Friday, January 27, 2023

Market and Econonmic Update

 The Market Rally

Equity markets have begun the year on an uptrend, driven by various factors, including lower inflation data and growing expectations that the Federal Reserve may end its interest rate hikes soon. Some speculate that the Fed may even lower rates later in the year. The S&P 500 finished the week at 4070, surpassing key technical indicators such as the 50-day, 100-day, and 200-day simple moving averages and breaking a long-standing trendline. This is considered to be a bullish signal, indicating that the market could continue to rise in the near term. It's worth noting that the S&P 500 recently reached this level on November 30th and September 12th, indicating that there may also be resistance at this price point.

S&P 500 Fair Value

One method to determine a fair value for the S&P 500 is to use a multiple of earnings estimate. This involves taking earnings estimates for the companies in the index and applying a multiple, such as a price-to-earnings ratio (P/E ratio), that reflects the price investors are willing to pay for expected earnings. This method can give an idea of where the index should be trading based on the anticipated earnings of its component companies.

The Rule of 20 is a method for arriving at a fair P/E multiple, which is used to estimate the intrinsic value of a stock or index. The Rule of 20 states that the fair P/E ratio is equal to 20 minus the inflation rate. The idea is that when inflation is high, investors will pay less for future earnings, and when inflation is low, investors will pay more for future earnings. This Rule is based on the assumption that a P/E ratio of 20 is fair when inflation is zero and that the fair P/E ratio should be adjusted based on the current inflation rate.

Earnings estimates for 2023 have been revised downward over the past year, with initial projections starting at $252. The current 2023 S&P 500 earnings estimate, according to S&P Dow Jones Indices, is $223. The P/E ratio, calculated using today's closing level of the S&P 500, is 18. 4070 would be fair value for the S&P 500 if the inflation rate fell to 2% and the current earnings estimates for 2023 are not revised downward any further.

Let's wait until next week

I want to be completely transparent. Our portfolio models remain defensively positioned and have underperformed their benchmarks in January. We are in earnings season, when companies announce their earnings for the previous quarter and give guidance for the following year. About a fifth of the S&P 500 have reported their earnings so far, and they have been okay but not impressive. Next week we will hear from some of the largest companies in the S&P 500 and the Technology sector, which has been the main driving force behind the recent market rally. Wednesday, the Federal Reserve will conclude its two-day meeting with a rate decision and a press conference, and on Friday, the monthly jobs report will be released. The market rally seems premature ahead of so many unknowns.

Outside the U.S.

The ongoing war in Ukraine continues to be a significant geopolitical risk. On February 5th, Europe will impose additional restrictions on Russian petroleum distillates, which could lead to increased price pressures on diesel and gasoline. While China's reopening is expected to be positive for the global economy, the increased economic activity will also lead to a rise in energy demand, further adding to the price pressure on oil. As a result, I anticipate that U.S. gasoline prices may rise in the coming weeks and months, contributing to inflation and inflation expectations.

Recession Risks

The 10-Year to 3-Month Treasury Yield Spread, a reliable recession indicator, remains inverted by -1.22%. The consumer remains resilient though we are beginning to see a slide in consumer spending. As long as the unemployment rate remains below the Feds' projected 4.5%, I would expect any recession to be mild unless you're one of the 4.5%. The Fed Funds Futures market implies the Fed will cut interest rates later this year, which would also suggest anticipation of a weakening economy and rising unemployment.

Thursday, November 17, 2022

The Rhino Report - November 17, 202

The econonmic data can tell us a story if we'll read it objectively. Let's review some of the current econonmic data and see what conclusions we can draw.


Tuesday, November 1, 2022

The JOLTS Report and the Fed

Today’s JOLTS Report showed an increase in the number of job openings. A tight labor market is a headwind for inflation and may mean that the Fed has more work to do, and rates may be higher for longer. Please watch the video for details.


Saturday, October 22, 2022

The Rhino Report

Earnings season kicked off in earnest this week, and some common themes are developing. Most of the banks who have reported had solid earnings but are increasing their loan loss reserves in anticipation of a weakening economy, factoring in the possibility of an impending recession and an increase in loan defaults.

  •  Bank of America CEO Brian Moynihan said, "Our U.S. consumer clients remained resilient with strong, although slower growing, spending levels and still maintained elevated deposit amounts."
  • JPMorgan CEO Jamie Dimon said, "There are significant headwinds immediately in front of us – stubbornly high inflation leading to higher global interest rates, the uncertain impacts of quantitative tightening, the war in Ukraine, which is increasing all geopolitical risks, and the fragile state of oil supply and prices."
  • Goldman Sachs also beat estimates. Goldman issues a credit card in partnership with Apple. In an interview on CNBC, Goldman Sachs CEO David Solomon explained that they see consumers paying off their balances more frequently than expected.
  •  Some retailers have reported excess inventories and will need to reduce prices to sell their overstock. Sales could be plentiful and create early bargains for holiday shoppers.
  • Delta, United, and American Airlines reported high demand with no sign of a slowdown. Some historical travel patterns are changing as remote workers live in one location and commute to be on-site a couple of days a week. Some people are combining leisure travel with remote work.
  • Shipping container costs have dropped 70%, and railroads, trucking companies, and package delivery services have reported a falloff in freight traffic.

My takeaway is that there is evidence that some areas of the economy are slowing. But, with the unemployment rate at 3.5%, the consumer is employed, has money, and remains resilient. People are managing inflation by buying fewer goods while spending more on services and experiences. Almost 150 S&P 500 companies report earnings next week, which should give us further insight into the state of the consumer and economy.

Equity markets rallied Friday based on two pieces of news. An article in the Wall Street Journal (link) suggested that future Fed rate hikes may be smaller after the 0.75% expected in November. This view was reinforced by comments from San Francisco Fed President Mary Daly, who said the Fed should avoid putting the economy into an "unforced downturn" by raising interest rates too sharply, and it's time to start talking about slowing the pace of the hikes in borrowing costs (link). At some point, Fed rate hikes will slow and then stop, at which time markets can stage a sustainable rally. Until then, all rallies are suspect.

 Thursday, we'll get third-quarter GDP. The Federal Reserve Bank of Atlanta's GDPNow estimate for third-quarter GDP is 2.9% (link). As a reminder, first-quarter GDP was negative 1.6%, and second-quarter GDP was negative 0.6%. If third-quarter GDP comes in positive, it would be a short-term trend and suggest the economy is expanding following a brief, shallow contraction.

Friday, we'll get the PCE (Personal Consumption Expenditures) report, a measure of inflation favored by the Fed. The Federal Reserve Bank of Cleveland Inflation NowCast shows PCE (Personal Consumption Expenditures) and CPI (Consumer Price Index) growing by 0.8% month over month (link).

We'll learn a lot about the economy in the coming week. I'll be paying close attention to what companies have to say about their earnings, particularly regarding estimates for the future. If GDP shows growth without clear evidence that inflation is abating. I don't see how the Fed can become meaningfully less aggressive without further bringing their credibility into question. 

The Bear View –The Fed does not have a good record of being able to raise interest rates without causing a recession. If we are in or on the cusp of a recession, it would be unusual for markets to have bottomed. Markets don't usually bottom before a recession has even been declared. Typically, markets do not find a bottom until the Fed has stopped raising interest rates. It's difficult for market participants to assign a value to a company's stock until there is clarity about how high interest rates might go and the impact on earnings. Earnings estimates have come down but may need to come down further. We could see the S&P 500 settle in the 3200 to 3400 range depending on earnings and the market multiple applied.

The Bull View - There is no guarantee that anything that has happened in the past will ever occur in the future. The economy shows signs of weakness in some areas and strength in others, and it is hard for the economy to contract significantly with low unemployment. The fourth quarter is a seasonally strong period for equity markets, and there is historical precedence for markets to rally following mid-term elections. The S&P 500 could move higher before meeting technical resistance at the 100-day simple moving average (3918) and then the 200-day simple moving average (4134). Above this level, I think we would need a fundamental catalyst.

A simplified explanation of a typical cycle is as follows:

1.)   Inflation rises due to an overheated economy

2.)   The Fed raises interest rates to fight inflation

3.)   Higher rates make borrowing more expensive, reducing demand

4.)   The economy begins to slow

5.)   Higher rates and reduced economic activity put pressure on corporate earnings

6.)   Lower corporate earnings equate to lower stock prices

7.)   The economy begins to contract, and inflation moves lower

8.)   The Fed eases monetary conditions to stimulate the economy

Nothing about anything that has happened in recent years has been typical. The Fed was easing monetary policy in response to the Pandemic, not an overheated economy, and probably remained accommodative longer than needed resulting in higher inflation. Market highs were driven by unusually easy Fed policy, so when the Fed began to tighten and raise interest rates, the market anticipated the process, jumped ahead, and moved lower. We have to let the cycle run its course and allow the market and the economy to find equilibrium based on economic fundamentals.

Friday, October 7, 2022

JOLTS, Jobs & Inflation

This week’s strong employment data is fueling fears that the tight labor market is contributing to inflation, and the Fed will need to raise interest rates further in response.

Saturday, September 17, 2022


 "Stocks Crash Worst Since 29"

"Sharp New Stock Drop Spurs Worry on Plant and Consumer Spending"


These are not 2022 headlines; these are headlines from 1962.


On December 12th, 1961, the S&P 500 hit a near-term high; 196 days later, on June 26th, the S&P 500 bottomed down 28%. The market rallied through the Summer, rising 13% into August. Then the market traded down 10% into late October before staging a fourth-quarter rally, gaining 18% into year-end.


On January 3rd, 2021, the S&P 500 hit a near-term high; 164 days later, on June 16th, the S&P 500 bottomed down 24%. The market rallied through the Summer, rising 17% into August. The S&P 500 has been trending down since August 16th. Could we be setting up for a fourth-quarter rally paralleling 1962?


In 1962 we were in a conflict with Russia; that was the year of the Cuban Missile Crisis.

1962 was a mid-term election year.


"History doesn't repeat itself, but it often rhymes." - Samuel Clemens

"Past performance does not guarantee future results." – My Compliance Consultant


There are some significant differences between 1962 and 2022. The Fed was not raising interest rates in 1962, and the country was coming out of a recession that ended in 1961, not possibly entering a recession.


Market patterns are interesting and should be considered because human behavior often follows patterns. But people also see ice cream castles in the clouds and people's faces in burnt toast, so giving more weight to market fundamentals is probably prudent.


Notable News this Week

  • The Federal Reserve Bank of Atlanta's GDPNowcast for the 3rd quarter was 2.1% in July and has now fallen to 0.5%. An indicator that the economy is slowing.
  •  FedEx withdrew full-year guidance and issued an earnings warning citing softening global shipping volumes. The transport sector is often an early indicator of economic weakness because they move boxes of stuff.
  • Investment bank Jefferies cut its ratings on three paper companies warning there is a "massive inventory glut" in cardboard. Cardboard is used to make boxes that companies put stuff they sell in. Companies that use fewer cardboard boxes are probably selling less or expecting to sell less stuff.

Sunday, September 11, 2022

The Ghost of Arthur Burns

In 1970 Arthur Burns became the 10th Chairman of the Federal Reserve. You may not know who Arthur Burns was or why you should care, but in economic circles, his name is well known as the Federal Reserve Chairman, whose monetary policy missteps were responsible for or contributed to Stagflation and the Great Inflation of the seventies, which later led to a deep recession in the early eighties. The Arab Oil Embargo, budget deficits fueled by Lyndon Johnson's “Great Society” programs, and the Vietnam War sent inflation to 12% by the mid-1970s. The Federal Reserve responded by timidly raising interest rates. In late 1974 inflation showed signs of rolling over, and the Federal Reserve adopted a stop and go policy as inflation moderated. Some have speculated that President Nixon pressured Burns to cut rates while under pressure from the Watergate scandal, though there is no evidence this happened. In early 1977 inflation began rising again and tripled over the next three years going from 5% to 15%. Many economists believe Burns stop-and-go policy and cutting interest rates too soon before having inflation under control led to inflation becoming embedded in the economy.

In 1979 Paul Volker took over the helm of the Federal Reserve and aggressively attacked inflation with a strategy to shock the economy and break the back of inflation. By December 1980, the overnight Fed Funds rate had reached 22%. His strategy eventually brought inflation down but also caused a recession in 1981, with the unemployment rate rising to 11%.

There are signs that inflation may be rolling over. Some market participants expect the Federal Reserve to begin easing monetary policy early next year. Chairman Powell and Federal Open Market Committee members are aware of the legacy of Arthur Burns and do not want to repeat his policy mistakes. Through the eighties and nineties, the average Fed Funds rate was several percent higher than the inflation rate keeping inflation at bay. The Federal Reserve is targeting a 2% inflation rate and has suggested its current plan is to raise the Fed Funds rate to 4% and remain there for some time. I take the Fed at its word. Unless we see an illiquidity event in Treasury markets or a sharp spike in the unemployment rate, the Fed can use its monetary tools with a single focus to bring inflation under control.

During testimony before Congress, Chairman Powell was asked if the Fed had the resolve to do what it takes to stabilize prices as Paul Volker did decades earlier. Chairman Powell greatly admires Paul Volker and confirmed that the Fed is dedicated to price stabilization. Recently, at an economic conference in Jackson Hole, Wyo., Powell acknowledged that higher rates would likely cause some short-term pain for families and businesses. Powell said that unemployment might increase, and the economy may grow more slowly, but "without price stability, the economy does not work for anyone."

With inflation at levels we haven’t seen in 40 years, Chairman Powell and the Federal Reserve are being haunted by the ghost of Arthur Burns and will try to avoid following in his footsteps. No Federal Reserve Chairman wants their policies compared to those of Arthur Burns. Chairman Powell has channeled Paul Volker in several speeches to indicate that he intends for history to remember him as a Fed Chairman who fought against inflation rather than fueling it. We should take the Fed at its word and expect rates to go higher and remain at that level for longer. 

Sunday, July 17, 2022

Economic and Market Update

  • Markets - We are in a Bear Market, which means the S&P 500 is down 20% or more from a recent high. Some analysts expect the S&P 500 to bottom in the 3400 to 3500 range, roughly 10% lower than current levels. I believe markets are going through a bottoming process now and would expect markets to find a bottom within the next 90 days. However, that is not something anyone can know for sure, and circumstances and data can change. Markets may move higher once the Fed signals that interest rate increases will be less aggressive or ending.
  • Recession - I believe we are in a mild recession. Many define a recession as two consecutive quarters of negative economic growth. First-quarter Gross Domestic Product (GDP) was -1.6%. The Federal Reserve Bank of Atlanta publishes GDPNow and estimates that second-quarter GDP will be -1.5%. We will get the next GDP report on July 28. I would consider a recession mild if unemployment remains below 5%. People with jobs have money to spend on goods and services. Consumer spending drives 70% of the economy. It would be difficult to have a deep recession with low unemployment. On average, recessions last 6 to 18 months. So, we may already be halfway or more through a recession.
  • The Fed - The Federal Reserve will end a two-day meeting on July 27 and is expected to raise interest rates by 0.75%. There has been talk that The Fed may raise by 1% after higher-than-expected inflation reports at the consumer and producer levels. The Fed has intentionally communicated its policy path, and I would be surprised if they deviated now. There is no August meeting, and there is reason to believe inflation could be meaningfully lower by the September meeting.
  • Inflation – Tuesday, the Bureau of Labor Statistics released the June Consumer Price Index (CPI), showing inflation at 9.06%, the highest rate in 40 years. However, data shows that inflation may have peaked and is moving lower. Monday, we got weekly retail gas prices from the Energy Information Administration (EIA), indicating average gas prices have fallen 7% to $4.74 over the previous four weeks. If you drive around, gas prices have fallen lower since this data was collected. The prices of other commodities such as oil, lumber, copper, and grains are also falling. Over time these lower commodity prices will work their way into retail prices. In earnings calls from several retailers, it was revealed that some have inventory surpluses and were lowering prices to clear excess. Remember at the beginning of the Pandemic when there was a run on toilet paper? Purchasing managers are people too. It seems that some retailers overordered during a period when they were uncertain what they could actually get due to supply chain constraints.
  • Politics – Politics, politics, all God's children got their politics. I manage client accounts in pursuit of the best risk-adjusted outcomes considering current and expected policies regardless of whose team has the ball. It is expected that Republicans will gain control of one or both houses of Congress. Markets often do better during periods of divided government as significant legislative and regulatory changes are less likely. Regardless of the outcome of an election, once the election has passed, so does the related uncertainty.
  • Other Data – Friday, we got the Index of Consumer Sentiment (ICS) from the University of Michigan. The index increased to 51 from 50 the previous month, not a lot but moving in the right direction. We also got the Retail and Food Services Sales report showing a 1% gain following five months of decline. These two data indicate that though consumers say they have a negative view of the economy, they continue to spend. In the coming weeks, we'll get more second-quarter corporate earnings results. There is an expectation that some companies will miss expectations and guide lower for the rest of the year. Analysts have already begun lowering year-end forecasts for corporate earnings and the S&P 500. In the coming weeks, we’ll get more second-quarter earnings reports which should give us more insight into the state of the economy.

  • Final Thoughts
    • The data suggests we are in a bear market and mild recession.
    • During a recession, the average drawdown for the S&P 500 is 30%; so far, we’re down 20%, making another leg down a reasonable expectation, but we can’t know that for sure.
    • Recessions typically last 6 to 18 months. Measuring from the January high, we may be closer to the end than the beginning.
    • Recessions are the shortest stage of a typical business cycle. During a recession, economic excesses and dislocations are corrected. The most damaging recessions are often associated with a problem in the financial system. This recession is part of the aftermath of the Pandemic and not distress in the financial system.
    • During the Pandemic, governments and central banks worldwide provided businesses and individuals with additional liquidity. As economies reopened, supply chain disruptions limited the availability of goods and services. The prices of the available goods and services rose in response to higher demand resulting in inflation.
    • Central banks worldwide are raising interest rates and removing monetary accommodation to combat inflation. Higher interest rates slow economic activity resulting in lower corporate earnings and stock prices.
    • As supply chains continue to normalize and inflation subsides, a balance will be reached, and central banks will become less aggressive. As things normalize, the economy and markets can grow again.
    • The war in Ukraine adds to the economic uncertainty. Any resolution to the conflict could go a long way toward improving the global economy.

Sunday, July 10, 2022

Reason to Believe Double Digit Returns may be Coming

The first half of the year has been volatile as expected. The S&P 500 was down 20.58% during the first six months of this year. Looking at previous times when the S&P 500 has been down 20% or more over two consecutive quarters, the S&P 500 had double-digit returns over the following 12 months 100% of the time, averaging a gain of 31.36%. Past performance doesn't guarantee future returns, and we may not have seen the lows for 2022, but if the S&P 500 follows historical patterns, markets may be significantly higher next summer.

10/01/08 - 03/31/09 -31.28%
03/31/09 - 03/31/10 +46.57%

07/01/08 - 12/31/08 -29.70%
12/31/08 - 12/31/09 +23.45%

04/01/02 - 09/30/02 -28.89%
09/30/02 - 09/30/03 +22.16%

07/01/74 - 12/31/74 -20.30%
12/31/74 - 12/31/75 +31.55%

04/01/74 - 09/30/74 -31.86%
09/30/74 - 09/30/75 +32.00%

01/01/70 - 06/30/70 -21.81%
06/30/70 - 06/30/71 +37.10%

01/01/62 - 06/30/62 -22.84%
06/30/62 - 06/30/63 +26.70%

Data Source: YCharts