Here's Why the Stock Market is at Risk of Further Decline

The chart above shows the S&P 500 (SPX) relative to the price of the 10-year U.S. Treasury bond (1/US10Y). As you can see, when adjusted in this way, the S&P 500's decline in 2022 is no longer apparent. This could be a warning that further stock market decline is to come.

Let's walk through why this may be. First, it is important to understand that an interest rate is simply the cost of money. Central banks use interest rates to raise or lower the cost of money, which can impact the money supply by lowering or raising it.

For details on how the interest rate can impact the supply of money, you can check out my post here:
When we look at a chart of the yields on the 10-year U.S. Treasury bond, as shown below, what we're actually looking at is a chart of the cost of money.

When the Fed says it will continue to hike rates and hold them higher for longer, what the Fed is really saying is that it will continue to raise the cost of money and keep money costlier for longer. This is bad news for the stock market because it is unlikely to undergo a massive bull run while money remains scarce. In fact, Fed Chair Powell recently stated that a high stock market valuation is a cause of the labor shortage. High stock market returns incentivize people to retire early and live off of investment income. Combined with the already difficult demographic headwind of an aging population, the economy becomes faced with too many people consuming and too few people producing. This is a major cause of the labor shortage. Thus, if high stock market returns are a cause for the labor shortage, and the Fed's goal is to mitigate the labor shortage to mitigate inflation, then the stock market is likely to face prolonged headwinds.

A massive bull run in the yields on bonds has come along with a rapidly declining supply of money. Until this trend ends, there is simply not enough money to propel the stock market to new all-time highs. Remember that the stock market is largely a measure of corporate earnings, and corporations can only ever earn some subset of the total money supply. What might a record decline in the money supply say about the future of corporate earnings?

Government bonds, especially U.S. Treasury bonds, are considered risk-free assets since the central government, which issues these bonds, has the ability to print more money and thus can always afford to avoid default. In a normal market, whenever higher interest rates are demanded by market participants for an asset the market is saying that it perceives greater risks associated with that asset. The higher interest rates compensate investors for the greater risk. Since the rates on U.S. Treasurys have soared, the market is sending the message that it now perceives these assets as riskier. Although Treasurys can be perceived as risk-free from a default perspective, there is still a risk of loss, especially when higher inflation becomes entrenched for the long term. The increased risk can actually become a positive feedback loop because as the market demands higher rates due to inflation, then the government will have to pay more to service its debt. Such an expansion in the cost of debt service can cause the market to then believe the bond risk is higher, and the market may demand yet even higher interest rates. (Although the central government can always print more money to pay its increased debt, for political reasons it may choose default instead. Thus, there is a risk of default even for theoretically risk-free bonds). Furthermore, even if the central government chooses not to default, it will be forced to print more money to service higher debt which could worsen inflation and, in turn, keep rates higher for longer.

Therefore, it is important to understand that in the face of high inflation, risk-free Treasurys have become risky relative to their historical norm. In that regard, since all other assets except physical gold (e.g. stocks, corporate bonds, cryptocurrency) are inherently more risky than Treasurys, all other assets become less stable. This concept is illustrated in Exter's Pyramid, shown below.

When an asset class lower down in the inverted pyramid becomes unstable, everything above it will experience some greater degree of instability. The most speculative fringes of the market (the top of the inverted pyramid) are likely to experience outright liquidity crises. We are already beginning to see this in the cryptocurrency space which is not pictured on the pyramid, but which if it were, would be near the top.

So a massive bull run of the S&P 500 relative to the price of 10-year US Treasurys is not a good sign.

What this chart is showing is that the S&P 500 is becoming more and more overvalued relative to risk-free Treasurys, even as the S&P 500 nonetheless sells off! The amount of capital that is currently invested in the S&P 500 is too high for the yields on 10-year Treasurys to be as high as they are. This suggests that capital will tend to flow out of the stock market and into less risky and higher-yielding Treasury bonds.

The Federal Reserve is trapped by commodity inflation because it cannot cut interest rates, or make money cheaper, without worsening commodity inflation. If scarcities of commodities continue to weigh on commodity prices, keeping them elevated even as demand cools, then the coming stagflation is likely to be severe.

Since the yields on the risk-free Treasurys have skyrocketed, this means that even after all the declines we've seen so far, most assets are still overvalued. Look how high the value of Nasdaq 100 stocks has risen relative to the risk-free 10-year Treasury.

The last time this happened was right before the Dotcom Bust in 2000.

Although this relative chart does not predict whether the price of Nasdaq 100 stocks will go down, or the yields of 10-year Treasurys will go down, it does suggest that if the yields of 10-year Treasurys remain elevated, as the Fed suggests will happen, then the price of Nasdaq 100 stocks is likely to fall even further.

In the chart below, we can see that the fastest and most extreme yield curve inversion in history is occurring right now. This could suggest that the onset of the impending recession could be as equally fast and as extreme. The abruptness of FTX's collapse due to liquidity issues could be a harbinger of what's to come.

The Federal Reserve is already adding liquidity back into the banking system.

Job openings likely reached their cycle high and will continue to decline into the foreseeable future as the supply of money remains some degree tighter into perpetuity.

In the U.S., population and GDP grew at an exponential rate over much of the past century. This, in large part, allowed for the money supply to also grow at an exponential rate without high inflation. Since the stock market tracks the money supply, the stock market also largely grew exponentially as well. However, as population and GDP growth slow, this creates the risk that an exponentially growing money supply may result in persistently high inflation.

In the coming recession, which will likely be characterized by severe stagflation, central banks will likely have to convince the market that high inflation is good.
The Bank for International Settlements (BIS), often thought of as the central bank of central banks, just published a warning that forebodes a coming global liquidity crisis.

Reuters article: www.reuters.com/mark...s-urgent-2022-12-05/

BIS article: www.bis.org/publ/qtrpdf/r_qt2212h.htm

BIS Video: www.youtube.com/watch?v=LOz9NQu1...

It's interesting that the BIS is using similar words as those that Sam Bankman-Fried used following the collapse of FTX.

They warn that there are extremely large dollar debt obligations that do not appear on balance sheets, which represent $80 trillion in hidden dollar debt.

They note that the total outstanding obligations in U.S. dollar debt "exceed the stocks of dollar Treasury bills, repo, and commercial paper combined". In other words, even if these assets were totally liquidated, the debt obligation would still not be satisfied, thus making the situation vulnerable to dollar funding squeezes and a bank-run type of liquidity crisis. Already we see the liquidity crisis contagion growing along the speculative fringes of the market (in the cryptocurrency space).

The big problem is that although these FX swaps, forwards, and currency swaps that give rise to these massive dollar obligations were backstopped in 2008 and 2020 by central banks. This time around central banks are forced to tighten liquidity in order to control spiraling inflation.

Central banks are in a Catch-22. They must choose between one of two crises: Prevent higher inflation and cause massive liquidity issues, or prevent massive liquidity issues and cause higher inflation. Which path they choose is largely insignificant because both paths will likely lead to the same outcome: economic decline.

At the first signs of a liquidity crisis within the banking system, or within a major non-bank fund, they will likely choose to cause high inflation. But first, they need to convince you that high inflation is good.

The Fed's tactic will likely be to increase its inflation target to 3% and claim that this new, higher inflation rate is completely consistent with a healthy economy.

As Milton Friedman said: Inflation is the only form of taxation that can be levied without any legislation. Inflation acts as a tax because like taxes, it erodes wealth and purchasing power.

The only question that remains is just how high this hidden inflation tax will need to get in order to prevent a liquidity crisis, and whether or not that level will be consistent with social stability.

Ultimately, central banks will likely whipsaw monetary conditions (repeatedly tightening and loosening in rapid alternation) as they grapple with the persistent problem of stagflation.
The below post provides a continuation of the above post:

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