The continuing volatility in the stock market is troubling. It is likely signaling difficult times ahead as early as January or February 2022. As such, it is time to consider risk management.

 

After over a decade of steadily rising equity prices with few interruptions, investors have been lulled into believing that investing in stocks is a riskless game of never-ending profitability. Newcomers to the stock market arena, like your typical Robinhood investor, have been using stocks to supplement, or even replace, earned income.  Unfortunately, I believe we are entering an environment where the investment themes are changing to our detriment.

 

The most important change I see has been the pivot in the Federal Reserve Bank's monetary policy from dovish to hawkish. The Fed's focus switch from full employment to combating inflation is expected to reduce liquidity in the markets. That decline in liquidity, which has been supporting the financial markets for years, is going to impact the equity markets negatively. I believe that process has already begun. 

 

Inflation, one of the worst economic aftershocks of the pandemic, is the second variable that I see impacting stocks and bonds. Do I expect a hyperinflationary environment in 2022? No, but I do believe inflation will remain persistent throughout most of the year before subsiding. A little inflation, experts say, is good for stocks. That's probably true, but we are beyond "a little" at this point. Inflation is impacting corporate earnings, reducing profit margins, and forcing many companies and small businesses to raise prices.

 

That leads me to believe that in the first half of 2022, a lower level of corporate earnings will not be able to justify the present price levels of the stock market. As earnings and guidance weaken somewhat, so will the stock market. That is not a good environment for further market gains.

 

The economy will also suffer. Consumers, thanks to continued price increases, may reach a point where they curtail some of their purchases. They may focus on buying things they need, like consumer staples, as opposed to things they want. That will slow the economy. As a result, we could live through a few months that could best be described as "stagflation." That means a slowing economy and rising inflation.

 

I think that this stagflation, if it were to occur, would be a transitory event. By the second half of the year, we could see inflation begin to moderate (as supply shortages are resolved) and the economy grow, even if it is at a slower rate. If all the above were to occur, it would put the Fed between a rock and a hard place. They may be forced to choose between protecting Main Street from the crippling effect of further rises in inflation. But if they do raise interest rates, as they intend to, they risk precipitating a serious decline in the stock market.

 

What therefore should an investor do as we enter the New Year? In the very short term, nothing. We may still enjoy a somewhat abbreviated Santa Rally next week. I expect a possible pullback on Monday into Tuesday and then up again for a day or two. No different than what we have been dealing with for the last few weeks. Overall, therefore, I see a bigger chance that the markets will gain a little more between Christmas and New Year.

 

I expect that positive momentum to last through the first half of January 2022, but beyond that I am expecting trouble. A double-digit decline in the stock market (20 percent-plus) sometime in the first quarter would not surprise me. It could happen as early as the third week in January and last through February or beyond.

 

At the very least, investors should reduce risk. And there is no guarantee that "buying the dip" will work this time around. And even if it does, the equity rewards may lie elsewhere. International markets, for example, or commodities, or both may hold better promise than stocks in the U.S.

 

For those who have been managing money on their own, I advise you to seek out a professional investment manager and do it quickly. The coming environment will demand experience, knowledge, and a cool hand. If you need advice on how or whom, give me a call or send me an email.

 

In the meantime, have a happy holiday season and enjoy the last move higher in the stock markets.

 

As most investors expected, the Federal Open Market Committee announced the start of their tapering effort but doubled the pace of the monthly taper to $30 billion a month until March 2022 when the effort will conclude. In addition, FOMC members see three, 25-basis-point increases in the Fed Funds interest rate next year, and more in 2023.

 

Faced with the end of a decades-long era of loose monetary policy, historical behavior would indicate interest rates up, equities down. That still seems a good bet despite the market's immediate reaction to the Fed announcement.

 

Some participants may still be scratching their heads after Wednesday's (Dec. 16) Federal Reserve Bank meeting this week. Normally, an announcement that monetary policy has pivoted to tightening and will likely continue over the next several years would send stocks lower. The opposite happened. Stocks went up. The S&P 500 Index jumped more than 1.5 percent, while the NSDAQ climbed 2.28 percent. The dollar declined, the VIX (the fear Index) dropped below 20 and commodities rallied.

 

There may be two reasons why the initial reaction to the announcement was contrary to expectations. During Monday, Tuesday, and most of Wednesday, the stock market dropped continuously with the S&P 500 declining by about 100 points. The tech-heavy NASDAQ did even worse. In my opinion, investors went overboard in discounting the Fed's negative news (which was largely already known by the markets). It was a classic "sell the rumor" market play. Jerome Powell and his band of monetary men failed to deliver anything more negative than what was expected, so the signal flipped to "buy the news."

 

The second explanation might be that despite the Fed's intention to raise interest rates next year, some on Wall Street doubt that will occur, or if it does, at a slower rate than the Fed has telegraphed. Why would that be the case?

 

There is a growing belief among some in the financial markets (including myself) that the first, and possibly second, quarter of 2022 may not be as strong as many expect. A combination of continued supply chain bottlenecks, higher inflation, and a winter surge in the infection rates of the coronavirus mutations (Delta and Omicron) could combine to slow economic growth.

 

If so, the Fed may not be willing to add to a slowdown by raising interest rates. It may also call into question how strong corporate earnings and guidance might be. And even of the Fed did try and raise interest rates with that background, the stock market would swoon. That would make the Fed quickly rethink further hikes in my opinion.

 

You might ask how the Fed's pivot to tightening might impact your investments in the stock market? My initial response is not encouraging. The market's upward response to the FOMC was all about the absence of additional negatives. There was nothing in the statement that was positive for equities. If you have been managing your portfolios on your own, I would advise you to hire good investment adviser — pronto.

 

The market action during the past few weeks is troubling. Professional investors are deleveraging. They are getting out of high-priced stocks with little or no earnings. Underneath the averages, many stocks are getting clobbered. Defensive stocks such as consumer durables, Real Estate Investment Trusts (REITS), telecom, and health care stocks are getting a bid, while all but the top five or six tech stocks (the FANG stocks) are being sold.

 

As I said last week, equity strategists are all over the place in their 2022 predictions. What that tells me is that they don't know what is in store for the markets in 2022. As for me, if I just look out to the end of the year (2021), I see continued volatility. Sure, next week we could see the markets bounce, but I have my doubts that we will see a normal end-of-the year Santa Rally.

 

The VIX still hovers above 20, which means volatility will remain high. Day to day, rotation between sectors seems to be increasing without rhyme or reason. The rally after the Fed announcement on Wednesday was sold down on Thursday with the technology sector erasing all its' gains. The smart money seems to be gravitating towards defensives, or if they are inflation bulls, moving into commodities.

 

I would be especially cautious as we move into the new year. It would come as no surprise to me if we were to see a substantial pullback. One larger than any we have experienced in 2021. It's time to get an investment adviser.

 

Most investors blame the discovery of a new, possibly more virulent mutation of the coronavirus for the decline in stocks this week. No doubt there is some truth to that, but equally as important was the change in monetary policy enunciated by Jerome Powell, the chairman of the Federal Reserve Bank, this week.

 

Readers have seen the S&P 500 Index decline by about 4 percent since the Thanksgiving week. The announcement that a new COVID 19 variant, dubbed Omicron, had been discovered in Africa, surprised the investment world. Friday, Nov. 26, we saw a substantial 2 percent downdraft in the financial markets. The move was exaggerated by the absence of a sizable number of traders who had decided to take a long weekend. Since then, markets have been whipsawed daily based on the latest Omicron headlines.

 

Unfortunately, it will take several weeks before scientists and the medical community can determine the severity of this new threat and if the present regimen of vaccinations are effective against this new mutation.  In the meantime, every strategist, pundit and taxicab driver will throw their two cents into the virus mix, creating even more confusion.

 

Of course, the direct outcome would be that the present vaccines are not effective against Omicron. Global economies would need to shut down once again, and new vaccinations, which would take months to create, would be required to stop the spread of sickness and death.

 

On the positive side, some believe that while Omicron is more contagious, it is not as lethal. In which case, the rapid spread of the mutation would first infect and then inoculate the unvaccinated worldwide, thus creating a sort of herd immunity. I think that somewhere in between lies the truth.

 

While Omicron has become a negative factor, it was not the only change in the financial picture. On Tuesday, Nov. 30, during testimony before the U.S. Senate Banking Committee, Powell did what appeared to be an about face on monetary policy. Until now, the Fed's chief goal was to reduce unemployment at the expense of a higher inflation rate. Powell appeared to take on a new mantle, that of the nation's chief inflation fighter, casting aside his former dovish stance towards continued easing of monetary stimulus.

 

Readers should refer to this week's "The Retired Investor" Thursday column for the reasons why. While investors and consumers will likely be relieved that the Fed's focus is switching to fighting inflation, the policy shift presents some clear and present dangers. The main weapon in the Fed's arsenal in reducing inflation is less monetary stimulus. Powell has already said that the FOMC, in their December 2021 meeting, will be discussing moving up their timetable for reductions in asset purchases.

 

The obvious next move would be to move forward with their plans to raise interest rates. Higher interest rates, after over a decade of rate declines, might create more than a few hiccups in a stock market close to record highs. I suspect that much of the downside this last week in equities was as much about the Fed's plans as it was about Omicron.

 

So where does that leave the markets this month? I suspect we will see more of the same kind of volatile action in the weeks ahead. I am tempted to say that we have already put in the highs of the year, but I don't want to sound like the Grinch Who Stole Christmas quite yet. We could still see a Santa Claus rally, but we face some formidable barriers to more upside.

 

We have the debt ceiling deadline on Dec. 13, 2021, followed a day later by the two-day FOMC meeting. We could see an impasse on the debt ceiling, as well as a decision by the Fed to further reduce their asset purchase program. And Omicron could turn out to be worse than anyone expects.

 

What troubles me about today's market is the elevated level of the VIX, the risk index. It is at the highest level since the COVID-19 crisis of March 2020. Anything above 20 on the VIX indicates a high probability of large swings in prices for stocks and indexes. If I look at price behavior on the S&P 500 Index, I suspect we are in a wide 200-point range of volatility with as much downside risk as 100 points to 4,450 potentially 100 points higher to 4,650. If we drop below this range, prepare for a bad Christmas. On the plus side, I would give the markets an all clear above 4,650.  

 

Stocks and bonds traded in a tight range for most of the week. Some stocks were rewarded, while others punished, based on their earnings results. The U.S. dollar hit a series of new yearly highs, and just about everyone is waiting for President Biden's pick to head the Federal Reserve Bank.

 

That announcement could come as early as this weekend. Chairman Jerome Powell's term will end in February 2022. He is a Republican, picked by former President Donald Trump. He had a somewhat rocky relationship with the ex-president but did manage to maintain the independence of the central bank despite Trump's attempted interference. His track record through the pandemic makes him a strong choice for a second term.

 

An equally strong candidate for the job is Lael Brainard, a Fed Governor since 2014, and an economist (as well as a Democrat). She is perceived to be a bit more dovish than Powell (if that is possible), but as far as policy is concerned there is little difference between the two candidates.

 

There has been some talk that there may be a more hawkish dark horse candidate in the wings. Inflation has become both an economic as well as a political problem for the president. While the pandemic and its aftermath are the reasons inflation has risen, it is the person sitting in the White House who catches the blame. As such, some think Biden might be tempted to look further afield, picking someone who might be able to reign in inflation a little faster. 

 

The House was scheduled to vote Friday on the $1.7 trillion Biden social spending program. The Congressional Budget Office (CBO) released its estimate of what all this spending will ultimately cost the country in the years ahead. The CBO found that the bill would contribute $367 billion to the deficit over a decade. The Democrat leadership immediately pushed for a vote and will likely succeed. Next, the legislation goes to the Senate where it will be debated and changed before coming up for a vote. That process will probably require several weeks.

 

Expectations for a strong holiday spending season were reinforced this week by several big retail companies who are predicting that the consumers will be willing to spend, despite labor shortages, supply chain issues, and higher price tags due to inflation. While this is good news for the economy, it creates additional worries over the future rate of inflation for investors.

 

We are already seeing the impact of inflation on some companies where profit margins have suffered due to higher input costs. Passing those costs on to consumers works for now in some sectors, but there will come a time when consumers reduce their spending in the face of still-higher price increases.

 

The higher the inflation rate climbs, the more pressure it places on central banks to control it by raising interest rates. As I have written, several central banks (especially in emerging market countries) have already begun that process. Investors fret that the Fed has miscalculated the strength of inflation and will be forced to taper faster and raise interest rates sooner than they have indicated. The bond market is assuming the Fed will raise rates three times in 2022 — in June, September, and a third hike in December. A change in those assumptions could spell trouble for the financial markets.

 

Normally, the holiday-shortened week ahead is kind to the stock markets. But there is no such thing as normal in today's markets. Technically, financial markets are open all week, except for Thursday and half of Friday, but most traders take Friday off. Therefore, it wouldn't take much to move markets given the anemic volume and lack of participants. It wouldn't surprise me to see an abnormal week ahead, either up or down.

 

The stock and bond markets knew inflation was coming. This week's 6.2 percent jump in the Consumer Price Index drove home the fact that inflation has become a fact of economic life, at least for the near future.

 

The jury is still out on whether inflation will prove to be "transitory" as the Federal Reserve Bank argues and as some economists believe. Others fear that we could be on the verge of something a little more serious. The fear is that the Fed might be forced to raise interest rates if that were the case.

 

The Producer Price Index (PPI) and the Consumer Price Index (CPI) both came in a little warmer than forecasted on a year-over-year basis, but not as high as some expected. And yet the U.S. dollar spiked to new highs, the yield on the U.S. Treasury rose by more than 10 basis points, gold and silver jumped, and stocks dropped.

 

The culprit behind the ongoing pressure on the inflation rate, as readers know, is the heightened consumer demand caused by the reopening of the economy and the supply chain issues that do not seem to be easing. The pandemic can be blamed for both conditions.

 

For me, the markets were so over-extended and in need of a pullback that traders were just looking for a reason to take down the averages. As you may recall, I had been expecting a minor bout of profit-taking, no more than 3 percent or so, in the markets. This week, the S&P 500 Index lost almost 2 percent, while some other indexes like the small-cap, Russell 2000 Index and some technology areas were down more than 3 percent before rebounding.

 

Between the good news on the passage of the $1 trillion infrastructure bi-partisan spending program (which now awaits signing by President Biden) and the climbing rate of inflation, the market winners have been mostly in sectors that benefit from construction and inflation. Mines and metals, gold and silver, basic materials, lithium, uranium and rare earth plays have climbed during the past few days. These sectors have played a back seat to large-cap technology stocks over the last two months. We have seen this kind of rotation many times in the past. Once prices have been bid up to unreasonable levels, short-term traders will switch their focus back to technology, or reopening plays. What is important to understand is that the overall markets tend to rise, or at worse move sideways, as some sectors that are out of favor are simply replaced by those in favor. 

 

Consolidation is healthy for the markets. A period of digesting gains, possibly over the next few days, would do wonders for reducing the overbought conditions that presently plague many stocks and sectors. Investors should keep their eyes on the U.S. dollar, which appears to want to climb even higher. If it does, it could squash the present rise in commodities.

 

Gold is another asset I am tracking closely. It has been one of the world's worst performing assets in 2021. If inflation fears continue to worry investors, there is a possibility that gold may reemerge in its traditional role as an inflation hedge.

 

Last, but not least is the cannabis space. A bill introduced by Nancy Mace, a Republican House member from South Carolina, to decriminalize and regulate what is now a federally illegal substance, sent pot stocks higher. This could be a huge boost for the U.S. cannabis industry. Stock prices in this industry has languished all year, despite improving profitability in many cases.