Stocks rose sharply all week as the NASDAQ rebounded out of bear market territory and both the Dow and S&P 500 cut their 2022 losses roughly in half. Oil prices remained volatile closing at over $100 per barrel. Pain at the pump continues but it isn’t getting worse, at least for now. Interest rates rose as the Fed commenced what is certain to be a series of increases in the Federal Funds rate.
Today, I want to reassess. As I have noted repeatedly, three factors have weighed on the market since late last year: the purging of excess speculation, rising inflation and the realization that the Fed would have to take action to slow demand, and the war in Ukraine.
No one can argue that the purging of speculation has been painful for that part of the asset world that drew in the most speculative dollars. Many high-profile stocks fell 50-80% from their 52-week highs. The flow of new SPACs and IPOs has stopped. With the Fed reversing course and no longer dropping money out of helicopters, and Congress stifled in its efforts to keep spending trillions, the only ingredient left to feed the speculative frenzy has been excess savings. Inflation is eating away at that. Without new buyers, these speculative assets cannot retain their value. Hence, their collapse. Is it over or was last week’s rally just a dead cat bounce? My suspicion is that the worst of the correction may be over. But, in some cases, maybe many cases, what we witnessed last week, if not a dead cat bounce, is certainly unsustainable. Here I am talking exclusively of companies that have little or no earnings, lots of promise, and uncertain performance records. Investors are rightfully asking how well ride sharing works in a world of $4+ gasoline. How much are we willing to pay for home delivery when both wage and fuel costs are rising sharply? Are all those stay-at-home conveniences worth as much when we are no longer confined? Will there be another EV story as successful as Tesla? Moore’s law said the power of semiconductors rises rapidly as the price of chips fall. Will demand grow as fast as chip prices rise? Can that be sustained? Six months ago, the answers to all these questions were very positive. At a minimum, outcomes today are questionable. Clearly there are some real diamonds embedded within the speculative froth, but very few. The purge isn’t over but a lot of the pain may have already been felt.
As for the war, it now appears to be in somewhat of a stalemate phase. I can’t predict the final outcome any better than you can. Nor can I determine the limits of Putin’s ruthlessness. In economic terms, which is what the financial markets focus on, most sanctions are now in place. The impact on key commodities has been felt and somewhat assimilated. Resettling 1-5 million refugees will be expensive and unsettling, but we are starting to get a handle on the task. Barring a sudden shift in the course of the war, it should become less of a factor on day-to-day swings in the market.
And that brings us back to the biggie, the war against inflation. First comes inflation itself. It is probably peaking about now as the effects of spiking oil and wheat prices reach end markets, but that leaves lots of unanswered questions:
1. How fast might inflation recede and to what base level?
2. How fast will the Fed have to raise rates and where is the end point for the Federal Funds rate? Current consensus is about 2.5%.
3. Will the Fed begin to reduce the size of its balance sheet (almost certainly) and, if so, how quickly and to what level?
4. Can the Fed do its task without creating a recession? That is the ultimate question, one nobody has an answer to yet.
Here’s what we do know.
1. While high inflation is keeping nominal GDP growth high, there are indications that real demand is being pressured, that retail and restaurant sales, for instance, are already seeing resistance and even some pushback on price increases.
2. Overall, demand is strong. Airline travel is near pre-pandemic levels even with reduced foreign travel. Housing prices continue to rise. Only the lack of inventory is impeding sales. Even with rising mortgage rates, future homebuyers don’t want to be left behind.
3. The war uncertainties probably prevented the Fed from raising rates 50 basis points last week. Whether it will start to increase by 50 basis points in the future will depend on data. Clearly quite a few increases are needed to get the Fed Funds rate to a point where the cost to borrow exceeds the rate of inflation even allowing for the likelihood that inflation will start to fall in the months ahead.
4. Inflation itself is starting to crimp demand for non-essential products and services. It is shifting the proportion of what we spend collectively toward essentials and away from discretionary items. It does so unevenly. As noted earlier, Americans are flying more, taking the money away from discretionary retail items.
What does all this mean for the stock and bond markets. If the Fed can succeed, expect the Fed Funds rate in 1-2 years to be either side of 2%. If the fight is more difficult than expected, the Fed Funds rate can exceed 2.5%. The 10-year Treasury yield is already up to about 2.2% and is likely to keep climbing. Consensus forecasts are for the yield to reach 2.5% by year end. That’s only another 30 basis points in a little over nine months, only a bit over 3 basis points per month. Unless one expects inflation to slow to 2-3% by year end, the only way I see rates staying below 2.5% is if we are headed for recession. While it is an increasingly popular forecast to suggest that recession is likely in 2023 or 2024, there is scant evidence behind that forecast. Weather forecasters can tell me with some accuracy whether it will rain on Thursday. They have no clue about the last Thursday in May. Similarly, economists simply have no clue what 2023 will look like. There are simply too many variables. Go back just a year and look at the predictions for today by the members of the FOMC. You will be shocked how far off they were.
Historically, markets have a bit of a hissy fit prior to the first Fed rate increase. Subsequently, markets tend to rise at least until there is evidence of a material slowing of the growth rate. Obviously, there will be some impact on demand from a series of rate increases, but there will be no immediate changes from one increase to a whopping 25 basis points. Rising interest rates will ultimately slow demand, but rising rates aren’t the only factor affecting economic growth rates. The war matters. Consumer confidence matters. There is an estimated $2 trillion in excess savings still sloshing around. Some of that will be spent over the next year or two. That will cushion the downside.
Earnings estimates for the S&P 500 still center around $230 this year and $250+ for next year. Stocks are a lot cheaper today than they were a year ago, but they still aren’t very cheap by historic standards. In technical terms, last week’s rally brought stocks back toward their declining trend lines. Most are still below, meaning the longer-term downtrend is still intact. Fundamentally, stocks are no longer startingly overpriced, but they aren’t bargains either. With that said, there are both pockets of strength and pockets of value. Strength lies in some obvious areas like energy and defense. I suspect most of those names are no longer cheap. Other names that have been very strong lately include insurance, rails (much more energy efficient than trucks), domestic banks, and healthcare. Remember that Joe Biden was VP when Obama was President and enacted the Affordable Care Act. That was a very good period for healthcare. He seems on a similar path trying to make healthcare more affordable for more Americans.
For more than a decade, buyers had the advantage over sellers. Borrowers had the advantage over lenders. Declining rates meant expanding P/Es favoring growth over value. Excessive money fed speculation. Today, sellers can raise prices, lenders make more money, P/Es are falling, and no entity is refilling the speculation buckets. Investors have to reset. Yet you buy stocks offensively. Companies have to grow to be more valuable. Our firm invests with the philosophy of growth at a reasonable price or GARP. That makes sense today. What is likely to work going forward is a combination that favors the growthiest part of the value chain. Growth at any price simply doesn’t work well in a rising interest rate market. In all times, there are companies whose value is so compelling that they grow in good and bad times. Think of names like Apple#, as an example. That’s quite different from a maker of bleach where demand surged during a pandemic but normalizes thereafter.
So, rather than guess whether there was a bottom two weeks ago or not, focus on who benefits and who doesn’t in the economic world that has changed vastly over the past 24 months.
Today, both Mathew Broderick and Rosie O’Donnell turn 60. Actor Gary Oldman turns 64.
James M. Meyer, CFA 610-260-2220