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When the Levee Breaks

Written by Briton Ryle
Posted May 5, 2021

I have to share the message I sent to my Real income Trader subscribers yesterday. It is a very important message for any investor. And it gets even more significant considering what a certain Treasury secretary said at an economic summit yesterday...

Last week, investors reacted to the Fed’s “froth in equities market” by sending stocks... higher. You gotta love it.

This market reminds me of a high-stakes game of chicken. Investors keep bidding stocks higher, challenging the Fed, “Well, what’re you gonna do about it?” 

And inflation is asking the exact same question.

So what will the Fed do?  

Even if the Fed stands by its promise to keep rates unchanged through next year, there’s still the little issue of $60 billion in Treasury purchases every month. I say it is highly likely that the Fed will announce plans to taper that spending before this year is over. 

After all, the Fed will want to make policy adjustments during the good times, when there is still plenty of economic growth to offset tighter monetary conditions. But that doesn't mean the market will like it. Recall that Yellen’s “taper tantrum” led to a full 20% correction for stocks…

You can write that 20% down with a Sharpie. A correction is inevitable. The only thing we need to pencil in is when this will actually happen.

When the Levee Breaks

Fed Chair Powell says that he will give investors plenty of notice for any policy changes, so there is plenty of time to react. Thanks for that. But I have questions. Like: have you seen how investors react to bad news? “Measured” and “gradual” are not in the playbook. 

Don’t forget that around 75% of all trading is algo-driven. Algos are programmed with a given set of conditions and appropriate responses. Change the program inputs and the response changes. So when “tighter monetary conditions” goes into the programs, the response will be instant. 

They say the stock market looks ahead six months, a year…

Whatever the time frame, some kind of action from the Fed is no longer some murky image on the horizon. We are churning at all-time highs because investors clearly see the inevitable. 

First-quarter GDP came in at 6.4%. And if inventories had been fully built up, the number would’ve hit 9%. If anything, first-quarter earnings look even better than those GDP numbers would suggest. 

But once this earnings season is over, what's going to distract investors from the Fed? I don’t know, so I think the odds are high that we get some Fed-related selling before second-quarter earnings season kicks off in mid-July. 

Now let’s say we do get a full 20% correction, like we did thanks to the taper tantrum. Lop 20% off the forward P/E of the S&P 500 and we’d have a multiple of around 16 or 17 for the index. Stocks might actually look attractive, especially given the 5% GDP growth that is expected in 2022. 

I think this message about an interest rate-driven correction just got a whole lot more relevant. Because yesterday, Treasury secretary and former Fed chief Janet Yellen said, "It may be that interest rates will have to rise somewhat to make sure that our economy doesn't overheat.”

Make no mistake: This was not an off-the-cuff statement. It was a trial balloon. Yellen is starting the process that will culminate with a tapering of QE and higher interest rates.

A Simple Plan

One of the big ironies of the current market is what I’m calling the “select corrective rotation.” 

Big investment funds have managed to keep the indexes up at all-time highs, but below the surface a tempest rages in certain sectors. Like tech…

I hate to keep talking about Cathie Wood and her ARK funds all the time. People might get the wrong idea. But her funds have become a kind of proxy for the stocks that carried the market during the pandemic. 

Her flagship Ark Innovation fund has been crushed, down 25% since late February. On a percentage basis, her top three holdings are Tesla, Square, and Teladoc. Yeeesh. 

ark 5 5 21

In a “caution to the wind” market boiling over with enthusiasm, sure, these stocks sound great. But in a “back to reality” market where valuations and growth suddenly matter, Square’s 12x revenue and book value of 41 look a tad high.

And looking at that chart, sure, you could argue that the fund is making a triple bottom down around $110. But shares have broken below all moving averages. If those algos really get bearish, the path of least resistance for ARKK will be down. 

Right now I favor stocks that will do better with marginally higher interest rates. Banks are a decent choice, though my favorite one, Bank of America, has finally reached a price-to-book level that makes it fairly valued. 

I think Rocket Mortgage (NYSE: RKT) may be a better choice. It is rate-sensitive (in a good way) and has much more attractive valuations. Plus, it will be a more direct play on homebuying trends. 

I still like the lumber company I told you about last week, Resolute Forest Products (NYSE: RFP), which has a forward P/E of 3.5.

A new stock popped on my radar recently, U.S. Steel (X: NYSE). I got Real Income Trader subscribers into X at $22 and it's currently at $27. It is also a great stock for covered call trading.

And finally, if you can’t help yourself and need to buy some tech, Qualcomm (NASDAQ: QCOM) looks like a no-brainer to me.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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