Wesley Chapel, FL

The markets just finished their best January since 2001 with the S&P 500 up over 6% and the Nasdaq up over 10%… what could possibly go wrong?

Some of you might remember 2001. For those of us who don’t remember 20+ years ago that clearly, let me help you out. January 2001 was about the midway point of the stock market meltdown that followed “DotCom” bubble. That January, I was just about 5 months from graduating high school!

Leading up to that January, the S&P 500 was down about 20% from March of 2000 through its low in December 2000 and the Nasdaq was down over 50% over the same timeframe.

Sound familiar? If not, let me point out that the S&P 500 was down more than 20% last year at its low point while the Nasdaq was down 37% from its peak to its low in 2022.

So, what happened after that January rally over 20 years ago?

The Nasdaq subsequently dropped another 67% and the S&P 500 did much better… only falling 43% over the following 20+ months.

Nasdaq 100 Index Performance | Click Image to Enlarge

During those subsequent declines, both the Nasdaq and the S&P 500 experienced violent bear market rallies. Two of the bear market rallies in the Nasdaq saw the index rise over 50%! From the top (March 2000) to the bottom (October 2002) the Nasdaq saw not one, not two, not three… but 11 different bear market rallies of 10% or more. ELEVEN!

It wasn’t until #12 that a new bull market began.

They say history doesn’t repeat exactly, but it often rhymes. I am not suggesting that I believe we are in for a 20-month losing streak that erases between 40% and 70% of market value. But I am also not ruling it out.

As we like to say around here, if your retirement income plan depends on accurately predicting the markets, you are doing it wrong! We don’t predict, we prepare.

Right now, as much as I would love to believe that we are out of the woods, and the bear market is over, neither history nor economics support that belief.

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Sure, this time it could be different. But I think it is unlikely. Ultimately, I don’t feel comfortable risking your family’s (or my own) hard earned capital by aggressively buying stocks on “hope.”

There are several economic factors and indicators that I am watching very closely as I try to gain the confidence necessary to once again turn bullish. I am going to try to cover as many of those as I can in this commentary without missing my publishing deadline!

So, let’s get into it.

The Federal Reserve Bank (The FED) hiked the overnight lending rate, the FED Funds Rate, by 0.25% last week, as expected. Believe it or not, I have been projecting that they would hike by 0.25% in their February meeting since way back in the October commentary. At that time I also projected that the FED would slow the pace of rate hikes from 0.75% to 0.50% in December, which also turned out to be accurate.

So, now what? I project at least one more rate hike of 0.25% in March. After that, I was originally projecting a “pause,” which to be clear, is not a “pivot” to cutting the rate. But now, based on what Chairman Powell said in his press conference following last week’s meeting, I am considering adding another 0.25% hike for the May meeting to my projections.

The comment that I am specifically referring to is this one:

“…we've raised rates four and a half percentage points and we're talking about a couple more rate hikes to get to that level we think is appropriately restrictive. And why do we think that's probably necessary? We think because inflation is still running very hot.”

So, I was projecting just one more quarter-point hike but Powell said very clearly that he is expecting a couple more. I will update my projections at a later time and share them next month if anything changes. For now, you can find my current projections below.

One other positive development is that I am now projecting that we achieve a positive real FED Funds Rate next month – with or without hiking rates. That was projected to happen in May last time I shared the projections.

For new readers, or for those who may have forgotten, the reason I originally put these projections together was because the FED had never stopped a rate hike cycle before achieving a positive real FED Funds Rate. The “real” rate is the midpoint of FED Funds rate minus the annual CPI rate. Any time you see the word “real” in front of a rate, you can assume that an inflation rate is being subtracted from some other nominal rate. You can find another example of real rates nearby, courtesy of JP Morgan’s Guide to the Markets. This one shows the “real yield” of the US 10-year Treasury Bond.

Click Image to Enlarge
Source: JP Morgan Guide to the Markets

Question: If you are earning 3.53%/yr but the cost of things you buy is going up by 5.69%/yr, how much are you “really” making?

Answer: You are really losing 2.16%/yr in purchasing power.

And that is why it is important to understand real rates vs. nominal rates.

Another tool the FED is using to fight inflation is Quantitative Tightening, or QT. They are systematically reducing the size of their balance sheet which consists mostly of US Treasury Bonds. The FED has purchased these assets during four separate rounds of Quantitative Easing (QE) going back to the 2008-09 financial crisis, with the goal of keeping interest rates artificially low and thereby saving the stock market from further collapse.

As the FED bought all these assets, they caused the prices of bonds and the overall stock market to rally. Lower interest rates lead to higher present values of future cash flows. Without getting too technical, once the FED cut rates to zero, rather than implement negative nominal interest rates (which basically means you’d pay the bank to hold your cash) they decided to print money and use it to buy government bonds.

The net effect was the “everything bubble.”

And now, with the FED finally unwinding those policies and taking the opposite approach, what happens to the price of stocks and bonds should be the exact opposite, which means down… like a weather spy balloon from China…

So, even after the FED does ultimately pause the hiking of its overnight lending rate, they will still likely be tightening monetary policy through reducing the size of the balance sheet. And I wouldn’t expect that to stop until or unless the stock market really drops hard (think 30% or more) from here, or inflation gets back below 2%/yr. And we are a long way from 2% inflation. Even the FED doesn’t see inflation dropping to 2% by 2025.

The FED isn’t even actively selling assets from its balance sheet. Rather, It is simply allowing those bonds to mature and instead of taking the cash from those maturations and replacing the maturing bonds with new issues, they are effectively taking that cash and lighting it on fire. Not literally lighting it on fire but virtually. Those dollars are coming out of circulation. This activity has led to an extremely unique situation that we have never seen before in our economy.

Reducing the number of dollars in circulation is a great way to combat inflation. Every year, the government prints a little more money into circulation and this causes prices to rise. It is why you can’t find a movie ticket for 10 cents or a penny candy store anymore. If you want to know more about this I recommend you get a copy of “What Ever Happened to Penny Candy” by Richard Maybury. Don’t let the title of cover fool you, it is for people of all ages.

And why does the government want prices to rise?

Well, if you thought prices were going to fall, would you spend your money as quickly? Most people would wait as long as possible to replace things or buy new stuff. And because consumerism is what makes our economy tick (almost 70% of GDP is from consumer spending) that wouldn’t work out well.

So, stable but slowly rising prices are the best incentive to keep people spending and our economy functioning. That is why the FED has a target of 2% annual inflation.

A decline in prices is a big no-no. That would mean deflation and our economy would grind to a halt.

Anyway, back to the point I am trying to make. The extreme development that I am trying to call your attention to is that the supply of money in our economy, as measured by what economists call “M2,” shrank for the first time in recorded history over the past year.

That’s right. This hasn’t ever happened before – and “ever” as they say, is a long time.

I don’t pretend to know how this will impact the economy, or markets overall, let alone any one market in particular, but I know that it gives me pause. When you see something you’ve never seen before, the best thing to do (in my experience) is wait, watch, and learn, before deciding how to move. My first instinct is that if allowed to continue, a sustained reduction in money supply largely due to the FED reducing its balance sheet, would correspond to a deflationary environment.

On the other hand, if the FED stops letting assets roll off its balance sheet too quickly, absent a corresponding hiking of interest rates, prices could once again accelerate higher undoing the work of the past year or so.

After last week’s jobs report which was much better than expected, the unemployment rate dropped back to 3.4%. Unemployment rates this low give the FED permission, if not encouragement, to continue hiking rates. Usually, the biggest reason not to hike rates too far, too fast, is because it would put people out of work. That isn’t happening, according to the data.

Click Image to Enlarge | Thanks for sharing with me Eddie Z!

What’s more is that there are currently still almost 2 jobs available for every 1 person looking for work. That situation alone is inflationary. Think about it this way, if there are 10 jobs available in a small town, and only 5 people are looking for work, what are the employers going to have to do to attract 1 of those 5 candidates? That’s right, they will have to increase the compensation.

If an employer has to pay more in wages to employees, what do they do with the prices of the goods or services they provide? That’s right, they raise them!

It’s a vicious cycle. Higher wages lead to higher prices and higher prices lead to workers looking for higher wages.

It is weird to me is that wages aren’t rising more (in fact the growth rate has declined recently - see the blue line in the chart below) given the number of job openings per unemployed person. I guess we don’t know exactly what types of jobs have openings, or how much they pay compared to how much an unemployed person used to make in their old job. It sort of feels like a lot of white collar jobs are being axed, and a lot of blue collar jobs are being created. But I don’t have any concrete evidence for that.

Another economic indicator that has my attention is the yield curve, or more accurately the spread between long-term interest rates and short-term interest rates. In normal times the interest rate on long-term loans is higher than the interest rate on relatively shorter-term loans. But the current environment is anything but normal.

Subtracting the 2-year US Treasury yield from the 10-year US Treasury yield normally gives you a positive number. Today, it gives you a negative number. When this spread goes negative it has historically indicated that a recession was imminent, usually within 18 months or so. The more deeply negative the spread, the worse the recession. Today the “10’s minus 2’s” spread is -0.81% - its lowest level since 1981.

Despite Mr. Powell’s hopes for a “soft landing,” the current structure of the yield curve leads me to believe he will be disappointed. A soft landing by the way just basically means that the FED can return inflation to 2% without a recession. Here is a quote from his press conference after hiking rates last week:

“My base case is that the economy can return to 2 percent inflation without a really significant downturn or a really big increase in unemployment. I think that's a possible outcome. I think many, many forecasters would say it's not the most likely outcome, but I would say there's a chance of it.”

This comment really raises my eyebrows. He said his “base case” was for something he admits is not the most likely outcome for most forecasters. And then he essentially goes on to say, “but there is a chance!” That doesn’t make it sound like he is very confident in his own base case…

It reminds me of the move Dumb and Dumber…. “So, you’re telling me there is a chance!”

I think “soft landing” is the new “transitory.” Remember, Powell also told us for over a year in 2021 that inflation was going to be “transitory” and would come down by itself after the COVID supply chain disruptions dissipated. So much for that…

You can read his full comments and Q&A transcript from his press conference last week, here.

I am also keeping my eye on valuations and earnings. The following chart from hedge fund manager John Hussman gauges whether markets are closer to a top or bottom using a ratio that divides the total market capitalization of U.S. businesses by their “gross value-added,” a measure of profitability. When this ratio is high, it means U.S. businesses are expensive relative to their earnings. When it is low, the opposite is true.

The chart below shows that this valuation metric remains near all-time highs, despite a modest decline from the record levels. So if the lows are in for the U.S. stock market, it would be the most expensive bear market bottom of all time:

Click Image to Enlarge
Source: Hussman Funds

Using another, simpler measure of valuation, the S&P 500 currently trades at 2.4 times its sales. Yes, at the recent peak of the “everything bubble” in November 2021 it traded over 3 times sales, so we’ve backed off a bit from there. But setting aside the FED fueled 2021 highs, S&P price-to-sales is sitting at its highest levels in history.

It is amazing that in light of all the issues we have in our economy, stocks still aren’t cheap relative to history. To be clear, I do understand that the market can go higher and higher even with the economic indicators being terrible. That is what happened all of 2021. The difference between then and now is the FED. Back then, the FED was stimulating the economy and easing monetary policy. Today, they are doing the exact opposite.

All the while earnings are coming down for S&P 500 companies.

This is only natural for a disinflationary environment. If inflation means prices going up, and deflation means prices going down, disinflation means prices still going up but by less than they were. For example, if inflation was 9% and now it is 6%, prices were going up by 9% and now they are only going up by 6%. Prices are still going up, just not by as much. This is a disinflationary environment.

S&P 500 Earnings this quarter | Click Image to Enlarge
Source: Bloomberg

During times of disinflation, you see companies like Tesla drop the price of their cars, across the board. But overall, cars are still more expensive than they once were. That said, this leads to a reduction in earnings for Tesla. This is happening around the country and as a result, halfway through the current earnings season, S&P 500 companies have reported a decline in earnings of 3.55% from the prior year.

Click Image to Enlarge
Source: Bloomberg

Earnings recessions lead to actual recessions as the S&P 500 companies are indicative of overall GDP. During recessions stocks tend to drop by 20% or more.

Meanwhile, Americans have more credit card debt than ever… and more people are carrying balances from one month to the next at the highest interest rate on record. A report by Bankrate found that 35% of U.S. adults carry credit card debt from month to month, up from 29% last year and 46% of credit cardholders carry debt from month to month on at least one card, up from 39% last year.

What’s more, apart from higher debt balances, 43% of U.S. adults that carry balances don’t know all of their interest rates which could lead to a vicious debt spiral if not managed carefully.

Currently, the average credit card interest rate is 20.04%.

Credit Balances | Click Image to Enlarge
Source: Federal Reserve Bank of St. Louis

Credit Card Interest | Click Image to Enlarge
Source: Federal Reserve Bank of St. Louis

Click Image to Enlarge | An index value above 100 signifies that a family earning the median income has more than enough income to qualify for a mortgage loan on a median-priced home.
Source: JP Morgan Guide to the Markets

Additionally, according to Business Insider more and more Americans earning over $100,000/yr are living paycheck to paycheck and the housing affordability index has dropped below 100 for the first time since the 1980’s.

Believe it or not, I could actually keep going with data and I have already decided to leave out several charts and images that I originally wanted to include. But I think I’ve probably gotten my point across here.

To finish things up, I will note that the current charts of the S&P 500 and Nasdaq “look” bullish, for now. Markets have climbed back above their 200-day moving averages and if I had no fundamental economic data to consider, I would probably be aggressively buying these charts.

Unfortunately, (or fortunately as the case may be) I do have all this fundamental data. And that data is totally out of alignment with the technical picture. I expect the fundamentals and the technicals to come into alignment one way or the other, and if that is bullish, then I will aggressively put money back to work.

In the meantime, I will continue to be patient. I have opened two new positions in the past week - one in Growth and one in Value. We are earning over 4.5% on our cash. My base case expectation is for a recession to hit in 2023, and a fresh leg down in the markets to materialize. I am open to being wrong and I will be actively looking for good reasons to change my mind.

One last thing, we didn’t receive very many predictions for the S&P 500 this year so we are going to maybe give it another month, or potentially just skip the prediction contest this year. Stay tuned.

Clients, please click here to access your performance portal.

Until next time, I thank God for each of you, and I thank each of you for reading this commentary.

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor

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