On Friday, we had one of the most anticipated events in the asset markets, often more important than earnings: A policy announcement from the Federal Reserve.
Ultimately, Fed Chair Powell announced that it is too early to taper bond purchases and that he will revisit the decision next month.
Here’s a quick breakdown of what this means:
For a long time, the federal reserve has held a dual mandate to promote price stability and full employment. They do this by performing actions which they consider to be either tightening or loosening monetary policy. Up until the great financial crisis, they would primarily use tools controlling overnight interest rates.
Once these hit zero, they followed the Japanese and European central banks into a policy of asset purchases that they call Quantitative Easing. They roughly use this as the next interest rate lever, where more purchases per month is considered easing and less purchases per month is considered tightening. At first it was debated whether reducing those asset purchases was really tightening rather than just “easing less,” but a 2013 event called the “taper tantrum,” where a slight reduction in the federal reserve’s monthly purchases resulted in a spike in interest rates and a drop in the stock market, solidified the view that tapering is tightening.
Since July 2020, the federal reserve has been engaging in Quantitative Easing, where the central bank purchases $80 billion in treasury securities and $40 billion in mortgage-backed securities every month. Powell simply announced that these purchases would continue at the same level for now, which is perceived as “not tightening”, which is perceived as bullish.
What did market participants expect? It depends on their views (inflation vs deflation):
As usual, this brought out the vigorous inflation vs deflation debate back into center stage. Inflationists expected the federal reserve to announce a schedule to reduce asset purchases toward zero, while deflationists expected the federal reserve to wait on that decision.
I am in the deflation camp and I expected Powell not to taper, but here are the arguments as I see them:
- Inflationists point out that the CPI has been above 5% for the last 3 months. Deflationists point out the following:
- This also happened in 2008 before a deflationary bust
- The numbers are narrowly based in 20% of the index. This reflects temporary tightened supply in a few things while true dollar devaluation would show throughout the index.
- The numbers are year-on-year comparisons and 2020 was filled with anomalies.
- Inflationists point out that the payroll numbers were strong and there are many more job openings than job seekers. This could lead to wage gains, and those are problematic because they are sticky and difficult to reverse. Deflationists point out the following:
- The jobs report has many seasonal adjustment factors which make the headline numbers misleading to the upside. While seasonally adjusted payrolls are up 943,000 the non-adjusted numbers are down by 133,000.
- The counting of unfilled jobs is questionable, as the methods leave plenty of room for double- or triple-counting open jobs.
- Most of the unfilled jobs are the very low wage retail and service jobs that were lost in the pandemic response. While some employers are experimenting with one-time payouts or temporary raises, few are actually increasing hourly pay. Also, these are typically high turnover jobs and there are many examples over the last decade of employees being replaced by workers at lower wages.
- The boosted government unemployment benefits are about to end. The people receiving this money are at the low end of the income spectrum, so all of this money tends to be spent. Whether they stay on reduced unemployment or opt for low wage jobs, less money will be spent into the economy so it will have a deflationary effect.
- Inflationists point out the skyrocketing asset prices in stocks, bonds, and housing as a negative side effect of QE that will lead to increased rents and increased wealth disparity. This one’s an interesting narrative, but I’ll point out the following:
- The federal reserve has consistently shown that it favors higher asset prices and fears asset price declines. In addition, they have repeatedly claimed that their actions do not promote wealth disparity. Regardless of what you think on this issue, this is clearly not something that they are considering as a factor in reducing asset purchases at this time.
- Rents are not set by cost of housing, but by the supply and demand of renters. Supply of rental units is about to increase. A bunch of people will be evicted as the moratorium on evictions comes to an end. Many of the evicted renters could not afford their previous situation so they will be both unable to afford a similar unit and unable to pass the typical background & credit checks that most apartments require. At the same time, demand of rental units will be limited to the ability and willingness of renters to pay.
- Inflationists point to the central bank balance sheet and how fast it’s grown. In fact, it has more than doubled since 2020. That represents a large increase in the money supply which should ultimately cut the value of the dollar in half. This is a very common misconception, so I’ll point out the following:
- Quantitative Easing is not money printing. All it does is take government backed assets from the big banks and replace them with an overnight reserve asset. This reserve asset is not money, and it cannot be spent by the banks or used to pay down debt; it can only be transferred between the large banks that have accounts with the federal reserve.
- The Bank of Japan first announced negative interest rates in 1999 and quantitative easing in 2001. These policies have not lead to any inflation in the Japanese Yen.
- Most of the asset price increases following the federal reserve policies have been offset by increases in debt. Housing has gone up in price along with levels of mortgage debt. Stock prices have gone up along with levels of margin debt. This leads to a dangerous situation where a stall in the increase of these asset values can lead to sales to pay down this debt, which reduces prices and then cascades into a deflationary flood of sales and margin calls as seen at the end of any asset bubble. Even if this deflationary bust doesn’t occur, higher prices for the same income streams (in stocks, bonds, and housing/rents) mean that more of these income streams must be diverted toward debt servicing which is again deflationary.
How did the fed decision affect asset classes:
I haven’t explored this in a while, but stockcharts.com has a “CandleGlance” function which allows you to see a lot of indices side by side. This is very useful for sector analysis. I have reorganized these using Paint, with my own notes added.
As you can see above, there were bullish reactions to everything except for the defensive Utilities and Health Care Sectors. Note that I judged a bullish reaction as a price increase on the day, a bullish trend as one with a 20-day moving average above the 50-day moving average, and I put Flat/Bullish where the moving averages were crossing a lot or very close.
Another side note is Technology, which was traditionally considered growth along with consumer discretionary, but there have been debates about changing that designation. I call it defensive, seeing the big drivers in the sector more as cash cows like staples or utilities than as growth names (Apple, Microsoft, Facebook, Google, Amazon… think about it).
The big question is always “where do we go from here?” There are some worrying signs. Margin debt is a big one, which has actually shown a slight decrease this last month. There is also a low in protective puts on individual names, though this is largely because these moved to index ETF’s. Many of the twitter handles I follow have different sentiment readings, which are surprisingly neutral. Valuations are a major concern, but they are notoriously bad in predicting price action.
I’ll go with my gut and say that if the federal reserved is seen as dovish than asset prices are more likely to rise from here. I still think we’re at a dangerous point in the cycle, but if you look at the final manic rises in the 1989 Nikkei or 1999 NASDAQ they were quite spectacular.
I’m not changing my strategy, but I’ll re-state what it is:
- Accumulate junior miners on big dips and patiently wait when they aren’t dipping. The trend is bearish – expect more dips rather than quick gains. The valuations are fantastic in my opinion if you can wait out the trend until that matters, which could take weeks, months, or years. Be mindful that when the bottom hits, though it may be considerably lower, it will be selling off because everyone expects further lows in the future.
- Be cautious of puts as a hedge. Use them only in short term bets based on reasonable technical analysis. I still like both TLT calls and unallocated cash as hedges.
- Don’t be adverse to considering other opportunities. I recently signed up to receive technical setups from twitter handle @derecks_trades and I’m hoping to get in on some when I come up with a system for doing so, possibly with alerts from the Yahoo Finance app. This system is essential for be because I work full time and I can’t follow the market effectively during trading hours.
As far as opportunities go, I’m not adverse to benefitting from the crazy meme stock activity that I experimented with earlier this year. A couple of the stocks I trade have shown heavy call options activity in the past which have lead to price spikes – particularly AG and CCJ – so I check the options charts periodically.
Here’s what I found interesting:
The open interest column shows a lot of Sept 17 call options being purchased for CCJ. The federal reserve statement catalyzed bullish action, pushing those $17 strike calls firmly in the money. Options dealers will have to buy to hedge and others could joint the party leading to another price spike. I decided to join in with calls at the $19 strike – a bit of a gamble but with decent odds.
Anyway, here’s where my portfolio ended up:
- HEDGES (19.5%)
- 19.5% TLT Calls
- PRECIOUS METALS (48.5%)
- 9.9% AG (Silver), mainly shares some calls
- 6.3% SAND (Gold, Silver & others), all calls
- 5.7% LGDTF (Gold)
- 5.1% EQX (Gold), shares & calls
- 4.3% SILV (Silver)
- 3.9% SILVRF (Silver)
- 3.7% MTA (Gold & Silver)
- 3.5% MGMLF (Gold)
- 1.7% RSNVF (Silver)
- 1.7% SSVFF (Silver)
- 1.5% WPM (Gold, Copper & Silver), all calls
- 1.1% GOLD (Gold, Copper), all calls
- OTHER COMMODITIES (17.8%)
- 5.3% NOVRF (Nickel/Copper)
- 6.5% CCJ (Uranium)
- 0.4% CCJ Calls
- 4.1% UUUU (Uranium, Vanadium, Copper)
- 1.5% BQSSF (Uranium)
- CANNABIS (5.7%)
- 1.8% CRLBF
- 1.8% GTBIF
- 1.8% TRSSF
- CASH (8.8%)