…than it is that the SMH will bounce back in a major way…….Yes, the SMH is getting close to oversold levels…but it’s not there yet…so investors should be quite wary of the action in this group right now.

7) The Treasury market has seen a strong bounce recently…which obviously means yields have seen a meaningful decline. The weakness in growth deserves a lot of the credit for this move, but the yield was quite overbought to begin with. We’d also note that with recession fears rising, some of the move can be attributed to a “flight to safety” trade for many investors…..If yields stay down, it will depend on WHY they stay down when it comes to trying to figure out what it means for the stock market.

The Treasury market has rallied strongly from its very oversold condition (overbought on yield)…since mid-June, and a lot of people are thinking this is telling us that the Fed will reverse their tightening policy soon. This might indeed be the case, but given what we have said above on the subject, you won’t be surprised by the fact that we’re not taking this move in the bond market as one that will push the Fed in any material way.

We’d note that the yield on the 10yr note dropped between 5% and 10% a full seven times when Chairman Volcker was putting the screws to inflation in 1981 and 1982. We’d also note that the 17% drop in the 10yr yield is about the same as the 16% drop that took place in March. Back in March, some people call it the low for this cycle, but obviously bounced back quite quickly. (There was also a 12% drop in the 10yr yield in May…and that was followed by a strong bounce as well.) No market moves in a straight line…and this includes the bond market…even when the Fed is tightening in a meaningful way.

Having said all this, the price on the 10yr has not become overbought (and thus the yield on the 10yr Treasury note is not oversold). Therefore, they could keep moving in their current directions for a while longer (up price, down in yield.) A lot of people might think this would be quite positive for the stock market. However, we have to be careful what we wish for. If the Treasury market rallies further (and yields continue to drop), it could very well signal that a “flight to safety” move is taking place…rather than an upcoming change in Fed policy.

Either way, we’ll be watching the late May low in yield of 2.75%. If the yield drops below that level…thus giving it a key “lower-low,” it should mean that the rally in Treasuries has legs. Therefore, those who like the TLT Treasury ETF (or Treasury bonds in general) should look at that level for guidance…when they’re trying to figure just how long this rally will last. (It should last longer if that yield level is broken.)………In other words, we think that a further rally in Treasuries (lower yields) is quite possible. We do not, however, think it will necessarily be a bullish development for the stock market.

8) China’s is moving away from their severe lockdown rules…and the Chinese “election” is coming up. We also have the Shanghai Index and the FXI China large-cap ETF testing key resistance levels. Therefore, the rally we’ve seen in Chinese stocks could continue quite nicely in the coming months.

China took another step towards easing covid restrictions last week by allowing most people to move freely around Shanghai…and announcing that that they will allow transit via a third country. Therefore, the slowdown in global growth we’ve been seeing should get a little bit of help from this part of the world going forward. As you can gather from what we’ve been saying in this weekend’s piece, we do not believe it will be enough to the slowdown from continuing, but it could/should make one of the headwinds were facing a bit less severe.

We’d also note that the Chinese “elections” are coming up in November…with President Xi basically looking to become their leader for life. It sure doesn’t look like Mr. Xi will have any problems getting re-elected, but he also know that there IS one thing that could throw a wrench in the works over the next few months. That one thing is widespread social unrest. The odds of this becoming a big problem for XI are EXTREMELY LOW, but why take the chance? In other words, re-opening the country to a certain degree…and holding off from cracking down any further on any of their industries…would seem like the right play for President Xi to make right now. (Once he has an even firmer grip on power, he can resume the policies he’d like to use. No, we’re not saying that Mr. XI is going to engage in another round of crack-downs right after the election…but it IS quite possible. However, it makes sense to us that he’d hold off until then. (It sure as hell wouldn’t be the first time he changed strategies for a period of months before a big event in his country.)

These developments are taking place at a time when the Chinese stock market is testing a key resistance level. The Shanghai Index is testing its 200-DMA

Posted to The Maley Report on Jul 06, 2022 — 4:07 PM
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