What Could Go Right? | Stock Talk Podcast
2022 has been a bad nine months for investors in stocks and bonds globally as our Federal Reserve has vowed to bust inflation now. Never mind that our Fed fueled a large part of the inflation currently in the system by downplaying inflation in 2021 and the job market ahead of their inflation goals.
Even Fed Governor Christopher Waller admitted last week that they are looking at lagging data, particularly lagging housing market data. Even though they are watching the same data, they are determined to right their wrong in 2021.
They have reversed course placing inflation taming over jobs. Jerome Powell and his team are now playing the game of we “won’t make an Arthur Burns, early 1970’s, inflation mistake.” Our Fed is taking the current inflation problem deathly seriously with these 75bps rate hikes, trying to make sure inflation doesn’t become a fixture in our future economy.
One where consumers and businesses expect prices to rise in the future. They are pushing so hard that things are starting to break around esoteric areas of the financial markets. But Viewers, the S&P500 peaked on an absolute basis almost exactly at the year-end of 2021. I know this puts most long-term investors in a foul mood, including myself, now with the markets having a year to date posted its first bear market decline in years. Ex a few hedge funds I know, most investors, retail or otherwise are feeling depressed nowadays having emotionally “marked to market” their net worths or companies AUM much higher on December 31st, 2021.
However, many sectors, groups, and single stocks had been diverging from the S&P500 for months, if not quarters, all the way back to the late first quarter of 2021 when the yield curve peaked. While our team had expected our first market correction since the Covid bottom, we did not expect our first broad bear market in years. The S&P500 has roundtripped two years of gains through the end of 3rd quarter, which while common during Fed rate increases, is not enjoyable for anyone outside traders.
I am Chris Perras with Oak Harvest Financial Group in Houston, Texas, and welcome to our weekly stock talk podcast, keeping you connected to your money. Before we get into this week’s topic, “What could go right from here?” Please take a moment to click on the subscribe button and click on the notification bell so you will be alerted when our team uploads our latest content.
The stock and bonds markets have both declined in unison year to date primarily for one reason. The Federal Reserve has moved with historically significant interest rate hikes, from the lowest level on record, at one of the fastest paces in 100 years, after being overly easy from a monetary standpoint for years. I’ll say it. The Fed’s moves in 2022 have been unprecedented for the last 50 years. Only Greenspan in 1994 came close when he doubled rates by 300 basis points in 12 months.
Take a look at the comparison in the Change in Fed Funds Rate chart. Putting this in perspective, the pace of interest rate increases is about the same but opposite direction as how fast the Fed cut rates in 2008. So, the question to me now isn’t down negative twenty to twenty-five percent on the S&P500 over ten months, “what could go wrong” now? That list is well known by now. The question I want to ask is, what could go right? Our team had expected the first three quarters of 2022 to be a mess, including a correction of -10-12.5%. We have been correct on direction but admittingly off on magnitude, almost entirely the last six weeks post-Chairman Powell’s Jackson Hole speech on August 26th.
Yes, until then, the over S&P500 was down almost precisely 12.5% off its tip-top 4800+ highs. Since then, Jerome Powell’s and the rest of the FOMC’s nonstop hawkish talk caused the 3rd quarter swoon. What would it take for the stock markets to rally and convincingly hold those gains? Well, the Fed needs to do their November 1-2 interest rate raise of 50 or 75 basis points and slow down.
They don’t need to pause in my book. Greenspan didn’t pause in the 4th quarter of 1994. Instead, he slowed the pace. The markets would collectively exhale if the Fed Communicated to the markets that while they are still on a path of raising rates and even holding them there longer, they are seeing signs in the real-time data that everyone else already sees, and that makes them optimistic for 2023.
Say they admit to seeing the real estate data grinding to a halt? Fed Governor Waller last week admitted to the real-time data there heading lower, even though the BLS data will likely continue to be higher next quarter. He sees that apartment rental prices are falling.
Maybe they admit to seeing commodity prices tanking. More likely, they admit to seeing the number of job openings, also called the Jolts number, heading materially lower in real-time as companies announce layoffs. Ford layoffs? Siemens? Layoffs? Remax, JP Morgan, Wells Fargo, Microsoft, Shopify, 7-11, Snap, Twilio, Peloton, DocuSign, Twitter, Facebook, Oracle, and Netflix? All layoffs. Layoffs are deflationary. Jobs are the last thing to roll over in a recession caused by the Fed hiking due to inflationary pressure For those who think the markets might barely “bounce” a bit on an actual slowing or pause by the Fed, here is the chart of the S&P500 year to date.
History says otherwise. We discussed Greenspan’s slowing in late 1994, and even this year, it’s easy to see on the charts. Late in the 2nd quarter, the S&P500 rallied almost 19% from its mid-June lows to its mid-august highs on just the hope of a Fed pivot in the fourth quarter of 2022. In fact, the index rallied over 550 points and 16% in one month, from mid-July option expiration through mid-August expiration. Those are the types of moves that happen when volatility is high, sentiment is low, investors despondent, and positioning is underweight.
Those are the types of moves that happen when volatility gets sucked out of the markets, pessimism flips to optimism, and large, shorter-term investors feel panic and FOMO to push their chips into the center of the table. These types of up moves are quite common in mid-term election years in the 4th quarter, which brings me to my second point of what could go right. Mid-term election year stock return seasonality, historically, like it or not; like who is president or not, has been a “thing.” There are all sorts of reasons people give as to why it happens.
The easiest and most logical one to me is that the second half of the second year of a presidential term usually represents the slowest economic period in a president’s term if there was an early honeymoon period that ended quarters ago. If the administration induced programs to initially juice the economy in their first year, those have been calendarized, and their initial sugar high has worn off. Mid-term election years tend to be messes for the first three quarters of the year. On average, U.S. midterm election year declines are -20%. 2022’s slightly greater than 20% decline places it in the standard declines during mid-term years.
That deserves a Charlie Brown. Ugh. The average and median midterm year corrections for the SPX are 20.8% and 19.8%, respectively, according to Merrill Lynch. Historically, the best part of the Presidential Cycle is from the midterm year low, usually in the late third quarter, through Year 3 of the cycle. Rallies off the low into yearend can be strong and have an average return of 17.6% (13.3% median). The potential for a sharp yearend rally in 2022 is aligned with the path that the S&P500 has usually taken after the Federal Reserve begins a rate hiking cycle.
A cycle in which we should be approaching peak hawkishness and peak momentum now through the November Fed meeting. Take a look at the historical data for those who are interested. Year to date, we have followed very similar patterns to 1962 and 1994. Over the last 70+ years, stocks have had a positive return one year after the mid-term elections every time.
The average return has been almost 15%. Previously, we have discussed that stock markets tend to be largely indifferent about the results of U.S. elections outside of saying that a split government, and the predictability that gridlock brings, is the market’s favorite outcome. Remember, these Federal reserve monetary policies and government fiscal policies work with a lag both on the way up and down. The stimulative Covid responses in the second quarter of 2020 took six to nine months to work their way into the economy.
That’s even though the stock market had already anticipated its effects. Stocks moved broadly and sharply higher into the first quarter of 2021 in advance of the economic recovery that happened. Small-cap stocks and most cyclical groups led the first nine months of the Covid recovery.
Looking back, many companies and sectors got a significant one-time bounce. Unfortunately, many of these same group’s stocks anticipated slow to negative economic growth in the first half of 2022 against near-impossible comparable growth in the second half of 2020 and the first half of 2021. Looking out to 2023, particularly the post-first quarter, the comps for revenue growth should get easier at the same time that many companies’ cost curves peak and begin declining. Goldilocks for markets are moderate but sustainable revenue growth, troughing and expanding margins, and inflections up in free cash flow.
Opposite of what has been transpiring in the first quarter of 2021 for many smaller companies and large 2021 for larger multinational companies. Investor sentiment is bordering on somber. According to Merrill Lynch, inflows to cash accounts are at their highest levels since April of 2020, which, of course, was? The peak fear of Covid and the lows in the stock and bond markets for the next 18 months.
The investor sentiment data, regardless of how it’s measured, is almost universally at lows not seen since the dot.com bubble burst or the Great Financial Crises lows. Take a look at the chart from Merrill Lynch on margin debt levels. It has dropped at its fastest pace since near the market’s lows in 2001 and 2009.
Besides the Federal reserves rhetoric on inflation and interest rates, positive mid-term election seasonality and anemic investor sentiment, and positioning, a couple of other things that could tilt the markets way favorably are the war in Ukraine coming to a conclusion over the next six months and China scrapping its zero-covid tolerance policy post the upcoming elections there. Both would go a long way toward improving investor sentiment and setting up 2023 for an acceleration in global growth off the rapid slowdown that 2022 has presented the world.
The impacts from recent Fed rate hikes are being quickly passed on to the financial markets and other markets, such as the housing market and other credit markets, such as junk bonds. Unfortunately, areas of the economy that the Fed is watching, such as jobs and wages, have yet to feel the full impact of these aggressive rate hikes. Viewers, they will be impacted. As the Fed says, Monetary policy actions tend to influence economic activity, employment, and prices with a long and variable lag. Since Jackson Hole, the Fed has been using harsh rhetoric and forward guidance because they know it can immediately affect financial markets and the economy without a lag.
When will this downturn in stocks end? No one knows for certain, but it has historically happened during periods of pessimism and months, if not quarters before the data gets better and people call the coast is clear. Unlike the data the Fed is watching, market Inflation expectations looked to have peaked months ago. However, the markets are still waiting and in uncertainty mode until the Fed slows its pace. The September CPI is released on Thursday, October 13th, along with other data series Fed watchers track. And then, the Fed meets on November 1st and 2nd, and Jerome Powell will do his afternoon question and answers.
We should know in a few weeks. If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team does have insurance-based tools that do not have the volatility of public markets. However, we remind you, that these investments may also have lower long-term expected returns.
At Oak harvest, we think our clients are best served by us helping them plan for their future needs, instead of focusing on the past. The future and stock markets are always uncertain and that is why our retirement planning teams plan for your retirement needs first, and your greed second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040 and schedule an advisor consultation. We are here to help you on your financial journey into and through retirement.
– I’m Chris Perras and from everyone here at Oak Harvest Financial Group, Have a blessed Weekend.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.