All my losses and then some came back today. I even wrote some 0.5 DTE puts today against SQQQ at 62 while avoiding assignment on all the SQQQ covered calls I wrote yesterday at 65, milking the high volatility as best I've ever done. These were limited bets, but it's fun to have one's entire portfolio go +1.2% on a day the Nasdaq lost 3%. This one day performance gap translates to a year of retirement someday per the 4% rule!
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The unpredictability and volatility is a reminder we should be thinking about long-range trends, not day trades, and focusing very hard on whether we've turned a corner. I'm trying to be on the right side of history, not win a few hundred dollars in a zero-sum game.
Inflation Since June = Either 2% or 6% AnnualizedCPI has adopted a new and only slightly positive trendline since June. If we look at the CPI as an index since June, and tell FRED to set June 1, 2022 as the index date with a value of 100, then CPI is now, three months later, 100.5. In other words, since June, CPI has been on a 3-month course that would be roughly (0.5*4=) 2% annualized inflation. This is why the pundits are screaming about how the FOMC has done enough and needs to quit.
Core CPI since June becomes 101.5, which would be ~6% annualized. Note how Core CPI is rising much more quickly than CPI, due to the fall in energy and food commodity prices over the past 3 months. This is why the Fed's focus is shifting to Core CPI; they don't want to declare victory over inflation just because commodities corrected. Arguably the Ukraine war set off a commodities bubble that is bursting, and this temporary effect has little to do with monetary policy, velocity, or supply. PPI has experienced slight deflation over the past 3 months, and is now at 99.8.
Falling commodities prices will eventually catch up with CPI, and the unemployment rate can only go up from here. Thus CPI will probably continue to taper down as the comparison point from 12 months ago goes higher and higher and prices for things stay about the same.
Future Rate HikesIf nothing breaks(see my other thread for that discussion) I still think we're looking at 0.75% hikes in both November and December. That puts the FFR at 4.75% at the end of the year, in line with futures market predictions. Beyond December the crystal ball gets hazy. The FedWatch tool says market participants are expecting a 0.25% hike in February and maybe March. That would put the FFR upper bound at either 5% or 5.25%. These numbers represent the highest the market thinks we're going to go, and by that time I think we're likely to see inversion of the entire yield curve below 10 year durations.
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.htmlTaylor Rule Is Looking GoodI've said before that Taylor Rule guidance probably applies here, and the latest inflation numbers make me more confident about that statement. The rate hikes we've had so far may have slowed the pace of inflation slightly, but they appear to be insufficient, unless we want to theorize about long lag times.
Rates need to go above inflation in order to slow down monetary velocity and inhibit people from treating cash like a hot potato. People and institutions will continue to unload cash when the cost of holding it is greater than the interest rate they can earn. They will continue to borrow at less than the rate of inflation too.
According to this perspective, for the Fed to engineer a soft landing, they will have to gently intersect the FFR with the rate of inflation (we should use Core CPI as our inflation metric here, because of recent commodities volatility). Thus the current target for the FFR's terminal rate should be about 6%. However, there are a lot of moving parts:
- Core CPI is likely to be different next spring than it is now. What if, by then, 5% is the intercept point? A lower Core CPI by spring scenario makes sense if you think a slight effect from the most recent rate hikes will just start to be felt by then.
- We know monetary policy works with a lag, but how much? I think about 2 months is the theoretical minimum here, because that's the shortest lag between rate decisions and the reporting of CPI numbers that fully reflect any change after those decisions. The theoretical maximum may be a year or more. This means the FOMC might raise rates in February, only to discover in March that February's inflation rate was already lower than the FFR. It also means the FOMC might raise the FFR above the rate of inflation, and not see results for the next several meetings, which could cause them to enact more rate hikes and overshoot during the lag time.
- The Fed is now looking at shorter-duration treasuries for longer-duration treasuries, presumably in order to reduce inversion of the yield curve, enhance the consumption-reducing effects of rate hikes, relieve pressure on financial institutions, and inject liquidity into the narrowing treasury market. This is what the UK was just forced to do, and it is reminiscent of "Operation Twist" but in the opposite direction we saw in 2011.
https://www.marketwatch.com/story/this-is-not-qe-or-qt-this-is-none-of-those-why-the-u-s-treasury-is-exploring-debt-buybacks-11665775104?mod=home-page
https://www.investopedia.com/terms/o/operation-twist.asp - If "something breaks" such as the repo or treasury markets freezing up, that might lead to an immediate six-month pause in the rate hikes and/or QT.
- Stocks are discounted based on the 10y treasury yield more so than the FFR. But the 10y treasury yield might be less than the FFR at its peak. The FFR-10y gap was ~0.75% just prior to the GFC, for example. Thus we cannot just say if FFR=6%, then 10y yield=7%, then stock earnings yield =8%. For all we know it may be more like FFR=6%, 10y=5.5%, and stock earnings yield=5% if we are in an earnings recession and markets expect rate cuts plus earnings growth.
When To Go Long?So to summarize, I think the buy signal is when the FFR intersects with or surpasses Core CPI. At that point, we know inflation is going down. The Fed will either take a pause at this point, or something will have broken, meaning there will be no need to account for future rate hikes when discounting stocks, and the 10y yield is likely as high as it's going to go. My current prediction is that this intersection will occur in March at somewhere between 5% and 5.5% for both the FFR and Core CPI ***
IF*** a crisis does not break out before then.
For stocks, this means we should discount future earnings at about a 5% 10y treasury yield (+/-0.5%), plus a solid risk premium of 1.5% to 2%. This puts our expected earnings yield at 6.5% to 7%. That translates into a forward PE ratio of 14-15, which is the same target I've been looking at for months. We are currently at a forward PE of 15.5 for the S&P500, and strategically it might be wise to go long at this point rather than accepting the risk of being left behind because you tried to catch the absolute bottom.
https://www.yardeni.com/pub/stockmktperatio.pdfHowever, if you strongly believe that a recession is coming, as I do, any forward PE estimate looks a bit optimistic. We're already 5 months into a trend of sharply falling earnings, according to the estimated monthly earnings table on multpl.com. Who predicted that?
https://www.multpl.com/s-p-500-pe-ratioIf we calculate a PE for the S&P500 based on the 12 months of earnings prior to the last 5 months to represent the stock market's potential if all the problems went away, that PE ratio would be about 12! I'm not saying we can go back to the low rates / low inflation world that created those earnings, but I
am saying stocks and expectations have fallen a long way, and may have priced in both a mild recession and a 5% treasury yield.
I want to swing for the fences and wait to go long when there's blood in the streets, financial institutions and nations defaulting, unemployment going up, 100% doom headlines, people jumping from skyscrapers, etc. However there's also a serious risk of being left behind, as I was in 2018 and 2020. Therefore I might pick up some long-duration, relatively high gamma OTM calls if we get a day of low enough volatility. If the market stays down amid a nasty recession, I'll lose the option premium but retain the opportunity to deploy most of my assets in the future at bargain bin prices. If markets go up, I'll sell the options for the difference (losing the time value) and deploy my remaining assets plus profits from the calls, mitigating most, all, or more than the damage from being left in the dust.
I also might fill my fixed income allocation now with some attractive IG bonds and preferreds yielding 6-8%. If rates don't have to go much higher than what is currently priced in before they intersect with Core CPI, then maybe these yields are close to as good as it will get. I think it makes sense to increase one's bond allocation now that interest rates are back in the range where the 60/40 portfolio used to be considered ideal. If things got bad enough, like SHTF 2008-2009 bad, then I could imagine myself doing 20/80 call options or futures / bonds and seeing how I look a year later.