Stocks fell again despite a CPI report that was a bit better than expected. Investor fears of inflation continue to rise as real time survey data begins to show some slowdown. Slowdown isn’t recession, but no one can disprove a premise that deceleration won’t end until the economy is slipping backwards.
Earnings season begins this morning as JPMorgan Chase# reported weak numbers roughly in line with expectations. With the market in a bad mood, and management offering an outlook that suggests tougher times ahead, look for the stock to open at a new 52-week low today.
Over the past few weeks there has been particular weakness in several cyclical industries that have benefitted for several years from both strong demand and strong pricing. While supply has yet to catch up with demand in most cases, investors are assuming that will happen sooner rather than later. For instance, home builders have been setting new lows despite record prices and record demand. That surge has led to higher margins that history says are not sustainable. In some parts of the country, home prices are 30-40% or more above last year’s levels. That has created some fear of being left out, but it also chases potential buyers away. Sellers, seeing ever higher prices, are deferring any plans to sell until they sense some sort of peak. But that peak inevitably comes. When it happens, sellers will suddenly reappear, and prices will reverse course. With that said, 2022 isn’t 2008. Mortgage standards are much better today. Mass foreclosures aren’t going to happen, but prices will fall, as will margins. That clearly is already built into the prices of the home builder stocks, several of which now sell at book value. They may be long-term bargains, but they won’t start back up until there are signs of an economic bottom.
What I just said about home builders can be applied to a wide range of cyclical industries, from trucking to semiconductor manufacturing. In all these cases, any slip in volume or demand is likely to be accompanied by lower prices and lower margins. At some point, that will be fully reflected in stock prices. The bottom for these stocks will happen well before the bottom in earnings and margins.
A few weeks ago, inflation was the most talked about word on Wall Street. Today, inflation is competing with recession as the talking point du jour. No one can disprove any theories of when inflation will be defeated or whether our economy will slip into recession or not. To date there has been just one interest rate increase by the Fed, and no balance sheet reduction. The headwind to real economic growth is entirely caused by the pain of escalating inflation. As inflation recedes, and it will, the headwinds will be the rising borrowing costs associated with the pending series of Federal Reserve-induced rate increases. If there is to be a recession, it likely won’t happen this year. It may not even happen next year. Typically, a Fed-induced interest rate cycle leads to recession more than 50% of the time, but the recession doesn’t actually begin for 1-2 years. Does that mean stocks have to fall for another 1-2 years? Highly unlikely. For one, markets look ahead. One can argue whether they are pricing in a slowdown or a recession at this point in time, but clearly declines to date are discounting a level of slower economic activity to come at a time when all economic indicators still show a robust economy. Look at airline travel – domestically, it is above pre-pandemic levels. Home buying is still robust. Car sales are strong with only the lack of inventory holding back sales.
While markets react to expected slower growth in the future, they are also continuing to purge excess inflation. High multiple names, especially companies long on promise and short on earnings, continue to get savaged. That process is ongoing and is clearly not over.
It would appear, at least in my crystal ball, that markets are headed for a retest of the February lows. I will let markets judge whether the lows should hold or not. There is not likely to be any economic data to support either a further decline or a reprieve. The current data simply doesn’t support all the negative sentiment. An old Wall Street saw is that markets have forecasted 11 of the past 5 recessions. They do overdo it sometimes. At the same time, it is also true that long Fed cycles of increasing interest rates induce recessions more than 50% of the time.
As I say repeatedly, at the moment there are more questions than answers. Historically, markets peak when earnings peak. 2022 earnings should be higher than those achieved in 2021. That argues for some reprieve in the current negative sentiment before too long. Perhaps that suggests this current downdraft will end as stocks approach the February lows. But with that said, watch which companies set new lows and which stay strong. The bifurcation at the moment is clear. Defensives (utilities, drugs, consumer staples, etc.) are leading, while high-multiple stocks and price-sensitive cyclicals are lagging. Perhaps we are near the point where defensives are too expensive and/or cyclicals are too cheap. But until those signs appear, stay with what’s working.
If I had to guess, I would think that the Fed Funds rate will get to 2% fairly quickly, but the path beyond that level is unclear. The Fed wants to slow inflation but doesn’t want to crush the economy. Inflation will retreat from 8%+ quickly, but getting it down from 4% to 2% will be more difficult and time consuming. With that said, a few months in a row of receding inflation should improve investor sentiment. That may be a month or two away, but not much longer.
Today, R&B singer Al Green is 76.
James M. Meyer, CFA 610-260-2220