Stocks rose smartly yesterday, with most major averages rising close to 3% or more. Tech stocks led the advance. The only losers were energy names as WTI oil prices dipped back below $100 per barrel. Interest rates continued to climb as the Fed began its FOMC meeting which will end this afternoon with the first Federal Funds rate increase since 2018.
Futures are higher again this morning. Should the market end the day on a strong note, it could be the first back-to-back strong sessions this year. As I have pointed out multiple times, there are three factors that have been weighing on equities over the course of the recent decline.
1. The fight against inflation – Most agree that the Fed waited too long to accept the fact that the economy was at full employment and inflation was not a transient event. But today the battle begins. What investors want to hear is that the Fed will stay the course – that it will raise rates in a manner that will slow demand, while at the same time, keep the economy growing. That would be a nice plan. Chairman Powell will try to articulate such this afternoon. Whether markets buy his tune or whether recession can be avoided are different questions.
2. The War in Ukraine – War itself is not a major economic event. Stocks rose while American forces battled in WWII, Korea, Vietnam, Iraq and Afghanistan. But sanctions are an economic event, particularly when they come during a peak bout of inflation. We have witnessed large spikes in commodity prices in recent weeks, representing those fears. The sanctions themselves are too new to have a true physical impact on supply and demand. Indeed, this morning crude oil futures are back to levels that existed before the Ukraine invasion, before the latest sanctions were imposed.
3. The purge of excess speculation – The excesses were created over more than a decade of excessively expansionary monetary policy and over $5 trillion of new spending authorized by Congress. Much of this was handed out at a time when everyone around the globe was restricted from spending in some manner. The excesses reached a peak early in 2022 during the SPAC boom, when NFT art works were selling for tens of millions of dollars, and when Bitcoin rose to $60,000. However, once Congress slowed spending and the Fed announced the lid was going to be put back on the cookie jar, speculative fever faded. Is it gone? Probably not completely.
On top of this have been China concerns, mid-term politics, and of course the ever-present Covid-19, which at the moment is shutting activity in part of China. But that stoppage is transitory, maybe a few weeks at most, and it won’t impact the long-term value of anything.
Therefore, let’s look at where we stand today on the three major issues affecting markets. I’ll start with the purging of speculation because I just made my primary point. A purge like we have been witnessing on the NASDAQ doesn’t just end one day. For one, investors have to separate real enduring growth companies from what I will call one-hit wonders. I have used Peloton before as an example. It makes a nice training bike for home use, and that’s worth something. It’s not worth anywhere near what its stock sold for a year ago. It reminds me a bit of Blackberry. Its phone was a one-hit wonder usurped by Apple and Samsung. Its core software was outstanding and still exists under a different and modified wrapper, but it is a shell of its former self. Peloton and hundreds of other IPOs and SPACs will fit under this umbrella before all is said and done.
Then there are the story stocks. Think Theranos. These are names that are hyped with absolutely nothing but a pipe dream behind them. They include some one-drug biotech wannabies, companies promising to be the next Tesla, or names that will create new energy sources that will truly eliminate the need for fossil fuels. They emerge during every speculative frenzy. They will stop going down when they hit zero.
Then there are real companies at insanely hyped prices. Every day for the past two months one or more fell 10-50% as its revenue or earnings (if there were any) failed to reach excessive expectations. Some still sell at 10x+ revenues. These are real companies. Some could be the next superstar, but they are still overvalued.
But, and this is a big but, there are some instances of the baby being thrown out with the bath water. Really good companies growing nicely whose stocks have fallen too far, too fast caught up in the purging of the ridiculous. Most of these are familiar names. Indeed, they were overpriced for a while, but not today. Without mentioning names, these are companies growing 2-3 times the rate of the average corporation whose stock now sells close to a market multiple.
In summary, the speculative purge may have occurred a little too fast in some cases, creating values in a sea of many casualties. If the market rallies, this entire sector will rally hard. But quickly the wheat will be separated from the chaff. Real names will stabilize or rally. The pretenders will sink to the bottom. Be careful here.
Now to the war. Predicting war outcomes is out of my league. But barring an enduring cease fire, this looks like a horrible human tragedy that isn’t going to end soon. The only true winners will be defense stocks. NATO can no longer count on American protection the way it has in the past. That isn’t a knock on President Biden who has pulled together a unified front, but it is a reflection on both Russian aggression and the fact that we have very different Presidents every 4-8 years. The war has created some commodity spikes that aggravate inflationary pressures near term, but except for a few metals and wheat, its impact won’t be enduring economically.
And that brings us back to the biggie, the battle against inflation. The good news is that it should be peaking within a month or two. Unless oil prices spike significantly higher from here, we may have seen the worse. Once again, note that inflation is not a measure of price but the rate of change in prices. If prices stay elevated, but stop rising, inflation falls toward zero.
To be sure, inflationary pressures won’t suddenly go away. Hourly workers are still behind the curve despite higher wage increases. They have some catching up to do. Rent or imputed rent increases within inflation measures haven’t caught up to the real world yet. They should this year. But we are also starting to see some of the supply chain issues resolve themselves. The number of ships anchored off California ports is down by almost two-thirds since December. The backlogs won’t be solved overnight, but they seem to be moving in the right direction. As the situation clears, hoarding and double-ordering will subside. As new car dealer inventories rise, and may take another year to fill lots, used car prices will come down. Higher gasoline prices will keep more people working from home while others will carpool or use public transportation.
Inflation today is about 8%. 10-year Treasury yields are barely over 2%. TIPS spreads are still under 3%. Markets believe that inflation will be arrested. With that said, the 10-year yields are rising and yield curves are flattening. Investors aren’t convinced that inflation is going back to 2% or lower and they are increasingly skeptical that a recession can be avoided.
I doubt we will see a recession this year. There is still $1-2 trillion of excess savings Americans will fall back on. Home construction is booming. Builders’ sales for 2022 are already booked. Auto sales will rise as more new cars are built. Next year isn’t so clear. It will depend on whether the Fed dampens or crushes demand. Employment is a lagging indicator. Employers don’t lay off workers in anticipation of slower sales, they do so after sales slow.
Soon we will get first quarter earnings reports. It has been a tough quarter that tests management acumen. Omicron peaked in January. Shortages continued. War began in late February. Sanctions brought spikes in prices, particularly for fuel and freight. Some will skate through; some will hit potholes. As investors, watching reactions to any preannouncements will be key. If stocks slough off bad news, it means it was anticipated. If they drop heavily, there is more pain ahead.
Today will be an important trading session. FOMC days are always volatile, but much of what the Fed is likely to say is already anticipated. Markets want to hear that Chairman Powell intends to bring inflation down, but they don’t want a message so hawkish that it raises recession fears. It’s a fine line. Powell has learned how to traverse it. Hopefully, he does so again today.
Today, Joel Embiid is 28. Actor Victor Garber is 73. Former Wall Street leader Sandy Weill turns 89.
James M. Meyer, CFA 610-260-2220