Market Update

The S&P 500 fell 4.6% last week to a three-month low. The Nasdaq fell 5.1% and the Dow was down 4.0%. The Dow is down 19.6% from its all-time high and at its lowest close in 2022. The S&P finished at 3693.23 and will likely test the June 16th low at 3636.87 in the next week or two. The June low is supported and might hold. It might not. The next support is 3370 which is the bottom of the downward sloping trading channel.

One likely scenario has the S&P bouncing off the bottom boundary of the trading channel in the next few weeks. The S&P would need to decline around 9% from its Friday close to hit the lower boundary. Fear might then reach a level that allows an intermediate-term bottom to form. A rally into year-end from 3370 could take the index back up to the 3600-3800 level. A bounce off 3370 and year-end close around 3700 would amount to a 10% year-end rally. A Christmas present of sorts. It would also be a round trip from current levels. It’s a plausible scenario given investor sentiment and market fundamentals. Although not the only plausible scenario. Regardless, more downside is likely in the near term.

The level of pessimism is hitting extremes as detailed in last week's newsletter. But the VIX couldn’t hold above 30 Friday after hitting a high of 32.31 earlier in the day. Close but not quite panic levels. The VIX peaked at 35 during the June low. The S&P rallied 19% over two months following that volatility peak. The VIX has hit 35 or higher four times in 2022. We need to see 40 or greater from the VIX before any longer-term bottom is put in place. The Friday peak of 32.31 doesn’t seem enough to signal another rally of any duration. Norwood Economics expects further declines in October. A short relief rally before the downside materializes is most likely.

Bond yields moved higher again last week. The two-year Treasury is yielding 4.25%. It is the highest it’s been since 2007. The 10-year yield finished the week at 3.71%. The 3-month is at 3.24%. A recession is likely next year, which means long-term bonds are setting up for a good 2023. The short end is likely to move higher over the next six months as the Fed raises the federal funds rate to 4.5%-4.75%. The Fed’s dot plot is predicting 4.25% - 4.5% by year-end. The latest dot plot has the funds rate at 4.5%-4.75% by the end of next year. Of course, the Fed is notoriously bad at forecasting. Short-term rates will continue to rise if the dot plot predictions come to pass. Long-term rates are likely to start falling by year-end though as they begin to price in recession.

Economic Indicators

Economic indicators last week continued to show a sluggish economy. They did not show an economy in recession, at least not yet. The Leading Economic Indicators (LEI) for August was minus 0.3%. It was an improvement from July’s negative 0.5% but still pointed toward economic stagnation. The S&P U.S. manufacturing PMI in September was 51.8 up from 51.5. The Services PMI was 49.2 up from 43.7. A number above 50 indicates growth, below 50 contraction. The housing market is also continuing to weaken. Existing home sales were 4.8 million in August down from 4.82 million the prior month. Building permits are a leading indicator and they declined to 1.52 million in August from 1.69 million. The NAHB home builders’ index fell to 46 from 49 in September.

Meanwhile, the Federal Reserve continues to raise the Fed funds rate aggressively. The 0.75% hike last week was the third outsized hike in a row. The Fed’s dot plot indicates another 1.25% in rate hikes before year-end. Additionally, the Fed is shrinking its balance sheet by $95 billion monthly. A shrinking Fed balance sheet means rising interest rates, regardless of whether the Fed follows through on its fed funds rate hikes.

The U.S. national debt is approximately $32 trillion. It takes around 12.7% of total federal spending to service the national debt. Rising interest rates make it more expensive to service the national debt. Gross domestic product is about $22.8 trillion which means the national debt is 140% of GDP. The federal deficit in 2022 is expected to add another trillion to the national debt. A trillion is 4.5% of GDP, much higher than the U.S. sustainable growth rate of about 2%. The debt can’t grow faster than GDP forever. The trend will end because mathematically it must end. As well, the U.S. government can’t afford higher interest rates. Federal spending on servicing the debt is rapidly approaching what we spend on National Defense. The Federal Reserve will stop raising rates and stop shrinking its balance sheet sooner than expected. The Federal Reserve and the Federal government need inflation. It makes servicing the debt easier.

Trading isn't Investing

Too many investors have too short a time frame. Professional money managers are included in that critique. Time is one of our greatest advantages. Short-term forces offset over the years, leading to returns based on fundamentals. Long-term returns are the result of corporate earnings growth. Corporate earnings grow as the economy grows. Corporate earnings growth leads to rising stock prices. Over 90% of an investor’s 10-year returns are the result of fundamentals. Short-term forces swing markets one way and then back the other way. They have a negligible impact over the long run. Yet people react to short-term results instead of allowing time to work for them. Market going up? Let’s buy more! Market going down? Let’s go to cash.

Norwood Economics sold a stock last week. We didn’t sell it because the stock market was getting shellacked. We sold it because the business was trading at fair value. The money will go into businesses that are significantly undervalued. We are tracking six stocks that we’d like to own. They are all in a downtrend. Some of them are falling rapidly. Not a single one of the companies has any real risk of going out of business. They are all well-established, profitable businesses with stable business models. Instead, the stocks are falling because of short-term trends. There is no real risk of a permanent loss at current prices for any of them.

Recessions don’t last forever. Recessions in the U.S. have averaged about 17 months from 1854 to 2020 according to NBER data. They have averaged about 10 months since 1945. The short-sightedness of the many allows the few to buy good companies on sale. We've already done the research on the underlying businesses in the case of the six companies we are tracking. Picking an entry point is all that remains. Norwood Economics uses technical analysis to help with entry and exit points. Technical analysis is helpful when used properly.

But back to short-term forces and allowing them to dissipate over time. Last week our stock portfolio took a hit due to macroeconomic factors. We didn’t see any significant negative company-specific news. Yet our portfolio went down along with the rest of the market. Institutional investors executed their trading programs without regard to company-specific fundamentals. The value of our companies didn’t change last week, just the price at which investors were willing to own them.

For example, we own five British companies. All five were hit hard by the pound’s 2% drop on Friday. A 2% decline in a major currency in a single day is a big move. Our stocks dropped right along with the pound. The dollar is at a twenty-year high against a basket of major currencies. It is at a 24-year high against the Japanese Yen. The dollar will eventually give much of its gain back. It just might take a few years. Emerging market stocks have also fallen this year due to the strengthening dollar. We have our clients in diversified portfolios that include emerging market stocks. Exposure to emerging market stocks has been a drag on our performance in 2022. The Vanguard Emerging Market Index ETF (VWO) has underperformed the S&P by about 7% YTD. Emerging markets have underperformed the U.S. by about 22% over the last two years. Emerging market stocks will make up the underperformance when the dollar starts to fall. The dollar will fall when the Federal Reserve begins to cut interest rates once again. Emerging market stocks have returned 4.4% annually over the last 20 years. U.S. stocks have returned 4.1% annually over that time. Emerging market stocks provide substantial diversification, resulting in higher risk-adjusted returns.

Our five British companies are paying dividends of 7.6%, 5.4%, 3.1%, 7.6%, and 4.8%. They are trading well below their 52-week highs and well below what the companies are worth. We will be buying more of all five of them with new client money. It is likely that all five of them will deliver superior risk-adjusted returns over the next two to three years. Short-term investing leads to poor results. Short-term investors give up one of their greatest advantages. Time in the market and time in a stock matter. Buying stocks with a three-to-five-year time horizon or longer allows short-term forces to reverse and fundamentals to come to the forefront.

Regards,

Christopher R Norwood, CFA



Chief Market Strategist