By Gunjan Banerji, The Wall Street Journal, Dec. 18, 2022
During the wildest year for global markets since 2008, individual investors have been doubling down on stocks. Many professionals, on the other hand, appear to have bailed out.
U.S. equity mutual and exchange-traded funds, which are popular among individual investors, have attracted more than $100 billion in net inflows this year, one of the highest amounts on record in EPFR data going back to 2000.
Hedge funds, meanwhile, have been paring how much risk they are taking in stocks or making outright bets that major U.S. indexes will tumble…
The buy-the-dip trade, which rewarded investors handsomely in the decade after the 2008 financial crisis, is on pace for its worst year since 1979, with stocks falling around 0.7% the week after a 1% decline… [end quote]
Here’s an article that advises focusing on the next 10 years of market performance. That makes sense if you expect to be around in 10 years. (As a cancer survivor, I’m pretty uncertain about myself lasting 10 years.)
In fact, the article’s advice to maintain a balanced portfolio isn’t terrible since both stocks and bonds have been pounded down pretty well in 2022 so they aren’t in outright bubbles at the moment. But they are far from cheap on a historical basis.
The stock market is finally starting to actually believe what Fed Chair Jerome Powell (and other Fed officials) have been stating clearly for months. The Fed is determined to raise the fed funds rate until inflation (PCE inflation, their preferred measure) has declined to 2% and stayed there for an “extended” period of time. They recall the experience of the 1970s when inflation popped back up when the Fed loosened.
The Fed released its Summary of Economic Projections 4 days ago. These are PDF files but their table results can be seen here:
Their 4Q2022 to 4Q2023 forcast changes are:
Change in real GDP 0.4%
Unemployment rate 4.6%
PCE inflation 3.1%
Core PCE inflation 3.5%
The Fed is expecting their monetary tightening to slow real GDP growth and increase unemployment. They carefully avoided a negative GDP number because the financial press would have freaked out, but 0.4% is pretty darn close to zero and could easily slip into recession. They carefully avoided the term “stagflation” even though the picture is clearly for inflation plus a stagnant (if not outright deflationary) economy.
Core PCE inflation is still higher than their target of 2%. The Fed will maintain its higher fed funds rate throughout 2023. Their forecast in black and white is contrary to market predictions that the Fed will pivot and cut rates in 2023.
To see the Fed’s “dot plot” of FOMC participants’ assessments of appropriate monetary policy go to this link and read the explanation. The Fed - Guide to the Summary of Economic Projections
The actual “dot plot” is a PDF. The Fed’s dot plots have changed at every meeting this year, sliding the expected fed funds rate upward. Powell discussed this at his press conference and said that the next meeting might follow this pattern – higher rates announced – if inflation doesn’t decline as expected.
The December 2022 dot plot shows a fed funds rate centering on
2025: 3.0% (but a lot of spread much higher and lower from participants)
Longer term: 2.5%
Since the Fed is targeting a 2% inflation rate and has declared they want a “neutral” fed funds rate eventually they are targeting a long-term REAL fed funds rate of 0.5%. This is a far cry from their 0% nominal rate (negative 2% REAL rate) which the Fed maintained for years which caused the Everything Bubble.
The markets simply don’t believe the Fed. They are looking at the long-term fed funds rate chart where a succession of Fed chairs, starting with Alan Greenspan, cut the fed funds rate to zero (or close).
The impact of a neutral, positive REAL fed funds rate on the stock and bond markets will be immense. This is equivalent to weaning a methamphetamine addict off his stimulant and telling him he can never use it again. Never experience that high again. OY VEY!
The older professional traders understand the implications. The market conditions of the past 20 years will shift back to pre-2000 monetary policy and all assets will need to be re-priced lower for the long term. They saw how excess government spending and high energy prices caused stubborn inflation in the 1970s and how a stagflation stock market can drift lower (with high volatility) for over a decade. (Note the check box for inflation adjustment.)
The small, individual investors may be too young to have ever experienced inflation, much less have experience of a stagflationary stock market. Their experience is that the stock market always rises so buy the dip.
The Control Panel shows that investors are finally starting to believe the Fed.
The stock market began to roll over to resume its 2022 pattern of lower highs and lower lows. The Fear & Greed Index declined from Neutral to Fear.
Investors moved to safe long-term Treasuries, causing the yield curve to become more negative than it has been in many years. This is a clear predictor of coming recession. In previous recessions the yield curve usually became positive before the recession hit as the Fed cut fed funds rate when the economy slowed. But the Fed does not intend to cut this time. (Barring a crisis.) The market doesn’t believe the Fed will hold firm this time.
The USD is falling as other central banks are raising their own rates. Gold, silver and copper are rising. Oil is falling. Natgas is stabilizing.
The METAR for next week is cloudy. Many institutional investors will be re-balancing their portfolios which they do every quarter. Since 4Q22 was good for stocks, these institutional investors may be forced to sell stocks and buy bonds to bring their funds back to the mandated balance. That would depress stock prices and bond yields.
On the other hand, there might be a Christmas rally.
I don’t see any unexpected Macroeconomic shocks blowing up at the moment.
Wishing all METARs a very happy holiday season.