Market review 24.08.04

Expanding on ‘The Great Normalization’ Concept

Hello everyone,

The main message on this blog this year has been:

1. Interest rates and inflation are coming down.

2. Stocks remain bullish, but many warning signs are building.

Regarding the first point, we looked last week at how TNX could gradually fall to 3% and stay there for a while – returning to a steady macro world. I still believe in this aspect of the “Great Normalization.”

I also discussed how falling rates could allow for a sustained rotation into areas such as banks, real estate, and biotech. I believe this part is incorrect.

In today’s blog post, I’ll discuss why commodities, real estate, and stocks are likely all coming down with rates.

Let’s begin.

The Intermarket

In the prior two decades, anytime we saw a correction in stocks, we also saw industrial commodities (eg. copper, oil) take a hit while bonds saw a flight to safety. This is what we’ve come to expect as “normal.”

But this dynamic has been flipped on its head for the past three years. Rising inflation (especially oil prices) meant a rise in rates and USD, which caused a drop in stocks (and vice versa):

We could now be coming out of this Twilight Zone period and returning to long-standing historical correlations.

This week, the S&P 500 fell another 2% - its third consecutive weekly decline. The worst performers were Energy, Airlines, Bitcoin, Banks, and Micro-caps (each down over 8%). The best performers were Treasury bonds, followed by defensive sectors.

The chart below is an important one to study.

The bond market is prescient. When 3-month T-bill yields fall below the Fed Funds Rate, the Fed begins a rate-cutting cycle, which historically has coincided with a declining stock market.

We’re now on the cusp of a new cutting cycle, and stocks can remain weak for months or quarters.

This is Milton Friedman’s “long and variable lags” concept. Interest rates have been kept elevated at multi-decade highs for the past two years. With a lag, the overheated economy, overleveraged consumers, and overvalued assets felt the pinch. Many small fintech stocks peaked last year, while Bitcoin and blue-chip credit card stocks (Mastercard and Visa) peaked five months ago. Rates are having their intended effect.

A weakening economy and declining asset prices (stocks, commodities, real estate) are what will allow rates to continue easing. Contrast this with the incorrect thinking that falling rates will cause asset prices to soar.