Steve Tomisek, CFP®

By: W. Kirk Taylor, CFP®; Chief Investment Officer

January, much to the chagrin of the consensus that was steadfastly calling for tough sledding in the first half of the year, has ushered in all sorts of technical “buy” signals and reviving the markets animal spirits in the process. At a minimum, these buy signals are suggesting more gains lie ahead for investors. They may be pointing to the start of the new bull market, but we are skeptical. We tend to agree with the bullish camp over the short-term but we do so with a few key caveats.

Prognosticators continue to hotly debate whether the Fed will become dovish i.e., they will pause, or they will halt altogether their aggressive rate hike campaign. Some even forecast that the Fed will lower interest rates in the latter part of the year; hardly something to be bullish about in our view as there is only one reason for the Fed to lower interest rates; to prop up a sagging economy. 

The bears on the other hand fear that the Fed will keep pumping the brakes of monetary policy far too long, unintentionally sending the economy head-on into the wall of a recession. This is not a risk to take lightly.

Both camps make compelling arguments for their view, but the former “doveish” camp is winning out for now. The market wants the Fed to pause. They believe the Fed can engineer a soft-landing. They may also believe in unicorns.

As Warren Buffet has famously said, “In the short run, the stock market is a voting machine. In the long run, it is a weighing machine.” In other words, sentiment and psychology can dictate the near-term direction of the market but eventually sentiment and psychology will give way to the cold reality of the underlying fundamentals, whether good or bad.

The Technical Take

2023 is off to a good start after a challenging 2022. Stocks are rising broadly with small, mid and large cap companies performing well. Interestingly, growth-oriented stocks are up but value-oriented stocks are up more. Non-US equities are up on the heels of a weakening dollar and bond prices are rising as interest rates fall. Everywhere you look, there’s nothing but “green on the screen” of Bloomberg terminals and in client portfolios. What a relief!

We observe that “breadth” is strong, moving averages are giving “golden cross” buy signals and “sentiment” is improving among individual investors as they believe the worst is behind us. Investors seem to be saying “Keep Calm and Carry On”.

We believe this bout of optimism may prove to be different than the optimism that drove multiple failed rallies in 2022. According to some analysts, we may see double-digit gains for the S&P 500 during the first part of the year given the strength of the technical indicator.

We caution investors however to “not drink the Kool-Aid”.

For investors who lowered their equity allocation in 2022 in a prudent defensive posture, we see a brief window of opportunity to broadly increase their exposure to stocks and bonds on pullbacks. For the time being, it’s safe to “buy the dip”. Just recognize, as we lay out below, that more challenging times likely await investors in the second half of the year.

Don’t Fight the Fed

In 1970, famed investor Marty Zweig coined the phrase “Don’t Fight the Fed.” He observed that both stock and bond market returns are highly correlated with the direction of short-term interest rates i.e., the Federal Funds Rate (FFR) established by the Federal Open Market Committee (FOMC). The FFR serves as a “guide” for overnight lending rates among U.S. banks, which in turn impacts the interest for all borrowers. Notably, for consumers it means less disposable income to spend on non-discretionary and big-ticket items.

 In short, when the Fed is raising rates, thereby contracting the supply of money, investors should be cautious given the damaging effects of higher interest rates on all borrowers – corporations, consumers, and the US government.

The opposite is true when the Fed is lowering interest rates and expanding the supply of money, as lower interest rates translate into lower borrowing costs for all borrowers. This in turn translates in to increased discretionary spending by consumers. Given that consumer spending accounts for two-thirds of Gross Domestic Product, this spending naturally leads to an expanding economy, higher corporate profits and of course higher stock prices. As always, stock prices head higher well in advance of the actual rebound.

Looking back over the past two plus decades, there are three shining examples of the powerful impact that lower interest rates can have on the economy: the 2001 recession, the Great Recession and the COVID recession. In each case, the stock market ultimately skyrocketed in anticipation of an economic recovery when the Fed flooded with the economy with cheap money.

In each instance, once the Fed opened the monetary spigot and figuratively dropped money from a helicopter, the mantra of “Don’t Fight the Fed.” was plastered over every news outlet and media publication in the land as justification for spurring an economic recovery and importantly, a rebound in stock prices.

During a 60 Minutes interview with Scott Pelley in 2009, then Fed Chairman Ben Bernanke, tacitly admitted that by dropping the FFR to nearly zero, the FOMC was hoping to prop up the economy, and thus the stock market, via the ”wealth effect”; a theory in which consumers increase their spending more than they might otherwise have because their stock portfolio and home values are appreciating. They “feel” wealthier than before, thus they spend more. How simple is that?!?!.

During the COVID crisis, the Fed once again lowered the FFR to near zero. This policy soon became known as ZIRP – Zero Interest Rate Policy. ZIRP was followed by TINA – There is No Alternative to stocks and finally FOMO – Fear of Missing Out. Low and behold it worked. From mid-March 2009, (the depths of The Great Recession) when the S&P 500 closed at 666, through December 2021, the S&P 500 gained 4,100 points or a whopping 615% in less than 12 years.

To put the magnitude of this stunning gain into context, at the end of 2021, the 3-year, 5-year and 10-year average annualized return for the S&P 500 was plus 15%. For perspective, the average annualized return for the S&P 500 since 1926 is approximately 10%. In other words, and rather remarkably, the S&P 500 gained FIFTY PERCENT MORE than the nearly 100-year average over the preceding 3, 5, and 10-year periods. That’s a rare occurrence.

It’s easy to see how impactful lower interest rates can be on spurring an economic recovery and boosting stock prices. I guess you could say that Marty Zweig was spot on when he said, “Don’t Fight the Fed.”

The Slope of Hope

Not to be cynical, but one has to wonder if lowering interest rates to zero and keeping them at zero for a prolonged period of time can have such a profound impact on the economy and stock prices, shouldn’t the opposite be true?

In other words, can a prolonged period of high interest rates also be the catalyst for the next bull market? We think not, and we think investors may be sorely underestimating the impact of higher interest rates on the overall health of the economy and equity valuations.

Therein lies the great conundrum for investors in 2023. As we pointed out in our Feb 2022 commentary, “The Winds of Change?” in 2021, investors looked past a bevy of risk factors, including the prospects for higher interest rates, as the S&P 500 rose nearly 26%, driven by ZIRP.

In 2022 that changed. Investors could no longer look the other way as the Fed was removing the proverbial punch bowl from the party in the form of five rate hikes that totaled 350 basis points in one year. This was simply a steady campaign of interest rate hikes, designed to combat a 40-year high in inflation. The result, much as we suggested one year ago in our “Are You Prepared for the Great Rotation”, commentary, was that growth stocks were pummeled (the NASDAQ fell over 30%) while the S&P 500 narrowly avoided a formal bear market, defined as a 20% loss, by declining 18%. Yet again, “Don’t Fight the Fed” proved to be more than just cute saying.

At the start of 2023, investors are back at it once again. They’ve hung their hats on the fact that inflation, at least as measured by goods inflation seems to have peaked, leading the Fed to soon pause its aggressive rate hike campaign. As mentioned previously, some even expect the Fed to lower the FFR later in the year, as economy meanders toward a recession in 2023. Again, there is only one reason for the Fed to lower interest rates, and that is because the economy is in trouble.

As my colleague, Dr. Mark D. Troutman, CFP®, detailed in our recent accompanying Economic Commentary titled “Inflation: Maybe Not Dead Yet”, the other side of the inflation coin, which is comprised largely of labor and services inflation, shows little sign of abating anytime soon. Unlike goods inflation, wage inflation is quite “sticky”, especially with unemployment at an all-time low of ~3.5%.

There are simply too few workers (at the moment) to meet demand despite puny layoffs from Big Tech giants like Meta and Alphabet. At the same time and given the supply and demand imbalances in the labor market, employees are emboldened to not only ask for pay increases but without reservation they are demanding other benefits and perks e.g., working remotely full-time.

As we ponder what is ahead for investors in the form of risks and opportunities, our primary concern is that the Fed is likely to disappoint investors regarding the highly anticipated pause in rate hikes. The Fed may indeed pause after the March rate hike but unless wage inflation falls, which it is currently not doing, the Fed may once again be forced to increase the FFR, not lower the FFR later in the year as the unicorn believers are hoping for.

While Mark describes in detail why “sticky” inflation has a long way to go before approaching the Fed’s 2% target, he also details the destructive nature of higher interest rates on corporate profits and discretionary income for individuals. Remember, “Don’t Fight the Fed.” was coined at a time when inflation was front-of-mind for investors and decimating their standard of living.

Our fundamental outlook on inflation, interest rates and thus the economy, leads us to a somewhat sanguine view for the market for the latter part of 2023. Moreover, when it comes to engineering the soft-landing that so many investors are expecting, there is scant evidence of the Fed’s ability to do so.

Remember, this is the same Fed that kept interest rates far too low, for far too long. Their rather poor forecasting skills played a definitive role in creating a 40-year high in inflation; inflation they are now steadfastly committed to returning to their longstanding target of 2%. 

Although the reasonably strong start to the year likely has more upside before rolling over, the advance in stock prices feels more like the “The Slope of Hope” than it does the start of a new bull market.

Having said that, and unlike the conventional wisdom coming into the beginning of the year, we suspect the first portion of the year may surprise investors in terms of its upside. It is the back portion of the year that worries us. Investors may unknowingly be standing on a trap door as the expectations of a soft-landing fade.

Valuations Matter

The forecast for corporate earnings for the full year of 2023 for the S&P 500 is currently in a range of $195 to $225. The S&P 500 closed at ~ 4,195 on February 2^nd, the peak so far for the year.

Earnings forecasts are backloaded as analysts are looking for a moderate decline in the economy and earnings in the first half of 2023, and then a notable increase in both indicators in the second half. The softness in the first half is the “soft landing” that virtually everyone is expecting. We have come to learn over the years that it’s often wise to be skeptical of the consensus. And we are.

For context, and per J.P. Morgan, the long-run median forward P/E multiple is 16.5. At 4,195 the S&P 500 is trading relatively close to the peak P/E multiple of 21 in 2021. It’s hard to imagine that there’s a tremendous amount of sustainable upside in the market at current levels.

If anything, and even though the S&P 500 was down nearly 20% in 2022, one could argue that the S&P 500 seems priced for perfection. Previous bear market lows have occurred when the S&P 500 traded in the 12-14 P/E range, not in the 18-20 P/E range. Consequently, we think there are tremendous risks in market in the back half of the year.

Outlier Risks

Not to complicate an already complicated and complex set of forces impacting the outlook for the economy and the market, investors should pay close attention to a few outliers that may create more uncertainty in the coming months.

Notably, China, in a stark turnaround driven by social unrest, has moved away from its strict “Zero COVID” policy. While deaths have and will continue to rise, perhaps the bigger risk is that pent up demand in China may spur already high inflationary pressures as their economy reopens. Should this prove to be the case, the Fed’s job will only get harder and more complicated.

Outside of China, geopolitical risks loom large given the ongoing Russian invasion of Ukraine, and the potential for a Chinese invasion of Tiawan. A further risk surrounds the unfolding struggle over raising the debt ceiling. Many will remember the summer of 2011, when the last incident of debt ceiling brinkmanship eroded consumer confidence and sparked a 17% decline in the S&P 500.

Play The Long Game

We certainly have concerns about the myriad of risk factors facing investors later in the year, and as a consequence, we see limited upside for equity investors beyond the first half of the year.

Having said that, we strongly suspect that a great buying opportunity lies ahead for patient investors who created some dry powder in 2022. We would like to see a soft landing for the economy as much as anyone else, but our decades of experience tell us that the Fed is unlikely to pull that rabbit out of its hat. As always be patient and stay disciplined while looking for opportunities in the second half of the year. They’ll be here before you know it.

Inflation: Maybe Not Dead Yet

By: Mark D. Troutman PhD, CFP

In the 1974 cult classic, Monty Python and the Holy Grail, viewers are invited to engage in a bit of black humor as the film traces the characters through the plague-ridden Middle Ages. As one of the characters proclaims “…I’m not dead yet!…” one of the village residents “helpfully” strikes the unfortunate character to “help him on his way” and get village life back to normal. In some ways, the macabre incident could describe the attitude toward inflation with the victims being workers and investors.

Perhaps the most anticipated question of 2023 is “…will there be a recession?” The answer: in all likelihood, yes. In order to restore price stability and its credibility, the Federal Reserve may have to accept higher unemployment and lower output for a time in order to restore price stability, defined as 2% inflation on a sustained basis.

We will outline the investment implications of this environment in our upcoming Market Commentary titled “Don’t Fight the Fed.” The basic problem for investors stems from the fact that Fed policy and economic fundamentals are pointing toward a recession while market optimism may allow for further expansion. If the Fed restores price stability, defined by a return to CPI inflation at 2.0 on a sustained basis, it will set the conditions for an expansion and resurgence in equity prices. However, this could take longer than investors expect, and optimism could quickly fade. Consequently, investors should remain defensive, hold cash, and prepare to take opportunities that will develop in 2023 and beyond.

Too Low For Too Long

First, some historical perspective. The Federal Reserve, in a desire to favor employment growth and recovery from the COVID-induced recession, held interest rates too low and expanded its balance sheet for too long. The Fed thought that inflation would be temporary as the recovering global economy resolved supply disruptions and labor returned to work.

The view of temporary inflation has proved half right. Goods prices have peaked and are falling, though the process has taken longer than Fed leaders anticipated. In its December (latest) inflation report, the Department of Labor reported that the core Consumer Price Index had fallen to 5.7% and was clearly on a downward path. Absent any further disruptions, we expect this path to continue, and the goods prices will continue to fall. We outlined these factors in earlier commentaries, and our analysis has proved largely accurate.

But – goods prices are not the whole of inflation. They represent 43% of the Consumer Price Index (CPI). Most of the CPI (57%) consists of services such as transportation, dining, medical, and travel. Services are labor intensive and comprise 4/5 of US jobs, so wages heavily impact this category. Service prices are still headed upwards at a 6% annual rate. In short, the path to price stability requires a cooling in wage and ultimately service inflation, and the case for this cooling is not yet convincing.

Wages are still increasing, and labor markets are still tight. The latest unemployment report (December 2022) was a “goldilocks” report in the estimation of one labor economist. Unemployment stood at 3.5% and job growth notched 223K against a consensus forecast of 202K. Payroll growth, which averaged a gain of 375K jobs per month through 2022, has markedly slowed. Wages grew at 4.1 % (annual), down from nearly 6% annual growth in previous months. We must ask whether this perfect scenario will continue in future reports.

Labor remains scarce and there still exist 1.7 job openings for every available worker. Labor force participation remains lower than pre-COVID levels, and 2.1 million workers have not returned to the workforce. It seems that the path to cooling wages must come by moderating the demand for labor. This is the view that the Federal Reserve has adopted and that Fed Chair Powell articulated in his speech at the Brookings Institution on 30 November 2022. Other Fed governors have acknowledged the signs of moderating inflation while at the same time stressing the need for labor demand to cool.

Hope Springs Eternal

Market participants, as they have done for the last few months, reacted with optimism to the favorable inflation reports. They sparked a mini-rally on hopes that favorable inflation reports and mentions of a pause to evaluate the effects of rate rises would be followed by a fall in interest rates. The S&P 500, which closed 2022 and traded the first week of 2023 with a 5.3% decline, recovered nearly all its losses by January 23^rd and has continued to rise. While the rebound in stock prices is good news in the short term, it complicates the Fed’s aim by loosening financial conditions when the goal, in actuality, is to tighten them. This “push-pull” illustrates the delicate nature of engineering a soft landing… something the Fed has a scant history of achieving.

The Fed leadership responded to these conditions with admonitions that the central bank remains focused on price stability and that as a consequence, interest rates would have to remain elevated for some time until there was solid evidence of a return to 2% inflation.

It should not be lost on investors that most of the senior leadership of the Fed came of age during the Volcker years, so we can expect them to avoid at all costs the error of giving up the fight prematurely.

In the backdrop of these developments, the Federal Reserve continues to quietly reduce the size of its balance sheet at a rate of $95B per month. Some studies estimate that this translates to an additional 50 – 100 basis points of upward pressure on interest rates. Should the Fed continue this policy through 2023, this will remove more than $1.1B of demand for treasuries from bond markets. This will create additional tightening and upward pressure on interest rates. In sum, monetary policy is sharply contractionary, and while yields have fallen over the past several months, upward pressure on interest rates remains.

Fiscal policy, by contrast, remains expansionary even as the massive COVID stimulus packages wind down. The Fiscal 2023 omnibus budget package increased discretionary spending by 9%. The flagship Social Security program includes an 8.7% increase in benefits payments to offset inflation.

By: W. Kirk Taylor, CFP®

Executive Summary:

As we enter the second half of 2022, investors will continue to face a myriad of economic cross- currents. These include persistently high inflation, the prospect of rising interest rates, economic contraction and falling corporate profits. While it’s too soon to say with confidence… these are the hallmarks of stagflation; an economic scenario that investors have not seen since the 70s.

Clearly, the Fed has its hands full as it attempts to engineer a soft landing. Investors have doubts about the Fed’s ability to do so, as evidenced by growing forecasts for a recession in late 2022 or early 2023. The Fed has backed itself into a corner and their track record for engineering a soft landing is dubious at best.

As we entered 2021, the S&P 500 was trading at 22 times forward earnings, well above the 50-year average of 16.5 times earnings but below the all-time high P/E ratios seen just prior to The Great Crash in 1929 and the Tech Bubble of the late 90’s. Stock valuations are more compelling today at roughly 16-17 times earnings, but the outlook for corporate earnings is quite uncertain at present. If corporate earnings disappoint in the coming quarters as some expect, investors should be prepared for the prospect that stock prices will overshoot to the downside.

According to Stock Trader’s Almanac mid-term election years are characterized by above average volatility, particularly during the summer months. The silver lining is that mid-term corrections generally end by late summer or early fall, ahead of the November election. This period generally marks the start of an extended rebound in stock prices.

In short, investors should brace for more volatility and uncertainty over the next several months, while being prepared to take advantage of the next great buying opportunity that lies ahead!

Roller Coaster Ride

The first half of 2022 was bumpy to say the least, with the tech laden NASDAQ falling 30.3% through June 30th (it’s worst quarter first half since 2008), and the S&P 500 flirting with bear market territory as denoted by a 20% or more, peak-to-trough decline. It was the worst six month start for the stock market in decades. [1]

In what can only be described as classic bear-market action, the broader market year-to-date, has experienced multiple rallies of 8%-10% before giving way to even lower prices. This kind of action is often referred to as the “slope of hope”.

The cause? Persistent inflationary pressures, brought on by a “one-two punch” of the Fed’s excessively easy monetary policy and massive COVID-induced government spending in the trillions combined with supply shortages brought on by pandemic shutdowns and Russia’s invasion of Ukraine. Collectively, these forces, along with the prospects of much higher interest rates and a have investors on edge. 

The Inflation Genie

Clearly, the “inflation genie” is out of the bottle, and the Fed has it’s back against the wall. Putting a genie back in the bottle is no easy feat… which you know, if you ever watched the sixties sitcom I Dream of Jeannie.

Recent Consumer Price Data (CPI) and Producer Price Data (PPI) indicate that inflation is running at levels not seen in over four decades. The Fed has stated its commitment to bringing inflation down from 8%, and closer to its 2% target, but its own admission monetary policy is a blunt tool.

Monetary policy can’t fix supply chain problems and it can’t cool off one area of the economy where inflation is extra hot without cooling off areas where inflation is less intense. I guess you can call this the “law of unintended consequences.” We can hope for a soft landing, but history tells us that such an outcome is very hard to achieve.

While “goods” inflation and commodity prices might be on the verge of peaking as COVID-driven supply chain issues appear to be subsiding, wage inflation is still very prevalent in corporate America, especially with unemployment at historically low levels. The JOLTS survey tells us that employers still can’t find enough workers to meet demand, so one must assume that wages won’t slow until the economy has cooled dramatically.

It’s hard to imagine that the same Fed that kept interest rates too low, for too long, has the ability to rein in inflation without causing a recession.

The Interest Rate Outlook

With higher inflation comes higher interest rates. The two are undeniably linked. Simply put, higher interest rates translate into higher borrowing costs for both corporations and consumers. In turn, higher interest rates translate into lower corporate profits for companies and less disposable income for consumers. For example, in just six months, Home Depot’s cost to borrow funds over a year period soared from 1.875% to 3.25%. Wildly unpredictable inflationary pressures on corporations clearly explains downbeat corporate earnings, as well as the recent uptick in credit delinquencies for consumers.

Higher interest rates are having a significant impact on the residential housing market as the double-whammy of soaring housing prices and interest rates, have led to a plummeting in the housing affordability index, i.e., housing is the least affordable it has been in decades. Over the past 18-24 months, the 30-year mortgage rate has surged from roughly 2.75% to over 5%.

Consumer spending, of which housing is a significant portion, can only slow given these forces. Hence, consumer spending rose at its slowest pace in 2022, as consumers struggled to manage the higher food, housing, transportation and energy prices.

Rising Treasury yields, in turn, are cascading throughout the economy in the form of higher borrowing costs, squeezing households and businesses alike. Car loans, credit cards and corporate debt all stand to get more expensive as rates rise. [2]

The Earnings Wildcard

According to FactSet, “on a year-over-year basis, the S&P 500 is reporting its lowest earnings growth since Q4 2020. During the upcoming week 175 S&P 500 companies are scheduled to report. In aggregate, both revenues and earnings are set to come in well below the long-term averages. As noted earlier, P/E ratios have contracted to levels that are more realistic given the significantly. At the end of day though, market prices will directly reflect the direction of earnings. If earnings fall, so will broad market averages. Fortunately, the reverse is also true. [3]

It\’s the Economy Stupid

About 90% of investors expect the U.S. to enter a recession before the end of 2023, and 72% of investors surveyed said they expect the S&P 500 to fall further before it stages a sustained recovery. according to a survey published Thursday by Deutsche Bank.

At the beginning of 2022, the average interest rate on a 30-year mortgage hovered above 3%. Today it stands at 4.72%, according to Freddie Mac.

Higher rates will make monthly mortgage payments—already at the least affordable level since November 2008—even less so. A median American household needed 34.2% of its gross income to cover mortgage payments on a median-priced home in January, according to the Federal Reserve Bank of Atlanta. That is up from 29% a year earlier. [4]

The Good News!

While an economic slowdown likely awaits investors, the good news is that consumer balance sheets are relatively strong, the banking system is on solid ground and any contraction in the economy is likely to be limited. The broader market may move lower over the coming months, but we are not likely headed for another 1999 bubble bursting or for a Great Recession seen in ’08-’09.

The best advice for investors at present, is to be defensive but on the lookout for a great buying opportunity. We are watching every day for evidence of a turn!

Footnotes:

[1] S&P 500 Posts Worst First Half of Year Since 1970, The Wall Street Journal June 30, 2022, https://www.wsj.com/articles/global-stocks-markets-dow-update-06-30-2022-11656487667-11656574533?mod=hp_lead_pos1&mod=hp_lead_pos5 

[2] Cooling Consumer Spending Points to Further Economic Slowdown, The Wall Street Journal June 30, https://www.wsj.com/articles/inflation-consumer-spending-personal-income-may-2022-11656531317?mod=article_inline 

[3] S&P 500 Earnings Season Update, Factset July 22, 2022, https://insight.factset.com/sp-500-earnings-season-update-july-22-2022

[4] Interest-Rate Surge Ripples Through Economy, From Homes to Car Loans, The Wall Street Journal April 8, 2022, https://www.wsj.com/articles/interest-rate-surge-ripples-through-economy-from-homes-to-car-loans-11649426081?mod=series_stockmarket