Market Update

The S&P 500 gained 4% last week to finish at 3901.06. The Dow gained 5.7% while the Nasdaq gained 2.2%. The Dow is up 14.4% in October. It looks as if it will be the best month for the index since January 1976 when it rose 14.41%. The S&P 500 has gained 8.8% in October. The Nasdaq is up 5% this month. The S&P 500 is down 18% year-to-date. The Nasdaq is down 29%. Alphabet, Microsoft, Meta, and Amazon have all fallen sharply in 2022. All four were hit when reporting earnings last week. Apple has fared better but is down double digits as well.

We wrote late last year that large-cap growth stocks were no longer the place to be. From one of our December newsletters, “U.S. large-cap stocks have returned 88.5% since the start of 2019. The index is trading at 21.5 times forward 12-month earnings. The index has averaged 15.5x over the long run and 18x over the last twenty years. Investors will benefit from diversifying away from U.S. large-cap growth stocks in the coming years.” To be fair we didn’t know when the underperformance would start. We did know it was inevitable and now it is here.

Likewise, we wrote last December that bonds were dangerous. From one of our December newsletters, “Treasury bonds are considered safe investments. They are not safe now, given the likelihood of rising rates over the next 10 years.” Again, we didn’t know exactly when the bloodshed would begin. Fast forward 10 months and there is no doubt that it has begun. Bonds are having their worst year in seven decades. The good news is that the bloodshed should be about over, at least for now. The 3M/10Yr yield curve has inverted. The three-month finished the week at 4.15%. The 10-year yields 4.02%. It can take up to two years before the ensuing recession appears though. Norwood Economics is expecting a recession by the middle of 2023. Quite a few other market strategists are as well. That fact is not comforting. Economists are famous for getting the big calls wrong as often as right.

The bear market rally has continued. Earnings season has gone better than expected. The Fed will raise the funds rate by another 0.75% this week. The December hike might only be 0.5%. The futures market is placing a higher chance of a 0.5% hike than 0.75% now.

Regardless, QT continues. Liquidity is likely to become an issue in the next few quarters. The Federal Reserve was a big buyer of MBS and Treasuries, but no longer. A recession in 2023 is almost a certainty. M2 growth has fallen to 1.7% as of early October. It was up 2.6% year-over-year as of September. The equation of exchange is MV=PQ. M equals the money supply. V equals the velocity of money. P equals price and Q equals volume. PQ equals nominal GDP.

Price (P) is rising at more than 8% per year right now. It is difficult to see how volume (Q) doesn’t fall with price rising 8% and the money supply (M) only rising by 2.6%. Velocity (V) could account for the difference by rising, but that isn’t likely. (Velocity is the number of times a dollar changes hands per year.) Velocity falls when the number of transactions falls. The number of transactions falls when economic activity declines.

The Fed’s interest rate hikes and QT will lead to more demand destruction. More demand destruction will lead to declining economic activity. Declining economic activity will lead to fewer transactions. Fewer transactions will lead to declining Velocity (V) not rising Velocity. Falling M2 growth (M) and stable to falling velocity (V) along with rising prices (P) means a drop in the volume of goods and service produced (Q). Because MV equals PQ, always.

The S&P 500 is trading at 16.3x 2023 earnings, but earnings estimates are too high. Earnings growth will slow along with economic growth. Expect a resumption of the bear market by the first quarter of 2023 if not sooner. Meanwhile, the index could bounce as high as 4,200 before the rally falls apart. It remains a stock pickers market.

Economic Indicators

The economic data last week was weak. Both the S&P U.S. Manufacturing and Services indexes showed contraction. The U.S. manufacturing index was 49.9 in October down from 52.0. The U.S. services index was 46.6 down from 49.5. Anything under 50.0 shows contraction. The housing market continues to weaken. Housing makes up 15% of the economy. The S&P Case-Shiller U.S. home price index fell -9.8% in August after falling -5.3% the prior month. The FHFA U.S. home price index declined -7.6% in August after falling -7.3% in July. The new home sales number declined in September to 603,000 from 677,000 in August.

Real gross domestic product rose 2.6% in Q3, a good number but deceptive. The gains came mostly from a shrinking trade deficit and growing business inventories. The trade deficit and business inventories were primarily responsible for the negative GDP prints in Q1 and Q2. The Q3 number saw a reversal of both factors. Economists are more concerned with real final sales to domestic purchasers. Consumers make up over 70% of GDP. Real final sales rose 0.50% in Q3 up from 0.20% in Q2 but down from 1.30% in Q1. Real final sales growth has slowed sharply in 2022. It averaged 5.45% in 2021. Final sales are likely to continue to fall given the decline in real disposable income growth. Real disposable income rose 0.6% in September down from a gain of 2.3% the prior month. Businesses are reining in spending as well. Core capital equipment orders fell -0.7% in September after rising 0.8% in August. Economists had expected an increase of 0.5%.

Last week’s numbers did nothing to change the narrative of a weakening economy. Yet the Federal Reserve is going to hike by 0.75% this week as inflation remains high. The core PCE price index 12-month change was 5.1% in September up from 4.9%. The core PCE 3-month change was 4.2%, down from 5.0% but a long way from the 2.0% target. All in all, last week's data indicated a weakening economy with too much inflation. Norwood Economics is forecasting a recession in 2023. We also think inflation will hang around longer than expected.

Tax Loss Selling

Most people don’t like paying taxes. Warren Buffet says he doesn’t mind but I bet he doesn’t love it either. Mutual funds generate capital gains. Investors pay taxes on those capital gains if they have non-qualified accounts. Investors who buy stocks also pay capital gains taxes. It’s difficult to offset capital gains with capital losses using mutual funds. Most years mutual fund share prices rise. Investors can take advantage of mutual fund losses by selling the mutual fund when they do fall. Mutual funds have fallen in 2022. Investors must wait 30 days before buying the mutual fund back or they run afoul of the wash sale rule. The wash rule disallows capital losses on investments repurchased within 30 days of their sale.

It is easier to do tax loss selling with a stock portfolio. Again, the investor must wait at least 30 days before buying back the stock. The investor runs the risk of the stock price rising while they’re out of the stock of course. Tax loss selling can be costly if the market bounces hard at the wrong time. Bear market rallies are frequent. We’re having one now. There’s also the risk of good fundamental news causing a stock to jump higher. AT&T's earnings report has sent shares up 28% since 13 October.

One strategy to avoid being out of the stock for 30 days is to double up. Buy the additional shares, wait 30 days, and then sell the original position. The risk with this strategy is the additional exposure to the stock during the 30-day period. Investors also must make sure they leave themselves enough time to execute the strategy. They must hold the new shares for 30 days before selling the original shares. Selling the original shares must happen before year-end. Otherwise, investors can’t book the tax loss until the following year.

Investors should not let the tax tail wag the investment dog. Taxes should be a consideration though. Tax loss selling can add value if done correctly. The horrific stock performance year-to-date has left no shortage of tax loss-selling candidates. It is something to consider as year-end approaches.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist