Stocks staged a solid rally on Friday on the heels of a sharp recovery Thursday afternoon. An encouraging sign was a strong last half hour although a surge late Friday may have been no more than short covering going into the weekend. The strength late Thursday and Friday, however, didn’t erase earlier losses in the week. As a result, the Dow Industrials declined for the 7th week in a row for the first time since the Great Depression.
Not to beat a dead horse, but the two negative influences on the market are the Fed’s pivot toward a tighter monetary policy and the purge of speculation that reached heights akin to the internet bubble of the late 90s, during 2021.
I wish I could tell you the twin correction processes are complete. Of course, no one really can without hindsight. Clearly, the pace of decline, particularly over the last few weeks, resembles the left side of a V-shape that usually characterizes market bottoms. The fact that stocks have declined in unrelenting fashion for seven straight weeks is a sign that a lot of damage has been done. There are some who suggest that the pace and breadth of decline last Wednesday and Thursday had characteristics of capitulation. Clearly, there has been some. With the S&P touching bear market territory on Thursday (down at least 20%) and the NASDAQ down much further, there has been a lot of pain without any hint of a serious economic slowdown. We will learn a bit more this week when retail sales and housing starts for April are reported. Both will show tepid or no growth in real terms. Retail sales are expected to be up about 7%, almost all price. Housing starts may decline as the impact of higher mortgage rates starts to kick in but any observer of the housing market would still characterize it as robust. In short, while the decline in stock prices has more and more investors convinced that a recession next year is inevitable, there is still no concrete evidence to back that up. Moreover, should there be a recession, all indications are that it will be relatively mild. The Fed would love for interest rate hikes to put some measure of slack back, but some measure of slack doesn’t mean high unemployment or a sharp drop in growth. To lick inflation, one has to restore balance. To goal is to stop the pace of price increases. That is what inflation measures. The goal is not to create a collapse of prices or growth.
It stands to reason that the Fed won’t thread the needle perfectly. It also stands to reason that if the Fed moves forward in a measured way, it can reverse policy or simply pause for a time to allow the impact of higher rates to flow through the economy. The hard part relates to the time gap between rate increases and impact. Look at the housing market. Mortgage rates today are over 5%. They were less that 3% just a few months ago. We know, anecdotally, that the higher rates are starting to impact demand. They are starting to limit the ability of potential buyers to purchase homes. But, to date, the evidence of impact is scant. This week’s housing start data will likely be the first early sign. OK, higher mortgage rates are starting to have an effect. What will demand look like around Labor Day? Will price increases slow? Will they start to fall? Collapse? We don’t know. Housing is an early cycle industry meaning we should see the impact of Fed policy there first. Home prices amid an imbalance of supply and demand were one of the first hints of runaway inflation more than a year ago. They could prove to be a harbinger of what lies ahead. Housing is also a point of political sensitivity. Young buyers want to own a home. They want to own it at a reasonable price. In addition, a home is likely to be a young family’s biggest investment. They certainly don’t want to see prices tumble after they buy. Thus, the key is moderation. Ideally, higher rates will let prices peak and maybe roll back a bit. That’s the ideal. Any deviation will be an early sign that Fed policy is still too loose or is too aggressive.
Economically, the bottom line for now is that the Fed will take short-term rates to a point where growth is restricted. That will alleviate some inflationary pressures. By the end of this year, inflation could slow to 4%, plus or minus 50-basis points. Assuming the full impact of policy takes longer, next year it could fall to 3%. Whether it falls below that will require both wage and rent pressures to return to pre-pandemic levels. Both will require adequate supply, meaning some enduring slack in the labor force and a balance of supply and demand in the housing market. It is far too early to make any rational conclusion whether one or both will happen. Labor force rebalancing will require a period of time when the growth in the labor force exceeds the rate of real growth. Housing rebalancing needs a healthy ongoing pace of new home construction.
For markets, the correction has reset investors’ expectations to a realistic level. Stock prices are back to a level that sits within the range of past norms. While P/Es on forward earnings are still a smidge above historic norms, long term interest rates are below historic norms. For a bear market to end, prices generally don’t fall back to normal; they become so cheap that values entice more buyers than sellers.
And that brings me back to the correcting of the speculative surge. It is easy to say that some of the more high-profile speculative names are down 75% or more from their recent peaks, but that isn’t the whole tale. Percentages can play tricks on us. The number of Covid cases may have doubled in recent weeks (Panic!!!), but the actual number of hospitalizations and deaths remains a small fraction of what they were during the Delta and first Omicron waves. Yes, four cases instead of two is an increase of 100% but hardly a cause for real concern.
Similarly, a decline of 75% means little. We know most assets were overpriced and many were absurdly overpriced. What matters is whether the reset has returned prices to fair value. For some, the answer is yes, but only for some. As noted earlier, returning to fair value may not be enough to entice serious buyers. For others, the process simply isn’t over. The future for names like Zoom, Peloton, and Beyond Meat is sobering at best. Every home isn’t going to have an exercise bike, let alone a Peloton. The non-meat substitute market has been there for years. McDonald’s is synonymous with a hamburger, french fries and a Coke. It isn’t the home of the veggie burger. If you don’t want to eat meat, you don’t go to McDonald’s. I suspect that Peloton, Beyond Meat and Zoom, just to name three. will never earn money to justify their current prices. In the EV market, only Rivian appears to have sufficient capital to get to the point where it can produce enough vehicles to make a profit. And there is no guarantee that even Rivian will get to that point. As for all the hundreds, maybe thousands, of other newbies, that had lots of promise and little to show beyond hope, many are on the path toward zero. Just as in the Internet bubble, backers provided funds to grow revenues and infrastructure. Profits didn’t matter. However, once growth and infrastructure were in place, more capital would be needed assuming proof of concept was achieved. Historically, that was done in the venture and private equity worlds. With SPACs, further support will require public support. Don’t count on it.
The net is that even if markets can find a bottom here, many or most out on the speculative fringes are going to die. As for the real companies that were simply overpriced, they are in the process of revaluation, but to attract buyers in a market falling rapidly, being fairly priced isn’t enough.
When bear markets end, it isn’t generally the speculative fringes that rally first. Assuming investors want to jump back in, they will look to do so with limited risk. Yes, some of the most high-profile names will have a dead cat bounce. Those bounces can only be sustained with solid and improving fundamentals. Investor favorites still selling at 10x expected revenues will not be able to sustain leadership. Twenty years after the Internet bubble burst, Cisco# and Intel sport record profits but their stock prices are still below 2000 peaks. In short, the speculative purge doesn’t end until the graveyard fills up a bit more.
That doesn’t mean the stock market can’t recover before the speculative purge ends. There are many stocks today selling well below historic norms at steep discounts to the overall market that can rally sharply, particularly if there is only a mild or no recession in front of us.
If you are looking for a marker to judge the end of excess speculation, look no further than bitcoin. Last week, it tumbled to less than $25,000 before recovering after one of the more popular stable coins (the new oxymoron of the crypto world) fell by more than 50%. While bitcoin has rallied back to the $30,000 area, its price action in recent weeks attests to the obvious, that it is an instrument of speculation rather than a currency or a placeholder of value. For the vast majority of bitcoin buyers, its sole attraction is the possibility to sell it at a profit. Since crypto currencies have no intrinsic or government backing (except El Salvador in the case of bitcoin), no one can measure their real worth. I have no idea what a proper value might be. I suspect the recent correction, and the lack of volume at exchanges like Coinbase have moderated some of the speculative appetite. The bottom is probably well below what pundits say the support level is today.
Mondays are not usually good days in bear markets. Futures are fairly flat preopening giving little hint as to what is in store today. Given that stocks have fallen sharply for 7 weeks, some relief is quite possible, if not likely. For any rally to be sustained, some fundamental support is necessary. At the moment, that’s hard to define. Perhaps stocks are entering a holding period of volatile sideways motion waiting for further evidence of what lies ahead. Bear markets don’t go straight down. In the economic world, little is absolute. There are some very tradable rallies within bear markets. Timing wise, it would seem to me that the time for a true bottom might be the fall. By then, inflation should show convincing signs of retreat amid an economy that continues to grow but at a very tepid pace. Earnings, thanks in part to inflation, will still be rising. Housing will be softer but still healthy. Supply chain issues should be on the path to resolution. Until then markets will shift gears away from relentless selling and fear.
Beyond the fall and beyond the current tightening monetary cycle, we likely face a long period of very slow growth. Birth rates are down as is immigration. I see no technological breakthrough that will ignite productivity growth beyond 2%. Thus, long-term growth is likely to be no greater than 2%. Add in slower growth ahead for developing nations and China, and you come to a conclusion that growth going forward will be slower than at any time this century. Once supply/demand balance is restored, inflation should stay close to its 2% target. That suggests long-term returns on equities somewhat lower than the average of the last century, perhaps 6-8% instead of 7-9%. Nothing wrong with that ignoring the fact that we were all spoiled by 2018-2021.
Today, Megan Fox is 36. Janet Jackson turns 56. Pierce Brosnan is 69 and one of the great bad guy character actors of all-time, Danny Trejo, turns 78. You may not know the name but Google him; I’m sure you will know the face.
James M. Meyer, CFA 610-260-2220