Markets, Economy, Portfolio Management Summer 2022
The S&P 500 had its worst first half of a year in more than 5 decades and so did the Bond market. What happens next? My assessment is that the S&P 500 Index bottoms setting stage for stocks to rally over next twelve months. A normal Bear market last on average 11 months and declines 28% on average. This Bear market is in its 7th month and has given up intra-day gains of 24.5% from it’s high. The decline in stock values reflects stagflation economic conditions. The S&P 500 Index could decline another 4% from here if the economy is just in a shallow recession (3% or less contraction in real economic growth).
Historically, many investors who moved out of stocks during down markets did not fare as well as those who stayed the course at this point. A hypothetical investor who missed just the best 10 days in the market over the past 4 decades could have reduced their long-term gains by 55% according to Fidelity research. Many of those best days occur after a Bear market bottom.
S&P 500 Index declines a median 23% into a short mild recession. We are already there considering this year’s stock declines and negative economic growth for the first two quarters. Expect a sharp rebound after this Bear bottom is in. The largest average returns occur from a market bottom to a few months out. In total the S&P has risen 59% on average during the 14 months period following a bottom according to research by CFRA. Investors must stay the course to recoup unrealized losses.
Furthermore, after 20% decline threshold is reached, in most past Bear markets without deep prolong recession, a low was in within two months (third quarter), and forward returns over the next 12 months tend to be better than average with a median return of 23.9% 78% time since 1945 according to Bespoke.
Presently, an economic slowdown is priced into earnings growth but not a pro-long recession. Recent Retail sales report confirmed that the consumer spending is cutting back (almost 70% of U.S. economy is consumer spending). The University of Michigan consumer sentiment survey hit an all-time low that does not bode well for consumer spending. Decreasing wealth effect will lower consumer spending along with higher energy prices. Real median household income is declining. On the other hand, household debt service payments as percent of disposable income are exceptionally low. The cushion in extra discretionary income due to low debt service payments will fade as Fed policy make credit more expensive in household finances. All this means earnings estimates should be lower than projected. I do not expect them to crater as in a recession.
Earnings is now the focus for markets. Analysts lowered their earnings estimates for the second quarter but not by much according to FactSet. As a result, the S&P 500 index is expected to report its lowest earnings growth since Q4 2020. More S&P 500 companies are issuing negative earnings guidance for 2022 but not at an alarming level. Companies are concerned about a recession. Earnings growth estimates of 8.5% and 9% for 2022, and 2023 respectively are too rosy given slowing economy. Analyst typically overestimate earnings late in the cycle, so investors are weary of Analyst estimates. The second quarter earnings season will be the telltale on whether Analyst are right.
The S&P 500 trades at 15.8 times forward earnings estimates. That is about an average multiple for the S&P 500 Index in an economy growing and not in a recession. However, those earnings estimates are too optimistic given softening spending, consumer sentiment, and tighter financial conditions. If the Fed continues to be aggressive with its rate hikes in the second half of the year, and economy does slip into recession, then earnings estimates would surely be cut by at least 20%. Of course, consumer spending headwinds and the aggressiveness of monetary policy could reverse course and save us from deep cut to earnings.
Profit margins, and valuations are adjusting to slower economic growth but not a full-blown recession. Profit margins for the median S&P 500 company are above average level for last five years but are declining from record high according to S&P Global. Profit margins should decline further as economy slows and cost of operating/labor stays high, just another headwind for stock valuations in the short run.
Investors who make decisions by looking backwards, it is like driving your car by looking through the rearview mirror, will not be successful long-term investors. Be forward looking to become a better investor, buy on extreme price weakness, after a lot of bad news is priced into stocks, to generate higher long-term returns.
CFRA research shows that since WWII, the S&P 500 Index rises 40% on average over the next 12 months after Bear market ends. Moreover, in the nineteen previous times the S&P 500 fell at least 15% in a single quarter (2Q22), the next quarter it rebounded 68% of the time by a median of 6.8%. Two quarters later, the S&P 500 has been up 100% of the time by a median of 13.0%. One year later, a 25.1% median gain 100% of the time.
What else? Historically, in a Mid-term election year, the fourth quarter along with the first two quarters of the following year, are among the best quarters according to CFRA. By the Fall the market will have discounted any recession, inflation should be moving lower, and the Fed should be shifting away from hawkish dovish commentary. History shows that next Bull market begins three months after the end of the bear market. I figure that the current Bear will bottom sometime before November.
First-quarter growth declined at a 1.6% annualized rate, and an estimate from the Atlanta Fed, GDPNow tracker, projects -1.9% GDP growth rate in the second quarter. Two consecutive quarters of negative real growth is a technical recession by one definition. According to the National Bureau of Economic Research (NBER), a recession refers to a significant decline in economic activity, lasting more than a few months, normally visible in real gross domestic product, real income, employment, industrial production, and wholesale-retail sales. The U.S. economy is not there yet but slipping that way.
Nominal growth in the economy is still positive a sign that parts of the economy is growing while other parts are slowing. The latest ISM Services and Manufacturing Indexes are still in expansion territory. Coincident Indicators point to slower growth not recession yet. Lastly, Leading Economic Indicators (LEI) fell again in May, due to sharply lower stock prices, a slowdown in housing construction, and recession level consumer expectations. The index is still in expansion readings, but the current reading suggests weaker economic activity is in the near term with tighter monetary policy acting as a strong headwind to economic growth. The Global Purchasing Manager indices, show that the Fed’s tightening actions are having an immediate impact on demand in the U.S. economy. Key economic indicators are not yet at recessionary levels. Instead, they point towards a slowdown, and considerable risk of recession.
The economy is in a period of stagflation. Stagflation is when the economy experiences higher inflation (3-4%) and lower economic growth. The combination often leads to higher unemployment which results in households cutting back on spending. The good news that businesses, and households are in excellent financial shape, and unemployment likely not to hit levels associated with past recessions. Consumer financial obligations ratio finished 2021 at 14.0%. That is the share of consumers’ after-tax incomes that they need to use on debt obligations (like mortgage payments and car loans) as well as recurring payments such as property taxes, homeowners’ insurance, and car lease payments. Since 1980 the ratio was never lower than 14.7%. Moreover, as of year-end, household net worth was more than eight times annual after-tax income, the highest ratio on record (checkable deposits and currency of $4.1 trillion).
Unemployment is at cyclical lows of 3.6% says economy is not in a recession. Unemployment would be 2.2% higher at 5-6% range if economy were in a recession. The 4-Week Moving Average of Initial Claims, the best coincident indicator of a recession, shows that economy is not in one. The Initial Claims 4-week Moving average must hit 400,000 to signal a recession. Presently, it is 231,750. The unemployment rate is more than likely to rise over next twelve months above 4%. Job gains, low unemployment claims have seen their best days. Minor layoffs by firms are occurring and hiring is slowing. If hiring drops off and layoffs begin in meaningful scale, then more parts of a strict definition of a recession would be met. In the past, when the U.S economy has had two consecutive quarters of declining GDP, it has had a recession since WWII era. Past recessions lasted 10 months on average since 1948 according to CFRA.
Inflation remains stubbornly high at levels not seen since the 1980’s, However, many inflation indicators and contributors are gradually losing steam. Money Supply has fallen precipitously since Fed began hiking. Commodities, materials, oil, and Personal Consumption Expenditures are rolling over. The Federal Reserve’s preferred measure, Core personal consumption expenditures (PCE) prices rose 4.7% year-over-year, below previous level. Core PCE inflation which excludes energy and food inflation has slightly moderated. The Consumer Price Index, which measures a broad range of goods and services, rose 8.6% in May, the fastest advance in more than 40 years. Markets are anticipating that future prints may show peak inflation this summer. Higher interest rates, layoffs, lower energy prices (gasoline peaked), lower commodity prices, stronger U.S. dollar (20-year high), should feed into lower future prints. Wholesale prices which feed into retail inflation appears to have peaked at record levels. The latest report released by BEA shows consumption rising but inflation and higher rates are beginning to slow down consumer spending. The Fed will be successful in destroying demand to lower “goods” prices.
In June, the Fed raised its key rate, the Federal Funds Rate, by 0.75 basis points. The biggest hike since 1994 comes with inflation running at its fastest pace decades. The policy tightening is happening with economic growth already slowing while inflation hovers at cyclical highs, a condition known as stagflation. Other research shows that Inflation at current levels with a fast-tightening policy has consistently caused a downturn in the economy. Monetary policy’s takes 9-18 months on average to stall aggregate consumer demand, create tight financial conditions, and higher unemployment.
Recent inflation indicators show early signs that inflation is slowing. A couple more prints should confirm its trend. Inflation expectations are coming down which means the Fed might not need to hike as much as planned. The FOMC planned hikes combined with its quantitative tightening program is creating tighter financial conditions than necessary to quell inflation.
Price movements in the Yield curve and credit markets are signaling greater risks of recession. The yield curve inverted in some parts. The 2’s and 10’s part is signaling that the U.S. economy is slipping in a recession. When the 3’s 10’s, the best indicator of a recession, inverts it will be a closed case and a late call. Whereas the credit market spreads have widened warning of slower economic growth and credit risks.
Portfolio Management Actions
The business cycle is rapidly moving through its late stage, economic activity and demand have peaked in the face of Monetary and Fiscal policy headwinds.
It is too late to underweight equities. I would stay the course with equities because equities should outperform over the next 12 months as the stock market bottoms ahead of the economy. In 2023 Fed hikes end, and the S&P 500 Index should be significantly higher than today as it anticipates a rebound in economic activity. Today’s pain will be next year’s gain for both stocks and bonds. It is time to start dollar-cost-averaging into stocks and bonds. Be defensive by buying high quality profitable stocks. At this point buy cyclical stocks versus defensive ones. Buy investment grade bonds only.
Non-recessionary bear markets have seen cheaper cyclical sectors outperform expensive defensive sectors about six months into a bear market, on average according to NDR research. Cyclical Growth stocks seem to be bottoming given no recession or just a shallow one. Defensives could outperform cyclicals if there is a recession. After broad market bottoms the worst four sectors, cyclicals sectors such as Consumer Discretionary, Industrials, Technology, Financials, outperform over next 12 months according to CFRA. Technology stocks underperform most sectors at the beginning of a tightening cycle; however, the tables turn after mid-recession outperforming early defensive leaders in the tightening cycle. Financials outperform when the yield curve steepens in the recession anticipating expansion ahead.
I have bought defensive Healthcare sector stocks but not ignoring better long-term buying opportunities in high quality growth stocks in cyclical sectors. Consumer Staples and Health Care stocks are by far the best-performing sectors once a recession begins. However, leadership changes to cyclicals by mid-point. It is too late to buy expensive Utilities and Consumer Staple stocks. Utilities and Consumer Staple stocks trade at multiples higher than the S&P 500 Index and beneficiary of extreme cash inflows (a contrarian sell signal). Overall, equity multiples have normalized and trade below latest 10-years averages suggesting that equities offer decent long term forward returns. Growth stock multiples were shaved by as much as 40% now trade at historically average valuations.
I am overwhelmingly in high quality stocks that can weather a recession and can be counted on to rebound in a recovery. Collectively, quality companies have healthy financial statements, profitable, positive free-cash-flow, sales growth, and dividend growth. Vanguard Dividend Appreciation ETF is chock full of quality dividend growing stocks. A real hedge against inflation is an investment that is going to increase cash flow over time and use cash flow to raise its dividend. Dividend growth is an inflation hedge because it helps maintain purchasing during inflationary periods.
Given my stagflation view, I am favoring more defensive Large-caps over Small-caps. Large caps are more defensive because they are less economically sensitive. When the 2-Year Treasury yield peaks it is time start buying Small-caps again. That might happen by end of the quarter.
I am at extreme underweight exposure to Foreign equities. Global slowdown and higher energy prices should hurt foreign economies more than U.S. Moreover, the U.S dollar strength favors buying U.S Equities over Foreign stocks.
I am holding onto overweight position in the Energy sector even though global economy is slowing. Oil supply and demand will remain imbalanced for next five years says CEO of Exxon. Chinese demand for oil projected to rebound in Q4 from COVID related slowdowns. That provides support for high oil about $100. Russia might cut off gas supplies to Europe this winter. Oil embargo on Russian oil creates even more shortage in supply. Energy is the biggest contributor to forward estimates for the S&P 500 Index in 2022. The energy sector’s profits and free cash flow has never been higher, and it is still selling at a multiple that is lower than S&P 500 Index, Utilities, and Consumer Staples.
I am now in the camp that bond yields will peak by year-end. The Bond market has discounted a Fed Funds Rate terminal rate 3.8% when it could be lower if inflation heads lower. The Bond market is way ahead of Fed with its discounting bond prices lower. The Bond market had its worst half year in fifty years creating attractive prices and higher yields that compensate investors for risk. I am dollar cost averaging into investment grade long term bonds while prices are cheap and to get higher current income.
Fixed-Income assets are invested in investment grade only securities. Portfolios own securities that offer floating rates. The Fed will continue to hike into beginning of 2023. Floating-rate securities rates will be adjusted upward every time the Fed hikes, so their price will not decline like a fixed rate security. Attractive floating rate securities are preferred stocks, and floating rate loans. Preferred stocks have interest rate risk like bonds, but some offer floating rate option. Preferred stocks are mostly issued by investment grade banks.
Portfolios adjusted last year to investment grade short-term corporate bonds to reduce interest rate risk. Short term bond prices drop less than long term bonds as interest rate rise. I am holding and adding to corporate short-term bonds until yield curve steepens.
I recently sold entire fixed income position in Senior Loans. Senior Loans invest in the most liquid segment of the bank-loan market. Senior Bank Loans are non-investment grade issuance. Given the U.S economy is vulnerable to a recession, investment grade bonds usually outperform non-investment grade bonds during periods of recession.
I sold my commodity ETF position in all accounts. Commodities are rolling off as the global economy slows. I am holding onto material sector securities. Next year could be a better year for the Global economy and demand for materials.