We have so many issues to mention that are negative I don’t intend to bore you with a full explanation of each, but just so we can reference them, the more important ones are:
- Russia/Ukraine Conflict
- Rising Interest Rates
- Rising Inflation
- Slowing Economy
- Debt-Ceiling Debate (latest)
- "Sell in May & Go Away"
Along with these, we have a President who seems to have acuity issues and earnings estimates that are too high. Even though, as of May 1st, 64% of the companies that have reported earnings have beaten estimates by 7%. Is this a case of underpromise and over-deliver? Again, the markets are more of a function of measuring possible desirable outcomes vs. a risk-free rate of around 5%. As Warren Buffet said a couple of weeks ago, “Short-term rates up at this level has created a complete revaluation of real estate, stocks, and bonds, across the globe.”
All this may be going on, but the stock markets of the world refuse to go down. They’ve gone up, progressively, since October of 2022. This is almost six months of a new uptrend! Evidently, the stock market sees better times ahead. Mr. Market tried to throw in the towel last week with two severe, 80% down days, only to be followed up by some pretty ferocious up moves on Thursday and Friday. Monday started with a bang when it was declared that JPMorgan had purchased First Republic. Since this represented one of the biggest bank failures to be seen (the second biggest in history to be exact), the expectation was surely for the stock market to drop in sympathy, yet it shook it off as yet another hurdle. Saturday morning didn't start too good either as Barron's focused on an article titled, "The Fed Has No Good Options. The Risk of a Misstep Is Growing."
The Fed's job was never going to be easy. Taming inflation is not something it's particularly good at. It tends to raise rates too far, throw the economy into a tailspin, hit the gas again, and surely needs to squash inflation in a second try after a painful recession. The closest comparison is the Volker period (1978-1982). As can be seen below, not only are these two periods similar, they both eerily dropped exactly 27% and then both recovered!
The key here is that markets tend to bottom BEFORE the fundamentals do. Now, it will not be clear that the bottom last October is truly "the" bottom, or whether the markets will go down into another swoon, but with all that is being thrown at it (see ample list above) it does seem to be showing incredible resilience. This week arguably could be the most critical in some time as it could be the time that the Fed raises rates and then states that it is on hold until the economy gets a chance to digest the amount of tightening that they have done. In looking at CPI (the index of consumer prices), it appears that over half of the components of CPI are actually in outright deflation. This is also very similar to the Volker era as seen in the picture below:
So, this brings me to my most logical question, "If Volker took the market down 27% before it rebounded, and this time it appears that the market has also begun its rebound after a 27% decline, how long did it take the market to get back on its feet and reverse this decline during the Volker era?" The answer is that the entire decline was erased in four months. I am not saying this to imply that the same recovery was/is expected here, but what I am saying is that the markets seldom wait till the Fed is done to begin its recovery. To show you what happened back in the early '80s, see below:
This brings me to my last important point and that is the fact that the Fed seems most fixated on the labor markets. If unemployment doesn't rise and wages don't stop rising, the Fed fears that inflation would surely continue at an unacceptable pace and the need to raise interest rates will continue. The missing point here is that technology is deflationary. Increasingly powerful and specialized software adds efficiency in numerous ways. Adding globalization to this picture and this deflation even improves more. Across the world, we are doing more with less, and more with fewer employees. This means greater margins, fewer fixed costs, less waste, and better timing of everything. We are actually at a point of labor shortage across the world. Global population growth is slowing and has been for some time. Remember birth restrictions in China? Now, in the US, younger people are just simply averse to bringing new kids into a world they find so bad. So, if we have a labor shortfall, the measure of unemployment should be skewed incorrectly and consequently wages would remain stubborn as there would be fewer entering the labor force.
So, to finish, I want to provide you with a list of current facts of why I believe that we are in a better place, even though higher interest rates have been a difficult pill to swallow. According to Thomas Lee, of FundStrat, who has happened to be the most accurate public writer and commentator on the markets in this cycle, October 12, 2022, was the probable low. The reason why it has remained difficult to accept this is that there is so much negative news and crosscurrents that appear to each be nasty enough that individually they could put the markets back into another tailspin and break to lower lows (again reference the list at the beginning of this commentary, and feel free to add any more you would like). In looking at the table below, Mr. Lee doesn't prognosticate anything but rather provides statistics that cannot be disputed as they are historical facts.
- Inflation Peaked: on June 22nd. In the 3 prior inflation bear markets, equities bottomed with a CPI peak.
- Rule of 1st 5 days: on January 5, 2023. Since 1950, the 7 preceding instances of the negative prior year and 1rst 5 days gain} 1.4%, 7 out of 7 times.
- 2 consecutive quarters of gains: March 31, 2023, since 1950 this has never happened in a bear market.
- Over 15 weeks above the 200-week moving average: February 14, 2023, since 1950, 12 instances and never a single instance of markets made a new low.
- AAII percentage of bulls -26% (52-week average): January 12, 2023, only 3rd time since 1987. 1991 and 2009 occurred after the low.
So, it is pretty obvious why this week's data will be critical. We started the week with First Republic's final demise, we then get the Fed's latest actions on inflation, and we get closer to the debate over the debt ceiling (Biden has called for a May 9th meeting). Kevin McCarthy set forth some solutions that the Republicans supported, and Biden said he wouldn't comply and refused to negotiate. Sounds like another reason to stay up at night. Let's hope that our political leaders can come to some compromise before we have a national liquidity issue. I will be sure to keep you informed of what we see that is important and give you indications of what we feel could be the outcomes. Please don't hesitate to call with any questions you may have.
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