Shall We Dance?

Shall We Dance?

Where do markets go from here? It seems like there are a lot of strongly held ideas out there, but I’d say, overall, it’s a pretty complicated dance. Depending on your time horizon, I would think both sides will be able to claim victory.

Short term, it’s easy to imagine we could get a market bounce. The dollar got very overbought, everything else got pretty oversold, and as quarterly OpEx and related hedging ends, the fuel is there for a bounce. Great.

Unfortunately, everything else looks bad. QT is really starting to hit liquidity, more hikes are expected, inflation data has stopped going down, jobs and spending data aren’t telling the Fed to stop, volatility remains persistently high, most companies are in their buyback blackout period, and we’re entering mutual fund tax-loss season.

In terms of future data, inflation has become the Fed’s only job, so every inflation data point is of outsized importance. We get the next CPI numbers Oct. 13th. The Cleveland Fed Inflation Nowcast isn’t very optimistic on the number, and I have no reason to doubt them. They currently expect headline CPI of 8.2% and Core CPI of 6.64%. That’s just too high for the Fed to back off, and that means their intentions of hiking 75bps on Nov. 2nd are likely to come to fruition, unless something breaks spectacularly before then.

Third quarter earnings could be very interesting and fairly binary. On the one hand, recent earnings calls and warnings have been quite ominous, but on the other hand, could too much bearishness lead to a repeat of Q2 earnings, where not-so-great earnings were met with buying?

Corporate earnings are a nominal number. In theory, inflation can be a positive for earnings. While you do have the question of their costs, Darius Dale of 42Macro points out that while employment costs are up, they’re not up as much as nominal growth, and that’s a major corporate cost. That helps explain why corporate earnings have sustained as well as they have, as inflation has outpaced employment costs. Can that continue for another quarter?

My expectation is that earnings end up looking bad. This is a common time for companies to reassess both the current year and next year, and we’ve been seeing that with a wide variety of corporate warnings. It seems price hikes haven’t been enough to cover other problems, like waning demand. Recessions contain earnings recessions, and we haven’t seen one, yet.

That said, if data surprises, we could see volatility express to the upside. The way I broadly view risk is like a rubber band stretching. Most of the time, the rubber band snaps back, but sometimes, it breaks. When dealing with unusual circumstances, I think experience starts to matter more. In this case, I keep thinking about how real market crashes come from oversold conditions. The rubber band stretches, then it breaks.

I can’t say a break is definitely going to happen, but bear markets are designed to hurt bulls and bears alike. Protecting the downside is of primary importance, so you have to consider those risks, and control risk as well as you can until conditions start to clear.

So, what’s the plan? A short-term bounce seems pretty reasonable, and we’d use that potential upside to make sure we’re happy with our portfolio’s ability to withstand potential pain. Until we see financial conditions loosen, it’s hard to see any lasting rally.

That said, the further we go down, the greater the potential bounce. Imagine if the Fed did relax? The reaction should be quick and powerful. Unfortunately, the most likely way we see a Fed pivot is a major accident. That’s a painful journey, so it doesn’t pay to anticipate that event, though others have clearly been conditioned to do so by the last 14 years of easy financial conditions. Times change. The foreign exchange (FX) and bond volatility (see below) are unlike anything we’ve seen in decades, and arguably are worse than we’ve ever seen. This is a dangerous dance, and we need to keep that in mind.

Times will get better, but for now, at least, we need to stay on guard. We also need to stay very humble and open-minded, though, as the volatility can happen both up and down. Maybe corporate earnings aren’t so bad, or are priced in. Maybe CPI data isn’t so bad. Maybe the Fed is just a little less hawkish. Maybe a BoE-like surprise will happen here. This is a time to watch very carefully and thoughtfully.

One way or another, there will be a better market, and I’d say there’s a good chance we will see higher levels than we’re seeing now, likely within the next year, and I’d guess sooner than that. It’s too dangerous to have much confidence investing right now, though, because there are too many potential problems. That will change, and the current plan is to arrive at that change with as much wealth intact as we can.