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2021 Peak Policy Extreme. 2022 Challenges And Opportunities.

2021 was a Fed sponsored market freak show.

The markets were dominated by record levels of liquidity, leverage and speculation with the most stimulative financial conditions ever. This produced market distortions and price behavior that has never been experienced before.

Investors need to understand that the big cap equity index averages disguise an uneven distribution of performance across all individual listed stocks.  A limited number of big cap stocks attracted most of the liquidity and performance as never before. If we measure US equity markets in a different way, using the number of stocks performing well, rather than a market cap weighted aggregate, a very different picture emerges. 

The chart above shows that peak momentum and participation of stocks in the Nadaq composite was in the first quarter of 2021. Thereafter, the majority of stocks fell in to a bear market below the 200 day moving average.

In 2021 the Fed’s liquidity excessively inflated US equity indexes, but mainly through supercharging just a few stocks to extraordinary valuations. As I have shown in previous notes, the standouts were zombie stocks, who don’t make any profits, meme stocks like AMC, and a few mega cap stocks.

This kind of action can flourish in a quad 2 reflation environment, but quad 2 ended in November, 2021.

The peak for US stocks and bond yields more broadly was in Q1 2021 (see below). Beyond this point the markets experienced unprecedented and extreme breaks in normal behavior and correlations.

In the US government bond market prices not only broke, but completely reversed their negative correlation with the CPI inflation rate in Q2, 2021. Bond prices rose even as the CPI exploded to its highest level in 40 years. As a result, real interest rates on Treasury bonds fell to their lowest level in history!

Even after inflation had exploded to multidecade highs, the Fed kept financial conditions at record levels of stimulation.

Investors need to understand that the unprecedented markets of 2021 will likely be tested in 2022 by a very different set of circumstances. (discussed below)

Its worth reviewing 2021 in the context of recent years to grasp the scale and significance of what is at stake in 2022. 

Key US equity market Indicators peaked in February 2021


The Chart above shows that peaks in these two equity indicators coincided in February 2021.

  1. The price of the S&P 500 relative to its 200 day moving average reached a 10 year peak. So this was a significant momentum high.
  2. At the same time there was also a breadth high in the much broader index of all stocks trading on the NYSE. The greatest number of stocks in the last 10 years were participating in the uptrend.

There were also peaks for the year in February 2021 in the Chinese stock market and in IWO, the Russell 2000 growth stock ETF.

Furthermore, the bond market yield also peaked in Q1 2021 as did yield curve steepening.

Q1 2021 was therfore a significant multi market high in a range of indicators. 

From that point forward market behavior changed significantly. It seems there was a division in the markets between a few big cap stocks which disproportionately boosted the S&P 500, while most stocks declined, and the bond market never made new 10 year yield highs as it ignored the explosion in the CPI to 40 year highs over the rest of the year!

The last half of 2021 was mainly erratic and directionless. While big cap stocks made new highs, wider  participation in the rally collapsed. It seems that liquidity helped to extend the big cap rally somewhat, but important indexes like the IWO, wiped out all the gains of the year.

Investors need to realize that the main reason for the outsized equity index gains in recent years has been policy, not organic economic development.

Despite broad economic failure over the decade that followed the 2008 stock market collapse, the same policies were massively increased at the beginning of this decade. In 2019 the central bank commited themselves to the maximum policy action of zero interest rates, trillions of asset purchases, massive government spending and debt: 

“Time to ignite all engines, BIS says in its Annual Economic Report”

In this document the central banks gave themselves discretion to extend the scale and breadth of their policies to extremes. Why? As my review in January 2, 2020 showed, the prior 10 years of policy had showed disappointing results.

Everything that has followed, in policy terms, has been in line with this new commitment, to go bigger and broader than ever before on policy measures. The questionable efficacy of doubling down on failing policies does not seem to have been a concern.

Policy injections do improve the economy and markets in the short term. While policy is implemented growth is rising, and big cap equity indexes do too. No surprise and initially it seems that there is no problem with this new more aggressive strain of economic stimulus.

Just the liquidity from these policies is enough to boost prices. In 2021 record equity buybacks of over $1 Trillion, added to well over $1 Trillion of Fed asset purchases caused a flood of liquidity flowing into markets in a short period. Initially this creates a uptrend that excites participants to record allocations and leverage. With record government spending economic growth is rising, who can resist the prospect of making money fast?

In this environment, speculation becomes the preferred investment style. Risk management becomes an outdated inconvenience that limits exposure and short term returns. More leverage is what the speculators really want. While the firehose of liquidity is turned on the bigger the position the better.

The Central Banks converted markets to negative return investing and speculation

As this process matures few consider the notion that longer term expected returns on the rising assets are declining or become negative. So when the liquidity impact fades, there is nothing to hold on to and no one left to support the record high valuations. As assets come to represent “return free risk” the longer term dynamics have changed. This is speculation not investment. Unsupportable prices will reverse and without risk management speculators will only sell once the pain of losses becomes too great. Every speculator will eventually sell and most will leave with painful losses.

The problem with unsustainable policy settings is that despite the initial excitement and seemingly benign effects, this approach sets off unproductive incentives and behaviour that creates long term economic damage over time. The Fed’s policies will likely just achieve the same long term disappointment as before, but with greater intensity in line with the new scale of their policy intervention.

To go more deeply in to this, here is the outstanding insight of Dr Lacy Hunt in his latest interview.

Now the 2019 central bank BIS plan will face the downside of its discretionary extremism.

Wall Street and the Fed are underestimating the challenge of 2022

Politically the Fed had to pay lip service to the “inflation problem”, and hopes that a few minor measures taken slowly over time will address the problem. However,  the Fed may run into a problem if inflation stays high as the Fed maintains still stimulative policies. At some point the Fed may have to make a choice between inflation on the one hand and markets and growth on the other.

In other words, the Fed is still thinking the way it has thought for the entirety of the twelve years since 2009, when today’s QE experiment began. In that view of the world, it’s never the right time to end unconventional monetary policy. It’s never the right time to sell off assets. It’s never the right time to let interest rates increase by more than a percent or two. Meanwhile, the reality for ordinary people has been one of the weakest and slowest recoveries in history. But the Fed justifies it all to itself because Wall Street is happy.

That’s been the reality for more than a decade. And there are no signs that the Fed is “pivoting” away from that any time soon.”

While the Fed will need to make some key decisions next year, investors need to understand that already, the high probability outlook for 2022 is potentially the opposite of 2021. In 2022, not only will Fed policy become less stimulative, but in addition government spending will decline year over year. Furthermore, it is already likely that both the inflation and growth cycles will turn down early next year. Quad 2 reflation over most of 2021 is giving way to Quad 4 deflation conditions in early 2022.

Reinforcing that view we can see that the global credit impulse is turning down. The policy stimulus was meant to be a bridge back to the private sector becoming self sustaining again. That is not the signal being given by the global credit impulse.–global-credit-impulse-update-17122021

“The Credit Impulse represents the flow of new credit issued from the private sector as a percentage of GDP. It is the second derivative of credit growth and arguably the largest driver behind economic growth.”

The policy and economic cycles are likely turning to opposites from 2021 conditions as we enter 2022. Investors and speculators need to review their allocations urgently. Better still, have a systematic process in place to adjust your portfolio in real time as the cycles evolve.

Opportunities in 2022

As we enter 2022 the best prospects are in Chinese domestic stocks which have signalled buy conditions for the first time in almost a year and will likely experience much better cyclical conditions in 2022. Swiss equities are currently the best European prospect as a recovery may finally emerge. Most likely Gold will finally have a better year as it a major beneficiay of Quad 4 conditions and, with a lag, gold miners look well placed.



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Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

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