“When the train leaves the station, it doesn’t back up to let latecomers on. If it does, there’s something wrong with the train.” – Walter Deemer
“Successful investing is having everyone agree with you… later.” – Jim Grant
All data as of 07/01/2022, 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.]
In our May Market Review letter we took a step back from the small stuff to give a broader overview of what affects stock market performance. We touched on interest rates, corporate earnings and the general economy. If you missed it, or would like to give it another read, you can find it here.
The stock market doesn’t exist in a vacuum. What happens with commodities, interest rates, credit spreads, the exchange rate of the US Dollar, among others, all help determine the value of stocks and the stock markets. This month we wanted to continue the big picture discussion with a focus on these relationships to get a better look at what is happening and what may happen in the coming months.
Current State of the Stock Market
As we cross into the second half of 2022 the US stock market indexes are all deep into negative territory. After three great years of gains from 2019 through 2021 Magellan Financial felt 2022 would be a year to protect and participate. In our 2022 Market Outlook we put it like this:
“We do find this to be a compelling reason to protect, but do not view it as a persuasive reason to batten down the hatches and load up on cash and gold. Truth be told, we believe there is never a good time to swing for the fences with a big bet either for or against the markets.”
Our analysis was based on the world we were in at the end of 2021. A world that has changed drastically over the past six months. What we didn’t anticipate was the Russian invasion of Ukraine, 8%+ inflation and the most hawkish Federal Reserve interest rate policy since the early-1980 which was at least partially induced by the January outbreak of COVID here and in China. And, really, no one else did either.
Notably, we do not believe there is a reason to move from our protect and participate philosophy. There is a lot of talk about recession – everyone from POTUS to Cardi B. Some are even saying we are in a recession right now! Yet, despite the noise and rhetoric, the economy is slowing down but not in a recession. The Conference Board Economic Outlook, as of June 22, 2022, is estimating real GDP growth for the United States to come in at 2.0%, and then falling to 0.6% in 2023. A shallow, brief recession in early 2023 is assumed in these numbers. Not great, but not the end of the world.
Corporate earnings expectations haven’t fallen (Barron’s), and might not, even as valuations have dropped substantially since the beginning of the year. Profits ultimately come down to margins. This is in part due to price increases that have already occurred, in part a result of companies looking to control costs.
With this as the background, the stock market has been on a downward path since the beginning of the year. As is obvious on the charts below, 2022 has seen the trend turn to lower highs and lower lows.
As we stated at the top, stock market pricing can, and is, influenced by other markets. This clearly on display in the first half of 2022. Commodity prices were up substantially, along with bond yields and the US Dollar. At the same time credit spreads on US Treasury Bonds flattened out. All of this was bad for the stock market.
It also suggests, at best, an economic slowdown, at worst a mild recession on the horizon.
And if you listen to what seemingly every pundit is saying these days the bad times are sure to come. Yet if you look at the following four charts you can see why the stock market has reacted like it has, but also reason for hope moving forward.
But here’s the thing …
“The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.” – Howard Marks
Pessimism is running wild right now in the investment community. Given the data we just presented, some level of pessimism is absolutely justifiable. BUT … and this is a big but … we do not believe that the future is as bleak as some would lead you to believe. In fact, the high level of pessimism is a solid reason for a more optimistic outlook for the future of the stock market.
What a quick scan of the charts presented in the previous section misses is the larger picture. While it may seem obvious that commodities are much more expensive and credit spreads are tight, it is also easy to miss what appear to be some important inflection points on all the charts. Notable that these inflection points are lining up at one point in time (now).
Commodities (Chart #3) peaked in early June before a swift move lower. This could be a counter-trend correction before a move to higher levels, the start of a move to a price range, or it could be the end of the bull market. In the first scenario inflation will likely continue to be a problem, in the others inflation moderates or recedes.
The US Dollar (Chart #4) is trading just above the top of a range over the past eight years. If the strength of our currency continues higher, history tells us that the stock market is likely to struggle. Weakness vs. other currencies, on the other hand, could be a real plus for corporate earnings and the stock market.
Long-term interest rates on US Treasury bonds (Chart #5) are back to where they were at the end of 2018. This is notable for a few reasons. The 4th quarter of 2018 was a particularly poor one for stocks with a 19%+ correction that coincided with the rate bump. That was also a time, like now, that yields were above the downtrend line. We would expect more stock market pain with a breakout above these yield levels. Lower yields would suggest better stock performance.
Finally, the US Treasury Yield Spread (chart #6) is currently extraordinarily flat. A flat yield curve can easily help push the economy into an economic recession. No guarantees, of course. A move into inversion (short term rates higher than longer term rates) would worsen the situation. A steeper yield curve would have positive implications.
Putting it All Together
“Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.” — Nobel laureate and economist Paul Samuelson, in a September 1966 column in Newsweek.
What moves equity valuations and the economy is a much more complex than we are led to believe by the simple stories we are told in the business press. While there are times that one variable will appear to move the markets – spiking oil prices is a good example – under the surface there is much more going on. Moreso at times when the stock market is changing directions.
Right now, we enter July at what we believe could be an important inflection point. In our experience it is rare to find a situation where so much of the data is presenting a change of direction.
What happens in the coming weeks will determine if there is another leg down for the stock market or if we have hit THE bottom for this cycle. A breakout higher for the US Dollar, bond yields, or commodities would indicate another move down is likely. A sustained move to a negative yield curve would not be helpful.
In any event, we are not calling for a robust rebound starting on July 1. What we are arguing for is some patience as the stock market works through a changing world and a weakening global economy. Sometimes the stock market bottoms violently, others it is a process that takes time.
Investor sentiment is rightfully at extremely low levels right now. It is easy to forget that markets peak when sentiment is high and it feels good to invest your money. Think about how good it felt to open your statement the first week in January. At the other end of the investment spectrum, markets tend to bottom at what feels like the worst time to be an investor.
While we certainly do not want to minimize the discomfort investors are enduring so far in 2022, we don’t want you to give up on investing either. We get it. The data looks bad. The nightly news looks bad. The situation feels bad.
Ironically, all that bad news isn’t as bad as it feels.
It is extremely easy for investors to buy into a story about what the stock market will do. This is one of the main reasons that, at the extremes, individual stocks as well as the stock market will go higher or lower than seems reasonable in retrospect. See the technology boom of the 1990s and the “tech wreck” of 2000-2002 as a good example of both extremes.
Right now – after one of the worst starts to a year in history – we are at a moment where our emotions can get the best of us. Right now, there are hucksters and pundits who have a story to sell you everywhere you look. Right now, buying into a specific theme that feels and sounds reasonable on the surface can be easy.
Our advice: Don’t Do It!!!
The greatest risk you can make with your investments is casting your lot with a specific scenario that may or may not come true in the coming months. There is no guarantee on which way the stock market and the economy will move in the short term. The chances of the S&P500 hitting 7,000 or half the corporate debt going bankrupt in the near future are outlier outcomes at best.
The better approach, in our opinion, is to think time IN the market, not timing OF the market. Every bull market has ended with a correction, or bear market. Every bear market has resolved itself with a new move higher.
You can take advantage of the market by staying the course with your investment plan, or take your chances with a theory you heard somewhere by someone on tv.
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.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
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