A Large Bubble in Search of a Large Pin

We have been telling you for a long time that markets are expensive. This week, they got a little cheaper. Is it over? Yes and no. Markets don’t go down in straight lines and this market is very oversold on a short-term basis, so a rally sometime next week would seem to be a reasonable bet. But is it really over? We suspect not. As with any bubble, the bigger the bubble, the more fragile it is, and it tends to hang around until something pops it. From the very first day, all bubbles are in search of a pin.

The much more difficult question is what the pin will be. The accepted wisdom was that markets can handle higher interest rates. The Fed has successfully prepared markets for this and the anticipated rate hikes for the next 12 months were effectively priced in. Then came this week. So, what gives? Did investors suddenly wake up and realize interest rates were going to rise? We think not.

Since the Great Financial Crisis of 2008, markets have been driven primarily by liquidity derived from QE. We won’t belabor QE again here. Suffice it to say that the Fed buys securities and pays for them with new money. Presto! There is more liquidity in financial markets and that drives prices higher. Indeed, driving prices higher (the wealth effect) is the primary function of a QE program.

Late last week, speculation began to build that the Fed would be even more aggressive than advertised in addressing inflation. That meant that QE would end sooner and rates would rise sooner. Fair enough. What got added, in a speech by Fed Chair Powell, is that the Fed may proactively drain liquidity (QT – the opposite of QE).

QE is a very effective stimulant for financial markets. Once you have some, you want more. The more you get, the more dependent you become. The more dependent you are, the more frightening is it to think about liquidity disappearing. It’s time to face facts. Markets are hooked, and weaning markets from their nasty habit will be a long and difficult road.

We came across the chart on the following page while surfing zerohedge.com. This is a chart of an index created by Goldman Sachs tracking unprofitable technology stocks. This group has been the first to get hit really hard. The S&P 500 is down roughly 7% in January as this is written, but over the last 12 months, the S&P is still up about 14%. As you can see in the chart below, these tech stocks are down about 50% in roughly the same 12-month time frame. Normally, a 50% decline would pique our interest, but not this time. For that index to get back to where it was in early 2020, it has to fall another 50% from here! This is no ordinary bubble. This is a huge bubble and it is being pricked by a very large liquidity pin.

This is not a done deal. The questions that lie ahead will, to some extent, will be addressed at next week’s Fed meeting. The last thing the Fed wants is a panic, so we expect them to attempt to calm market nerves by projecting a less aggressive path.

And that is the conundrum. The Fed can’t be too aggressive because it is so disruptive to markets. If markets get too out of control, the Fed will have to step in again and provide more liquidity. On the other hand, if the Fed gets too passive, they run the risk of inflation taking a strong hold. They are walking a tight rope and their history of successfully traversing these walks is not a good one.