Third Quarter Market Update
The harsh market environment of 2022 continues to challenge us all. Most financial commentary this year naturally has primarily bad news to share. We won’t break with that trend at the outset of this newsletter, but we try to include a few glimmers of hope in our task to deliver context.
Stock market declines typically steal the front-page news coverage, and why shouldn’t they? The S&P 500 fell -24.77% through the end of the third quarter, and growth-oriented and international stocks declined more than -30%. Historically speaking, that’s a rough year, though still a far cry from other bear markets in recent history.
In our opinion, the main story lies not in the challenging year for stocks but rather in the unparalleled decline in bond markets. As measured by Bloomberg, the aggregate US bond market declined -14.62%, and corporate bonds fell -18.72% through September 30th. Those returns for typically revered ‘safe’ assets have never been seen before. Through the end of the third quarter, the vaunted Bloomberg 60/40 stock/bond portfolio was down -20.93%.
Throughout the year, we’ve held substantial positions in cash and gold. By doing so, we’ve managed to preserve capital and put portfolios in a position to capitalize on the next phase of this bear market.
We understand that this economic/political/geopolitical backdrop can be nerve-wracking. Please let us know if you would like to schedule a more in-depth review of our strategy and outlook. We feel that our approach is uniquely suited in times like this to preserve assets and peace of mind.
To comprehend past periods of market stress, you’d often have to understand a wide range of acronyms or convoluted economic concepts. The more notable have been: systematic trading, stock insurance, C/R-MBS, synthetic CDOs, investment trusts, balance of payments crises, sovereign defaults, irrational exuberance, etc.
This episode of market instability, on the other hand, is very straightforward. The equation goes something like this: HIGH AND RISING INFLATION = HIGHER INTEREST RATES = SLOWER ECONOMIC GROWTH = FALLING STOCKS (AND BONDS) = FINANCIAL CALAMITY (SOMETIMES).
The inverse relationship between interest rates and economic growth/stock prices is foundational to modern finance. Yet after a decade of interest rates near zero, market participants had become complacent.
Let’s start our review with the trajectory of interest rates over the past 50 years. The chart below represents the borrowing costs for the US Treasury when they borrow money for a 10-year term.
Higher borrowing costs make businesses less efficient or restrict their ability to expand, and they also offer investors an alternative to risky assets. Both the level and rate of ascent/descent matter. A 10-year treasury yield of 3.9% is not inherently negative or positive – it’s effectively the average long-term yield. It's the pace of rate rises that's the proximate issue for markets. So, are rates headed even higher from here?
Stock markets around the globe sure hope not. Each rate surge this year has been met with a bout of selling in equities.
Interestingly, the S&P 500 has set only marginal new lows on the most recent rate surge. If the market finds the ability to acclimate to higher rates, that might cause optimism.
Yet, we know there must be a breaking point where economic growth succumbs and investor capital is lured away from stocks and into bonds. In the short term, somewhere between 4-6% is a decent guess of where those pressures increase. Only time will tell.
Although, keep in mind that, like the proverbial frog in a pot of water, the temperature matters, but the time spent in the water matters more.
The world’s central banks will dictate the duration we must spend in a restrictive interest rate regime. And they’re singularly focused on one thing: inflation.
Whichever your preferred measure of inflation might be, it’s telling the same story – inflation is persistently high.
So long as inflation is high and rising, you can expect a challenging investing world. But don’t get trapped in an echo chamber – that’s been the story all year. Any hint of relenting inflation is all market outlooks need to snap right back to the bullish thesis of low-interest rates = stable economic growth.
In 2022, the story of the markets really is that simple. Unfortunately, simple to describe doesn’t mean easy to navigate.
How Much is Enough?!
Sometimes once we’ve had enough, we just can’t take any more. Other times, we want so much that we just can’t get enough. So, when do we know that enough is enough?
Consumers have had enough inflation. Two months ago, consumers (as surveyed by the University of Michigan) were as pessimistic about their situation as they’ve ever been. Luckily, gas prices fell, so they feel a bit better. Let’s hope the trend persists.
The Conference Board indicates that consumers are depressed, but not exceptionally so. The University of Michigan data set correlates more strongly with feelings surrounding big-ticket purchases and inflation. So the deviation between the two data sets makes sense.
Investor pessimism is palpable; measured by the American Association of Individual Investors, the spread between optimistic and pessimistic survey respondents has reached levels that in the past have signaled extremes. For every bullish (optimistic) respondent, there are more than three bears (pessimists). That’s a level scarcely seen in history.
Ironically, investors throwing their hands up and saying they’ve had enough can indicate that enough damage has been done to warrant market stabilization.
Stock market valuations have taken a beating due to higher interest rates. The 100 most egregiously expensive stocks (represented by the top of the grey shadow) have fallen dramatically. The 100 cheapest stocks (represented by the bottom of the shadow) are now at levels not seen since the financial crisis of 2008. The valuation for the median stock sits only slightly below its long-term average.
If you’re going to make the case that enough damage has been done to individual stocks to warrant a bargain basement buy, you’ll need the support of interest rates (see above) or confidence in a stable earnings outlook.
Lucky for your bullish case, companies are earning record profits and revenues with historically high margins. Although, market strategists fear we’ve seen the best of the earnings growth for this cycle, and falling earnings could undo some of the valuation correction we’ve seen this year.
Earnings are being revised lower, but expectations remain that they’ll continue to grow over the next 18 months. As the third-quarter earnings reporting season plays out over the next few weeks, we’ll hear directly from company management about underlying business trends. That will go a long way towards alleviating or exacerbating the economic slowdown narrative.
Signs of Hope?
Throughout this inflationary saga, we’ve stuck to two themes - first, that a post-war inflation boom was likely, and then that it would take a good bit of time to work through. We’re still in the ‘working through it’ phase and probably will be for many more months.
Dealing with inflationary pressures is a cycle of people addressing ‘me’ problems. We’re all just trying to defend our margins. Manufacturers pass on higher input and transportation costs, car dealers mark up prices due to elevated inventory costs, business managers boost invoices to meet corporate targets, and workers everywhere demand cost of living increases. Around and around we go.
That interconnected process of defending margins is cyclical. The hope is that each subsequent wave of solving ‘me’ problems results in a diminishing rate of price increase. While it’s still too soon to declare dramatic progress in the inflation fight, there are signs that the initial inflationary impulse from the pandemic may be subsiding.
Lumber prices were front and center not too long ago as an indicator of supply chains gone awry.
Now they’re back to the high side of normal.
Freight rates also took center stage in the ‘can you believe it?’ pageant.
They, too, are back to the high end of normal.
If you’re in the market for a house or a car, I imagine you’re not pleased with the pricing. But signs are beginning to emerge that those assets are also starting to normalize.
Many other single-item examples of easing supply chain stresses or one-off commodity shortages are out there. On a broader basis, the Institute for Supply Management surveys businesses on the pricing trends they are seeing. The data set tends to correlate highly with inflation reporting from the government.
The survey results paint a picture of receding pricing pressures, especially in manufacturing businesses. A reading above 50 indicates rising data, so we have yet to see any outright deflation, but this is a clear sign of healing at the wholesale level of our economy.
For all you Fed junkies who would feel slighted by a lack of outright monetary policy coverage – here’s the projected path of tightening as laid out by the members of the Open Market Committee. Markets continue to fall over themselves to predict an eventual pause at a terminal rate, although each time they do, they’ve had to reprice their terminal rate higher.
If that path were to play out, the white line and dots on the following chart are how this tightening cycle would stack up versus the previous eight cycles. We’re on a truly historic pace of tightening.
Thanks for taking the time to review our newsletter. As always, if you’d like to continue the conversation, please let us know. We always have more charts and storylines ready to present.