First of all, we hope everyone is safe and their power is back on now, or soon will be. The refugees in our house now have the power back on at their place, so if anyone needs a cool bedroom, please let us know.
The question most people have asked us, or at least asked themselves, is “What the **** is going on with the markets?” Good question. The talking heads like to hone in on “inflation is out of control,” or “interest rates are out of control,” or “the Fed is out of control.” The common theme is out of control. This is a good time to understand that securities prices are not in anyone’s control, not yours, not ours. The market will decide prices each day simply based on who is buying and who is selling. The vast majority of people are doing neither, but those who are trading get to dictate prices. Some of these traders are shorting stocks, betting that they will fall further. Some are investors who are panicking and throwing in the towel.
The question that likely follows is “what do we do about it?” There is undoubtedly no shortage of portfolio managers who are concerned that their clients think they’re not doing enough to “protect” them. Maybe some had put clients into assets that were admittedly too risky, and need to save some face now. Or they hadn’t stored up enough cash, income, and bond maturities for clients’ distribution needs for the next 6-12 months. Those aren’t good reasons, but at least have a shot at sounding justifiable to some clients.
Hopefully we have done our job ensuring cash needs are met without needing to sell at what we believe is an inopportune time. Of course, some cash needs occur that were not predicted ahead of time…such is life. We want to have either cash, safe bonds whose value hasn’t fallen, a cash-like bond fund, or safe stocks which have gone up this year to fund those surprise distributions. If there is excess cash, we would love to go hunting with that cash, because stocks are much cheaper and bond yields are suddenly decent.
If you don’t have any cash needs, you have a portfolio whose value fluctuates daily, sometimes up, sometimes down. The old saying is that you don’t incur a loss until you realize the loss, by selling something and cashing out. Tax-loss harvesting is different: it’s okay to sell one stock to grab a tax loss, and replace it with another stock, because you didn’t just create a risk that the market suddenly rebounds and you’re sitting on cash instead.
During bull markets, we often think back to past bear markets as simply tough times, but we don’t remember as much the anxiety and the anguish we feel on days like today. So is the market about to bottom? Obviously we have no idea. We have seen a lot of pseudo-capitulation but no real revulsive capitulation. So far in 2022, the most pain has been felt in the riskiest assets, such as unprofitable tech companies, IPOs, SPACs, and cryptocurrencies. On the other hand, the highest-quality stocks have performed relatively well, such as those in safety sectors like consumer staples and health care. Many of our core stocks are up in 2022.
Energy, materials, and defense stocks have performed well for one obvious reason: Russia’s invasion of Ukraine. Inflation has taken a turn for the worse thanks to the effects of the war: grain that can’t get out of Ukraine, oil that’s stuck in Russia because sanctions prevent the West from buying, natural gas that Russia is now withholding from Europe. At the same time, the 2-month covid shutdown in China has dealt our supply chain yet another unwelcome blow. This has created even more inflation, and has given the Fed the green light to raise rates in large increments until they believe they have tamed inflation.
It is worth going back to Econ 101: supply and demand. The best way for rising prices to be tamed would be for supply to increase. Greater supply is obviously what is needed right now just to satisfy current demand in our economy. Think about all the things that are in short supply because manufacturers can’t make enough of them; cars and houses are just the two biggest markets but the list is long. We all had hoped that, by now, higher prices would have induced supply responses, and they have, but not much. We also would have hoped for better policies that didn’t encourage labor to stay home, prevented immigrants from coming to America to work, and discouraged oil companies from drilling for more oil and especially natural gas. But who are we to judge…
The Fed has clearly lost a degree of hope in a supply response, and are now going after demand. That’s the other side of the price equation: a reduction in demand should lead to a reduction in prices, if supply remains the same. The Fed still wants to walk a fine line in hoping for an eventual supply response, but also doing what they can to try to rein in demand.
Remember that a reduction in demand is, by definition, a recession. There are different ways to slice and dice it, and also adjustments that can and should be made. For example, in the first quarter of 2022, real GDP (stripping out price increases) fell at a 1.5% annual rate from 4Q21. Note that nominal GDP (which includes price increases) rose at a 6.5% annual rate. Companies’ sales and profits grow in nominal terms. But even looking at that negative real GDP number, it was distorted by trade and inventories. So, while our economy produced 0.4% less goods and services in 1Q22 versus 4Q21, we (as an economy) actually consumed 0.9% more goods and services, as defined by final sales to domestic purchasers. That’s the best way to gauge underlying demand. That would equate to 3.6% annual real GDP growth.
The current quarter will probably see another negative real GDP headline number again, so there will be folks who say that’s a recession. We would disagree. Real final sales might actually drop too, but it would be the first quarter to do so. Still, the likelihood of a drop in the 3rd quarter is pretty high now.
That said, underlying demand is still being distorted by all the shortages, so consumers can’t buy all that they really want. Listed housing inventory has started rising a little bit as demand starts to cool off (thanks to high prices and rising mortgage rates), but is still less than half the level of 2019. As for cars, the SAAR (seasonally-adjusted annual rate) for new car and light truck sales in May was 12.68 million units. Pre-covid, auto demand was consistently around 17 million units annually. Demand has obviously shot up in the last couple years versus pre-covid, so underlying demand must be way north of 17 million, but only 12.68 million were sold.
Our biggest concern coming out of covid, since 2020, has been that the consumer would go on a spending binge once they are free to safely get out and spend (on experiences, travel, and entertainment especially). Then there would be a hangover in spending on the other side of the binge. The successive covid waves continued to push that off, allowing for a more steady pattern of consumer spending, and also allowing consumers to build their savings by $2.3 trillion more than they otherwise would have. As of April, that $2.3 trillion has come down by $0.1 trillion since the peak in December; in other words, it really hasn’t come down at all. Right now, inflation is having the same effect as the covid waves, convincing consumers and businesses to wait to spend in a growing number of cases.
How this will play out next? We don’t know that, but we would much prefer a gradual spending pattern than a binge and then a bust. So if we are correct in our assessment, the consumer is pausing spending, at a time when they still have excess savings. This is actually a good thing.
So why is consumer sentiment at an all-time low? Because we all hate inflation, and we hate the fact that we’re supplying a lot more of our hard-earned cash to oil companies, the Saudis, and even the Russians. Maybe the cows are less villainous than the Saudis, so it’s hard to blame them (or all the overworked meatpacking employees) for high meat prices. Plus, many of us are now putting on hold dream vacations that we have been planning for two years. It would be hard to come up with a better way to make consumers mad than what we have right now.
But at the end of the day, and hopefully that day isn’t far off, there will be demand destruction and supply chain easings. The stock market will be watching closely for signs of either fading demand or improvements in supply. The contrarian call would be that the market would welcome either, in the interest of killing inflation and sending the Fed back to the sidelines. Frankly, we already are seeing some prices come down. Metals prices are off their highs. Copper peaked in March and is suddenly down 20% since then. Aluminum is off 32%. Even steel is off recent highs. Retailers are sitting on inventories that suddenly went from too low to too high. Target has signaled that they will be discounting product in order to move inventories. Think about that for a minute: consumers have essentially been 100% price takers since the beginning of 2021, accepting all price increases, but now, they suddenly have some leverage, and can be patient to buy. Wal-Mart and Amazon have too much stuff. Even Apple and Samsung have started telling suppliers that they will be reducing orders. Clearly this hasn’t happened in markets where supply is still constrained (housing, cars), but it is starting to show up in more places.
The S&P 500 is now down about 24% from its intraday high as we write this. The bond market is down 12% this year. Thankfully, our stocks and bonds have generally held up much better. It is almost unprecedented to have both stocks and bonds down this much. The S&P 500 is now almost back down to the pre-covid February 2020 level, despite earnings having risen from $155 in 2019 to an estimated $228 in 2022. We have seen all sorts of charts lately from our research providers that show future returns in stocks should be very good, given current indicators. These indicators include: 5-day periods when the S&P fell 10%, advance/decline levels, and consumer stress levels.
It may seem counterintuitive that buying stocks is a good idea when the consumer is paying high gas prices, higher mortgage rates, and higher food prices. And yet, history shows that it is the best time to buy stocks, because stocks have already dropped, and because (in theory), this line will eventually start to turn down:
Here’s how the market has historically performed in the 12 months after high readings for consumer stress. This chart ranks all months into quintiles of 20% of the months each. After the 20% of highest months for consumer stress (quintile 1), stock market returns are the best, at +17.4% on average. See the bar on the left side above “Q1”:
Again, we know not the date when the market bottoms; we never do. We’ve seen a few days lately when the best-performing stocks this year have been trashed suddenly, which typically happens near the end: investors “sell what they can,” meaning that which has held up well, rather than a stock that’s already down 90% from its high. Rising interest rates have been the main impediment for stocks, and they probably will continue to be until inflation starts to look tamer and convinces the Fed to back off raising rates. The Fed raised rates 0.75% yesterday, which was not a surprise. Fed members expect to raise rates by another 1.75% to 3.4% by the end of 2022, and to 3.8% by the end of 2023. Those increases have not happened yet, and yet are baked into the market’s current expectations. So any backing off from those predicted levels would be well-received by the market.
Interestingly, at the beginning of today, treasury bond rates were up 0.20% across the curve, from the short end to the long end. Stocks sold off, and by the end of the day, the short end of the curve was down as much as 0.15% from yesterday, and the long end is now flat for the day. There appears to finally be some flight to safety in bonds. The yield curve is basically flat from 2 years to 10 years at around 3.2-3.4%.
The door is always open should you want to talk about anything with us!