“Don’t fight The Fed.” – Old Stock Market Adage
August is a month that is usually not so kind to the markets. The 2022 edition was no exception with the equity markets we follow losing about half the gains picked up in July. The only exception to this is the MSCI Emerging Markets index, which produced a slight increase for the month. The upswing in interest rates during the month pushed the bond index to a loss. Commodities continued a multi-month slow decline, which has coincided with continued strength in the US Dollar.
All data as of 09/01/2022, Source: Wells Fargo Investment Institute. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
Patience is the name of the game in today’s markets. Last month we laid out the arguments for both a stock market rebound and lower equity prices. We stand by that analysis as the big picture fundamentals have not changed in the past 31 days. From our perspective the stock market is sitting in a no-man’s land in two critical areas.
First is valuations. The Discounted Cash Flow Model (DCF) is a mathematical model that is designed to measure the value of an investment based on the expected future cash flow. Not getting into the weeds on how the model works (you can do that here) or some of the problems associated with utilizing such a model, we like to think of its stock market implications.
Broadly speaking, a higher interest rate environment will dictate lower valuations (Price-to-Earnings) and favor value stocks over growth companies. In a falling interest rate environment growth stocks and broadening valuations would be expected.
Currently, the stock market indexes have seen valuations moderate along with the market’s decline, but they are nowhere near what we would consider “cheap.” Further increases in rates would likely change this at some point. On the other hand, if the Federal Reserve Board (The Fed) moderates its position on rate increases, a contraction in valuations (and thus stock prices) becomes less of an issue, and possibly a non-factor.
The other no-man’s land we see for the stock market is on the charts. Chart #1 is the S&P500. The first thing we illustrate here is that the index is below the 200-day moving average (long-term negative) and just at the 50-day moving average (short-term neutral). The second thing it shows us is the rally that started in June and ended in mid-August was stopped right at the 200-DMA and between two important Fibonacci retracement levels. Big picture, we view the strength of the rebound to be a positive.
The next chart is where we get a bit concerned about the overall market. The market has given back about half of the gains the final two weeks of August. In real time this is positive. What is not known at present, is if the market is turning back up or heading back to the June 17 lows or possibly to lower levels.
As you can see, there’s a reason for both optimism and concern.
Inflation and The Fed
Mohamed El-Erian was on CNBC on August 30 discussing the possibilities for rate hikes at the next Fed meeting, scheduled for September 20-21. He stated that you need to watch the actions The Fed takes, not the rhetoric they state in public. This came right after Chairman Powell gave a hawkish speech in Jackson Hole, WY that many have interpreted as another large rate increase is in the cards for the September meeting.
His point: The Fed makes decisions that are data dependent. The August economic data won’t be available for a period of time. Until they have it and analyze it, the board members cannot make a judgement on what to do with rates. Anyone with an opinion on what will happen at the September meeting is simply guessing. Once we see what they do with rates (and what their forward-looking opinion is at that time) investment decisions can be made.
In other words … No-Man’s Land!!!
Here are some of what we see that suggests steep rate increases aren’t necessary:
- July inflation was better but by no means great, but may have shown that we are past peak inflation
- The pace of rent increases has started to slow and is accelerating to the downside
- Money supply (M2) has “essentially flat-lined since last January … (which) means that the behavior of M2 is obviating the need for the Fed to pursue a typical tightening, which almost always ends with a recession.”
- The CRB Commodities Index (CRB) looks like it may have peaked and started to reverse lower, suggesting lower prices and lower inflation.
The argument for FOR continued aggressive is that inflation is still well above where policy makers want it to be.
No matter what happens at the September meeting, we believe it is safe to say that there has been a secular shift from low inflation to a more inflationary economic environment. To be clear, we do not believe what the country is currently experiencing is anything like the stagflation of the 1970s. Our central bankers are charged with making policy that keeps inflation in check while also keeping unemployment low. We have no reason to believe they will pursue a path that would exasperate the situation.
Bottom line: even as it appears that inflation is at least moderating, there is no guarantees that the next policy decision will be stock market positive.
Interest Rates and the U.S. Dollar
With the US being a relatively strong economy and the rate increases this year, the US Dollar has strengthened. At the end of August, the US Dollar Index was back at levels last seen in 2002. Further increases in short-term interest rates could further pressure the dollar’s value higher.
For the stock market a strong dollar is a headwind at best. For multi-national corporations an overly strong dollar suppresses non-US earnings, as foreign currencies convert into less dollars. For the US economy in general, an overly strong dollar makes exports more expensive for our trading partners. This is bad for the trade deficit.
Bottom line: The current strength of the dollar is a headwind for company earnings, thus an issue for the stock market indexes.
No market trend moves in one direction. All bull markets have pullbacks; All bear markets have rallies. Since the start of 2022 we have (obviously) been in a bear market. This bear market, we believe, is a cyclical bear market in the middle of a secular bull market.
Corporate earnings have been good. Consumer spending has continued to increase. The financial sector is in great shape as banks balance sheets are better than they have been in decades. These are all very positive for the longer-term outlook for both the economy and the stock market.
Of course, that hasn’t made 2022 any easier for investors.
In the more immediate, the direction of the stock market will be very dependent on interest rates. If the September meeting of the Federal Reserve Bank turns out to be as hawkish as policy makers have indicated we expect it to act as a headwind for stock prices. On the other hand, The Fed could conclude that inflation is trending in the right direction and there is less of a need for aggressive action. In that case, we would expect the stock market to resolve to higher levels.
Bottom Line: Watch Fed policy, not their rhetoric. Don’t Fight the Fed!
College Student Financial Aid
September is back to school for many, but also time to start thinking about financial aid for high school seniors as well as those currently in college. All financial aid starts with completing the Federal Student Aid Application Form (FAFSA). You want to get your form submitted as early as possible, but no earlier than October 1, 2022 for the 2023-24 school year.
There have been a number of changes to the form, which we outline in our annual FAFSA review. For those with children who will be attending college or university, we think this is a must-read. Not filling out the form, or making a mistake, can be a costly endeavor.
On behalf of Magellan Financial, we would like to thank you for taking the time out of your busy day to take in our thoughts and opinions. If you found this helpful, please forward it on to others. If you have any questions on the materials presented, would like to be added to our email list, or would like our help with your investments, we can be contacted at 610-437-5650 or via email.
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Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 “blue-chip” industrial U.S. stocks.
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
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Russell 2000® Index: The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents
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