Market Update

The S&P 500 lost 0.6%, falling to 4432.99 last week. The index is 2.5% off its all-time high. The S&P closed below its 50-day moving average Friday. (We wrote last week that the S&P 500 looked set to test the 50-day.) It was the first close below the 50-day since June 18th. Investors tested the moving average Tuesday, Wednesday, and Thursday. All three days saw daily lows right above the 50-day. The average has acted as support eight times since last fall. The S&P hasn’t closed below the 50-day two days in a row in 218 trading days. It is the second-longest streak since 1990. Monday is important to traders. A second close below makes it more likely the 2.5% drop from all-time highs will turn into something bigger.

Fundamentals are deteriorating as well. Economic growth has peaked. Third-quarter GDP growth estimates are dropping. The first two quarters saw GDP growth of around 6.5%. Third-quarter growth is forecast to be around 3.5%. It is still strong, but slowing growth will make investors nervous. Earnings estimates are also under pressure and not only from a slowing economy. Producer prices are rising much faster than consumer prices. The producer-price index rose a record 8.3% in August from the year prior. Consumer prices rose 5.3%. The margin squeeze companies are facing is the largest since the 1970s. Producers will either eat the rising input costs or try to pass price increases on to consumers. Neither is good for economic growth or corporate profits.

FactSet expects third-quarter earnings to be 27.9% above last year’s. The consensus is for 9.3% growth in 2022. The S&P 500 is expensive. Any reduction in forecast earnings growth increases the chances of a pullback. Margin pressures are bad enough. Tightening monetary policy, tax increases, and fading fiscal stimulus adds to the risk of weaker than expected earnings. The likelihood of a full-blown correction is rising.

Economic Update

Three-year inflation expectations rose to 4.0% from 3.7%. Inflation is self-fulfilling to a large extent. People behave differently when inflation is expected. They demand higher wages. They hoard goods in the belief that prices will rise. A buy while you can mentality takes over. There is a reason the Federal Reserve watches inflation expectations closely. The core consumer price index (CPI) did rise only 0.1% in August with the headline number rising 0.3%. It was a noticeable improvement, but inflation is still running hot.

The Empire State index was 34.3 up from 18.3. The Philadelphia Fed manufacturing survey was 30.7 in September up from 19.4 in August. On the other hand, industrial production only rose 0.4% in August, down from 0.8% a month earlier. Retail sales improved by 0.7% in August and increased 1.8% ex-autos. Both numbers were a marked improvement over the prior month. The University of Michigan consumer sentiment index remained weak in September. It was 71.0 compared to 70.3 in August.

Forecasts for economic growth in Q3 have dropped to the mid-3% range from mid-6%. The next few quarters will be critical to determining Federal Reserve monetary policy. The consensus is still for tapering beginning later this year. The Fed may address timing of both tapering and rate hikes at the FOMC meeting this week.

Financial Advisors have Conflicts of Interest

Financial advisors have conflicts of interest. Fee-based advisors are charging a fee, but also selling products for commissions. American Funds A shares, for instance, have front-loaded commissions. Anytime you’re selling products to clients there is a conflict of interest. There are less obvious conflicts though, conflicts shared by fee-only advisors.

Financial advisors are paid based on assets under management. The more assets they manage the more money they make. They have less money to manage if you use it to pay off your mortgage. People are people. A loss of management fees is on an advisor’s mind when you ask them whether you should pay off your mortgage early or not. For the record, paying off your mortgage early is usually not the correct call with interest rates so low. A 3% mortgage rate isn’t much of a hurdle. Making 6% or 7% with a diversified portfolio leaves you with more wealth down the road if you keep your mortgage. Still, there are times when you might want to pay off the mortgage early anyway. Your financial advisor loses in those situations.

Social Security is another conflict for advisors. Many advisors will tell you to take your social security early. I had a 401(k) plan participant last week tell me his Edward Jones advisor told him to take the benefit early. The plan participant claimed his advisor told him, “We can beat 8% in the market.” He was referring to the 8% annual increase in the social security benefit from full retirement age until 70 years of age. The 401(k) plan participant's full retirement age for social security is 66. Had he waited until 70 he’d get 132% of the full retirement age benefit. The Edward Jones advisor is wrong for several different reasons.

Social Security is an income stream, not an investment. The 8% annual increase in the income stream from full retirement age until age 70 is guaranteed. The increase is for life. The income stream is used in retirement to meet basic spending needs. The income stream is guaranteed until both you and your spouse die. It is also inflation-adjusted. Telling someone that they can beat 8% in the market is irrelevant when deciding when to take social security. It is a nonsensical statement.

What the Edward Jones advisor was really all about were more assets to manage. Telling his client to take social security early is a ploy to divert social security income to savings with the Edward Jones advisor. More savings means more money for the advisor. Of course, no one saves 100% of their social security for the rest of their lives and invests it. As well, most people shouldn’t be in an aggressive mostly stock portfolio the rest of their lives either. The U.S. stock market has returned between 9% and 10% annually over the very long run. Beating an 8% return the rest of your life means holding 90% or more in stocks the rest of your life – appropriate for almost no one.

The Edward Jones advisor did his client a grave disservice. Odds are it will cost his client and client's wife tens of thousands in benefits. Money they could use to make their retirement more comfortable. What a shame.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist