Market Update

The S&P 500 rose 5.9% last week to close at 3992.93. The Nasdaq rose 8.1%. The S&P bottomed for the week Wednesday. Thursday saw big gains on the back of the CPI report. The 20-day has crossed the 50-day to the upside. A cross is considered a short-term positive for the market by technicians. The S&P also finally broke above the 100-day. It had failed during four consecutive attempts beginning Friday 28 October before falling to 3698.15 on 3 November. Friday's follow-through after Thursday's big gain is also a short-term positive. The first upside target is the 200-day at 4080. The second upside target is the upper boundary of the downward-trending trading band at 4130.

The fed-funds futures market is pricing in an 85% probability of a 50-basis point hike in mid-December. The stock market is back to hoping that the Federal Reserve will slow the pace of interest rate hikes. Investors are hoping for an outright pause to rate hikes by early next year. The 10-year Treasury is yielding 3.82%. The 3-month is yielding 4.18% and the 2-year 4.38%. Both the 2yr/10yr and the 3m/10yr yield curves are inverted. A recession is still coming despite the stock market’s leap higher on Thursday. The curve inversion isn’t a correlation but a causation. An inverted yield curve reduces credit creation. Banks can’t borrow short and lend long profitably. The lack of free-flowing credit leads to demand destruction and eventually recession.

The yield curve is inverted because the Federal Reserve is raising the federal funds rate. The Federal Reserve is raising the federal funds rate because inflation is high. The CPI number Thursday was 7.7%, not as bad as expected but still bad. Inflation is high because of the supply shock created by the response to Covid. Inflation is also high because of an increase in demand. The increase in demand was caused by low-interest rates and expansionary fiscal policy. Decreasing supply causes prices to rise. Increasing demand causes prices to rise. Combined they’ve led to forty-year highs in inflation.

The Federal Reserve can only impact monetary policy. The federal government handles fiscal policy. The Federal Reserve can increase the money supply to reduce interest rates. It can decrease the money supply to increase interest rates. Currently, it is reducing the money supply to increase interest rates. It is increasing interest rates to reduce inflation (a rise in the general price level). Increasing interest rates reduces inflation by reducing demand. Increasing interest rates reduce demand in two ways. First, higher rates mean less borrowing. Less borrowing means less spending. Second, higher rates can strengthen the dollar against other currencies. A strong dollar means lower exports and higher imports. Lower exports and higher imports mean lower net exports (exports minus imports). Net exports are part of Gross Domestic Product. Higher prices reduce demand independent of the rise in interest rates. Spending is reduced because of the Real Balance Effect. Cash and non-interest-bearing money can buy less when prices are rising.

The Federal Reserve’s campaign against inflation will result in demand destruction. Rising prices will also reduce demand independent of the Fed’s tightening campaign. Demand will fall causing inflation to fall. The question is how fast will the process play out? The stock market currently seems to believe that it will happen in a few quarters.

Rob Arnott of Research Affiliates believes it will take years. He and Omid Shakernia recently wrote a paper with their findings, according to Barron’s. They found that when year-over-year inflation rises above 8% it accelerates 70% of the time. They looked at data from 14 advanced economies dating back to January of 1970. Even if inflation doesn’t accelerate, controlling it requires more restrictive monetary policy. It requires the more restrictive monetary policy for longer periods of time as well. U.S. inflation has exceeded 6% for over a year and exceeded 8% for the seven months through September. Arnott and Shakernia point out that the median time it takes for inflation to drop below 3% is 10 years. Neither the stock market nor the bond market is pricing in an extended period of high inflation and high-interest rates. The five-year inflation breakeven rate is 2.47%. The 10-year inflation breakeven rate is 2.39%. The odds favor taking the over for both.

Economic Indicators

The inflation data was the alpha and omega last week. The stock market bounced hard after the CPI release. The drop from 8.2% to 7.7% is a step in the right direction but only a step. The odds favor elevated inflation and interest rates for years to come. Cost pressures mean compressed margins for businesses. Rising labor and material costs mean lower earnings growth. Lower aggregate demand means lower earnings growth as well. Earnings estimates for 2023 are too high and will come down. Earnings estimates for 2022 call for a 5.9% increase from 2021. Earnings estimates for 2023 call for a 14.8% increase year-over-year. Accelerating earnings growth in the face of rising interest rates and reduced fiscal spending is unlikely. Earnings are more likely to fall in 2023 than rise double digits. The stock market will fall if earnings disappoint in 2023.

Investing

I read another article on Roth conversions and how much sense they make with the stock and bond markets down double digits. They do not make sense for most people. Opportunity cost is neglected by the many authors that write about the benefits of Roth conversions. The fact is you do not start making back the taxes you paid during the conversion until you begin taking distributions from your IRA. You do not need to take distributions until the year in which you turn 72. Your IRA will continue to earn tax-free throughout your life just like a Roth does. The difference is you are keeping the government’s money and investing it. You get to keep the money you make with the government’s money. Leverage is always a good thing. Most people won’t live long enough to make back the taxes (plus future earnings on those taxes) paid during a conversion. Their wealth is diminished as a result.

Unless you are certain you have sufficient money for your retirement you should not do a conversion. Unless you want to pay the taxes in advance for your beneficiaries you should not do a conversion. Unless you believe your tax bracket will be higher in retirement than now you should not do a conversion. Unless you believe your children’s tax bracket will be higher than yours you should not do a conversion. Ignore the advice of accountants and advisors that recommend the conversion. Keep your money working for you as long as possible.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist