The above image was stolen from Twitter.
With stocks just about 1% to 3% off of all-time highs, one has to wonder if Santa Claus is going to bring stock gains to all the little good boys and girls buying out of the money call options. Possibly though, it could be a massive head-fake topping event that gives shorts an opportunity to load up on cheap put options and take positions for 2022.
Here are a few reasons not to be bullish about next year.
Midterm election years aren’t historically great for equities.
The Federal Reserve has an inflation problem.
Stock breadth and money flows still mediocre.
Valuations still stretch.
There’s a $3 trillion PONZI scheme in crypto.
Midterm Elections
There are a few charts floating around out in the internet. The following chart takes a view of the Dow Jones over a 115 year period ending in 2015. Over that time, midterm election years clearly showed the weakest market performance for equities. 1
Here’s another view of the S&P 500 with a bit more detail on a month by month basis from 1931 through 2018.2 Historically markets are choppy for the first nine months of the midterm election year.
This time could be different, but this doesn’t make a great case for bullishness in early 2022.
The Federal Reserve’s Inflation Problem
For years, the Fed has said that they were targeting a 2% inflation rate. In the past, they also referenced the Phillips Curve. This was the simple correlation between employment and inflation that nearly all Fed officials referenced for decades.
What is the Phillips Curve?
The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment. 3
Here’s the rub. The Federal Reserve stopped referencing this relationship. They threw it out. This might have been their biggest blunder recently.
In the middle of 2019, Powell basically said that this time it is different.
“The relationship between the slack in the economy or unemployment and inflation was a strong one 50 years ago ... and has gone away,” Powell says.4
Instead of focusing on the dual mandate of keeping inflation low and unemployment low. The ignored the trade-off and pumped the markets full of stimulus in the form of quantitative easing. This created an equities market exempt from corrections and overly confident. It also created a massive asset bubble.
What’s interesting is that this time, it is NOT different. We have above target inflation with a strong labor market. The curve has possibly shifted to a higher inflation/unemployment point, but the unemployment rate doesn’t reflect real labor market conditions. This failure to react to an overheating economy may be the Fed’s big policy blunder of this decade and it happened before the pandemic began.
Job openings are at an all-time high, but also the number of job openings less unemployed people is also at an all-time high.
Historically, the Federal Reserve has stepped in to raise interest rates when inflation is above target and employment is stable. Currently, inflation is at a 39-year high at 6.8%. The last time inflation was this high in 1982, the Fed Funds rate was 9.00%.5 Today, the same rate is 0.25%. The Federal Reserve will need to raise rates since they have recently admitted this inflation is not transitory.6
The period of raising rates has been known as “taking away the punch bowl.” Some people will say that this time it is different. It is not.
Stock Breadth and Money Flows
This is not a new topic for me, but I will add this tidbit. Stock market breadth and money flows were negative right before the Thanksgiving mini-crash, but have since recovered briefly. Using the below McClellan Oscillator as a guide, you can see the short-term recovery in money flowing into markets.7 You might also notice what could be described a potential triple top in the S&P 500 and possible head and shoulders in the Nasdaq composite. That’s not a prediction, but a simple observation.
For the Nasdaq, which is heavy on large cap growth, the The New Highs - New Lows indicator is still not looking great. This indicator shows the difference between the number of stocks reaching new 52-week highs and the number of stocks reaching new 52-week lows. For the Nasdaq, this is still negative, meaning that gains are coming from a smaller number of mega-caps.
Valuations
Again, I am going to circle back to something I have written on repeatedly since starting this substack. Market Cap to GDP is elevated. This tweet popped up in my feed and came across the same little-researched rebuttal in the responses.
The same rebuttal is often repeated and it reads, “This metric keeps getting promoted and is so irrelevant. The world is more global now and the majority of the companies in sp500 have global operations. No reason this metric should still be used”
This is incorrect. In my previous post, I inserted supporting evidence that the S&P 500 is almost exactly the same amount foreign exposed as it was in 2000. For twenty years, foreign sales as a percentage of total S&P 500 company sales has generally remained the same. In the first study, the evidence supports a nominal 1% or 2% gain for the 10-year period ending in 20108 and Goldman Sachs actually asserts a drop in the total percentage foreign sales over the next ten years.9 This makes an apples to apples comparison for the 20-year period.
Therefore, this bubble is indeed larger than the dotcom bubble. What’s even more interesting is the bubble shown above doesn’t include cryptocurrencies.
For the interest of keeping things new, let’s put up a chart of the S&P 500 Price to Sales ratio. This ignores earnings adjustments. This ignores domestic GDP. It’s purely a valuation metric and you can easily see that the current bubble dwarfs the dotcom bubble.
Again, cryptocurrencies don’t have sales and are not included in the S&P 500. The total value of all stocks in the S&P 500 was about $38.41 trillion in October.10 It has since risen about 3%.
The $3 Trillion Ponzi
With the S&P 500 around $39-$40 trillion right this moment, it may come as a surprise that cryptocurrencies were worth about $3 trillion just a few weeks ago. That’s a big Ponzi scheme and arguably the biggest Ponzi scheme ever.
I am not the first or last person to call cryptocurrencies a Ponzi scheme. What’s interesting is that the people making money on these schemes, and covering them like securities, are also openly calling them Ponzi schemes. At the time of this writing, Coindesk hadn’t even taken down the tweet below, which to me seems like a public admission of guilt. Perhaps none of them remember what happened to Bernie Madoff.
I remain mostly long, but very bearish and have been adding more Invesco QQQ ETF (QQQ) put options as the market rises. Duration on these options is one to three months.
When Bad Turns Good - Mid-Term Election Year Stock Market Performance, http://www.financialperspectives.biz/perspectives-investment-blog/j9x7k2j6twsyrek65fzcsaby7ht6l2
U.S. midterm elections and market moves: 5 charts to watch, https://www.capitalgroup.com/advisor/ca/en/insights/content/articles/us-midterm-elections-and-market-moves.html
Phillips Curve, https://www.investopedia.com/terms/p/phillipscurve.asp
The Fed chairman says the relationship between inflation and unemployment is gone, https://www.cnbc.com/2019/07/11/the-fed-chairman-says-the-relationship-between-inflation-and-unemployment-is-gone.html
Recession of 1981–82, https://www.federalreservehistory.org/essays/recession-of-1981-82#:~:text=By%20October%201982%2C%20inflation%20had,Federal%20Reserve%20Bank%20of%20St.
Why U.S. officials say inflation is no longer ‘transitory’, https://fortune.com/2021/12/03/inflation-no-longer-transitory-higher-prices-fed-chair-powell-treasury-yellen/#:~:text=%E2%80%9CWe%20tend%20to%20use%20%5Btransitory,a%20congressional%20hearing%20on%20Tuesday.
McClellan Oscillator and New Highs, https://www.marketinout.com/chart/market.php?breadth=mcclellan-oscillator
Understanding the S&P 500, https://napllc.com/wp-content/uploads/2013/03/JIC-UnderstandingSP500-IndraniDe.pdf
S&P 500 companies' non-US revenue share hits 10-year low – Goldman Sachs, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/s-p-500-companies-non-us-revenue-share-hits-10-year-low-8211-goldman-sachs-590949
The S&P 500 Index: Standard & Poor's 500 Index, https://www.investopedia.com/terms/s/sp500.asp
The World’s Cryptocurrency Is Now Worth More Than $3 Trillion, https://time.com/6115300/cryptocurrency-value-3-trillion/
Coindesk Tweet, http s://twitter.com/CoinDesk/status/1469677423423799302?s=20