Weekly Hard Assets Insights
By David McAlvany

Risks and Opportunities: A volatile Cocktail

Markets ended the week on a notably negative note. After a positive start to the day Friday, markets turned down shortly after market open, and continued to trend lower throughout the day. The move lower was fairly broad-based. Large cap, small cap, tech, industrials, and most commodities (with the exception of a number of soft commodities) were all lower.

Precious metals were also significantly lower, adding to the cautionary nature of the broad market behavior. Despite being a “safe haven,” when risk-off takes hold and selling breaks out across the market, precious metals often get caught in the initial decline. On the other side of the flight to safety equation, bonds rallied, the dollar was bid higher, and defensive utilities saw inflows.

Adding to the bearish scent in the air were the facts that this market activity involved higher volume (although options expirations undoubtedly contributed to increased volume) and under the surface the selling was rather extreme. According to Chris Vermeulen, Chief Market Strategist at Technical Traders Ltd., “There was panic selling on the NYSE…with a ratio of five shares being sold on the bid vs. one bought at the ask.” This late week weakness in markets may not amount to much, but there are a number of additional underlying contextual factors that are raising the caution flag as well.

To start with, as our very own Doug Noland eloquently chronicled in great detail in yesterday’s Tactical Short quarterly call, we have significant bubble dynamics on our hands across markets. While all bubbles are volatile, this one has an exacerbating factor: many years of exponentially escalating global monetary and fiscal stimulus injections that have built an artificial and fragile structural foundation beneath this bull market. As Doug also pointed out, we are now seeing some potential cracks emerge in China’s credit markets. Any unraveling of that massive market will likely have global consequences that range from serious to catastrophic.

We also have to contend with the factor of significant “transitory” inflation that, rather than catching the bus out of town, stubbornly continues to build and assert itself. Just this week, the government reported that June headline CPI increased 0.9%, the largest monthly gain since 2008, while core CPI (excluding food and energy prices) also increased at a 0.9% clip. The increase in core CPI matches the April monthly gain, and both represent the most significant monthly increases since 1982. Both headline and core CPI readings came in smoking hot, as the increases far outpaced estimates.

According to James Carson, former chief economist at Alliance Bernstein, “Core producer prices for intermediate materials and supplies increased 2.3% in June. Since the start of 2021, these prices have increased at an annualized rate of 32%. That surge is the largest in nearly 50 years, and is a harbinger of more consumer price inflation in the months ahead.” Carson goes on to say that, “Failure to include housing prices in the reported inflation readings makes inflation appear less problematic than in the 1970s. But in reality, it is similar to the 1970s…. Using the measurement practices of owners’ housing costs of the 1970s would push the current consumer price inflation readings close to the double-digit gains last seen in the 1970s.” Carson concludes ominously by stating “That means the US is experiencing a more significant ‘inflation bubble’ than is being reported or recognized by everyone. Investors forewarned.”

The longer this inflationary environment persists and builds, whether ultimately transitory or not, the more it could limit future monetary and fiscal stimulus—which has been the lifeblood of this market.

The inflationary impulse also has significant implications for corporate margins. Even if increased costs could be fully passed on to consumers, the likelihood would still be that higher prices would eventually weigh on sales. Either way you slice it, whether through weakening corporate margins or eroding sales numbers, equity multiples would be expected to drop. Throughout this bull market, when equity markets have begun to show signs of rolling over into declines, the Fed and government have come to the rescue. Will that continue to be tenable if inflation proves not to be transitory?

Big picture analysis must also acknowledge the well-chronicled fact that all broad market valuation metrics are historically stretched, and are at or above levels consistent with past major market tops. Adding to the need for investor vigilance, and more specifically to the market action of this week, are several smaller-scale indicators arguing for caution.

This week’s Investors Intelligence Advisors’ Survey from InvestorsIntelligence.com reports market bulls outnumber bears by 61.2% to 15.3%. This leaves the contrarian indicator at a skew the service describes as being in the “danger zone” and predictive of market declines. Singing a similar tune, trade-futures.com has an eight-day daily sentiment index that this week reached 84.3% bullish. These are levels that have preceded significant market corrections in the past.

Another indication of caution comes from the NYSE Advance/Decline line. Since mid-June, while the S&P 500 has marched on to numerous new all-time highs, the A/D line has been flat to lower, and isn’t confirming the S&P rally. The implication is that the recent push higher in the S&P is being propelled by an ever-shrinking number of the biggest market cap companies, while an increasing majority of stocks are declining. This is a historically unhealthy dynamic for a rally, and often precedes a larger decline in the overall index.

On this Friday, an upward support trendline underneath a seven-month advancing trend for the A/D line was violated to the downside. So at this point, in addition to the divergence in the A/D line vs. the S&P’s rally, we now have a significant break in the overall structure of the advance we have seen for the last seven months. That is a bearish development for this market.

Other notable sub-indexes have also been flashing divergences from the broad market. While the S&P has been making new highs, the housing index is down 16%, banks are off 11%, and transports have declined by 10%, just to name a few. Meanwhile, as a possible sign of waning speculative fervor on the periphery of the market risk spectrum, bitcoin has fallen 50% from its recent highs.

All the while, upside price momentum, inflating bubble dynamics, ongoing liquidity injections, and the implied central bank “put” that has conditioned market participants to expect to be protected from losses place a tremendous amount of upside pressure on market prices. Market bubbles typically experience euphoric blow-off tops with tremendous and relentless price gains. Many market participants refuse to miss out on that expected phase of perceived “easy money.”

Interestingly, most investors seem to always believe the blow-off top remains ahead, and the temptation is to ride the crazy ride higher to some satisfying point before exiting ahead of the inevitable pop. While many market participants take comfort in the gains they will see in the pending blow-off, history will reveal whether the blow-off is yet to come, or if the 100% surge in the S&P 500 since the Covid lows constitutes a blow-off top that’s largely behind us.

There are plenty of reasons to believe that further gains lie ahead of us, and that the market will continue to post many more new highs ahead. With that said, however, the point is that risks are increasing, caution signals are flashing, and increasing volatility is likely. In this environment, market participants need to watch any potentially brewing weakness seriously. At MWM, we see both risks and opportunities. This week’s declines are, in and of themselves, relatively minor. However, it’s important to stay focused and vigilant, and remember that major declines always start somewhere.

As for weekly performance: The S&P 500 closed the week down 0.97%. Gold was up 0.24% while silver was down 1.66% on the week. Platinum was up 1.17% while palladium took a beating, dropping 6.21%. The HUI gold miners index was off 1.42%. The IFRA iShares U.S. Infrastructure ETF was down 1.69%. Energy commodities were mixed, in a volatile week. Oil was down 4.02%, while natural gas prices were nearly flat, up 0.11%. The CRB Commodity Index was up 0.21%, while copper lost 0.69%. The Dow Jones U.S. Real Estate Index ended the week up 0.42%, while the Dow Jones Utility Average Index gained 2.28%. The dollar gained 0.66% to close the week at 92.71. The yield on the 10-year Treasury lost another 6 bps to close the week at 1.31%.

Have a great weekend!

Best Regards,

David McAlvany
Chief Executive Officer
MWM LLC