Correction Moving on Up

Over the past year we have seen a massive crash in energy stocks, followed by choppy slow moving corrections in small and midsize companies. The correction is now coming to large caps. How bad will it get? Hard to know, a lot is up to Janet and the Feds.

The big news this week was of course China lowering its peg to the dollar by 3.5% in two increments. By tomorrow, the Chinese might devalue again. We don’t know. The reason markets did not take it well is because it was unexpected and smacks of the desperation that many didn’t believe China had. 

As I have written and said repeatedly, don’t trust China or the China story. China’s corporate governance and government are both corrupt to the point of being too hard to invest in. Finding ways to short Chinese stocks is difficult as well because you don’t know when the government or PBOC will prop things up a bit. The government’s direct foray into buying stock is a clear sign of manipulation.

If you are watching the webcasts, Rick has been showing how various markets are making lower lows and lower highs. We have also noted that leadership in the markets has become narrowed, with fewer winners and more losers. The indexes are not being hammered yet as the largest companies in the indexes haven’t been hit yet. That keeps the indexes up as they are market cap weighted (bigger companies count more). 

When the largest companies in the indexes get hit, then we will be close to the end of the correction. I believe that event is imminent. Quite likely the correction is over just before Janet and the Feds have their September meeting.

Rick believes the Fed will not raise rates until next year if at all, and has openly speculated about QE4. If that is the scenario then our overweighting of natural gas stocks on their massive correction will prove very profitable. 

I believe the Fed will find an excuse to get off the zero bound and raise interest rates sooner. It could be a one time event as I do believe the world economy is going to be flatter than many expect and possibly go into recession in the next year or two. 

It is interesting to me that the Chinese lowered their peg not too far in advance of the Chinese Premier coming to America and the Fed widely anticipated to be raising interest rates in September. I don’t know exactly what to make of it all. 

On the one hand, the economy is clearly not at the growth and inflation that central bankers say they want. On the other hand, I’m not sure I believe that’s all the Fed cares about. If the Fed has ulterior motives that aren’t officially part of their charter, then anything is possible. 

One scenario I have discussed a bit is that I think the Fed could use slightly warmer summer numbers to raise rates in September in order to get off of zero. If they need to simultaneously stimulate to offset that increase, they can easily lower the interest paid on excess reserves held at the Fed by banks. This would cause those banks to lend that money to make up the lost interest. 

What I think could be at work here is that there is a lot of cash on hand among the banks, corporations and very wealthy that the Fed wants to see moving. Velocity of money is too slow. Speeding it up would give them the inflation they want. The Fed in my opinion is likely to maneuver in a way to get that money moving. Raising one interest rate while lowering another could accomplish that. 

The residual impact of raising rates would be some disruptions in emerging markets, both negative as bonds get crushed and positive as some nations become more competitive with the dollar remaining firm. With our banks, corporations and wealthy holding a lot of cash, if stock prices fall globally, that would enable American money to invest in tomorrow’s growth in younger, lower debt, resource rich economies. I don’t put it past the Fed to shake the tree a bit for her constituents, who are the banks, corporations and very wealthy – it’s not us. 

Regardless, the markets are slightly to very overvalued in some places yet. Natural gas and to a lesser extent oil stocks are an exception to that. Technically, there is not a lot of support likely to develop for markets for a month or two. Again, stranger things have happened than a rally on air, but at a minimum, risk is high and further declines are likely at least short-term. I plan to have my bucket ready to find bargains.

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