Before I dive into this week’s focus, I want to take a moment and talk about some major policy items that people should be aware of:
- First, I want you to remember that the markets (stock, bond, currency, and commodity markets) are discounting mechanisms. What I mean by this is that the price action that they are in is representative of what is expected to happen 12-16 months from now, not current behavior or what is being reported from last quarter.
- The second thing that should be acknowledged is interest rates. There are really three kinds of interest rates: the real short term (Fed Funds) that reflects the Federal Reserve's actions, the 10-year that reflects what happens in the business sector and is the dominant rate that mortgages are based on, and the long bond (the 30-year) that reflects the expectations of the economy.
- The third is the seasonal or Presidential Election Cycles. The last is corporate earnings, as a result, reflecting what companies are doing.
- Finally, I want you to notice what is happening with the various indicators that I pay attention to for the five primary causes of a bear market. See below for the five causes.
Now diving! I want to revisit the Presidential Election Cycle that I referenced in last week’s newsletter. This Cycle is a consistent indicator of general market action. Not only is it important as we are now in sort of a "dead time" for the current administration, but it is beginning to be clear that they want to save all their voter bullets for next year — with 2023 being an election year when they make everything look as good as possible to support their party. You will notice in the chart below that this Mid-Term year tends to not be a particularly good one. Needless to say, this dovetails with some very different economic indicators this year, rising inflation, and remnants of a global shutdown that most still don't understand or agree with. When all these unknowns are put together, it is clear that we have a less approachable market that could last into the second quarter.
The next point I would like to address is interest rates. I must confess that I do derive a degree of satisfaction to see four members of the Fed walking back their hawkish statement of Wednesday, January 26th. The media was there to scare the public and they did a solid job in doing so.
What was missed was what Powell said was the US Government's mandate. He stated repeatedly that the US Federal Reserve System was created in 1913 to perform all roles monetary. One of their key statutory mandates, however, is "to maintain orderly economic growth and price stability." It wasn't created to promote hyperinflation or to create depressions. Although the Federal Reserve officials said they want to avoid unnecessarily disrupting the economy, Powell declined to give specific guidance on the policy path, apart from saying that support should be removed steadily, and policy has to be more sensitive in responding to economic data. He was quoted as saying, "You always want to go gradually, in the economy. It is in no one's interest to try to upset the economy with unexpected adjustments."
That agency has better insight than any "Guru" in the world, particularly the ones on Wall Street. So, every time these Wall Street and Media self-proclaimed experts talk about "problems," it’s interesting to see that they rarely can provide a solution. So, if we are to look at the current status of 10-year interest rates, as I had stated above, they have ALREADY risen to a level that would indicate where rates should be when the economy is completely out of lockdown and after the heaps of money that has been thrown at the economy has filtered through to the places it is most needed.
Now notice the chart below, which reflects the 10-year yields. You can easily see how much and how quickly they have risen. You will also notice that we are right back to where they were in January of 2020, just before the Pandemic! Not a coincidence!
To build off the bond chart above is the move in oil that has been experienced. Please note that if one were to cut out the 6-month period of COVID (January-June 2020), oil has been on a steady rise, not a spike. With all the conversations about becoming carbon neutral, switching to all-electric vehicles, and taking up a more plant-based diet (getting rid of methane-producing beef cattle), oil continues to rise.
Why does it continue to rise? Because regardless of how we try and reduce our consumption, we still use it in other products such as paint, plastics, and various materials.
What I am trying to say is that oil tends to reflect economic prosperity at the manufacturing and industry level. Hence, after over ten years of dramatic underperformance of energies vs. technologies, the baton seems to have been passed. For how long will this change in leadership exist? That we don’t know but must be watching! Please take a moment and look at the progression of oil prices in the picture below. This is going back to late 2017, and you can see that oil prices have finally lifted off above the lid that was placed on them around $80 per barrel.
To address the course of earnings progression for the last quarter of 2021, I took a moment and examined how the reports have been coming out. As of last Friday, 56% of the firms in the S&P 500 had reported earnings. In Q4 earnings were up on average 27.1% on the back of revenue growth of 16.2%. Some 76% of firms that have reported have exceeded analyst estimates! This either means that analysts were way off in their expectations or companies in the face of all the issues either are way smarter than credit has been given, or the underlying economy is far stronger than originally thought.
Last week the market was described as "gut-wrenching," as markets across the world have been quite volatile. It was really a week of the good, the bad, and the ugly. So, to no surprise, the market volatility reflected this. If one is to remember last week, the only memorable news item was the dramatic decline in the largest social media company on the planet. Nobody even seemed to notice that the biggest internet AI and search engine company not only lurched to new all-time highs on the day following earnings, but also declared a 20 for 1 stock split.
Last, I want to update the five primary causes of a bear market that are the underpinning of the stock market behavior:
- Tight Money - The Fed has started its three-step process to reduce the level of accommodation it put in place. Step one was ending the Quantitative Easing program, which will end in March. The second is a series of rate increases into the end of 2022. The third and trickiest will be to institute a Quantitative Tightening program where they try and get some of this excess capital out of the system. These will all take time, and the bond market will tell you if they are going too fast or too slow.
- High Inflation - The current spike in inflation is due to three main factors: 1) extremely aggressive monetary accommodation on the part of the Fed who threw their entire toolbox at the Virus issue, 2) an extraordinary level of fiscal stimulus in 2020 and 2021 which created excess demand caused by inventory building due to the pandemic, 3) an almost complete shut down to the supply chain, therefore, cutting off the flow of inventory and causing the excess demand to be even more abrupt. The current inflation is around 7% - the highest since 1982. This acts as a tax on consumers, particularly those living paycheck to paycheck. As supply chain issues abate and inventory building stops, demand should be curtailed. Higher gas prices and higher interest rates should impose cost increases that should turn around price levels.
- Rapid Growth - Economic growth is clearly not keeping pace with the short-term measures of inflation. Labor is strong, but wage rates and hours worked are not. Corporate tax rates are not being raised nor are individual rates, so a level of low consistency should be welcomed. Long-term, fundamental GDP is growing in the 2% range, and population growth is declining. So, the fear of too rapid overall economic growth seems to be in check. Since the end of World War II, the rate of GDP has been around 2.1%.
- Rising Rates - The direction of interest rates can be more important than the actual level of rates themselves. As a result, rate increases from an incredibly low level can be challenging to businesses and investors. This has been evident in the actions out of the markets since the interest rate lows in July of last year. It must be remembered that the Fed had to throw everything they had at a situation that had never been dealt with on a scale that we have been experiencing, and they must bring things back to a level of normalcy for the economy to stay on a consistent growth path. This spike in everything the last few months will need to level off and possibly decline somewhat for us to be back on our normal course of supply and demand balance. It should be remembered that interest rates at the 10-year and 30-year price points could begin to flatten or turn down a bit, if the economy feels that short rates are doing the job that the Fed intends.
- Overvaluation - Expected earnings on the S&P 500 are expected to be around $220 for 2022 and $235 for 2023 based on current GDP estimates. This should mean the price to earnings ratio on the S&P 500 should be around 20-22 and therefore see itself move into the 5,000 range from the current 4,500. Not a huge increase, but an increase all the same. Given my first point of Presidential Election Cycles and interest rate volatility, the next few months could prove somewhat challenging until inflation and normalization are in check.
In closing, I don't see a recession coming on, nor do I expect the Fed to allow runaway inflation and spiking interest rates to be in the cards. For this reason, I feel it is super important to be sensitive to changes in the sectors that are performing and not performing as well as keeping a close focus on the leading companies in each of these. Commodities should continue to rise in price due to demand still being there and the excess purchasing power still lingering. Bonds should prove to be the worst place to invest, followed by the international markets that are heavily dependent on our consumption of their goods and services. Please take a moment to look at your retirement plans at work and make sure that you have adjusted the balance to reflect the current market environment. If you have questions, please feel free to call as we are all here to help any way we can.
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