With the S&P 500 and the GDXJ ETF declining on June 8, the daily shift from optimism to pessimism highlights the fundamental frailty of the financial markets. Moreover, while some investors assume that overly-bearish positing can elicit more than just short-covering rallies, the reality is that the S&P 500 and the GDXJ ETF are likely nowhere near medium-term bottoms.
To explain, Cathie Wood – who runs ARK Invest – may go down as the poster child of this bubble. With the oracle confusing speculative growth stocks for generational innovation, the ghosts of QE have some assuming that 2020/2021 was the norm and not an aberration. However, with ARK Innovation’s flagship fund down by more than 70% from its highs, you would think her mystic would have fallen along with it.
Please see below:
Yet, with the ARK Innovation ETF recording $1.38 billion in net inflows in 2022, retail investors continue to pour money into the embattled fund.
Please see below:
As a result, there is no fear in the financial markets. With the consensus assuming the Fed will turn dovish and solve all of the U.S.’s economic problems, investors have lined up to throw good money at bad investments. To that point, I noted on May 25 that the psychological effect of the Fed’s continuously pacifying the markets has clouded the judgment of a generation of investors. I wrote:
We’ve officially entered the monetary version of The Boy Who Cried Wolf. With Fed officials running to the rescue each time the financial markets show signs of stress, investors are programmed to ignore their hawkish threats. However, while these post-GFC pivots occurred with inflation perched near 2%, investors are so steadfast in their belief that they ignore the climactic consequences of unanchored inflation.
Therefore, while investors either don’t know or don’t care about history, they have complete faith in a shepherd that has already led them to slaughter. For example, Wood told Bloomberg on Jun. 8:
“I’ve never seen [retail] inventory surges like this in my career and I’ve been around for a long time. This inventory issue highlights the cyclical reason we’ve been saying we think inflation will unravel.”
Please see below:
Source: Bloomberg
However, notice what Wood wrote on Twitter on May 15, 2021?
Throwing Good Money at Bad Investments
Thus, it’s been more than 12 months since her “powerful sources of deflation” haven’t materialized. Yet, despite the ~70% drawdown, investors continue to believe that her losing streak will be reversed. As such, is this the kind of unwavering faith you see at market bottoms? In reality, these managers often suffer the brunt of the criticism when bull markets unravel.
Furthermore, it’s not only the speculative corners of the stock market that have seen inflows. On aggregate, money is still fowling into mutual funds and ETFs as retail investors “buy the dip.”
Please see below:
To explain, the purple line above tracks the ISM’s manufacturing PMI, while the blue line above tracks the three-month percentage change in equity fund flows as a percentage of assets under management. If you analyze the right side of the chart, you can see that flows have decelerated but remain positive.
On top of that, Bank of America’s Global Wealth and Investment Management (GWIM) clients – who are generally high net-worth individuals – equity allocations remain well above their historical average of ~56%.
Please see below:
To explain, the blue line above tracks GWIM client holdings as a percentage of assets under management. If you analyze the right side of the chart, you can see that the S&P 500’s struggles have only resulted in an immaterial drop in equity allocation.
Moreover, when the Fed fanned the hawkish flames from 2015 to 2019, GWIM clients recorded sharp declines in equity allocations. However, with investors bracing for a dovish pivot, their Boy Who Cried Wolf belief couldn’t be more apparent.
As a result, while many sentiment measures are profoundly bearish, actions speak louder than words. Furthermore, when speculative stock buying is abundant, retail investors continue to push chips into their mutual funds, and GWIM clients won’t sell, I highlighted on May 19 that hope has overtaken objective analysis. I wrote:
While Fed officials realize that inflation will only subside if commodity and stock prices fall, a near 20% peak-to-trough decline in the S&P 500 still hasn’t spooked market participants. Moreover, while some claim that sentiment is extremely bearish on Wall Street, the reality is that no one fears the Fed.
To that point, Wood’s comment that the “inventory issue highlights the cyclical reason we’ve been saying we think inflation will unravel” lacks fundamental credibility. For example, I noted the inventory builds at Walmart (NYSE:WMT) and Target (NYSE:TGT) previously, but referenced how Ralf Lauren, Nordstrom (NYSE:JWN), Home Depot (NYSE:HD), Foot Locker (NYSE:FL), Canada Goose, TJX Companies (NYSE:TJX), and Macy’s (NYSE:M) painted much more different portraits.
More importantly, Wood and the consensus don’t realize that input inflation is a catch-22. To explain, if companies pass on higher input costs to consumers, it will increase the Consumer Price Index (CPI) and elicit more hawkish responses from the Fed. In contrast, if companies don’t pass on higher input costs, their profit margins erode. Moreover, why would investors pay near-record multiples for stocks if their profit margins are decelerating?
Thus, input inflation is a lose-lose situation for the S&P 500, as both sides of the equation are fundamentally bearish. In addition, input inflation remains abundant; and with S&P 500 companies confronted with the conundrum above, it will take a recession to calm economically-sensitive commodities’ fervor.
Please see below:
Source: Investing.com
To explain, the table above highlights the performance of commodities over various timeframes. If you analyze the vertical red rectangle, you can see that most commodities have risen materially over the last month. Moreover, lumber is the only commodity that’s fallen off a cliff over the last ~30 days.
As a result, these prices will flow into S&P 500 companies’ cost structures in the months ahead and present them with the catch-22: raise prices and stoke inflation or absorb the costs and erode their profit margins. Thus, the Fed needs to reduce input inflation for the bull market to resume, and three rate hikes have done little to deter the commodity enthusiasts.
To that point, the U.S. Energy Information Administration (EIA) released its Weekly Petroleum Status Report on Jun. 8. An excerpt read:
“At 416.8 million barrels, U.S. crude oil inventories are about 15% below the five year average for this time of year. Total motor gasoline inventories decreased by 0.8 million barrels last week and are about 10% below the five year average for this time of year.”
Please see below:
To explain, the blue line above tracks gasoline inventories, while the gray shaded area above reflects the five-year range. If you analyze the right side of the chart, you can see that gasoline stocks have fallen materially below the lower band. Therefore, who is burning all of this gasoline? Many Americans are still working from home, so they're not commuting to and from work. Thus, the sharp drop highlights inflationary demand.
In support of this argument, please have a look at refinery capacity utilization rates. With 93% of U.S. refiners online, why are inventories declining when output is increasing? For context, U.S. refiners produced more gasoline than last week and this time last year. Yet, there still isn't enough supply to meet demand.
Source: EIA
Thus, it’s another week and another all-time high for retail gasoline prices.
Please see below:
The bottom line? More than a decade of dovish pivots have programmed investors to “buy the dip” and await the Fed’s rescue. However, the consensus miscalculates the task at hand. With inflation raging, unrelenting commodity bulls will only be emboldened by a dovish 180. Moreover, if the Fed backs off, the U.S. dollar would suffer, increasing import-related inflation on an FX-adjusted basis. As a result, the bulls don’t realize that the stock market’s swan song has already begun.
In conclusion, the PMs were mixed on Jun. 8, as gold closed in the green. However, volatility has day traders chasing several rallies and dips, and the latter should rule the day over the medium term. As such, while history shows the bulls will hold on until the very end, the economic outlook continues to worsen with each passing day.