Market Update

The S&P 500 fell 2.2% last week to finish at 4594.62. The Nasdaq lost 3.5%. The S&P set a record Monday morning before backing off by 11 a.m. The index lost almost 1% in the last hour of trading Monday. Tuesday and Wednesday were sideways, leaving the index where it had started the week. All last week's loss came Friday. Covid was back in the news Thursday. The U.S. market was closed. Friday’s shortened trading day is usually a non-event. Black Friday this year was ugly as the stock market tanked on light volume. It fell 2.3%.



The narrative is that the new Covid variant emerging from South Africa was to blame. It seems more likely that algorithms kicked in as the S&P 500 opened below its 20-day moving average. Technicals do hold sway in the short term. The 20-day had acted as support on Tuesday and Wednesday. Opening below the 20-day Friday gave the green light for profit-taking.

It’s likely that the narrative this week will shift to the positive. The obvious meme is that the new Covid variant will slow Central Bank tightening. After all, the Fed has our backs. It might be mid-week before that narrative starts making the rounds, but it is coming. Traders will most likely try to take back the 20-day. We will see if we get a quick rebound above or whether more profit taking occurs. The 50-day is support at 4525.

The S&P 500 is still up almost 5% over the last seven weeks. The uptrend is still intact. The path of least resistance is up. Norwood Economics does not think a correction is likely until after the first of the year.

Economic Indicators

The Chicago Fed national activity index (CFNAI) rose 0.76 in October after falling 0.18 the prior month. The CFNAI is composed of 85 economic indicators. The indicators come from all categories of economic data. A positive reading signals growth above the historical trend rate. The rise in the headline index was broad-based.

Existing home sales were up. Initial jobless claims were down, below 200,000 for the first time since 1969. Q3 GDP was revised up to 2.1% from 2.0%. Personal income rose 0.5% in October after falling 1.0% in September. Consumer spending grew 1.3% after rising 0.6% the prior month. The data indicates the economy is growing and maybe re-accelerating.

Inflation is accelerating as well though. Core inflation was 0.4% in October up from 0.2% in September. Core year-over-year inflation was 4.1% in October up from 3.7% in September. The stronger economic growth and rising inflation points to a need for Fed tightening. However, there are economists who believe that inflation will subside on its own. David Rosenberg, for instance, believes the economy is too fragile to handle higher interest rates. Rosenberg was Gluskin Sheff’s chief economist and strategist before starting his own firm. He was also the chief North American economist at Bank of America Merrill Lynch. He is well respected by Wall Street.

Rosenberg believes that the U.S. economy is more sensitive than ever to asset prices, according to Barron’s. He also thinks the housing and stock markets are each about 15% overvalued. Rising rates are likely to trigger mean-reversion in asset prices. The mean-reversion will generate a deflationary headwind in the economy. He does not believe the Federal Reserve will raise rates at all in 2022.

Accepting the Reality of Future Returns

We have many biases. Our thinking is controlled by them. Status quo bias keeps us from making changes as often as logic would dictate. It is the “it’s good enough” bias. The Endowment Effect leads us to value our possessions more than is rational. It is why we think our coffee mug is more valuable than someone else’s identical coffee mug. Overconfidence bias is our tendency to overestimate our abilities. Overconfidence bias is what leads so many people to believe they are better investors than their track record indicates. Optimism is the difference between a person’s expectation and the actual outcome. There are many more biases that rule our decision-making and lead us astray in the financial realm. Current return expectations by the public are only explainable through our biases.

The S&P 500 is almost certainly going to return far less than the 9% to 10% long-run average over the next decade. The data is compelling. Yet very few people are willing to believe the data. I last ran into this disconnect in 1999-2000. Bank of America’s quantitative model last indicated negative returns for the S&P 500 for the coming decade in 1999 by the way. Again, the data is overwhelming whether looking at Market Cap to GDP, Price to Sales, Replacement Cost, or Shiller’s P/E. Price dictates returns over the long run, always. Importantly, it does not tell you how the return will occur. The market might flatline. It might fall and recover multiple times. Price dictates return. It does not shed light on how that return is achieved.

The S&P 500 is going to earn almost nothing over the next 10 years. We just don’t know how that return will be generated. Let’s look at the Cyclically Adjusted Price to Earnings (CAPE) ratio to show why the S&P 500 is not going to be any higher 10 years from now. The CAPE is at 40 with the S&P at 4700. The S&P 500’s average CAPE over the last 100 years hasn't changed much. For most of that time it was 15. It has been 18 over the last 20 years. The S&P 500 has been overvalued much of the last 20 years due to extremely easy Federal Reserve monetary policy. Nevertheless, we’ll use 18 as the new average.

CAPE is over twice its average value of the last 20 years. It is higher now than the peak of the roaring 20’s. It is approaching the dot.com bubble peak of 1999-2000. The S&P 500 did have a negative return from 1999 to 2009. The S&P 500 is likely to have a low single-digit return over the next 10 years now.

Importantly, there are many stocks that will do very well over the next 10 years. Norwood Economics owns stocks with price-to-earnings ratios under 15, with many under 10x. Most of our stocks pay dividends of 3% or more with some paying dividends of more than 5%. We are NOT pessimistic about our holdings. We DO believe that our clients will earn a mid-single-digit or better return from our stock portfolio. It is the expensive stocks like Tesla that will stagnate and fall over the next ten years.

Price dictates return over the long run. Look for good companies on sale with strong balance sheets paying an above-average dividend. Forget about buying the market because the market is likely going nowhere fast during the next decade.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist