Risky 2022 ahead? What are the leading indicators telling us?
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Early 2021, I had a few big views for how 2021 would play out:
(You can find the original article here.)
Three of these views proved correct:
1) I was positive the economy, I wrote: "This means that in the coming months, we’ll see some of the best economic data ever."
2) I was positive risk assets and I thought interest rates would move higher in 2021. I wrote: "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."
3) Because interest rates had just broken out, I was bearish gold. I wrote: "Given the trajectory higher in interest rates, I’m not bullish on gold for the next few weeks/months."
My last view was incorrect:
4) I thought interest rates and the stock market would peak together somewhere in 2021. I indicated that a rising USD would put pressure on the market and that the Fed would need to step in (perhaps with YCC). This would be the moment to buy gold.
Even though I correctly called the USD bottom in 2021 (see this article) and there were several technical signals that we could be seeing a top in risk assets, the general market kept rising. I was thus too early in this view.
However, as I explained in another article (see here), a lot of risk assets like commodities, crypto currencies and technology stocks have seen considerable drawdowns. Also, small cap and mid cap stocks have essentially gone nowhere since March/April of 2021. In my opinion, the call was thus not completely wrong with regards to the risk asset part of it.
Enough about last year, let's look at what 2022 will bring.
In this article I'll have a look at my leading indicators with regards to the fundamentals.
I know that a lot of people just look at technicals and those that use fundamentals, often believe in a certain narrative instead of being data driven.
I wrote an article in the past on the importance of using fundamentals. When I say that you should use fundamentals, I mean you should use leading indicators. You shouldn't buy an asset because 'the fed is printing money' or because 'we are living in a bubble'. These are just stories that are popular on twitter but don't help you make money.
With the use of leading indicators, you can form an educated view on the future direction of asset markets without having to believe in some kind of story. (I wrote an article on this in the past, see here.)
I'll thus share with you some leading indicators in this article so that you can develop your own views.
Once we had a look at the leading indicators, I'll share some of my initial thoughts on what this wil possibly mean for several asset markets. (More detailed analysis will follow in future articles.)
If you read my investment outlook of last year, you know that both growth and inflation are the two most important factors affecting asset markets.
As Bridgewater explains:
Bridgewater (source: The all weather strategy): "While asset classes incorporate expectations about a wide number of economic factors, growth and inflation are the two most important determinants of asset class pricing (both because of their direct impact and the fact that they encompass expectations about most other relevant factors). Asset class returns are largely the result of whether growth and inflation end up being higher or lower than expected, and how these expectations change."
Last year the leading indicators were showing that both growth and inflation would become much stronger. This was one of the reasons why I was bullish risk assets last year.
What are the leading indicators telling us now?
Let's first have a look at growth. The ISM PMI is a leading indicator for GDP growth.
Below I plot the ISM PMI (blue line) together with my leading indicator (orange line).
The leading indicator is clearly showing that the ISM PMI has peaked and will come down in 2022.
I have another model, based on completely different inputs, that is showing the same thing:
(Beware, the leading indicator is here in blue and the ISM PMI is in orange. I didn't update the data for ISM PMI in this chart. But the point I want to share is of course that the model is predicting that we have seen the peak.)
So, as these two models clearly show, we have probably seen the peak in economic growth. (on a rate of change basis)
(Please note that when I write that growth has probably peaked, I don't mean we are heading into a recession. We'll probably see growth slow, after which it can accelerate again. But since markets move on a rate of change basis, looking at actual data against prior expectations, this growth slowdown is important.)
Let's now have a look at inflation.
Below I plot the US CPI inflation rate (orange line), together with my leading indicator (blue line.
The model is clearly showing that inflation has very likely peaked.
Now that we know what growth and inflation will do in 2022, we can have a look at another very important factor driving markets: earnings.
The leading indicator I developed for S&P500 earnings is based on the insights that Stanley Druckenmiller used for what he called "...one of the best bets I ever made."
As you can clearly see, the leading indicator is going straight down.
The way I primarily like to use this indicator is as follows: when we have had a stock market correction and earnings have declined but the leading indicator is showing strength, that is the best time to buy stocks.
You can see this for example in early 2020 (with the Corona crash). Earnings (blue line) and the stock market had collapsed but the leading indicator was showing that earnings would rise sharply.
I indicated this on the following chart.
What I take away from this model is that the support that the stock market had from earnings will be gone.
To summarize, the macro economic backdrop will be completely different than the one we had last year.
The following chart by Prometheus Research shows this clearly. The grey line shows the probability that is priced into asset markets for a declining growth and declining inflation regime. (the other colored lines show the probability of other possible regimes)
As you can see, we saw a high probability in early 2020 for this worrisome regime. What followed was the Corona crash. In 2022, the model is showing an increased probability of this regime coming back, exactly as my own leading indicators are showing.
Source: Prometheus Research, @prometheusmacro
Now that we know what the leading indicators are showing us, let's have a look at the potential impact on several asset markets.
Please note that the thoughts I'll share on several markets are just "my first thoughts". I won't immediately take positions based on them because I'll need to do more research first to confirm some of these ideas. I'll update you in future articles.
I think we'll see a significant correction in the broad markets this year (15% drop or higher?).
As explained earlier in the article, a lot of markets have already seen significant corrections. The following chart from Sentimentrader is very interesting. It shows the percentage of Nasdaq stocks that are down 50% from their 52-week high. As you can see, 40% of Nasdaq components have lost half of their value. Even more astonishing is the fact that the broad Nasdaq is still at all time highs.
When the big components finally start to roll over, the Nasdaq will follow and it won't be difficult to see a significant correction in broader markets.
I indicated 4 other instances (orange vertical lines) when the percentage of Nasdaq stocks down 50% were as high as today.
The last two times, these were buying opportunities. (early 2016 and the end of 2018)
The two times before that, it were selling opportunities.
We can't be 100% sure but with what the leading indicators are showing, I think chances are higher that this is a selling opportunity.
Before you panic and sell everything, I think the stock market has some time left. I'm still long the Nasdaq but in a few weeks time, I'll be 100% cash, ready to profit from the scenario I'm seeing for 2022.
If the market decides to start its correction earlier than I anticipate, I'll risk manage my current position of course.
Early last year, I indicated the breakout in interest rates and wrote that it would be bad for gold.
Last week, it seems that interest rate have broken out again. You could interpret this as a clear signal that a new move higher in rates has started.
The fact that financials (XLF) have also broken out, would support this view.
However, this price action is the opposite of what my leading indicators are telling me.
With both growth and inflation slowing in 2022, how likely is it that interest rates will move substantially higher? Not so likely if you ask me.
We must also not forget that the Federal Reserve will start to tighten monetary policy in 2022. As always, they have the timing perfectly right (I'm not serious to be clear...), they'll tighten into a growth slowdown.
For now, the price action is telling that interest rates will go higher, but my current guess is that fundamentals will trump the technicals.
With inflation peaking, and the correlation between commodities and inflation being very high, I think chances of another good year for commodities are rather low.
I shared on twitter some charts supporting this view, see here.
On top of that, Barron's came out with the following front cover: "The commodities boom". On their site, you can read the following: "Why it's time to invest in commodities, and how to do it."
Anyone who has any experience in financial markets knows how awfully wrong the timing of these magazine cover stories often is. If you are not familiar with this, I shared some examples on Twitter, see here.
Finally, with the PBoC tightening liquidity, chances are not very high that commodities will have a good year in 2022. The following chart by CrossBorder Capital clearly shows the strong relationship between liquidity and commodity prices.
Source: CrossBorder Capital, @crossbordercap
Gold and silver had a terrible year in 2021. The reason was of course that real growth came in much stronger than markets anticipated.
With both growth and inflation peaking this year, I think the worst is over for gold.
I'll be looking to identify nice buy set-ups in these markets.
It's been a long time seen I've written on gold, but expect this to change in 2022.
In November I wrote an article stating that you shouldn't be afraid to buy the breakout in Bitcoin. (see here)
Now that Bitcoin and other cryptocurrencies have declined substantially in value, you might be of the opinion that the article I wrote and my analysis in it was absolute garbage and that I lost a lot of money.
Luckily not. Why not? Because I know that the key to success is not my ability to predict markets but to admit my mistakes and to change my positions. That's exactly what I did, as I detailed in another article (see here) and on Twitter.
I think both articles contain a lot of valuable lessons for a lot of people. I get a bit annoyed when I see all the Crypto "experts" on Twitter with all their fancy charts. They're learning the hard way that too much of a strong belief in fancy charts and a lack of risk management are not very helpful for long term investment success.
Anyway, what are the leading indicators telling us for crypto currencies? Well, the fact that the two most important crypto currencies (BTC and ETH) have now had confirmed failed breakouts, is not giving me much hope for the bullish side.
Add to that the risk-off environment I see coming in 2022 and I can't see any reason to become bullish on these assets.
I'll update my views on Twitter and in future articles.
Thank you very much for reading my article!