STATE OF THE MARKET: INFLATION & YIELD DESPERATION

28 NOVEMBER 2021

I haven’t written much on the general market in a while. The reason is simple: nothing fundamental in the trends I outlined have changed – inflation raged on, energy stocks and commodities performed well, and the West still seems immersed in COVID chaos.

While I believe those trends will continue for many years to come, I think they’re about to encounter some increased volatility as greater market trends change.

Inflation is the root problem

YTD 2021 Annual CPI

YTD 2021 Annual CPI

For most of this year, inflation has been over the Fed’s target rate of 2%. This shouldn’t be news to anyone since a quick trip to the grocery store will let you know “real” inflation is probably in the double digits.

What does this mean for the stock market?

It means holding cash is making people poorer, forcing them to risk their money in the market to get some yield.

This has always been the case ever since the US brought the world onto its monetary standard 50 years ago. The difference now is the problem is much more severe.

The following explanation shows the problem of inflation clearly.

Let’s just assume the government isn’t lying about their inflation numbers. And let’s assume you want to maintain your purchasing power for 10 years. In other words, how much does $1 have to be worth in 10 years so you can buy the same amount of stuff?

Before COVID lockdowns, inflation was around 1.5%/year. Assuming it stays at 1.5%, you will need $1 to be worth $1.16 in 10 years to maintain your purchasing power.

$1 with 1.5% inflation compounded over 10 years: $1 * (1.015^10) = $1.16

Now do the same calculation with 2021’s inflation of 6.2%.

$1 with 6.2% inflation compounded over 10 years: $1 * (1.062^10) = $1.82

In the first situation, you would only need a 16% return in 10 years to keep your purchasing power/”keep up with inflation”. This can be reliably done by holding lower risk assets like certain bonds or stable, dividend-paying blue-chip stocks like 3M.

In the second situation, you would need an 82% return in 10 years. That’s almost a double. This can’t be done (as reliably) with stable, blue-chip companies since they don’t grow fast and economic conditions may be poor some years. So the only logical next step is for you to go “further out in the risk curve”, which means throwing money at riskier, typically overvalued companies in hopes they can outgrow inflation.

This is exactly why people are jumping into overvalued tech stocks and EVs – since 3M’s 3% dividend is not enough, people have to pray an EV company with nothing but a CAD design will be able to sell enough cars 10 years in the future.

Most recently, even many tech stocks are not enough to combat inflation. Thus we’re seeing people piling into shitcoins like Shiba Inu and NFT “art” I can create in MS Paint in 5 minutes!

And that’s just various asset markets. The labour shortage, labour destruction, energy crisis, massive trade deficit and political unrest all stem from inflation.

Market indicators at extremes

As a result of ludicrous fundamentals, quite a few technical and market indicators are waving red flags.

  • The SP500, Dow, Nasdaq and TSX are at all-time highs and well above their 50 and 200 day moving averages. This is when foreign markets are rolling over or just recovering to their pre-COVID highs
Nasdaq QQQ Nov 2021 Overvalued

QQQ YTD

Asia Europe ETF FTSE RAFI PXF Nov 2021

PXF Foreign Developed Markets

  • People are buying six times more leveraged long ETFs than short ETFs.
Leveraged ETF Long vs Short 2021
  • Wilshire 5000, which tracks 5000 US listed companies compared to margin debt.
Wilshire 5000 Margin Debt 2021
Margin Debt as Percentage of Wilshire 5000 2021
  • Active fund managers are highly exposed (they’re long and optimistic). Values above 80 are considered overly optimistic.

Etcetera, etcetera. You get the idea. I’m not huge on technical analysis, but it does quantitatively contextualize the fundamentals.

Bigs getting bigger

While so much money is being invested, most of that money is chasing just a handful of large-cap stocks. In fact, many mid and small-cap stocks are flat or taking a beating this year.

Notably, if we look at Cathie Wood’s ARKK fund, which mainly holds big-promise tech stocks under $100 billion, most of her stocks are down.

ARKK Individual Stock Performance 2021 YTD Dec

ARKK individual holdings performance

Basically, the only thing keeping her alive is Tesla!

Indeed, Tesla is a top gainer YTD in the Nasdaq 100 along with a bunch of other high flyers.

Nasdaq 100 Top Gainers YTD 2021 Dec

Top 20 gainers YTD Nasdaq 100

So the bigs are getting bigger as investors doggy pile into the last “mainstream” stocks that may provide them with a yield worthy of beating inflation.

Inflation – temporary enemy

If you’ve been on my site for a while, you’ll know inflation is the default. If you haven’t, read the first 19 pages of my Gold and Silver Report.

Even though inflation ran hot this year and I believe it will continue long-term (until it can’t), that doesn’t mean there won’t be periods of deflation. The purpose of this article is to say I believe we are at one of those periods.

First off, markets are extended as mentioned above.

Second, inflation is (finally) soooo obvious it’s making headlines on news media and the average Joe is noticing its effects. From gas to food to haircuts, even leftists who claim to love inflation are suffering from an increasing cost of living.

The State is doing whatever it can to sweep the problem under the rug. First they denied inflation existed, and then they said it would be transitory, and now they’re blaming the Saudis and corporations for squeezing us for profit.

2021 Changing Inflation Narrative

But now, because more of the public is looking negatively at inflation, I believe the State has a timely excuse to tackle the problem (or at least appear to). This way, Biden can take credit for any good things brought about by deflation – cheaper gas, energy and groceries, while scapegoating Powell for any stock market turmoil (it’s one reason I believe Powell was renominated).

In the end, the State and the Fed retain their legitimacy and the charade goes on.

Short the doggy pile

Ignore the following trade if you have a poor sense of market sentiment. It relies on having a pulse on the market. This is not the usual buy and hold investment.

To profit from a possible deflationary speed bump, I like shorting the doggy pile, which I loosely define as the promise-based, low earnings, high-flying tech stocks. EV stocks, Tesla, Nvidia, AMD, Shopify, top-gaining Nasdaq 100 stocks as well as ETFs like QQQ and SOXX are in this pile.

I suggest being nimble and treating this as a short-term trade/swing trade. Short on short-term run ups and trim/close your positions fast. Rinse and repeat. I don’t recommend holding your short position for “the crash”. This is more about getting exposure to a limited upside, probable high downside situation in inflated stocks. Trying to pull off “The Big Short Version TSLA” is just a bad idea: https://www.youtube.com/watch?v=Az3CA7J_39c

I’ll provide an update article or To the Point dispatch when the narrative changes again.

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