Market Update

The S&P climbed 1.9% last week to finish at 4,045.64. The Nasdaq rose 2.6%. The S&P gapped up at the open Monday. It was a continuation of the bounce off the 200-day moving average that began Friday morning. We wrote last week, “…the bounce off the 200-day Friday gives a slight edge to the upside on Monday.” The gap-up opening Monday sent a clear message to the day traders and computers. Except it didn't.

The S&P hit its high for the day of 4,018.05 in the first hour of trading Monday. It was down from there. There is an old axiom on Wall Street that says the dumb money trades in the morning. Wall Street lore also claims that smart money trades late in the day and late in the week. The belief is that the public overreacts at the beginning of the day (week) to overnight (weekend) news. The smart money takes the other side of the trade. "First way wrong way" is another old Wall Street saying.

Perhaps it was a surge of dumb money buying Monday morning. The surge was met with selling after the first hour of trading. The S&P peaked at 4,018.05 and then moved lower until finding a bottom Thursday morning at 3,928.16. The sell-off from peak to trough was 89 points or 2.2%. The index was weak late in the day Monday, Tuesday, and Wednesday when smart money is said to trade.

The S&P bottomed for the week in the first 15 minutes of trading Thursday morning. (First way wrong way). It rallied the rest of Thursday and into the close on Friday, climbing 117 points or 3.0%. Pundits struggled to come up with a believable reason for the two-day rally. The economic news Thursday and Friday didn't support the rally.

The 117-point surge might have been due to profit taking on short positions by “smart money”. Or it might have been market makers hedging short option positions by buying the underlying stocks.

Here’s as likely an explanation as any. Dumb money buys at the open on Monday pushing the S&P 500 up 48 points or 1.2%. Smart money sells the rally, profiting on the subsequent decline. Smart money selling pushes the index to a low for the week of 3,928.16 by Thursday morning. Smart money pockets the 89-point decline (2.2%). Smart money turns around late in the week and rips the market higher to close at 4,045.64. Smart money pockets 117 points or another 3%. Wall Street traders are kings of the world. Hey, it's as good an explanation as any.

All the action last week was bereft of fundamentals. When there's no fundamental reason for the market to move you can make up any reason you like. And so, pundits and the news media do. Last week's trading was nothing more than noise as traders went about the zero-sum game of trading. Burton Malkiel's random walk at work.

Fire and Ice

The Fed is raising the Fed funds rate. Interest rates along the curve are climbing. Earnings estimates continue to fall. As well, the disinflation narrative is increasingly in question. The ISM manufacturing report showed a rise in the prices paid index. The index rose from 46.5 to 51.3 last month, well ahead of estimates of 46.5. A number above 50 indicates an increase in prices. It is the first time the index has been above 50 since September.

Also of note is the rise in copper prices. Copper prices are a strong leading indicator for the ISM prices paid index. The rise in copper prices means likely inflationary pressure coming from the manufacturing sector over the next few months. China reopening is another possible source of inflationary pressure. Investors would do well to keep an eye on the commodity complex.

Inflation expectations continue to increase. One-year break evens are at almost 3.5% up from 1.63% on January 9th. Inflation expectations have doubled in less than two months. Inflation swaps now peg CPI at 3.1% by June up from 2.0% at the beginning of the year. It is a rapid change in expectations and explains the big move in interest rates.

The Federal Reserve is fighting the forest fire that is inflation. There is no question that the fire has been reduced but it has not gone out. The Bloomberg core services ex-housing inflation rate is still at 6.2% for instance. And like any fire inflation can come back if there is fuel available to burn. Inflation is a monetary phenomenon. It is fueled by too much money. The Fed allowed the money supply to surge in 2020 and 2021. U.S. M2 money supply grew by almost 40% in less than two years. There is plenty of fuel left to burn.

But money supply is falling. U.S. M2 is contracting. It has declined at a 1.7% rate over the last 12 months. It is the largest year-over-year decline on record dating back to 1959. Interest rates have zoomed higher since March of 2022. The 6-month Treasury yield is 5.14%, the highest since February of 2007. The yield was at 0.69% one year ago and 0.05% two years ago. The U.S. debt was much smaller in 2007. The impact of the highest interest rates in 16 years on a heavily indebted America has not yet been felt.

The fire of inflation will be doused by the contraction in money supply. High-interest rates in a heavily indebted economy make it likely that the U.S. experiences a recession in the process.

Economic Indicators

The economic numbers last week show an economy that is still growing, albeit slowly. It also shows that inflationary pressures are not yet under control. Core durable goods orders rose 0.8% in January after falling 0.3% the prior month. Pending home sales surged by 8.1% in January after climbing 1.1% the prior month. The unseasonably warm weather likely caused seasonal adjustments to misrepresent housing strength. The Case Shiller home price index rose 4.6% in December down from a 6.8% rise the prior month.

The Chicago business barometer was 43.6 in February down from 44.3 the prior month. The consumer confidence index slipped to a three-month low. The ISM manufacturing index continued to show contraction in February, coming in at 47.7. Jobless claims were 190,000 last week down from 192,000 the prior week.

The Fed will continue to raise rates and then keep rates high until the labor market starts to weaken. U.S. unit-labor costs rose by 3.2% in Q4 up from 1.1% in Q3. The revision was worse than expected. The rise in unit labor costs is fueling inflation. Furthermore, the ISM services index continued to show strength at 55.1% in February. A growing service sector along with rising wages means more rate hikes and higher rates for longer.

Are We Beating the Market?

My daughter asked me that question the other day. She’s 34 so not a kid. She is a client. My answer was “maybe”. I told her I don’t like to talk about performance if I can avoid it. It’s a complicated topic, easily misunderstood. Also, if you live by performance you’ll die by performance. Everyone’s investment style underperforms from time to time. Or it doesn’t but your client thinks it has.

Anyway, I decided to look at our performance. We don’t have a single firmwide performance number. Too much time and effort calculating a number that clients will misunderstand anyway. Instead, I looked at a couple of client portfolios, the clients that have been with us the longest. I should point out that we moved clients to Charles Schwab throughout 2018 and early 2019. We use Schwab’s portfolio performance software. None of the track records are quite to five years yet. Of course, clients we’ve picked up since have even shorter performance track records.

All that said it appears as if we’ve earned around 30% annually in our stock portfolio. That number is a good estimate for clients who've been with us since some time in the fall of 2018. Not all clients did that well. Some did better some did worse. One client has only earned around 26% annually in her stock portfolio since the fall of 2018. There are likely others that have earned less than that. (Different start dates and somewhat different stock portfolios). By comparison, the Nasdaq has averaged around 12% and the S&P 500 around 11.5% since the fall of 2018.

It appears as if our Growth & Income portfolios have returned a bit more than 8% since the fall of 2018. Let's stop right there for a second and make sure everyone is on the same page. A client in a Growth & Income portfolio has earned around 30% (plus or minus 10% or so) in the stock part of their portfolio. They have only earned a bit more than 8% for their entire portfolio. Two different numbers. One well ahead of the stock indexes. One trailing the Nasdaq and S&P.

Have we outperformed? Yes and no. Our stock portfolio has outperformed. The entire portfolio though has trailed the S&P and the Nasdaq. Is that underperformance or outperformance?

The Growth & Income portfolio is less risky than the two major stock indexes. We saw that last year when the portfolio was approximately flat. The S&P fell almost 20% and the Nasdaq fell around 32% in comparison. The Growth & Income portfolio allocates 64% to individual stocks. The rest is in bonds, real estate, gold, and an emerging stock market ETF.

The portfolio earned a bit more than 10% over the trailing three-year period. The Nasdaq beat it by a little and the S&P 500 by about 2% annually. Again, is that underperformance? Maybe but maybe not once risk is considered. We’d need to do some math to find out. Certainly, comparing a 100% stock index against a multi-asset portfolio isn’t appropriate. We’d want to benchmark the bonds against a bond index for instance. We’d also want to compare the risk in the stock portfolios. Kraft Heinz and Verizon aren’t as risky as Tesla or Nvidia for instance.

Like I wrote initially, performance is complicated.

So in the end I stuck with “maybe” as my answer to my daughter’s question.

(Nothing in this newsletter constitutes a claim about how we might do with our stock picking going forward. We will have good years. We also will have some years where we make a mistake (or two) with the businesses we buy. Also, I am not trying to beat any index at all let alone any particular index. I make no claims about how our value style will do over the long run. I will point out that historically value investing has outperformed growth. Clients feel free to call, email, or stop by if you’d like to discuss your portfolio. We’ll do so at your next annual review in any case.)

Regards,

Christopher R Norwood, CFA

Chief Market Strategist