Mid-week market update: As 2022 opens, I have become increasingly cautious about the stock market. The put/call ratio (CPC) is a bit low, indicating rising complacency. Past instances of a combination of a rapidly falling CPC and low CPC have seen the market struggle to advance. While this is not immediately bearish, it is a flag for caution.
As long as central banks were in unconventional policy mode, the party could keep going. But the asset and credit bubbles may deflate in 2022 when policy normalization starts. Moreover, inflation, slower growth, and geopolitical and systemic risks could create the conditions for a market correction in 2022. Come what may, investors are likely to remain on the edge of their seats for most of the year.
Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures. These participants noted, however, that a measured approach to tightening policy would help enable the Committee to assess incoming data and be in position to react to the full range of plausible economic outcomes.
Some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process, especially in light of abundant liquidity in money markets and elevated usage of the ON RRP facility.
The popping speculative growth bubble
As the Fed has shifted toward tapering and a slowing in the flood of liquidity has begun to get priced in, we are seeing cracks emerge in the bubbliest segments of the market.
As we have noted before, the unprecedented flood of liquidity following COVID has caused our bubble measures to flash red in certain pockets of global markets. We have studied bubbles and built measures of whether economies or individual markets are in them. By our measures, there are likely bubbles in emerging technology stocks, SPACs, cryptocurrencies, NFTs, collectibles, etc. These bubbles have been particularly pronounced in the US, where households piled savings into the markets as their incomes were supported by massive government checks, their spending was curtailed by the lockdown, and lower-cost trading driven by competition and technology made investing (and speculation) easier than ever before.
Of the several key risks that Bridgewater outlined, there are two that I am most concerned about:
- Forced retail liquidation effect: “If the bubble turns, retail traders, especially those who have used leverage either directly or via options, may be forced to liquidate other positions, widening the breadth of the sell-off.”
- Cash generative large-cap growth stocks are not immune to a popped bubble. “These [startup] companies, as well as the broader venture capital ecosystem, have important implications for the earnings of the most important companies in the S&P 500. As shown below, early stage companies deploy a significant share of their cash on things like cloud services and online advertising, which then ends up being revenue for the US tech giants… customer acquisition (Facebook, Google) and cloud providers (Amazon, Microsoft), these companies end up earning significant profits from startup spending.”
Santa Claus has left the building
In conclusion, I don’t mean to imply that the market is about to crash, but the stock market is vulnerable to a setback. I don’t know if today’s risk-off reaction to the release of the FOMC minutes is the bearish trigger.
Subscribers received an alert that my inner trader sold all his long positions yesterday and stepped to the sidelines, citing event risks such as the release of the FOMC minutes today and Friday’s NFP report. If this is the start of a major bear leg, my inner trader is waiting for the sell signal and believes there will be sufficient time to profit accordingly in a falling market.