Stocks sank on Friday to close out one of the most miserable months for equities in many years. The NASDAQ took it on the chin the worst after Amazon# reported a weaker than expected outlook for its retail business when it reported results Thursday night. On Friday, Amazon# suffered its worst percentage loss since the collapse of the Internet bubble. For all of April, the NASDAQ had its biggest monthly decline since October 2008 during the abyss of the Great Recession.
Amid all this, bond yields stayed constrained after rising sharply earlier this year. All along the yield curve, Treasury rates remained in a 2.75-3.00% range, and largely discounted a move in the Fed Funds rate toward 3.00% close to the end of this calendar year. Although headline Q1 GDP numbers showed a surprising decline, if one backed out changes in inventory and world trade deficits, the economy grew close to 3% despite an Omicron surge early in the quarter, and the increased Russian sanctions as a result of the war in Ukraine. Q1 earnings reported to date indicate a growth rate of over 6% year-over-year. The outlook for the remainder of this year remains positive.
Stocks have been declining all year due to the rise in rates, a surge in inflation, and the likelihood that growth will slow as the Fed embarks on a path of interest rate increases. Why was the stock market, in particular, so weak last week?
There is an old expression we all know, “You live by the sword, you die by the sword.” Over the past many years, the S&P 500 soared led by a handful plus of growth stocks that caught investor fancy. Investors piled into index funds as a safe way to match market performance. Over 25% of the value of the index became concentrated in names like Apple#, Microsoft#, Amazon#, Alphabet# and Meta Platforms# (formerly Facebook). If you were an institutional investor bent on outperforming a market led by these five names and a few others, you had good odds of doing so if you owned more of each of these names than their market weighting in the S&P 500.
Last week, these companies all reported earnings. These reports came after a three-month period of market weakness already had investors skittish, but when only one of the five (Microsoft) reported a continuation of strong results, investors panicked. Not only did they sell most of the others (Meta actually rose, but for different reasons), but in order to outperform the S&P going forward, the selling became intensified by the desire of those focused on beating the S&P 500 who now want to underweight the leadership names.
As the selling in the names that made up a quarter of the index intensified, and investors moved to exit S&P 500 related index funds, the funds themselves became sellers of everything spreading the selling pressure beyond the top names to every company contained within the index. Once those 500 names went into freefall, virtually everything else followed.
Thus, we lived by the sword, chasing the growth stock led parade up for years, and now we are dying by the sword as the deteriorating outlooks of the S&P 500 leaders dragged the whole market lower.
Let me take a brief look at the big favorites of the recent past. Apple# actually reported ongoing strong growth. Its wart was supply chain problems caused by the rise of Covid-19 in China. That will pass. Apple# should do fine. On the other hand, the same can’t be said for Amazon# or Netflix#. Twenty years ago, there was barely any Internet shopping and there was no streaming. During the pandemic, everyone shopped at home and we watched lots of movies and serial TV productions, but now we are out and about. The mall isn’t just a series of stores; it’s a fun day out. We don’t just sit in a dark room watching Stranger Things or reruns of “The Office”; we resume our normal lives. Simply said, while the number of new Internet shoppers and Netflix# subscribers is likely to keep creeping up, these business segments have begun to mature. Growth rates of new users is now likely to be closer to GDP growth than 2-3x that number. I don’t need to go on. What has happened, on top of everything else that has been spooking investors, is that the market leaders, collectively, are maturing. Not every segment of every submarket is near the point of maturity yet. The movement to cloud computing is still probably in the middle innings. Artificial intelligence is still in relative infancy. Autonomous vehicles are still in the future. Tech isn’t dead at all. But just as the “old tech” names like Intel and Cisco# now grow revenues at rates close to GDP growth or less, the top dogs in the S&P 500 face a similar future, not tomorrow, but certainly over the next several years.
This realization, happening while markets are already in the unsettled process of adjusting to higher rates and lower growth, sent stocks reeling last week.
All this happens in front of an important Fed meeting this week. What isn’t in doubt anymore is that the Fed will raise the Federal Funds rate by 50 basis points. What everyone will focus on will be Jerome Powell’s forward-looking comments after the meeting concludes. In particular, investors want to hear plans to reduce the size of the Fed’s balance sheet. When the Fed is buying assets (Treasuries and mortgage-backed securities) it adds money to the economy as it certainly did for over a dozen years as it expanded its balance sheet from about $1 trillion to over $9 trillion. While that increase buffered the impact of the Great Recession and the immediate impact of Covid-19, it also fueled speculation leading to a sharp rise in asset prices. It also, ultimately, fueled inflation. Now the Fed is putting the lid back on the punchbowl. We already know its current plan to raise the Federal Funds rate to 3% or beyond by early in 2023, but what is less clear is how fast it might allow its balance sheet to decline.
Bonds mature. If the Fed did nothing, eventually, all its holdings, all $9 trillion worth, would mature and the balance sheet would go to zero. That isn’t going to happen. If the Fed simply chose to roll over maturing bonds, it could keep its balance sheet constant. The Fed knows that an expanding balance sheet fuels both inflation and speculation. It wants to dampen both. Rate increases will accomplish that, so will balance sheet reduction. We also know that as the result of previous actions both by the Fed and Congress to pour trillions into an economy that was partially locked down and limited as to how it could spend all the added money, there was a buildup of savings. It is estimated that $2-4 trillion of excess savings remains. Those savings aren’t evenly divided. The wealthy who own both stocks and their homes are the primary beneficiaries. Those at the bottom of the economic pyramid, without savings, see inflation erode their purchasing power. When the Fed raises rates, it impacts everyone who borrows. That means everyone looking to buy a car or home with credit. It means everyone with a credit card balance. When the Fed reduces the size of its balance sheet, essentially withdrawing the excess money sloshing around that feeds speculation, the ones hurt the most are those owning financial assets. All this is a long way to say, balance sheet reduction can help to limit the pain associated with higher rates, shifting at least some of the burden to the owners of assets.
The assumed Fed timetable incorporates 50 basis point rate increases at each of the next three meetings in May, June and July. The Fed most likely doesn’t want to start actively selling assets off its balance sheet at the same time. It probably will allow maturing bonds to run off, effectively starting the process of balance sheet reduction. The real key will be Mr. Powell’s hints on Wednesday during his post FOMC press conference, as to when the Fed will begin to proactively sell bonds and at what pace.
Simply said, when the Fed expands its balance sheet it is seeking to accelerate growth. If that happens when there is economic slack, it can do so without raising inflation. When the Fed reduces the size of its balance sheet, it works to decelerate the pace of growth. It also works to reduce inflation, but if it moves too fast, the risks of recession rise.
For months, we have learned the basic outline of Fed policy. As inflation proved more persistent, that policy has gotten more aggressive. Signs now point to an inflation peak that may have already passed, but the keys are wages and rents, both still rising sharply within tight labor and housing markets respectively. It will take months to determine when higher rates and balance sheet reduction begin to take effect.
We do know one certainty. As excess money flows out, the fuel for speculation is less. There isn’t any question, at least in my mind, that all the excess money fueled an enormous wave of speculation during the pandemic. Favored names like Peloton and Zoom have collapsed. Yet, that process may not be complete yet. Many stocks caught up in the frenzy are already down 50-80% from their highs. Before the dust settles, they may end up down 80-100%, but speculation wasn’t limited to those names. Netflix#, Amazon# and others just months ago were selling at prices far beyond historic norms, even allowing for the fact that interest rates were at historic lows. In the end, the purge gets to everyone. The stalwarts simply get beaten up last.
Given the price action last week, is the purge finally coming to an end? Maybe. You never know until after the fact. Let me make a few points.
1. If the goal for now is a series of interest rate hikes designed to bring the Fed Funds rate to 3.00% or a bit higher, most of the adjustment in bond prices is now behind us. Even if the Fed moves to 4%, a possibility but not a probability at this time, most of the impact is already priced in.
2. Growth has started to slow because of the impact of inflation on purchasing power, Covid-19 ongoing impact (particularly in China), and the war in Ukraine. It hasn’t stopped. The odds of recession are still no greater than 50-50 and, if there is a recession, it should be a relatively mild one. The financial underpinnings of our economy are solid, technology will spur growth in many sectors, and American consumer balance sheets are strong.
3. The law of large numbers always works in the end. Economic leadership changes. The five largest companies in the S&P 500 10-20 years from now will include names not yet born. Technology is an accelerant to change. Today’s disruptor is tomorrow’s disrupted.
Stocks are now down 10-15% overall from their highs. Many are down 20% or more. As noted, along the speculative fringes, stocks are down 50%+. Maybe the poster child is Robin Hood, the new brokerage platform aimed at younger speculators. Its trading volume is now down sharply and its stock is down close to 90% in less than a year. Survival isn’t certain.
A lot of damage has been done. Investors anxiously await what the Fed has to say Wednesday. Chairman Powell has no desire to spook markets further after the savage beating taken in April. He is likely to be as supportive of markets as he can be while saying the Fed will methodically fight the inflation battle until it wins. No one doubts it has the tools to win. We can only argue about how painful the battle might be. He will certainly try and make the argument that a strong early thrust can move the inflation needle without wrecking the economy.
With all that said, I am not convinced Friday’s carnage was the ultimate ending. The S&P 500 is now back to its winter lows. The NASDAQ is at new lows. Short-term, stocks could find some support here. Earnings are still growing and the burden of rising Treasury yields should recede in the months ahead. Another sharp leg lower will need evidence that the odds of inflation are dramatically higher than they are today.
Months as bad as April don’t generally repeat themselves the following month. Volatility and uncertainty remain. No one is raising outlooks or expecting lower interest rates any time soon. At 16.5x forward earnings, stocks are now fairly priced by almost any historic measure. No reason to panic now, but they aren’t cheap according to history either. To me this suggests directionless volatility for several months assuming no great changes in the economic data. May-October is often directionless. Clearly, the near-term key is whether Mr. Powell surprises markets Wednesday. If he doesn’t, a relief rally could ensue, but a relief rally isn’t an end point. That depends on trends in wage and rent inflation later this year.
Today, Dwayne Johnson is 50. Christine Baranski turns 70. Finally, Engelbert Humperdinck is 86.
James M. Meyer, CFA 610-260-2220