Zulauf expects the S&P 500 to see a pullback of about 15% next January, driven by Santa Claus, but ……
History may be about to repeat itself. Felix Zulauf, a veteran of many roundtables and head of Switzerland’s Zulauf Consulting, articulated his typically scathing Swiss perspective on global markets, which is always a useful complement to the inevitably optimistic speculation of most Wall Street prophets.
For now Zulauf thinks markets will continue to rise. He recognizes the well-publicized technical negatives in the stock market – for example, the extreme optimism suggests that investors have gone all in with few new buyers. At the same time, market winners continue to be concentrated in large tech companies, and deteriorating market breadth is a warning sign. But he believes the positive liquidity trend should continue to push prices higher.
Zulauf , rather than the workings of the Fed itself. While investors remain focused on the U.S. central bank’s manipulation of its federal funds target rate, Zulauf is focused on the supply of liquidity provided through changes in the central bank’s balance sheet.
At first glance, it may appear that Fed Chairman Jerome Powell and his team are pulling money out of the economy as they shrink assets from a peak of about $9 trillion to just under $7 trillion, but from a financial market perspective, the reduction in one Fed liability – so-called reverse repurchase agreements – has pumped in more than $2 trillion.Zulauf says this has fueled a rally in risk markets.
The reduction in another Fed liability, the Treasury General Account (TGA), will provide more momentum to markets starting after New Year’s 25. At that time, the federal government’s debt ceiling suspension will end, which means the Treasury will have to dip into its accounts rather than continue borrowing. When Uncle Sam pays his bills with the cash he had previously stored, that cash will be pumped into the financial system.
That will be because Congress rejected President-elect Trump’s call to raise or lift the debt ceiling, which was passed to avoid a government shutdown before it went into effect on December 21st. He estimates that the reduction in the TGA should inject about $600 billion in new liquidity into financial markets.
In addition to this positive liquidity trend, Zulauf notes that the calendar has also provided a boost to the markets. Looking back over the past 100 years, years ending in 5 have been positive. The exception was 2015, when the stock market returned negative 1% – not bad. He hypothesizes that this pattern is related to the so-called Juglar cycle, which is associated with capital spending.
Note: The Juglar Cycle refers to the existence of a 9 to 10 year cyclical fluctuation in the capitalist economy
Zulauf expects a pullback of about 15% in the S&P 500 after the Christmas rally ends next January, but that should pave the way for new highs, but as for how high, he says, “I’d tell you if I knew.” He also didn’t point to an exact time when U.S. stocks will peak sometime next year.
But he added, “I think the long-term liquidity indicators suggest that we will peak in ‘25 and then fall sharply in ’26, which means we could reach the final market peak in ’25.”
For now, the U.S. exceptionalism should continue.
He argues, “From an economic perspective, the world economy is underperforming. The U.S. economy is doing well. The European economy is stagnant, and I think Europe’s woes are so deep that it could last three or four years of stagnant structural recession.”
Zulauf went on to say that Europe and its largest economy, Germany, are vulnerable. And Europe is more vulnerable to Trump’s threatened tariffs. The U.S. wants to export cars and agricultural products, where Europe has excess capacity. Europe is an export-oriented economy, which further makes it vulnerable to tariffs.
Exchange rate changes may offset the impact on trade flows. In his estimation, the dollar is overvalued by a considerable amount, about 15-20%. He thinks Trump will make a case for reversing the dollar’s steady rise since 2008.
Some observers believe there could be a “Haiku Manor Accord,” similar to the 1985 Plaza Accord, which reversed the sharp appreciation of the dollar during Ronald Reagan’s first term.
The most extreme example of an exchange rate mismatch is the yen, which is worth about 88 to the dollar based on purchasing power parity, which is how much of a tradable good a currency can buy, but a dollar is currently worth 156 yen, suggesting that the dollar is very strong and the yen is weak, Zulauf said. “I don’t want to be prime minister of Japan at my next meeting with Trump,” he observed, given the president-elect’s oft-expressed preference for a more competitive dollar to boost U.S. exports.
Zulauf emphasized that a stronger yen would have important implications for financial markets outside of Japan. He noted that there is a close correlation between the yen-dollar exchange rate and the Nasdaq 100, with a weaker yen coinciding with a rise in large U.S. technology stocks.
He explains that this linkage is the result of using the yen to borrow at ultra-low interest rates to fund purchases of higher-return assets, such as the seven major tech stocks that drive the Invesco QQQ Trust ETF. Borrowing in yen effectively means shorting the yen, which has lost about a quarter of its value relative to the dollar over the past three years.
As a result, both sides of the deal – shorting the yen and going long QQQ – made huge profits. The yen fell below 162 at one point earlier this year, then rallied to 140 on expectations that the Bank of Japan would tighten policy and the Federal Reserve would ease.
Since then, however, the yen has weakened, and Zulauf said the yen’s long-term trend has been broken, and there is still a long way to go before it reaches PPP 88. He compared the current situation to 1998, when the general mood of the dollar is extremely optimistic, and he was short the dollar, and “full position” of the dollar against the yen put options, when the dollar against the yen fell from 148 to 108, which allowed him to spend his best year.
Zulauf continued, similar exchange rate fluctuations will have a negative impact on the stock market, and thus the U.S. economy. The conventional wisdom is that the stock market is driven by the economy. But he argues that the relationship has been reversed.
The rise of the stock market and cryptocurrencies has strengthened consumers’ balance sheets, allowing them to save less and spend more. Meanwhile, an oversupplied U.S. labor market has pushed up wages – and strong asset prices have enabled more Americans to quit their jobs and enjoy early retirement.
But a stock market reversal would have a negative impact. “I spend a lot of time in Florida, and I know a lot of people who are wealthy and have strong balance sheets,” Zulauf said. “I can tell you that if the market goes down 20 percent, they’re going to reduce spending and cut back. I’ve seen that happen in the past and I’ll see it happen in the future.” Meanwhile, poorer people with relatively few assets and strained balance sheets account for a much smaller share of spending, he added.
For now, those holding stocks should continue to do so, but should be prepared to withdraw decisively from the market later this year or in 2026. Bonds will get interesting when the stock market reverses, but Zulauf sees the 10-year U.S. Treasury yield staying in a range of about 3% to 5% over the next 18 months. However, if this benchmark bond yield decisively breaks the upper end of that range, he believes the Fed will implement some form of yield curve control.
This strategy, he continues, will be inflationary, which will benefit gold over the long term. In fact, gold has risen slightly more than the S&P 500 in 2024, but Zulauf believes it could make a short-term pullback to about $2,400 from its recent peak of $2,800 an ounce and current price of about $2,630. At that point, he says, he will once again be a buyer.
Ultimately, Zulauf concludes, central banks will resort to printing money to solve the global market conundrum. In the meantime, get ready for a rollercoaster ride to 2025 and prepare for an eventual decline.
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