The further away from multiple banks failing and another shoe not dropping, the more constructive investors are becoming. While it would be rare for contagion to not occur, it is not impossible. Bank withdrawals are slowing. Fed borrowings are showing some semblance of returning to normalcy. Interest rates have spiked lower, which helps reduce the mark-to-market losses banks would incur if they needed to raise capital. It also makes borrowing more attractive, even if lenders are going to require improved financial records. As we have been saying, this is not 2008. Banks are in much better financial shape. Loans on their books are well below history. That does not mean we have an all-clear signal, but it is possible the worst is behind us, at least for bank runs. Stocks have recouped all of their post-Silicon Valley bankruptcy losses over the past several positive trading sessions as we enter the final day of the first quarter of 2023.
In the end, what mostly matters are earnings. Numerous companies report off-quarter, meaning they do not follow a typical calendar year and a March quarter-end. Many world-class operators have posted their latest quarterly results over the past few weeks. Those include Nike#, Lululemon#, Accenture#, McCormick, Oracle#, Marriott, KB Home and FedEx#. Each one of these companies bested street estimates, some by a very wide margin. Take another look at that list; it is well diversified with representation in many different sectors of the economy. This typically bodes well for the upcoming onslaught of earnings updates, starting with major banks in a few weeks. Granted, these are backward-looking numbers and do not reflect our new reality of a much tighter banking market, but we will take what we can get. They also do not include a slower March month. A soft landing is still quite possible if corporate profits can hold up and job losses do not accelerate. Consumer spending remains the driver of GDP.
Futures markets are also pricing in a rapid slowing of inflationary conditions. Money supply has gone negative for the first time in decades. Inverted yield curves precede deflation. Layoffs are starting to show up in sectors outside of Technology. Going forward, year-over-year CPI comparisons are going to get a lot easier following spikes last spring, after the Russian invasion. To name a few commodity price declines from this point last year: Natural Gas (61%), Lumber (56%), Cotton (41%), Wheat (33%), Crude (33%), Zinc (27%), Coffee (19%), Copper (14%), Corn (14%), Soybeans (12%). That does not mean that prices are going to come down dramatically, but CPI measures should start to slow quickly towards the 2% target as they are based off comparisons from elevated levels. Shelter inflation is wildly overstated as well, but has a lag effect. Prices and rental rates peaked last year, which will be the largest influence in bringing CPI back to preferred trends. Recall, shelter alone has a ~33% weighting. If inflation is finally beaten, the Fed can end this tightening phase. While positive on the surface, history points to less than stellar outcomes.
Fed Rate Cuts In History:
One of my most favorite investment phrases is “Don’t Fight the Fed.” It works out quite well when looking at the past. More importantly, it makes economic sense. When a central bank is in easing mode, they allow looser financial conditions, rising money supply, lower short-term interest rates and an opportune time for borrowers. This directly points to future growth expansion. Quite the opposite scenario occurs when the Fed is tightening, as markets have shown over the past 12 months.
However, as with any market mantra, there are some caveats. First and foremost, the Fed always makes a mistake and usually in both directions. Case in point from just the past few years, they let inflation run rampant and are now raising rates too far, too fast, breaking some bank balance sheets along the way. This also explains why stock markets do not immediately turn upwards when a tightening phase ends and an easing phase begins. Below are the past 9 rate cutting cycles dating back to the 60’s and their subsequent drawdowns.
As you can see (if not, email me for a clean version of the chart), immediate success does not happen. Since the Fed is usually in the process of making some sort of a mistake, they are late to the rate-cutting party. Oftentimes, this is because they increased rates too far in the previous cycle and economic conditions are in freefall. They do not recognize the oncoming growth slowdown until it is too late, causing earnings to drop and stocks to go along with them. Over the past 9 rate cutting cycles (which eventually proved bullish), the average drawdown before a final bottom was a whopping 27%. Even taking out Y2K and the housing bubble equates to a 20% decline from the onset of Central Bank interest rate cuts. While market pundits and headlines will cheer the Fed’s eventual pivot, history says to remain patient until economic conditions improve, or at a minimum, stop worsening. The Fed will not change its stripes until something bigger breaks their will to do so.
Brief Quarter-End Recap:
To say this was a wild quarter would be an understatement. We had two of the largest bank defaults ever. Inflation remained rampant. Future Fed rate hike expectations jumped by 100bps before dropping by 100bps a month later. Small banks lost billions of dollars in deposits. Gold neared a new all-time high in a flight to safety. Digital gold, aka Bitcoin, jumped 70% in another flight to an asset not tied to physical currencies. The Financial, Energy, Real Estate and Healthcare sectors were down 7%, 6%, 5% and 4% respectively during the first three months of 2023. All is lost, right?
Well, it was a tale of two markets. The Technology, Communications and Basic Material sectors were up 19%, 18% and 3% respectively. This goes in line with my previous notion of a rolling recession, where different pockets of the economy experience a sudden slowdown while others stay afloat. This is a direct side effect of shutting down parts of the economy during Covid while leaving others to operate in full. We are still far from a “normal economic cycle” as imbalances are still being worked off. Consumers are flush with cash, although at a depleting rate. Their homes are remodeled but vacation plans are ongoing.
To that end, the major averages also showed wide dispersion among the winners and losers. The Dow Jones, Russell 2000 and Equal Weight S&P 500 are basically flat for the year. However, the Tech-heavy Nasdaq is already up a whopping 15%. Although the average stock has not moved much, mega-cap FANGMAN is back, jumping 36% on average. Combined, this represents over 20% of the S&P 500, which is up 5% this year.
To put it another way: the 15 largest stocks in the S&P 500 have added $1.8 trillion in value, while the remaining 485 companies have lost $21 billion. The mega-caps are holding the S&P up, while the average stock treads water. Diversification be darned! I jest, but these statistics show how confusing stocks can be during pivotal times. Be careful what you own and remain true to your discipline. Every quarter will not contain such massive moves in both directions. As we near the end of this tightening phase, quality should continue to offer solid risk/reward. Most of all though, patience remains the rule of the game. Another bull market awaits.
Ewan McGregor turns 52 today. Christopher Walken is now 80. Al Gore and Rhea Perlman turn 75. Lesser-known Twitter co-founder, Evan Williams, is 51.
James Vogt, 610-260-2214