The Fog of Mania – July 21, 2023

The Fog of Mania – July 21, 2023
Morgan Lewis Posted on July 22, 2023

The Fog of Mania

For many months, HAI has been of the opinion that the current “goldilocks” environment is on borrowed time. Many market participants believe the economy will avoid recession as inflation sails effortlessly down to the Fed’s 2% inflation target. The next step in such a sequence, then, is assumed to be predictable—the Fed will cut interest rates, remove what minor burden higher rates impose on the private sector and the consumer, and the spiked punch-bowl party on Wall Street can rage on in perpetuity. It’s a tempting thought. Like a warm blanket, its easy, pleasing, and oh so comforting. But in HAI’s view, it’s an idea that’s entirely unlikely and, hence, decidedly dangerous. This is an incredibly treacherous set-up for complacent risk-on positioning. Nevertheless, widespread complacency has arrived in spades and is surging throughout financial markets.

Remember that measures of market complacency and sentiment are almost always contrary indicators. Euphoric optimism prevails at market peaks, and pervasive pessimism reigns at market bottoms. As Warren Buffet famously said, “be fearful when others are greedy, and greedy when others are fearful.” Sentiment indicators are an attempt to capture and quantify just how fearful or greedy (risk complacent) market participants are at any given time. Well, at present, risk-complacency and bulled-up sentiment measures are white-hot. The Investors Intelligence Bullish Percent Index is now at an even higher level of optimism than was recorded at the 2021 all-time market peak. The American Association of Individual Investors Sentiment Survey has similarly surged in just the last couple of weeks to higher levels of risk-complacent optimism than at the peak of the Everything Bubble. And the CNN Fear and Greed Index has now spiked further into “Extreme Greed” territory than anything seen since zero-interest rates and trillions of stimulus dollars introduced utter mania in the market peak of the post-Covid era.

At the same time, volatility traders are indicating the least level of concern for a significant market decline since the last time they were wrong—at the stock market peak in 2021. Painting a similar picture of bulls frothing at the mouth, the number of bullish calls being purchased relative to bearish puts in the options market has now hit a historically unsustainable extreme. Once again, financial assets are widely perceived to be a one-way highway to the stratosphere, and an instant ticket to infinite riches. This is a dangerous set-up.

Meanwhile, under the surface of the market the picture is a little different. The Conference Board Leading Economic Index is substantially negative year-over-year to a degree not seen outside a recession in over 55 years of data. Yields on junk bonds are not confirming the rosy economic picture being painted by the rally in equities. Industrial production just this week turned negative year-over-year (something that rarely ever occurs outside of recession). And Synchrony Financial reported on Tuesday that US consumer credit scores are notably deteriorating and U.S. credit card delinquencies for borrowers under the age of 50 have hit the lofty levels seen in the great financial crisis era. That, by the way, is happening before student debt repayments (the equivalent of anti-stimulus checks) resume this fall.

This week also offered up another set notes distinctly out of tune with the bullish melody the rallying equity market is playing. On Tuesday, a Bloomberg article titled “Billions in Corporate Debt: Wave of Bankruptcies Threatens Global Economy” pointed out that corporate bankruptcies in 2023 are rising at the fastest pace since 2010. On Thursday, Private global real estate investment giant Starwood Capital’s famed CEO Barry Sternlicht commented on the commercial real estate (CRE) challenges he’s seeing develop. He called the situation a “category 5 hurricane.” An estimated $1.4 trillion in CRE debt comes due over the next 18 months, right into the teeth of dramatically higher interest rates spurred by the Fed’s rate-hiking cycle.

These are all indications that the first damaging waves of the interest rate hiking cycle are coming ashore after “long and variable lags.” Further, and of crucial significance, the Fed has yet to stop hiking rates. The overwhelming consensus is that Powell will again raise the target fed funds rate by 25 bps at next week’s Federal Reserve FOMC meeting. Despite the fact that crazed equity markets couldn’t care less for now, when the fog of the present mania fades, danger awaits.

One of the clear vulnerabilities in this ongoing market rally is a reacceleration of inflation that would immediately cut two important legs (lower inflation and imminent rate cuts) right out from under the current bull thesis. Recent HAIs have described energy prices as the great inflation force multiplier and discussed the increasing risk that oil prices may begin to stabilize and even move higher. In so doing, they will incline broader inflation metrics upward again. 

A reacceleration of inflation would keep the Fed trapped on an even-higher-rates-for-even-longer trajectory. While energy prices have indeed started to rally over recent weeks, this week the entire commodity complex, as measured by the CRB index, turned higher and broke out above its recent range. It also broke above the always-important 50-week moving average for the first time since the autumn of 2022. There’s no confirmed breakout just yet, but the chart, at weekly close, looks incredibly bullish. 

HAI will watch closely in the days and weeks ahead. If in addition to energy the entire commodity complex is ready to rally, it spells serious trouble for the inflation fight and, by extension, the stock market. If commodities break out, the message will be clear: commodities will join the party if financial assets continue to rally. Higher prices in commodity markets will intensify inflation and keep the monetary policy clamp tighter for longer. The net effect will undermine the goldilocks narrative currently underpinning the manic move higher in the stock market.

Markets have deemed the sharp rally in stock prices to be an all-clear signal (even though it’s completely consistent with past late-cycle market dynamics leading into major market tops). HAI believes the rally to be less an all clear than a crescendo of short squeezes and misplaced optimism. The market’s upbeat view of the economy, inflation, and Fed policy is fueling an ill-fated blow-off sentiment surge. The fear of missing out (FOMO) has turned into panic of missing out (POMO) that will ultimately run headlong into the reality of a combined business cycle, credit cycle, and market cycle downturn that still looms ahead of us.

This cycle downturn remains the base case expectation. As HAI discussed last week, however, some very important variables are indeed different this time. Because of that fact, the risk is very real that defiant equity strength could be the result of early Austrian crack-up-boom dynamics taking hold of markets. A crack-up-boom happens when the overall outlook turns sufficiently inflationary that capital, regardless of economic fundamentals, begins en masse to chase real values in scarce assets rather than hold rapidly depreciating currency. 

A true crack-up-boom is a total disaster that ends in a devastating currency collapse. Let’s hope we’re not there yet. The risk, however, is real. Upcoming HAIs will explore some of what’s different this time that could be pushing markets in this disturbing direction. In the meantime, all eyes this week turn to Fed Chairman Powell as he takes his next steps in the effort to navigate out of what is nothing short of a monetary policy minefield.

Weekly performance: The S&P 500 gained 0.69%. Gold was nearly flat, up 0.11%. Silver lost 1.35%, platinum was down 1.23%, and palladium gained 1.59%. The HUI gold miners index was off 1.07%. The IFRA iShares US Infrastructure ETF was up 1.57%. Energy commodities were volatile and higher on the week. WTI crude oil was up 2.19%. Natural gas gained 6.85%. The CRB Commodity Index was up 2.10%, and copper was off 2.87%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 1.30%, while the Vanguard Utilities ETF was up 2.37%. The dollar rebounded, up 1.19%, to close at 100.80. The yield on the 10-yr Treasury was up 1 bp, ending the week at 3.84%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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