In my July 2020 Pro Perspectives note, I said “with the Fed absorbing all credit risk, and flooding the country with money, the banks are profit printing machines.”
With that in mind, three of the big banks reported on Q4 this morning, kicking off Q4 earnings season. All beat earnings estimates, again (as they have throughout the pandemic environment). All are buying back stock.
For the full year 2021, Wells Fargo made $21.5 billion (net income). Citi made $22 billion. JP Morgan made $48 billion.
Combined, that’s better than the total economic output of 70% of the countries in the world.
So the banks win in crisis, as policy makers intervene to backstop risk.
And the banks win in recovery, as a tight labor market and strong consumer and business balance sheets lead to hotter demand for bank products — add to that, rising interest rates, where banks benefit more profitable lending spreads.
That said, bank stocks remain cheap. Against last year’s earnings JP Morgan trades at a P/E of 10. Wells Fargo at a P/E of 11.8, and Citi at a P/E of 6.6 (the cheapest of the big banks). Compare that to a broad market P/E of 29.
What’s showing up early in the earnings calls? Last year it was the supply chain disruption and inflation. This year it’s labor costs.
With that, a bigger move in wages is coming this year.
Few are more in tune with the economy and political agenda than Jamie Dimon (JPM CEO), and he said today that they are willing to squeeze margins in the name of pay. And he also sees a far more aggressive Fed this year than is anticipated (he thinks 6 or 7 hikes).
The SCOTUS decision on the Biden vaccine mandate for the private sector was a huge hurdle cleared today. This should bolster an already tight employment situation.
And with that, we may see the upward pressure on wages pickup. The wage reset has already happened at the low end. The higher earners are next, and are well positioned to command higher wages.
Hotter wage growth will only add fuel to the inflation fire.
With this, the inflation situation and (consequently) the interest rate outlook haven’t been a good formula for the high multiple tech stocks.
On that front, let’s take a look at a victim of this environment, and a potential destabilizing force to keep an eye on for markets: Cathie Wood’s infamous ARK ETFs.
As you likely know, she has been a financial media darling (likely thanks to a well compensated PR agency), as a leading investor in the “companies of the future.” Just a year ago, she had amassed more than $60 billion in ETF assets. It’s since been cut in half.
As the tide is going out on the growth trade, people are realizing that the structure of an ETF isn’t a fit for a private equity-like investment process.
What does that mean? The ARK ETFs give intraday liquidity to investors investing in long-term structural themes. It’s a mismatch. And that can create forced buying when things are going higher (over inflating some of these tech stocks, as we’ve seen), and forced selling when things aren’t working (which can spiral to the downside).
We’re seeing the latter. As you can see in the chart below (the orange line), some of the excess from the “companies of the future” has been rapidly unwinding. And as you can also see, it may be a bad influence on the “money of the future.”
On Friday we talked about the set up for a dollar decline, to reflect 1) U.S. government spending recklessly beyond a rational crisis response, and 2) a Fed that denied the inflationary impact of such a fiscal response for too long.
And we looked at the long term cycles for the dollar. We are about 70% of the way (in time) through a very shallow bearish cycle, which argues that we could have a very steep drop in the dollar over the next two years.
With that in mind, we looked at a shorter term chart of the dollar yesterday. The dollar looked vulnerable to a break-down (lower).
Here’s an updated look…
Indeed the dollar broke to two-month lows today – and it looks like this technical break will get the ball rolling.
This comes on a day when the inflation report showed a 7% year-over-year increase in prices (the highest in 20 years).
With that, notice in this chart the clear trend in CPI, and where it started in March of last year.
I focus on March of last year, because that’s when the word “transitory” started showing up in the Fed lexicon. Clearly, they were wrong.
As important, that language gave the politicians on Capitol Hill the cover of a “no inflation problem” to push through another $1.9 trillion in spending, a $1.2 trillion “infrastructure” package, and advance the dangerous (and massive) clean energy and social agenda spending plan, which finally fell flat, ONLY when Jay Powell did an about face on the inflation view.
Bottom line: The dollar may be in the early innings of paying the price for the monetary and fiscal policy errors of the past year.
Stocks continued the big bounce today into technical support.
Let’s take an updated look at the S&P 500 chart …
So, we had a 5.5% decline in this benchmark index to start the year, and now we have a sharp bounce of nearly 3% from this big technical trendline, which comes in from the election day lows of November 2020 (an important marker).
We heard from Jay Powell today, in his renomination hearings before the Senate. He did nothing to change the expectations on the Fed’s guidance on the rate path. Whether it be three or four hikes this year, we’ve just finished a year with around 10% nominal growth and over 5% inflation.
The coming year may be more of the same, and yet we have a market and Fed posturing and speculating over how close to 1% the Fed Funds rate might be by year end. That dynamic only adds fuel to the inflation and growth fire.
On that note, we’ve been watching three key spots that should be on the move with this policy outlook: bonds (down), gold (up) and the dollar (down).
Gold was up 1.25% today, making another run at this 1830-50 level. If that level gives way, the move in gold should accelerate. As you can see in the chart, we would get a breakout from this big corrective trend that comes down from the August 2020 all-time highs.
On a related note (dollar down, commodities up), the dollar looks vulnerable to a breakdown technically …
We kick off fourth quarter earnings this week. We’ll hear from the big banks on Friday: JP Morgan, Citi and Wells Fargo.
Bank of America and Goldman Sachs earnings will come early next week.
Last year, across the broad market, the table was set for positive earnings surprises, against a backdrop of deliberately dialed down expectations. And those low expectations were against a low base of 2020, pandemic/lockdown numbers.
With that, we’ve had positive earnings surprises throughout the first three quarters of 2021. The expectation is for 21% earnings growth for Q4, which would give us four consecutive quarters of 20%+ earnings growth and 40% earnings growth on the year.
That said, of the nearly 100 S&P 500 companies that have issued guidance for Q4, 60% are negative. That’s straight from the corporate America playbook: Using the cover of the Omicron news from late November to lower expectations, to position themselves to manufacture positive earning surprises OR withhold some earnings power for next quarter.
So, in addition to the changing interest rate cycle, could the slide in stocks to open the year have something to do with weaker Q4 earnings? Maybe.
On that note, let’s take a look at the big technical support hit today …
In the chart above, the S&P 500 hit this big trendline that comes in from election day. This rise in stocks, of course, has everything to do with an agenda that entailed even more massive fiscal spending programs — AND a central bank that remained in an ultra-easy stance.
Indeed, we’ve since had another $1.9 trillion spend passed in late January of last year, plus a $1.2 trillion infrastructure package later in 2021.
Now we have a Fed that has flipped the script, and the additional bazooka agenda-driven fiscal package has been blocked — and we get a test of this big trendline.
The good news: The line held today, and stocks bounced aggressively (about 100 S&P points) into the close.
As you can see in the chart below, we have a similar line in the Nasdaq, dating back to the election. This breached but closed back above the line today.
With the above in mind, we should expect the banks to continue putting up big numbers to kick off the earnings season later this week. That will be fuel for stocks.
Remember, the banks set aside a war chest of loan loss reserves early in the pandemic, and they have been moving those reserves to the bottom line since, at their discretion. As an example, both Citi and JP Morgan have another $5 billion to release, to bring their loan loss reserves back in line with pre-pandemic levels. That’s $5 billion (each) that will be turned into earnings.
We’ve talked about rising interest rates all week. That has been the theme influencing all markets for the new year.
Importantly, it’s not US-centric.
As we discussed last month, when the Fed laid out a timeline for the end of QE and a potential liftoff in rates, it signaled the end of globally coordinated easy money policies.
On that note, among the biggest shifts in the interest rate market have come, and will continue to come, from Europe.
After a near debt-default explosion in Europe ten years ago, and consequently, the near demise of the single currency (the euro), Europe has had three bouts with deflation over the past twelve years. With that, the European Central Bank went bold in 2014, taking interest rates negative — a stimulative policy that forces banks to lend, or pay interest on their excess capital.
But this negative rate policy should be coming to an end, quickly — especially after today’s eurozone inflation number…the highest on record.
With this, the benchmark German 10-year yield nearly traded into positive yield territory today, for the first time in two-and-a-half years (this is bullish for the euro and European equities).
With the above in mind, we opened the week (and new year) talking about the three spots to watch (in addition to a decline in growth stocks): gold, the dollar and bonds.
Thus far, in a world of ultra-accommodative fiscal and monetary policy, still running in the face of hot inflation, bonds have begun the move we should expect (down, interest rates up).
Gold hasn’t yet responded. Nor has the dollar. But today’s inflation data from Europe may be the catalyst to get the dollar moving, lower.
As we know, fiat currencies have been devalued over the past two years against asset prices — by the design of the massive fiscal response(s) to the pandemic. But the relative value of major currencies have been stable. That may be changing, and it would be driven by two factors: 1) the U.S. government spending recklessly beyond a rational crisis response, and 2) a Fed that denied the inflationary impact of such a fiscal response for too long.
This fundamental case for punishing the dollar would align with the technical case.
We’ve looked at my chart of the long-term dollar cycles many times.
If we mark the top of the most recent full cycle in early January of 2017, the bull cycle matched the longest cycle in duration (at 8.8 years) and came in just shy of the long-term average performance of the five complete cycles. This means we are now five years into a bear cycle for the dollar, and thus far, it would be the shallowest in performance on record. That would argue the next two years (to complete an average cycle) could be dramatically lower for the dollar, to the tune of a more than 40% decline against major currencies.
That would, of course, align with the outlook for a continuation of a young bull cycle in commodities prices (lower dollar, higher commodities prices).
The comparisons are being made between the current wind down of QE (and projected rate tightening cycle), and the “taper tantrum” of 2013.
As you may recall, back in May of 2013, after three rounds of QE, Bernanke indicated that the Fed would begin winding down QE by the end of the year.
The interest rate market did this …
This time around, the Fed’s July 2021 minutes hinted toward a tapering of QE by year end. The 10-year yield has since done this …
What was a big difference between now and then?
In 2013-2014, with a soft-fragile economy, and inflation running around 1.5%, the risk of a Fed policy mistake was skewed toward the Fed being too aggressive (pre-mature) and crushing feeble growth. With that, after the knee-jerk reaction in the interest rate markets, the 10-year yield ultimately gave way to a more rational level of around 2%.
What about this time? Inflation is hot. The economy is hot. And the risk of a policy mistake is skewed toward the Fed being too late, and not aggressive enough. With that, the likelihood of a sharp spike higher in market interest rates, after the Fed exits the bond market in March, is high.
We talked yesterday about the regime shift for markets for the new year. This is the first year in a very long time that the Fed will have the task of inflation fighting. And they are behind.
On that note, as we also discussed yesterday, the markets are beginning to price in a more aggressive Fed. Higher rates are bad news for high growth, high valuation stocks. We saw a continuation of that today.
The media will point to the Fed minutes today as some sort of trigger for a sell off in stocks. But the minutes only confirmed what Jay Powell told us a few weeks ago.
Powell set the table for rate hikes, as early as March, in his December (post FOMC) press conference. And he also said in that press conference, that the committee had discussed shrinking the Fed’s balance sheet, and in a manner that would be more aggressive than last time, due to the nature of the strength of the current economy and the inflation threat.
So, with this guidance, we should expect the interest rate market to move higher. It is. The 10-year traded to 1.70% today … and 2% is coming. As you can see in the chart, that would be pre-covid levels.
With this chart above in mind, the Fed has been in control of the interest rate market since March of 2020. By March of this year, they will be out of it. That means we could see a reality check in the coming months — for market interest rates to finally (and maybe quickly) begin reflecting an economy dealing with 7% inflation.
Markets are already adjusting into the second day of the new year.
And the adjustment has everything to do with inflation and the interest rate path.
Remember, last month, the Fed calmed markets by suggesting it would indeed start a tightening cycle. But, importantly, they projected a shallow path for interest rates (never needing to exceed the Fed’s long-term target Fed Funds rate of 2.5% over the coming years). Stocks liked that, particularly the high flying, high multiple stocks (i.e. big tech “innovators”).
So, staring down the barrel of 7% inflation, the Fed told us, just a few weeks ago, that they would tame inflation, to land close to their 2% target, by this year (2022).
And they told us that they would do so, this year, while producing a 4% growth economy (well above trend) at 3.5% unemployment (near record levels) — all while keeping the Fed Funds rate under 1%.
Those are the expectations the Fed attempted to set for the market.
The market is now beginning to price in a more realistic scenario. That scenario entails hot inflation, and a more aggressive rate hiking campaign.
With that, over the past two days, the interest rate market has been on the move. What was priced in to be a June liftoff in rates is now looking like March.
As we discussed into the end to the year, a rising rate environment all sets up for money to move out of the high flyer/no eps stocks, and into value stocks with strong cash flow. A more aggressive Fed would only amplify this rotation.
When you think of value and cash flow, energy fits the bill. This is the only sector in the S&P 500 that is in the red over the past five year period. And with an anti-fossil fuel regulatory environment restricting new investment, the survivors of the storm are selling production at higher prices, and instead of plowing money into exploration, they are producing cash and returning that cash to shareholders. With that formula, no surprise that oil stocks have been on a tear to open the year.
With a sharply steepening yield curve over the past two days, the bank stocks have been on fire. Bank of America is up 8% in two days. Wells is up 10%. Goldman is up 6.6% in two days. And Citi is up over 5%.
Now, with the above in mind, we shouldn’t underestimate the power of the calendar. With a new year, often comes regime changes in markets. We’re seeing signs of it.
As we’ve discussed, this will be the year the Fed is tested, and bad policy may be exposed. With that, we should keep a close eye on these three spots (gold, the dollar and bonds).
If you came in last year loading up on gold (the historic inflation hedge), in anticipation of hot inflation, you got the hot inflation. But gold lost 4% on the year. The dollar didn’t unravel under the pressure of extravagant deficit spending and money printing (in the face of a hot economy). The dollar went up in value against major currencies, not down. And Treasuries, which would, in theory, be dumped under inflationary policies, did very little on the year.
We have another day with a lot of green on the screens: stocks, commodities … everything UP.
Remember, we looked at this chart on Monday …
The S&P 500 was trading into this big trendline (circled). The Nasdaq was trading into a similar trendline (originating from the Fed's massive March 2020 response).
As we discussed, with this big technical support in play, and adding the catalyst of an optimal outcome to the "Build Back Better" negotiations (i.e. a "no deal"), this set up for what looked like a big bounce. We've had it, just in a couple of days.
I suspect we will see new highs, and plenty of fuel for stocks into the New Year, until we hit the date of the Fed's first rate hike (which could come anywhere from March to June). Then, if history is our guide, we should expect a shift to a market that rewards good stock picking (value, over growth and momentum).
As of tomorrow afternoon, I'll be taking the remainder of the year off to spend time with my family.
So this will be my last Pro Perspectives note for the year. For my Billionaire's Portfolio members, please keep an eye out for a note from me tomorrow morning. We will be making a new addition to the portfolio.
If you are not a member, I'd like to invite you to join us. You can get involved by clicking here.
Thank you for being a loyal reader of my daily Pro Perspectives notes. I want to extend my best wishes for a Merry Christmas and a Happy and Healthy New Year!
