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Musings Report 2022-5 1-29-22 Bull, Bear or Crash?
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For those who are new to the Musings reports: they're a glimpse into my notebook, the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books. As always, I hope the Musings spark new appraisals and insights. Thank you for supporting the site and for inviting me into your circle of correspondents.
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Bull, Bear or Crash?
Imagine a highly unconventional hedge fund offered to pay me an absurdly large sum for my analysis of what's most likely to happen in the asset markets and economy (only a highly unconventional hedge fund would even think of paying for my opinion).
Since no fund is crazy enough to make such an offer, I'm going to provide my analysis here. All banter aside, everything I lay out here could become consequential.
There are three basic scenarios for what happens in 2022: bull, bear and crash.
These aren't necessarily mutually exclusive: 2022 could include all three.
Within the Bull camp, the conventional "calm the masses" view is the bull market for stocks is intact and will resume its orderly ascent.
A contrarian view espoused by David Hunter foresees a massive blow-off rally to new highs followed by an 80% crash. Hunter forecast SPX 4,500 long before it was close to 4,000 so he has the credence earned by being right.
His targets are: SPX 6,000, Dow 45,000, Nasdaq 20,000 and the Russell 2000 at 3,000.
The Bearish camp can be subdivided into those who are a bit squeamish about calling for a bear market (having been burned for the past 13 years) and so their cloaked bearish call is for "higher volatility," which tends to manifest as wild swings up and down, i.e. a chop-fest that never establishes a long-term trend.
The second bear camp calls for an outright crash. Jeremy Grantham recently issued a forecast for a 50% decline in stocks as the immense "everything bubble" finally pops.
A popular view holds that stocks go up or down solely based on flows, i.e. money in or out of the market. With central bank money spigots wide open, flows have been into stocks, and so stocks have continued lofting higher regardless of any fundamentals..
Now that the Federal Reserve is proposing to tighten the spigot, it's reasonable to assume the flow of money into stocks will decrease, fatally weakening the bull market unless an alternative inflow of new money arises.
Two possible sources of new inflows:
1. If interest rates rise, that attracts capital seeking low-risk returns, but it also crushes the value of existing bonds paying lower returns.
Those holding the depreciating bonds might decide to sell their bonds. Since interest rates are moving higher, it's not smart to buy long-term bonds, which will depreciate as rates rise. So some of this money might rotate into stocks that might benefit from inflation. Since the bond market is so much larger than the stock market, even a slice of the bond market going into stocks could be consequential.
2. Global capital might start fleeing emerging markets as the global economy weakens and the US dollar strengthens, and some of this capital might seek the "safe haven" of dollar-denominated assets, as these will appreciate as the USD gains value relative to weaker currencies. Some of this capital might flow into US stocks.
If there is no new source of inflows into US stocks as the Fed tightens, it's hard to see how the bull market can continue higher, much less soar.
If one or both of these inflows materialize, bears could be wrong in assuming stocks will fall as the economy weakens. It's all about flows, and if $10 trillion is seeking the relative safety of US assets, stocks might benefit despite profits falling, costs rising, etc.
A significant amount of stock buying is based on the astounding increase in options trading as the younger generations of stock buyers trade options more than cautious seniors.
Each option--a call or put--controls 100 shares of the underlying security. So when a market maker sells you an option, they typically will buy 100 shares of the underlying security to settle the option when it expires.
All this is rather complicated, but if punters buy 100,000 options, then those issuing the options must own (or buy) 10 million shares of the underlying securities (1 option = 100 shares).
When millions of options are originated, hundreds of millions shares must be purchased. In effect, the options "tail" is wagging the stock market "dog."
This enables demand to be synthetically goosed: if I buy 100,000 puts, whomever sold me those puts needs to buy 10 million shares of the underlying security. Absent mass selling, this will push the securities higher.
In other words, the market is now much more sensitive to synthetic demand of options trading, and this, along with algorithmic trading, has changed the dynamics of the market, increasing the odds of the trading computers and options traders withdrawing from the market to reduce risk.
Absent these supports, the market is exposed to self-reinforcing selling and a crash.
One hears the word "liquidity" frequently. The shorthand meaning is simple: liquidity means there are buyers all the way down a decline in stock prices. If buyers vanish, the market is illiquid.
Former Fed Chair Alan Greenspan confessed that the drying up of liquidity in the 2008 crash--that is, the disappearance of buyers willing to buy shares from sellers--surprised him.
Absent massive direct purchases by central banks or their proxies, illiquid markets crash.
Insider trading scandals and the vast expansion of wealth inequality in the US will limit the Fed's ability to bail out the super-wealthy, banks and financial institutions. The Fed's role in enabling insider trading and boosting wealth inequality is now widely understood, and so the Fed faces political constraints for the first time.
Another potential factor is the reversal of the immense stimulus that was showered on households and enterprises in the pandemic era. These trillions were either spent or dumped into stock trading, and so it shouldn't surprise us that stock trading exploded higher and the real-world economy overheated as trillions in "free money" were spent within a short period of time.
Now the sugar rush is ending, there is no replacement source of "free trillions" to support stock trading or consumer spending.
I have made a number of arguments why inflation is now systemic, embedded and self-reinforcing; it is not "transitory." Inflation expectations will drive workers to demand higher pay and to higher prices, which will then push wages higher, and so on.
Simply put, the 40-year cycle of low inflation declining interest rates, and labor losing purchasing power, has reversed.
Supply chain costs will continue to rise as global labor and energy costs increase. Inflation is generally a negative headwind for stocks, as profits and consumer spending are both crimped.
If inflation is a negative force on stocks, then those who sell first will get the highest prices and those who "hold on for dear life" will absorb enormous losses.
It's not too difficult to imagine "smart money" selling to those who believe inflation is transitory, and propping up markets as they sell by buying huge quantities of options, forcing issuers to buy the underlying securities, artificially elevating markets to give the appearance of robust demand.
A few other dynamics receive relatively little media coverage. One is the hollowing out of US healthcare by the pandemic. The system was busy consuming itself even before the pandemic, and all the negative dynamics were reinforced and accelerated by the pandemic. There is no way to repair the system without making systemic changes, which insiders and profiteering corporations will resist with all their might.
The decay and collapse of healthcare is obviously not a positive for society or the economy.
Global energy supply is under pressure for systemic reasons I've covered many times, and the odds of supply declining faster than demand introduces the possibility of an "energy cliff" in which supply of oil and natural gas decline sharply, triggering supply / price shockjs which push consumer economies over the cliff into deep recession.
Since supply is inelastic--it takes years and billions of dollars to bring new sources online--such an energy-triggered recession would be a pit from which there would be no escape: Cheap energy has always been the escape ladder. No more cheap energy, no ladder out of recession.
Lastly, there's the largely unnoticed erosion of institutional competence and efficacy. Institutions that the public assumed were permanently competent and effective are increasingly revealed as lacking competent leadership, staffing, procedures, and accountability.
In effect, those inside institutions have been so compartmentalized and incentivized to put procedure above results (a topic I explore in my new book) that few even grasp the institution is failing.
Just as energy supplies can decline and then suddenly fall off a cliff, so too can institutional effectiveness and public trust.
How can a society and economy thrive as its core institutions decay and fail?
How long can a stock market soar as the economy it is embedded in decays?
In summary, here are the sources of crashes:
1. a decline in inflows
2. a disappearance of buyers (liquidity), both machine and human, as markets fall.
3. inflation isn't transitory and the risk-averse escaping from stocks turns into a stampede.
4. consumer spending and profits decline, removing the "growth" narrative as the support for stocks.
5. institutional failure causes public trust to decay.
6. The Federal Reserve is now constrained from bailing out insiders and "too big to fail" institutions.
If there is one single source of a market crash, then other dynamics can work together to reverse the crash.
But if multiple dynamics are largely reinforcing decay and collapse, then the market will not have any source for recovery.
Could Hunter be right and a final blow-off top take stocks to new highs? Yes, if massive inflows manifest.
But would such a blow-off top resolve all the other issues? No.
It's one thing to comment on the game from the stands. That's safe. It's another thing to go out on the field, make the play call, take the snap, and evade the linebackers intent on flattening you into the turf.
The glory of throwing the "Long Bomb" and scoring a game-winning touchdown beckons, but so does being sacked for a game-losing loss.
Are you willing to make the call and take the snap? If not, the sidelines are much, much safer.
Highlights of the Blog
podcast:
Charles Hugh Smith on Why Many are Resigning From Their Jobs (35 minutes)
posts:
No Wonder the Market Is Skittish 1/28/22
Inflation Winners and Losers 1/26/22
Why Bear Markets Are Tough 1/24/22
Best Thing That Happened To Me This Week
Enjoyed lunch at the oldest restaurant in Hawaii, the Manago Hotel in Captain Cook, Hawaii. Charming wood-frame hotel and restaurant, started in 1917 and still in the family.
Hawaii’s Treasured Time-Warp Hotels: The Manago Hotel, on the Big Island, opened more a century ago and feels remarkably unchanged (WSJ.com, 8/3/21)
From Left Field
NOTE TO NEW READERS: This list is not comprised of articles I agree with or that I judge to be correct or of the highest quality. It is representative of the content I find interesting as reflections of the current zeitgeist. The list is intended to be perused with an open, critical, occasionally amused mind.
We Shouldn’t Have to Work So Damn Much
How Much Did That New Kitchen Cost? No One’s Going to Tell You.--if you have to ask, you can't afford it....
On the Loss of Public Spiritedness in the West and the Impact on Politics
Why Don't People “Trust The Science?” Because Scientists Are Often Caught Lying--oops, this is inconvenient... people can be corrupted by money...
When Fossil Fuels Run Out, What Then? -- warp drive and dilithium crystals....
Trends in income and wealth inequality (2020) -- by the numbers...
United States Household Income Distribution (2021)
0.01% of Bitcoin holders control 27% of all circulating coins: Study
Job Recovery Lags in Many of Most Populated Cities in U.S.
Climate Clues from the Past Prompt a New Look at History
Entertainment Monopolies Are Zombifying Mass Culture: Mass culture is becoming a museum dedicated to itself, its artifacts curated by an ever-narrowing family of conglomerates. -- Star Wars #73 now competing with Batman #68...
What It Means to See Jesus: Robert Hudson’s 'Seeing Jesus: Visionary Encounters from the First Century to the Present'.
"If a battle cannot be won, do not fight it." Sun Tzu
Thanks for reading--
charles |
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