Market Update

The S&P 500 rose 3.3% to finish at 4280.15. The Nasdaq rose 3.1%. The catalyst for the gains was better than expected inflation news. The Consumer Price Index (CPI) rose 8.5% year-over-year in July, down from 9.1% the prior month. The Wall Street narrative is straightforward. Inflation has peaked and will continue to decline. The Fed will stop raising rates sooner than expected as a result. Wall Street strategists might be right about the first. Inflation may have peaked. They are likely wrong about the second. The Federal Reserve is unlikely to stop rate hikes anytime soon. Inflation is too far above its 2% target. It's also unlikely to fall below 5% before year-end.

It is the idea that the Fed is almost done tightening that has the stock market surging. Falling inflation will stay the Fed’s hand say the market strategists. An end to interest rate hikes will keep the economy from falling into recession. An end to interest rate hikes brings interest rate cuts that much closer. Interest rate cuts means a new bull market. Wishful thinking at its finest.

Richard Bernstein is a long-time Fed watcher. He thinks, “one good print isn’t going to change the Fed’s modus operandi,” according to Barron’s. Inflation is likely to be stickier than investors are expecting as well. Services, particularly rents, represent a growing portion of inflationary pressure, according to Alfonso Peccatiello, author of the Macro Compass newsletter. Peccatiello points out that core services, excluding energy, are the stickiest. They go up late in the business cycle. It takes time for that type of inflation to dissipate. Citi economists are also warning that details of the July CPI report don’t point to slowing.

Furthermore, the Federal Reserve Bank of Cleveland is highlighting sticky inflation as a problem. The Cleveland Fed has developed an alternate core CPI measure that doesn’t exclude food and energy. Instead, it excludes extreme increases and decreases. The idea is to better capture underlying inflation without omitting food and energy. People buy both after all. The Cleveland Fed’s median CPI rose 6.3% in July. Its trimmed CPI rose 7%. Both readings made new year-over-year highs in July.

Investors expecting an end to rate hikes by year-end will be disappointed. What's more, interest rate hikes are only one way to tighten financial conditions. Investors are forgetting about QT. The Fed is doubling down on balance sheet shrinkage beginning in September. Its balance sheet will shrink by $95 billion monthly, which is $1.14 trillion a year. Balance sheet shrinkage means fewer dollars in the system. Fewer dollars mean higher interest rates. It is basic supply and demand. The impact of QT will be significant if the last round of QT in 2018 is any guide.

Furthermore, the 2022 fiscal cliff has arrived. The government deficit was $2.8 trillion in FY 2021. It is forecast to be $1 trillion in FY 2022. Government spending is one of the four components of GDP. A $1.8 trillion decline in government spending is equal to over 7% of GDP. The fiscal cliff is rarely mentioned by market strategists. Both QT and the fiscal cliff make a recession probable in 2023 (if not 2022).

The inverted yield curve is signaling as much. The 2/10 is already inverted. The more reliable 3m/10yr is getting closer to inversion as well. The 10-year is at 2.84% and the 3-month is at 2.65%. A recession will bring inflation relief. A recession will also bring a resumption of the bear market in stocks. Bonds might be the better bet in 2023.

Technically, the current bear market bounce has been typical so far. According to Bloomberg the average bounce is 16% and takes place over 40 trading days. The current bear market rally has returned 17.7% over 39 trading days. The 200-day is at 4350 and so is the top boundary of the descending trading channel. The stock market is overbought with stiff resistance immediately overhead. The odds of a sizable pullback before any serious attempt to take out that resistance is high.

Economic Indicators

The big news last week was about inflation receding – maybe. The CPI year-over-year fell to 8.5% from 9.1%. The core CPI did not fall, however. It held steady at 5.9% in July. The 3-month core CPI average did decline to 6.8% from 7.9%. But as previously mentioned the Cleveland Fed’s trimmed CPI rose to a year-over-year high of 7%. The NY Fed 3-year inflation expectations reading fell to 3.2% from 3.6%. But the UMich 5-year inflation expectations for August rose to 3.0% from 2.9%. Inflation expectations are important because they do influence inflation.

Inflation pressures are still evident. Unit labor costs rose 10.8% in Q2 after rising 12.7% in Q1. Expectations were for a rise of 9.5%. Labor is the largest input cost. It is unlikely that unit labor costs will recede soon. Workers won't stop asking for big raises until food, energy, and shelter costs stop rising so fast. Housing makes up 40% of the CPI and housing costs are still surging, particularly rents. Workers will continue to demand raises given the surge in the cost of living. The labor market is tight. It is a seller’s market and businesses are struggling to find workers. They will need to pay up.

Investing and Bear Markets

Bear markets are a wonderful buying opportunity if you have cash to spend. Bear markets are also difficult investing opportunities because no one likes losing money. It goes against human nature to buy into declining markets. The inclination is to hoard cash or even raise cash. The fear of losing money takes over from rational analysis.

Stocks are ownership in businesses. Buying businesses at lower prices leads to higher returns over the long run. Buying stocks that are falling is uncomfortable though. Stocks that are going down must be bad investments, or so your brain tells you. Yet declining stocks mean better prices for the underlying businesses. Buying businesses when they are on sale is profitable.

Norwood Economics has sold six stocks this year. It has also bought six stocks. We currently hold 26 stocks for clients, although not everyone owns all of them. It was difficult to sell six stocks that were going up. It was difficult to buy six stocks that were going down. Selling rising stocks and buying falling stocks hurts performance in the short term. (I know I know, why don’t we wait you’re asking. Because we can’t time markets, which by extension means we can’t time individual stocks. Warren Buffet is supposedly off by about six months on average with his buys so we’re in good company.)

Three of the six stocks we sold were energy stocks. Norwood Economics thinks the energy sector will do fine in the coming years (not a recommendation to buy). We sold the three energy stocks because they were no longer undervalued. We also sold them because we had seven energy stocks at the time. Risk management is important. Getting greedy is costly. Norwood Economics deemed it prudent to reduce our energy exposure after the huge runup in prices. We still have significant exposure to the energy sector.

The bear market isn’t over. It’s taking a pause. The pause may be about over. Or the pause will last into next year. No one knows. A recession is coming though, most likely in 2023. The stock market will respond to that economic reality at some point. Investors with cash should be buyers when it does.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist