If the stock market crashes in 2023 it will be the fault of the Fed and U.S. banks. Here’s what could go wrong.

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Wall Street is in the red after a slew of early earnings and as Microsoft results await. That’s a day after soft-economic landing hopes fueled fresh 2023 highs for the S&P 500 and Nasdaq Composite

Diving straight in, our call of the day taps into a potential market worry that may be off investors’ radars, from Stock Traders Daily and portfolio manager at Equity Logic, Thomas H. Kee Jr., who warns that liquidity leaving the financial system could upset markets in 2023.

In a recent report to clients, Kee noted similarities between current markets and 2019, when big banks started questioning levels of liquidity due to a Fed drain, and ultimately pushed overnight lending rates to over 8.5%. The Fed got things under control in a short space of time via massive liquidity injections.

Kee is worried about a 2019-style event for this year amid an increasingly “aggressive” Fed balance sheet runoff —the bank lets a portion of the securities that mature each month fall off its books — and already higher rates. But things could get ugly and it can’t “buy its way out of the problem” this time, he says.

Back then, the Fed “stopped the balance sheet reduction, slashed rates to 0% again, started asset purchases again, and the market took off in 2019.” Unlike now, back then “very few people were pointing to stimulus and asset purchases as catalysts for inflation and inflated asset price appreciation.”

He notes that another $1 trillion needs to come off the Fed balance sheet before it matches the 2019 balance sheet reduction.

Kee’s proprietary Evitar Corte crash indicator, which gauges Fed monetary policy to try to avoid market meltdowns, signaled a crash warning in 2019. He flagged budding liquidity issues to MarketWatch last November.

“We identified massive changes to liquidity (new money) last year, as the FOMC reduced stimulus to $0.  This year the risks of a market crash warning is high, and we have identified liquidity drains from the FOMC (net negative stimulus),” he added in emailed comments. “Between last year and this year, the FOMC has gone from highly simulative, to a massive drain on liquidity.”

What to watch out for? “Recall that the banks became concerned months before the trough in the balance sheet in 2019, so the signals are likely to start to come months before it reaches a boiling point this time too,” he said.

How to prepare? “The best way to approach this is to remain in nimble strategies, like our SPY-Cash Model,” said Kee, referring to his long-favored strategy of alternating between cash and the highly liquid SPDR S&P 500 ETF  .

“There is also enough volatility in the market for some investors to improve cost basis, but everyone needs to be in nimble strategies.  Our CORE Portfolio Strategy has been long all year, up about 8.5% YTD vs 4.4% for SP 500,” he said in emailed comments. (Read more on that here). “CORE also has the ability to neutralize market risk on a dime if the conditions call for it.”

Read: Technical strategist DeMark called the euro bottom. Here’s what he says now about the euro, bitcoin and the Nasdaq-100

The markets

Stocks are lower, with bond yields steady, and the dollar flat. Oil prices are flat. Bitcoin is holding above $23,000.

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The buzz

3M shares are falling after a disappointing outlook, and the industrial giant also announced 2,500 job cuts, while GE stock is choppy as its view was also downbeat. Verizon earnings came up short and shares are down. Better news from Johnson & Johnson whose shares are gaining on an upbeat profit view, Raytheon stock is up after announcing plans to split into three businesses.

Microsoft and Texas Instruments will headline after hours. Microsoft on Tuesday announced a  “multiyear, multibillion-dollar investment” in AI startup OpenAI, maker of ChatGPT. Our tech editor Jeremy Owens says it’s unlikely the tech giant will be challenging Google in search now.

Amazon is planning a subscription prescription drug service.

The feds are reportedly preparing to sue Alphabet again, this time over dominance in the online ad market.

January’s flash services purchasing managers index climbed to 46.6 in January from 44.7 and the manufacturing PMI survey rose to 46.7 from 46.2.

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The chart

The commodities market may have priced in less of China’s reopening growth boost, “and may have more upside than more forward-looking assets like equities,” say Goldman Sachs analysts Callum Bruce and Romain Langlois, in a note.

“We estimate that this has largely been a result of higher interest rates and the associated volatility, keeping passive flows on the sidelines,” they said, adding that commodity markets should start to tighten up on China’s reopening, drawing more investor flows.

The tickers

These were the top-searched tickers on MarketWatch as of 6 a.m. Eastern:

Ticker Security name
Tesla
Bed Bath & Beyond
GameStop
Helbiz
AMC Entertainment
Genius Group
NIO
Apple
Mullen Automotive
AMC Entertainment Holdings preferred shares

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