The Market is Eroding

The pillars holding up the US stock market are crumbling now at a faster rate. Soon the overall market structure and the major averages should breach support levels and head down quickly. Between fundamental problems at Netflix (NFLX) and Meta (FB), and the Federal Reserve moving to aggressive tightening, the warning signs are there for all to see. So far the market movements have been orderly with the high in the first days of 2022. The Dow Jones Industrials peaked at 37,000 on the second day of trading this year. Since then we have seen declines followed by rallies but the lows have been lower each time and the recovery bounces have not exceeded prior bounces. For signs of the next serious decline watch for breaches of the late February lows:

• Dow Jones – 32,300
• S&P 500 – 4,114
• NASDAQ – 12,555

The NASDAQ is now in a bear market down 21% from the November 2021 high at last week Friday’s close.

In prior issues we have mentioned that we expected larger daily declines to occur and that soon we would see a few nasty daily declines of over 1,000 points for the Dow Jones Industrials Index. Last Friday, we got very close with the worst single down day since October 2020. The Dow fell 981 points or 2.8%. Europe saw 3% down days after the Russians started the Ukraine invasion and the NASDAQ has had some down days of over 3% this year. A 3% down day for the Dow at current levels would see a >1,000 point fall. In the coming weeks this is very likely.

Inflation is Rising

The fundamental shift is that inflation is no longer classified by the Fed Chairman as ‘transitory’. In a speech last week he called inflation ‘pernicious’ and commented that the Fed might raise rates by 50 BP and not the previously expected 25 BP rise. The Fed has in its consideration that the supply chain issues are not going to be resolved this year as China remains under tough lockdowns (more on this later) and that the US labour market was “extremely tight, historically so”. Their next two day FOMC meeting is on May 3-4 and his press conference the afternoon of Wednesday May 4th will be carefully watched to see his pronouncements and his tone. If the Fed announces that they will start reducing their US$9T balance sheet by not re-investing US$95B per month of maturities, then the overall tightening of liquidity will be nearly 10% of GDP which will surely push the US into recession. The 10% number comes from the end of the bond buying program of US$120B and the run down of the balance sheet of US$95B which in total is US$215B/month, or US$2.6T annually starting next month. This is as tough as anything done by Fed Chairman Paul Volker in the early 1980s to break the back of runaway inflation at that time. He used rising rates to crush inflation, Powell will remove liquidity in his battle to lower inflation to their 2% long term target (note March US PPI was a shocking 11.2%).

A global slowdown is now inevitable. How severe it gets is unknown. If Russia uses WMDs in their next phase of conquering eastern and southern Ukraine then more sanctions will be added, which could include cutting off Russian sales of crude oil to Europe. Germany and Austria are currently opposed to crude oil sanctions against Russia as they are big consumers of these supplies and can’t replace this source in a few short weeks or even months. If WMDs are used this could rapidly change as has Germany’s defense spending plans and its provision of military supplies to Ukraine. The horrors of the Ukraine invasion shocked the German people into changing their pacifist military stance.

The invasion has not been going well for Russia but a recent change in military leadership, repositioning battle groups and adding hardened and well trained soldiers who fought in the Syrian and Chechen wars is expected to stiffen the Russian military. The next few weeks could see major battles like those fought during WWII.

So between war in Europe, supply chain issues worldwide getting worse, central bank tightening (rising interest rates and lowering liquidity) and food inflation exploding; the environment for stock market bulls is dissipating. Once the breach level noted above are broken we could see markets decline in a waterfall fashion as we saw in 2008-2009 and in Q1/20 and many bear markets throughout history. Market stress is back and the VIX is rising.

How low we go will be determined by the depths of the above issues but I am “highly confident” that we will see the Dow decline into Q3/22 to the 24,000-25,000 level for an overall market decline from the opening high of over 30%. Valuations in the market remain stressed and overvalued. In Chart#1, we show the percent of companies trading above 10x sales. The recent level is down a bit from the unprecedented high but remains above the peak of 2000 when the Dot-Com bubble burst. Thereafter there was market carnage and stocks got battered.

Netflix the darling of the pandemic rose to a peak of US$700.99 in November 2021 (when the NASDAQ peaked) and last week’s subscriber declines and future decline forecasts smashed the stock down to US$215.52 or down by 69% in just over five months (Chart #2). Meta Platforms (formerly Facebook) is under the gun from regulators and from weakening advertising as their models loses support from users. The stock peaked in August 2021 at US$384.33 (Chart #3) and recently plunged to below US$200 per share. It hit US$184.11 last Friday, down 52% over that time frame.

So here we have two of the FAANG stocks getting hammered. With the MEME stock rout and now the FAANGs under attack, the pillars of the market are clearly being eroded. When this translates into a significant market decline is the upcoming battle between the bulls and the bears. The direction downward seems the outcome to us and the timeline for a BUY window is likely during Q3/22. So the next 4-6 months are going to be nasty for bullish investors. We have prepared our subscribers for this erosion and the pain phase is now underway. The energy sector historically lags the general stock market peaks. So just like we saw in July 2008 once the market plunge caused intermarket margin calls, even energy which had great fundamentals at that time (with WTI crude exceeding the record high over US$147/b), the sector does get smacked down when overall markets plunge.

So now is the time to be defensively postured. We hope you are!