Elite investors are privately warning that the market is headed for a second wave of pain
The stock market has started off the year in a state of euphoria, shrugging off the anxieties that dominated investors’ minds over the previous 12 months: inflation, hot war, cold war, soaring interest rates, recession.
The good news is undeniable. I get that. A milder winter in Europe has kept energy prices low. China is reopening from the economic standstill that was “zero COVID.” And the US economy is stunning everyone with its resilience.
“The economy is BOOMING! now,” one legendary hedge-fund manager told me via email, citing the 517,000 jobs created in the US in January. “That is not what a recession looks like.”
This elation has lulled Wall Street into a false sense of security, according to the investing world’s elite who I’ve spoken with over the past few weeks. Privately, these market masters warn that this complacency will make the coming reversal more excruciating.
“The surprise is that inflation is about to reaccelerate, and the Federal Reserve will have to respond by doing much more,” the hedge-fund manager, who spoke on condition of anonymity to talk freely about his positioning, said. “At that point, we may wind up with the hard landing part.”
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1. “The Big Short: Inside the Doomsday Machine” by Michael Lewis
2. “Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies” by Jeremy Siegel
3. “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein
4. “Reminiscences of a Stock Operator” by Edwin Lefèvre
5. “Market Wizards: Interviews with Top Traders” by Jack D. Schwager
6. “Lords of Finance: The Bankers Who Broke the World” by Liaquat Ahamed
7. “The Asian Financial Crisis 1995-98: Birth of the Age of Debt” by Russell Napier
8. “The Black Swan: The Impact of the Highly Improbable” by Nassim Taleb
9. “A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing” by Burton Malkiel
10. “Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms” by Russell Napier
11. “Manias, Panics, and Crashes: A History of Financial Crises” by Charles P. Kindleberger
12. “Debt: The First 5,000 Years” by David Graeber
13. “Stabilizing an Unstable Economy” by Hyman Minsky
14. “Triumph of the Optimists: 101 Years of Global Investment Returns” by Elroy Dimson, Mike Staunton, and Paul Marsh
15. “A Short History of Financial Euphoria” by John Kenneth Galbraith
16. “Too Big To Fail” by Andrew Ross Sorkin
17. “Irrational Exuberance” by Robert J. Shiller
18. “Boom and Bust: A Global History of Financial Bubbles” by John D. Turner and William Quinn
19. “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay
20. “The Dow Jones-Irwin Guide to Modern Portfolio Theory” by Robert Hagin
Rapid US economic growth makes inflation harder to kill. It means the Federal Reserve has to continue hiking interest rates, which breeds volatility and uncertainty across the markets. It means the story of the global economy’s normalization is still being written. And it means recession continues to be one of the many scenarios on the table. The stock market is still deep in the woods — and there are bears in this forest.
What we do in the bear markets
It’s easy to forget about a bear market when things are looking good. Even with some recent weakness, the S&P 500 is up nearly 5% year to date, and the Nasdaq is up just under 11% for the year. The US economy is continuing to surprise with strong consumer spending and bumper job growth. It’s like all the good little boys and girls on Wall Street asked for a rally for Christmas and got it.
While a hot economy is all good for average Americans, it’s a double-edged sword for Wall Street. For months, analysts and investors have debated whether the battle with inflation will result in a hard or soft landing for the economy. In a hard landing, the Fed’s interest-rate hikes slow the economy so much that it tips the country into a recession and unemployment spikes. In a soft landing, the Fed is able to bring inflation down to its target of 2% without doing much damage to the economy. Apollo Global Management’s chief economist, Torsten Slok, has started telling his clients this strong economy and still high inflation mean the US could be heading toward a third option: a no-landing scenario.
In a no-landing scenario, we’re chasing inflation, and it’s a greased pig. Our strong economy and robust consumer prevent supply and demand from fully realigning, increasing the risk of inflation flare-ups and keeping the consumer price index above that 2% target for a protracted period. As a result, the Fed will have to continue hiking interest rates, which makes cash harder to come by for businesses and for investors. Debt becomes more expensive to carry, too. All that squeezes profits and profit margins, harming businesses’ bottom lines.
As it stands, we remain far away from any sort of landing: The consumer price index — the most widely watched measure of inflation — has come down from its peak of 9.1% in June, but it was still at 6.4% in January, well above the Fed’s goal and barely a nudge down from December’s 6.5%. The Fed must consider the possibility that the 6% range is a sticky spot for inflation — and to get prices down, it could be forced to hike rates higher than what analysts have been expecting.
Fed Chair Jerome Powell has made clear that he takes this no-landing scenario seriously, reminding Wall Street that he can and will hike rates further if prices remain high. In a speech on February 7, he said he saw a “bumpy” path for inflation ahead if the job market remained strong. Raphael Bostic, the Federal Reserve Bank of Atlanta’s president, warned in a separate interview that the Fed may have to hike rates higher than expected to fully beat inflation.
But do you think Wall Street listened to those words of caution? Hell, no: It’s rally time.
“Until Cathie Wood selling fantasies with an adoring press isn’t a thing, we haven’t left the bubble,” the investment chief for a large family office told me. He added that nonprofessional retail investors’ strong return to the market indicated an unsustainable rally. “Everyone believes the Fed will cut rates by year-end, but the market itself is ensuring that can’t happen,” the investment chief said. The Fed’s goal is to soak up the cash floating around the economy that’s making it run hot. And nothing says “still too warm” like Americans revving up their Robinhood accounts to buy meme stocks again.
And just because the market is headed back up doesn’t mean the economic gravity can’t pull it back down. Charles Lemonides, the founder of the hedge fund ValueWorks, recently reminded me that bear markets were characterized by long, grinding downward moves in stock prices, followed by sharp, rip-your-face-off rallies. Since the market turned down in March, we’ve seen two such sucker-punch rallies — one in August and another in November — but neither of them lasted. And sure, maybe this one is different. But Lemonides, who’s fund returned 39.3% last year, according to documents viewed by Insider, is keeping his eye laser-focused on what’s happening under the hood.
“Inflation at current levels remains unacceptably high,” he wrote in a letter to investors last month. “So I expect tight monetary policy to continue to drain liquidity for more than another couple of months. Whether that culminates in economic contraction or just slower growth is to my mind a very open question that does not in itself lead to investment conclusions. Either way, I would expect tighter policy will weigh on equity prices for at least the first half of 2023.”
The economic conditions that prompted the market’s initial paradigm shift — rising interest rates and inflation — are not going away soon. Anytime Wall Street has forgotten that over the past year, it has gotten punished. In fact, with the economy as strong as it is, inflation may even try to stage a comeback. The dramatic variability of outcomes injects volatility into the market that even the most seasoned investors find hard to navigate.
The little rays of sunlight motivating the current market rally aren’t coming from just the US: Investors are starting to see signs of life in China and Europe as well. But much like the good-news-now-means-bad-news-later scenario in the US, top investors are cautious about the overseas turnaround.
The reason for optimism in China is obvious. The country is reopening to the world after nearly three years of COVID-19 lockdowns. The relaxed restrictions also came with a more-conciliatory tone from Beijing toward investors — a clear attempt to reheat enthusiasm for the country’s financial markets. Chinese officials were rewarded for that sweet talk: Foreign investors plowed $21 billion back into Chinese stocks in January.
In Europe, the energy-supply shock created by Russia’s invasion of Ukraine has not battered the economy as badly as some had feared. Optimistic analysts also think that renewed demand from China will help boost Europe’s biggest economy, Germany — which exports a lot of goods to the country.
But according to Justin Simon, the founder of the hedge fund Jasper Capital, the recent good news from both regions are head fakes. Eventually, their long-term problems — inflation in the EU and structural growth constraints in China — will rear their heads, Simon told me. It’s just a matter of when.
Inflation remains persistently high in the eurozone, so policymakers will need to remain aggressive. This isn’t inflation directly related to the war in Ukraine, either. German core inflation — that means stripping out food and energy — came in at 5% over the past year and 6% annualized over the past six months. That means it’s not out of the woods yet and tighter policy is still coming.
In China, there are signs that its reopened economy will not create the demand that it has in the past. Economists are seeing this dynamic in prices for commodities like oil and copper. China used to gobble that stuff up. But when the country reopened a few months ago, the prices didn’t surge; they fell. At the same time, China’s policymakers are trying to be as accommodating as possible, cutting interest rates, relaxing lending restrictions on its overinflated property sector, and injecting record amounts of cash.
“Price action, caused by central banks easing financial conditions, has initiated a chase for performance,” said Simon, whose fund returned over 40% in 2022, according to people familiar with the situation. “I’m skeptical that conditions will remain this accommodating for the remainder of the year.”
If China’s strategy for growth sounds familiar to you, that’s because it’s an old playbook the country has been trying to wean its economy off of for years. We know how it works. The banks start lending to the property companies again — which make up 30% of China’s gross domestic product. Those property developers pay for land from local governments, and the whole system inflates again.
That is, of course, until it looks like it’s going to topple under its own weight again, like it did in 2015, in 2019, and in 2021. There is a ceiling to this economic-growth strategy, and it’s getting lower. China’s population is also shrinking. That’s why it has admitted that it will have to accept slower growth and that it needs to change its economic model. All this will be painful and take time to shake out. But, hey, if you want to make some fast money on Chinese internet stocks while the head of state Xi Jinping says it’s OK for everyone to get in the pool, take a dip.
There can be only one
The economic growth we’re seeing is strong, but it’s not going to save stocks from the influence of rising rates. There is only one way to bring certainty and stability back to the market, and that’s by reaching the Fed’s 2% inflation target. Consider the rallies that come before that a test, perhaps a painful one but only a test.
There are people telling Powell to “chill” on interest-rate hikes since it seems like inflation is going down on its own. But Powell has said in speeches that would be his biggest mistake. Powell does not want to chill too early and then see inflation spin out of control while he is — and I hate to use this word again — chilling.
The same stock promoters who — at this time two years ago — were encouraging investors to jump into the market and buy anything are now preaching the religion of accounting metrics and due diligence at private investment conferences. Something has shifted. And Wall Street’s most adept investors know that our economy’s journey to something like normalization doesn’t have to move in one consistent direction. Like I said, it’s a greased pig.
We don’t know at which rate, or how high they will go, but more hikes are coming. And that means Wall Street will eventually have to open its eyes, take its fingers out of its ears, and watch this bear-market rally fall apart.
Linette Lopez is a senior correspondent at Insider.