Jerome Powell’s Biggest Decision Of His Career Could Stop This Rally, What To Do

First, let me set up this binary decision

Anyone who’s more than a casual observer of the economy and stocks will state the obvious. The inflation dragon has been slayed. We have months of watching the inflation rate down by a third. Many economists expect inflation to fall to 3% by the end of ‘23, early Q1 ‘24 latest. This realization has been telegraphed by the bond market for months by the 2-Y trading well below 5%. December ‘22 ended miserably because of huge tax loss selling. Now in January, we are seeing a very strong rally forming. This rally is broadly supported by multiple sectors, it is building like a tidal wave and the crest is likely to be so high as to reignite money supply growth sharply. As the great Nobel Prize-winning economist said – “Inflation is always and everywhere a monetary phenomenon”. Jay Powell of course knows this economic law very well. Targeting the job market is justified only by the number of open job slots per available worker would sustain higher salaries which in turn raise the money supply. Low unemployment by itself is not inflationary. In fact, in many ways employing more working people can bring inflation down. Here is the conundrum, even if the terminal rate is 5.10% we are coming to an end of rate rises. It is widely expected that Powell will announce a .25% rise. This will be taken in the same way a starter’s pistol at a foot race signals the meet. I am using this metaphor regarding stock market participants. There is about $4T in cash available that would fund a humongous rally for every class of stocks besides utilities and staples. I would expect a parabolic leap in stock prices to create huge wealth and in turn, too many dollars will chase too few goods and services. Powell can choose to end his rate raising and hope what he has wrought will finally bite the economy harder or he can try some tactics to cool the market heating up to molten lava.

Powell successfully beat back inflation, now his problem is he beat back inflation.

If even a fraction of this additional cash pours into the stock market that could jump 15% and 20% before the end of Q1. Inflation wouldn’t likely lift if the market rose 15%, 20%, or even more in a year. But in 6 to 8 weeks? It becomes a distinct possibility this fast money propels inflation to over 7% at the same time. This would be a disaster for the economy, by raising inflation expectations and reigniting the fearsome wage/price spiral. It would also destroy Powell’s chances for redeeming his legacy. Powell wants nothing more than to NOT be known as the guy who brought the 70s back and then is branded the “New Arthur Burns”. He wants to be sure that inflation keeps to its downward slope, just the way it has been going. I hope that I have established the problem for Powell. So what can he do?

Powell must prescribe a bitter pill to swallow in order to keep inflation in check

The are several options that come to mind immediately:

• The market is expecting .25%, Powell goes .50% and hints there might be more

• Take QT in earnest and with a bigger “T”. The goal was $95B per month, announce $115B and really stick to it. There are reports that the Fed has missed that goal a number of times

• Start selling 10 and 20-year bonds, and mortgage-backed securities. The Fed has just let the MBS run off. Instead they should sell more into the market.

• An order that margin leverage to be lowered.

• I am not sure of the mechanism but I am sure the Fed can push the major banks to raise interest rates to savings accounts and even to require that retail checking accounts pay an interest rate

• A side effect of raising money for the treasury that could fund the debt ceiling. This could be the justification for selling more bonds.

Any of the above actions could throttle back the growing animal spirits in this market

This is not a prediction, I am pointing out a risk that I feel is being ignored by the financial media. I am also not stating that the Fed does all of this at once. Perhaps, he announces a temporary halt or lower the leverage on all new margin trades for the next 60 days. The least controversial move would be to raise the rate by .50%. If no pre-warning “leak” comes from the WSJ.com journalist as is customary, there is no customary statement from the Fed and there is no Q&A, that would give the raise the maximum effect. A simple statement that inflation progress has been made but inflation is still way too high at 6.56 percent. Also, it is time to directly address speculation, put a temporary ceiling on margin debt of some kind and that should do plenty to introduce some reserve back into the market. I do believe that QT should be pushed to the fore as moving much further past 5% will cause a recession, and Powell doesn’t want to cause one unless it is absolutely necessary. Aggressive QT is tantamount to raising interest rates on the long end anyway. Selling MBS will raise mortgage rates back to 6.5%. The reason why the Fed wasn’t aggressively selling the long-end was that it wanted the inverted yield curve in place to as a break on over-exuberance in the market. This ruse is outliving its usefulness as the indexes are getting bulled up and about to charge back upward.

This is the last act of the Fed’s anti-inflation fight from the monetary side

I have listed a number of unorthodox ways that the Fed can beat back the bull. It is now up to the executive branch and congress to pull back on the flood of money from government largesse. If there was better coordination these drastic actions wouldn’t be necessary. Right now as sure as day turns into night that if the Fed announces a quarter point and announces that it is data dependent, stocks will shoot up like a SpaceX rocket. This is something that the Fed wants to avoid. If my reasoning doesn’t persuade you, then perhaps Jay Powell will think of some action more creative than I to tamp down the “Soft Recovery Faction” of the bulls. I can’t believe he will ignite this explosion of speculation further. Some of you might be thinking why doesn’t he address the Q4 earnings season that just started? Isn’t everyone expecting stocks to fall because earnings will be bad? I for one don’t believe that earnings are bad, that said, the Fed “pivot” will be a much more powerful goad to bid up stock prices despite any bad earnings news.

All this is academic if the ECI data that is going to be revealed on January 31 is showing employment costs are still rising. The FOMC meeting is on February 1, so a bad reading could immediately call for further higher rates and we are on the same path we’ve been since last year. In any case, something has to be done to repress the market, that is my base case.

What to do

The first step is to bank your profits and sell enough of your positions equal to your current profits. Make sure that stays in cash so if you want to start a new position sell an existing position or part of a position to pay for it. You have 2 weeks to set aside a significant size of cash in your trading account. I would recommend setting aside over 25%. In order to get there you should be trimming you should also sell some of your losers, If the market does slam down you can add back to the positions you sold beforehand at higher prices.

If the market does break out and gets close to or goes over 4100, I would put on some hedges to the indexes. You can use an inverse ETF if you are afraid of options. Just remember not to be sitting in them for more than a few weeks. In this case, we are talking about the first or second week of February. So if you don’t see the S&P blast through 4100 and you think the Fed is not going to do anything drastic, no hedging is necessary. If you think there is a chance for .50% despite the market not going parabolic, you can use the 3X inverse ETFs to hedge. However, if the Fed chooses not to do anything you should close out these hedges quickly. For those that are fine with options, there is any number of ways to hedge the index, your underlying could be the SPY or the 3X bull ETF, and you can do the same with the QQQ or the bull ETF longing Puts. Right now I don’t have any hedges on the indexes, but that isn’t to say that I won’t do so this week.

My Trades

As I said in my last article, I have started to select individual stocks to go against. I feel that a company with a flawed business model for the current economy will underperform in any rally or strongly decline in any sell-off. Last week I started with some put options on Bed Bath & Beyond (BBBY). They filed a “going concern notice” with the SEC. Instead of crashing the stock started to move up. All the while it started to soar, and I kept adding. This past Friday BBBY ran to over $5, then it did reverse and fell back. I hope to see it continue to fall back to earth. I had some put options on Coinbase (COIN) starting the last trading day of December, and these Put options were not successful. I am thinking of reassessing them and closing out these positions. I did add a new Put option that takes the position out to March. So perhaps I will sell the old options and continue with the new ones. I have a brand new short in Carvana (CVNA), I couldn’t believe my eyes when I saw it above $8 so this Friday I got it when it was about 7.5, and that is where my strike is. I am still holding DoorDash (DASH), I am expecting the Instacart IPO to happen soon and I still believe that DASH will be a source of funds for those who want to participate in the new IPO. I was added to my Nordstrom (JWN) position but it expires in February. I may have to roll it out to March expiration. I am a bit underwater with JWN as well. I am not worried though, I think JWN will sell off going into its earnings, and as well as selling off with department stores in general. I am still in CarMax (KMX) having Put options out to February and April. I still believe that KMX has two issues, an inventory of high-priced used cars that it has to carry on the balance sheet, and an ever-larger supply of new cars coming into dealerships every day. On the other hand, if we do have a recession, it will likely show up first in the subprime used car loan business. Even if KMX doesn’t engage in subprime car loans any such bad news will still hurt their stock. At this point, I am mildly underwater here considering the huge rally we have going. I have the same situation with Southwest Airlines (LUV), the strong rally lifted up the shares, but I have been adding put contracts out to March. The CEO will have to announce some huge project overhauls which will cost them extra billions because they need these changes right away. Until then they are going to be forced by the Biden administration to be generous with their jilted passengers. We are still in the snow season and there is no reason to expect smooth sailing from here. So I am still short via Puts. I did add long positions. I went long on DexCom (DXCM), the best continuous glucose monitor there is. It is being used for type 1 and type 2 diabetes, and it is only a matter of time before that is prescribed to pre-diabetics so they can monitor their glucose spikes and learn how to manage their food intake to lower their glucose levels before they graduate to type 2. This will have the potential to lower the cost of chronic diabetes and save millions from an early death. DXCM fell to 105 on Friday and I snapped them up. I closed out my position in Caterpillar (CAT) and moved the funds into CaseNewHolland (CNHI), CNHI has farm and construction equipment. Since CAT has made all-time high levels a few days in a row, I feel like it should consolidate. It was a small position anyway, and I am trying to lower the number of positions if I can. I did my usual trimming on Friday, and I couldn’t help but notice that WTI is about to break above 80. I am going to add to my oil names I would like to get long EOG Resources (EOG), and perhaps Diamondback Energy (FANG). I am certainly not going to be selling any more shares of Coterra (CTRA), and Devon (DVN).

Well that is about it. I know I have been talking about the S&P500 and the NDX100 as moving up higher. What if they don’t, what if instead of breaking above 4100, it breaks below 3800? What if there is Fedspeak this week that can’t be ignored, like perhaps talk about letting QT be the focus of the Fed once they stop raising interest rates? Perhaps they float the idea of $100B to $200B per month of selling if only to keep the engine of government running. That could introduce a level of soberness that Powell wants without yet doing anything. Of course, if that happens, I will be very happy to have my shorts on.