Expecting The Expected Unexpected

“Freddo, you handle the pitch. But on the translation controllers, all backwards. So if the Earth starts drifting down you need to thrust aft, not forwards.”
— Tom Hanks as Jim Lovell, Apollo 13

I watched Apollo 13 on Netflix this weekend and was having recollections of this scene as I thought about the stock market getting ready for the week ahead.

The scene is as the crew are preparing for their manual burn to right their course, as they attempt an emergency landing back on Earth. Astronaut Jim Lovell is essentially reminding one of his crewmembers, who is maneuvering their lunar module, that all of the controls are backwards.

Talk about a great analogy for the stock market.

If there’s a lesson to be learned about being dead wrong about the market crashing due to high interest rates, it should be that because the market is a forward-looking mechanism, and because economic data often arrives with a lag, sometimes stocks literally do the polar opposite of what they "should" do.

Here’s the performance of stocks during the fastest and highest rate hike cycle in history, sitting on top of the largest pile of debt humanity has ever seen accrue:

It wasn’t really insane to postulate over the last two years that a quick spike in interest rates would eventually lead to economic calamity and markets crashing. Hell, it may still very well happen. But, putting aside whether or not I got the timing or the thesis wrong, let’s examine quickly why I’ve been wrong so far to begin with.

First, as I noted in an article last week, there is more excess savings left over from the multi-trillion dollar Covid liquidity dump that the Fed set off back in 2020 than expected. Ergo, this gives people more discretionary income and staves off the economic time bomb for a little bit longer than it normally would have taken to blow up with rates at 5%.

Second, rates moved higher than any time in recent history, but they also did it faster than any time in recent history as well. Given that there is about an 18 month to 2 year lag from the time rate hikes go into effect until they have an impact on the economy, we literally may not have even “hit the wall” yet. We could be looking at more of a blindingly quick, unexpected crash into the side of the mountain, as opposed to a prolonged, slow, grueling chokehold of rate hikes, which resulted in the crashes that we saw back in December 2018 — the worst December since 1931. To believe in the soft landing bullshit, you have to look at the below chart and believe the first slow, chokehold of rates moving higher caused a crash, but that the second increase in rates will not cause a crash.

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Does that seem likely, or does it seem like we’re just early in predicting it? The first crash came 3 years after we started hiking.

Third, think of this analogy: we are standing on one side of a river, and the river represents economic consequences. The other side of the river represents where we need to wind up as an economy - the “landing”. Despite all of the jawboning on CNBC and by the Biden Administration, we remain on the first side of the river. All of the victory laps being taken by Krugman, CNBC and the government right now amount to us simply talking about how we’re going to cross the river and how great it’s going to be there, but we haven’t even started to forge our way across yet. Remember The Oregon Trail? We’re literally just “looking around”.

The regional banking crisis was the first “dip of the toe” in the water, to which we responded by bailing out the banks — essentially pulling our foot hastily back out of the water, running away and resorting to more jawboning instead of actually making our way across the river.

Everyone is once again closing their eyes and pretending that there isn’t a rate hike timebomb in the economic river of the country somewhere and we’ve all held hands, sung Kumbaya and collectively decided that it’s totally possible and completely rational to expect to jump from 0% rates — all the way across the river from hikes to anticipating Fed cuts — without touching the stream of consequences between the two.

Anyway, read this closely: just because we have made it this far without a major economic calamity, and just because we have reached the point where the market is looking forward to rate cuts, doesn’t mean that we have successfully leapt from one side of the river to the next. In fact, we are still on the side we started at, spinning yarns about how wonderful it’s going to be when we reach the other side.

We have no idea what will take place when we try to cross the river. Here’s what I think 2024 will hold:

And then eventually:

How’s that for economic analysis?

Finally, layered on top of all of these mechanisms that are fooling the populace into thinking that nothing is wrong, we have a foul, sour layer of icing on the cake that tastes like heavy cream that’s been sitting in the summer sun for a week: financial media and every single person in the Biden administration and at the Federal Reserve crowing about how we have, once again, “beaten the game” and usurped the laws of basic economics, leading us further down the path to their vision of utopia, where a dollar loses 50% of its purchasing power in 8 seconds and the wealth inequality gap expands, accordion-like, resembling Chris Christie’s gullet before he attempts to swallow an entire sheet cake whole, without chewing.

For example, inflation apologist Paul Krugman is proud to proclaim that 2023 was a “miraculous year”.

But I digress. Obviously, two years is a long time to be predicting that the market will crash, only to watch it rage to new all-time highs. And so, take my analysis with a grain of salt, as I also try to do. As I look back over the last two years and think about what I wish I had known when we started raising rates, it would have been all of the above items. Now, looking forward, how can I use what I have learned to try and better forecast where we are heading over the next year or so?

I already laid out at the beginning of the year what I thought the biggest risks were for the stock market going forward in my article laying out my 24 stocks I'm watching for the year. Let’s review these:

Geo-political unrest from hot wars. I continue to see risk for the global economy and the world from the ongoing conflicts in Ukraine and the Middle East. Not only do these conflicts have the potential to drag other nations into them, metastasizing across the globe, but they also had and will have financial consequences for the United States, which is involved in subsidizing these wars in both locations. Continued empire building is the last thing the United States' fiscal policy needs right now, and the longer these conflicts drag on, the more of a negative effect they will likely have on the financial condition of our country. The wild cards here are the United States presidential election and whether or not China will attempt to take Taiwan. I think the latter hinges on the former, although there is a case to be made for China making its move before President Biden is potentially shown the door.
Bifurcation of the world in general. As a result of Russia's attack on Ukraine and the subsequent seizure of hundreds of billions of dollars in Russian FX reserves, the United States and the West have drawn a line in the sand between them and the BRICS nations. Globally, countries are aligning with either NATO and the West or BRICS, China, and Russia. As the delta between these two sides of the world continues to widen, the chance for profound catastrophic conflict grows. I’m not saying World War III is going to happen in 2024, but I am saying that the setup for it looks clearer each passing day. Along with challenging the Western way of life, countries like Russia, China, and India have made it clear that they want to challenge the US dollar — and they control a lot of the world’s commodities (especially oil). For the first time since the 1970s, Saudi Arabia is trading oil in a currency other than the US dollar. Russia, China, and India have also made marked declarations to trade and settle in local currencies. The central banks of China and Russia have been stock-piling gold. There is as much risk of a conflict economically, and through the means of cyber warfare, as there is of a military conflict, in my opinion. At some point, our creditors are going to call our bluff, and the treasury market could dry up. It wouldn’t surprise me if 2024 is the year for this.
The US is unlikely to find a needle in the financial haystack. As everyone enjoys their holidays and looks forward to the new year, very few people seem to understand how precarious the United States' financial position is. Not only is our debt to GDP soaring at around 120%, but our government and the people in charge have made no marked effort to arrest and cauterize the problem. On the contrary, we continue to spend money we don’t have aggressively and have bet everything on the heavy favorite that the US dollar's reserve status is going to hold up. As anybody who lays chalk in the sports betting world knows, heavy favorites often come in, but they don’t always come in. With the stock market overvalued on pretty much any historical metric you can find and interest rates at 5% with no Covid-style helicopter money coming down the pipe, conditions for another year of economic and financial status quo and complacency can only be met by finding a needle in the financial haystack. While TV news anchors crow about a soft landing, the reality is that the plane hasn’t touched ground yet and what nobody seems to understand is that Jerome Powell is tasked with landing a B-52 bomber on the head of a pin. And as strategists need an excuse to continue pumping the stock market, all the major market industries are banking on now is hope. Stocks have pulled forward the idea of rate cuts, and we are once again just closing our eyes and hoping that animal spirits—hereafter referred to as figments of our fucking imagination—continue to drive stocks higher. I think we are overdrawn at the good news bank and are going to need to make a substantial deposit at some point soon.
Inflation or deflation surprises. Despite spending the last decade publicly admitting that inflation is a mystery and we have no idea how it works, how it is created, or why we need or don’t need it, we have somehow felt confident enough to declare victory over it. I find the irony of that hilarious. I don’t know which situation is more likely, but in the coming year I don’t think inflation is just going to mellow out at 2% and hold that line because Janet Yellen keeps repeating it over and over, as if that is the solution to conjuring up the sought-after result. Rather, I think inflation will either surprise us and tick back up again, especially if the Fed starts to ease and liquidity in the economy frees up a little bit more or – the slightly more likely scenario in my opinion – 5% rates and the lag of the last two years of hikes will continue to grind the economy to a halt, and we might even see deflation. This would usher in de-leveraging and a thirst for liquidity that might have everybody selling everything that isn’t bolted down. Ultimately, the deflationary scenario would eventually result in even more quantitative easing because the Fed would be able to say that they are trying to bring inflation back and trying to jumpstart the economy while saving the stock market at the same time. In both situations, it’s tough to envision a scenario where the Fed doesn’t return to some type of emergency easing over the next 12 to 18 months.

And so the fifth risk I want to introduce today is the idea that the market may do exactly the opposite of what people think it is supposed to do, similar to the way it has acted over the last two years.

If you recall, there were several pieces over the last two years where I wrote about the fact that market crashes didn’t start until the Feds started to cut rates. As a refresher, the red dots are rate cuts:

Cuts usually come just after hikes have happened and are set to manifest in the economy.

Bearing all of this in mind, it feels apt to ask what would happen if, once again, the market did the opposite of what it “should” be doing.

As we head into this year, with a major expectation of cuts – despite the fact that inflation isn’t necessarily a finished task yet – what would happen if the market started to experience a drawdown? From there, ask what would happen if that drawdown continued, or even accelerated, as the Fed rushed to try and cut rates to cushion the blow?

Right now, the market is living by the “economic delay and excess liquidity” sword.

This could ultimately be the same sword that the market may die from over the next year or two.

If we had two years of interest rate hikes, and then the next two years were spent euphorically bidding up stocks, while those rate hikes did their dirty work in the underbelly of the economy, and then, the next two years we spent cutting rates, what would the market be doing if its reaction was based on a rolling two-year delay of past events? This is the above scenario where the Fed could be cutting rates, and the market could be crashing at the same time.

The idea is that in the event the market crashes while the Fed is riding to the rescue, or planning to ride to the rescue, it doesn’t mean that there will be a swift turnaround in equities like there was in March 2022. I don’t think people understand this at all, and that this could stun people and cause panic. In fact, such a situation could wind up serving as the breaking point for 15 years of flawed behavioral psychology that reinforced significant malinvestment dating back almost two decades.

It seems like a situation that is extremely unlikely, right? The market, sentiment, and animal spirits, all breaking at the same time for the first time in 20 years during a period of Fed interest rate cuts? It seems completely unprecedented. But I can’t help but think that now is one of the best times in economic history to remind ourselves that the path we are on has been unprecedented in of itself.

Unprecedented paths lead to unprecedented outcomes. Expected the expected unexpected.

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