Another week, another frenzy of forecasts on what the Fed will do.
Powell’s comments from last week’s meeting were taken as hawkish, setting gold back (it seems the market is refusing once again to acknowledge that gold gains alongside rates once a hiking cycle beings), hurting stocks, and lifting the dollar. Then four Fed governors emphasized in speeches that they do not expect to be aggressive or surprising as they tighten. Everything reversed.
I believe the Fed will avoid surprises at almost all costs. They’ve spent the last decade establishing trust with the markets that they will telegraph their intentions clearly. On that basis, I tend to believe what they say.
But they have to tighten because inflation at 7% steals half your wealth in 10 years. And loss in spending power because wages fall behind inflation can derail an economy based 70% on consumer spending pretty easily.
I have been characterizing the Fed’s task as threading the needle: they must tighten enough to tame inflation without suffocating growth or upending the markets.
That’s not an easy task. In fact, when I considered that task last fall I thought it almost impossible, which led me to think that a stock or bond market tantrum could well stop tightening in its path.
But now that we’re many months along the path toward tightening, I have a more nuanced theory. I don’t think traders will throw a tantrum to stop the Fed from tightening, or that a tantrum would solicit a reaction from the Fed. But I do think a legit stock market correction, or crash, is certainly possible as tightening makes debt more expensive and the end of COVID hurts the tech stocks that powered markets higher over the last two years.
On whether the Fed would pause its plans because markets corrected: one of the most interesting answers Fed Chair Jerome Powell gave during last week’s press conference came when he was asked to compare the rate hike setup today with that for the hiking cycle that starting in late 2015.
“We fully appreciate that this is a different situation. If you look back to where we were in 2015, ’16, ’17, ’18 when we were raising rates, inflation was very close to 2 percent, 3 even below 2 percent. Unemployment was not at our estimates of natural rate and growth was, you know, in the 2 to 3 percent range. Right now we have inflation running substantially above 2 percent and more persistently than we would like. We have growth – even in the somewhat reduced forecasts for 2022 we still see growth substantially higher than what we estimate to be the preferred growth rate. And we see a labor market that by so many measures it is historically tight.”
Those words made me rethink my Rate Rage idea. The last hiking cycle had nothing to do with fighting inflation or taming an overheating economy. It was only about normalization – getting off zero rates for the sake of getting off of zero. “In that type of environment, any economic headwind or market volatility was a reason for the Fed to pause,” as Bloomberg’s Joe Weisenthal put it.
Today is different. Inflation is hot, unemployment is sub-4%, and most forecasts see good persistent growth. With an impressive recovery established, the Fed can now spend some of those gains to fight inflation.
That’s a big difference. So I no longer think Fed will suspend tightening at a simple stock market correction.
That said, a stock market crash would be another thing. And there are lots out there who see one coming.
The most convincing such argument I’ve seen of late came from Fred Hickey, who has published The High Tech Strategist newsletter monthly for the last 35 years. (Despite the name, the letter covers macroeconomics, technology, and precious metals.) The team at Incrementum, which publishes the annual In Gold We Trust report, invited Hickey onto their quarterly call.
I read the transcript. You can read his thoughts directly or you can carry on here and I’ll summarize his arguments on tech stock valuations and catalysts.
Hickey argues that the current bubble in tech stocks is greater than what we saw in 2000. Stocks don’t appear quite that overvalued because “fancy financial engineering”, like stripping out stock-based compensation and amortization on intangibles (which is pretty nuts when you’re a software company so intangibles is your primary business), is suppressing price-to-earnings ratios. If you strip out the fancy footwork, P/E ratios are already far higher than they were in 2000.
Bubbles don’t end only because valuations are extreme; there must be a catalyst. Hickey thinks that is already underway: tech stock benefitted extensively from COVID and maintaining those revenue numbers will be impossible this year. Apple is an example: Apple had been growing at 2.7% compounded from 2015 to 2019…then it grew 33% in 2021. iPad sales were up 79%. Hickey listed similar examples: Amazon, Google, Meta, Microsoft.
“Every one of those big tech companies benefitted significantly and that is the reason their numbers were so fantastic. That is how you get to Apple with a 33 P/E. They were 4 growing at that level. Now they are growing at nothing. Analysts are estimating Apple will go back to single digit growth and they are too optimistic. This year I think it will be negative.”
That’s a very real threat to the biggest stocks in the market.
Then layer in that it is very hard to reign in high inflation without hurting stocks. Like many, Hickey thinks “the Fed will have to choose between letting inflation go or letting the stock market go. It’s one OR the other.”
So he thinks tech, which has powered the broad stock market for years and especially in the last two years, is tipping over. He already sees parallel between the dot com crash and the last 11 months. The bubble arguably burst for the ‘crazy’ stocks, the unicorn IPOs and profitless tech stocks, last February but big tech is only starting to feel the pressure now. A similar pattern played out in the dot com crash, when the big tech stocks didn’t crash until 15 months after the early high fliers started to dive.
“That is just the way it is: people are enamored with these tech stocks and they don’t lose faith in them overnight. They rushed into them for a long period when they were called a “safe haven” and they are calling Apple a ‘safe haven’ now. Apple is not a safe place to be. You can’t justify the P/E ratio looking ahead.”
And don’t forget to look back: since March 2020 “we have seen those eight tech names go from US$4 trillion to almost US$12 trillion in market valuation if you include Tesla. All of the money from the institutions was piling into these big names, just as they did in 2000.”
When everyone is doing the same thing and it’s working, there is no interest in gold.
When the setup changes, it can change hard. The big tech names held on until 2001 and then they fell 60 to 90% overnight. I don’t know if that’s coming…but 33 P/E for Apple is insane.
It took time for gold to start moving up last time: through the two-year crash, gold barely budged. It wasn’t until 2002 that gold starting taking off.
I am not saying the tech bubble is definitively bursting. But I think Hickey’s point that the biggest names in the market rose to bubble-territory valuations over the last two years because of show-stopping numbers that cannot continue as consumers and businesses stop buying based on COVID (think Pelaton) makes a lot of sense.
Just today we saw Meta and Spotify plunge after disappointing results and outlooks.
So while I’m downgrading the likelihood that a Rate Rage correction in the stock market will put tightening on pause, at the same time I’m upgrading the possibility that the market will crash for its own reasons. And while the Fed will not pause just because the market declines, a true crash would put tightening on hold.
US Household ownership of equities is at record highs of US$45 trillion, twice the size of the US economy and a level that would make a 20% dip in stocks feel like a lot more. And this chart keeps me awake when thinking about these things. I know I’ve printed it several times recently but this much margin does not end lightly.
I’ll repeat my usual line: a stock market crash would pull commodities down with it, including gold. But gold would very likely rebound hard and fast as investors looking to take advantage of the crash move into a reliable rebound bet. And between the overall strength of the economy and the ramp-ups in demand from the green energy paradigm shift, I think commodities would follow gold back up pretty quickly.
That general premise sets me up for a discussion next week on some other commodity opportunities. Here I’m talking fertilizers, copper, uranium, and met coal.
