Stock Market is in a Quandary When Bad News is Good News

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Inflation is hot, and the Fed is promising to raise rates and draw down aggressively on its balance sheet until “the job is done” of bringing inflation down to their target level of 2%. That’s a very far cry and stretch from how it will accomplish this objective when the commodity markets, supply chain disruptions, the war in Ukraine, crumbling global currencies and geopolitical risks that contribute to inflation are out of their control.

Friday’s employment data that showed the unemployment rate ticking up to 3.7% from 3.5%, and factory orders for July falling by a lower-than-forecast 1.0%. These figures provided the catalyst for the market to curb the five-day drubbing, where the S&P shed 6% and the Nasdaq just over 10%.

The technicians that called the move higher off of the June lows a bear market rally were right, as all the major averages were repelled at their respective downward-sloping 200-day moving averages.

The oxymoronic thing about the current market landscape is that the investors who want to see the bull trend restore itself need to be rooting for bad economic news to cross the tape in the coming weeks. The Fed is set to raise the federal funds rate by 75 basis points at the next Federal Open Market Committee (FOMC) meeting on Sept. 21. In order for the market to be convinced that it will pause on further future hikes, the Fed needs to see a steady stream of disappointing data that shows evidence of a slowing economy.

When inflation gets embedded in the economy, it doesn’t recede easily. Back in 1981, when inflation was roaring, then-Fed Chairman Paul Volker oversaw the federal funds rate climbing to 16.4% to kill off inflation that was running at 13.5%. 30-year mortgages were pegged at 18.4%, and money markets were the greatest investment of the time, paying 18.9%.

This is what the current Fed is terrified of, and hence all the tough talk in Jackson Hole by Jay Powell a little over a week ago. Inflation is like a force of nature that is released to do its damage on the cost of living. With the Fed’s balance sheet at nearly $9 trillion, and the U.S. national debt at nearly $31 trillion, higher interest rates much above where they currently trade will put massive stress on the ability to pay what would be soaring interest costs.

When investors are in a “bad news is good news” environment, stocks rallying because the economy is slowing is not a good long-term situation. Ultimately, sales and earnings growth will slow, stock valuations will contract and the market will discount some level of recessionary forces that call into question the business of a soft or hard landing. A soft landing, also called a growth recession, is what the current Fed is aiming for.

This objective is threading a monetary needle and only time will tell how it will play out. The value of the dollar is trading at levels not seen since the dot.com days, which ended in 2002 with the S&P 500 losing 43%. In my view, this is why the dollar is the most crowded trade in the world — global macro events and inflation carry very high levels of uncertainty.

The Fed had a chance to stave off inflation in early 2021, but instead chose to embrace the “transitory” message that put it squarely behind the curve. It is now in a very challenging position. What lies ahead is about as clear as the fog in the Bay Area, and until the fog lifts, the market will remain cautious and patient for clearer conditions.

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