Wow, it’s been quite the year so far. It has also been a while since we’ve sent out a market update and a big reason for that is the lack of visibility and thus, inability to forecast anything of substance. Lack of visibility could be the key theme for 2022, which we will get into more below. Before digging into the variety of topics we’ll discuss, we wanted to thank you for the trust placed in our team here at MFG. It is a big responsibility to manage investments for our clients and we do not take that responsibility lightly. Our team is truly grateful for the opportunity to partner with each of our clients in the pursuit of financial freedom for themselves and their families.
Here is a summary of the topics we’ll discuss and how each of them seem to play into the stock market and the economy more broadly:
Investor expectations relative to history
Federal Reserve and the path of monetary policy (interest rates and balance sheet)
Inflation
Energy Prices
War in Eastern Europe (Russia and Ukraine) and China’s Zero Covid Policy
Upside Down News Cycle – Is bad news actually good news for stocks and vice versa?
Bear Markets and Investor Psychology (Fed Put / Buy the dip)
Investor Capitulation – what does that mean?
Multiple Contraction
Hedges – What are they and why do we use them?
Investor expectations relative to history
It’s easy to look back to a chart of the S&P 500 today and think, yeah of course the market has sold off this year, especially considering the three years prior – 2019 (28% return) 2020 (16% return) 2021 (26% return) approximately. The Stock Market has historically kicked out 8-10% annual returns on average for the last 100 years. For those averages to ring true, we know there are years that are higher than the average and years that are lower than the average and even years where the market declines in value. We have just lived through several years with returns much greater than those levels so it’s not unreasonable to expect there to be some periods on the lower end of the spectrum as well. That’s all part of participating in the stock market. When it comes to investor expectations, it’s very important to view swings in the market with this lens as it helps protect against knee jerk reactions to market fluctuation.
Federal Reserve and the Path of Monetary Policy
We believe the Federal Reserve (Fed) is one of the biggest drivers of what happens in the stock market. Bear with us as we walk through a story that started in March of 2020. Mandated lockdowns of the US economy and much of the rest of the world was the initial response to Covid-19. To avoid a significant and lasting recession caused by the mandated shutdowns, there was massive, enormous, unprecedented, (insert your favorite BIG adjective) level of stimulus from both the Monetary (Federal Reserve) and Fiscal (Government Spending) side injected into the economy. What initially started as a lifeline to keep the economy from drowning, turned into crutches as the lockdowns were lifted. The Fed continued to stimulate the economy until the end of 2021, long after the US economy was fully opened and running again, the thought process was to build a strong foundation from which the Fed can eventually withdraw, and the economy would be healed enough to walk on its own two feet without support.
You might remember the term “transitory”. This is the word many economists, including the Chairman of the Federal Reserve, Jay Powell used to describe the first hints of inflation seen in 2021. What they meant was that inflation would last for a short period of time and would eventually come back down again. Looking back now, it is clear the Fed made a big mistake, but at the time they were operating under the assumption that the world was moving past Covid lockdowns and supply chains would be up and running again. But unfortunately, there were both the Delta and Omicron waves of Covid, which lead to many states and many countries locking down their citizens again. Regardless of opinion on that approach, it happened, and the result is that global supply chains continued to be disrupted. We’ll get into the details in the inflation section. But without supply chains operating, inflation being “transitory” was no longer a likely outcome.
Which brings us to late 2021 and early 2022 when the Fed began a shift in monetary policy, from stimulative to restrictive. When Fed policy is stimulative, they are lowering interest rates and are purchasing assets, this reduces the cost of borrowing and pumps money into the system. When Fed policy is restrictive, they are raising interest rates and are shrinking their balance sheet by either selling assets or at least not renewing their asset purchases, letting certain contracts fall off the balance sheet, effectively shrinking it and reducing the amount of money circulating within the economy. Two of the Fed’s primary mandates are Maximum Employment and Stable Prices. With inflation running hot and no signs of it rolling over they had to intervene by moving to restrictive monetary policy. By the way, all through the second half of 2021, they signaled the shift was coming eventually (sometime in 2023) but inflation being persistent forced the Fed to move up the timeline.
What we have been living through all year in 2022 is the digestion of that change in monetary policy. Seeing if the economy can thrive on its own without the Fed’s help. We would argue it probably can, as the labor market is remarkably strong. However, to battle inflation, the Fed now must go even further, effectively injuring the economy in order to reduce demand, with the goal of bringing inflation back down to their target of 2%.
Inflation
Inflation hasn’t been a topic of conversation for many years, but it’s one of the hottest topics of the year in 2022. In fact, we’ve only seen inflation above 8% in roughly 9 of the last 100 years.
What causes inflation? Dr. Will, a professor at UIndy does a good job of simplifying it by saying it’s the product of money vs. stuff. Meaning it boils down to a function of supply and demand. If there is more money being put into the system, there needs to be enough stuff (goods and services) to buy, otherwise prices will go up and vice versa – more stuff but less money moves prices down. We’ve just lived through significant increase in the money supply while at the same time, a decrease in production (think lockdowns and broken supply chains). As a result, we are seeing significant levels of inflation. An easy example is the housing market – with interest rates being at all-time lows, that increases the number of people who can afford a mortgage which increases the number of buyers, which is why homes were selling for tens of thousands of dollars above asking price, inflating the price of homes.
There are so many factors that bleed into inflation, many of which we’ll look at further below. But it boils down to supply and demand. What’s especially difficult for the Federal reserve right now, is they only have control over the demand side of the equation. The original plan was for the supply side to improve and that’s what would return equilibrium and inflation would end up being transitory. That hasn’t happened which means to combat inflation, the Fed actually has to break the back of demand. Ideally for the economy, the supply side would get fixed, and inflation would settle. The Fed had been waiting and waiting for this but it never happened, so they were forced to take matters into their own hands. Remember, they only have direct control over demand and to defeat inflation they’re actively trying to hurt demand by reducing the money supply. The big debate is if this will lead to a recession or if they can thread the needle and orchestrate a soft landing (bring down inflation without causing a recession).
Energy Prices
The increase in energy prices is a major factor for the inflation story. Not only because of the increase of prices at the pump for the consumer, but because the costs of moving anything around the world has increased, not to mention that fact that refined oil is one of the key raw materials in almost everything we consume – Plastics, cell phones, even our clothing. You’d be hard pressed to find a product that doesn’t use oil at some point in its production line. We could do many blogs on the energy market, but in summary it is once again a supply and demand issue. Years of underinvestment have now caught up to us and the world is demanding more oil & gas than is being produced, that leads to an increase in prices. In an interview with Ryan Lance, the CEO of ConocoPhillips, he was asked the following question: If you decided today, that you want to increase production capacity, how long until the first drop of new oil? His response was “Eight to twelve months”. Essentially meaning even if they wanted to, they can’t provide immediate relief to the increase in prices. Not to mention that he’s also running a business and there is a huge cost outlay initially to develop a drill sight. For them to invest in a new project they would need to expect a return on that investment. In a decade where there are calls almost daily for an end to the oil and gas industry and boycotts of investing in the space, companies have been reluctant to invest in additional drill sights because they don’t know if there would be any return on investment down the road. As a result, there has been a dramatic underinvestment in production to keep up with the increasing demand. Therefore, prices are going up. With prices going up, that makes new investment feasible, but there is a long delay before that new supply will hit the market.
Russia’s invasion of Ukraine and the resulting sanctions on Russian oil are also a factor. However, they are a very small one as Russian oil is still making its way to market. See a WSJ article on this for more detail: Article Link So Russian supply hasn’t changed materially, it’s just been rerouted to India and China. In fact, it’s actually going up according to reporting by CNBC’s Brian Sullivan on the OPEC+ quotas for July – Russia is estimated to be producing 20,000 barrels a day more in July than in June. Report Link
War in Eastern Europe (Russia and Ukraine) and China’s Zero Covid Policy
The humanitarian aspect aside which is tragic, both of these factors result in further disruption of supply chains, which feeds inflation, leading to a more hawkish Fed because if supply chains don’t improve, the only way to beat inflation is by reducing demand.
We’ve been discussing a lot of negatives in this blog as they are outweighing any positives. That being said, the market is smarter than any one person’s opinion and has already priced in a lot of what we’ve discussed. What that means is any incrementally positive news on the supply side of things would likely be a positive fundamental for the stock market, because that means some work is being done for the Fed and they might not need to be as aggressive in raising rates.
Upside Down News Cycle – Is bad news actually good news for stocks and vice versa?
The tricky part of navigating the stock market right now is understanding market moves relative to new economic data and developments on any of the topics discussed above. There is a chain of events that seem to happen when a new fundamental development comes across the tape, and it seems to filter down into two buckets: Economy is strong vs. Fed is Hawkish. These two ideas are currently working against each other. Which is why some perceived “good news” is often taken as “bad news” for markets, here’s why. As mentioned above, the Fed needs to hamper demand, effectively slowing the economy to bring down inflation. So, when we get good economic data or good jobs numbers reported, when that normally points to strong fundamentals which would be bullish for the stock market, the market seems to be digesting it as the Fed needs to be more aggressive because the economy is still doing well which means demand isn’t slowing and high inflation is lasting longer and longer. See how good news can be digested as bad news? Something good now might mean we’ll be forced to operate in an even more restrictive monetary environment down the road and stocks are forward looking – discounting future events. What’s particularly challenging is you might think that bad news would be digested as good news, because things are slowing and the Fed can be less aggressive. This has played out to a certain degree, but with bad news comes the reality that we may be looking at a Fed induced recession and longer term, that’s also a challenging environment.
Bear Markets and Investor Psychology (Fed Put / Buy the dip)
Over the last 10 years or so and most notably the last 2 years. The “buy the dip” mentality has been fabulously rewarded. Although the prudent investor does want to be buying stocks when fear is rampant and prices have fallen, the last two years have provided instant gratification for this strategy, 5-10% pullbacks have been quickly met with swings straight back up again. Investors have grown accustomed to that reality, making it easy to plug your nose and do some buying on bad days knowing you’ll probably be rewarded quickly for it. However, we’ve seen this strategy unravel to a certain degree this year, which is crushing to investor confidence and sentiment. Dip buyers might see a quick bounce that turns into an even worse selloff the next day. This has played out many times in 2022 giving more and more people reasons to get out and stay out of the market as it has been very painful. We believe we’re in a season where there will continue to be heightened volatility because of interest rates going up and the reduction of the Fed’s balance sheet and the unknown of how long that will go on for and what the ultimate ramifications will be.
A bear market by definition is a 20% decline from the previous high. The S&P 500 did dip below 20% intraday on May 20th however, it closed the day above that 20% level so technically, the S&P 500 isn’t in a bear market, but the Nasdaq has been in one for quite some time now, and the price action we’ve seen the last couple of months is certainly indicative of bear market action. There seem to be two schools of thought circulating right now:
We are currently mid-cycle in a temporary growth slowdown. Meaning expansion can continue for years, we’re just in a brief hiccup period. They will point to the job market as an indicator of economic health to build their case on.
We are late cycle and headed into a recession. They will point to inflation and the crushing of demand by the Fed and how recession is inevitable in that scenario.
There are incredibly smart people who can make convincing arguments for both sides. We believe the only path forward for option number 1 is if we see improvement in supply chains. That is the key because it means the Fed won’t have to crush the economy by design and we could move into a period of growth again in the not-too-distant future. Option number 2 becomes more likely by our assessment if there isn’t improvement from the supply side, because to achieve ultimate victory in the inflation battle, the Fed will be forced to slow the economy significantly, leading to a recession. How long the current bear market lasts we believe will be dependent on which of the above scenarios ends up playing out.
Investor Capitulation – what does that mean?
Within bear markets there are often periods that last for a couple of days, weeks, or even months when the market rallies for a time before rolling over and heading lower again. Some call these bear market rallies or dead cat bounces. But basically, the idea is if something falls long enough eventually it bounces, even a dead cat can bounce if dropped from high enough. There comes a time when the sellers get exhausted and start covering their short positions, or value investors start to see some oversold companies they want to buy, and then momentum traders start betting on a move up, whatever the reason, there are periods within bear markets when the market rallies, sometimes significantly. The difficulty is judging if something is just a dead cat bounce or if it’s the beginnings of a sustained market shift that leads to a lasting bull market again. A key element that many market technicians look for in a sustained market bottom is all out capitulation. A day or period when there is indiscriminate selling across the board and the volatility index blasts above 40. That tells you investors have given up and are heading for the hills, that is the day that will often mark the bottom of a market selloff. We haven’t seen that yet this year. Certainly, there have been very painful days, but the selling has remained fairly orderly – like a slinky falling down stairs in a slow grind rather than a rock falling off a cliff. There doesn’t always have to be a capitulation day but that is something we are keeping an eye on for the all clear to begin investing aggressively again.
Multiple Contraction
Before digging into multiple contraction, it’s helpful to understand the concept of investment duration. Duration is an investing term that considers the time frame for getting a return on investment. Most often used in the bond market, for how long it will take to recoup your principal investment by receiving interest payments. But it can be applied to all investments. For this purpose, we’ll discuss long duration assets vs. short duration assets. Think of it this way, if you buy shares in a start-up company that is borrowing money to fund their operations, no profits yet. But the goal is for the company to grow and grow to the point where they do become profitable and can repay you for your investment in the business, that’s a long duration asset because it might be 15 years or more before they have positive cash flows. Whereas a well-established company that is already churning out positive cash flows might be quicker to repay you for your investment, this would be a shorter duration asset.
Inflation and interest rate risk are the primary risk factors for long duration assets because they can both change the value of future dollars, meaning every tick up of inflation, or every increase in interest rates, decreases the value of that future cash flow you’re counting on 15 years from now. That is why a 15-year mortgage rate is almost always lower than a 30-year mortgage rate, the duration is shorter and therefore the lender doesn’t demand as high of an interest rate due to the lower level of risk.
Now let’s consider multiple contraction. There are several ways to evaluate if a company is trading at an attractive price. One of those methods is by looking at the Price to Earnings Ratio. You divide the stock price by the company’s earnings and arrive at a number, which you can then compare to other companies in a similar industry and evaluate if you think a company is undervalued or overvalued relative to its peers. The historical average PE ratio for the S&P 500 is in the ballpark of 15 -16. That doesn’t mean every company should trade at PE of 15, it’s an average with many companies way above and many way below that figure. To trade above that would be trading at a premium. Which is very reasonable for high quality companies, particularly high growth companies because their earnings are estimated to be much higher in the future which would bring that ratio back down to more reasonable levels over time.
Since mid-year 2021, roughly when the Fed started to signal rate increases were coming at some point in the future, a period of multiple contraction began – which means long duration assets have been dropping in value, some of which have fallen to the tune of 80% or more. The question now is, how much contraction needs to happen? The S&P 500 which had been trading at a PE above 30 at times in the last couple years did briefly touch down at a Forward PE of 16 on May 20th, which is using forward earnings estimates, not current earnings. Often when multiples are contracting, they will overshoot to the downside into maybe the 12-14 range before enough damage has been done – that’s where the capitulation would come into the mix.
Hedges – what are they and why do we use them?
We put out a blog on this back in 2020 which you can read here: Blog Link
In summary, hedges are positions in the portfolio to protect against the downside in the market. Essentially, we use them as insurance policies for our accounts. Like all insurance, it sometimes costs money, but the house doesn’t burn down. However, if the house does burn down, a person is very thankful they had insurance. We use hedges in the portfolio when the risk of a major market sell-off presents itself. For example, major indexes breaking through certain price levels of support in the market would be a scenario which signals much further downside could be in the picture.
As you can see there are many pieces of the investing puzzle right now, certainly more than we’ve seen in the last 30 years. Most of them also bleed into the other factors to varying degrees as well, let’s go through a possible headline and the potential ripple effects. If we see the headline “Russia and Ukraine agree to a ceasefire” there may be an immediate reaction – perhaps a drop in oil price futures, another ripple is the possibility of more grain coming out of Ukraine, providing a small amount of relief to price inflation on food. If both of those happen, that could relieve some major inflationary pressures which then means the Federal Reserve might not have to be as hawkish as previously estimated because some inflation pressures will be taking care of themselves. Which ultimately could mean a rally in most parts of the market and most especially growth companies (long duration assets) that have experienced the most pain from Fed actions.
Although we’ve highlighted a lot of factors, many of which seem to be negative. As mentioned before, the market already knows everything we’ve said and many of the negative factors have already been baked into the market. So what are some possible positives?
Resolution in Eastern Europe
Mid-term elections. If republicans take back the house in November, that would create gridlock in Washington which is ideal for business investment because they have visibility for the next two years knowing politicians likely aren’t going to change the rules of the game, so they can invest in new projects with confidence.
Onshoring of supply chains. After seeing the disruption and political risk of having a majority of production in other countries, many US companies are investing in plants back on US soil. Some are calling it deglobalization, moving away from a system that relies on production from dozens of countries for a single end product to land on the shelves here in the US. While that is positive for job creation here in the US, it also feeds the inflation story because costs of production and labor are higher in the US than in most other countries. So it’s a double edged sword.
Stock prices have come down significantly already in certain sectors of the market. This presents rare opportunities to buy great companies at big discounts.
It’s not fun to go through rough markets like this, but we are not discouraged because we know periods like this do happen every once in a while, and are healthy for long term market function. Valuations tend to get very high during times of expansion, like we’ve seen over the past decade or so. History does tend to repeat itself and although this period has been challenging and yes, multifaceted, we are beginning to see opportunities as a result.
We hope this has helped you with some understanding and once again thank you for trusting MFG to manage your assets even through times like this.
Authored by: Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.