Market Update

The S&P 500 rose 4.3% last week to finish at 4130.29. The Nasdaq rose 4.6%. The S&P had its best month since 2020. The Nasdaq and Dow did as well. The S&P will need to chew through resistance at around 4175 to continue its advance. It might, but the bear market is almost certainly not over. Relief rallies can last months, especially when markets fall as much as they did in the first half. One of the ugliest six-month periods on record deserves a robust bear market rally.

The bear market is likely not over because the economy is heading into a recession. The NBER might not declare one based on the first two quarters of 2022. It is likely to declare one sometime before the end of 2023. The inverted yield curve is screaming recession. The 10-year Treasury closed the week at 2.65%. The 2-year Treasury closed the week at 2.90%. An inverted yield curve makes recession almost a certainty. Banks don’t lend when they can’t make money. Banks make money by borrowing short and lending long. They can’t make money when short-term rates are higher than long-term rates. Banks provide the credit that makes an economy function. Contracting credit means a contracting economy.

Consumer sentiment is the lowest ever. The University of Michigan Consumer Sentiment Index is lower than it was during record high inflation in the 1980s. It is lower than it was after the dot-com bubble burst in the early 2000s. It is lower than it was after 9/11, during the 2007-09 Great Recession, and during Covid when the unemployment rate rose to almost 15%. The number of firms looking to hire and invest is falling, according to the National Federation of Independent businesses in its June survey. As well, the Wells Fargo Animal Spirits Index has been negative six months in a row. The index includes the Conference Board’s consumer confidence survey, the S&P 500, and the yield spread among other indicators. A decline of six straight months has never failed to predict a recession, according to Azhar Iqbal, an econometrician at Wells Fargo.

Norwood Economics is expecting a mild recession in 2022 with the possibility of a double-dip recession in 2023. The S&P 500 is likely to retest the 3636 low hit on 17 June. It's a question of timing.

Economic Indicators

The CFNAI was -0.19 in June. The Fed's index is composed of 85 separate indicators. A negative number indicates below trend growth for the economy. New home sales fell to 590,000 in June from 642,000 in May. Pending home sales fell 8.6% in June. GDP in Q2 fell 0.9% after falling 1.6% in Q1. There are increasing signs that the economic weakness is becoming broad-based.



The Core PCE rose 4.8% year-over-year in June up from 4.7% the prior month. The Core PCE is the Fed’s main gauge of inflation. A rising number does not give the Fed cover to throttle back on its interest rate hike plans. Inflation expectations ticked up as well. UMich 5-year inflation expectations rose to 2.9% from 2.8%. Meanwhile, the 5-year breakeven inflation rate rose to 2.73% and the 10-year to 2.53%. Rising consumer inflation expectations doesn’t give the Fed cover to reduce its tightening plans either. The employment-cost index (ECI) jumped a record 5.7% in June year-over-year. The ECI is considered by many economists to be the best measure of workers’ compensation. The record jump in the ECI will make it difficult for the Fed to ease off on the interest rate hikes.

Understanding Risk

I write about risk frequently. I do so because most people struggle to judge risk. They either fear it too much or not enough. I talked with both types of people last week. The first was a 34-year-old who has recently inherited $1.6 million. She is worried about losing it since she’s never had this much money before. She wants to pay cash for a $250,000 townhome because she’s worried about having a mortgage. Her dad is urging her to pay cash as well. He is conservative as well and likely projecting his situation onto her.

She should not pay cash for the town home, nor should she invest the money conservatively. She has a job, is only 34 years old and instead should be invested for the long run. She can make around 9% annually in a diversified stock portfolio over the next 30 years. Her mortgage interest will be around 5% currently. The spread between her 9% expected return and 5% mortgage cost is 4%. Earning 4% net on her money over a 30-year period generates substantially more wealth.

The volatility of an all-stock portfolio is not the appropriate measure of her risk. The appropriate measure of risk for her is the probability of a permanent loss of capital. The U.S. stock market has only had two 10-year periods in which it lost money. It has never had a 20-year period in which it lost money. The average return for the U.S. stock market dating back to 1871 has been about 9.5%. The chance of her experiencing a permanent loss of capital over a twenty-year period is extremely low. The chance of her making more than 5% (her mortgage rate) on her investment portfolio over a 20-year period is high, approaching 100%.

I talked with another person last week who put $90,000 with one of the cryptocurrency exchanges. He said he was guaranteed 9%. All he had to do was let his money sit there at The Voyager. The Voyager operates as a crypto broker. He thought it was a low-risk investment. The fact that the Voyager was paying him 9% should have screamed high-risk investment. The 10-year Treasury bond is paying 2.65% today. Treasuries are considered risk-free investments. Of course, they are no such thing. The Vanguard Long-Term Treasury ETF is down 19% on the year. The Vanguard Short-Term Treasury ETF is down 2.65% on the year. Low-risk investments are not going to yield 9% in a sub-3% world. Understanding investment risk includes understanding that simple fact. Unfortunately, he did not. The Voyager is in bankruptcy and there is a real chance he will never get his $90,000 back.

Many people are in portfolios inappropriate for their situation. Sometimes they are too conservative than they should be. The consequences include having to save more and work longer before retiring. More often people are in investments that are riskier than they realize. The 62-year-old with 90% of her money in the S&P 500 and the rest in a Vanguard real estate fund. The 74-year-old with 85% of his money in stocks, half of it in Tech stocks. The 30-something with almost half of his money in a cryptocurrency exchange. Understanding risk, understanding how much risk you’re taking, and understanding how much risk you should be taking are critical to your success. Otherwise, you risk working longer and living poorer.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist