Quite the wild ride for those following minute by minute action yesterday. Futures markets attempted to rebound early yesterday morning when the UK Government (finally) decided that their tax cutting package was not a great idea during inflationary times. Interest rates dropped across the board, the dollar weakened and futures spiked higher. As we noted a few weeks ago, some things that our governments agree to just do not compute. Domestically, it looks like the administration’s $400B college debt relief package will be defeated in courts over the coming weeks as well. Spending and handouts got us into this mess. Adding to them makes zero economic sense, even in an election year.
However, that pre-market positive shift lasted all of a few minutes following the latest inflation data release in the U.S. CPI came in handily above estimates, pointing to inflation continuing to stay elevated. Rents, a lagging indicator, were strong as expected. Services kept seeing rising prices as well. Healthcare costs rose more than expected. Lower gas prices, stabilizing food costs, lower shipping prices, apparel inventory woes and declining PC prices are not major needle movers. The worker shortage issues remain. Delta reported earnings yesterday and noted again that flight schedules are tight due to a lack of pilots. Less flights means fewer open seats. Fewer open seats mean each seat has a higher price. Lower on the wage scale, restaurants still cannot fill waitress staffs, truck driver shortages remain, nurses keep changing careers and numerous other areas are seeing no increase in applicants. All of which adds up to wage pressure, giving consumers more money to spend and helping to keep inflation elevated. The Fed explicitly wants to dampen wage growth and get more people unemployed. Interesting times!
The CPI report helped reverse early overseas momentum, bringing forth a 1,000 point negative swing in the Dow Jones. The Nasdaq opened down 3%. Interest rates spiked higher, most evident on the short-end with 2 Year Treasuries breaking through 4.5%. The dollar continued its ascent and most commodities experienced 2% – 5% declines.
Surprisingly, about an hour later buyers stepped in with aggressiveness, bringing forth a 1,500-point positive swing. Financials, many of which possess single digit P/E’s and 3% – 5% dividend yields, led the charge, gaining over 4%. Material, Energy and Technology stocks also posted extraordinary gains.
We have noted on numerous occasions that investor sentiment and positioning are powerful forces. When everyone is bearish, it also means they have already sold. Washout conditions have been prevalent for a while now. Reactions to negative news events like yesterday’s CPI report are important. That opening drop and massive recovery is a good sign that this pressure is finally nearing an end. While one day does not make a market, there is enough evidence to say that many “puke points” were hit. This is another term to describe indiscriminate, “get me out at any price,” “I cannot take any more pain” selling, where price does not matter. These prove to be horrible long-term financial decisions but always occur at some point towards the end of a bear market. Many stocks moved 10% from early in the morning to the close. To name a few: Blackrock# went from an opening low of $503 to close at $566, Netflix# from $211 to $233, Amazon from $105 to $112 and Domino’s Pizza from $301 to $335. Those are solid yearly moves, let alone intraday!
Oversold conditions were quite clear. Stocks were down 13% following August’s CPI release just 4 weeks ago. That update added an additional 25 – 50bps onto the Fed Rate hike schedule. It is quite clear that market participants have priced in an inevitable recession. 99% of corporate CEO’s think Europe will have one soon, if they are not in one already. Surprisingly, the bulk of this pain came from the safety of Utility stocks, which are down 20% over the past month. The only other times that happened were March 2020, October 2008, late 2002 and in the 1930’s. And yes, those were all serious bear markets. REIT’s were also crushed over the past month, falling precipitously. These are debt dependent industries, where refinancing needs are going to be met with original 2% -4% coupons being replaced at 5% – 10% depending on credit quality. This will seriously hamper expansion, refurbishing and investment needs…which then hampers growth rates. Obviously, this impacts earnings going forward. On that front, we are now entering critical Q3 updates.
Earnings Season is Here
Numerous banks kick off 3rd quarter earnings reporting season this morning, where they will also provide guidance for year-end. While the Fed, interest rates, global economic volatility and jobs data have controlled markets recently, what really matters to investors is how that will affect corporate profits. Initially it looks solid on the surface, with strong beats across the board and revenue growth in the high-single digits for most. Conference calls start as I write this, so anything could happen to damper the enthusiasm so far this morning.
The earnings game is alive and well. Companies are loathe to report any type of “miss,” so they guide expectations downward to the investment community when times are tough. This has certainly been one of those tough times to say the least. Excluding the pandemic shutdown, this quarter witnessed the largest downside earnings revision over the past decade. Simply put, expectations have been reigned in. Any “beat” should be taken with a grain of salt, as most estimates are not even close to where management teams initially guided just a few months ago.
In addition to the sensitivity during quarterly reviews, management teams will discuss what they foresee going into year-end. CEO confidence is already low. Consumer sentiment is just as bad. Markets have priced in a lot of bad news. Projections from here are not going to be rosy. What will be important is how stocks react to the updates. Similar to the inflation report reaction yesterday, how much bad news is already priced in? If guidance is worse than expected and the stock price holds steady, it will be a good sign. On the other hand, Nike# and FedEx# stocks were already down ~25%+ from their highs before updating guidance a few weeks ago, only to see another 10% chopped off their valuations. Clearly, some areas are safer than others. Separating the wheat from the chaff will be difficult from here. As noted in prior comments, long-term values are apparent, but the short-term volatility is not gone by any stretch.
Something else to watch during earnings season will be the margin crunch. A company’s ability to pass along rising prices and maintaining margins while labor and interest rate costs spike will be critically important. For every Pepsi#, which was able to raise prices by 17% and not lose volume, there will be a Procter & Gamble. Consumers are reluctant to give up their soda and chips, but will be quick to buy a private label paper towel at half the price of Bounty. On the other hand, some items must be purchased. Everyone who installed a pool during the pandemic will continue to hire someone to help close it for the winter, even if prices are up 25%. Ditto for HVAC, auto or home repairs. That is a big piece of why services inflation is sticky and goods deflation is becoming a real issue.
Others, such as taking vacations, buying new cars, going out to eat or even making home improvements do not have the same stickiness. For example, housing related markets are likely to see an elongated retrenchment from the middle to low-end consumer as pocketbooks are tightened. The ultra-low interest rate period pulled forward demand for new homes, upgrades, additions to existing properties and entertainment areas like that expensive deck patio with a fireplace and 4K TV. Home owners refinanced at sub 4% rates while pulling cash out to make extravagant purchases. Today, the 30-year mortgage is busting out over 7%. In dollar terms, monthly payments on a median-priced home have increased $1,000 or more over the past year, causing mortgage applications to fall by over 30%. There simply are not many homeowners with mortgages over 7% where it makes sense to refinance. This will prohibit using homes as ATM’s and takes a lot of discretionary spending capabilities out of the market. Fortunately for investors, much of the bad news here has already been priced in with 30% – 60% drops across the Consumer Discretionary sector. The quicker inflation can be beaten, the quicker interest rates can get back to an acceptable range and this sector can stabilize.
As noted before, many companies which have pricing power, are not debt laden, have a leadership product line, and repeatable business lines, are getting into long-term buy zones. There is no secret sauce for the near-term and volatility is likely here to stay, especially during the buyback blackout period and tax loss harvesting season. Proceed with caution unless you are focused on the long haul.
Usher is 44 today. Ralph Lauren is a young 83.
James Vogt, 610-260-2214