Re-testing the Lows, What Next ?

Now that we are breaching the 3,850 level we were discussing this week, what next? Right now, earnings weakness is front and center, and this mood will continue for another 7 weeks until the next round of earnings. Frankly, its not looking good for second quarter earnings: input prices are rising fast, employees are demanding and getting much higher compensation, and its difficult for companies to hike prices quickly.

Often markets explode upwards when there is a big catalyst. For example, GFC stimulus programs like "cash for clunkers" turned out to be great buy signals. More recently, Fed stimulus in response to covid marked the time to buy. Here is a short list of potential catalysts:

• Fed easing or Fed stops hawkishness - this WILL happen - maybe this year

• Russia reversing course or Putin overthrown

• Energy prices fall on their own

• The USA, the world's largest energy country, implements exploration & production incentives

In the absence of huge catalysts like this, we are looking at the normal 9 to 18 months for a recessionary economy to re-emerge stronger. Since the top was November, we are now 6 months into the downturn. Most likely the supply-chain issues will be worked out within a year and by then energy prices will have almost certainly stopped rising. A year from now, investors will be "Ukrained-out", so its looking likely that the upturn is 12 months or less from now. The Fed is unlikely to be fighting inflation 12 months from now, very unlikely without a clean slate. Its been 6 months, how much have they actually raised rates? LOL.

The graph below is a bit small, but its extremely clear that the combination of both oil prices and short term interest rates rising simultaneously is likely to cause recession.

On Sep 30th 1988, WTI oil prices were $13.33 and the effective Fed Funds rate was 8.54%. Nine months later on Jun 30th 1989, WTI had risen 50% to $20.29 and Fed Funds to 9.63%. Real estate prices had a big runup and recession came soon after. On Mar 4th 1999, WTI oil was $13.32 and Fed Funds 4.80% - by Mar 7th 2000, WTI oil prices were $33.90 and Fed Funds 5.68%. Of course, real estate prices had been rising and recession came soon after. A longer cycle preceded the GFC: on Jan 1st 2004, WTI Oil was $32.51 and Fed Funds was 1.0% - by the end of March 2008, oil was $105 and the Fed had CUT rates OVER 3% but it was too late - real estate had been on a tear, and energy prices up 3.5x and interest rates going from 1% to 5%, all in 4 years, was enough to cause the GFC.

In all the scenarios above, both energy prices and interest rates went up a lot, and eventually the economy responded with a big slowdown. Note that for the first time in history, interest rates stayed near zero for over 5 years, and guess what - no downturn.

What to do? Depending on your personality, a few rational choices might be:

• Sit in short term cash-alternatives & patiently wait for your opportunity to get longer

• Pick opportunities carefully: don't place many trades, be greedy & go big on the few & far between mispricings

• Trade tight time horizons if you have a good system

Don't count on the Fed or the government to get it right. Eventually the capitalist system fixes problems, so things like supply chain and high oil prices are likely to be fixed within a year. The recent resilience of oil prices suggests that supply is not ramping up quickly enough, which is one reason we are not medium term bullish yet.