The market has been volatile all year, but last week was volatility on steroids. The Federal Reserve on Wednesday did exactly what we outlined last Wednesday prior to the conclusion of the FOMC meeting. Exactly. It raised the Fed Funds rate by 50 basis points. It said it would likely do the same at the next two meetings. It set a course to reduce the size of its balance sheet at exactly the pace we outlined before the meeting ended. Oh, you could argue about tone, level of long-term optimism, etc., but the facts were as outlined, and no one should have raised or lowered expectations of future actions based on what was said on Wednesday.
With that as a backdrop, markets rallied before the meeting, hoping for a relief rally. By the end of the day on Wednesday, the Dow was up well over 1000 points for the week-to-date. Then on Thursday the bears reappeared, wiping out all the gains in a few hours. Friday morning continued the decline. An afternoon rally left both the Dow and S&P down less than 0.2% for the week, despite the wild swings. The NASDAQ, however, continued to fall, with a drop of 1.5%, in line with further increases in the 10-year Treasury rate. Economic data last week, ending with Friday’s solid jobs report, showed continued employment gains in April. Most of the data reinforced a moderate decline in the pace of economic growth. At the same time, the economy continues to improve, with no signs of impending recession.
Where that leaves us is in a continued land of uncertainty. We know what the Fed intends to do for the next several months. The Fed Funds rate will likely be 1.75% by mid-Summer, and at least 2.5% by year end. If inflation doesn’t subside at a measurable rate, 3% is possible by year end. We also know that the Fed intends to reduce its balance sheet, reaching a pace close to $100 billion per month by late Summer. That will suck up some of the excess capital that has been sloshing around the system for months. It will also further dampen speculation in the stock market, housing, Bitcoin, and other corners of speculation. While we have a fairly good idea of what the Fed intends to do, we have much less conviction surrounding the outcomes of those actions.
Let’s examine the positives and negatives, starting with the positives. If the Fed succeeds, population growth, greater participation in the labor force post-Covid, better supply as pent-up demand is satisfied, and lower demand caused by higher rates will combine to create a soft landing. A soft landing might be defined as low single-digit growth coupled with decelerating inflation. Few expect inflation to retreat to 2% overnight, but if the rate falls to 3% by early 2023 that would be considered a victory. How could that happen? A lot must go right. Oil prices have to stabilize. Right now is the normal seasonal peak. Higher interest rates will suppress housing demand, slow the pace of price increases (maybe even reverse them), and eventually halt the skyrocketing rents. Slower demand at retail, a slack housing market, and other deflationary pressures would slow the rate of wage increases as well. If all this comes about, long-term inflation expectations would remain at or below current levels, while earnings could continue to grow. Stocks would find a bottom when the end of the Fed’s interest rate increases is in sight and intervening data shows dual success in moderating both GDP growth and the pace of wage gains. In that scenario, earnings could reach $250 or higher in the S&P 500 next year, and the P/E ratio could rise as rates start to fall when the Fed becomes less aggressive.
Now the negative picture. Inflation remains stubbornly persistent. Despite some healing of broken supply chains, there remains enough demand to keep wage rates rising at rates too high for the Fed to release its pressure. The selling of assets off its balance sheet further diminishes speculation leading to further declines in the price of speculative assets. These include high growth stocks listed on NASDAQ, cryptocurrencies, second homes, NFTs and other forms of leading-edge art, and long-term bonds, particularly those of lesser quality. GDP doesn’t recede to slow growth; it falls to negative growth. Earnings start to decline. Lower earnings and higher P/Es lead to a bear market of unknown size. The S&P 500 is off more than 13% from its peak, but that doesn’t discount recession or lower earnings.
Both outcomes are quite possible. Obviously, on Wednesday afternoon investors were betting on the former. On Thursday and Friday mornings, the vote was the opposite.
So, what is one to do?
Think of sailing into a storm. The goal is to survive the bad weather. We have had a lot of bad weather lately. There are no believable forecasts yet of clear blue skies ahead. Here’s a strategy:
1. Reduce risk and protect capital. That is THE primary goal. In any storm, survival and damage mitigation is the first goal.
2. Don’t lose sight of the fact that storms end. The Fed isn’t going to raise interest rates forever. Some companies can continue to grow even in the worst of economic times. There are necessities we all need. Spectacular new products will get buyers’ attention even in the worst of economic times.
3. The last two recessions were in 2007-2009 and in 2020. Should we be facing one, it will be unlike either. The 2007-2009 recession resulted from a way over-leveraged housing market, and a poorly capitalized banking system. Too much reliance on derivative securities. That isn’t the case today. The 2020 recession was entirely caused by a lockdown caused by Covid-19. That isn’t happening again. Any recession this time around is going to be the result of rebalancing supply and demand within a financial system that is sound. Such recessions exude short-term pain, but long-term the forces of population growth and productivity win out. There will be sunshine after the storm
4. Move toward low-beta stocks. Bet on growth stocks selling at below market P/E ratios. A dividend well supported by free cash flow that rises annually and yields more than 10-year Treasuries currently offers solid support. Overweight companies that are less dependent on a strong economy for success. Stay away from companies dependent on low interest rates. Most of all, avoid stocks that sport very high P/E ratios. It may be interesting to note that over 20% of the stocks in the S&P 500 are up year-to-date. On the bond side, overweight high quality and short-term maturities. Spreads widen when the economy deteriorates. Lower quality bonds may offer higher yields today, but their prices will weaken if markets start to favor higher-quality debt instruments.
5. Most importantly, watch your asset allocation. Bias it below your historic norm but within normal ranges. In doing so, favor short-duration bonds.
This is not the time to be a hero. Nor is it the time to panic. In taxable accounts, many investors have large unrealized gains. Suppose you own a stock at $100 with a cost basis of $40. You may have to pay 25% on the $60 gain, or $15. Thus, your net is $85. That’s your “real” net. Therefore, you must ask, “is it a sale at $100, given I am only going to realize $85?”. If I sell one stock at $100 to buy another with my $85 proceeds, now or later, am I likely to come out ahead? The answer could still be yes. But it’s a question to be asked. If you own equities in an IRA or other tax-free account, the question is different because there are no tax consequences.
Clearly, we are entering a storm. This one is created by the Fed. Growth will slow. Interest rates have been rising and seem likely to continue going up. That means P/Es are falling. So far, earnings are holding up, but the path forward is uncertain. As I noted above, don’t panic. Decisions are rarely black and white, but rather shades of gray. If you are nervous and don’t see clear skies ahead, take some money off the table. Some. Maybe 10% of your equity exposure. Then stand back, take a deep breath and relax. It is highly unlikely that our economy is going to fall apart in the next 3 months. By the end of July, after two more Fed Funds rate increases, one can reassess. If growth is still evident and inflation shows any signs of moderating, perhaps blue skies will start to appear and there will be a better path to equities.
All of us want to see our portfolios grow, but we know markets don’t go straight up. There are times for greater caution with the understanding that the long-term path is upward. Selling now works only if you buy back at an appropriate time and price. History shows again and again that the average investor sells too late and buys back too late to the detriment of long-term total returns. The first four months of 2022 were the worst for equities since the start of 1939. A fair amount of negativism is already priced in. Good investors keep a level head. They sell and buy in increments. During storms they moderate risk-taking, but they don’t sell companies selling at fair value or less, capable of above-average growth for many years to come.
In the short-run, emotion trumps real data. Last week’s volatility is a case in point. Today is likely to be more of the same. But heightened volatility, particularly without support from rapidly changing fundamentals, doesn’t last long and can quickly reverse. Sell what you perceive as overvalued. Don’t simply yield to emotion. The best investors can control their emotions. The best investors are looking for the baby being thrown out with the bath water. If there is a recession next year or the year after, it should be moderate at worst and not long lasting. The fact that any recession is still too far out to forecast accurately almost ensures a volatile path forward, but volatile doesn’t mean straight down. Bear markets have rallies. Use them as opportunities to adjust.
Today, Billy Joel is 73.
James M. Meyer, CFA 610-260-2220