Standing on the cliff

Today, as the Russian drama (or is it a circus?) plays out, the world stands on the edge of another transformation. And in the financial arena, the era of cheap money is ending as interest rates trend up. This is transforming the outlook for financial markets that have been buoyed by copious amounts of the stuff.

Last time, I highlighted the impact higher rates and bond yields are having on public finances. Here in the highly socialised UK, the pressure on national finances is extreme – last week we learned that the UK national debt has just exceeded the nation’s annual GDP. That means taxes will increase even further, putting pressure on disposable incomes. That is a headwind for domestic shares.

In the US, the latest Fed move was a ‘skip’ in rates but they are slated to resume hiking next month. One fine day, investors will take them seriously at their word. There has been a lag in market response to previous hikes but last week, the penny dropped – and share markets fell. Is this the initial slip before they cascade down the cliff?

Stock markets have advanced at least since WW2 as economies have expanded with greater international trade expanding wealth and the expansion of the fiat money system with the US dollar as the linchpin. This has been accompanied by a general rise in bullish sentiment and confidence in the future despite a few minor setbacks..

As an result of this expansion, families have been lead to believe that their children will ‘have it better’ than their parents’ generation. And that held true – until recently. Today, fewer children believe that as they struggle to move out of their family home (unaffordable housing) even into their 30s. That forward dynamic has changed – and is a reflection of the lowering of expectations for the future – and a lowering of social mood which will fuel the upcoming stock market crash.

The most sensitive index to the general outlook is the Russell 2000 US small cap index and this is the one that is leading the charge lower. I have been highlighting this index for Club members.

It made its relief rally high on 14 June at an exquisitely timed spot – a kiss I am naming The Kiss of Death on a major trendline and at the Fib 2/3 retrace off the wave down off the 30 January high on daily chart below Note that the RSI made a rare hit on the overbought 70 line on the approach to the high (only the third time since the August 2022 high).

Let’s see how t his fits into the larger picture on the weekly:

Since the wave 1 low was made exactly a year ago, the market has traced out a series of waves that I can now identify is a textbook five-wave wave 2 with the fifth (‘e’) wave topping last week at the Kiss of Death. So for a year, the market has gone nowhere. That is about to change.

It is down by 22% off its ATH to date – while bullish enthusiasm for companies such as Nvidia, Tesla and the like are surging. A fractured stock market indeed.

This year-long thrashing around in a trading range has been a nightmare for trend-followers but I believe our patience will coon be rewarded.

If my analysis is correct, we should see a downward break of all nearby support in a vicious third wave. Remember, third waves in a bear market are usually long and strong and take no prisoners. Be warned!

So let’s compare the real world Russell with the more fantastical Nasdaq where most of the recent speculative mania has been concentrated on AI shares:

Here, the Nasdaq has lost only half of the Russell’s and has reached the Fib 76% retrace on a very overbought RSI. This would also be an ideal place for wave 3 down to kick off.

A great question is this: with the forward-looking visionary Nasdaq only 10% off its ATH, how has this been achieved from the liquidity (money supply) perspective? It is often claimed that share valuations are directed by the money supply. And in recent years, the money spigots have been turned full on with the QE operations and furlough payments.

Yes, remember when workers were ordered to sit on the sofa in lockdown and watch Netflix movies – and get paid? Netflix shares rocketed, of course – as did the national debt and money supply. We are now starting to pay the price for that indulgence in higher price inflation. Here is the amazing chart of US money supply and the recent sharp falls in its growth. Note the Pandemic Party surge – and the hangover now firmly in place.

Note that this is not necessarily a drop in money supply – only a slowdown in its growth. But even this kind of slowdown can herald a recession ahead. And the Leading Economic Indicators can also signal a recession is fast approaching:

Recent Purchasing Managers Index (PMI) from the US and Eurozone also are flashing recession signals.

But the Fed and other central banks are again caught between a rock and a hard place. Do they keep hiking until they reach their stated 2% inflation mandate? If they do they will slaughter the economy and bring about worse unemployment even than in the 1930s Great Depression.

If they ease up and make money easier, they will stoke inflation and make currency worthless a la 1920s Weimar Republic where you needed wheelbarrows full of notes to buy a loaf of bread – and double that the next day.

Is it a coincidence that this scenario is a possibility exactly one hundred years later?

But whatever they do, they are stuffed. Of course, they will take the ‘easy’ way out when the pips start to squeak and print more dosh and let inflation run out of control. After all, politicians have a limited life span and most will be gone on generous pensions when the brown stuff hits the fan – with no sanctions on them. The current labour situation with NHS doctors and rail workers will be a litmus test for the government holding its nerve (or not) to restrict pay awards. The NHS fight will be seen as epic in due course. And inevitably lead to higher taxes to pay for it all.

And talking about Netflix – I see it as a low risk short

The wave 1 down off the ATH has a textbook five waves with a long and strong third wave (as was the fifth wave) to a deeply oversold RSI a year or so ago. The relief rally since then has been relatively tame and has formed a classic three up to the Fib 62% retrace on a highly overbought mom and RSI.

This pattern is matched by several other high profile Big Tech names and as such lends credence to the idea a major turn is on the cards. Only another general Big Tech surge from here could amend this forecast.

I have often noted that major turns occur when conditions look super rosy and downsides are considered very limited. Experienced traders know that this is the time to start looking at taking the other side of that trade just when exuberance is elevated.

It pays to be a contrarian – but only when your timing is right! As is said, stocks fall out of the window faster than they climb the stairs.