Despite Surging Inflation, The Bulls Shake Off Weakness

By Lance Roberts | May 15, 2021

In this issue of “Despite Surging Inflation, The Bulls Shake Off Weakness.

  • Market Review And Update
  • Rates Doing The Fed’s Work
  • The Fed Will Be Late
  • Portfolio Positioning
  • #MacroView: NFIB Data Says It’s Only A Recovery
  • Sector & Market Analysis
  • 401k Plan Manager

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Catch Up On What You Missed Last Week

Market Review & Update

Well, that didn’t work out as planned. Last week, we said:

“Notably, the ‘money flow buy signal’ seemed to cross; however, we need some follow-through action on Monday to confirm. As shown, the uptick in money flows did allow us to add some exposure to portfolios in holdings we had taken profits in with the previous ‘sell’ signal.”

Well, that follow-through failed to occur. Not only did the “buy signal” not trigger, but the market also broke down through the previous consolidation range. As I said, it did not work out as planned. The last exposure we took on is now pressuring the portfolio momentarily, but we should benefit from the turn if we are correct.

With markets deeply oversold on a short-term basis, with signals at levels that generally precede short-term rallies, the rally on Thursday and Friday was not unexpected. Importantly, the S&P 500 did hold support at the 50-dma and rallied back into the previous trading range. Furthermore, institutional investors have cut their exposures by 50% in just two weeks, primarily big tech, which provides fuel for a rally.

We will hold exposures at current levels for now. However, instead of looking for a more extended rally into mid-summer, we suspect this rally will be fairly short-lived.

As stated last week, overall, the market trend remains bullish, so there is no need to be overly defensive. We still expect to see a deeper correction as stimulus fades from the system in the next month. At that point, we will become more defensive in positioning as the peak of economic growth and earnings becomes more apparent.

An Inflation Primer

On Thursday’s “3-Minutes” video, I review the recent inflation numbers to put them into perspective. While there is some panic over the headline numbers, there are valid reasons to expect inflationary pressures to be transient.

As stated above, we expect inflation to subside later this year, along with economic growth.

As such, we continue to focus on our risk management accordingly for now. If we are correct in our assessment about the roll-off effect of stimulus and liquidity, we could well see bonds outperform stocks in 2022. We are watching very closely as we currently hold minimal duration in our fixed-income portfolios. If we begin to see the very negative sentiment on bonds reverse, as inflationary pressures subside, we could well see an excellent buying opportunity.

The problem for the markets is the Fed is going to be late.

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

Rates Doing The “Fed’s Work”

In last week’s message, we said:

“Over the next couple of months, there will be an evident surge in inflation, which the Fed wanted. However, that surge in inflation may come in a lot “hotter” than they anticipated. If that occurs, bond yields will jump higher, effectively “tightening” monetary policy very quickly.”

Such is what we saw on Thursday as bond yields jumped to nearly 1.7%. While rates did fall back mildly on Friday, the rise in rates from the August lows increases the cost of capital. (Chart shows the percentage increase in rates versus the annual inflation rate,)

Given the long and highly correlated history of GDP, Inflation, and Interest Rates, it is no surprise to see rates pacing inflation currently. As noted in “No, Bonds Aren’t Overvalued:”

“As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”

Note: The “economic composite” is a compilation of inflation (CPI), economic growth (GDP), and wages.

Bonds Overvalued, #MacroView: No, Bonds Aren’t Overvalued. They’re A Warning Sign.

At the peak of nominal economic growth over the last decade, interest rates rose to 3% as GDP temporarily hit 6%. However, what rates predicted is that economic growth would return to its long-term downtrend, and inflation would drop with it. Bonds were right as the economy fell into recession in 2020.

Once again, economists predict 6% or better economic growth, yet interest rates are roughly 50% lower than previously. The bond market is screaming that:

  • Economic growth will average between 1.75% and 2% over the next few years; and,
  • Deflation still trumps deflation.

Moreover, the Fed is manipulating inflation expectations.

The Fed Is Driving Inflation Expectations

In recent months, the market participants continue to rely heavily on implied inflation expectations. The reliance has led to much media-driven commentary relating to allocation decisions in the “inflationary environment.” From that analysis, investors piled into materials, energy, and financial companies, which did indeed provide short-term outperformance. The more deflationary sectors of technology, staples, and utilities, not surprisingly, underperformed.

The problem is the “market-based” expectations aren’t market-based at all. The first graph below shows the massive amounts of inflation-protected Treasury bonds and notes. Such large purchases create distortions in the very market investors are relying on for inflationary information. Instead, the Fed is skewing the implied inflation calculations.

The following chart from our analyst, Nick Lane, shows the history of these purchases and the impact on inflationary expectations.

Just as the Fed’s monetary interventions led to an inflation of market assets, a break of price-discovery, and a detachment from the underlying fundamentals, the same is now occurring in the TIPs market.

In other words, investors depend on signals from the market to allocate capital and adjust allocations. However, when those signals get manipulated, providing false information can lead to a more significant future dislocation when reality collides with the fantasy.

Such is why the Fed will make a mistake.

The Fed Is Going To Make A Mistake

As discussed, the “base effects” (comparison versus last year’s data) make price inflation appear much higher than it is. The graph below puts the CPI indexes in context with their trends of the previous five years.

Currently, the broad CPI index is only .011% above its trend. The Core CPI, which excludes food and energy, is running 1.06% above its trend. If the inflationary impulse is, in fact, transitory and dies out over the next few months, inflation data will end up close to where it was pre-pandemic.

The Fed is now potentially in a difficult position with inflationary “expectations” rising, caused by their actions, which could lead to a “policy mistake.” 

Given the Fed waiting so long into the economic cycle to hike rates, to begin with, they weren’t able to gain much of a spread before the economy contracted. Historically, there have been ZERO times the Federal Reserve hiked rates that did not negatively affect outcomes.

The problem for the Fed is that the bond market is not worried about surging inflation. Despite economic growth expectations of as much as 6%, interest rates are trading below 2%. Given the close correlation shown above, it is a message you should not dismiss quickly.

The “real economy” is heavily debt-financed, and as such, cannot withstand substantially higher rates. Consequently, the Fed is caught between hiking rates to quell transient inflationary pressures, thereby deflating the most significant asset bubble in financial history, or doing nothing and hoping no one pushes the “big red button.”

Unfortunately, history is full of instances where someone panicked.

Portfolio Update

“The road to hell is paved with good intentions.” – Unknown

As noted above, our attempt to “front-run” our “money flow signal” did not work out as planned as the signal did not turn.  While we did not take on a tremendous amount of exposure, the increased exposure to the decline mid-week was certainly not part of our plans.

As is always the case, technical analysis works best when you wait for the signals to occur. While a harsh lesson to relearn, the damage was minimal. With our signal triggering a “buy” on Friday, we bought at levels that should reward us over the next few weeks.

The market has been in a “selling stampede” for 14-sessions which is the average for a correction period. While not expecting an exceptional move higher, the downside is limited for now.

Timing is always the tricky part.

As Michael Lebowitz concluded in “Fortify Your Wealth:”

“Given the economic climate and extreme market risks and rewards, we continue to take an agnostic view of markets. We are not wed to opinions of economic activity or inflation, or how they may steer markets. 

Paying top dollar for assets requires independent thinking and careful attention to market activity. From the brightest traders on Wall Street to the halls of the Federal Reserve and in the studios of the self-anointed media economic experts, there is zero appreciation for the potential of massive forecasting errors.”

Historically, investors get rewarded for going against the crowd. Such is especially the case when the masses are in agreement on what the future holds.

“When all experts agree, something else is bound to happen.” – Bob Farrell

The MacroView

If you need help or have questions, we are always glad to help. Just email me.

See You Next Week

By Lance Roberts, CIO

Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members

S&P 500 Tear Sheet

Performance Analysis

Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” is oversold. The current reading is 84.70 out of a possible 100.

Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 68.32 out of a possible 100.

Sector Model Analysis & Risk Ranges

How To Read This Table

  • The table compares each sector and market to the S&P 500 index on relative performance.
  • “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the “beta” of the sector or market.
  • Table shows the price deviation above and below the weekly moving averages.

Weekly Stock Screens

Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

 Low P/B, High-Value Score, High Dividend Screen

Fundamental Growth Screen

Aggressive Growth Strategy

Portfolio / Client Update

In last week’s note, we said:

Our main concern remains the Fed. There is likely about to be a rather large ‘shock’ of inflation as the ‘base effects’  from the shutdown last year come roaring through the data. The problem for the Fed is counterbalancing their stance of “doing nothing,” with the market’s reaction to increasing input and labor costs.”

That is what happened and caused a panic in the market with a rapid rotation of assets. However, as money jumped from inflationary trades to deflationary trades, it kept our “sell signals” intact for the week. As such, we are still awaiting our next “buy signal,” which is very close. While the upside remains limited, the breakdown of the consolidation last week was certainly “not in the game plan.” 

Nonetheless, we continue to make minor tweaks to portfolios to adjust allocations and rebalance risks. Our short-term concern is the Fed “panics” and makes a mistake that shocks the market. It won’t be the first time it has happened and is always unexpected.

However, for now, we continue with our game plan and continue to focus on risk controls.

Portfolio Changes

During the past week, we made minor changes to portfolios. We post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

“We are continuing to build a trading position in QQQ for an approaching “buy signal” on our “money flow” indicator. After our initial add of 2% of the portfolio, we are increasing the position by another 1% bringing the total portfolio weight to 3%.” – 05/13/21

Equity & ETF Models

  • Add 1% of the portfolio to the existing position in QQQ

“We are going to build into a position of QQQ over the next several trading days looking for a relative pickup in performance relative to the S&P 500. We are starting with a 2% position in QQQ and will add to it if we get further weakness.” – 05/11/21

Equity & ETF Model

  • Initiate a 2% trading position in QQQ 

“We are taking some profits in the Equity and ETF Models in more grossly extended positions. In the Equity model, we are paring back to model weights of 2% in UPS and ALB back to 4% of the portfolio. In the ETF model, we reduced IYT (Transportation) back to model weight as well.” – 05-10-21

Equity Model

  • Reduce UPS to 2% of the portfolio
  • Reduce ALB to 4% of the portfolio

ETF Model

  • Reduce IYT to 2% of the portfolio

As always, our short-term concern remains the protection of your portfolio. We have now shifted our focus from the election back to the economic recovery and where we go from here.

Lance Roberts



A Conservative Strategy For Long-Term Investors

If you need help after reading the alert, do not hesitate to contact me.

Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.  

Have a great week!

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Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube
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