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April 13, 2022 – Investors are increasingly assuming that a recession is likely. Stocks of cyclical industries highly dependent on both volume and price growth are getting slaughtered, a sure sign that thoughts of recession are quickly becoming imbedded in stock prices. Market assumptions aren’t always correct. Bond prices, while rising, don’t suggest that 3%+ inflation is embedded in long-term expectations. Perhaps some signs that inflation is moderating in the months ahead will be key to stopping the current market downdraft.

//  by Tower Bridge Advisors

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

Additional information is available upon request.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

Filed Under: Market Commentary

Previous Post: « April 11, 2022 – Markets remain both cautious and conflicted. Defensive stocks rule. But as evidence starts to appear in the months ahead that inflation will start to recede, markets will rotate once again. That inflection point is still ahead of us, but buying defensive stocks today, near all-time valuation highs, is much riskier than it was two months ago. Meanwhile, the purge of excess speculation continues. That battle isn’t over.
Next Post: April 18, 2022 – We are entering peak earnings season. The focus will be almost exclusively on forward-looking guidance. Expect it to be tempered but positive. There are signs of a slowing economy but no signs yet of a pending downturn. »

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  • May 23, 2022 – We avoided a bear market with a late day rally on Friday, but it’s hard to assume that a bottom is in. With stocks now down about 20%, we are more than halfway to a bear market bottom using historic averages as a guide. If we assume, at least for now, that any pending recession might be milder than average, hopefully, peak-to-trough, this market can be kinder to investors than the average bear market. Bear markets are ugly but they don’t last long, usually months, not years. Hopefully, we can see an end before too long.
  • May 20, 2022 – Retail earnings wreaked even more havoc on stock prices this week. Discretionary and Staple stocks suffered the most, and bonds finally offered a safe haven. A small relief rally yesterday came as options expire today. Volatility is still here, but valuations are back to historic norms.
  • May 18, 2022 – Stocks have finally begun to rally, a sign that market valuations have normalized. Perhaps the recent sharp declines were too much. While a V-shape may be forming, hinting at a bottom, there are few signs that speculative fever has been fully purged or that investors can see clearly past the series of interest rate increases to come. An interim bottom seems more logical than a final one.
  • May 16, 2022 – Stocks had a strong rally Friday after a sharp recovery Thursday afternoon, but to be convincing, we need another strong follow through today. We’ll see. Markets seem to have made a fair adjustment to a slowing economic outlook and a good part of the speculative purge has been accomplished. But, while stocks have returned to fair value, they may not yet be cheap enough to ignite a powerful, sustainable rally.
  • May 13, 2022 – The 2nd worst start to the year for equities is finally bringing numerous signs of finding a floor. We’re not at the all-clear signal yet, but many world class companies are now trading at relatively favorable entry points for long-term investors. Numerous questions remain, so baby steps are suggested for those with excess cash waiting to re-enter markets.
  • May 11, 2022 – The messages of the bond and stock markets over the past week have been quite different. Bond prices are about where they were before the FOMC meeting, while stocks continue in free fall. The NASDAQ has performed worse as speculation continues to be purged from the market. That process is well advanced but shows no sign of ending yet.
  • May 9, 2022 – Last week’s market was highly volatile, with very little net change except for the high P/E NASDAQ names. The Fed did what was expected, and both earnings and economic data were in line with forecasts. Unless the outlook changes appreciably in the weeks ahead, expect volatility to slow. Against that backdrop, reducing risk is a better path than speculation.
  • May 6, 2022- Cinco de Mayo was not a festive affair. Initially, it seemed Chair Powell threaded the needle yet again with stocks staging a massive run after his speech Wednesday afternoon. That rally only lasted a few hours as rates spiked and stocks got whacked yesterday. We remain range-bound but are teetering on critical support levels.
  • May 4, 2022 – The key to the market today is Jerome Powell’s press conference at the conclusion of the FOMC meeting. What is key is whether or not he deviates from the current consensus on rate hikes and future reductions in the Fed’s balance sheet. Stocks are off to their worst annual start since 1939. I suspect today isn’t the day Mr. Powell wants to add more fuel to the fire.
  • May 2, 2022- When leadership gets taken out to the woodshed, the whole market dies. That is what happened last week. While some escaped (e.g., Microsoft) the loud and clear message is that the big boys of the S&P 500 are now at or near economic maturity. That isn’t a message a market already worried about interest rates and recession wanted to hear.

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