Price Discovery Re-emerges
Alarm bells rang loudly throughout Wall Street this week as stocks sold off aggressively. All major indices were swimming in red. The selling was heavy, indiscriminate, and relentless. The Dow Jones Industrial Average was down 5%, the S&P 500 shed 5.68%, and both the Nasdaq and the Russell 2000 small cap index incurred crushing 8% losses.
Despite the fact that it’s only been a couple of weeks since the Dow Jones was at record all-time highs in early January, on Friday, after six consecutive days of losses, the index made its lowest weekly close in over six months. The Nasdaq Composite index closed the week at its lowest daily close since the start of June last year and is now down 15% from it’s November all-time high. Bonds and Treasury yields had an incredibly volatile week, and the VIX Volatility Index surged a whopping 50% by Friday’s close. Interestingly, a number of commodities were spared the carnage, and the precious metals complex had a constructive week that could be the start of a breakout move higher.
So, what happened this week to catalyze such intense market reactions? As the US Federal Reserve moves in a more hawkish direction, a broad market repricing is taking place. The anticipated combination of the Fed ending quantitative easing, raising interest rates, and beginning quantitative tightening is triggering a market regime change. The factors effectively determining market prices are changing. Up until recently, central bank market accommodation has been primarily responsible for setting market prices. What we appear to be seeing now is the return of genuine fundamental price discovery into the price-setting mix. JP Morgan’s Andrew Tyler explained the events of the week by suggesting that the “overarching story is how the Fed is changing investor behavior.”
The first change in investor behavior had been that which occurred in response to over a decade of escalating rounds of central bank market-accommodative support. The promise of perpetual artificial market support changed behavior by incentivizing and creating a speculative mania.
Market commentator John Train describes the dynamics of a wide-eyed speculative bull market as one in which an increasing number of speculators become ever more confident in their assurance of a market “that will grow all the way up to the sky.” As Train illustrates, the logic of the speculative process is tight. “As the speculators rush in, the price rises… The speculators, confirmed in their wisdom, buy more, putting the price still higher. New speculators rush in. Soon the whole self-confirming perpetual motion machine is grossly overinflated beyond any reasonable investment value.”
Well, the “everything bubble” has not been priced according to “reasonable investment value.” Rather, this bull market has been built and priced on the speculation that governments and central banks will deliver price growth to the sky in perpetuity.
Now that the reality of 7% consumer price inflation has arrived, the realization is finally taking hold that, at least for now, the Fed simply must back away from its accommodative but inflationary policy support. As a result, investor behavior is changing again. This time, the behavior change is away from unbridled speculation and toward genuine price discovery, de-risking, and de-leveraging.
Recent survey data underscores the extent to which the inflation eruption is inflicting underlying damage to the consumer and the real economy. The latest University of Michigan Surveys of Consumers preliminary update for January helps illustrate why the Fed has been forced toward an abrupt hawkish pivot.
Despite a highly touted economic recovery and a booming stock market since the 2020 Covid shutdown, consumer sentiment in January was at the second lowest level in a decade. According to survey chief economist Richard Curtin, when consumers were asked to assess their finances, amazingly, “33% reported being worse off financially than a year earlier, just above the April 2020 shutdown low of 32%.” This was the worst reading since 2014, and, “inflationary erosion of living standards was the main explanation offered by these consumers.” Furthermore, “the importance of inflation in determining their future financial prospects was dominated by how consumers judged their future inflation-adjusted incomes. Nearly half of all consumers (48%) anticipated that the inflation rate would outdistance income increases to produce real income declines. Just 17% anticipated real income gains in 2022.”
The survey also revealed that confidence in government economic policies is at its lowest level since 2014. According to Dr. Curtin, “it will be a difficult task to gauge the appropriate mix of fiscal and monetary policies when such fine tuning is necessary in an era of large economic and non-economic disruptions.” Curtin goes on to state that, “the most crucial and difficult task will be defusing the developing wage-price spiral.”
This grim consumer survey data may be contributing to the accelerating market sell-off. If the market had been skeptical that the Fed would actually follow through on its newly hawkish rhetoric, the consumer data may be convincing market participants to rethink that skepticism. The Fed’s ability to prioritize support for financial assets amid low inflation is well documented, but with 7% inflation, the Fed may simply be unable to protect markets. Perhaps the growing realization is that politics will dictate policy now. The politics of 7% inflation, widespread consumer awareness of real income declines, a crisis of confidence in government economic policies, and plunging presidential approval ratings may be what matters now. Perhaps the market is conceding that, for now, policymakers may have no choice but to dramatically change policy and tighten financial conditions even if it means sacrificing the stock market.
On Thursday, investing legend and first ballot hall of famer Jeremy Grantham released his most recent note, titled “Let The Wild Rumpus Begin.” Grantham has an excellent track record of accurately calling bubbles and their eventual collapse. His assessment? We are in the final throes of the fourth “super-bubble” of the last century. Currently, he views markets as containing “the most dangerous breadth of asset overpricing in financial history,” and is “nearly certain” that this super-bubble has already begun to burst. According to Grantham, the “checklist for a super-bubble running through its phases is now complete and the wild rumpus can begin at any time.” Grantham went on to offer his view that when pessimism returns to the market (a development we are beginning to witness in real time), “we face the largest potential markdown of perceived wealth in US history.”
So, has the bubble begun to burst? Have the final highs for this bull market already been established? That’s very difficult to say. What can be said is that the aggressive waves of selling this week broke significant technical support levels in the indexes and that investor behavior is changing. Despite being extremely short-term oversold, strong bounce attempts on Wednesday, Thursday, and Friday all failed spectacularly. In a notable change of character for the recent history of this bull-market, at least for this past week, the instrument of pain was applied to any market participants buying dips. By the end of Friday, the extent of the short-term oversold conditions in the major market indexes argues strongly for an imminent bounce. That said, unless the Fed can inspire a dramatic new wave of genuine risk-appetite at next week’s FOMC meeting, the odds are increasing that after the potential for a convincing bounce, new lows are more likely than new highs.
Weekly performance: The S&P 500 was down 5.68% this week. Gold was up 0.84%, silver gained 6.12%, and platinum was up 7.31%. Palladium was the standout within the PM complex, surging 12.04% on the week. The HUI gold miners index was up 1.84%. The IFRA iShares US Infrastructure ETF was lower by 5.50%. Energy commodities were mixed. WTI crude oil gained 1.57%, while natural gas lost 11.26%. The CRB Commodity Index was up 1.87%. Copper was up 2.35%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 2.73%, while the Vanguard Utilities ETF (VPU) was off by 1.00%. The dollar was higher this week by 0.50% to close the week at 95.64. The yield on the 10-year Treasury had an exceptionally volatile week, but closed the week lower by 3 bps at 1.75%.
Have a wonderful weekend!
Chief Executive Officer