Kirk Spano’s Q2 2022 Outlook And Game Plan For A Tighter Fed (NASDAQ:QQQ)

New year 2022 to 2024 and yellow arrow on asphalt road

Kirk Spano’s Q2 2022 Market Outlook & Game Plan

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The Federal Reserve has already raised interest rates once and is promising to shrink their massive balance sheet imminently.

In 2018 the Federal Reserve embarked on a quantitative tightening of their balance sheet and the stock market suffered two significant corrections. The S&P 500 (NYSEARCA:SPY) ended 2018 down 6.24%.

As I described in my year opening letter, I expect 2022 to be very similar to 2018.

My 2022 Futile Forecast: The Dollar, Stocks, REITs, Crypto, Inflation

The sections in today’s piece are short hand designed to help you navigate your investments for the next few months. As always, the topics in this outlook and game plan will be covered more in depth throughout the quarter, so please follow along to see more analysis.

The Fed’s Plan You Know

As I said in Macro Dashes: The Fed Is Reloading Its Bazooka For Next Time:

[I]n the short run, the Fed is going to tighten aggressively. That will cause the dollar to continue to rise, and soon enough, asset prices, including stocks, will fall.

Since then, the Fed has embarked on a tightening regimen that is set to accelerate based on Fed Chairman Jerome Powell’s statements.

Stock prices have fallen in line with the Fed’s intentions, with the first quarter finishing down over 5%, but with the losses front loaded.

In March, there was a bit of a rebound rally, especially in the Nasdaq 100. I discussed that rebound was coming in Ukraine Won’t Matter To Stocks In A Month, where I also said buy the Invesco QQQ ETF (QQQ). QQQ has risen since that article:


QQQ (Kirk Spano)

The dollar has also remained stronger than the years before President Biden, with only a very minor pullback in recent weeks. I’d expect the pullback to end soon enough.

Here is my long-term dollar tracker which I started in 2012 when I wrote on MarketWatch that the dollar would get stronger versus other major currencies over time due to unique American economic advantages:


Dollar (Kirk Spano)

With the Fed tightening like 2018 we saw two significant bouts of volatility. One early in the year and one late. I drew this chart in December 2021.


Volatility (Kirk Spano)

We have seen the rise in volatility since the Fed announced its intentions to taper QE and raise rates. In the past month we have seen volatility come down on the rebound rally. Why shouldn’t we expect it to rise soon given the Fed’s intentions?

What we likely have coming sometime this year, possibly by summer, is another correction. How deep is the only real question in my mind.

2018 Market Volatility

2018 Market Volatility (Kirk Spano)

Why would the 2022 stock market react much differently than its reaction to the fed tightening in 2018?

We know that while sentiment drives markets short-term, but we quants also know that liquidity generally drives sentiment. Why is that? Well, logically, loose money fuels speculation. Most studies ably demonstrate that reality too.

I’ll write a bit more about not fighting the Fed soon and will consider many of the thoughts in this article by David Rosenberg from June 2020:

Don’t fight the Fed? Why investors should be wary of market manipulation

I suggest reading that.

Short-term Narratives Vs Long-term Fundamentals

One of the things that traders glom onto are narratives that justify their short-term trades. The repetitive chant of some narrative, amplified by social media, blog posts and “influencer” videos (and wannabe influencers) becomes true, at least for a little while, when the chart is headed in the right direction.

When the chart turns, then the chants change to the new narrative. As we all know, the world changes dramatically in just a few hours all the time. I remember that one time when everything was different that time.

For longer term investors (at least 4 out of 5 of you should be longer term position traders measuring investments years), today’s narratives should simply serve as the occasional opportunity to buy or sell long-term investments at prices the short-term traders pump or dump to.

As an investor, you love volatility. You love the idea of wild swings because it means more things are going to get mispriced. – Warren Buffett

Today’s Inflation And Fed Narratives

Right now, the popular narrative is that the Fed caused inflation and now it has to be hyper tighten to bring it down. I flat out reject that.

Macro Dashes – Inflation Is Transitory, Most Prices Are Permanent

In a recent Twitter thread, Tavi Costa echoed a point I have been making in my weekly investment webinars. That is, while the Fed has to slow demand growth, it can not raise the cost of capital too high or it will hurt supply.

Inflation vs Cost of Capital

Inflation vs Cost of Capital (@KirkSpano on Twitter)

What really is causing inflation is oil and supply chains. The BLS has shown that quite convincingly.

Energy Impact On Inflation

Energy Impact On Inflation (BLS)

While excess liquidity has certainly helped the stock market…

S&P 500 vs Fed Balance Sheet

S&P 500 vs Fed Balance Sheet (FRED)

and many have pointed to this, what they miss is that change in liquidity is more important:

Change in rate of Fed Balance Sheet To S&P 500

Change In Rates S&P 500 and Fed Balance Sheet (FRED)

What you can see is that the Fed and markets react to each other. Whichever acts first with some sort of change, the other reacts. The question becomes, when the stock market falls, how low can it go before the Fed reacts? More on that in the next section. But first, let’s continue with today’s narrative and why it is wrong.

Consider the following passages from this article written in the Economic Times just before the 2008 Financial Crisis:

From ancient times, Indian rulers have always blamed inflation on the perfidious bania. That is happening globally today. Politicians everywhere are blaming speculators for high inflation.

Actually, inflation occurs when too much money chases too few goods. Today, no great shortfall in goods is evident. World oil production is rising , though slowly. Mineral and metal production is up. The FAO predicts a record global harvest in 2008.

But the world has long been awash in money. The US kept interest rates at just 1% for years after the 2001 recession. This encouraged Americans to spend more than they earned, creating a huge US trade deficit and corresponding trade surpluses in China and other Third World exporters. Initially, this flood of dollars lifted all global boats world GDP grew at record rates in 2004-08. Inflation was kept down by rising productivity, and by outsourcing manufacturing and services respectively to low-wage centres in China and India.

That was a couple months BEFORE the Financial Crisis hit.

Here’s a bit more:

Money supply expanded fast in Third World countries too (including India ). This was partly because central banks bought up dollars in forex markets rather than let their currencies appreciate.

Alas, a flood of money cannot for long lift production alone. Soon it starts raising prices. First the excess money raised housing prices, and everybody was happy. Then it raised stock market prices, and people were very happy. Finally, the flood of money raised consumer prices, and suddenly people are very unhappy.

And, that’s where we are now. Unhappy inflation.

But, is it the Fed’s fault? Certainly they could have been a little behind the curve on slowing growth out of the Covid crash. Wasn’t that the safer path though given the unknowns on Covid and China’s lockdown policies. I can give the Fed a pass for being loose a little longer because I am not one of the wannabe Austrian economists who look for every opportunity to chant “fiat currency” and “end the Fed.”

Here’s what we really know: Saudi Arabia and Russia conspired to constrict oil supply a few years after flooding the market with oil wiping out dozens of U.S. oil companies – many during the Trump era. That double whammy has lowered global oil supply leading to energy inflation noted above by the BLS.

U.S. Oil Bankruptcies

U.S. Oil Bankruptcies (Haynes Boone)

We also know that supply chains are jammed up all over the world. Ships at sea and in port are delayed for unloading. Truckers are wild cat striking over wages and vaccines. Labor is generally short as a million American Millennial men choose to not work like adults and we constrict immigration.

The result is that raw materials are not getting to production facilities and final products are not getting to market. In addition, Covid lockdowns in China are stunting production.

And, while are not growling quite yet, we are not going to have a record harvest this year as there was in 2007, due to Russia’s war on Ukraine. Wait until that winds its way through the system.

It’s a tangled and complicated web, but the simple explanation is that it’s not a few thousand extra dollars per capita over 2 years that is causing inflation.

What’s causing inflation is a lack of energy production and goods making it to market. Almost like America’s frenemies and enemies are in cahoots. Though, maybe just coincidence. I suspect some of both.

So, where does that leave the Fed. Certainly, they can cause a recession and contract demand if they are aggressive enough. But, if they do that, does it alleviate supply side issues?

The answer is no. A very aggressive Fed could have the double trouble of a recession and capital too expensive to allow for increased energy production and clearing of supply chains.

We need cheap enough capital so that we can domestically produce more semiconductors, materials, food, energy and the EVs needed to lower dependence on global oil markets.

A very aggressive Fed could be a recipe for stagflation that I foreshadowed on these pages almost exactly 4 years ago, and expected a whiff of in 2020 before Covid hit.

Here’s What Gary Cohn Sees: Tariffs = Inflation + Slow Growth = Stagflation

2020 Outlook: Euphoria To Despair

And, that bring us full circle to “Slow Growth Forever” thesis which has been a recurring theme here since my writings nearly a decade ago on the topic of the deflationary pressures of demographics, debt and technology, which I updated last May.

Long-Term Deflation Vs. Inflationary Policy

The bottom line is that the narrative of “the Fed caused inflation” is so blatantly false, we have to really think about what can we expect next?

The Fed’s Plan You Don’t Know

The Fed knows it is between a rock and hard place. On one hand cause a stagflationary recession. On the other, let inflation get out of control.

In that scenario, what is the right policy prescription?

I think it is to “reload the bazooka” as quickly as possible… and then stop.

I expect a 50 basis point increase in the Fed funds rate in May. And maybe again in June.

I also expect the Fed to simultaneously start reducing the Fed balance sheet. I don’t know how fast, but as fast is needed to slow growth down to a point where it is not creating inflation from the monetary side. So, not much lower since growth has already slowed to around 2%.


GDPNow (Atlanta Fed)

In reality land, not fiat currency end the Fed land, the Fed could roll their balance sheet, literally almost forever without much impact. So, I don’t expect much reduction in the balance sheet.

And, there is a trillion dollars sitting in reserve in case the Repo market gets jittery. Back in September 2019, the Fed started adding to the Repo market, a form of QE light, that indeed lifted stocks.

What’s An Investor To Do?

I agree with Morgan Stanley and several other big investors I follow in this case. I think we will soon reenter “sell the rip” territory once again.

I know folks will say I’m always in sell the rip territory, because I was very cautious at the height of Covid. I freely admit, I did not know how that would play out.

Did anyone know if the Fed could beat a disease that killed the economy? Anyone who says they knew are just afraid to say they gambled and got lucky to win.

I say that as a guy with some professional poker cashes. Sometimes, you gamble and win. You don’t give the money back, but you know you gambled and won.

Gambling isn’t really a great investment strategy. That’s why I perpetually tease most short-term traders with their magic gambling systems. Like gamblers, they talk about when they win and quietly rationalize when they lose.

In the long run, the only times to gamble as an investor are when the bet is “tie, win or win more.” Knowing that comes down to reading what others don’t and having the proper perspective to begin with, which starts with being humble.

Right now, there are some tie, win or win more bets. They are mostly in small cap stocks. Historically, those are where you find the most growth. I think at least for the next few years, the Justice Department’s anti-trust policy preventing the big guys from snuffing out the little guys killing competition is going to be good for small caps.

Many of those small caps will become mid caps. And, as we know, mid caps are a bit of a sweet spot in the market too, as they get to S&P 500 size and the investment inflows from getting into that index and its ETFs.

As the dollar rises on volatility, which it usually does and looks like it will this year at some point, emerging markets usually get beaten up. When the next leg down in emerging markets occurs, ex-China because I don’t want commie stocks, we will have several interesting opportunities there that I monitor.

Nations that have young educated populations, property rights and a good or improving resource position are on my list. I’ll talk about those places throughout the year.

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