It's So Bad That It Is Good! Inflation Expectations Are Falling.
Many have heard the story about a person who walked into a room and saw a
man banging his head against the wall. He asked the other man why he was
banging his head against the wall and the reply was, “because it feels so
good when I stop.” Sometimes, conditions are so bad that they are good.
I have learned that trying to create a market outlook by figuring out if there are
more positive or negative factors does not work at times like this. We must always
remember that stock and bond markets are forward looking mechanisms. They are
like a barometer instead of a thermometer. Investors are usually reacting today
based on what they think will happen 6 to 12 months from now. This is why
markets can start to rise well before there is a meaningful improvement in the
economy or to the factors that are causing problems.
Therefore, I have found that the best way to determine when markets are close
to a bottom is to see how severe the selling and pessimism has been compared to
other times when bear markets have ended. The situation is always different but
there is one constant that has not changed in thousands of years - which is human
nature. As a result, the human reaction to negative events has been very similar
over the decades.
First of all, the selling last week was the worst since the S&P 500 fell 34%
during the Covid selloff in March 2020. Selling last week was unusually heavy,
similar to other times when the selling has been exhausted. Pessimism, according
to Investors Intelligence, increased even more last week to the highest level since
the Financial Crisis in October 2008. The editor writes, “Negative spreads point to
lower risk for longs (buyers) the larger they get!” See how high levels of
pessimism are correlated with market lows in the green chart of the S&P 500 on
the previous page. Sentiment is now so bad that it is good.
Many indicators are accurate 75% or 80% of the time, but I like to look at
indicators that have been accurate 100% of the time over a long period. There are
not many of these!
ModelEdge has a model analyzing factors that measures excessive optimism
and pessimism. It is also a gauge for how investors are acting to taking risk (Risk
On) or avoid risk (Risk Off). This model just reached zero for only the sixth time
in the last 22 years, as indicated by the red dots. This is also so bad that it is good!
Please see the table showing the returns after this indicator has reached zero below.
The S&P 500 was up four times out of five after 1 month with an average gain
of 5.4%. The worst result was a loss of only 1.1%. The S&P 500 was up 100% of
the time after 2 months with an average gain of 6.2%. Stocks were also up 100% of
the time after 3 months with an average gain of 7.1%. The indicator was premature
in its projections during the Financial Crisis when stocks sold off for almost 2
years. Even so, the average gain after 6 months was 11%, which includes the loss
of 3.7% after the indicator reached zero in February 2008.
Stocks were in a consolidation phase during the Financial Crisis and are in a
growth phase now. The yield curve inverted AND oil prices rose 80% in a 12-
month period before the Financial Crisis. This time, the yield curve has not
inverted. However, oil prices did rise more than 80% in a 12-month period as of
last year, warning us that there could be a 20% stock market decline in the next 18
months. This what we have been experiencing.
What we can learn from this is that excessive pessimism and the move away
from risky assets has now reached a rare extreme, moving this indicator to zero. If
history repeats, the risk of additional declines in the next two and three months is
also zero. The probability of respectable progress in the next three months is as
high as it can get. If we look at the 6-month results, the worst-case was a loss of
3.7%, which is not severe. However, as mentioned on the previous page,
conditions now are very different than they were in 2008. In summary, after
falling 10 out of the last 12 weeks, the probability that stocks have bottomed is
extremely high. It is important to understand that this conclusion is not based on
my opinion about all the variables at play. It is based on how human behaviour is
reacting to current events in the marketplace and comparing this to how they have
reacted in the past. In my experience, this is the best way to understand what
should actually happen in the future.
Inflation Expectations Are Already Falling
Rising interest rates are the major concern right now, which makes a lot of
sense. Interest rates are indeed one of the most important factors that affect all
asset prices. Supply chain issues caused by Covid has caused rising prices, which
gave inflation a boost. The Russian invasion of the Ukraine caused prices for oil
and many other essential materials to shoot higher. This all created a perfect storm
for inflation, which is now being reflected in the current inflation data.
The question investors have to ask is, how likely is it that prices are going to
continue to rise at this current pace? What will the inflation level be in 6 months
or 12 months from now? US employment levels are now back to pre-Covid levels.
Lockdowns in China due to Covid are ending. This should help to get the global
production of goods closer to normal levels as well.
Based on the history of what has happened during long-term cycles in the past,
my forecast for oil prices, made in the December 9, 2014 Investment Update, was
that oil prices should trade in a range of US$35 to US$75 for the next decade or
so. Oil prices were in the US$100 range at that time. The chart from Trading
Economics on the previous page shows that oil prices have indeed spent most of
the last 8 years trading in the range of $35 to $75. Prices have dipped below $35,
falling to below zero for a few weeks (which this monthly chart does not show),
and are now trading above $75. However, if history continues to repeat, my
forecast should continue to be accurate. This suggests that oil prices should fall
down below $75, not rise from here.
High inflation has forced the Bank of Canada, the Fed and other central
banks to raise interest rates after keeping them at historically low levels for too
long. It seems many are expecting interest rates to move much higher in order to
slow down ever-rising inflation. However, oil prices have already declined from
$120 reached in March to $107 now. Bringing more oil production online to make
up for Russian oil should eventually result in lower energy prices. As supply chain
issues are resolved and oil prices come down, inflation should also decline,
perhaps significantly. If this happens, interest rates would not have to rise nearly
as much as some are worrying about. In recent weeks, it seems investors have
been getting carried away by the worst-case scenario that inflation and interest
rates will continue to rise. We must be aware that selling and sentiment tends to
become overdone when stock prices are at major lows. Even now, studies are
showing that inflation expectations are already declining. This suggests that
investors are now starting to realize and accept that inflation will not continue to
rise as much as they thought only a few weeks ago. If that is the case, then interest
rates will not have to rise as much as was the consensus a few weeks ago. This in
turns means that they have been too pessimistic. These are the initial signs that
some confidence is starting to creep back into the minds of investors. This is
likely what has been the factor in enabling US stock prices to stage a strong rally
this week, with the S&P 500 up 5.7% for the week. This is only the second
week out of the last 12 weeks that US stock prices are up. The S&P 500 is now
out of bear market territory. Please see the dark blue line on the chart below
showing that US inflation expectations are falling. Thank you for your trust and
confidence as we navigate these uncharted waters!
Please see the photo of Rainbow Falls along the Harrison East Forest Service
Road (there are a series of five amazing waterfalls like this on this stream). After
months of rain and another atmospheric river two weeks ago, water levels are
high and the ground is saturated. Thank goodness the Pacific Northwest is now
getting some dry warmer weather. Have a great week my friend!
