What’s Going on in the Markets August 6, 2024

With the lazy, hazy days of summer come the doldrums in the stock markets—or so everyone thought.

July went out with a bang as the market rally broadened significantly to include small-caps and mid-caps, while the red-hot technology stocks took a breather. Sure, the S&P 500 index was only up 1%, but the small caps were up 11%, the mid-caps were up 7%, and even the bonds were up 3%.

But since then, if July was the lion, August has been the bear. The S&P 500 index is down 5% in just three August trading days, the small caps have given back almost 10%, and the tech-heavy NASDAQ 100 has slid 7.5%. In the digital age, markets move fast.

Now, mind you, the S&P 500 is still up about 15% over the last 12 months (and up 9.5% year-to-date), but every 10-12 months, we should expect a 5%- 9% pullback in the markets. We had a 5.3% pullback in April, but the last time we saw a pullback of this size ended last October. The markets have been remarkably calm over the past year, and we went 356 trading days without a 2% daily pullback in the S&P 500 index. That may be why this pullback feels so jarring.

Pundits and the media will posit several reasons for the pullback, such as:

·       The Federal Reserve is on the cusp of making a policy mistake by keeping interest rates higher for longer and is pushing the country into a recession.

·       The July monthly jobs report, which was out on Friday, spooked traders and investors as it came in much lighter than expected, and the unemployment rate ticked up. This fanned the fears that a recession was on the way (there’s always a recession on the way; the trick is knowing when we’re in one.)

·       Over the weekend, news broke that legendary investor Warren Buffet sold half of his stake in Apple during the past quarter and is stockpiling cash.

·       The possibility of a bigger, more freely spending government—regardless of party—is giving traders fits. The markets crave certainty, and summertime offers little of it in election years.

·       Escalating tensions in the Middle East.

·       The unwinding of a long-running Japanese Yen carry trade, in which traders sold the Yen and invested it in higher-paying countries and other opportunities for months if not years. Now, that trade is unwinding and directly affects the world’s stock markets.

You can cite any of the above reasons for the selloff, but the selling will stop when the fear that’s getting the better of so many traders and investors goes away. But certainty about the election is about three months away. Absent a market crash, any possibility of a short-term interest rate cut is about 45 days away. So, buckle up, meanwhile.

In our client portfolios, we’ve been getting defensive by taking some money off the table for weeks now. We are hedged with money market cash earning 5%, Treasury Bills, bonds, inverse funds, and options sold against our positions. We’re prepared to get more defensive if things get worse, but this is a time to look for quality stocks and funds that were too expensive about a week ago. We did some shopping for some clients last week.

We’ve had a fantastic start to the year, and historically, an election year tends to be volatile from the summer into September/October. Once the overhang from the election uncertainty is gone, the market should resume its uptrend by the end of the year.

In short, as I’ve repeated before, the secret to success in accumulating wealth is not to get scared out of your positions. It’s never about completely avoiding risk in the markets but reducing risk. If you’re losing sleep over your investments, consider reducing your exposure or contact us to help determine if you’re overly invested.

Meanwhile, try and stay cool!

If you would like to review your current investment portfolio or discuss any other retirement, tax, or financial planning matters, please don’t hesitate to contact us at 734-447-5305 or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client, an initial consultation is complimentary, and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client and your financial plan and investment objectives are different.

What Persistent Inflation Could Mean for the U.S. Economy

Economic reports of late seem to point to a weakening economy and stubborn inflation.

On April 30, the Employment Cost Index for the first calendar quarter of 2024 showed a 1.2% increase (4.2% year-over-year); that was 25% higher than the consensus estimate of 0.9%.

The FHFA House Price Index for February 2024 was much hotter than expected, coming in at 1.2% versus 0.1% expected (7.0% year-over-year.) Similarly, the February Case-Shiller 20-City Home Price Index came in at 0.6% versus 0.1% expected (7.3% year-over-year.)

At the same time, two more economic reports were released on April 30.

The Chicago Purchasing Managers’ Index (PMI) came in at 37.9 (versus 45 expected).

The Conference Board’s Consumer Confidence Index also came in far below expectations (97 versus 104 expected).

The stock markets were understandably confused: Normally, lower economic activity means lower inflation. Instead, what we got was higher inflation and lower economic activity.

In the stock markets, confusion equals selling now and asking questions later. That’s what we are seeing now.

Persistant Inflation

On April 10, 2024, the U.S. Bureau of Labor Statistics released the Consumer Price Index (CPI) for March, and the increase in CPI — the most commonly cited measure of inflation — was higher than expected. The rate for all items (headline inflation) was 3.5% over the previous year, while the "core CPI" rate, which strips out volatile food and energy prices, was even higher at 3.8%. The month-over-month change was also higher than anticipated at 0.4%. (1)

The stock market then dropped sharply on this news and continued to slide over the following days, while economists engaged in public handwringing over why their projections had been wrong and what the higher numbers might mean for the future path of interest rates. Most projections were off by just 0.1% — core CPI was expected to increase by 3.7% instead of 3.8% — which hardly seems earth-shattering to the casual observer. But this small difference suggested that inflation was proving more resistant to the Federal Reserve's high interest-rate regimen (raising interest rates is one of the most common ways to curb spending and corporate investing to reduce inflationary pressures.) (2)

It's important to remember that the most dangerous battle against inflation seems to have been won. CPI inflation peaked at 9.1% in June 2022, and there were fears of runaway inflation similar to the 1980s. That did not happen; inflation declined steadily through the end of 2023. The issue now is that there has been upward movement during the first three months of 2024.(3) This is best seen by looking at the monthly rates, which capture the current situation better than the 12-month rates. March 2024 was the third increase month that points to higher inflation (see chart).

High for longer

While price increases hit consumers directly in the pocketbook, the stock market reacted primarily to what stubborn inflation might mean for the benchmark federal funds rate and U.S. businesses. From March 2022 to July 2023, the Federal Open Market Committee (FOMC or AKA the Fed) raised the funds rate from near-zero to the current range of 5.25%–5.5% to slow the economy and hold back inflation.

At the end of 2023, with inflation moving firmly toward the Fed's target of 2%, the FOMC projected three quarter-percentage point decreases in 2024, and some observers expected the first decrease might be this spring. Now it's clear that the Fed will have to wait to reduce rates. (4)(5)

Higher interest rates make it more expensive for businesses and consumers to borrow. For businesses, this can hold back expansion and cut into profits when revenue is used to service debt. This is especially difficult for smaller companies, which often depend on debt to grow and sustain operations. Tech companies and banks are also sensitive to high rates. (6)

As mentioned above, in theory, high interest rates should hold back consumer spending and help reduce prices by suppressing demand. So far, however, consumer spending has remained strong. In March 2024, personal consumption expenditures — the standard measure of consumer spending — rose at an unusually strong monthly rate of 0.8% in current dollars or 0.5% when adjusted for inflation. (7)

The job market has also stayed strong, with unemployment below 4% for 26 consecutive months and wages rising steadily. (8)

The fear of keeping interest rates too high for too long is that it could slow the economy, but that is not the case, making it difficult for the Fed to justify rate cuts.

What's driving inflation?

The Consumer Price Index measures price changes in a fixed market basket of goods and services, and some inputs are weighted more heavily than others.

The cost of shelter is the largest single category, accounting for about 36% of the index and almost 38% of the March increase in CPI. (9) The good news is that measurements of shelter costs — primarily actual rent and estimated rent that homeowners might receive if they rented their homes — tend to lag current price changes, and other measures suggest that rents are leveling or going down. (10)

Two lesser components contributed well above their weight. Gas prices, which are always volatile, comprised only 3.3% of the index but accounted for 15% of the overall increase in CPI. Motor vehicle insurance prices comprised just 2.5% of the index but accounted for more than 18% of the increase. Together, shelter, gasoline, and motor vehicle insurance drove 70% of March CPI inflation. On the positive side, food prices comprised 13.5% of the index and rose by only 0.1%, effectively reducing inflation. (11)

While the Fed pays close attention to the CPI, its preferred inflation measure is the personal consumption expenditures (PCE) price index, which places less emphasis on shelter costs, includes a broader range of inputs, and accounts for changes in consumer behavior. Due to these factors, PCE inflation tends to run lower than CPI. The annual increase in March was 2.7% for all items and 2.8% for core PCE, excluding food and energy. The monthly increase was 0.3% for both measures. (12)

Although these figures are closer to the Fed's 2% target, they are not low enough, given strong employment and consumer spending, to suggest that the Fed will reduce interest rates anytime soon. It's also unlikely that the Fed will raise rates.

The Fed seems poised to give current interest rates more time to push inflation to a healthy level, ideally without slowing economic activity. (13)

And since higher interest rates mean more competition for investment dollars and lower corporate earnings, stock markets don’t tend to react favorably, especially when 3-4 interest rate cuts were expected earlier this year.

The Fed issues its next interest rate decision on Wednesday afternoon, May 1, 2024. No change in interest rates is all but a given. However, what Federal Reserve Chairman Jerome Powell says about the recent economic data and the Fed’s stance on when future rate cuts are coming will no doubt be parsed word for word for clues when the press conference is convened.

Please pass the popcorn.

If you would like to review your current investment portfolio or discuss any other retirement, tax, or financial planning matters, please don’t hesitate to contact us at 734-447-5305 or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client, an initial consultation is complimentary, and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client and your financial plan and investment objectives are different.

Footnotes:

 1, 3, 8–9, 11) U.S. Bureau of Labor Statistics, 2024

 2)The New York Times, April 10, 2024

4) Federal Reserve, 2023

5) Forbes, December 5, 2023

6) The Wall Street Journal, April 15, 2024

7, 12) U.S. Bureau of Economic Analysis, 2024

10) NPR, April 18, 2024

13) Bloomberg, April 19, 2024

What’s Going on in the Markets November 29, 2023

Who ya’ gonna believe? The headlines or the market?

The latest economic headlines read:

“Credit Card Defaults are on the rise”
“Household savings rates are at historic lows”
“Banking Credit Contracts to Levels Not Seen Since the Global Financial Crisis”
“Home Builder Confidence from the National Association of Homebuilders takes another sharp drop”
“Trucking Employment is Contracting at a rate not seen since the 2000 and 2008 Crises.”
“The Conference Board of Leading Economic Indicators Declined for the 19th consecutive month”
“Yield Curves are Steepening after being extensively inverted, a sign of recession”
“Overdue commercial property loans hit 10-year high at US banks”
“No End in Sight for the Ukraine-Russia War”
“Could The War in the Middle East be the start of World War 3?”
“World Panics as supply of Twinkies Shrinks” (OK I made that one up to see if you’re paying attention)

With headlines like these, you’d think the stock markets were crashing, and we’re already in a deep recession.

Instead, the markets are having one of their best Novembers in history (after an awful October), which has led to headlines like these:

“The stock market is following a rare pattern that could signal double-digit gains next year”
“Extreme investor bearishness suggests stock market gains of 16% are coming in the next 12 months”
“The S&P 500 could soar more than 20% in the next year after an ultra-rare buy signal just flashed”
“This stock market signal points to the S&P 500 surging 25% within the next year”
“The Dow just flashed a bullish 'golden cross' Two days after the bearish 'death cross' signal”

High inflation and interest rates, two prominent wars, and unprecedented dichotomies continue to mount throughout the market and the economy, which can only mean that Wall Street’s roller-coaster ride is far from over. Let’s take a closer look at some of the headlines driving the markets.

Leading Economic Indicators

The Conference Board’s Leading Economic Indicator (LEI) has warned of trouble all year. It has declined for 19 consecutive months, its third-longest streak on record. When viewed as a ratio with the Conference Board’s Coincident Economic Indicator (CEI), declines from peaks have typically led to recessions. When decreasing, this ratio provides evidence that coincident indicators are holding up, but leading indicators are deteriorating. The Leading-to-Coincident Ratio has steeply declined since its peak in December 2021. Never has this ratio fallen this far and at such a rapid rate without a corresponding recession.

Treasury Yields

Another warning sign still flashing red and has a near-perfect track record for predicting recessions is the yield spread between 10-year and 2-year Treasurys.

Typically, one would expect to receive a higher interest rate on longer-duration bonds, CDs, debt, etc. After all, the more time a debt is outstanding, the more risk the lender takes (e.g., default risk, interest rate risk, bankruptcy, death, etc.). 10-year Treasurys should normally pay a higher interest rate than 2-year Treasurys to compensate lenders (the public) for this added risk.

An inversion means shorter-duration Treasurys command a higher interest rate than longer-duration Treasurys. Historically, inversions are unusual and indicate the economy is vulnerable. After all, if you’re concerned about the economy, it means you’re concerned about corporations being able to pay back their debt. Hence, you’re more likely to buy shorter-term debt. That pushes shorter-term interest rates into inversion. Simply put, if you had concerns about your brother-in-law paying back a personal loan, you’re more likely to keep the term shorter rather than longer, right?

The most recent inversion of the 10-year treasury bill and the 2-year treasury bill interest rates began in July of 2022 and quickly became its deepest (widest) since the early 1980s. The initial inversion is an early warning sign of a potential oncoming recession, but when this yield spread moves back above 0.0 (or it un-inverts), historically, there are four months on average before the onset of a recession. So, this is another definite recession warning sign.

Institute for Supply Management (ISM) Economic Indicators

A few macroeconomic indicators bounced back from dire levels or improved earlier this year, spurring hopes of a soft landing. However, unfortunately, many of these improvements have recently reversed course.

The ISM manufacturing index, also known as the purchasing managers' index (PMI), is a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It is a key indicator of the state of the U.S. economy. The PMI measures the change in production levels across the U.S. economy from month to month. The PMI report is released on the first business day of each month.

The 50 level in the PMI (both manufacturing and services) is the demarcation between economic expansion and contraction. Above 50, it’s expanding; below 50, it’s contracting.

Late last year, the ISM Manufacturing PMI index fell into contraction territory (<50.0) and has yet to move back into expansion. It has contracted for 12 consecutive months, showing some improvement mid-year before dropping once again in October.

The ISM Non-Manufacturing (or services) Index is an economic index based on surveys of more than 400 non-manufacturing (or services) firms' purchasing and supply executives. The ISM Services PMI comes out in the first week of each month and provides a detailed view of the U.S. economy from a non-manufacturing standpoint.

The ISM Services Index has been resilient this year, dropping below 50.0 just once since the pandemic. After initially improving in early 2023, it has declined for the past two months and is now at a five-month low. Because more than 70% of the economy is services-based, any contraction would not benefit the whole economy.

Housing and Real Estate

Housing, another major economic sector, accounts for 15-18% of U.S. GDP and is also on somewhat of a roller coaster ride of its own. Despite its improvement earlier this year, home sales have retracted and are at their lowest levels since 2010.

Existing home sales, which comprise most of the housing market, decreased 4.1% in October 2023 from the level in September to a seasonally adjusted annual rate of 3.79 million, the lowest rate since August 2010, according to the National Association of Realtors. October sales fell 14.6% from a year earlier.

New home sales for October came in lower than expected at 679,000, lower than September’s surprise of 759,000 but slightly higher than August’s 675,000. Despite being below expectations, these numbers are pretty robust (not surprising, given that existing homeowners with low mortgage rates are not selling).

Today’s housing market is still one of the most unaffordable in U.S. history. Home prices have exceeded the extremes of the 2005 housing bubble peak. With today’s high mortgage rates, high home prices, and ever-increasing ownership costs, housing activity seems to be at a standstill overall. Continued declines in home sales would hint at a bursting housing bubble.

On November 8, the Financial Times reported that overdue commercial property loans hit a 10-year high at U.S. banks. The Federal Reserve’s hiking campaign to curb inflation has caused borrowing costs of all types to surge this year, including in commercial real estate. Combined with empty building space from the pandemic work-from-home trend, commercial real estate is in a tight spot. The Green Street Commercial Property Price Index is now down nearly 20% from its 2022 peak and back to a level not seen since the short COVID-induced recession in 2020.

Inflation

While commercial property prices have fallen, price pressures elsewhere have reaccelerated in recent months, prompting consumers to expect inflation to remain elevated in the months ahead. After all, how many items at the grocery or department store have you seen come down in price (besides perhaps eggs and gasoline?)

For October, while headline and Core Consumer Price Indexes (CPI) improved slightly (inflation down), the recent acceleration in consumer inflation expectations indicates that this improvement could be temporary.

In consumer sentiment surveys, the first half of this year saw consumers growing more optimistic about the economy as inflation slowed; however, expectations of future inflation have surged since then, and consumers are becoming discouraged again. Discouraged consumers turn into non-confident consumers who tend to put away their wallets and walk away from discretionary purchases.

Since September, consumer expectations of higher inflation in 12 months have increased significantly to 4.4%. Meanwhile, inflation expectations in five years reached 3.2% as of October’s interim report, their highest level in over a decade. Despite the recent easing in the CPI data, this inflationary expectation pressures the Federal Reserve to keep interest rates elevated.

Inflation expectations notwithstanding, consumers have enthusiastically supported the economy this year despite inflationary challenges. However, the upward trend in credit card delinquency rates indicates an increasingly stressed consumer. Figures from the Federal Reserve show that credit card delinquencies have risen to 2011 levels, and delinquent auto loans are at their highest since 2010. Though not at the extreme levels seen during the Great Financial Crisis (2007-2009), these delinquencies are not slowing and could quickly surge higher if stronger parts of the economy begin to falter.

Jobs

Employment continues to be the last bastion of strength in today’s economy and is important to watch. Jobs remain plentiful, and employees increasingly view employment as transactional (as opposed to long-term). While the unemployment rate remains at historic lows, it has trended upward recently, which could become worrisome.

The unemployment rate in October clocked in at 3.9%, quite low by historical standards but 0.5 percentage points higher than the low rate we saw earlier this year (3.4%).  Increases in the unemployment rate of at least 0.6 percentage points from a cyclical low have confirmed the onset of nearly every recession of the past 50 years, with only one false signal in 1959. Accordingly, the unemployment rate is now just 0.1 percentage points away from reaching this threshold, which would confirm the onset of a recession. The November monthly jobs report and the unemployment rate are scheduled to be released on Friday, December 8.

The Stock Markets: What? Me Worry?

Since the start of November, the S&P 500 Index has been up about 8.5%. The tech-heavy NASDAQ index is up about 10.8%.

Rocket-boosted by the Magnificent Seven tech stocks (Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla), the indexes would not be anywhere nearly as strong without them. While the combined seven stocks are up about 80% year-to-date, the other 493 stocks in the S&P 500 Index are flat. While historically, a handful of stocks “carry” the indexes, we usually see better performance from the rest, and we’re largely not seeing that. Lately, the rally is showing signs of slowly broadening out, which is a good sign going into year's end.

If you look at the S&P 500 Index on an equal-weight basis (where each stock has an equal “vote,” as opposed to a weighted approach based on company size), the index would be up only 3.8% year-to-date. The Mid-cap 400 index is also up 3.8% year-to-date, and the Small Cap 600 is up 3.3%.

Since we’re in the 4^th quarter of a pre-election year, the markets have two reasons to be seasonally positive. True to form, November has reclaimed most of the losses from August to October and looks poised to take out the July high in December. As long as the S&P 500 Index holds the 4400 level, things look good. Daily new high prices among stocks that outnumber new low prices are also encouraging and add to the rally's strength.

My main concern is with the valuation of the Magnificent Seven Stocks. Compared with the Nifty Fifty Stocks in 1972 and the Tech bubble in 2000, these seven stocks are just as overvalued. Momentum trading combined with valuations this extreme can turn great companies into terrible investments, so buyers at these levels should beware. Should the drive to buy anything related to AI (Artificial Intelligence) cool off in 2024, these seven stocks will have a disproportionate effect on the indexes, driving down the markets quickly, especially since so many portfolio managers have piled into them as “safe havens.” I’m not saying to sell them now, but if you’re overexposed to them and have enjoyed the ride, it would be prudent to trim them at their current levels (this is not a recommendation to buy or sell.)

Recession Watch

A strong consumer, robust labor market, the housing wealth effect, and the lasting effects of a zero interest rate policy held in place too long have made 2023 recession callers look foolish (including me).

Underestimating the U.S. Consumer has always been a bad bet, especially when locked down for months, saving their stimulus checks and unspent wages and ultimately coming out of the gates splurging. While their savings are nearly depleted, I would not completely count them out just yet, and a recession in 2024 is definitely not a sure thing, although I still believe we will have one next year.

As discussed above, there are signs that the post-pandemic fiscal and monetary drugs are starting to wear off for the world’s economies, and a hangover might be on the horizon. Whether and when that hangover turns gross domestic product in a negative direction and, therefore, an economic recession, is anyone’s guess. I like what Bloomberg Points of Return writer John Authers wrote this week on that topic:

“…Having got this far, there’s now a pretty good chance the US can get through the next two years without a recession. But the odds still point more to a downturn. That explains the negativity in opinion polls and surveys of consumers, even if it completely fails to explain the enthusiasm among consumers when they go shopping. And then there’s the issue of stock market sentiment, which is utterly baffling.”

It would be understandable to read this post and think that things look grim and that it's time to batten down the hatches and sell everything. It's not. When it comes to discounting the future, the markets usually have it right (looking out 6-9 months), and we may just be experiencing some economic indigestion that will resolve itself, and the stock markets will challenge and exceed the all-time highs in 2024.

Election years are positive for a reason: the incumbents want to be re-elected, so you can't underestimate the levers they can pull to keep the economy firing on all cylinders and postpone any recession until a later year. Never underestimate what determined politicians can do.

Is the Bull Market Really Ready to Charge?

On June 8, 2023, the S&P 500 index closed at 4,293.93, just over 20% higher than its lowest recent closing value of 3,577.03 reached on October 12, 2022.(1) According to a common definition of market cycles, this indicated that the benchmark index was officially in a bull market (uptrend) after a bear market (downtrend) that began in January 2022. By this definition, the current bull market began on October 13, 2022, the day after the bear market ended at its lowest point.

In more general terms, a bull market is an extended period of rising stock values. Bull markets tend to last longer than bear markets, and bull gains tend to be greater than bear losses. Since the end of World War II, the average bull market has lasted more than five years with a cumulative gain of 177%. By contrast, the average bear market has lasted about a year with a cumulative loss of 33%.(2)

Although a bull market is typically a time for celebration by investors, the current bull is being met cautiously, and it is unclear whether it will keep charging or shift into retreat. While it is impossible to predict market direction,  here are some factors to consider.

It's important to understand that while a 20% rally off last October’s bottom technically qualifies as a new bull market by Wall Street standards, it does not signal clear sailing ahead.

Over the past 100 years, a dozen bear market rallies of 20% or more occurred in protracted long-term bear markets. Not so surprisingly, five of these occurred in the 1929-32 slide into the Great Depression. A not-so-humorous anecdote from that era was that seven months after the October 1929 Crash, the stock market had recovered over half of its loss, and exuberant confidence had returned to both Wall Street and Main Street.

"While the crash only took place six months ago, I am convinced we have now passed the worst, and with continued unity of effort we shall rapidly recover." President Hoover – May 1, 1930

Yet the majority of the 1929-32 bear market still lay ahead.

Likewise, more recently, the 2000-02 bear market was interrupted by two very alluring back-to-back bear market rallies. One was +49%, that technically, by Wall Street standards– would have qualified for new bull market status.

It's important to consider how long every major stock market bottom has taken to achieve the 20% status to qualify as a “new” bull market. Since 1932, the median length of time to reach a 20% "liftoff" has been 64 days.

Today’s bull market required a lengthy 164 trading days to reach a +20% gain. Instead of a V-shaped bottom from extreme oversold and undervalued levels, this has turned into a grueling struggle. Ironically, the longest period in the past 100 years was in the 1947 bull market (281 days), which peaked with only a +24.4% gain just one month after reaching the 20% level. Real bull markets charge forward and are not timid.

Still lagging behind the high

One reason the new bull might not seem convincing is that (as of late June) the S&P 500 remains well below the record bull market peak in early January 2022. (3) Investors who hold positions in the broader market are still looking at paper losses and could face real losses if they choose to sell, a situation that may not generate the kind of widespread confidence that often drives extended rallies.

The current bull market is already eight months old, and it's unknown how much longer it might take to recover the total bear loss of about 25%, but recent history offers contrasting possibilities (remember, a 25% loss requires a 33% gain just to get back to even).

The last bull market regained the pandemic bear loss of 34% in five months and went on to a cumulative gain of 114%. The long bull market that followed the Great Recession of 2007-2009 took more than four years to recover an even steeper loss of 57%. But that bull kept charging and went on to a cumulative gain of 400%. (4–5)

A more pressing question is whether the recent surge could be a temporary bear market rally that quickly slips back into bear territory. This happened during the bear markets of 2000–2002 and 2007–2009. However, in 12 other "bear exits" since World War II, a gain of 20% from the most recent low was the beginning of a solid bull market. (6)

A narrow rally

Another key concern is that the current rally has been driven by large technology companies, which have posted big gains, due in part to excitement over the future of artificial intelligence. (7) The S&P 500  is a market-cap-weighted index, which means that companies with larger market capitalization (number of shares multiplied by share price) have an outsized effect on index performance.  As of May 31, the ten biggest companies, including eight technology companies, accounted for more than 30% of the index value. (8) Fewer than one out of four S&P 500 stocks have beaten the index in 2023, and nearly half have dropped in value. While it is not unusual for a relatively small number of companies to drive a rally, the current situation is more imbalanced than usual, and it remains to be seen whether exuberance for Big Tech will spread to the broader market. (9–10)

The market and the economy

While the stock market sometimes seems to have a mind of its own, it is anchored over the longer term to the U.S. economy, and the current economy continues to send mixed signals. The long-predicted recession has failed to materialize, and consumer spending and the job market remain strong. (11) On the other hand, inflation, while improving, is still too high for a healthy economy. Although the Fed paused its aggressive rate hikes in June — one reason for the market rally — a majority of Fed officials projected two more increases by the end of the year, and Fed Chair Jerome Powell confirmed the prospect of higher rates in Congressional testimony on June 21. (12)

Higher interest rates are intended to slow the economy and inflation by making it more expensive for consumers and businesses to borrow, which should slow consumer spending and business growth — and could send the economy into a recession. Although it may seem counterintuitive, bull markets usually begin during a recession, or to look at it another way, the market usually hits bottom while the economy is down and recovers along with the broader economy. Along the same lines, a bull market typically begins when the Fed is lowering interest rates to stimulate the economy, not when it's raising them to slow it down. (13) The current bull will have to buck both of these trends to sustain momentum.  And if a recession does develop, it could turn the bull into a bear.

Corporate earnings

Although investor enthusiasm can carry the market a long way, corporate earnings are the most fundamental factor in market performance, and the earnings picture is also mixed. Earnings declined by 2%  in Q1 2023 — less of a loss than analysts expected but the second consecutive quarter of earnings declines. The slide is expected to continue with a 6.4% projected decrease in Q2, which would be the largest decline since the pandemic rocked the market in Q2 2020.  The good news is that earnings growth is expected to return in the second half of the year, with robust growth of 8.2% in Q4. However, as with the current market rally, the surge is projected to be driven by large technology companies. (14)

Clearly, this bull market faces serious headwinds, and it may be some time before its true character emerges. While market cycles are important, it's generally not wise to overreact to short-term shifts, and it's better to focus on a long-term investment strategy appropriate for your personal goals, time frame, and risk tolerance.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Disclaimer: The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. The S&P 500 index is an unmanaged group of securities that is considered to be representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Actual results will vary. Forecasts are based on current conditions, are subject to change, and may not come to pass.

1, 3–4, 8) S&P Dow Jones Indices, 2023

2, 5) Yardeni Research, October 28, 2022

6) MarketWatch, June 8, 2023

7, 9) CNN, June 9, 2023

10)  Associated Press, June 8, 2023

11) Fitch Ratings, June 8, 2023

12) CNBC, June 21, 2021

13)  Bloomberg, June 5, 2023

14) FactSet, June 9, 2023

What's going on in the Markets June 20, 2022

With ten days to go in the 2^nd calendar quarter and the end of the first half of 2022, we’ve witnessed one of the worst yearly starts in the markets since 1962 with a decline of about 23% in the S&P 500 index. This makes this year the 3^rd worst start for the index in market history.  

The good news? Of the fourteen other worst starts to the year since 1931, ten of them went on to turn in positive returns for the rest of the year, although only five of those fourteen years turned things around and closed with positive returns for the entire year.

Mid-term election years (the 2^nd year of a president’s term) have historically been lackluster, but that doesn’t entirely explain why this year has been so awful. Of course, the same culprits outlined in my What’s Going on in the Markets May 8, 2022 newsletter are still front and center today: 1. The war in the Ukraine; 2. Rising inflation; 3. Higher interest rates. A resolution in any of these three culprits could send the markets on a big trek higher.

To be fair, the markets were rife with speculation in all manners of stocks, special purpose acquisition companies (SPACs), initial public offerings, crypto-currencies, non-fungible tokens (NFTs) and other insane valuations of art, homes, antiques, etc. Most of this rampant speculation was fueled by the unprecedented fiscal and monetary stimulus unleashed in the markets by the Federal Reserve and Federal Government to combat a potential economic depression caused by COVID-19. As happens most often, a pendulum that swings too far in one direction must swing too far in the other direction to correct the excess. That’s the nature of cycles-both economic and markets.

From the pandemic low in March 2020 to the high in January 2022, the S&P 500 index more than doubled (+108%), so a market that moves that far in less than two years would historically be expected to give back (retrace) some of those gains at some point. To most students of long-term markets, giving back 50% or more of those gains would not be unusual at all before the uptrend might resume. At a closing level of about 3,678 as of last Friday, that would take the S&P 500 index to around 3,500, about 5% lower than Friday’s close. Nothing says it must stop there, but that level historically would be expected to generate at least a decent bounce or short-term rally.

Adding insult to injury, this has also been one of the worst starts in over 40 years in the bond markets. Long adding ballast to portfolios and a relative haven from the stock market storms, bonds on average are down over 12% year-to-date, with long term treasuries down over 24%. Even 1–3 year treasury bills are down about 3.7%, making even the safest and shortest of duration government bonds not immune from the carnage. Of course, when bond prices decline, their yields increase, so they become more attractive for new investments.

The perfect storm of a bond and stock market decline means that there have been few places to hide, other than energy and commodity stocks. Of course, energy and commodity stock outperformance mean higher prices for goods, which is at the heart of the inflation problem we now have.

Inflation Marches Higher

When so much stimulus enters the economy and markets in a short time, inflation inevitably rears its ugly head. Think of fiscal and monetary stimulus as money printing, and you can quickly understand how adding so many dollars to the money supply would tend to de-value those dollars. Indeed, when the inflation numbers were released for April and May (8.6% and 8.4% consumer price index respectively), they were higher than expected.  Relief in the supply chain logjam was not enough to offset the increased cost of labor, energy, and commodities (mostly raw materials and foodstuff).

Obviously, inflation at this level cannot be sustained longer term and needs to be tamed before it crashes the economy as consumers begin having trouble affording necessities, let alone discretionary purchases. It’s one of the two mandates of the Federal Reserve (The Fed): to reel in inflation using the tools at their disposal to prevent an economic crash.

Interest Rate Hikes

The dual mandates of The Fed are to:

1. Maintain price stability (by keeping inflation to 2% or less) and,

2. Ensure maximum employment.

With unemployment at historic lows, maintaining price stability is currently job #1 for The Fed.

When the pandemic hit, you may recall that The Fed immediately reduced short-term interest rates from 2.25% to 0% to counter the expected economic contraction effects of the COVID-19 pandemic. They also launched one of the biggest asset purchase plans (bond buying) in history as an emergency measure to ensure enough liquidity in the financial system to keep the economy and commerce from seizing up. The Fed kept these asset purchases up through March of this year (far longer than necessary in my opinion), thereby flooding the markets with stimulus.

Beginning in April, The Fed raised short term interest rates by 0.25% for the first time and announced that the bonds bought over the past several years would be sold off over time. Of course, if injecting the markets with all that stimulus and maintaining low interest rates props the markets up, withdrawing that liquidity and raising interest rates should have the exact opposite effect--and of course it has.

The Fed followed up with a 0.5% and 0.75% short term interest rate hike in May and June respectively, bringing the short-term rate to around 1.5%. During the June meeting, The Fed telegraphed that a further 0.5% or 0.75% interest rate hike could be forthcoming in July (and future months) if inflation doesn’t ease in the coming month. Of course, with inflation running over 8%, The Fed, with short term interest rates around 1.5%, is still woefully behind the curve. Many pundits and critics want them to move much faster to tame inflation.

Low interest rates (near 0% for over two years) represent “cheap money” to individuals and companies, encouraging investment, spending, borrowing, and of course speculation. All of that tends to make for an overheated economy, pushing prices higher. Raising interest rates tends to curb the demand for capital and overall spending, thereby reducing pressure on the supply of goods and services, and in turn, reducing pressure on prices. But by doing so, The Fed risks pushing the economy into a recession.

Recession or Soft Landing

The Fed has acknowledged that lifting interest rates may curb consumer and corporate demand enough to push the economy into a recession. Fact is, it’s possible that we’re already in a recession but don’t know it yet.

The textbook definition of a recession is at least “two consecutive calendar quarters of negative gross domestic product or GDP.” For the first quarter of 2022, the economy did register a negative GDP of 1.3%, and the second quarter could potentially register a similar small negative GDP. As of Friday June 16, the Atlanta Federal Reserve lowered GDP estimates for the 2^nd quarter to about 0%, which means that it could easily turn negative by the end of the quarter, putting us into a an official recession.

Regardless of how the 2^nd quarter plays out, textbook recession or not, I would expect that any recession would be another mild or short one (like the short-lived COVID recession of 2020) as we try and squeeze out much of the excesses brought on by the post-COVID over-stimulus. While you’re likely to be bombarded (and scared witless) by the news media about how the economy has officially fallen into a recession, it remains to be seen how long and how bad it might get. With housing and employment still strong, and corporate earnings holding steady, (albeit weakening somewhat with everything else), the recession should prove to be mild or moderate in my opinion.

What To Do Now

The market is currently in what I would characterize as “no-man’s land”. That’s to say that it’s too late to sell and yet probably too early to buy. As mentioned above, we have the potential to visit the 50% retracement level of S&P 500 at 3,500, 5% lower from here. But the selling was so intense last week, that could be considered somewhat exhaustive, or capitulatory as some refer to it in the business. While bad things tend to get worse in the markets before they get better, the proverbial rubber band to the downside is firmly stretched, meaning that a strong snapback rally could start as early as tomorrow, if not later this week or next.

In a mid-term election year, we tend to see a summer rally from late June into mid-July, with weakness or sideways movement persisting throughout the August-October period. But post-election, a year-end relief rally into the spring tends to be strong. So unfortunately, any relief rally in June/July may prove fleeting, with much better probabilities for a long-term rally coming in the 4^th quarter. Of course, this is all crystal ball prognostication, relying on history to project future returns. This should not be relied on to make investment/portfolio decisions.

So, what about nibbling at stocks and stock funds (and even bonds) with the market down so much? While dollar cost averaging over time has a successful track record, the key is your own personal discipline to continue investing at regular intervals and knowing that it may take months or years to become profitable on new buys, especially if this market doesn’t find a bottom until late this year or next.

Those who bought in mid-2008 thinking that the bottom was in found out that they had to endure another 30% drawdown until the ultimate bottom in March 2009. In the end, this all turned out great for long term holders, albeit with a little pain.

If you are confident that you won’t sell everything if the market continues lower and reach your own capitulation point, there’s nothing wrong with nibbling on names that have come down to attractive levels. Personally, I prefer to see signs of strong demand returning from large institutions, something that is still absent at these levels. The path of least resistance, as of today, is unfortunately lower, but that could easily change in a day or two of strong buying.

For our client portfolios, we came into the 2^nd quarter with one of our lowest allocations to stocks and bonds in years. We continue to be hedged with cash, stock options and bear market funds, and we continue to harvest profits and raise cash. If we see further weakness and no return of demand from institutions, we will further increase our hedges and continue to sell underperforming positions into any rallies that “peter out” in short order.

If you find yourself stuck in positions that no longer meet your initial criteria for buying them in the first place, consider using upcoming rallies to sell them (even at a loss) and upgrade your portfolio with better performing companies at the right time. Instead of big bites, take little nibbles, and keep in mind that bear market rallies are very good at sucking in investors and convincing them that the selloff is over, only to roll over and make lower lows. This is not a recommendation to buy or sell any security.

No one knows how deep the market will pull back. Have we seen the lows, or do we have some ways to go? I personally think we may have seen the worst of it, but that’s just a gut feeling. That doesn’t mean that I believe that the sell-off is over. Similarly, we have no idea if the next rally will mark the bottom of this pullback or just be another “suckers’ rally”.

In the end, these somewhat painful periods always end, paving the way for a new long-term uptrend (a.k.a., a bull market). As I always echo, investing in the stock market is great for long term returns, as long as you don’t get scared out of it at the wrong time. After all, enduring volatility is the price we pay for outsized long-term returns. Be patient and stay small with buys to keep your risk in line with your own tolerance.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.