· The financial markets remain in limbo, directionless, some weeks pushed higher by the same data (economic, corporate, Fed, interest rates) that pushes it lower during others. That said, as we noted last week, we believe that regardless of the short-term direction of stocks, the landscape over the intermediate-term which we would define as twelve to thirty-six months is becoming more favorable as the tightening of monetary policy has definitely slowed economic growth which if not too damaging will ultimately pair lacking supply with demand.
The bottom line – a new bull market is most likely forming/evolving, but not yet here.
· The Open Market Committee of the Federal Reserve (FOMC), the body that determines monetary policy, including the direction of interest rates as well as the supply of money meets this coming Tuesday and Wednesday. After four consecutive 0.75% rate hikes, the consensus is for the FOMC to raise interest rates by 0.50% to 4.25% at its conclusion. In addition to the Fed, the European Central Bank (ECB) meets this coming Wednesday and Thursday. After two consecutive ¾ point hikes, the consensus is for the ECB to follow the Fed’s lead and hike by ½ point.
· As noted below, prices at the Wholesale level as measured by the Producer Price Index (PPI) rose 0.3% during November. What surprised the market was that the sharp drop in energy cost was more than offset by stubbornly high food prices.
· According to data released from the Commerce Department, the personal savings rate as a percent of disposable income fell to 2.3%, the lowest since 2005. According to Sal Guatieri, senior economist at BMO Capital, “households continue to mine mountains of extra funds piled up during the pandemic. This extra piggy bank could last another year.” As we noted above, this also bodes well for an eventual return to the labor force.
· The yield curve continued to shows signs of a pending slowdown in the economy as the inverted spread between the two-year U.S. Treasury Note as compared to the ten-year as well as the three-month in relation to the thirty-year are near current economic cycle highs.
However, according to an article published by Ben Carlson on August 27, 2019 which extrapolated data from a study done by Eugene F. Fama and Kenneth R. French entitled “Inverted Yield Curves and Expected Stock Returns,” one which took a look at data dating back to 1975 in order to determine if this curve could predict the out- or underperformance of the stock market versus cash and/or cash equivalents “we find no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years.” According to the data, Carlson noted that the “switching strategy of going from stocks to cash underperformed a long-only buy and hold strategy in all 24 instances using the U.S. and World markets. The yield curve signal also underperformed in 19 of 24 World ex-U.S. backtests.”
· In our opinion, inflation will fall relatively quickly to the 4%-5% range. However, the next 2%-3% will take a long time, measured in years rather than quarters or months. The result should be meaningful yields on bonds and eventually include, Certificates of Deposits as well as money market accounts. With this in mind and if history is any guide, we consider the period 2010-2020 as more of an aberration rather than the norm with respect to the yields on 10-year US Treasury Notes.
· To those that are fortunate enough to have a Cash Balance Pension Plan and are nearing retirement, one must take into consideration the fact that, given the recent rise interest rates the lump-sum figure will decline substantially the next time it is recalculated. We would anticipate this number dropping 15% to 25%. However, the monthly income will not be affected.
· As we enter the final month of 2022, please note that for clients with non-qualified accounts, when beneficial, Fagan Associates will begin tax loss harvesting through a process of realizing unrealized losses, to include sales into cash, sales and then waiting thirty days to avoid the wash-sale rule or swaps to similar but not exact securities (for example, FedEx to UPS). Given the rise in interest rates during 2022, when appropriate we will also take a similar course of action with fixed income.
· The coming week is chock full of economic releases to include on Tuesday, a measure of inflation as the retail level as measured by the Consumer Price Index (CPI); on Thursday, the Weekly Report of Initial Claims for Unemployment Insurance, November Retail Sales, November Industrial Production, November Capacity Utilization and November Business Inventories.
· The earnings season has begun to wind down. That said, of note are reports from Coupa Software (COUP), Oracle (ORCL), Unilever (UL), Eli Lilly (LLY), Lennar (LEN), Trip.com (TRIP), Jabil (JBL), Adobe (ADBE), Darden Restaurants (DRI), Accenture (ACN), and Winnebago (WGO).
LONGER-LASTING ISSUES TO KEEP AT TOP OF MIND
o We are excited about the recent rise in the yield on fixed-income securities, especially U.S. Treasuries. With yields above three and one-half percent all along the curve, should the Fed succeed in reigning in inflation without inflicting too much long-term damage on the economy, real returns on treasuries will turn positive. This will provide conservative investors with a viable alternative to equities and allow them to reduce portfolio risk.
o We liken the aggressive policy of the Fed to rain. The ground (economy) can absorb a couple inches of rain over an extended period of time. However, it cannot absorb it over an hour or two. We believe that after this upcoming hike it would behoove the Fed to pay more than just lip service to their claim of data dependency or once again, run the risk of cooling off economic growth more than what is needed to quell inflation.
o Unlike the past couple of bear market where investors witnessed a V-shaped bottom, this should be more of a “U,” or a process rather than an event. Not to worry, as we believe this bottom will usher in a new, longer-lasting, more durable bull market, one in which the Fed will not be the center of attraction. However, prior to that, we will need to see inflation ebb and the Fed pivot.
o The yield curve has continued to invert meaningfully. The curve, historically a predictor of an economic slowdown, measures the relationship between like bonds of different maturities. In fact, an inverted yield curve has predicted every recession since 1955. That said, it has also predicted recessions when one did not occur. This past week, the yields on the two- and five-year Treasury Notes were inverted or higher when compared to the ten-year U.S. Treasury Note at 4.33% and 3.75% versus 3.57%. Many market pundits will point to this as evidence of a looming recession. At this time, a technical recession brought about by the Fed raising interest rates is likely, the depths of which are most likely shallow as it will not have been caused by a collapse in the credit markets a la 2007—early 2009.
o Keep in mind that the stock and bond markets are anticipatory in nature, historically moving six to nine months ahead of the confirming data. It is precisely for this reason that investors hoping to “buy when things look better” never get the chance to do so. Unfortunately, by the time the economic data turns for the better, stock prices have already taken this into account. For example, during the pandemic, the stock market bottomed on March 23, 2020, just as the economy was shutting down. Three months later stocks had risen forty percent!
o A component to traditional, longer-lasting bear markets is the emotional strain it places upon the investor. Just as bull markets place pressure on investors sitting on the sidelines, bear markets exert the same force on those that have money in the market. Should the market remain choppy as we believe it will at least throughout the autumn, you can count on a steady drumbeat from talking heads questioning the validity of long-term investing. We have regularly noted that unlike recent pullbacks, the recovery from this one will most likely be more of a process rather than an event and recommend that our clients ignore the short-term and focus on your long-term objectives.
o The Fed has become too important in regulating the economy. Hopefully, when this is over, we can get to a more normalized economy with less overt Fed intervention. Recessions are necessary as they bring back into balance supply and demand. In addition, vis a vis creative destruction, recessions revitalize the economy, positioning it for a new era of growth.
o We continue to monitor the returns of the Vanguard Balanced Index Fund (VBAIX) to illustrate the extent of the selloff even in balanced accounts, including the bond market. VBAIX, somewhat of a proxy for balanced investors has fallen 15.19% through the close of business Friday, as in addition to the pullback in stocks, bonds, which comprise nearly 40% of the portfolio, have been under pressure. For example, the Vanguard Total Bond Market Index Fund (VBMFX) has fallen 11.94%. In fact, even the Vanguard 2020 (VTWNX), a mutual fund designed for “investors planning to retire or leave the workforce in or within a few years of 2020 (the target year)” has dropped 12.64% year-to-date.