In this article I will present:
- the trends that are weakening the markets in the short term;
- the opposite trends that exist in the long term, and
- how to manage a portfolio that must balance between these two trends.
Let's start with the reasons for short-term market weakness (in order of importance):
- seasonality: September has always been among the worst months of the year;
- futures in contango: long maturity futures cost more than short maturity futures, as the market expects future stock prices to be higher than now.
This is certainly a bullish condition in the medium term, but it brings volatility in the short term, because traders have to get rid of shorter maturity futures in order not to be trapped by the time factor.
We then turn to ancillary factors:
- In the USA the public debt has again exceeded the limit set by law (debt ceiling).
Friday is the deadline for the government to reduce the debt below the limit or go into default.
We already had the same situation in 2018 and 2011. When it comes to this deadline, usually Republicans and Democrats, to defuse the danger of default, jointly vote for one of two:
- raising the debt limit, or
- suspending the deadline
As usual, though, this is an opportunity for the two parties to blackmail the other faction for favors in exchange for a favorable vote.
This time, the "negotiations" (the blackmail) went a little too far into the deadline, alarming the markets. But since no one in their right mind would ever want to become responsible for the default of the U.S. government, we can trust that this time, too, the two parties will come to an agreement.
- Increase of the interest rate on 10-year US Treasury bonds.
The rate is back to the levels that had so agitated the summer markets.
The point is that this rate had fallen towards the threshold of 1.2%. A threshold that is too low and not very sustainable in the long term; not so much because of inflation, but because there are factors that increase the sale of U.S. government bonds, resulting in lower prices and higher rates.
In a previous article I pointed out the reason for these sales: a dollar liquidity crisis in foreign banks, especially in emerging countries, which had pushed them to liquidate US government bonds in order to get cash dollars.
After Powell, a couple of months ago, had activated a program of supply of cash dollars in the repo market also intended for foreign banks, the liquidity problems in these countries seemed to have cooled down, moderating the flows of sales of US securities and thus bringing down the rates.
However, the serious (and in some ways incomprehensible) crisis in China, with the decision to close down the activities of major companies producing components for products destined for the West, has once again aggravated the dollar liquidity problems of non-Western banks, causing a resumption of sales of US government bonds in an attempt to recover cash dollars.
In the face of this new flow of sales, US government bond prices once again began to decline, driving up the interest rate, which is inverse to price.
In the West, rising interest rates produce automatisms in funds (both Etf and investment funds).
Even if human beings, not robots, manage these funds or decide to invest in them, a rise in interest rates always leads to the automatic behavior of selling shares, regardless of the reason why these rates rise.
Thus, the reduction in fund and ETF shares has further weakened the stock markets.
Let's now move on to list the factors that will reduce the upward trend of rates and therefore the volatility of stock exchanges in the medium and long term.
- The crisis in the economies of China and other non-Western countries will turn into a recession, which will also be transmitted to Western countries.
At that point, the economic data, even in the West, will worsen to the point of "reassuring" the Federal Reserve about the continuation of monetary easing (continuation of QE) without being subjected to the moral blackmail of the media, which instead press for "tapering".
- The increase in US public debt to levels never seen in history obliges the Federal Reserve to keep interest rates low by any means possible.
An increase of even a few percentage points in rates would in fact create an expense for the payment of interest on the debt that would be destructive for the state coffers.
Therefore, a true "tapering" and even worse a planned increase in rates is simply an economic, historical, political and social impossibility.
The increase in the use of high tech and automation, along with the worldwide digitalization plan, create an irresistible long-term force that tends to keep certain factors high, such as unemployment levels, which, once again, make it impossible for any government, in either the West or the East, to abandon monetary policies based on lowering rates and QE.
Inflation caused by the covid control measures and the aftermath they still cause in world economies is counterbalanced by deflation created by technological innovation, now at levels never seen in history, capable of creating products and services at progressively lower costs for companies.
If, therefore, the world economy in the medium term remains poised between these opposing trends:
- inflation and deflation,
- recession and technological innovation,
- token tapering and monetary easing,
- sales of government bonds to compensate for liquidity crises and purchases of the same bonds to use them as a safe haven,
what kind of securities portfolio should be built?
I believe that in this very particular situation, we should focus on the only thing that matters, i.e. on the value that a security can have regardless of the "background noise" of the markets.
Let me explain better...
Movements in the interest rate curve of government bonds produce short-term trends in the stock market. In the long term, however, equities are driven by far greater fundamental economic forces.
Stocks which represent companies on the stock exchange which are capable of generating profits in the long term follow a trend which depends almost entirely on the growth of these profits, irrespective of interest rate fluctuations.
Therefore, a stock portfolio composed of such stocks is the best defense against market volatility created by opposing currents.
This kind of portfolio can be divided into two similar, but not equal, categories:
A more conservative type composed of stocks of companies that are already making profits.
A more aggressive type composed of securities that are about to generate profits.
The choice of the portfolio should reflect one's own risk appetite, but in general a mixed portfolio can be a choice that applies to most people, so securities of companies that are already generating profits flanked also by securities of companies that have products in the pipeline that will produce profits.
These latter stocks should be chosen from those with the lowest possible prices compared to the potential profits that will be generated. In this way, they will tend to have much higher prices over time than stocks of companies that are already generating profits.
What has been said so far for equities is also true for cryptocurrencies which, however, by their nature, in general, are already high and very high risk assets.
Are they really? I will cover this topic in an upcoming article. Right now though, there are great opportunities to invest in great altcoins, with really interesting projects, at bargain prices, with 2X or 3X targets. I think this is one of the last moments before the bull market resumes, which should start between the first and second week of October, a bit like it happened last year ... and we know well how that went.
Thanks for reading, feel free to leave a comment below, I would appreciate it.
CREDITS
The photo Stock market direction by AbsolutVision, is released under the Unsplash license