The first five trading days of January has long been considered a harbinger of the full year. Some call it the January barometer. So where the market ends up at the close on Friday, 7 January has historical significance.

So far, not good. And while I’m on the subject of seasonal tendencies, December is the strongest month of the year for equities and they went nowhere. It is not a good look.

To get pragmatic, the market is finally starting to react to expectations of higher interest rates in 2022… much higher. The Federal Reserve has a reputation problem of sounding tough and then always chickening out when it comes to raising rates so we had this delayed reaction.

When the 10-year yield rise the mega cap stocks have struggled over the last few months. When yields pull back the stocks move higher.

Enter much higher rates across the board in the last few days and the Mega Caps are in retreat.

What happened today on the 5th was simple. The FOMC meeting notes were published and the market found out they are not only talking ending QE and jump starting raising interest rates, but also “unwinding their balance sheet” soonest. WOW.

I mean WOW!

So maybe they are serious. If nothing else, talking about it makes them look serious. But more importantly, they need to be serious.

Inflation is over 7% and the distorted 10-year Treasury is sitting below 2% which is a deeply negative real interest rate. It’s evil.

Here is the deal on stocks and interest rates…

The largest five companies on the SP500 account for close to 25% of its market value. So those five’s price movements matter. And they are currently achieving a 2% yield on their free cash flow. So to keep math simple, if the 10-year gets half way to where it should already be today (4%) and the SP500 big five yield follows via price adjustments, then they need at least a 50% haircut in price.

I’ve overloaded my website with valuation measures this last couple of years and we watched 2000 stock market bubble valuations in late 2018 move up another 50%. So if the entire SP500 reset a mere 50% lower, the valuation level would still be high by historic measures. This is not out of the realm.

A couple of points:

1. If the central banks were not distorting interest rates via suppression, we would not be in a stock market bubble and interest rates would be higher.
2. Central banks can not undistort rates overnight, it is going to be a process.
3. In that process, they will allow interest rates to rise, the stock market tanking will have an effect on the economy which may help bring inflation down – meaning interest rates will not need to rise to 8% to tame inflation.
4. The main street economy could be supported with fiscal support during the financial asset deflation, but this is very unpopular with the donor class.

It’s really inflation that is forcing the issue with the Fed. And they could not have picked a better time to tighten – record valuations and a decline in fiscal spending.

One valuation measure I have not mentioned uses SP500 dividends. It comes more into play as interest rates rise. Dividend yields will be pushed up with interest rates (this means prices drop). If the SP500 as a whole simply moves back to 2% dividend yield then the SP500 price has to drop to 3200 today (32% lower) and a 4% yield requires a 66% drop.

So expectations for rising interest rates is why the large caps are struggling today and it should get worse this year since rates are on the move.

Now let’s quickly do mortgage rates again.

A 4% 10-year Treasury forces a 5.5% 30-year mortgage rate on new loans. To afford monthly payments, then homes sold would have to be 30% lower in price. Today’s prices are already unaffordable with low rates, it gets much worse with rate rises.

Does anyone see a dilemma here? A lot of people do and their assumption is the Fed can not raise interest rates above some low level regardless of inflation. And this attitude emboldens more inflation expectations.

Everyone also forgets companies can restructure debt (default) and declare bankruptcy (wipe out shareholders) and then continue operations with new financing. This is how Capitalism is suppose to work – risk goes with returns.

So the Fed already talking about selling their balance sheet – it would accelerate interest rates rising to fight inflation – could tip this market over sooner than later.

It is going to be an interesting year.

Invest safe,

Michael Bond

PS. Most of my market commentary is found on my membership website. I provide much commentary even for our basic membership along with market warnings. I hope you take a look. 2022 will be an interesting year to follow.

TSP Smart & Vanguard Smart Investor serves serious and reluctant investors

Categories: Perspectives