Hope Springs Eternal

Hope Springs Eternal

Way back in July, we got to a level of stress historically consistent with the Fed coming in to save the day, at least over the last 25 years or so. Since then, we’ve seen an endless stream of investors betting on a Fed pivot.

The level of complacency is incredible. It seems fourteen years of a generally supportive Fed has created a comfortably numb investor class. Who cares that bond markets are getting destroyed and currency volatility is off the charts, investors are more afraid they’ll miss the second the Fed pivots, and that seems to be the greater motivation.

I am somewhat sympathetic. I’m not going to pretend I’m not looking for a pivot. After all, at some point a pivot will happen, and it seems likely a fair amount of money should be made. The difference is that I see the potential for a great deal of danger between now and a potential pivot.

In my mind, current optimism is dangerous for investors and also detrimental to getting a good risk/reward place to invest for a bear market rally.

It’s detrimental for two basic reasons. First, every rally loosens financial conditions, which encourages the Fed to stay tighter for longer. Have you noticed how the terminal Fed funds rate keeps trending up? Second, the average investor is just incinerating their capital, shrinking what they’ll start with when the market actually does present good opportunities. They invest, get burned, and do it again.

I’d been hoping this week would provide a potential base to launch off of, with elections and kind inflation allowing markets to run. Unfortunately, markets have already priced in a fair amount of friendly outcomes, and both the Cleveland Fed inflation nowcast and data we’ve seen recently make it seem less likely CPI will be friendly.

Realistically, it’s starting to seem less likely inflation will be kind soon. Energy has started to move upward again, and it’s hard to see where the fuel for a sharp, quick inflation downfall will come from, particularly if investors keep betting on a pivot and lifting energy prices.

Under what grounds can we still be hoping for a bear market rally, then? Realistically, for a near-term bear market rally, we’re going to need to see something break enough to force the Fed to shift from fighting inflation to worrying about economic troubles. Right now, that seems like quite a big ask, but as we’ve seen before, trouble can spring up quickly.

On March 1st, 2000, tech, media and telecom seemed indomitable. By March 31st, that was no longer the case. On September 1st, 2008, the market had been hit hard, but was hanging on. By September 30th, after Lehman failed, markets had started another big leg down, with more to come.

To be clear, I can’t point to what specifically would break, nor am I even trying to predict that anything will break, soon. Right now, that seems like a low probability event. My point is just that the exact same thing was true at the start of March 2000 and September 2008 (the vertical lines above.) We need to be prepared for the possibility of a negative surprise.

Ultimately, investors are doing themselves no favors by chasing every possible hint of a possible pivot. It has impoverished them and helps force the Fed to stay tighter for longer. In turn, that’s increasing the odds of a significant crisis, to the point where I, personally, think that crisis is the most likely outcome. We can’t anticipate anything, though, just consider the range of likely outcomes.

All we can do is watch the data roll in and also see if anything breaks hard enough to get the Fed’s attention. To many investors’ surprise, it could be a long wait, and it seems very likely there will be more bumps in the road. Hoping too hard, too early seems likely to continue to be painful.