Will the Fed Remain Tight for Too Long and Trigger a Recession?

Interest rate chicken, historical bear markets, market leadership, AI bubble, Japan inflation, sell in May?

Welcome! I’m Sarah Connor and this is my investing newsletter. If you’re new, please subscribe below:

Now on with the program…

1) St Louis Fed President James Bullard vs the market on the future of the Fed Funds rate. The biggest loser in this game of chicken will probably be the economy as the Fed pushes the limits of restrictive policy. What choice does it have? Inflation is still about 3x the Fed’s target.

Damn the torpedoes!

2) Why does James Bullard believe rates could/should raise another two times? Because relative to variations of the Taylor rule, monetary policy may not be sufficiently restrictive.

3) Is the bear market over? Did we miss the recession? History suggests the real collapse usually doesn’t begin until after the Fed Funds rate peaks. So if the Fed things another couple hikes are in order, we may still be a few months from any real pain. Remember, by the time the Fed starts to cut rates, the economy is often already in crisis mode. In this vein, rate cuts are a coincident bearish indicator.

4) One of these things doesn’t belong. The first two charts show the beginning of two major bull markets. During both periods, small caps lead the broader market. YTD 2023, the broad market is up 9.6%, with narrow leadership and outperforming small caps by a material margin. Is this time different?

5) The table below shows how YTD 2023 returns for the S&P 500 are being led by a handful of mega-cap names. In fact, the top 5 stocks account for 78% of YTD market returns.

6) Almost 70% of stocks are underperforming the S&P 500 right now (i.e. narrow market leadership).

7) So why is the broad market rallying if this isn’t the start of a bull market? The market did the same thing after Bear Stearns was bailed out in 2008, rising 15% in a matter of weeks and then collapsing later in the fall. Turned out there is never just one cockroach. Restrictive monetary policy has a way of bringing the garbage to the surface.

8) While we keep watch for a resurging bear market, a new bubble may already be forming. YTD 2023 AI-related stocks have outperformed dramatically. I firmly believe an AI bubble will soon start, if it hasn’t already. Evidence of a slowing economy might take AI stocks down a bit but that might prove to be a massive buying opportunity. AI is a 21st century industrial revolution. While it might destroy jobs, it will benefit the owners of capital - that includes shareholders.

9) Japan is finally getting what it desired for the past 30 years: inflation. All those bridges to nowhere are finally paying off. This could have profound consequences for an economy held down by deflation for decades.

10) Should you “sell in May and go away” (as the saying goes)? History shows avoiding the summer months means avoiding positive returns (most of the time).