Written by Lance Roberts, Clarity Financial
This past week was quite interesting as the “Reddit WallStreetBets” bunch turned their sites away from Gamestop to “Cannabis.” Early in the week, we saw the “mania” re-manifest itself into names like Tilray, Aphria, Cronos, and others.
Please share this article – Go to very top of page, right hand side, for social media buttons.
However, this time it looks like “Reddit” traders learned their lesson to “get out early” as the trade went “up in smoke” rather quickly.
Nonetheless, the “speculative mania” remains in the market overall as speculators continue to operate without “fear” of a correction.
Currently, retail net bullish call options are piling up on the most shorted stocks.
However, those are the stocks with the worst fundamental factors.
And as investors chase small and mid-cap stocks to record historical deviations from long-term means.
These are also the companies where the quality of fundamentals are deteriorating the most.
But these are just a view of the signs. I did a much more extensive review of the current speculation in “Is This The Biggest Bubble Ever?”
As my colleague Doug Kass noted previously:
“It is growing increasingly clear to me that global stock markets are in the process of making a speculative move (driven by global liquidity) that may even compare to the advances that culminated in the seminal market tops in the Fall of 1987 and in the Spring of 2000.
No longer is the market hostage to the real economy or sales and profit growth – stuff I have spent four decades analyzing. Instead, liquidity is seen as an overriding influence, actually it has become the sine quo non.
As such, historical valuations become increasingly irrelevant, and price momentum is the lodestar.“
He is right.
What could go wrong?
Two Important Threats
The question of what could wrong is extremely difficult to answer. The reason is that historically, the thing the “goes wrong,” is almost always something no one is talking about. In February 2020, estimates were for a raging bull market, and then the world was shut down by a pandemic.
“Stuff Happens,” and always when we least expect.
There are, however, two threats that could severely limit the market in the months and quarters ahead. Inflation and Interest Rates.
Interest Rates
With an economy pushing $85 trillion in debt, the entire premise of the “consumption function,” as well as “valuation justification” for the stock market, is based on low-interest rates. However, that is rapidly ending as the rise in rates is now approaching a “danger zone” for the markets. As noted by SentimenTrader on Thursday:
“The march higher in the yield on 10-year Treasury notes took a breather in recent days, but it’s mostly been a steady rise for most of the last 6 months. So much so that the 1-year z-score, a measure of how unusual the move is relative to recent history, just reached 1.5 standard deviations for the 4th distinct time in the past decade.”
As discussed in “Dollar & Rates Issue A Warning“, interest rates are rapidly approaching the 1.5% to 2.0% barrier, where higher payments will collide with disposable income. Historically, such has not ended well for markets.
Inflation
The second threat is inflation. as noted by Michael Lebowitz for our RIAPRO Subscribers (30-day free trial.)
“In February 2019 we wrote MMT and its Fictional Discipline.
“In 1998, the Bureau of Labor Statistics (BLS) changed the way they calculated real estate prices within CPI. The BLS replaced an index based on actual home prices with what is now called owner’s equivalent rent (OER). OER is a rental equivalence that calculates the price at which an owned house would rent.”
Since 2019, OER has risen 5.12% while the Case-Shiller Home Price Index (CS) is up 13.73%. OER comprises nearly a quarter of the CPI calculation. The graph below replaces OER with the CS Index in the CPI calculation to show how inflation is understated due to the sharp divergence between actual home prices and the BLS flawed methodology to compute home prices. Per the graph, CPI would be 2.62% and rising, versus .96% and trending lower. The low CPI reading provides cover for the Fed to keep printing, but at what cost?”
When it comes to the stock market, there is a decades-long correlation between interest rates and inflation. More importantly, as with debt, consumers may handle higher prices or debt payments, but not both.
While investors may be able to justify higher inflation or rates in the short-term, it is unlikely they can justify both. As inflation and rates slow economic growth due to the absorption of disposable income via higher prices and interest payments, the market will begin to reprice risk quickly.
Such could be a problem sooner than many think.
.
