Tag: 2022 Market Outlook

When confronted with a challenge, the committed heart will search for a solution. The undecided heart searches for an escape. Alpha Wolf Capital

 

The 3rd quarter certainly started off nicely enough with the S&P 500 rising 14% from July 1st to August 16th but the second half of the quarter was not nice declining 17% by quarter’s end delivering investors a -4.9% return for the quarter as a whole and now -24% for the year. Investors were in no mood for contrarian thinking as put volumes and premiums are setting records (wagers on additional market declines), portfolio cash levels are at their highest in twenty years and speculators are holding near record short positions in most major market indices.

The markets are clearly focused upon three concerns; inflation that they fear may continue to remain elevated and persistent, a Federal Reserve that seems intent on raising interest rates to the heavenly realms and an economy that responds to a hawkish fed by going into a recession with the accompanying harmful effects on corporate earnings. Why be a contrarian when seemingly there isn’t any reason to be contrary?

But there is. From April 2020 to January 2022 the S&P traded at levels of between 20 and 23 times earnings. Currently it is at 16 meaning that the market decline is attributable to valuation levels rather than lower earnings. The source of our current battle with rising prices is easy to explain. To offset the impact of having shuttered much of the national economy at the onset of the pandemic in March 2020 the federal government responded by an historically unprecedented bout of spending leading to a 26.4% increase in M2 money supply from April 2020 through year end 2021. For the past 9 months M2 has been rising at a miserly rate of just 2.3%. Commodity prices sniffed this out months ago. Both crude oil and copper are down 35%, echoing gold’s 22% fall since March.

Meanwhile consumers are in great shape. Much of that money that Uncle Sam spent hasn’t disappeared but is sitting in our bank accounts. Commercial bank deposits peaked at $3.2 trillion above their pre Covid levels and are still $2.7 trillion higher. That is an amount equal to more than 10% of the size of the US economy. The Atlanta Fed’s estimate for growth in the 3rd quarter is at 2.3%, a dramatic improvement over the near zero estimate of just several weeks ago. Remember, corporate earnings aren’t inflation adjusted so with inflation still tracking at 6% + levels, non-inflation adjusted GDP may well top 9%, significantly above its 6% average of the past 75 years.

Could it be that we’re near to being invited to share Goldilock’s “just right” bowl of economic and financial market offerings? Inflation past its peak and set to decline. A Federal Reserve near the end of its rate rising cycle and an economy poised to surprise to the upside. With this unfolding scenario marrying an equity market discounting a great deal of the negative, and very little of the possibility of the positive, maybe we should start to prepare ourselves to go bear hunting!

Perhaps the financial market exhibiting the most extreme forms of behavior is that of the global foreign exchange markets, with the value of the Euro and the Japanese Yen declining 14% and 20% respectively year to date, in relation to the US $. It is interesting that the Japanese market’s 26% and European market’s 29% declines are so similar to that of the S&P, but US investors returns are negatively impacted by holding assets valued in those currencies. For example, the Japanese TOPIX index is -7.65% year to date in Japan’s local currency terms. Should the dollar reverse course, the returns on foreign stocks could be particularly interesting for US investors.

The first three quarters of the year have been difficult for investors as bonds have followed stocks on their negative course. The 10 year US Treasury rate started the year at 1.52% and finished September at 3.83%. The dramatic rise in interest rates has damaged the market value of fixed income instruments with AGG, an index of the investment grade taxable US bond market, -15 ½% for the year. The result has been unpleasant declines in the value of investor’s portfolios with the equity shares -24.6% and the fixed income portion down approximately 18% leaving the 60/40 portfolio down 21.3% for the year.

 

Mark H. Tekamp/October 6, 2022

Life is like an ever-shifting kaleidoscope – a slight change, and all patterns alter. – Sharon Salzberg

 

The headlines of the various stories in the July 30th Wall Street Journal seemed to leave little doubt as to which direction this current version of the economic train was heading. “Recession or Not, the Recovery Has Ended.” “Are We in a Recession Now?” “Jobless Claims Hold Near Highest Level of the Year.” “Inflation Hits Fresh Four-Decade High.” “Heard on the Street: Recession Isn’t Necessary for Investors to Feel Bad.” With that by way of counsel another headline “S&P 500 Posts Best Month Since 2020 as Stocks Rally” seemed as out of place as a rose in a briar patch.

Certainly investors who, for much of the year, were long on suffering even as they were wishing they had been short on stocks, were grateful for the respite in their experience of a sea of red as the S&P 500 put in an 8% rise for July and 12.8% since the, don’t we hope, lows for the year on June 16th which, perhaps not coincidentally, was the day after a meeting of the Fed’s Open Market Committee where they voted to raise interest rates .75%. Curiously though, while with the one hand the Fed was raising the Fed Funds Rate, the interest rates set by the other hand, that of the financial markets, are declining. The high for the 2 Year Treasury Rate was 3.45% on June 14th. It currently rests at 2.85%. The 10 Year Treasury Rate peaked that same date at 3.49% and has since fallen to 2.68%. The financial markets, which, on June 14th, were predicting 90- day interest rates to reach 4.25% by year end now expect that rate to rise to just 3.50% at the beginning of December and then to begin to decline. In other words, the financial markets are predicting the Fed will be lowering interest rates before the end of the year. So, pray tell, what is going on here?

Could it be that the explanation is to be found in the news story headlines in the first paragraph of this commentary? The Fed is raising interest rates and those higher rates are threatening to, if not yet actually having already done so, push the economy into the purgatory of recession. Possibly, but not likely, as evidenced by a number of counterfactuals. Why is the stock market rallying? And not just that it is but how it is. The two best performing industries of the S&P 500 are, since June 16th through July 27th, Automobile Manufacturers +26.8% and Homebuilders +25.2%. And of the four sectors of the S&P 500 up the most in the month of July three of the four, Real Estate, Consumer Discretionary and Industrials (the fourth is, not surprisingly, Technology) are those sectors that tend to rally at the BEGINNING of an economic recovery. So truly we do have a collision of narratives here with headlines trumpeting recession and the stock market rally saying recovery.

Dare we say that it may be Goldilocks? The economy may be slowing enough to allow the Fed to hit the pause button on further interest rate increases after another likely .50% on September 21st that may allow an avoidance of notable damage to corporate earnings. Possibly there is another factor at work here as well. Inflation comes in two “flavors,” demand-pull and supply-push. The former is the classic “too much money chasing too few goods.” The latter, one less frequently commented upon, is a lack of supply leading to higher prices. The Fed can certainly reduce economic demand by raising rates sufficiently to push the economy into recession, but interest rate increases don’t do a thing to increase the output of gasoline or beef. Help though may be on the way. Producer Prices measure the cost of economic inputs, for instance the price of lumber as a cost of constructing a new house. The prices of Core Crude Goods, a rate excluding food and energy prices, is up 7.1% year over year and has been declining. The Headline rate, which does include those items, is up an eye watering 58% year over year but since June 1st energy and agriculture prices have fallen 7.45% and 10.24% respectively. So maybe it’s getting close to the time for the Fed to declare victory over inflation and to redirect its focus upon supporting economic growth rates.

If indeed Goldilocks is about to be served her meal just the way she likes it the good times for investors may be much closer to their beginning than their end. The S&P 500 is still negative 12.6% for the year, certainly a much better number than the low in mid- June of -22.5%, but corporate earnings are actually up for the year so the decline is solely attributable to a falling valuation level which is down to 17.2 times earnings, close to its historical average of 16. The story for Mid Cap and Small Cap stocks is a distinctly different one with their trading at 12.7 and 12.4 times their respective earnings. Also worth noting is that the US economy may, for the near future, be experiencing a rate of growth exceeding that of most of the rest of the world so, with their earnings being almost solely dependent upon domestic demand, which may be yet another characteristic in their favor.

So, some good news at last. For 60/40 portfolios the equity portion returned a cool 8% with Foreign’s 5% pulling that figure down below that of the S&P 500 but with small cap’s +9.60% partially offsetting it. Fixed Income contributed a modest +.50% aided by the month’s interest rate declines to overall portfolio returns of 4.5% reducing the negative year to date figure to -10.7%. Here is hoping for a hot August!

 

Mark H. Tekamp, August 1, 2022