Hello friends and clients, I hope you are enjoying Spring!
It is amazing how much our family is changing:
- Paul is stationed at Hanscomb AFB outside of Boston (he is a 2nd Lieutenant in the Air Force). He has a serious girlfriend.
- Catherine will be a Junior at Grand Canyon University in Phoenix; she will be spending the summer there this year working an internship. We will miss her terribly.
- Bernadette is going to High Point University in North Carolina. Like her siblings, she did a great job getting an academic scholarship and will be playing club volleyball. She plans on studying business.
- Bridget is transferring from Royalmont to Mount Notre Dame and will be a Junior.
- Ellie is homeschooling John and will continue for the next year as well. We will see where things go!
We know this post is long. If you don’t have time to read fully, Here are a few quick bullet points to know:
- Over the last few years, we have seen a shutdown and a deluge of government spending which resulted in historic inflation. This led to record interest rate increases which has caused both bonds and stocks to decrease in value. This tightening has previously always led to a recession and there are many signs that we are inching ever closer.
- Technical indicators are pointing Bullish – but Fundamental Indicators are pointing Recessionary.
- The markets may be overpriced and still processing rising interest rates and inflation.
- We want to be conservative and cautious with regards to risk. We think there will eventually be excellent buying opportunities, but patience is required.
- And as usual, I have lots of fun graphs! Read on…
Market and Economic Commentary
These last few years have been unprecedented in so many ways – from the COVID lockdowns, to the massive stimulus checks, to generational levels of inflation and government debt.
We are at a crossroads where there are many tensions in the market and economy.
We went from a market surge in 2020-2021 due to an unprecedented amount of liquidity/money printing to inflation such as we have not seen in over 40 years. This led to rising interest rates, which has led to stock declines.
The graph below walks you through this one step at a time.
Since January, the good news is that S&P 500 has had a good start. The less than good news is that these returns are largely driven by a handful of large cap growth names (NVDIA, Apple, Microsoft, Google, Tesla, etc). In the chart below you can see the Dow Jones has been largely flat for the year, and the Nasdaq is up 18%, and as expected the S&P is between them.
So what is going on?
While the bond market is pricing in a recession, the stock market is suggesting that:
- Inflation will come down to targets.
- The Fed will cut interest rates.
- A recession will be avoided.
- Corporate profits will grow significantly.
We have a highly unusual case in which market technicals suggest continued growth, whereas fundamentals suggest we may have seen market highs for the year.
Technicals are Bullish
This refers to how stock charts look. Certain patterns tend to lead to bullish outcomes and other patterns tend to be bearish.
- Higher highs – since the market bottomed in October last year, the market has averaged up.
- Higher lows – when the market has gone down, it has gone down less than the previous low.
- The S&P has gone above the 200-day moving average (the curvy orange line).
- The short-term average has gone above the long-term average.
These are all signals of bullishness in the market.
On the other hand, Fundamentals are showing Negative/Recessionary
Franklin Templeton’s “Anatomy of a Recession” site tracks many of the risk factors that predict a recession, and nearly all of them are negative. In fact, you can see in the image above they have been getting worse every month. These signals point towards a recession.
Either the fundamentals must improve or the technicals will diminish. The discrepancy must be resolved. What the market is doing and what it ‘should’ be doing have diverged.
The million-dollar question becomes which scenario is most likely?
I agree with the stock market suggesting that inflation is on its way down. However, I agree with the bond market that a recession is inevitable. The main question is when?
A clue can be found with the yield curve inversion. This means that long term rates are lower than short-term rates. Things are backwards.
Historically speaking, whenever the yield curve inverts, it is typically associated with a recession in the near future.
You will notice from the graph, that every time this inversion happened previously (since the year 2000) there has been a recession (indicated by the grey vertical bars). What is not as obvious is that a recession doesn’t normally happen until the yield curve gets rectified.
In other words, the recession typically comes once it looks like everything is ok. July will be the one year anniversary of the inversion and you can see that the curve appears to be ‘un-inverting’, but it’s not there yet.
This suggests that any potential recession may still be months away.
What we also believe is that:
- The market doesn’t hit bottom until the recession starts.
- It is normal for the market to start its decline before the recession.
- The market also tends to recover during the recession (but not always)
Currently the market is trying to process two things: Inflation and Recession. It is finishing the inflation process but has not started processing the recession.
One other clue is how the market is priced right now. It is VERY expensive. Based on Q4 earnings for the S&P and the price as of May 22, 2023, we are at 24 times PE (Price to Earnings ratio). Source: https://www.multpl.com/s-p-500-pe-ratio
What does that mean? If you looked at how much companies made in Q4 of last year and annualized it, you would need to wait 24 years for the profits to have equaled the stock price.
For comparison, the long-term historical average is closer to 15.
Additionally, while profits have come down, they are at historic levels due to the government stimulus. You can see from the graph how distorted corporate profits have been. The piper has to be paid.
We don’t think we are done with the banking crisis either. Additionally, politicians are torturing us with the debt ceiling negotiations which is an overhang on the market.
The last time congress and the president played chicken with the economy the market declined 20% and the US lost its triple A ratings.
Many companies are experiencing greater financial stressors due to excessive and rising debt payments. Consumers savings levels are also low while credit card balances are at historical levels (see the graph).
There is a lesson in all this – we cannot print ourselves to prosperity.
The economy can be compared to the seasons, we have to make it through Winter to get to Spring. I’m told that trees lay their roots deep in the wintertime and prepare for the new life of Spring.
Recessions are like a forest fire. They clear out the dead branches and overgrowth and eventually lead to new life and opportunities.
In 2009 people thought no asset allocation was complete without guns and gold. However, things turned out much better than anyone thought. My guess is that the same thing will happen again, but it takes patience and diligence.
Every market provides plenty of opportunities, and there are many reasons to think the future will be bright!
Thank you for the opportunity to serve you and I look forward to hearing your comments!
As always, if you have a friend that you think will benefit from a conversation, we would be happy to see if we can help.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Investing includes risks, including fluctuating prices and loss of principal. No strategy assures success or protects against loss.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.