Market Update

The S&P 500 rose 1.1% to finish the week at 4071.70. The index is up some 14% over the last six weeks. It has managed to close above its 200-day moving average three days in a row. The longer the S&P holds above the 200-day moving average the more likely the market rallies into year-end. The main obstacle to a continued rally is the upper bound of the downward-sloping trading channel (see chart above). The upper bound could prove strong resistance.

The CPI report is due 13 December. The Fed meets on 14 December. Either or both could drive the market higher or lower depending on results. Lower-than-expected inflation would likely send the index higher. A 0.5% hike by the Fed and dovish comments could as well. A higher-than-expected CPI number could send the index into a tailspin. The bear market rally that began on 13 October is based on the expectation of a Fed pivot early next year. A hotter inflation number would challenge that narrative. A hawkish Fed at the next Fed meeting would as well.

Not that the pivot narrative makes much sense in the first place. Let’s start with the meaning of pivot. The dictionary defines a pivot as “the central point, pin, or shaft on which a mechanism turns or oscillates. He swung around, pivoting on his heel.” The Fed is expected to pivot in 2023 from raising rates to lowering rates. The pivot point is the peak Fed funds rate. The futures market currently pegs that pivot point at 4.75%. The current funds rate is 3.75%.

The Federal Reserve is making it clear that there are more rate hikes coming. It is not talking about lowering interest rates in 2023. It is not even talking about lowering interest rates next year. Its focus is on continuing to hike interest rates until the job market weakens and wage gains slow. The Fed needs wage gains to slow. Cost-push inflation is the most difficult to control. Wages are a major type of cost-push inflation. Wage gains are showing no signs of slowing yet. Average hourly earnings were up 0.6% in November. They rose 5.8% at an annual clip over the past three months.

The fed-funds futures are pricing in a peak target range of 4.75% to 5% by midyear. Even if the futures market is correct that means another 1.00% in rate hikes are still coming. And it’s unclear that the futures market is correct. The pivot point could well be 5.5% or higher. Timing is the other issue. Federal Reserve members are talking about "higher for longer." The actual Fed pivot might not come for a year or more. Stopping rate hikes isn't a pivot. Lowering interest rates is required to pivot.

The Fed won't start cutting until the job market weakens and wage growth slows. The economy isn't there yet. At least not according to Steven Blitz, chief U.S. economist at TS Lombard. He sees evidence of economic acceleration, according to Barron’s. He thinks the Federal Reserve will need to lift the fed-funds rate above 5%. He also believes the funds rate will need to remain high for a significant amount of time. Fed Chairman Jerome Powell said as much in his speech last week. Powell also allowed that the Fed’s current fed-funds median forecast of 4.6% for year-end 2023 is apt to move higher. The Fed releases its next economic projections later this month.

The stock market continues to fight the Fed. Rates are moving higher. Quantitative tightening (QT) is ongoing. The Fed is showing no signs of a pivot, only of reducing the size of future rate hikes. The S&P 500 is at the top of the downward-sloping trading channel. A failure to move above the trading channel means the algorithms will shift to selling. A decline to the bottom boundary would take the S&P 500 down to about 3100.

The market won’t fall to 3,100 unless earnings collapse in 2023. Consensus S&P estimates have earnings growing by 5%, which is likely too high. The consensus estimate for 2024 is for a 9.5% gain in earnings. It seems unlikely that either forecast is close to the mark. Interest rates are rising, inflation is high, and QT is ongoing. Although earnings may not collapse, estimates will keep coming down. The bear market is probably not over. Investors should expect the current rally to end soon.

Economic Indicators

Home prices are falling. The S&P Case-Shiller home price index dropped 8.7% in September after falling 10.4% in August. The Chicago PMI was 37.2 in November down from 45.2 the prior month. Any reading below 50 indicates contraction. Job openings declined to 10.3 million in October from 10.7 million the prior month. Job openings are still high though. The core PCE price index was 0.2% higher in October, below the 0.3% forecast and the 0.5% prior month number. The trend is sideways, not down. Higher numbers have followed lower numbers over the last year. The year-over-year core PCE was 4.9% in December of 2021. It is 5.0% now. Inflation is showing stickiness.

The jobs report Friday showed a higher-than-expected 263,000 in nonfarm payrolls in November. The separate household survey showed a 138,000 drop in employment. The household survey fell 328,000 in October. Likewise, the average workweek declined by 0.3% last month. The decline is equal to a loss of 380,000 jobs, according to economist David Rosenberg. It’s unclear whether the job market is starting to weaken. What is clear is that wage growth is not weakening yet. Also, consumer spending is still solid. The economy will continue to grow until consumer spending falls. Expect a slow-growing economy for the next few quarters. Expect sticky inflation. Expect the Fed to continue to raise rates. Do not expect the Fed to cut rates until at least Q4 next year.

An Individual Stock Portfolio

Norwood Economics buys individual stocks for our U.S. and international equity exposure. Many of our clients aren’t used to owning individual stocks.

A few years ago, I had a client tell me with a straight face that he only wanted me to buy stocks that would go up. He didn’t want to own any stocks that were going to go down. The rest of the conversation was interesting to say the least. It ended with me suggesting we use index funds for him instead of individual stocks.

We meet annually with clients, more often if they want it. I always cover their portfolio along with an overview of the economy and capital markets. I try to avoid getting into too much detail when it comes to performance. People mostly don’t understand it. That’s not a knock on them, just reality. Measuring performance on a risk-adjusted basis is complicated.

I usually avoid pointing out the returns in our individual stocks as well. Clients often get too emotional when they see stocks in their portfolio that have gone down. We had energy stocks with gains of 100% to 200% in the portfolio earlier this year. Regardless, it was the stock that was down 20% that often drew a client's attention and sometimes their ire. It’s natural of course. People don’t like to lose money. Sometimes you can hear the anger in their voices as they ask, “What’s wrong with THAT stock”. Usually, there is nothing wrong with THAT stock except that the price has fallen. Sometimes stocks of good companies with temporary problems go down before they go up. Sometimes we miss the entry point, which can lead to bigger initial losses but still result in a successful investment. And sometimes I make a mistake and we end up having to sell the stock at a loss. It happens since no stock picker bats 1,000, not even Warren Buffet.

We’ve had good performance this year. Our client stock portfolios are up more than 9% in some cases. Those are the clients who've been with us for a couple of years. Our newer clients aren't up as much. Some of our newest clients are even down on the year. Those last are the clients that came to us in 2022. I have one client whose stock portfolio is down 13.4% since March of this year when we started managing it. The new client’s stock portfolio is ahead of the Nasdaq but well behind the Dow. The stocks are all good companies bought on sale. The portfolio should do fine over the next few years. Small comfort to a new client who doesn’t yet have the confidence that comes with a few years of good returns. Value investing works but it can be hard on the stomach at times. Warren Buffet once described value investing as lumpy. He's not wrong.

There are a few truths about investing that folks would do well to remember. All sorts of factors outside your control influence short-term results. Short-term performance isn’t based on company fundamentals. Fortunately, long-term performance is based on fundamentals. Long-term is a decade or more by the way, not six months or even a few years. Another truth is that every stock portfolio is going to have stocks that are down. Some of those losers will be sold at a loss eventually. No money manager is going to get it right 100% of the time. Risk management and a sell discipline will go a long way to ensuring that no one position sinks a portfolio.

At the end of the day (decade) of investing it is the portfolio's risk-adjusted return that matters. Individual stock losses happen, but it’s the portfolio return that counts.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist