The following is a summary of our November 22, 2019 Financial Sense Newshour podcast, The Liquidity Rush: Why Markets Are Heading Higher. To listen to this full podcast, click here.
Speaking in our Big Picture segment on Financial Sense Newshour, Jim Puplava noted that last year’s major pullback is unlikely to play out this time around. The Fed was sounding hawkish at that time, while trade tensions were still simmering. There are several differences between then and now.
In September 2018, the Fed signaled a hawkish turn towards more tightening, stating they were nowhere close to neutral, followed by other statements indicating quantitative tightening (QT) was basically on automatic pilot. The Fed subsequently raised interest rates four times, and we saw the December plunge emerge.
By the beginning of 2019, the Fed had indicated it might reverse course. During the market low, the expectation was for the Fed to raise interest rates three times this year. Instead, we’ve had just the opposite—three interest rate cuts.
The Fed’s January 2019 one-eighty was a pivotal point, Puplava noted. It was followed by the end of the QT program in September, which was previously removing liquidity from the markets.
This culminated with a spike in the overnight lending and repo rates, which went from almost 2 percent to 10 percent. Since then, the Fed has poured $102 billion into the market.
“We're calling this the liquidity rush,” Puplava said. “Basically, the Fed is in the process of undoing every single thing it did last year. That's the big difference.”
From Double Tightening to Double Stimulus
The shift in Fed policy was overdue, Puplava noted, especially in light of the fiscal stimulus in the form of tax cuts and an additional $300 billion of government spending that was acting at counter purposes to Fed tightening.
This created an awkward setup where the Fed and President Trump were at odds. Before raising rates, the Fed has been on record telling Congress that fiscal stimulus was needed.
However, when the Trump tax cuts came into effect in 2018 to stimulate the economy, the Fed was trying to tighten down on the economy.
The economy was not overheating at the time, and inflation pressures were low, and questions about the Fed’s aggressive stance started to mount. Additionally, conditions were such that we essentially experienced what Puplava called a 'double tightening', as the Fed was both raising interest rates and rolling over its balance sheet, which created contracting capital conditions in the stock market and led to the September spike in repo rates.
“The Fed is trying to correct this right now,” Puplava said. “The harsh tightening was out of sync with fiscal policy. And that's the first time, quite honestly, in my almost four decades in the business, that I've seen monetary policy heading in the opposite direction of fiscal policy. They normally work in conjunction and support each other. Thank goodness the Fed made that one hundred and eighty degree turn.”
The uncertainty around the 2020 presidential election could throw a wrench into markets, Puplava noted. The Democratic front runners are still Elizabeth Warren, Bernie Sanders and Joe Biden. And issues exist with each potential candidate.
For example, Elizabeth Warren has threatened to break up big banks, increase antitrust enforcement, disrupt the healthcare system, limit fracking and dismember the technology giants. All of this talk creates market instability, Puplava stated.
Warren has also said she wants to confiscate a half to two thirds of the wealth of the country's billionaires through a wealth tax, Puplava noted, and implement some sort of financial transaction tax of about a half a percent. It’s too early to panic because we still don't have a clear Democratic candidate, but if someone with more radical views emerges as the favorite, it could create problems.
“As we get closer to the elections next year, if Warren emerges as the number one candidate, I think this is going to have a negative impact because [her plans] would devastate the market,” Puplava said. “It would probably collapse the economy and the markets if she was to follow through with what she's proposing.”
Setup for 2020
While conditions look good going into December and early 2020, there are some uncertainties developing, Puplava noted. Right now, Financial Sense has increased its equity position in U.S. and international stocks.
Puplava likes dividend-paying stocks that have been beaten up recently, with some down as much as 25 to 35 percent. Some dividend yields are running as high as 3.5 percent, all the way above more than 6 percent.
Black Friday is about to drop, with the Christmas buying season coming into full force. Coupled with a low probability for a change in interest rates at this point, leaving markets in positive territory.
At the start of next year, however, certain events could create rocky conditions for markets. We can expect impeachment hearings early in 2020, for example, as Democrats have vowed to remove President Trump from office.
“I suspect we will kick off the beginning of the year with an impeachment trial in the Senate, so lots of stuff to keep your eyes on,” Puplava said. “The best thing we could say right now is that a lot of money is flowing into this market via Fed injections, and that should keep this market in an uptrend.”
A major contributing factor to the rally in stocks is a massive wave of liquidity into the markets, Jonathan Krinsky, CMT and chief market technician for Bay Crest Partners told Financial Sense Newshour.
First, Krinsky noted, it is important to acknowledge that the global equity market in aggregate, including the S&P 500, made a high back in January of 2018 but for the last 2 years, it has essentially only headed in a slightly upward sideways consolidation pattern.
Taking a wide perspective, Krinsky stated, it seems that we are now starting to emerge from a long consolidation phase, which may serve as a starting point for a higher move.
Instead of looking at this setup as the end of a massive rally, we should think of it as a setup for a possible breakout, he noted.
It is true that markets have come a long way in 2019 from the low we saw last December, he noted, and the rally has been impressive. Because of this, in the short term we may be due for a pause, Krinsky stated.
For one, markets appear somewhat overbought, judging by several metrics, Krinsky stated, and sentiment seems to need a reset.
To track short-term sentiment, Krinsky stated, he looks at the 10-day moving averages of put-call ratios, which are now down to the lowest levels in more than a year to two years.
“There's not much fear out there,” Krinsky said. “People aren't really hedging. Often, once we get this type of complacency, we see a bit of a reset or a pullback. That’s why we’re expecting a little bit of a pullback here into December, which could set up a nice year-end rally.”
Fear of Missing Out
Also known as FOMO, the “fear of missing out” is a factor that can propel markets higher as those on the sidelines seek to get in on a rising market. This is what we’ve seen in the last couple of weeks, Krinsky stated.
This goes hand-in-hand with put-call ratios, he noted. Investors are not buying as many puts as they have been, Krinsky stated, but they're buying more calls right now, which drives down the put-call ratio down.
Fear of missing a move higher is likely the reason why market dips have been so small, he noted. As those on the sidelines wait for a pullback, they become frustrated when it doesn’t materialize, raise their buy orders and chase markets on the upside.
“People are reaching for upside,” Krinsky said. “They're buying some of the more speculative stocks. The fear of missing out has certainly been prevalent. … I don't think that we're going to see anything like what we saw last December. That was certainly a once-in-a-generation December move. I think we could see a little bit of a shakeout, which would present a nice entry point.”
Sector Rotation in Play
For most of this year, the S&P’s defensive sectors, including consumer discretionary, staples, utilities and others, were doing well. Now, it appears financials are beginning to lift off, possibly along with healthcare and industrials.
A lot of money had gone into bond proxies or other high-dividend areas, Krinsky noted, and fears that an economic slowdown would materialize were high. That pressure is abating somewhat, he stated.
Instead, we’re seeing relative under-performance from some bond proxies along with relative out-performance from some of the more cyclical areas of the market. This is true of financials and industrials now, and we’re beginning to see the same setup in healthcare, Krinsky noted.
For example, the overall S&P 500 healthcare sector just broke out of its trading range to a new all-time high, he noted. Biotechs are starting to perform better as well, breaking out of their recent downtrends.
“There is a lot of interesting stuff happening below the surface,” Krinsky said. “This is more interesting to us than the overall S&P, which continues to make slow upside progress. It's really just churning here as we see an underlying rotation under the surface.”
Do Climbing Treasuries Pose Market Risk?
In August, Treasury yields hit some of the lowest levels we've seen since 2016, and now the 10-year is climbing from that lower level, reaching 1.85 at one point.
However, the correlation between yields and the market have broken down somewhat, Krinsky stated. Even as we’ve seen Treasury yields come down in the last couple of weeks, he noted, we’ve seen defensive market sectors come down in tandem.
The correlation may be breaking down a little bit, Krinsky stated. In the medium-term, Treasury yields may be range bound, he added.
“But ultimately, as long as it's not a spike higher, an increase in yields should be a helpful tailwind to some of the sectors we've talked about, such as financials,” Krinsky said. “Also, that should coincide with a bit of a pullback or underperformance in the consumer staples, utilities and REITs that have been beneficiaries of the move in yields.”
Small Caps May Outperform
While several indices have made new all-time highs particularly in the U.S., small caps have not. The Russell 2000 is still around one hundred points below its 2018 high, Krinsky noted.
Krinsky examined the history of the Russell 2000 dating back to around 1980. He studied conditions that existed between all of the times the index went at least a year without making a new 52-week high, and then did finally make a 52-week high within at least a year.
This setup has occurred 11 times, Krinsky noted. When the index makes that first 52-week high, 10 of 11 times the Russell has been higher 6 months later for a median gain of 13.4 percent, he stated.
The only exception occurred in 2002, where the index was lower 6 months later, which happened to occur in the midst of the end of the tech bubble bear market.
This means the chances for a new 52-week in small caps within the next 6 to 12 months are strong, Krinsky stated.
From a risk management perspective, it might be wise to take a small position and wait until we get confirmation of a breakout, he said.
“Structurally speaking, we should see a nice move higher in the small caps,” Krinsky said. “We can't say exactly when it will happen. If we're looking ahead for trades for next year, it's a very strong possibility for some strength in small caps … but we're not quite there yet. In our view, that would coincide with some outperformance from the Russell. Not only should it go up in absolute terms, but because of the fact that it's been underperforming the S&P over the last year, we think it has high potential to actually reverse. I think the Russell can move higher and actually do better than the S&P 500 if we finally get that new high.”
Staying the Course
Despite the possibility of a short-term pullback forming, Krinsky does not advise trying to trade now in anticipation. While it’s tempting to try to time a pullback, there’s no telling how deep it will go, he noted.
When an asset class has stayed range-bound for 2 years—and particularly in the case of equities—and then begins to break out that move can be powerful, he said.
This is similar to the setup the S&P experienced from 2010 to 2012 when the European Crisis and the Flash Crash led to large drawdowns in the S&P for 2 years.
After that period, we saw a nice 55 percent rally from 2012 into 2015, Krinsky noted. Then in 2015 through 2016, a similar sideways setup emerged that ended with the 2016 U.S. elections, followed by the run from the fall of 2016 into early 2018.
“If you look at that pattern, that’s the playbook that would make sense,” Krinsky said. “I think you want to probably stay the course and look for opportunities to buy into weakness. We think we should be getting one as we head into early December.”
Written by Ethan D. Mizer