The Big Flip?

Much was made about a potential big flip in inflation earlier this year, but now that the noise has died down - is it finally time?

I will save the “what is inflation?” question for another blog post - this will be quick.

The “Big Flip” was a thesis that basically said: 1) the Fed was late to raise rates, and the Fed gone far enough or quickly enough, 2) globally expansionary fiscal policy (stimulus) is so tremendous that it is overwhelming any quantitative tightening and interest rate increases, 3) the global economy will therefore reaccelerate which will eventually drive inflation much higher after a period of lower inflation which we are in now (this is the flip).

Why is it time? Simply put, the market likes to embarrass the biggest number of people. All the pundits appear to have moved past inflation and macro doom & gloom and bears have largely covered and capitulated. Therefore, maybe it’s time these ideas make a comeback.

Quick tangential points on Inflation, Yield Curve, and Recession:

1. Inflation is generally good for stocks because higher prices mean higher revenues and higher dollar profits (margins may expand or compress for different segments of various supply chains); and,

2. Shorting stocks/indices is quite difficult for many reasons including, but not limited to: timing, timing, and timing; and,

3. An inverted yield curve (typically 10y-2y is used) indicates a “coming recession”, but the actual recession indicator is when the yield curve un-inverts.

   • Panicking every time the yield curve inverts is a bad strategy for speculators or investors. The yield curve can remain inverted for long periods of time and equities can perform quite well during this period.

   • The yield curve and steepening trades will be the next topic we attempt to deep dive.

Compare the two charts below. The first is from FRED and shows the yield curve against shaded recessions. The second is a chart of the logarithmic S&P 500 Index with shaded recessions/crises. I tried to line them up to the best of my ability. Using our eyes, we can see that 1) an inverted yield curve does not mean equity prices are going down immediately, 2) equity prices can trend higher while the yield curve is inverted, and 3) the yield curve will eventually revert (un-invert?) and that is when the slowdown will arrive.

Back to inflation and economic activity…

Many believe the stock market is a leading indicator of the economy by about 6-9 months. If we take this as a truth, recent price action does suggest the economy is strong and therefore, the inflation battle may be unfinished. Take XLE and DBC for example (the white line is the 200 day moving average, a common “long term” trendline). XLE is the SPDR Energy Sector ETF and DBC is the Invesco Commodity Index Tracking Fund. I follow XLE much closer because the average dollar volumes are much higher.

The top 10 holdings in XLE are: Exxon Mobil, Chevron, SLB, ConocoPhillips, EOG Resources, Marathon Petroleum, Pioneer Natural Resources, Phillips 66, Valero Energy, and Occidental Petroleum.

Notice how price has recently flipped the 200 day moving average in both cases and consolidated just above it. This could lead to further upside action.

Here is the chart of XLI, the SPDR Industrial Sector ETF with Monthly candles. This chart is currently bullish, no two ways about it. XLI tends to be a pretty good leading indicator of economic activity. The largest holdings in the ETF include: Raytheon Technologies, Honeywell International, UPS, Caterpillar, Union Pacific, General Electric, Boeing, Deere, Lockheed Martin, and Automatic Data Processing.

However, with XLI, I am watching to make sure there is no reversal, which would be a bearish development. If breakouts fail, they can often move quickly in the other direction. Examples of this are circled at the end of 2007, 2014, and 2019

This is not a market call, economic call, or an inflation prediction. Honestly, I try to not care about “calling the data” and focus on interpreting how the market is responding to the data - that is what matters for making money.

The price action on these charts is bullish insofar as price has moved above a longer term moving average and that moving average is trending up (in the case of XLE) or is flattening out and about to begin trending up (in the case of DBC). Notice the bullish volume spikes on DBC as well, something we talked about earlier today.

At the time of writing, I am long shares of XLE (avg price of $85.25) and Reliance Steel (RS, avg price of $265) in my personal accounts and may add, reduce, or close either position at any time for any reason without updating this article or notifying readers.