Please read the Disclaimer before reading this article.
Disclaimer: I currently hold positions in QQQ and EEM
At the beginning of each year, I have the habit of formulating my investment outlook for the next 12 months. This year was the first year that I had some difficulty with formulating a view. Luckily, I’ve put together all the pieces and have a rather high conviction view now.
In every article I wrote on gold, I warned that there was one uncertainty that always bothered me. My view on interest rates was clouded. Now that interest rates have chosen a clear trajectory, everything is clear again. Let me explain.
(Throughout this article, I make reference to the leading indicators I use for the USD, the economy, interest rates,… I didn’t include the charts again in this article because I’ve shared them all in previous articles.)
Let’s start with an update on my bullish view on Emerging Markets. I wrote in my previous article that sentiment was running high and that the USD would probably go higher in the short term. These two factors were cautioning me to buy the Emerging Markets straight away.
Since that last article, we saw a +-5% correction in equity markets and the USD reached its target, just as expected.
I was expecting that the peak in the USD would coincide with the low in the equity markets but unfortunately, this was not the case. I therefore did not buy at the low. Even though my analysis was correct, it did not exactly go as planned. I don’t really care however because my conviction that risk assets will move higher is now much bigger than when I wrote my previous article.
Why will risk assets go higher? Three reasons. The first one is because the USD will go lower. (I showed you the leading indicators I use in previous articles.) You can see on the following chart that since the bottom in March 2020, each correction in the equity market (I use the S&P500 but the same goes for Emerging Markets) coincided with the USD going higher.
Since the USD is starting to go lower again, this should be good for equity markets.
The second reason why I think equity markets will move higher is because of the sentiment/positioning.
I warned in my previous article about the high sentiment and positioning of active investment managers.
You might think that a 5% drop in the equity market was not enough to reset sentiment. The fact is however that their exposure dropped from 112 to 79 in two weeks’ time.
Have a look at the following chart. We barely saw a 5% correction in the S&P500 and the VIX spiked more than in October last year when we saw a 10% correction. I saw some analysis on twitter that showed that we have never seen a spike like this in the VIX, given the (small) magnitude of the correction. This indicates that fear in the market was rather high.
On top of that, we saw an extreme de-grossing (almost as extreme as in March 2020!) in equity markets. So the correction we saw might not seem like a lot but when you look at what impact it had on market participants, it certainly was extreme.
Source: @Moritz_of_Hesse
The third reason I think why equities will go higher is because of fundamentals. Fundamentals you say? Isn’t this the biggest bubble in history? Valuations are extreme and the economy is suffering badly. There are no fundamentals supporting this rally!
Well, that all sound very reasonable but unfortunately, I’ve heard these ‘arguments’ since April last year and they clearly didn’t work.
The fact is that the stock market is a discounting mechanism. It will not rise when everything is fine in the world. It will rise when there is a lot of uncertainty and better future times are being discounted.
The worst economic prints we ever saw occurred last year in the months of March, April, and May.
This means that in the coming months, we’ll see some of the best economic data ever. The reason is because we measure it on a year-over-year basis. If we saw extremely bad figures in April last year, we’ll see extremely good figures in April this year because the figures to which we compare them are so low. (You need to think in rate of change terms, not in absolute levels. There is a lot of empirical evidence that markets work on a rate of change basis and not on absolute levels. I won’t explain why in detail here. But I advise you to think deeply about this because it makes a lot of sense. I’ll give you a tip at the end of this article.)
This strong economic data is also being predicted by the leading indicators I use.
I know that there are a lot of problems with the economic picture if we look at it on an absolute basis (high unemployment etc.) but this doesn’t matter yet for the market. It will matter in a few months’ time, but not yet now. I’ll get to that in a minute.
This thesis that we’ll see strong economic data is also supported by the movements we see in US interest rates. As the following chart shows, US interest rates broke out in early January. We saw a retest from the breakout and are now moving higher again. The first target I have is around the 1,44% level. With the economic data we’ll see coming through in the next months, it seems clear to me that interest rates will move higher.
Given the trajectory higher in interest rates, I’m not bullish on gold for the next few weeks/months. But, as I’ll explain, I already know when I’ll get bullish again. (If the price action shows me I’m wrong, I’ll adapt of course.)
Let’s quickly recapitulate the scenario I’m seeing. (The word scenario seems to imply that it’s some kind of a narrative I’m following, which it’s not. It’s all supported by my leading indicators which I’ve showed in previous articles.)
Both the equity market and interest rates will move higher on the strong data (on a rate of change basis) we’ll see coming through in the next few weeks/months.
Imagine we are April/May/June 2021 (I don’t know the specific point in time) and the S&P500 is 10-15% higher and interest rates have reached their target.
At this moment, bullish sentiment and positioning will be extreme. Everything will be priced into the equity market.
The higher interest rates will start to put pressure on the US economy and the US equity market will start to discount this.
I think that the US equity market will peak together with US interest rates, just like they did in October 2018. (see next chart)
The markets will correct and the Fed will need to step in. The Fed will see that higher interest rates are sending the US economy back into recession when unemployment is still extremely high and the economy extremely weak (on an absolute basis). This is the moment when the Fed will need to introduce Yield Curve Control (I talked about it in this article). This is also the moment that gold will start to rise again in a significant way.
So, there you have it. Every leading indicator and asset class I’m following is perfectly in sync with this ‘scenario’ I’m seeing. This is just a small part of my analysis. I have several models and indicators I follow on the stock market and bond market and they are all leading me to the same conclusion. (Remember in a previous article where I wrote that stock markets around the world are all giving the same signal. This is in sharp contrast to mid 2018 and early 2020, just before the market saw a big decline.)
For some, it might be strange that I make a distinction between the rate of change, and the absolute level in economic data.
However, take a look at the following from Bridgewater: “At their root level, asset prices represent expectations about future conditions and asset returns are driven by how conditions evolve relative to expectations and how expectations change.”
As you can see, it’s about the relative change in conditions and expectations, and these are measured on a rate of change basis, not on an absolute basis.
(If you ever read a book on the psychological reason why value stocks beat growth stocks in the long run, you’ll understand that investors are ‘very good’ in extrapolating recent trends into the future. Thus, a change from very good data to good data is bearish for risk assets since conditions come in lower than expectations. Why? Because investors extrapolate the recent past into the future and were thus having high expectations. By using leading indicators, you avoid falling into this trap.)
Let me explain it with an example.
Imagine the situation between April 2020 and now. All the news was negative. We saw the fastest decline ever in the stock market, economies worldwide were shut down, earnings were dropping like a stone, former central bankers were warning about a new depression, and fore many months, we literally had no perspective on a better future.
The stock market didn’t care however. The market bottomed on March 23 and has been rising despite all the negative news. Why? Because it was discounting a future that we couldn’t imagine yet. It was discounting human ingenuity. It was discounting that future conditions would be better than expectations. (Just go back to last year March and ask yourself what you thought the world would look like in a few months. I think we were all thinking the world would end (Not literally of course but you know what I mean.). When your expectation is that the world will end, and with the fastest stock market decline ever in March, the market seemed to agree, it wasn’t difficult afterwards to discount a better future than was priced into the market, thus equities rose despite all the negative news.)
Now imagine we are July 2021 and a lot of people got vaccinated, the US government is talking about huge stimulus bills and economic data is coming in strong. (On a year-on-year basis, supported by the leading indicators.)
Now, everyone will think that everything is fine again. Soon, we will be able to get our old live back, time to buy stocks!
No, at that moment, we need to think about which view of the future the stock market will be discounting. It will probably focus on the fact that unemployment is still extreme, on the fact that deficits are extremely high, on the fact that economic data going forward will not beat the extremely good relative levels we just saw. That will be the stock market peak. The market will correct. The fed will panic. The release valve will be the USD, which will get smoked. Equity markets will rise again (with Emerging Markets outperforming the US market) and gold will rise again.
Let’s see how my 2021 prediction plays out. I’ll write an update when some of my views change. Of course, it won’t go exactly as laid out here but if I get the big moves right, I can trade around those and make a lot of profits, that’s all that matters. As you already know, I’ll risk manage my positions with every investment I make.
The biggest risk is the USD. Rising interest rates in the US make the US currency more attractive. A rising USD will coincide with the next equity market correction. It is at this point that the Fed will need to step in. Rising interest rates and a rising USD will put the economy back in recession, it can’t allow that to happen.
If the USD starts to rise earlier than anticipated, watch out.
At the end of last year, I was wondering how the Fed would arrive at the point where they need to introduce YCC. It now fits in perfectly with the scenario I’m seeing, all supported by my leading indicators and by the price action in the major asset classes. This only adds to my conviction on this view.
Thank you very much for reading my article.
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