On the Verge of Lower Inflation and Peak in Interest Rates
Human behaviour in stock markets typically forms a double bottom at the
end of serious declines like this one. It looks as though that is exactly what is
happening once again. The S&P 500 reached a low of 3,667 on June 16th. Stock
prices recovered one-half of their losses by August 15th and then reversed course,
descending into the 3,600 range once again in late September. In spite of higher
bond yields, rising interest rates and greater pessimism, enough portfolio
managers and investors seem to believe that stock prices are attractive near the
3,660 range. Enough buying has come in near these levels to keep the S&P 500
close to the 3,650 range for almost a month now. This indicates that the selling
pressure and buying power are equal.
Why are stock prices holding up at the 3,660 level in spite of many forecasts
that stock prices should fall much farther? First, at a 24% discount from record
highs, stocks are attractive to longer-term investors like pension funds.
Second, stocks are extremely oversold on almost every level. Third, a number
of investors and portfolio managers have confidence that signs of sharply lower
inflation data could be observed at any moment.
Short selling has been at the highest level since Covid swept over the world in
February 2020. (Short sellers make profits when stock prices fall. They have to
buy back shares to avoid losses if stock prices rise.) The buying of put options
has been greater than the buying of call options for the first time since the Covid
low in March 2020. (Put options increase in value when stock prices fall. Call
options increase in value when stock prices rise. Stock prices have risen in the
long-term so it is much more difficult to make profits on put options.) When
stocks are this oversold while short selling and put buying are near record levels,
the smart money is aware that stock prices could spike higher in an instant and
keep on advancing as soon as there is any clear indication that inflation is trending
down. This is because signs of lower inflation would mean that the Fed and other
central banks may not raise interest rates any further.
I have been saying the Fed and other central banks are raising rates too much
too fast because we may even see deflation in six months. If you look at the
comments at the bottom right, from RBC Global Asset Management, you will
notice that it states: “Deflation scenario may be underappreciated by market.”
The price of energy and many other products peaked around March 2022.
While prices are much higher now than they were 12 months ago, by March 2023
prices for many items may actually be lower than they were in March 2022.
The table on the next page shows that many variables are at peak inflation. It
also shows how inflation should be affected by factors in the next year and over
the long-term. This conclusion by RBC GAM is that inflation should be very high
in 2022, rise less in 2023 and then return to a more normal 2%+ range after that.
We must remember that stock prices typically reflect what is expected to happen 6
to 12 months into the future. We are now 6 months away from March 2023.
It usually takes 6 to 12 months to see the full impact of changes in interest
rates in the economy as well. This means that we should just be seeing the initial
signs of the effect that the first interest rate increases in March are having on the
economy today.
On May 4, 2022, U.S. Federal Reserve Chairperson Jerome Powell said, “A
75 basis point increase is something that the committee is not actively
considering.” Yet, the Fed went ahead and raised rates by 0.75% on June 14th,
July 28th and September 21st! This is concrete evidence that we should not rely on
guidance from the Fed. Thus, when the Fed says they will keep raising rates into
2023, history shows that forecast could also be reversed in an instant.
The situation is like going into a shower and turning the lever to maximum hot
water to heat the water as fast as possible. The problem with doing that is that
you have to turn the dial back to avoid burning yourself once the water gets hot.
The Fed could be forced to reverse some of these rate increases sooner than we
expect. This is why any sign that inflation is slowing down could unleash a
violent reaction to the upside. Investors, speculators, hedge funds, pension funds
and institutional investors that are not positioned properly for a big move to the
upside could be climbing over themselves to adjust to a strong uptrend when it
happens.
The longer the S&P 500 remains in the 3,650 range, the more likely it is that a
base is forming exactly where it should be based on the double bottoming pattern.
Stock prices are now at the point where the seasonal pattern and mid-term
election year pattern suggest that a new uptrend should be starting.
In summary, concerns about rising inflation and interest rates have resulted in
selling and short selling that have pushed gauges to extremely oversold levels that
have only been seen at other major stock market bottoms. While recent declines
make it seem like stock prices should fall further, the opposite is likely. For
example, the more you try to push a beach ball under water, the greater the force
becomes to push it back up. The more you compress a spring, the greater the force
becomes to make it bounce back up. When a spring is completely compressed, it
cannot go down anymore. When stocks are as oversold as they are now, it is like a
spring that is totally compressed.
The Fed has implied that they will keep raising interest rates. Yet, we know
that what the Fed says and what they actually do can be completely different.
With signs of lower inflation and possibly even deflation early next year, any
positive news on the inflation front could be the catalyst to start a new bull
market. Selling pressure and buying power seems to have been evenly matched
for the last month. This has enabled stock prices to build a base to rise from.
These are the reasons why stock prices are likely to hold around these levels
until there is a surprise that instantly changes the view of the masses to the glass
being half empty to the glass being half full. I will continue to monitor how
investors are behaving in the marketplace in order to identify when this change
happens. Please see the blue bars for how U.S. CPI inflation for all items is
trending.
Funny Story
“Nothing looks good on me anymore,” wailed the customer modelling an outfit
in front of the department store mirror.
“Nonsense ma’am” soothed the sales clerk. “That dress says it all!”
“That’s the problem,” the woman said. “I need a dress that keeps its mouth
shut!”
Photo Below
The photo below shows the sun trying to shine through thick smoke from the
more than 20 wildfires in the eastern Fraser Valley and Washington state to the
south. The mountains in the background that are not far away at all are not even
visible. In the last three months, the southwestern corner of B.C. has received less
rainfall than Las Vegas, which is situated in the western part of the Mojave
Desert. We have never needed rain this badly before. Hopefully the precipitation
in the forecasts materializes in the coming days! Have a great weekend my friend!
