The leading stock market indices moved lower over the past week as the downtrend in the bond market weighed on equities. The beginning of the Q4 2021 earnings season has not supported stocks.
The S&P 500 moved 4.10% lower since January 12. The NASDAQ moved 5.58% to the downside, while the DJIA posted a 3.48% loss since last week. The VIX was at the 23.67 level, 33.88% above the level on January 12, as the stock market dropped. Stocks were at lofty levels. The prospects for higher interest rates and a decline in longer-term debt securities are attracting capital away from stocks into bonds.
The bond market declined on the continued prospects for higher interest rates in 2022. The markets face higher interest and tax rates this year, a bearish combination for the stock market. Time will tell if the stock market bull continues to charge to new highs or if substantial corrections are on the horizon over the coming days, weeks, and months. The markets will wait to see if the Fed is talking the market down or following through with action over the coming weeks and months. More clues will come from the Fed at the January and February FOMC meetings. The moment of truth will come in March when the Fed seems ready for liftoff from a zero percent Fed Funds rate. The market expects a 25-basis point hike in short-term rates, but inflationary pressure likely calls for at least a 50-basis point initial rise and a shift towards balance sheet reduction.
Chinese stocks outperformed the US stock market over the past week. Chinese stocks may offer value compared to the US market, but political and regulatory issues have caused them to lag all leading US indices. While US stocks posted impressive gains in 2021, the Chinese Large-Cap ETF (FXI) fell to a new low on January 5 before bouncing.
The FXI settled at the $37.86 level on Wednesday, as it fell 2.07% since January 12. Technical support stands at the March 2020 $33.10 low. The FXI product remains far below the all-time peak at $73.19 back in 2007, while US stocks made a string of record highs in 2021. The high for the FXI in 2021 came on February 17, 2021, at $54.52, the technical resistance level that continues to fade into the distance. FXI fell to a low of $35.23 on January 5, which is a support level. China is the demand side of the equation for commodities as it is the world’s second wealthiest and most populous nation.
As I have been writing:
“Chinese stocks carry significant political risk given the government’s heavy hand and role in business and international investments.”
Charlie Munger’s Alibaba (BABA) purchases in Q3 and Q4 caused buying in early Q4 and a bounce in early 2022, but Chinese stocks remain under pressure and continue to trend lower with lower highs and lower lows. The FXI would need to move above the December 9 $39.17 high to alter the bearish price trend.
March US 30-Year bonds declined since January 5. The bond market faces opposing forces as inflation increases, and the Fed is now on a more hawkish path. A significant correction in stocks would likely push bonds higher. The Fed Funds rate remains between 0% and 0.25%, with liftoff likely in March, but the central bank only determines short-term rates. Medium and long-term interest rates are a function of the supply and demand for bonds.
Meanwhile, contemplating reducing the balance sheet is a sign that quantitative tightening is on the horizon, which is bearish for bonds as the central bank will not replace bond positions when they mature.
Rising rates could ignite selling in stocks and create another crisis for the central bank, which is between a rock and a harder place. Even as the Fed moves towards a more hawkish stand on monetary policy, fiscal initiatives remain unprecedently dovish. Accelerating Fed Funds hikes into the first quarter of 2022 and reducing the balance sheet weighed on stocks since the latest Fed minutes.
Even the most aggressive tax hikes in history will not pay for the trillions in stimulus and other initiatives over the past year and those now before Congress. The US Treasury Secretary worked with other nations to establish a 15% minimum corporate tax structure. The initiative pushes the US towards economic globalism.
On Wednesday, January 19, the March long bond futures contract was at the 154-04 level as it moved 1.12% lower over the past week. The March 30-Year Treasury bonds futures made a new low at 153-07 on January 19, which is now technical support, below the recent low, it stands at the March 2019 continuous contract 144-07 low. Short-term technical resistance is at 156-28, the January 13 high on the March futures contract. Upward pressure on rates further out on the yield curve over the past year had been an inflationary signal for markets that the Fed ignored for far too long.
FOMC December meeting forecasts for a 0.90% Fed Funds rate in 2022 and 1.60% in 2023 mean that real interest rates will remain negative if inflation does not recede precipitously.
Energy, agricultural, metal, and mineral prices have been trending higher since reaching lows in 2020. Bull markets rarely move in a straight line. Commodities can be highly volatile; they rise higher than most believe possible, and corrections can take prices far lower than logical levels. However, the trends since the 2020 lows remain very bullish despite corrections. The most recent commodities to take the bullish torch has been NYMEX crude oil futures. After falling to a low of $62.43 on December 2 but were back near the $87 level on January 19, after eclipsing the October $85.41 high, which was the highest price since 2014. Cotton and FCOJ futures moved to new multi-year highs over the past week.
The tidal wave of liquidity and tsunami of stimulus since early 2020 comes with a price tag that will not be satisfied with a gradual shift towards tightening monetary policy. The stock market’s rise over the past year could be a mirage as it may reflect a decline in money’s purchasing power instead of bullish fundamentals for many companies.
Meanwhile, even the most aggressive bull markets rarely move in a straight line. Periodic severe selloffs are the norm, not the exception. Bull market corrections can be sudden and brutal, as witnessed recently in the crude oil futures arena. The overall trend in raw materials and other asset prices remains higher, a clear sign of inflationary or stagflationary pressures.
A capital gains tax hike could eventually cause selling in the stock market as investors cash in on significant profits and need to sell more shares to pay the government more at tax time. Moreover, higher corporate taxes trickle down to the consumer, so all Americans from rich to poor will be paying more to the government either directly or indirectly. Higher inheritance taxes could increase selling. Over the past years, retirement accounts have provided the stock market with consistent and natural buying, making the path of least resistance for stocks higher. Rising taxes could interfere with the phenomenon and balance buying and selling or even create periods where selling overwhelms buying, adding to stock market volatility and creating more significant downdrafts.
US government remains divided even though Democrats have majorities in the House of Representatives and the Senate. However, the majorities are razor-thin, and the 2022 midterm elections are coming closer each day. The agreement on infrastructure rebuilding creates more stimulus and stokes inflationary flames. The 2022 midterm elections will increase the partisan divide. The administration’s support has slipped in the polls because of the continuation of the pandemic, a hasty and problematic departure from Afghanistan, inflation, and other issues. The November 2021 election results were a five-alarm warning for Democrats.
The Build Back Better initiative seemed to go down in flames during the holiday season as West Virginia Senator Joe Manchin, a Democrat, said he cannot support the measure. The failure of the budget is a failure of the administration going into the mid-term elections. We could see a far smaller initiative in 2022 as the President seeks to strike a deal with the Senator who holds the deciding vote. Progressives are likely to oppose any smaller legislation, so gridlock will likely prevail.
As I pointed out over the past months, inflationary pressures that pushed the stock market to new highs could be a mirage if money’s purchasing power is declining at a faster rate than stocks are appreciating. The stock market showed it is highly sensitive to another wave of COVID-19 variants and interest rate hikes over the past weeks. Stocks were choppy since late November, but a Santa Claus rally emerged at the end of 2021 and in early 2022 until the Fed minutes poured cold water on the buying.
Open interest in the E-Mini S&P 500 futures contracts moved 1.15% higher since January 11. Open interest in the long bond futures moved 0.38% higher over the period. Over the long term, fighting the Fed has been a losing battle, but the last year remains an exception. The bond market is screaming that the Fed continues to respond far too slowly. The VIX at 23.67 on January 19 was 33.88% higher since January 12. Taxes and regulations will increase, which is not bullish for the stock market.
As I wrote in previous reports:
“I continue to favor trading the VIX and related products from the long side on price weakness. However, VIX-related products are not for long term investments. They are instruments to buy on dips and take profits on rallies. I am using very tight stops on VIX-related products, buying on dips.”
I favor buying the VIX with a tight risk-reward profile to take advantage of stock market weakness.
Commodities, stocks, cryptocurrencies, and bonds have been significant barometers of inflationary pressures over the past year. In 2021, the bond market told us that the Fed policies have significant inflationary side effects. A correction in stocks could provide some relief for the weak bond market.
Meanwhile, China is a substantial holder of US debt. As the tensions between Washington and Beijing remain elevated, any Chinese selling could push rates much higher further out along the yield curve. Financing the US debt through the bond market could cause the Treasury to issue bonds with longer maturities to pay for the trillions in stimulus packages, but they better hurry. Even though yields have increased, they remain historically low. Higher yields over the coming months and years could close a window of opportunity for fifty or one-hundred-year US debt securities to fund the deficit, which makes sense at today’s rates. It boggles the mind that the Treasury is not issuing very long-dated debt securities in the current interest rate environment. They may have missed the boat if rates are going to surge over the coming months and years.
The administration is looking to raise tax rates and take advantage of the growing wealth. We are either in a bubble, or fiat currencies are losing value at an accelerating pace. Higher interest rates and rising taxes are not a bullish cocktail for the stock market. However, TINA or there is no alternative to stocks for capital growth, and tax-advantaged retirement accounts continue to push money into the stock market.
As I wrote over the past weeks, hedging stock portfolios at or near all-time highs could be the optimal approach given the uncertain future of markets. Markets reflect the economic and political landscapes, creating high odds for lots of volatility over the coming months. I believe a very volatile period is on the horizon, and we will see lots of two-way price action in markets across all asset classes sooner rather than later. We have seen choppy stock and bond market conditions over the past weeks.
Be cautious in the stock and bond markets. Time will tell if the recent price action is a sign that a deeper correction is on the horizon.
Over the past reports, I wrote:
“Substantial sell offs and corrections tend to arrive when the market least expects them.”
My goal is always to be long or short when a significant trend emerges in all markets. Choppy markets involve short-term losses in the quest for substantial long-term gains when markets trend for an extended period.
I expect choppy conditions to continue as the market is focused on watching each monetary policy move or mistake the Fed makes. Geopolitical concerns surrounding Russia could also move markets over the coming weeks.
A Final Note
The December CPI and PPI data showed that inflationary pressures continue to rise. Meanwhile, the Fed’s forecasts for interest rate hikes in 2022 and 2023 point to a continuation of negative real interest rates, which is fundamentally bullish for commodity prices. WTI and Brent crude oil prices eclipsed the technical breakout level that could lead to a move to higher levels and triple-digit prices over the coming weeks and months. The stock market continues to look shaky during the Q4 earnings season, and bonds are near the recent lows, threatening after breaking below the March 2021 low. Precious metals are threatening to move higher in early 2022. Geopolitical tensions threaten to cause additional volatility in markets across all asset classes.
Approach all markets with caution and a plan for risk and reward. Do not allow short-term trades to become long-term investment positions because of adverse price moves.
Expect lots of volatility in markets across all asset classes over the coming weeks. The economic and political landscapes suggest we could be in for a highly volatile period in markets.
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Until next week,
Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein, or any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction.