Weekly Hard Assets Insights
By David McAlvany

A Santa Rally; or the Fed Who Stole Christmas?

It was another eventful week in financial markets. Major market indexes surged higher and energetically bounced from the deeply oversold technical conditions and extremely poor sentiment of the previous week. The big three indexes—the Dow Jones, the S&P 500, and the Nasdaq—all finished the week with robust gains exceeding 3.5%.

While the Russell 2000 small cap index gained a solid 2.42% for the week, small caps notably lagged behind the larger cap leaders once again, and actually closed lower on Friday. The struggle in small caps is evident when checking the leaderboard of the great American index horserace for new all-time highs. At present, the S&P 500 is only 0.67% off it’s highs, the Dow sits 1.72% off, the Nasdaq is down 3.59% from highs, while the Russell 2000 is over 10% below its high water mark.

Despite a strong breadth thrust early in the week, overall, breadth continues to lag and frustrate this market. Friday featured strong index performances, but the NYSE advance/decline index weakened throughout the day nevertheless, and closed negative. It was the same story for the McClellan Oscillator on Friday. Both breadth measures have started to show a distinct weakening trend over time. Despite energetic fits and starts, the overall trend has seen breadth measures increasingly exhibit negative divergences when compared with major index performance. Paris-based investment bank Société Générale highlights the issue in stark terms. According to the bank, just four stocks generated nearly 70% of the S&P 500’s return over the last six months. When an equity index is rising but breadth is breaking down, it’s a warning indicating that the index may be set to decline.

Interestingly, related to the breadth issue and the deteriorating performance of many risk assets in the face of a now hawkish Fed, Bank of America’s Michael Hartnett said this week that he believes market signals are suggesting risk-off as we enter 2022. According to the top BofA strategist, “the bubble in speculative froth has popped.” Hartnett drawls parallels between today and the trading environment of the 2000 tech bubble. During the end phase of the tech bubble, only a handful of the most dominant tech names propped up markets as shares of more vulnerable companies collapsed around them. Eventually, the selling penetrated the core of market leaders, and the bear market on the index level ensued. Contrary to the “buy the dip” strategy that has captivated investors and served them well for years, Hartnett now suggests investors, “sell the rips.”

In addition to breadth, technical momentum indicators are also negatively diverging from index performance. The implications with the momentum divergences are similar to that of breadth. If market momentum is breaking down, typically, in time, the indexes will usually follow. These negative divergences are not necessarily a good near-term indicator of price direction, but they are notable to mention as they are conditions consistently present during major market topping episodes.

After the first days of December, there was talk of a year without Santa, but this week visions of a mesmerizing rally danced in market participants’ heads. Was this week’s strength the highly anticipated start of Santa’s annual visit to Wall Street? Or, rather, was it just a powerful oversold bounce attempting to regain enough upside momentum to reengage positive seasonality? Only time will reveal the answer to that question, but several important factors loom large next week.

For one thing, Goldman Sachs notes that the all-important corporate buyback window closed this Friday. We will see how the rally attempt fares going forward without the participation of the deep pockets of relatively price-insensitive corporate buyers. Another huge factor will likely be the results of major central bank meetings next week. On Wednesday, the Fed will host a highly anticipated FOMC meeting, and on Thursday both the European Central Bank and the Bank of England will announce their final policy statements of 2021.

The results of next Wednesday’s Fed FOMC meeting will carry special significance after the recent decidedly hawkish pivot from Fed Chairman Powell and other Fed voices. Of the Fed’s duel mandate of full employment and price stability, the Fed has heavily favored accommodative policies up to this point in the post-Covid recovery, prioritizing a return to full employment over price stability. As inflation has raged, however, domestic pressure has mounted for the Fed to tackle broad-based price increases throughout the economy. 

Even outside the US, pressure on the Fed is mounting. The International Monetary Fund recently singled out the US when warning of intensifying inflationary pressures. The IMF advised US central bankers to focus policy more on the inflation risk. At this point, the Fed appears to be listening. Powell and company have now signaled that they are ready to shift their emphasis toward price stability and shift to a more hawkish policy. Chairman Powell has indicated that in next Wednesday’s meeting, the committee will discuss the possibility of accelerating the taper of asset purchases. The upcoming meeting will be an important first opportunity for the market to gauge how much real bite there is to the Fed’s newly hawkish bark.

The pressure on the Fed to do more than just talk tough next week is likely all the more acute following Friday’s release of November’s Consumer Price Index. The US Bureau of labor Statistics reported that consumer price inflation posted its largest annual increase since 1982. Headline CPI gained 0.8% in November and outpaced expectations for a 0.7% reading. Annually, the headline CPI reached 6.8%. The annual reading was in line with consensus expectations, and surpassed the previous month’s 6.2% annual increase. The blistering inflation hits just keep coming.

Perhaps explaining much of the Fed’s recent hawkish pivot, this latest escalation of inflation data comes on the heels of numerous recent data points showing a rapidly tightening labor market. This week, the Labor Department’s latest monthly Job Openings and Labor Turnover Survey (JOLTS) reported that job openings surged by 431,000 to a total of 11 million. This was the second highest number of openings on record. Signs of extremely high demand for labor were further supported by this week’s jobless claims numbers. Weekly jobless claims fell by 43,000 to 184,000. According to the report, “This is the lowest level for initial claims since September 6th, 1969, when it was 182,000.”

According to Bank of America’s chief economist, Ethan Harris, “virtually every part of the country and every industry is experiencing labor shortages.” Putting a fine point on both the state of employment and inflation was Harris’s boss, BofA CEO Brian Moynihan. Speaking with Bloomberg this week, Moynihan said that the US has already reached full employment, and added that the problem of inflation is “no longer up for debate” and will now require “hard work” to rein in. The ominous implications of surging demand for workers and a significant lack of slack in the labor markets is the risk of accelerating a highly inflationary wage-price spiral. It appears the Fed is clearly behind the curve with regard to inflation, and that the Central Bank’s policies have contributed to a seriously overheating labor market. As BofA’s Moynihan suggests, a necessary course correction will be “hard work.” The question at this stage is, can the Fed strike just the right policy balance to subdue inflation without sacrificing the strength of the labor market and the economy more broadly?

With his ever-timely commentary, University of Michigan Surveys of Consumers chief economist Richard Curtin this week gets right to the heart of the matter, and adds bonus insights to boot. In the preliminary survey results for December, consumer sentiment remains depressed at levels “nearly identical to the average reading in the prior four months.” Curtin, however, highlights an interesting disparity of reported sentiment. While the survey overall was little changed, the bottom third of wage earners saw notable improvement while the middle and high income brackets reported a modest deterioration in sentiment. Curtain says that such a disparity has only occurred once before, in 1980. Curtin goes on to explain that:

“…in 1980 it was the households in the bottom income third that initially signaled the end of the first part of the double recession in 1980-82, with upper income households following in subsequent months. The core of the renewed optimism among the bottom third was the expectation of income increases…. This suggests an emerging wage-price spiral that could propel inflation higher in the years ahead.”

“When directly asked whether inflation or unemployment was the more serious problem facing the nation, 76% selected inflation…. The dominance of inflation over unemployment was true for all income, age, education, region, and political subgroups. While a shift in policy emphasis is necessary, it will be difficult to gauge the right balance between fiscal and monetary policies that both trims inflation and maintains the unemployment rate near its current lows.”

Past HAIs have described the Fed as having to perfectly navigate a minefield or balance a perilous tightrope walk. If the Fed is forced to get serious about inflation, a sufficiently hawkish policy shift could deprive markets of the liquidity they have become dependent upon, prohibitively increase the interest costs of debt, and reverse the fragile underpinnings of the Covid recovery. Would the aggressive action necessary to put these burgeoning inflation dynamics back into the bottle slow the economy sufficiently to eventually set a course for another double dip recession? On the other hand, now that the labor market is perfectly teed-up to deliver even more inflation, will insufficient Fed action further exacerbate the problem by continuing to facilitate too much demand that’s chasing too few goods and workers? 

The problems now facing the economy and the Fed are very real. Fed officials may wish for inflation to suddenly vanish, but until that wish is realized, the Fed is wedged uncomfortably between a rock and a hard place. Next week will be the first opportunity for Powell and the gang to act upon their newfound hawkish footing. The market will be listening to words, but be especially attentive to action. While this week Santa Clause and his rally finally appeared, next week, we will find out if it’s the Fed who steals Christmas.

William Simon knew a thing or two about the sticky wicket that is inflation. He served as US Treasury Secretary from 1974-1977 amid the 1970s’ “great inflation.” As Mr. Simon aptly put it, “I continue to believe that the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it.” Well, Americans are currently remembering their hatred of inflation, but brace for trouble if the Fed starts to remove everything that causes it.

As for weekly performance: The S&P 500 surged 3.82% this week. Gold was nearly flat, up by 0.05% while silver lost 1.29% on the week. Platinum gained 0.86% while palladium dropped 3.46%. The HUI gold miners index lost 1.57%. The IFRA iShares US Infrastructure ETF was up 2.95% for the week. Energy commodities continue to be mixed and volatile. WTI crude oil gained 8.16%, while natural gas lost another 5.01% on the week. The CRB Commodity Index was up 2.65%, while copper was up 0.37%. The Dow Jones US Real Estate Index ended the week up 3.00%, while the Dow Jones Utility Average Index was up 2.37% on the week. The dollar was flat this week, down by 0.01% to close the week at 96.10. The yield on the 10-year Treasury increased 13 bps to close the week at 1.48%.

Best Regards,

David McAlvany
Chief Executive Officer
MWM LLC