Sunday, May 29, 2022

Could last Week’s Rally be a Head-Fake?

A Head-Fake?

The S&P 500 broke its seven-week losing streak last week with a solid multi-day rally of more than 6%. In recent years, we've become accustomed to market corrections followed by rallies to new highs. Last week's rally could be the beginning of stabilization in equity markets, but it could also be a head fake. There are no rules, but market corrections of greater than 10% are often resolved by a capitulation day; when 90% of stocks close lower, and the volatility index peaks above 36. It will seem like all hope is lost on that day and that nothing good will ever happen again. We haven't had a day like that yet. Analysts have suggested that markets could retest the 3800 level or lower before stabilizing later in the year. Market corrections can also end with the resolution of the issues that caused markets to correct. Before we can move to new highs, I expect we will need to see progress toward a solution to the war in Ukraine, evidence that supply chains are normalizing, and a statement from the Federal Reserve that inflation is improving, and and indication that their policy may be less restrictive going forward.


Hot Economy, Inflation, and Recession

It may seem counterintuitive because we want economic activity and growth, but the economy is running too hot, causing inflation. The Federal Reserve is shifting to a more restrictive monetary policy to combat inflation and slow the economy. Before markets can move higher, we need to see evidence that the Feds policy is working and the economy is coming into balance. When the Fed has tightened monetary policy in most past cycles, the economy has slowed, stalled, and contracted into a recession, making a recession probable but not imminent. I am not expecting a recession like we saw in 2001 or 2008. There is a tendency to prepare ourselves mentally to fight the last recession. It's important to know that recessions aren't bad; they are part of the economic cycle and correct excesses and dislocations in the economy. The Dot Com bubble bursting in 2001 was caused by excessive speculation in technology companies that had little revenue or earnings. The technology sector is now one of the more profitable areas of our economy. The Great Financial Crisis resulted from speculation in the housing market, questionable mortgage investment vehicles, and an overextended consumer. Since then, regulations have strengthened the financial system; there is more need for housing than supply, and consumer and corporate balance sheets are relatively good. It is unlikely that the next recession, whenever it comes, will look like previous recessions.


The Labor Market and Inflation

Because the unemployment rate is unusually low, employees have more bargaining power than they have had in a long time. Higher wages are an expense to the employer that gets passed on to the consumer through higher prices. Unlike supply-related inflation, which can be moderated by increasing supply, wage inflation is sticky. Once employees' wages are set higher, it is difficult for prices to fall as those higher wages would need to be cut. We need the gap between job openings and the number of unemployed people to shrink to slow inflation. The unemployment rate rising to 5% would reduce inflationary pressures, but that is unlikely in the near term.


Economic Reports

Monday – The Energy Department's Retail Gas Price Report showed the national average for a gallon of gasoline was $4.69, up from $4.59 the week before and 50% higher than one year ago. With China scheduled to begin some reopening in early June, increased air travel, and the summer driving season, I expect gas prices to rise until they reach some level of demand destruction.


Tuesday – The Census Bureau reported Sales of New Single-Family Homes were down 16.64% in April, the fourth consecutive month of slower sales, as rising home prices and rising interest rates are slowing demand. Real estate in some markets is beginning to come into a balance between the number of buyers and sellers.

At this point, a slowdown in new home sales is a good thing and part of why markets rallied last week. The housing market has been too hot, and rising home prices have contributed to inflation.


Wednesday – The Commerce Department reported a month-over-month rise in New orders for Durable Goods of 0.44%, suggesting moderate economic growth.


Thursday – The Labor Department released the weekly number of Initial Claims for Unemployment Insurance - 210K vs. 218K the previous week. We've seen some rise in claims from historically low levels but not enough to indicate a change in how tight the labor market is.

Freddie Mac's Primary Mortgage Market Survey® - The average 30 Year Fixed Mortgage Rate is 5.25%, compared to 5.30% last week and 2.94% a year ago.


Friday - The Bureau of Economic Analysis released the Core PCE report (Personal Consumption Expenditures). This is the Federal Reserve's preferred measure of inflation and is the inflation rate with food and energy stripped out. They remove food and energy because those tend to be more volatile over shorter periods and can distort inflation data. Year over year, this measure of inflation was 4.91%, compared to 5.20% last month and 5.30% the month before.

Lower inflation data was a catalyst for the market moving higher Friday. If inflation falls, the Fed will have less work to slow the economy.


Next Week

Tuesday - We'll get the Case-Shiller Home Price Index which will inform our view on inflation.

Wednesday – The Institute for Supply Management will release their Purchasing Managers Index, giving us insight into the manufacturing sector.

The Federal Reserve Bank of New York will update its 12-month recession probability report. Last month's recession probability was 5.49%, well below the longer-term average.

Thursday – We'll get ADP Nonfarm Payrolls, Weekly unemployment claims, and the Bureau of Labor Statistics quarterly productivity report. All will be closely watched.

Friday – The Bureau of Labor Statistics monthly jobs report. I would prefer to see a weaker report, suggesting the economy may be slowing on its own. Though some are calling for the Fed to be more aggressive, I would be happy for them to move slowly and not break anything.


There are some minor signs of improvement in supply chains and inflation, but it is too early to know how meaningful. I believe the Fed will remain on its current course and raise interest rates by 0.5% at their June and July meetings. I think markets will continue to be volatile, but we could see some moderation and higher levels later this year. I do not believe we will see a recession in 2022, but we should not be surprised by a mild recession in 2023. This is not based on any current economic data but rather on the Federal Reserve's poor record at navigating rising rates.

Sunday, May 15, 2022

Economic and Market Update

 The Economy

Consumer Sentiment - The Index of Consumer Sentiment, provided by the University of Michigan, tracks consumer sentiment in the US based on surveys of random samples of US households. The most recent data was released Friday. The current level of 59.10 decreased from 65.20 last month and from 82.90 one year ago, and the lowest level since 2011. This data, though not conclusive, would suggest we may be in a recession now. Consumer sentiment typically bottoms at the trough of a recession when consumers are under the most stress.


Inflation - The Consumer Price Index (CPI) is at 8.26%, down from 8.54% last month and 4.16% a year ago. The long-term average is 3.25%. Some believe that inflation may have already peaked and will begin declining. Here's the thing to know. The inflation rate is the rate of change, not the level of prices. Even though the inflation rate may fall, prices may remain elevated, just not rise at the same rate. Some of the inflation is now coming from increasing wages. For example, the supply of chickens may normalize, but the salaries paid to process the chickens are sticky. It is difficult to cut an employee's wages once raised.


Employment - The Unemployment Rate is unchanged from the previous month at 3.60%, down from 6.00% a year ago. The long-term average is 5.75%. The Job Openings and Labor Turnover Survey compared to the number of unemployed persons shows there are 1.9 job openings for every unemployed person. It would be difficult to have a deep recession with below-average unemployment. Unfilled jobs need to be reduced, and the unemployment rate may need to rise to get inflation under control. 


GDP – First quarter Gross Domestic Product (GDP) was -1.4%, following +6.9% in the fourth quarter of 2021. It is often cited that a recession begins with two consecutive quarters of negative GDP, of which this could be the first. The biggest detractor from first-quarter GDP was a drop in exports; it could be that the first-quarter surge in Omicron impacted GDP.


Recession – The economy is constantly expanding and contracting. A recession is an extended period of economic contraction usually characterized by high unemployment and declining equity prices. The New York Federal Reserve publishes the Probability of US Recession in the coming 12 months, and the current probability is 3.71%.


I do not see a recession developing in 2022. The US economy is a big ship to turn, and there are reasons to believe that a recession may not materialize. However, when the Federal Reserve raised interest rates in the past, it often resulted in a recession and makes a 2023 or 2024 recession more likely. In an interview with NPR Thursday, Federal Reserve Chairman Jerome Powell warned that he could not promise a soft landing, meaning getting inflation back to the Fed's 2% target while maintaining full employment may not be possible. The Fed may need to raise interest rates to the point that the economy slows enough to eliminate the current job surplus and cause some layoffs to get inflation under control. The stock market is a leading economic indicator suggesting that the recent market volatility may be market participants repricing what they are willing to pay for stocks in a period of slower economic growth.


Equity Markets

Markets remain volatile as market participants adjust to higher interest rates and a less accommodative Federal Reserve. Adding to the uncertainties are the war in Ukraine and the ongoing COVID-19 lockdowns in China. The world's second-largest wheat producer, India, has now banned wheat exports following lower than expected crop yields due to drought. Their food security was cited as the reason. Wheat prices on the global market have been rising, and banning exports may lower the domestic price in India while creating further shortages elsewhere. It was expected that India would be able to make up for some of the lost Ukrainian supply. There will be food shortages in parts of Asia and Africa. It's difficult to discuss the economic impact of war, pandemics, and potential famine without sounding insensitive. Our thoughts and prayers continue to go out to the people affected. I expected markets would be volatile in the first half of the year due to Fed policy changes. The geopolitical issues and the relentless pandemic further complicate market outlooks.


Earnings – Stock prices are a function of earnings. So far, 454 companies in the S&P 500 have reported their first-quarter earnings; most are beating estimates. Next week we get the Retail Sales report and earnings reports from Walmart, Target, Home Depot, and Lowes. These reports should give us a good indication of consumer spending, but consumers may have shifted from buying things to doing things.


Market levels – The level of the S&P 500 comprises two components. The first is earnings estimates. These are estimates of future earnings provided by companies to their shareholders and analysts who study and follow the companies. 2022 earnings estimates for the S&P 500 range from $210 to $245; let's use the average of $227.50. The second component is the earnings multiple. The earnings multiple is a value assigned by investors that reflects investors' confidence in the future earnings estimates in relation to the potential return on investment alternatives like bonds. It's how we think of the market as cheap or expensive when considering expected earnings. In recent years the multiples have ranged from 18 to 23. Pre-pandemic, we were trading at 19 times forward estimated earnings. Over the past 25 years, the average earnings multiple has been around 16. What we've seen so far this year is not necessarily economic weakness but instead falling confidence and multiple compression. Just as consumer confidence is falling, so is investor confidence. Investors believe that the Fed will raise interest rates and slow economic growth, so they have lowered the multiple they are willing to pay for the estimated growth. So far, most first-quarter corporate earnings have beat estimates, and analysts have not reduced their expectations for future earnings, they may in the future, but for now, we have to work with the data we have.


01/03/22 - S&P 500 4796 = $227.50 x 21.08

02/28/22 - S&P 500 4373 = $227.50 x 19.22

04/29/22 - S&P 500 4131 = $227.50 x 18.15

05/12/22 - S&P 500 3930 = $227.50 x 17.27

??/??/??  - S&P 500 3640 = $227.50 x 16.00


What makes being underinvested ill-advised is that there is so much negativity being priced into markets that markets could rise quickly if anything good happens. Suppose there was good news on the war in Ukraine or fewer lockdowns in China. What if we see supply chain improvement and lower inflation? These could cause market participants to begin multiple expansions or cause earnings estimates to rise, and the S&P 500 could also quickly rise.


If inflation persists, we want exposure to investments in areas where companies can pass on higher prices to consumers. That would be things like Energy and Consumer Staples. If we enter a recession, we want to be overweight areas that do better later in the business cycle, including Energy, Utilities, Healthcare, and Consumer Staples. I've added exposure to these sectors in the portfolio models. A recession is the shortest phase of the business cycle. Equity markets rise and fall in anticipation of what's coming next, meaning that equity markets may rise in the depths of a recession in anticipation of future economic growth. The economy and markets are always changing. I will continue to monitor the data and keep our clients informed.