The stock market indices closed strong at year end. The indices managed to pull a Santa Clause rally after a low was made on December 20th. But underneath the strong indices, the market is getting very defensive. Real Estate (XLRE)/Health care (XLV)/Staples (XLP)/Utilities (XLU) outperformed mega tech such as AAPL/MSFT/GOOGL in December. Mega tech had been the hiding place all year long in 2021 except in December.
This defensive rotation shows the market is worried about economic slow down in the presence of a tighter monetary policy and higher inflation. Crude oil closed above more than one yearly bullish reversal warning that indeed the 2020 low is a major low thereby confirming the uptrend to retest the 100 level in 2022. This is not a good news for the stock market. Crude oil made a historic high in 2008 that crushed the economy. From 2008 to 2020, the persistent low crude oil price acted like an invisible stimulus which helped the consumer spending and kept inflation low. Low inflation from 2008-2020 is one of the major reasons that the Fed was able to deploy unprecedented quantitative easing numerous times to help the market recover from the carnage of the 2008-2009 financial crisis. The prolonged super low interest rates and numerous quantitative easing created a 19-year old bull market in NASDAQ. The NASDAQ made a low in 2002 after the DOTCOM bubble while the S&P 500 and DOW made their lows after the 2008-2009 financial crisis in 2009. So the S&P 500 and DOW have a 12-year old bull market.
Entering 2022, we are very cautious about the stock market. Here are the list of things that keep us up at night:
- Higher energy price is a tax for everyone, that is very much a late cycle feature. Years of climate change activism restricted the traditional energy production capacity while the alternative energy is not enough to pick up the slack. OPEC+ refuses to increase supply significantly, oil prices are expected to remain high with the continued reopening of the economy.
- The stock market is at the highest valuation in the last 25 years. The companies such as Apple, Microsoft, Google and Nividia are the best of the best companies in the world. They are huge and can still grow consistently. But their valuation is not good. With a tighter monetary policy, all assets valuation will have to re-set because the price of money is now higher.
- Slow down in China has not been priced in. The slow down in China is real due to China’s zero tolerance COVID policy and tech regulation crack down. The effects of the Chinese real estate bubble burst are yet to be determined. The Chinese real estate bubble is not the same as the 2008-2009 US housing bubble because most of the speculative financial activities have been contained inside China. For sure it will impact Chinese domestic consumption.
In a longer term picture of the crude oil, the rally from the April 2020 low is considered a reaction rally against the down trend 2008-2020. A valid reaction rally typically lasts three units in time, meaning the crude oil could rally into 2023. The current stock market 4-year cycle will be heavily impacted by the higher crude oil price. Crude oil price has not been an issue for the stock market since 2008. This is the new element that we can’t ignore.
The previous stock market 4-year cycle (March 2003- March 2009) was heavily impacted by high crude oil price. XLE ETF was the best performing sector along with the financials XLF ETF during that period. This time it is not different. XLE was the best performing sector in 2021 with an annual return of 46% that beat AAPL at 34% and S&P 500 at 27%.
The disruptive growth ETF ARKK continues to be under pressure. The water torture in ARKK will not end until the crude oil price comes down. This prolonged water torture in ARKK are based on technical and fundamental reasons. Technically, ARKK had a 26-week momentum spike from March 2020 to February 2021. When we see 26-week momentum spike in the overall industry group, usually they have to correct for the better part of 24-36 months before a bottom is finally set in. ARKK has been under correction for the last 11 months, that is not enough time to for it to produce a durable bottom. Fundamentally, COVID helped ARKK pull valuation forward by 2-3 years. Cathie Wood is an excellent sales person who successfully sold the disruptive growth stocks stories to the retail investors and some Wall Street institutional players. Cathie Wood single-handedly created the valuation bubble in ARKK stocks. Her timing was perfect. Extreme easy money and COVID were the perfect catalysts to promote ARKK. Cathie Wood maybe right about the new world order arising from the disruptive technologies, but at the end of the day, valuation does matter. ARKK will rise again when it’s mostly hated. Right now, it is not hated enough.
What do we do in 2022 in the presence of an inflation cycle?
1. Long traditional energy assets even though buying oil stocks sounds like buying cigarettes. Oil is such a dirty word in the eyes of climate change activism. You could either buy XLE ETF or CVX or COP individual stocks. XOM is one of the major holdings inside XLE and XOM is under performing XLE. CVX/COP combo will outperform XLE.
2. XLE topped in October 2021 because of the concerns of new COVID variants. The Omicron is burning throughout the world like a wild fire now and we believe Omicron will turn the COVID pandemic into an endemic, meaning we are going to live with a much weakened COVID variant such as Omicron like a seasonal flu. It is impossible to stop Omicron from infection people. It doesn’t matter how preventative you are with Omicron, you will get infected one way or the other. It is a matter of time. We have not been going out at all, and we got infected with Omicron four days ago. Luckily, it is not a bad infection. While the Omicron is dominating the news cycle, airline cancellations will cause oil price go down temporarily.
3. Technically, the general market is due for a correction very soon. The Santa Clause rally kind of created some confusion. The next Fed meeting is scheduled on Jan 25-26. The catalyst for a correction could come immediately from the Fed meeting announcements. So between now and until the next Fed meeting, the general market will continue to present a bullet proof bullish picture, meaning nothing can take down the bull market.
4. The Producer Price Index for all commodities is set to peak in March 2022. Perhaps this peak PPI number will cause the stock market to make a bottom.
5. To defend her position, Cathie Wood consistently presented a contrarian point of view that deflation is the concern, not inflation. Cathie Wood calls crude oil as whale oil which was replaced by fossil fuel. Cathie Wood is right in the longer term picture. Eventually the fossil fuel will be replaced by alternative energy, but that’s a long way ahead of us. For the meaning time, we need heating oil otherwise we will all be frozen.
To sum it up, here is what we believe:
- Entering 2022 with a very cautious attitude, the stock market valuation is the concern.
- Will get long with traditional energy stocks during Q1 correction
- ARKK type of hyper growth are out of favor in the presence of inflation. But you can take a trade when it crashes in Q1. ARKK type of stocks will be so oversold when the general market finally corrects. It is only a trade, not for opening long term positions
Below is the S&P 500 daily chart. You can see the Santa Clause rally met resistance at the upper trendline. The selling pressure from the upper trendline is mild but the oscillators have turned down. This Santa Clause rally high is the daily cycle high, also could be the weekly cycle beta high. To confirm the pending correction, it needs to take out December low.
We should see continued rally in defensive sectors such as Real Estate/Health Care/Staples/Utilities while the money is rotating out of mega tech. Mega tech is bloated with money.
The correction in S&P 500 will not happen until the defensive sectors start to show weakness.