The stock rally since last Thursday's better than expected CPI report has been impressive, and on the surface, it only seems to be bolstered by Tuesday's PPI report, states Steve Reitmeister of Reitmeister Total Return.
Unfortunately, that would be missing the forest for the trees. Let's take a much deeper dive into why the Fed needs to fight inflation. And the tools at their disposal to do so. And why the sum total of that still equates to recession and bear market.
Meaning this is yet another sucker's rally before the bear market mauls stock prices even lower. This commentary will explain why and how to keep your portfolio on track.
Market Commentary
Today I recorded the November Platinum members webinar. I had some fresh ideas to explain the Fed’s inflation fight to clarify why things are still quite bearish. Those topics include:
- Stated Reasons Why the Fed Wants Lower Inflation
- Ulterior Motive for Wanting Lower Inflation
- Fed Tools to Fight Inflation
- Fed WANTS Bear Market
I know bullets two and four are kind of head scratchers on the surface. That’s why I explain it in full in the webinar, which reinforces why the bear market is still firmly in place.
Why Does the Fed Want to Fight Inflation?
Inflation is an economic disease that once “entrenched” leads to lower growth. Yes, that word “entrenched” keeps coming up in Fed speeches to point out that the longer inflation stays high...the more it becomes expected by everyone...the more it sticks arounds...the more it harms the economy.
But, how does high inflation hurt the economy?
The following equation showing the important connections and correlations is the quickest way to spell it out:
Higher Rates > Less Borrowing > Less Investment in Future Growth > Less Long-Term Employment > Less Spending > Slower Economic Growth
This benefit to the economy is the STATED reason why the Fed wants to fight inflation. Now let’s consider...
The Fed’s Ulterior Motive to Lower Inflation
Yes, I understand how conspiratorial that sounds on the surface. But when I spell it out you will appreciate why the Fed cannot publicly talk about this issue as it may create an untimely panic.
It should be a shock to no one that the US government has too much debt. Amazingly we keep piling on more debt without creating a crisis. One thing that has certainly helped in adding more debt is historically low borrowing rates over the past 12 years.
So the ulterior motive of the Fed to fight inflation is to avoid any risk of a government debt crisis. That because higher inflation begets higher interest rates for government bonds, which only puts more stress on the nation’s financial stability.
On top of that consider the massive entitlement programs like Social Security, Medicare, and government employee pension plans also would buckle under the pressure of much higher costs due to long-term inflation. This is money we simply do not have with a tremendous increase in taxes, which would only further harm the economy.
It should be clear that reining in inflation to subdue these issues would be pretty high on the Fed’s reasons to lower inflation. And the reason they can’t talk about this issue publicly is that the mere mention of their concern could well spark a debt crisis as investors may rush out of bonds only for rates to spike further.
Just because they are not saying this concern out loud doesn’t make it any less true.
What Tools Does the Fed Have to Lower Inflation?
The main goal of the Fed right now is to lower demand to bring down prices. This really goes back to Econ 101 to appreciate how supply and demand work together to beget prices.
Remember that this recent bout of inflation was caused by supply chain issues, which limited supply. That plus firm demand = higher prices.
Increasing supply is not really in the Fed’s toolbox. So, they have a better chance of lowering demand to bring down prices and thus tamp down the flames of inflation.
Now let’s talk about how the Fed can lower demand. First and most obvious is their desire to raise rates, which makes borrowing more expensive, which limits spending and investments in future growth (as shared earlier in the commentary).
We all know that they have raised rates six times this past year. Truly the fastest and most aggressive rate hike regime ever. Most signs point to them not being done, but may indeed slow down the pace of rate hikes to 25 or 50 basis points instead of the recent slate of 75.
The second and less talked about approach is Quantitative Tightening (QT). This is the opposite of Quantitative Easing (QE), which was a long-term program of the Fed to buy up $9 trillion worth of bonds on the open market and keep them on their balance sheet.
QE was invented to help lower rates to get the economy back on track after catastrophes like the Great Recession and the Covid crisis. Thus, QT is meant to do the opposite.
That being when the Fed sells $90 billion of bonds a month back to the open market it increases supply of bonds, which with equal demand begets lower prices and higher rates on those bonds. Like I said earlier...
Higher Rates > Less Borrowing > Less Investment in Future Growth > Less Long-Term Employment > Less Spending > Slower Economic Growth
The final tool in the Fed’s arsenal is the idea of “talking down the market.” Meaning to use their statements and speeches to help curb demand. This is a subtle yet effective approach where I tell you with all sincerity that the Fed WANTS to create a recession and bear market.
Let me take a step back to take the next step forward in our conversation.
Earlier I said the Fed wants to bring down inflation. But when you consider the long-term risk of a debt crisis, then they actually NEED to bring down inflation (and interest rates by extension).
So “talking down the market” is about creating a pessimistic atmosphere that leads to lower demand. That can best be understood by appreciating that the people who own the most stocks are also the wealthiest people in the country who spend the most as consumers. Those very same people are also the captains of industry who control corporate purse strings.
With that in mind now consider this chain reaction:
More Bearish on Stock Market > More Pessimistic Economic Outlook > Less Spending (consumer and business) > Lower Demand > Lower Inflation
Once again it seems that I am going the conspiratorial route with this conversation. But do consider the STERN comments made by Fed officials every time we have had a spike in stock prices over the last few months. This is the very essence of talking down the markets:
8/26/22 - Chairman Powell’s Jackson Hole speech about long-term inflation battle and to expect “economic pain.” This speech single handedly put a nail in the coffin of the 18% summer rally that took stocks up to 4,300. Next stop on the tour was hitting new lows under 3,500. That is the textbook definition of “talking down the market.”
11/2/22 - Chairman Powell’s speech to accompany the most recent 75 basis point rate hike. He reiterated many of the key points made in the Jackson Hole speech about this being a long-term battle to lower inflation. The key statement being the ability to generate a soft landing has greatly diminished. This also had stocks tumbling lower.
11/13/22 - Fed Governor Waller speaking at a UBS conference to combat the false ideas investors had about the recent CPI report. Here are the key quotes from that speech:
"The market seems to have gotten way out in front over this one CPI report. Everybody should just take a deep breath, calm down. We're going to see a continued run of this kind of behavior and inflation slowly starting to come down, before we really start thinking about taking our foot off the brakes here. We've got a long, long way to go…Rates are going to keep going up and they are going to stay high for a while until we see this inflation get down closer to our target (2%...not 7.7%)."
No doubt there will be more Fed statements in coming weeks to further talk down the market as investors are getting a bit too giddy. Interestingly, since the misunderstood CPI report created the most recent rally it was also accompanied by a spike in commodity prices, which is inflationary.
Meaning that the Fed is still on a long-term course to keep raising rates + QT + talking down the market to move CPI much lower. NOT from 8% to 7.7%. Remember they want to make it all the way down to 2%.
In conclusion, short-sighted traders have misunderstood the battle lines drawn in front of them and falsely bid up stock prices. Truly NOTHING has changed in the economic picture that stops the looming recession invented and fully supported by the Fed.
Once the Pandora’s Box known as recession comes on the scene it will start to take on a life of its own outside of the Fed’s control. Meaning we don’t know how bad employment will get and how steep will be the cuts to the corporate earnings outlook. This goes hand in hand with what is fair valuation to pay for those lower earnings.
When we have a better view of the bottom of that recessionary well is when stocks will find bottom for stock prices and investors can start preparing for the next bull market. That likely unfolds three-six months from now.
This means our bearish thesis and game plan are still VERY MUCH still in effect. We just need to patiently wade through another in a long line of ill-fated rallies before the bear mauls prices to new lows.
Not just the 3,500 level for the S&P 500 found in October. But likely somewhere between 2,800 and 3,200 is where true and lasting bottom will be found. Again, I suspect that will occur three-six months from now. I hope you have the patience to see the plan through for the betterment of your portfolio.
Gladly all bear markets end, and I very much look forward getting back to bullish times later in 2023. Until then hold firm until the bearish view as that is what will pay the bills in coming weeks and months.
