Stocks staged a relief rally yesterday, but based on the futures market overnight, it isn’t likely to last. Bond yields moved a bit higher but are falling back this morning. Oil and crypto are also giving back yesterday’s gains.
Last week was one of the worst weeks for stocks in recent memory. The first 5 ½ months of 2022 are off to the worst start for any year since 1932, during the depths of the Great Depression. In June of that year, Republicans were busy nominating Herbert Hoover for a second term. We know how that ended.
What sparked the decline, actually a carryover from the week before, was a CPI report that showed inflation continuing to stay elevated and a response by the Federal Reserve to accelerate its pace of interest rate increases. The 75-basis point boost was 25 basis points higher than anticipated before the CPI report. Other information coming out of the Fed’s FOMC meeting suggested that the Fed Funds rate would rise to well over 3% before year end and could reach 4% early next year.
Wall Street’s response was swift. Stocks fell sharply as investors became increasingly concerned that strong Fed action raises the odds of a possible recession. While the bond market was also volatile, rates across the curve didn’t move much at all. Last week’s reaction was all about the future pace of economic growth, the possibility of a recession, and a second look at 2023 earnings expectations.
As stocks declined, Wall Street strategists hurriedly redrew their roadmaps for the stock market outlook over the next year. All those thoughts that the S&P 500 could be at a record high close to 5000 by the end of this year were thrown into the garbage. Now 4000 appears optimistic and numbers below 3000 are being floated around. Indeed, last Monday I offered a wide range of outcomes based on projections for next year that vary from 3150-4150, largely dependent on whether a recession happens or not. We have been consistent for quite some time that until the Fed got to the point where its battle plan matched up with bond market expectations, stocks would have a difficult time moving higher.
When the news is good, expectations rise. Analysts and strategists raise targets to stay ahead of the game. When the news is bad, the opposite happens. All of a sudden, “how low can you go” seemed to be the game everyone was playing last week. We have already seen a dramatic change in the housing market. Two months ago, homes were sold before they could be formally listed. Now sellers are lowering asking prices and buyers are waiting to see how far down they are willing to go. That’s what a 2% rise in mortgage rates literally overnight will do. Housing reacted first because mortgage rates key off 10–30-year bond yields, not the Fed Funds rate. Other variable debt, like credit cards, react later to changes in the Fed Funds rate. Look for a reaction there soon. Retail sales, adjusted for inflation, have been down all year. The need to pay for necessities has crimped the abilities of many to splurge on discretionary items.
I often harken back to Newton’s law that says for every action there is an equivalent reaction. We all know by now that the Federal Reserve was way too late taking up the fight against inflation. As a result, it has had to raise rates more quickly over the past three months than it previously anticipated. The economic reaction to rising rates takes some time, some say months, a few say a year or more. But as we now see in housing, when the impact hits, it can hit hard. Housing is a bit unusual because it is an industry so dependent on long-term borrowing. The change in interest rates logically doesn’t impact how much toothpaste you buy. But borrowing costs are important in many ways, as they impact everything bought with a credit card, car loans, the cost to carry inventory, and the cost of capital to support expansion.
Because of the time gap between action (rate increases) and impact, the Federal Reserve is always flying a bit blind. It’s never sure how much medicine to give. Fed Chairman Jerome Powell has noted many times that he preferred to follow a slow steady path, but because the Fed was so far behind, that was a luxury he couldn’t afford. He has already promised a 50-75 basis point rate increase in July. As we saw in June, that isn’t even carved in stone.
When strategists and economists talk of pending recession related to the Fed’s efforts to tame inflation, what they really are suggesting is that the Fed will overmedicate. It will end up raising rates too far, causing a recession of uncertain duration and strength. Said slightly differently, when the Fed starts to see a slowdown in inflation, the economy could already be in freefall. By the time it starts to lower rates, it could be too late. That also brings into question the declining growth in the money supply (M2). When that dips below the level of inflation (it already has), real growth will decline unless there is an acceleration in monetary velocity, a term that describes how fast money changes hands. The problem is that when an economy slows down, so does monetary velocity most of the time.
Thus, the Fed is in a bind. It knows it has to create enough slack to rein in inflation. It wants to get inflation back to 2% over time. That’s a long way from 8%+ where we are today. While data already reported seems to show that medicine to date has had no impact, there is a lot of anecdotal evidence to suggest slowing has already begun. I noted housing. Home prices themselves are not included in the CPI or other inflation indices, but rents are. The CPI calculation attempts to place an implied rental rate for owned and occupied homes based on apartment rents or surveys asking homeowners what they think they could get as rent for their home. The actual number is usually a lagging number. It was far below the actual pace of rental increases for many months but has started to catch up lately. It will still be rising even if rents start to fall, but eventually will stabilize. Food and energy prices also show signs of either rising more slowly, or receding a bit. Thus, there is hope that over the next few months there will be some reduction in inflationary pressure. Some doesn’t mean we will see 2% inflation anytime soon, but it does mean that directionally, Fed actions are starting to take hold. If that happens, markets should react positively.
That brings me back to Newton. Investors are in a sour mood. Speculative money is drying up. Bitcoin fell below $18,000 over the weekend while other cryptocurrencies suffered more. All those growth giant wannabies that came public over the last few years without any hint of earnings are headed toward zero and may just get there. But for some companies and some industries, a lot if not most of the pending bad news may be priced in. Banks and investment banks have fallen below book value in some cases. Ditto for homebuilders. For a homebuilder, selling below book value means that the land on the books, accumulated over the past 5 years, isn’t worth what was paid. Furthermore, all the homes in process of being built will be sold for no profit. That’s almost certainly a bit draconian. When a company like Goldman Sachs sells below book value (all its assets are marked to market daily) it means the intellectual ability of its employees to make money on those assets is negative, i.e., they are more likely to lose money in the future than make money. Another draconian assumption. Stocks go down because there are more sellers than buyers. Just because a stock is a great value doesn’t mean it can’t become a greater value. Nibbling at stocks of well managed companies with predictable and steady rising cash flows at bargain prices isn’t a bad idea. Warren Buffett has said that the difference between stocks and socks, besides one missing letter, is that shoppers are happier to buy one at 25% off than the other.
Today and tomorrow, Jerome Powell will speak to Congress. It’s summertime in an election year. Mr. Powell will attempt to stay on message, consistent with the FOMC meeting last week. As long as that happens, the talks shouldn’t be yet another negative for markets.
Markets are oversold. Traders, even the most bearish ones, expect a relief rally of 5%+ before long. One-day rallies like yesterday don’t qualify. Next week is quarter’s end. There is a lot of window dressing and index rebalancing that could impact volatility. Beyond, earnings season starts in mid-July. The last one in April was badly received with a bunch of individual names, from Amazon# to Walmart to Netflix, getting clobbered. I don’t expect the same companies to have similar reactions again. Bleaker outlooks have already been built in. As always, earnings season is a contest between expectations and actual results. Clearly, over the past three months, expectations overall have been lowered, but almost everyone’s outlook going forward will be unclear and somber. Looking for positive news? It will likely have to come from the inflation front. After all, the fight against inflation is the epicenter of the current economic battle. Any hint of lower gasoline prices, for instance, or better supply/demand dynamics would be a big lift to confidence. Remember the saying that it’s always darkest before the dawn.
Today, Cyndi Lauper is 69. Both Senator Elizabeth Warren and Meryl Streep turn 73.
James M. Meyer, CFA 610-260-2220