Market Update
The S&P 500 lost 4.8% last week to close Friday at 3873.33. The Nasdaq fell 5.5% and the Dow Jones fell 4.1%. A worse-than-expected inflation number kicked off the selling Tuesday morning. The indices had their worst day since 2020. The CME FedWatch website is now estimating an 18% chance of a 1.00% rate hike. The probability of a 75-basis-point hike stands at 82%. Market strategists are raising their peak fed funds rate forecasts to as high as 5% in some cases. Billionaire investor Ray Dalio of Bridgewater Associates believes the Fed will need to raise the funds rate to between 4.5% and 6%. He is also predicting a major recession because of the rate hikes.
Bond yields moved higher last week in response to the inflation number. The two-year rose to 3.91%, its highest level since 2007. The 10-year rose to 3.46%. The average 30-year fixed mortgage rate rose to 6.02% last week, according to Freddie Mac. It is the first time the average 30-year fixed rate has been above 6% since 2008. Most yield curve spreads are inverted with the 2yr/10yr inversion at negative 0.45%. The 3m/10yr yield curve hasn’t inverted yet but is close. The 3m/10yr curve is positive by a mere 0.1%. A recession has always followed when the 3m/10yr inverts. The 3m/10yr is likely to invert in the next few weeks as the bond market prices in more Fed rate hikes. Yield curve inversion and recessions aren't a random correlation. Banks can’t make money lending when their borrowing costs are higher than the interest rates they charge. Yield curve inversion means fewer loans and less money creation. It is the decline in money creation that leads to less economic activity and in turn recession.
FedEx fired a recession warning shot on Friday. It fell 21.4% after pre-announcing poor earnings and withdrawing its FY23 guidance. FedEx and UPS are leading economic indicators. Falling shipping volumes are a sign of falling economic activity. FedEx reported that, “Global volumes declined as macroeconomic trends significantly worsened later in the quarter, both internationally and in the U.S.”
A word of caution to clients:
Market timing does not work. Knowing that we’re likely in a recession or soon will be doesn’t change the fact that market timing does not work. Also, we don’t own the market. We own individual stocks, many of which are already trading at 7x to 13x earnings. We also own gold, fixed income, emerging markets, and real estate in our client portfolios. We have no intention of adjusting our client portfolios. We are continuing to look for good companies on sale. Bear markets are a wonderful buying opportunity.
And finally, about market timing, there is this to consider…
Many market strategists, hedge fund managers, and mutual fund managers are expecting the stock market to fall further. In fact, BofA found in a recent survey that a record 52% of respondents are underweight stocks. The bank also found that a record 62% of respondents are overweight cash, according to the bank’s global fund manager survey. The bank’s survey found that the number of investors expecting a recession has reached the highest level since May 2020. The U.S. stock market bottomed in March 2020. Let that sink in for a moment. The S&P 500 bottomed two months before investors’ peak pessimism about the economy in May of 2020. The S&P 500 was up 25% from its March 2020 low until the middle of May 2020. A lot of pessimistic investors missed a big move off the March 2020 low. (The BofA survey included 212 participants with $616 billion under management in the week of September 8th.)
Meanwhile, Tuesday’s trading saw fewer than 1% of the stocks in the S&P 500 finish higher, according to Sundial Capital Research’s Jason Goepfert. A lopsided up/down result like Tuesday’s has happened 28 other times since 1940, according to Goepfert. The S&P 500 has gained an average of 15.6% over the following 12 months. The index was higher one year later 79% of the time.
Extreme levels of pessimism often lead to short-term rallies. We could be close to that oversold rally now. Money managers are underweight stocks and overweight cash. It wouldn't take much positive news to start a stampede back into stocks. Money managers can't afford to be left out when markets are moving higher. It could cost them their jobs. A further decline to around 3,000 to 3,200 after an oversold rally is likely. That last assumes we do experience a recession in the next two to three quarters. A new bull market from the 3,000 to 3,200 level starting next spring wouldn't be surprising. The stock market would be reacting by then to a Federal Reserve that has begun to talk about easing once again.
What should investors do in the meantime? Maintain their strategic asset allocation. Maintain their investment discipline. Don’t try to guess what the stock market will do. For its part, Norwood Economics will continue to look for good companies on sale.
Economic Indicators
The NFIB small-business index rose to 91.8 in August from 89.9 the prior month. Core CPI rose 0.6% in August, faster than the 0.3% the prior month and well above expectations of a 0.3% increase. Core CPI rose 6.3% year-over-year in August up from 5.9% the prior month. The Cleveland Fed’s median CPI rose a record 6.7% in August from a year prior. The Cleveland Fed’s modified CPI drops outliers to better measure the underlying trend.
The UMich consumer sentiment index rose to 59.5 in September from 58.2 the prior month. It is a five-month high. The UMich 5-year consumer inflation expectation survey was 2.8% down from 2.9%. One unexpected scenario that nevertheless could happen is a more rapid decline in inflation than strategists are now expecting. The heavy U.S. debt load and a Fed that is shrinking its balance sheet are two catalysts that could drive a rapid decline in inflation. There is also data to support that unexpected scenario. The UMich 5-year consumer inflation expectations number, five and ten-year breakeven inflation rates, the ICE BofA spread, and the long-end of the yield curve all point toward lower inflation. The stock market would rally hard once investors began to realize that inflation was subsiding.
Investing
One piece of data that doesn’t jibe with an impending recession is worth mentioning. The ICE BofA U.S. High Yield Index Option-Adjusted Spread peaked in early July at 5.99%. It is currently 4.77%. The spread is an indication of the bond market’s expectations for high-yield debt. Spreads widen when economic activity slows. Spreads widen when economic activity slows because of increased credit risk. Credit risk increases because businesses aren’t as profitable and may have more trouble servicing debt. The spread widened to 10.18% in September 2001. It widened to 19.88% in November 2008. The spread hit 8.77% in March 2020. The ICE spread is showing no signs that bond investors are expecting a sustained or severe decline in economic activity, at least not yet.
Regards,
Christopher R Norwood, CFA
Chief Market Strategist
