The Macro Ratio started off 2022 with a horrible call: “Recession Risks Are Rising: But U.S. equities are poised to make new highs this year before the next crash.” On the day of publication, April 12, the SPY closed above $438. Equities barely traded higher before going on to lose more than 12 percent through the end of the year. The bad call resulted from failing to correctly anticipate the slope of the Fed’s rate path. I came into 2022 thinking the Fed would end up hiking by 200 bps, less than half of what they have already done. Relying on the market’s consensus estimate in April of a 2.75 percent terminal rate in February 2023, undermined the analysis.
However, the same note drew attention to the relationship between the Purchasing Managers’ Index (“PMI”) and inflation. By extrapolating from peak PMI, The Macro Ratio forecast inflation would peak below 10 percent around June, in line with the (presumed) 9.1 percent peak in the June CPI data.
My forecast is inflation will peak at or below 10 percent before August. This forecast is based on the historical relationship between the Purchasing Managers’ Index (“PMI”) and inflation.
PMI measures how much manufacturing executives are ordering, what their inventory levels are like, how much they are producing and delivering, and their employment rate. A PMI reading above 50 indicates positive sentiment while below 50 is negative. When inflation rises and commodities become more expensive, input costs for manufacturers increase, and their sentiment sours. Negative sentiment reduces demand. Lower demand passes through the economy into lower prices. Thus, a peak in inflation tends to follow and flow from a peak in PMI.
The average number days between a peak in the PMI and the following peak in inflation is 413 days. ((399+518+854+336+273+462+182+273) / 8 = 412.125.) The average is 349 days when excluding the outlier (854 days). Based on the 31 May 2021 peak in PMI, I forecast a peak in inflation sometime between mid-May and mid-July 2022, in which case the peak will show up in the inflation data for June, July, or August 2022. Although the anticipated peak in inflation will come too late for the 3-4 May meeting of the FOMC, there is an increasing chance it comes in time for the June or July meetings, and, by September, it is more likely the Fed will see inflation as under control. This view is in line with the market’s expectation of three 50 basis point hikes in May, June, and July with 25 basis point hikes beginning in September.
(Emphases added.)
Two weeks later, on April 25, TheMacro Ratio started to diverge from market consensus by calling for a more aggressive policy path.
I expect the Biden administration to reverse course and push the Fed to keep rates at or below 3 percent. For this reason, unless there is a peak in inflation data this summer, which, as I wrote last week, is a significant possibility based on last year’s peak in PMI, the Fed is likely to front-load rate hikes in the coming meetings to get to a 2.5-2.75 percent as quickly as possible.
(Emphasis added.)
By May 11, price action in equities had invalidated my bull thesis, as the SPX continued to decline significantly despite the Fed’s initial reluctance to aggressively raise rates.
Inflation will continue to grow so long as the Fed’s target rate is below the neutral rate, which is the rate at which inflation is neither growing nor slowing. The longer it takes the Fed to get to a neutral rate, the higher peak inflation will be, the higher the target rate will have to be to bring inflation back down to target. It is safe to say the neutral rate is now above 3 percent. How far above 3 percent is a matter of debate but beside the immediate point: the earliest the Fed can get near neutral is September (using three consecutive 75 basis point hikes in June, July, and September).
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Meanwhile, the S&P 500 is currently trading at major support in the 3950-4000 range. My base case for this year remains equities to out-perform but price action is dangerously close to invalidating my thesis with a move below 4000.
(Emphasis added.)
On May 25th, with the SPX trading at 3978, The Macro Ratio recommended holding equities and accurately forecasted short-term price action.
In my view, it is more likely than not we see a bear-market rally towards the 4200 to 4500 range in June, although it is a significant possibility price might reach support at 3725 or 3660 on the downside before rallying.
SPX traded to a new low of 3636 on June 17 before rallying to a local high of 4325 on August 16. On June 11, near the low, I “hesitate[d] to issue a SELL rating on the SPX just yet. There are scenarios where prices can recover this year before a recession ahead of 2024. . . . That being said, I do not think it is a mistake to take risk off the table now; higher prices would be nice to trim positions, but beggars cannot be choosers.” The SPX rallied more than 12 percent through August 12 and ended the year flat vis-à-vis the June 11 price level, justifying the tactic of holding equities while trimming exposure during this summer’s rally.
Beginning on May 26, and continuing on June 5 and June 6, The Macro Ratio recommended a long merger arbitrage position in Twitter. These posts were supplemented by in-depth analysis of legal precedent on July 13 and July 18. The trade resulted in a 39 percent gain in 154 days (~87 annualized return on investment).
On June 1, The Macro Ratio observed, “Based on the news President Biden met with Chairman Powell yesterday, I think there is a moderate possibility the Fed will surprise with 75 bps at one of the next two meetings.” At the time of the warning, the market was pricing the probability of a 75 bps move at eitherthe June or July FOMC at less than 13 percent, and the probability of two consecutive 75 bps moves at less than 0.38 percent.
The Fed’s narrative then shifted to that of a “mild recession” or “soft landing,” raising the perception the FOMC might give more weight to unemployment and take their eye of inflation. The Macro Ratio started buying duration in Treasuries on June 22 in response to perception the Fed might “pause” in September 2022. Although way off the mark (given the Fed’s current rate is 4.25-4.50), by August 1, traders had begun raising their bets on the terminal rate, predicting a peak of 3.25-3.50 in February 2023. We closed our long-end position, almost taking out the low to capture most of the summer’s rally, booking a 3 percent gain and narrowly avoiding a 190 bps move higher in the 5-year yield that began on August 2. In the same note I also warned against buying the rally at 4121 SPX and said investors should be wary of a bull trap.
We then analyzed Chairman Powell’s assertion 2.25-2.50 was the neutral rate on August 3. Söderström (2002) shows aggressive monetary policy is the optimal response when uncertainty over the degree of inflation’s persistence is heightened. Based on Laubach & Williams (2003) estimates of the natural rate of interest during the Great Inflation, I estimated the neutral rate was between 3.00-3.50, and argued for a moderately restrictive terminal rate of 3.5-4 percent. The Fed has since chosen a more aggressive policy path, perhaps, as Stanley Druckenmiller noted, because “once inflation gets above 5%, it’s never come down unless the Fed Funds rate has gotten above the CPI.” The counter-argument is there is only one other time when CPI was above 5 percent, between October 1990 and September 1991, apart from the Great Inflation, so we do not have enough information to draw any firm conclusions. I would have preferred a more reserved approach after hiking aggressively to get to a 4 percent funds rate, as it takes 2.5 years for rate hikes to pass through fully into lower prices, and over-shooting into unnecessarily restrictive rates will exacerbate any recession.
But what I might want doesn’t really matter to investors trying to gauge the terminal rate! The Fed is now aiming for a terminal rate of around 5.1 percent. Although I was quick to anticipate the Fed’s shift to front-loading rate hikes, I significantly underestimated how high the Fed was going. This mistake was probably driven in part by complacency, as our front-end-only strategy has little exposure to interest rate risk, and I had, by this time, abandoned the tactic of trying to buy duration to time the Fed’s pivot. In my defense, I did at least warn the Fed would continuing hiking rates, even if inflation had already peaked in June.
History teaches us the neutral rate continued to climb despite a severe recession and the Fed going full Volcker to combat inflation. This is a critical insight most market participants do not appreciate: peak inflation does not mean the Fed can pivot to rate cuts. On the contrary, correct policy calls for the Fed to continue hiking after peak inflation to catch up with a still-increasing neutral rate.
In my next note on August 27, following Powell’s “higher for longer” speech, I lauded the Fed for turning hawkish and said the bear market rally was “clearly . . . over” at SPX 4059.
The bear-market rally went higher than expected, due to irrational buying driven by mere hope the Fed would pivot to prioritize market valuations and economic weakness ahead of sticky inflation. Although The Macro Ratio gave credence to the possibility of a pivot, that analysis was based on a presumption the Fed would continue to make policy errors. It is quite clear the Fed is now committed to the correct policy path.
In addition to a weakening macro environment, the technical picture clearly supports a call the bear-market rally is over. Price action took a hard bounce off the top of the long-term bull trendline (top purple line) and the top of the short-term bear trendline (top red line). Unless the August inflation data shows a sharp decline in core inflation, expect higher volume to favor sellers as prices are driven down to retest recent lows.
(Emphasis original.)
Results
Unfortunately, we decided to close our Twitter trade to book a 7 percent gain. This mistake was compounded by not following through with the planned series of articles addressing all of the most relevant legal precedents in the case, reflecting a lack of focus on the market and failure to follow up with complete due diligence. Considering the time I had already committed to developing the trade thesis, missing out on 30 percent was a bad mistake.
Apart from a brief foray into duration in June and July 2022, our overall strategy of holding dollars from May 2021 through to June 2022, and then moving into T-bills out to six months from June through today, all the while maintaining negligible exposure to equities (0.1 percent of portfolio value), has done well. Although the S&P 500 would go on to add 15 percent through to its all-time high in January 2022, while the Nasdaq added more than 25 percent, the equity markets are now down more than 8 percent and 20 percent, respectively, since May 6, 2021. Further, since June 2022, the portfolio beat the NASDAQ by 5.6 percent, while falling 1.08 percent short of the S&P 500, after accounting for dividend reinvestment. Despite being invested for less than six months in 2022, The Macro Ratio’s simple low-risk, low-volatility, front-end strategy beat the FY22 ROI of 197 of 198 professionally managed bond funds; only the T. Rowe Price Dynamic Global Bond Fund did better, returning +3.4%. And the portfolio generated 17 and 18 bps of alpha over benchmark ETFs like the SGOV (targeting 0-3 month bills) and SHV (0-1 year), respectively, by maintaining an average duration to maturity of 3-6 months and avoiding BlackRock’s 5 bps management fee (temporarily reduced from 12 bps through the end of June 2023). The portfolio offered peace of mind, with no drawdowns despite heavy volatility across assets, and required only a simple, two-minute operation to roll the bills as they matured each week.
In conclusion, by committing to asset-protection, in exchange for a real loss in purchasing power, the portfolio has avoided the nominal losses most other investors have incurred over the same period. These results justify our conservative decision in May 2021 not to chase a blow-off top in equity markets, but rather to maintain a cash position, which ended up being 100 percent dollars, until rates began to rise in the front-end. Inflation and significant rate hikes were foreseeable in May 2021 when investors had the choice of “buying the dip” or waiting for a larger margin of safety. As Bloomberg’s “Big Take” of 2022 observes, “[T]he mentality that felled the twenty-something-year-old bros chasing meme stock mania in the early days of the pandemic isn't ultimately all that different from the model taught at the country's elite financial institutions — markets only go up because, well, the Fed.” When professional investors start to believe “markets only go up,” that is but the very definition of the “new paradigm” irrational euphoria that has always marked the top of a bubble. It should not take hindsight to see as much. Mitigating or, better yet, avoiding severe drawdowns is the best way to beat the market in the long run, which is why our edge—the geo-Austrian theory of the business cycle, synthesizing monetary policy, capital goods, and real estate—is foundational to The Macro Ratio’s market analysis and outlook on 2023 . . . coming soon.
2022 Performance Review
2022 Performance Review
2022 Performance Review
The Macro Ratio started off 2022 with a horrible call: “Recession Risks Are Rising: But U.S. equities are poised to make new highs this year before the next crash.” On the day of publication, April 12, the SPY closed above $438. Equities barely traded higher before going on to lose more than 12 percent through the end of the year. The bad call resulted from failing to correctly anticipate the slope of the Fed’s rate path. I came into 2022 thinking the Fed would end up hiking by 200 bps, less than half of what they have already done. Relying on the market’s consensus estimate in April of a 2.75 percent terminal rate in February 2023, undermined the analysis.
However, the same note drew attention to the relationship between the Purchasing Managers’ Index (“PMI”) and inflation. By extrapolating from peak PMI, The Macro Ratio forecast inflation would peak below 10 percent around June, in line with the (presumed) 9.1 percent peak in the June CPI data.
(Emphases added.)
Two weeks later, on April 25, The Macro Ratio started to diverge from market consensus by calling for a more aggressive policy path.
(Emphasis added.)
By May 11, price action in equities had invalidated my bull thesis, as the SPX continued to decline significantly despite the Fed’s initial reluctance to aggressively raise rates.
(Emphasis added.)
On May 25th, with the SPX trading at 3978, The Macro Ratio recommended holding equities and accurately forecasted short-term price action.
SPX traded to a new low of 3636 on June 17 before rallying to a local high of 4325 on August 16. On June 11, near the low, I “hesitate[d] to issue a SELL rating on the SPX just yet. There are scenarios where prices can recover this year before a recession ahead of 2024. . . . That being said, I do not think it is a mistake to take risk off the table now; higher prices would be nice to trim positions, but beggars cannot be choosers.” The SPX rallied more than 12 percent through August 12 and ended the year flat vis-à-vis the June 11 price level, justifying the tactic of holding equities while trimming exposure during this summer’s rally.
Beginning on May 26, and continuing on June 5 and June 6, The Macro Ratio recommended a long merger arbitrage position in Twitter. These posts were supplemented by in-depth analysis of legal precedent on July 13 and July 18. The trade resulted in a 39 percent gain in 154 days (~87 annualized return on investment).
On June 1, The Macro Ratio observed, “Based on the news President Biden met with Chairman Powell yesterday, I think there is a moderate possibility the Fed will surprise with 75 bps at one of the next two meetings.” At the time of the warning, the market was pricing the probability of a 75 bps move at either the June or July FOMC at less than 13 percent, and the probability of two consecutive 75 bps moves at less than 0.38 percent.
The Fed’s narrative then shifted to that of a “mild recession” or “soft landing,” raising the perception the FOMC might give more weight to unemployment and take their eye of inflation. The Macro Ratio started buying duration in Treasuries on June 22 in response to perception the Fed might “pause” in September 2022. Although way off the mark (given the Fed’s current rate is 4.25-4.50), by August 1, traders had begun raising their bets on the terminal rate, predicting a peak of 3.25-3.50 in February 2023. We closed our long-end position, almost taking out the low to capture most of the summer’s rally, booking a 3 percent gain and narrowly avoiding a 190 bps move higher in the 5-year yield that began on August 2. In the same note I also warned against buying the rally at 4121 SPX and said investors should be wary of a bull trap.
We then analyzed Chairman Powell’s assertion 2.25-2.50 was the neutral rate on August 3. Söderström (2002) shows aggressive monetary policy is the optimal response when uncertainty over the degree of inflation’s persistence is heightened. Based on Laubach & Williams (2003) estimates of the natural rate of interest during the Great Inflation, I estimated the neutral rate was between 3.00-3.50, and argued for a moderately restrictive terminal rate of 3.5-4 percent. The Fed has since chosen a more aggressive policy path, perhaps, as Stanley Druckenmiller noted, because “once inflation gets above 5%, it’s never come down unless the Fed Funds rate has gotten above the CPI.” The counter-argument is there is only one other time when CPI was above 5 percent, between October 1990 and September 1991, apart from the Great Inflation, so we do not have enough information to draw any firm conclusions. I would have preferred a more reserved approach after hiking aggressively to get to a 4 percent funds rate, as it takes 2.5 years for rate hikes to pass through fully into lower prices, and over-shooting into unnecessarily restrictive rates will exacerbate any recession.
But what I might want doesn’t really matter to investors trying to gauge the terminal rate! The Fed is now aiming for a terminal rate of around 5.1 percent. Although I was quick to anticipate the Fed’s shift to front-loading rate hikes, I significantly underestimated how high the Fed was going. This mistake was probably driven in part by complacency, as our front-end-only strategy has little exposure to interest rate risk, and I had, by this time, abandoned the tactic of trying to buy duration to time the Fed’s pivot. In my defense, I did at least warn the Fed would continuing hiking rates, even if inflation had already peaked in June.
In my next note on August 27, following Powell’s “higher for longer” speech, I lauded the Fed for turning hawkish and said the bear market rally was “clearly . . . over” at SPX 4059.
(Emphasis original.)
Results
Unfortunately, we decided to close our Twitter trade to book a 7 percent gain. This mistake was compounded by not following through with the planned series of articles addressing all of the most relevant legal precedents in the case, reflecting a lack of focus on the market and failure to follow up with complete due diligence. Considering the time I had already committed to developing the trade thesis, missing out on 30 percent was a bad mistake.
Apart from a brief foray into duration in June and July 2022, our overall strategy of holding dollars from May 2021 through to June 2022, and then moving into T-bills out to six months from June through today, all the while maintaining negligible exposure to equities (0.1 percent of portfolio value), has done well. Although the S&P 500 would go on to add 15 percent through to its all-time high in January 2022, while the Nasdaq added more than 25 percent, the equity markets are now down more than 8 percent and 20 percent, respectively, since May 6, 2021. Further, since June 2022, the portfolio beat the NASDAQ by 5.6 percent, while falling 1.08 percent short of the S&P 500, after accounting for dividend reinvestment. Despite being invested for less than six months in 2022, The Macro Ratio’s simple low-risk, low-volatility, front-end strategy beat the FY22 ROI of 197 of 198 professionally managed bond funds; only the T. Rowe Price Dynamic Global Bond Fund did better, returning +3.4%. And the portfolio generated 17 and 18 bps of alpha over benchmark ETFs like the SGOV (targeting 0-3 month bills) and SHV (0-1 year), respectively, by maintaining an average duration to maturity of 3-6 months and avoiding BlackRock’s 5 bps management fee (temporarily reduced from 12 bps through the end of June 2023). The portfolio offered peace of mind, with no drawdowns despite heavy volatility across assets, and required only a simple, two-minute operation to roll the bills as they matured each week.
In conclusion, by committing to asset-protection, in exchange for a real loss in purchasing power, the portfolio has avoided the nominal losses most other investors have incurred over the same period. These results justify our conservative decision in May 2021 not to chase a blow-off top in equity markets, but rather to maintain a cash position, which ended up being 100 percent dollars, until rates began to rise in the front-end. Inflation and significant rate hikes were foreseeable in May 2021 when investors had the choice of “buying the dip” or waiting for a larger margin of safety. As Bloomberg’s “Big Take” of 2022 observes, “[T]he mentality that felled the twenty-something-year-old bros chasing meme stock mania in the early days of the pandemic isn't ultimately all that different from the model taught at the country's elite financial institutions — markets only go up because, well, the Fed.” When professional investors start to believe “markets only go up,” that is but the very definition of the “new paradigm” irrational euphoria that has always marked the top of a bubble. It should not take hindsight to see as much. Mitigating or, better yet, avoiding severe drawdowns is the best way to beat the market in the long run, which is why our edge—the geo-Austrian theory of the business cycle, synthesizing monetary policy, capital goods, and real estate—is foundational to The Macro Ratio’s market analysis and outlook on 2023 . . . coming soon.