Recent HAIs have chronicled the breakdown of Goldilocks economic conditions that has occurred in the post-Covid timeframe. Historically unprecedented massive government economic manipulation ultimately resulted in a 9.2% peak CPI inflation reading. Contrast that with the 2% inflation target that represents the Fed’s price stability mandate.
Since conceding that inflation was not transitory after all, Fed Chair Jay Powell invoked the name and inflation-fighting legacy of former Fed Chair Paul Volker to assure markets and concerned citizens that he would utilize Fed policy “tools” to “unconditionally” restore price stability. His underlying de facto message to markets and the world? The Fed will restore Goldilocks conditions—conditions defined as a simultaneous combination of maintained economic growth, low-interest rates, low government interest expense, fiscal sustainability, low inflation, and stable bond and currency markets. In other words, the Powell promise was “no need to worry, we’ll be back to business as usual in no time—trust me.”
Since CPI inflation hit its peak of 9.2% in 2022, the trust-me trade higher has been on, full blast, in financial markets. CPI inflation has eased back to a 3.4% headline reading and a 3.9% level on the core reading. It sure isn’t 2% target-price-stability perfection, but it’s all the progress markets needed for the trust-me trade to define 2023.
Now, however, it’s 2024 and the trust-me trade is overly consensus, overly extended, overbought, and overestimated. To date, it’s working because inflation has been declining and the Fed has started to talk about a stimulative pivot toward an “easier” policy setting in 2024.
However, HAI doesn’t believe Goldilocks as we’ve known it is coming back at all. A new secular backdrop of structurally higher levels of inflation and a government fiscal deficit doom-loop dynamic ensures that a full return to such conditions is highly improbable. That’s no trivial matter. Confidence in the imminent return of Goldilocks economic conditions followed by actually attaining them is what’s needed to indefinitely extend the ongoing financial asset bubble in anything resembling semi-stable form.
In short, the current trust-me dynamic is good for a trade higher in financial assets, but unless the narrative of easier policy and inflation lessening to target is actualized, the trade will eventually fail. Despite market hope, reality will intrude. A Fed easing cycle along with a $2.2 trillion annualized deficit spending bonanza as policy will retard and eventually reverse progress made to date on inflation.
In the face of that fact, the S&P 500 attained a new all-time record high this week by standing tall on the hulking shoulders of the trust-me trade. But those hulking shoulders, in HAI’s view, belong to a behemoth with buckling knees and a bad back, overwhelmed with troubles.
As of now, it appears that the Fed is likely to sacrifice the inflation and price stability variable in order to protect against fast-tracking an out-of-control fiscal crisis. When the market realizes that, instead of Goldilocks, we’re going to get a perpetual round of inflationary whack-a-mole policy, the trust-me trade is likely to end abruptly as the new and painfully corrective “reality” trade begins.
This week, Art Hogan at B Riley Wealth captured the zeitgeist that’s powered the S&P 500’s trust-me trade into all-time high territory; “we’re seeing a plausible path to inflation continuing to ease gradually, an end to Fed rate hikes, and a re-acceleration of economic growth in the back half of 2024.”
Fair enough, Mr. Hogan, but, again, if the Fed delivers the fistful of rate cuts the market now expects, and we get that economic re-acceleration in the back half of 2024, it’ll be like pouring gasoline on the now-simmering inflationary fire. Rate cuts and economic re-acceleration amid the current economic backdrop are ingredients for a spicy cocktail of higher commodity prices, booming energy prices, and resurgent inflation. What they’re distinctly not is a recipe for a tame and watery mocktail of “a plausible path to inflation continuing to ease gradually.”
At this point, it’s the strength of the magnificent seven—one of the most overcrowded and narrow trades in market history—that’s been strong enough to push the NASDAQ 100 and the S&P 500 to new highs. But at the same time, without the heaviest concentrations of mag-7 weightings, the S&P MidCap 400 index is down 6% from its November 2021 peak, the Value Line Composite index is down 18% from its November 2021 peak, and the Russell 2000 is down 21% from its November 2021 all-time high. As Steven Hochberg at Elliott Wave International warned this week, “A long-term, highly fractured market is not healthy. It’s what occurred at the 2000 market highs and it is occurring now.”
With the bellwether S&P 500 now having reached a new all-time high, copious amounts of cash will likely be drawn back into the market. But, unless Goldilocks can be reestablished and actualized, as that new money rushes in to chase the breakout, fear of missing out (FOMO) turned panic of missing out (POMO) will be an ideal opportunity for those that borrowed the trust-me trade for a profitable 2023 to sell back their shares for a graceful exit before the new reality trade takes hold in 2024. This is the process by which major market tops are made.
HAI doesn’t know if this week’s S&P 500 breakout to new all-time highs represents the end, the beginning of the end, or the end of the beginning for the powerful push higher in financial assets that began in 2023. However, unless Goldilocks makes a dramatic and improbable comeback, an end to the trust-me trade is indeed in sight. When the new reality trade kicks in, market risk and instability are likely to skyrocket, and the major market top of our financial asset bubble era may well be upon us.
In an admiring HAI hat tip to singer/songwriter Kenny Loggins for his 1986 classic from the Top Gun soundtrack, let’s just say the trust-me trade higher in the S&P 500 may well have been 2023’s highway to 2024’s stock market “Danger Zone.” The risk at this juncture is extremely high. Forewarned is forearmed.
Make no mistake, we have a mature financial asset bubble of historic proportions on our hands today. Meanwhile, as John Hussman says, “risk quietly extends across the whole system as a ‘skeleton of instability’,” just as HAI believes markets are poised for severe disappointment on the crucial Goldilocks narrative. Remember, when bubbles break, they tend to break hard. At this point, any loss of confidence risks putting a most devastating pin to the bubble. All things considered, risk adjusted, gold still looks like the best bet by a wide margin. Additionally, an emerging energy trade is beginning to take shape. For those looking to play an S&P breakout and capitalize on the late stages of the trust-me trade, however, HAI suggests, tread carefully.
Weekly performance: The S&P 500 gained 1.17%. Gold was down 1.09%, silver lost 2.66%, platinum dropped 1.53%, and palladium was down 3.05%. The HUI gold miners index was smacked down by 6.30%. The IFRA iShares US Infrastructure ETF was lower by 2.05%. Energy commodities were very volatile and mixed on the week. WTI crude oil gained 0.78%, while natural gas was obliterated, down 32.03%. The CRB Commodity Index was up 0.38%, and copper added 1.23%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 2.20%. The Vanguard Utilities ETF was off 3.67%. The dollar index was up 0.90% to close the week at 103.07. The yield on the 10-yr U.S. Treasury jumped 19 bps to end the week at 4.15%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager