It has been some time since we have had the “darlings” of Wall Street be the “heels” of the market for such an extended period of time. It could have been due to their unabated runs higher or maybe their valuations seeming stretched, or maybe hedge funds and mutual funds feeling the need to diversify their portfolios. Whatever the case, I'm not particularly concerned about the why from a historical perspective, I am far more involved with concentrating on where things are going and where strength is being observed.
With so much going on right now and so much headline risk, I believe all we can really do is take this market day by day. Each session we want to see signs of things getting better rather than things getting worse, yet we always seem to be one bad news flash away from dropping once again. This is a market where 79% of NASDAQ stocks are in long-term downtrends now, as measured by their 200-day moving averages. Since we are now a week into the Russian / Ukrainian conflict, I think it is really time to quantify exactly what is happening throughout the world with our trading partners, and domestically what we are dealing with here at home. I see it as basically four issues that should be sort of put in their own individual space and evaluated as to their ultimate effect on the markets.
COVID
COVID has been with us for two years now. We are in the fourth variant; I think they are calling the newest strain Omicron2. What is important is what we are doing coming out the backside of this pandemic. The shutdown of the economy is basically gone. The supply chain is being alleviated. See chart below:
The mask mandates have been lifted in most areas (even schools are over it). And vaccination requirements are being challenged for OSHA validity and the need for them going forward is now being challenged due to the falloff in infection and declining death rates. In Orange County, most masks are not being worn in stores and restaurants, yet out of respect to those people that still feel susceptible and uncomfortable, they are asking some employees to continue with the masks. Given the almost complete absence of media commentary now, it is sort of like in the old days when the circus left town. They closed up the tents and the wagons and when they left town the memory remained but other than that there was very little conversation about it until the next time it is coming back to town.
Interest Rates
It is clear that we are going to experience a rise in interest rates. The Federal Reserve says so. The Fed Chairman, Jerome Powell, is requested to give comment after comment about the need for rates to be higher, and we are relentlessly watching all economic indicators and their implications as to how slow or fast and ultimately how high the rates need to go. With COVID about being over, this helps the economy open up and get back in its normal rhythms. And just when we thought things were getting better, we have an explosion in oil prices and the negative effect on gas prices. The intent of raising interest rates is to normalize growth rates in the overall economy and stifle the current high level of inflation which is the highest that has been seen since 1982.
The Fed is paying attention to the economic indicators and the overall growth of the economy to determine their course of action and the speed with which they feel they need to take this action. Bob Brinker said it best in his March 2022 report, “The major risk to the economic outlook rests with the Federal Reserve in the event they make a policy mistake and overtighten monetary policy.” Gasoline is a great mitigator of the growth of an economy since it is such a vital component used by the entire population. In Barron's over this last weekend, it was said that for every $1 rise in the price of gasoline, this would decrease GDP by .2% on an annual basis. Since oil has moved from $25 to almost $100, this is quite significant. Until the conflict in Ukraine broke out, there was indecision about whether the Fed might hike rates by .5% or .25%. Now that oil has moved closer to $100 and the entire world is on pins and needles about the ultimate outcome of Russia's aggression, the feeling is that the growth rate of GDP is due to be negatively affected and they will most likely only do .25%.
In any case, we have an additional $15 Trillion in the economy and the Fed really needs to do something to make sure prices don't just completely run away. Our economy is a big one and it is yet to be seen how successful the first hike will be or if the markets themselves will be able to regulate a lot of the increase in the cost of capital on their own. I think that as an economy we have been really quite spoiled by a zero-interest rate environment and that a rise in rates might appear to be a recession-creating event but more likely it should probably only curb the rate of growth of GDP by a small extent.
Inflation
This is the one that I think might last the longest. If one is to look at the move in overall commodity prices, relative to US equities, this is the first time since October of 2011 that commodities, as a general asset class, are now outperforming the S&P 500. I stress that it is the commodity index in general as I do not feel that it is prudent for most investors to consider individual commodities given their inherent price volatility historically. Please take a moment and read my comments in last weekend’s Barron’s article titled, “The Russia-Ukraine War: What Investors Should- and Shouldn’t-Do Now". The most widely followed commodity is oil. If one is to look at oil from the drilling and refining perspective, the US is the world's largest producer, at 18.6 million barrels per day (MBD). This is 20% of the world's supply. Saudi Arabia is #2 with 10.6 MBD and Russia is #3 with 10.5 MBD. This brings me back to one of my favorite articles. It was an interview with Harold Hamm, of Continental Resources, in the Wall Street Journal. Please take a moment to look up this article. It is titled, "How North Dakota Became Saudi Arabia." It was written October 1, 2011! Is it any coincidence that this is the last time that commodity prices really took off? I think not! Once again this issue was brought up this past weekend on the cover of the NY Times, "Our Great Challenge of Energy Independence Still Exists." Again, the point is that we have the capacity to not just be the world's leading source of oil, but also we are clearly capable of being completely energy independent!
Ukrainian Conflict
I refuse to call this conflict a war as it is more of an act of bullying aggression by Russia against a far less formidable neighbor than a war. It is appearing, based on media accounts, that the Ukrainians are far more proud and stubborn than the Russians had first thought. What is important is that it is the next "problem de jour" that is the focus of market friction and media banter. All of this leads to increased investor anxiety. But, at the risk of sounding flippant about those affected by the invasion, financial markets are just that, flippant, often forming short-term bottoms on news of geopolitical crises. Sometimes, it's because the crisis wasn't as bad as feared, and other times it is a response to central banks coming to the rescue to alleviate market concerns. This could mean that our Fed feels less hasty about raising interest rates as the conflict psychologically throws the brakes on a lot of normal investor behaviors. Equity markets tend to weaken leading up to the start of hostilities and then recover fairly quickly.
This could end up being the case here as the world has known of the Russian build-up at the Ukraine border for weeks if not months. Also, when the market examines the effect on the global economies with the conflict, it is understood that this region has had less of an effect on global economies than many had initially feared. The points being considered here are as follows:
- Will Russia move on to other countries? It appears that moves onto other countries are unlikely due to the mutual defense treaty of NATO members. Russia is finally getting breathing room now that oil is above its production cost of $50/ barrel.
- Will the flow of Russian energy to Europe be cut off? The extent to which energy supplies from Russia could be cut off is unclear and will need to be monitored. Many countries, like Germany, desperately need their oil.
- How will the Ukraine situation impact inflation? The initial likely impact could be on grains and oil- the primary products coming out of the "breadbasket of Europe."
- Will Russia's conflict with the west expand cyber warfare? It appears that it could definitely worsen. Investment in cybersecurity has stepped up, but it will take time to see how successful these additional precautions will be.
On October 22, 2012, Mitt Romney sat across a table from then-President Obama for the final debate of the presidential election. In this debate, "A few months ago, when you were asked what's the biggest geopolitical threat facing America, you said Russian. Not al-Qaeda. You said, Russian." Obama told him. "And the 1980s are now calling to ask for their foreign policy back." Obama downplayed Romney's fears, but it has been clear that Russia is consistently doing all in its power to build back the old USSR. Today, while Russia occupies a vast landmass, it is a relatively small economy among the developed and emerging nations of the world today. According to the World Bank's purchasing power parity measures, it ranked 11th in the world in 2020, behind Canada and South Korea.
In Closing
The primary goal in writing these reports is to help determine when it's generally a good time to get aggressive and when it's a good time to pump or slam on the brakes. I also try to do the same risk vs. reward evaluation across various asset classes and areas of the stock market. I care less about top and bottom-ticking every fluctuation since that's just not going to be possible and it's not necessary to make money in the markets. I don’t think that we can treat this current environment like any other potential bottoming scenario due to what is happening in Europe. January and February were obviously not a great time to be playing hard on the long side for stocks (both US and foreign), bonds, or a currency other than the US Dollar. Not much worked beyond energy and commodities in general, and much of the market was crushed even beyond what is being reflected in the major indexes. Strange as it may seem, as of this past week, 476 or 95% of the firms in the S&P 500 index had reported earnings. On average they were up 30.3% in Q4 from a year ago on the back of revenue growth of 17.7%!
These earnings and revenue numbers are great, but at the lows last month, only 105 of stocks trading on the NASDAQ were above the 50-day moving average, one of the worst readings in years. As of last week, 62% of US stocks are down at least 20% from their 52-week high and almost one-third are down 50% or more! We have been in a bear market! I don't care what the broad index number measures are supposedly saying. But at some time, things become overdone. The average day at anchor in Los Angeles harbor has dropped from 25 days down to 5 days. Still above the normal 1-2, but clearly much better. January durable goods orders- a measure of future manufactured goods increased 1.9% in January. If this is unchanged in February and March, these shipments will be up at a 13.2% annualized rate in Q1- clearly an economy in an expansionary phase.
I still don't think we have quite enough evidence to suggest that the selling is completely done, but I continue t believe any additional near-term downside is not likely to extend too far beyond what we've been experiencing. In general, I am always focused more on what could go wrong than what could go right. It all comes back to evaluating risk vs. reward. Where are opportunities and where are land mines in abundance? Where are opportunities larger than possible negative outcomes? We've never followed a war on Instagram and Tik Tok. Things are very different "this time" but we promise to manage to the best of our abilities for your wellbeing. Please call if any questions arise.
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