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October 5, 2022 – Two huge up days in a row put bulls back in charge. Is this the market bottom? Only time will tell. It will largely depend on the severity of the pending economic downturn. But retreating interest rates, and weaking labor market statistics suggest the end to the Fed’s cycle of higher interest rates is nearing an end. That is at least one key ingredient to the end of a market downturn.

//  by Tower Bridge Advisors

For those of you who have read my letters over the years, you should know about my 2-day rule. It states that two consecutive days of outsized moves in the opposite direction of recent market trends marks a reversal. Certainly, the gains Monday and yesterday qualify as strong up sessions in sharp contrast to the sharp declines of late August and September. They signify a trend reversal. I use two days in my rule to eliminate sharp one-day rallies usually accelerated by short covering. The second day means real buyers are starting to step in while sellers hesitate.

The rule sounds a bit foolish but has a good track record. The real question is whether the rally that began Monday represents a market bottom or an interim bear market rally. To answer that, we need to first try to decipher what triggered it.

As I noted Monday, it is my belief that the steep interest rate increase cycle is nearly complete. As often happens when prices spike, either up or down, momentum can carry a bit too far. It is rare to see big daily moves in bond yields. Last week and so far this week, daily changes of 10-20 basis points have been the norm. 1-2 is normal. At one point, Friday, the 10-year Treasury yield reached 4.1%. The real yield, as measured by TIPS spreads exceeded 1.75%. Only in the last few months has that spread been positive, meaning there was a real cost to borrowing. By yesterday, the yield had settled back to about 3.6%, a more reasonable figure.

Again, as noted in recent letters, a material slowing of the upward slope for interest rates means the bear market P/E adjustment is coming to an end. Fed Fund futures suggest another increase of 50-75 basis points in November (just last week, 75 was a near certainty), perhaps another 50 in December, followed by a pause. Again, just last week, another 25 was predicted for early next year. I should note that the market forecast for Fed rate changes has been quite volatile for months. First the markets were more hawkish than the Fed. Then, by late August when Jerome Powell spoke forcefully at Jackson Hole, the Fed got more hawkish than the market sparking a sharp September decline in stock prices. It could always change again, depending on data. Key release dates to watch near term are Friday’s employment report for September, and an updated CPI reading before the market opens on October 13th. Either could move markets meaningfully.

If the P/E cycle is done, the next question is the earnings cycle. Right now, markets are discounting fairly flat earnings next year on top of sub-normal gains this year. That is synonymous with a slow economy but not a severe recession. At the moment, any prediction is more a guess than anything else.

Where does that leave us? If markets are in the range of fair value, it suggests any further rally from here should be fairly muted until there are clearer signs that a slowdown or recession is near an end. We should learn a lot more during earnings season. It should also remind us that the performance of any one company’s stock can deviate materially from the leading averages. Some companies and some industries are going to be hurt by a pending slowdown more than others. We saw similar divergences during and immediately after the pandemic. 70% of our GDP relates to consumer spending. In real terms, that should be flat to down a bit over the next year. In nominal terms, however, there will be growth, even if inflation slows. The ability to be able to raise prices, if necessary, is important and will vary company to company.

The bottom line is that I believe we are entering a phase where individual company performance will trump overall market trends. When markets are rising or falling at an annualized pace of 20-30%, that trend overwhelms individual company performance. When markets trade in a much narrower range, individual company performance dominates.

If this is a market bottom, expect a “dead cat bounce” for some of the names most beaten down in the bear market. Don’t be tempted. The word dead is part of that expression for a reason. What an investor is always looking for is a growing company with improving prospects. Warren Buffett famously opts for great companies at a fair price rather than decent companies at a cheap price. Market bottoms are a great time to find such great companies attractively valued.

I don’t know whether this is a market bottom or not. If there is a stronger than expected downturn next year, there will be another earnings adjustment needed and stocks could ultimately retreat to a final low, but I believe we are near a bottom. We will learn a lot more this earnings season that begins next week. If this isn’t a bottom, there is still room for a tradable rally within the context of a market groping for a bottom. If the economic bottom, the depth of the downturn, is to be reached sometime in the middle of 2023, a bottom could be near. Just as likely, a downturn could extend to the end of next year meaning the bear market isn’t over yet. I offered a current fair value range based on different earnings outcomes of 3200-3600 recently with upside to or above 4000 by the end of next year depending how bright the 2024 outlook is by the end of 2023. I still believe that post-recession or slowdown, real GDP growth will average no better than 1-2% with inflation close to 2.0-2.5%. Stocks will do well to average 5-7% per year after the initial bounce off bear market lows. The big difference versus last cycle is that I expect the days of free money to be over. A Fed Funds rate of 2-3% will be the new norm and longer duration rates closer to 4% or even a bit higher. Bonds that offer positive real returns will be more attractive than they were in the 2008-2021 era. Balanced portfolios are likely to revert to historic 60-40 mixes versus the 70-30 allocations of the past decade when real bond returns were negative.

Today, the artist Maya Lin, who designed the Vietnam Memorial in Washington, is 63. Neil deGrasse Tyson turns 64. It is also the 120th anniversary of the birth of McDonald’s founder Ray Kroc.

James M. Meyer, CFA 610-260-2220

 

Additional information is available upon request.

# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

Filed Under: Market Commentary

Previous Post: « August 26, 2022 – Markets continued to consolidate the ~20% spike off June’s low with minor rebounds the past few days. In anticipation of Chairman Powell’s long-awaited speech at Jackson Hole today, stocks are priced for a somewhat hawkish update. Anything that deviates from that position could release energy in either direction. Other news items require some attention as well that could affect GDP going forward.
Next Post: October 12, 2022- As we enter earnings season, attention will shift from interest rate fears to corporate performance. Pepsi kicked it off this morning with good results, hopefully an encouraging sign. As always, the story for the season will revolve around expectations versus reality. In July, reality beat expectations sparking the best rally of the year. The key will be the relative performance of the large tech names, notable laggards coming into earning season. »

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  • March 29, 2023 – Banks stocks are an important market indicator, usually outperforming as the market recovery begins. Current bank stock valuations suggest upside for the long term, but until investors are satisfied that banks are adequately reserved to withstand economic weakness, the volatility will continue. We take a deeper look at bank loan portfolios and the position of commercial loans.
  • March 27, 2023 – A hectic week ended with markets close to where they began. Banks continued to be a weak spot. Lower oil prices impacted the energy sector. Overall, the economy still seems resilient, but recent stress will impact activity as banks tighten loan standards and corporations seek liquidity.
  • March 24, 2023 – Contradictions abound as we close out the week following another volatile reaction to a Fed meeting. The Federal Reserve raised interest rates again, even though banks are begging for cash at the discount window at levels above the peak in 2008. Numerous officials preach that bank deposits are safe, but Secretary Yellen offered less enthusiasm than hoped for with her Congressional testimony. All of this adds up to more uncertainty and a range-bound market.
  • March 22, 2023 – Hang on to your hats. It’s FOMC day! Fed officials face a tough call, on whether to raise rates amid current banking turmoil. Markets believe they will. But the rate hiking cycle is nearing an end. Even assuming one more increase in May, summer inflation should have cooled enough to stop the rate hikes. The strong stock market rally of the past two days suggests a belief that the cost of the current banking turmoil can be contained. Whether that is hope or truth remains to be seen. It is rare for financial crises to end until the Fed changes direction.
  • March 20, 2023 – UBS buys out Credit Suisse and disaster is averted once again, but markets remain skittish. First Republic seems next in line. All this comes in front of Wednesday’s FOMC meeting. Crises don’t end until the Fed changes course. A pause is in order. That would contradict previous signals. A pause doesn’t have to concede that the fight against inflation is over. It would merely be a pause. If bank failure fears can be contained, another rise in rates in May would be possible, if needed. But there is a lot of evidence to suggest it won’t be. The stock market’s course near-term is clearly binary depending on what the Fed does Wednesday.
  • March 17, 2023 – While banks are scrounging for support, ancillary effects are becoming priced into cyclical sectors of the market as lower interest rates bring investors back to growth leaders. Quadruple options expiration and further bank concerns will drive more volatility to end this crazy week. A record breaking rush to the Fed Discount Window shows how desperate some banks are to cover recent withdrawals.
  • March 15, 2023 – Stocks rebounded yesterday, stemming losses from last week, but the recovery may be short-lived as European bank stocks are under severe pressure this morning. The failures of two banks in the last week may be the end of the crisis or the tip of the iceberg. We won’t know that for days or weeks. In the meantime, markets hate uncertainty, and the likelihood of recession has risen. Beware the Ides of March.
  • March 13, 2023 – The Fed and FDIC stepped in over the weekend to create a new lending program to save depositors of two large banks that failed since Friday. That’s an important first step, but the rules of engagement in the banking industry have changed. Banks will have to pay depositors to retain their money. The same will go for stock brokers. We are witnessing what happens when the Fed is forced to change the money landscape too quickly. Every tightening cycle has its crisis. We are in the midst of one now. Crises happen at the end of a cycle, a consequence of earlier actions. Now the Fed needs to find a new path to secure the economy and fight inflation.
  • March 10, 2023 – It is Friday Jobs Day yet again! Never before have so many backward-looking reports meant so much for markets. February CPI is next in line this coming Tuesday. Fed Chair Powell has not really changed much of his commentary; the Fed is data dependent and the Fed Funds rate will be higher for longer. However, recent stress in the banking sector may throw a wrench in their plans to raise rates much higher.
  • March 8, 2023- Fed Chair Jerome Powell spooked markets increasing the odds of another 50-basis point increase in the Fed Funds rate later this month, but calmer inflation numbers over the next 10 days could either calm or reinforce those odds. Meanwhile, both stocks and bonds remain rangebound despite yesterday’s sharp price drops.

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