Stocks are due for an unhealthy correction. Here’s why.

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This time, the bears are right. Here’s why.

Summary

A recession is likely if not a certainty at this point.

History shows that stocks and gold will continue to slump after the economy starts to sink into a recession.

However, gold will be the first to emerge out of the decline as soon as the Fed starts lowering interest rate and pump the money.

Stocks will take longer to find the bottom as investors need to see first evidence of bottom.

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History always repeats itself, albeit in a different fashion each time.

This time, the Fed has their hands tied and will be forced to increase interest rates for several reasons.

First, inflation is running way too hot and the Fed is clearly behind the curve as everyone now knows. The official CPI number was 8.5% and 8.3% in March and April respectively. But the actual inflation number is believed to be much higher than that. Michael Burry tweeted earlier that the CPI calculation has been altered by BLS to smooth out the inflation number. Particularly, they’ve smoothed out the housing cost such that the number we see is much lower than actual. In March, BLS reported 5.0% increase in housing cost YoY while Zillow rental data across the U.S. showed close to 20% increase YoY. Burry said that CPI was actually 12.0% which is in the vicinity of inflation rate in the 1980s.

twitter

Back then, the Fed had to hike rates north of 10% to reign in inflation. You may argue that this time inflation is caused mainly by oil price and supply chain constraint rather than an overheat in demand. Well, the circumstances in the 1980s were almost identical to today, just that the conflict was in a different part of the world. Larry Summers, former U.S. Treasury Secretary, said earlier this year that today’s inflation wouldn’t be so bad if the U.S. gov’t hadn’t poured 2+ trillion USD on the consumer. Interestingly, inflation didn’t start rising until April 2021 which was way after covid hit the world and supply chain woe started. So Russia and supply chain are not the only culprits of inflation we have today.

Second, there is a tremendous political pressure from Biden for J Powell to tame inflation as inflation is a form of regressive tax that hurts lower income earners the hardest. Biden knows this. If he lets inflation run high at this rate, voters will stage a revolt and his popularity will plummet faster than the price of Terra stablecoin. Mid-term election is coming this November. If you listen to the rhetoric recently, Biden puts inflation as his top priority in his speeches. Likewise, Powell has been loudly hawkish in his tone, reversing course entirely from end of 2021.

Lastly, there are already elements of inflation that are more permanent. Wages increased 5% YoY as recently as March 2022. That thing is not ever coming down even if the Fed hikes rates. Well, at least it won’t come down unless the Fed crash-lands the economy such that unemployment spikes so high that workers supply outweighs demand for workers by a large margin. In any way you dice and slice it, the outcome is horrifying. The last thing the Fed wants is a wage-price spiral because that will be the end of price stability as we know it.

Whether the Fed hikes rates or not, the economy is set to decline. It’s hard to fathom how the Fed can engineer a soft landing given where we are. Consider this:

1. If the Fed hikes rates, chances of a soft landing are extremely slim with inflation this high and the magnitude of fiscal and monetary drag we will have this year. So the economy and stock market are more than likely to plummet.

2. If the Fed doesn’t hike rates, changes are inflation will run even hotter which will see a big demand destruction and runaway inflation. The demand destruction happens as people face mounting costs of living from gasoline rising from $4 to $6 and food prices continuing to climb. Consumers will spend less on discretionary items and thus resulting in demand destruction.

In both cases, the economy is going nowhere but down.

The bulls I’ve talked to all pointed to the same reason why stocks will rebound — the consumer is still strong, which is why the economy will continue humming along stocks will stage a comeback as soon as inflation number shows signs of slowing down. What I think they forgot chiefly is that the strong consumer they so hope has been strong only because congress put out 2+ trillion of stimulus and interest rate has been 0% (the loosest financial condition ever). House prices have climbed over 30% in less than 2 years from 2020 to 2022. Well, leading up to the 2008 housing bubble crisis, it took 5 years for home prices to rise by the same amount.

Fed st.louis

Fed st.louis

From now on, there’s no more stimulus whether from Biden or the Fed, so the fiscal and monetary drag will be enormous. If you look at SP500 EPS, it was roughly $157 in 2019. It went up to $210 or so in 2021. That is a CAGR of 14%. The 10-year CAGR from 2010 is closer to 7.5%. Now you see that the incredible growth we’ve had in the U.S. has been fueled by gigantic stimulus which is coming to an end. What’s driving earnings now?

At this point, I’ve made the case for a high probability, if not a certainty, that a hard landing is in the pipeline. So it’s worth asking, what do we do in this situation?

Short answer: Get out of stocks. If a recession hits, EPS is likely to decrease by 30%, which sets us up for an SP500 EPS of 150 or so. If P/E multiple remains at 18x, that leaves us with SP500 index target of 2,700. In many instances, the market overshoots to the downside on the way down as the mass start to panic when they see the market continues dropping, so we can expect something <2,700.

Should you go to gold? History says no, until the Fed reverses course that is. Gold reacts to geopolitical event and monetary condition instantly. As the Fed raises rates, the opportunity cost of holding gold gets higher. The USD strengthens as we see recently. With 10-year yield hovering above 3%, it becomes increasingly attractive to own bonds vs. super volatile and fast-falling stocks. That’s why gold has been notching lower consistently for the past 2 months. The gold market has been used to the war already as well, so any headlines about war will just pass by with no reaction from the gold community.

You should wait to start buying gold as signs of recession are evident. The Fed is raising rates to find elevation so that they can lower them again when the consumer and stock market tap out. This is what Michael Burry, who predicted the 2008 crisis and most recently the current mess in the market, said earlier.

sp500 to gold ratio (macrotrends)

If you look at SP500 in terms of gold price, it has gone absolutely nowhere for the past century. So arguably, gold is the place to be as the Fed continues pumping money to keep the system afloat.

I’m writing this piece simply to share what I learned throughout these years so that you guys might be able to use it to navigate this period of tumult and confusion.

Before I end this writing, I’d like to leave you with this chart. Go figure.

sp500 (google)