Market Update

The S&P 500 fell 1.6% last week while the Nasdaq dropped 3.1%. The S&P bounced on Thursday but couldn’t break above the 20-day moving average. The 200-week moving average offered some support earlier in the week and again on Friday. But Thursday's reversal was all about the 50% retracement level. The algorithms kicked in big time at 3500. The buying catapulted the index 5% higher from the day's lows. The 3500 level represents a 50% retracement of the bull market rally from the March 2020 low to the January 4th peak. (Why is a 50 % retracement considered important support? Because humans decided it was and so it is. A self-fulfilling prophecy if ever there was one.)

The S&P closed the week at 3583.07, barely below the 200-week M.A. and above the 50% retracement level. The coming week will be critical. Holding the 50% retracement support means a shot at 3950 later this fall. Failing to hold 3500 means a substantial decline is likely. There is support at 3300 (bottom of the downtrend channel) and 3,178 (61.8% retracement of the rally from the Covid lows). The algorithms use the Fibonacci numbers which again makes it a real thing.

The odds favor more downside testing. Earnings season guidance is likely to be disappointing. A disappointing earnings season would serve as a catalyst for more selling. The VIX closed above 30 again but still needs to spike north of 40 for any chance of a meaningful bottom forming. Thursday’s swing from down 2.4% to up 2.6% is a good sign though. The S&P sold off as the core CPI hit a 40-year high. The 5% bounce off the 50% retracement level is the kind of reversal that leads to positive returns.

A 5% reversal has happened only nine times since 1983, according to Bespoke Investment Group. The S&P 500 was down 3.5% on average over the following three months. It was up an average of 14.6% over the next 12 months. The S&P may fall to 3,178 first but the odds favor that it will be higher than its current level 12 months from now. The bear market is in its 10th month. We are closer to the end than the beginning both in time and price.

Economic Indicators

The inflation numbers were the big news from last week. The PPI came out Wednesday, showing an increase of 0.4% for September. The prior month's PPI declined by -0.2%. September’s rise was the first in three months. It was double the Wall Street forecast. The year-over-year increase fell to 8.5% from 8.7% but is still near a 40-year high.

Thursday’s CPI report also showed inflation continuing to run higher than expected. The September increase of 0.4% was up from 0.1% and above the forecast of 0.3%. The core CPI rose 0.6% in September, higher than the 0.4% forecast. The year-over-year CPI was 8.2%, above the 8.1% forecast. The core CPI rose 6.6% year-over-year in September after rising 6.3% the prior month.

Bond yields rose in response to the inflation numbers. The two-year Treasury climbed to 4.55% by Friday’s close. The 10-year rose to 4.03%. The Fed funds futures rose to just shy of 5% by Friday. A 0.75% Fed funds rate hike in November is now a certainty. Investors are also expecting a 0.75% rate hike in December instead of 0.5%. Higher rates will continue to pressure both bonds and stocks in Q4.

Stock Investing 101

Buying stocks means buying businesses. Businesses have value because they generate profits for their owners. Owning a stock means owning part of a business and sharing in the profits of that business. It is possible to calculate the intrinsic value of a business.

The stock price is not the intrinsic value of the business per share. Most investors fail to realize that the stock price is not the business price per share. In fact, the stock price is almost never the same as the intrinsic value of the business per share. Stock prices are like a pendulum swinging from undervalued to overvalued. The pendulum only occasionally takes the stock price through a business’s intrinsic value. It is the job of a money manager to find stocks trading well below the intrinsic value of a business. Buy those undervalued businesses and wait for the stock pendulum to swing back the other way.

Intrinsic value is calculated by estimating all future owner’s earnings and discounting them back to the present value. Owner’s earnings are divided by the discount rate minus the growth rate of the business to calculate the intrinsic value of a business. Warren Buffet’s preferred estimate of owner’s earnings is reported earnings plus non-cash charges minus maintenance capital expenditures (capex). We can also use operating cash flow minus maintenance capex. More conservatively we can use operating cash flow minus all capex, which includes capex for growth.

The discount rate is used to discount all future cash flows back to the present. The Weighted Average Cost of Capital (WACC) is the formal method for calculating an appropriate discount rate. One can think of the discount rate as the required rate of return for making the investment. Skipping past WACC, Buffet prefers to use the 10-year Treasury rate adjusted for current conditions. He’s on record as adding a few points to the Treasury rate when interest rates are artificially low for instance.

The important takeaway from the intrinsic value discussion is that a business does have an intrinsic value and it can be estimated. The stock price is not a good estimate of intrinsic value most of the time. Factors other than owner’s earnings, growth rates, and discount rates determine short-term stock price movements. Fundamentals do matter over a decade or more, accounting for almost all a stock’s price movement. Fundamentals matter very little over shorter periods of time. The madness of crowds rules stock prices from year to year instead.

Why is all this important? Because investors are increasingly worried about falling stock prices. They fear a permanent loss of capital. Stock prices are falling because of short-term factors. Rising interest rates, high inflation, snarled supply chains, and a strong dollar are impacting stock prices. These factors are temporary and will have no impact on the value of the businesses we own over the next decade.



Norwood Economics buys businesses that are on sale. Buying a business at a discount doesn’t prevent you from losing money over short periods, say a few years. It does prevent you from losing money over longer periods. Buying at a discount also makes it likely that we’ll continue to earn high-risk-adjusted returns in the future. Any losses are temporary.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist