$5.5 Trillion Sidelined As The Fed Explores An End To Further Tightening

$5.5 Trillion Sidelined As The Fed Explores An End To Further Tightening

August 02, 2023

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Before I go into detail on August, I wanted to take a minute and talk about what has investors, both individual and institutional, on edge. If we take a step back and look at the last major correction period, it was the 2008 Financial Panic. Was that market breakdown a failure of bank risk management and borrower evaluation or was it the US Government? On one hand, we could say that lending standards were not stringent enough, but we could also say the US Government was equally if not more at fault due to it allowing banks to not be forced to use marked-to-market accounting and therefore not show the amount of bad loans on their books due to their upside-down real estate lending. This was then compounded by the government flooding the market with capital to save our banking system. Why does this matter now? We think a recession could be coming (on a sector-by-sector basis) because the economy was artificially stimulated during COVID. This created a kind of sugar high in the economy with the sugar being the massive amount of free money dumped on the economy.

In addition, due to super-high short-term interest rates, today, money is being sucked out of the system and parked. By rewarding short-term cash, the inverted yield curve (higher short-term rates than long-term rates) should eventually limit business investment and risk-taking in general. These are the parallels that are present. In 2008, the Government came to the rescue, and in 2020 the Government came to the rescue. In 2008 the banks soaked up all the cash to keep themselves afloat, and, in 2020, the money went to the public and subsidized people to do nothing. Both are very bad, but I am not smart enough to know exactly if not doing these actions would have resulted in worse economic shocks than have been experienced. 

This brings us to today. We are on the tail end of a Fed "tightening cycle." The Fed tends to stop tightening because it is beginning to see signs of economic slowdown, and, therefore, inflation should be squashed to an acceptable level. The issue, as is always the case, is that the Fed does as much as it feels "it should" but they tend to be wrong and either do too much or too little. Since this has been the most aggressive tightening cycle in some time, it would not be far-fetched to think that quite possibly they could be tightening too much, too quickly, and that a recession is sure to ensue. Since recessions normally take some time to materialize- often as long as two years, it is far too soon to be able to evaluate exactly where we are. The commercial real estate market seems to be saying that a recession is in the offing due to shocks caused by forced working from home and exorbitantly high refinance rates that don't support current prices. Refer to the article on the cover of the Wall Street Journal, Tuesday, August 1, 2023, “Shopping Malls Face Default, Fire Sales as Valuations Plunge.” On top of this, once people and businesses are accustomed to working from home, it is very difficult to bring people back to the office. Therefore, demand for commercial space has shrunk because of a "black swan" type of work environment change that nobody had planned for. 

Given the above backdrop, what are we as investors to do? The markets have been very strong for the first seven months of 2023. Is this over, or does it simply need a rest? Is there a chance that the $5.5 Trillion parked on the sidelines in short-term CDs and US Treasuries will need to come off the sidelines and look for higher expected returns in equities? To begin to answer these questions, we sit waiting for second-quarter earnings and corporate projections going forward for the remainder of 2023 and into 2024.

But before we get all the earnings, we are entering the month of August. I don't tend to pay attention to monthly returns specifically, but this year we are now testing the 4,600 level on the S&P 500, the 10-year interest rate is flirting once again with the 4% level, and August tends to be a non-performing month. Last year, in the heat of the 2022 bear market, it was down 4.2%. This doesn't seem like a big number, but this would equate to an almost 200-point decline in the S&P 500 if it were to happen again. Not fun by any means!

 

Anecdotally speaking, it seems most refer to August as a “month to lose money.” As mentioned above, last year, the S&P 500 fell 4.2% (but August 2022 took place when stocks were caught in a death vortex from January to September).

  • August is a month when many Europe and US-based investors take holiday, so there is a tendency for market depth to weaken. And if there is idiosyncratic news, the impact could be amplified.
  • As for “bad” Augusts, history bears this out, since 1950:
    • August Avg Returns; +0.01% (one of worst months)
    • Win-Ratio; 55%
    • Avg Drawdown; -3.2%, implying 150 points downside to S&P 4,430
  • When S&P 500 is up >15% thru July 31:
    • August Avg Return; -1.4%
    • Win-Ratio; 40%
    • Avg Drawdown; -3.5%

So, it seems that the stronger the year, the worse the August risk. What does this mean? It means one needs to respect the negative seasonal tendencies going into August. Moreover, as I mentioned, it does seem like many investors tend to be wary of the month. But keep in mind, in 2020 and 2021, August was an up month for stocks:

  • 2020; +7%
  • 2021; +3%

August is worrisome, but the media and many investors have already flagged August as a seasonal risk. The fact that so many are citing this as a risk, actually makes us think this is less likely to be the case as well.

Being a market watcher, I look for changes in the winds to let me know to be more careful or to pay more attention. Just like when the weather changes, it is sort of like one day the weather is from one season and the next day you wake up and everything seems to have changed. The wind could be from a different direction, or it could be stronger and colder, or it has been cloudy for some time and all of a sudden the sun is out and it is hot and humid. The same thing tends to occur in the markets. Well, last Thursday was that kind of a day. Wednesday the Fed raised 1/4 of 1% and didn't say anything different than had been expected. The markets did little and clearly didn't show the post-Fed meeting volatility that was expected. 

But on Thursday several things changed:

  • We got a GDP report that came in at 2.4% when the street estimates were for 1.8%. That is a pretty big difference from what was expected. Much greater strength. 
  • Japan came out and said that they were going to work to keep their interest rates low. This caused a currency disruption that also ends up affecting the valuation of equities. 
  • Oil broke its downtrend line at $80 per barrel which could mean higher gasoline prices. If gas is higher, this means less money to spend on other stuff, and therefore economic slowdown ensues. 

All three of these don’t create a recipe for disaster, but they do not help the economy stay on its feet. Instead, they further add fuel to the fear of a future recession right at the beginning of the least friendly month of the year.

So enough with the negativity! What could all of this portent for the rest of this year and into the beginning of next year? If history is any guide, this is nothing more than a pause that refreshes, and after a brief backing and filling, the S&P 500 tends to get back on its feet and continue its advance. Please see Ari Wald's illustration below which shows what has happened going back to the 1930s. What is important is that the S&P 500 is now nine months removed from the October 2022 low and after this short respite, the markets should advance going into the end of the year.

As the footnote on the above chart says, “These results cannot and should not be viewed as an indicator of future performance.” Markets never behave the same as the facts are always a bit different, but as has been seen, they often rhyme. You can rest assured that we will be paying close attention to what is going on today and what has happened historically.

Remember, August 3rd is the first pre-season professional football game. Doesn’t seem right in the middle of summer, but not a bad way to relax on a Thursday evening!

 

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