“The most important part of every plan is planning on your plan not going according to plan.” – Morgan Housel
The headliner for the month of November has to be that for the first time this year the equity indexes have posted back-to-back positive monthly returns. Across the board the returns were strong, with the MSCI Emerging Markets the leaders with a double-digit return. As we have been discussing all year long, both the US Dollar and the Aggregate Bond indexes have tracked inversely to equities. Bonds were down more than 3% while the dollar shed 5% of its value.
All data as of 12/01/2022, 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.].
As we have done for the past few months, we will start off this letter by taking a look at the most important chart for the stock market – the S&P 500 with the performance of the Dollar Index and the 2-year Treasury bond. All year the equity market has been moving in the opposite direction of these two important asset classes. Our thought at the end of October was that this trend would continue.
The good news for investors is that, indeed, the trend did continue higher for a second straight month. The S&P 500 has continued to recover losses sustained earlier this year as the dollar weakens and the 2-year Treasury’s yield continues to move sideways.
After a pretty solid move from the lows, the question we face at the start of December is very simple: is this the end of the 2022 bear market for equities or was this just another bear market rally?
The honest answer is … there is a compelling case that can be made for continued strength or a move lower.
The Bullish Case: The market of stocks that make up the market index is much more positive than it has been after the two rallies earlier in the year. The number of stocks trading above their 50-Day Moving Average (DMA) and 200-Day Moving Average (DMA) are both up substantially since the October lows. Put in simple terms, there are more stocks trading above what we consider to be short-term (50DMA) and long-term (200DMA) indicators of bull or bear market trend. The greater number of stocks above these lines, the more positive the underlying market is. As important, the S&P500 ended the month above the 200DMA for the first time since May.
From a fundamental perspective, Federal Reserve Board Chairman Jay Powell’s comments that smaller interest rate increases could start this month and continued moderating inflation rates have been helpful. Third quarter GDP came in at a surprisingly high 2.9%. For continued upside the Fed needs to follow through and inflation needs to continue to moderate.
The Bearish Case: The downtrend line from the market highs of Jan 2, 2022 has not yet been broken. And until this happens, it is hard to call this anything but a bear market rally. Fundamentally, the fear is that things are not as good as they may appear on the surface. The general consensus is that the Fed is looking in the rearview mirror, earnings expectations are overly optimistic and need to be reduced, and a recession in 2023 is a certainty.
With this background we remain optimistic but more cautious on the short-term than we were a month ago. We remain open minded to a number of different scenarios for the stock market going forward.
Is the Economy Really THAT Bad?
The pandemic, the reaction from governments across the globe, and its subsequent effects on the global economy have been unlike anything we have ever witnessed. In 2021, the American economy reopened for business and boomed in spite of problems with shortages of just about everything. Too much demand and not enough supply inevitably led to higher inflation. At the same time, a shortage of workers forced employers to increase wages, which leads to either lower profits or increasing the cost of goods and services provided (which adds to the inflationary pressures). Guess which choice big corporations made?
Which brings us too today.
Even with third quarter GDP coming in at a frothy 2.9% and little reason to believe there is a recession in the immediate future, things might not be as good as they appear on the surface. Seventy percent of the US economy is consumers, and consumers have continued to spend, fueled by credit card debt that is rapidly increasing. This is a trend that cannot continue forever.
The housing market is pretty much broken as new home sales are back to 2017 levels, mortgage applications are at 20-year lows, and existing home sales are back to where they were 10 years ago. Hard to make a case for moving if you have a 3% mortgage and would be replacing it with one that is more than twice that rate.
From an objective viewpoint, there is reason for concern, but right now the economy isn’t that bad. That said, we find it hard to have a definitive take on what direction the economy will turn next. The economy is doing well, but could easily stall at some point.
What About Inflation and Employment?
This economic cycle has been like no other we can remember. The Fed has rapidly increased the Fed Funds rate in order to bring down the inflation rate. The theory behind increasing rates is that higher rates will slow down economic activity, which will lead to higher unemployment, which will result in less consumer spending. Lower spending means less demand. Less demand moderates’ prices, and inflation is tamed.
But here’s the thing – no matter how much Chairman Powell raises rates the unemployment rate won’t go down. Technology company layoffs have been headlining the news, but companies are desperate for workers just about everywhere else. At the same time the government continues to spend money.
The definition of inflation is too much money chasing too few goods. With low unemployment, people have money to spend. With governments at all levels flush with cash, it is unlikely the spending will slow or reverse. This sets us up for more moderate levels of inflation but getting back to the 2% goal of policymakers feels like a big stretch.
What Does the Bond Market Think of the Economy?
The stock market is driven by emotions. The bond market is driven by fundamentals. During periods that aren’t so clear cut, it can be very helpful to see what the bond market is trying to tell us.
What we like to look at for clues on what the bond market sees for the economy going forward are three things – yields and the direction they are moving, the shape of the yield curve, and credit spreads.
When times are good economically, interest rates tend to trend higher, or at least hold within a range. This isn’t always the case, as central banks can and do have ways to manipulate yields, but that can be taken into account for when forming an opinion. The other thing we see in better economic times is a positive (normal) yield curve with long-term rates higher than short-term rates.
At the start of November interest rates on the 10-year Treasury Bond were trading above 4%. By the end of the month rates had backed off to 3.7%. At the same time, the 2-year Treasury continued to trade at 4.4%. Because of this, the yield curve enters December inverted by 0.70% (70bps). A yield curve this inverted is making the argument that an economic recession is coming.
At the same time, credit spreads between Treasuries (the “risk-free” rate) and high yield corporate bonds are off their July highs and not unreasonable. This suggests that the economy isn’t in terrible shape.
So, like everything else, a mixed bag.
It is important to remember that the stock market is not the economy, and the economy is not the stock market. Many people spend a lot of time thinking about economic growth, government policies and corporate profits in hopes of having an understanding of what’s ahead of us. Yet, whatever that plan may be, it probably isn’t going to go how it was written.
One year ago, there was absolutely no analyst we could find who was predicting the inflation and interest rate increases that have occurred this year. Right now the pundits are almost universally telling us there will be a recession sometime in 2023. This may be true. Or it might not. Honestly, without a newspaper from December 31, 2023 we can’t definitively tell you what’s going to happen over the next few months. The mixed messages from the markets and the economy are certainly not helping!!!
What we can say is that we have likely seen the worst for the stock and bond markets. The S&P 500 hit a low point in June, came back down to those levels in October, before rallying into the end of November.
This rally may continue or take a breather. This rally may be over and heading back towards the 3700 level or up toward the August highs of 4350 for the S&P500. Whatever the case, we believe that the stock market is in the middle of a bottoming process.
Remember, the economy and markets are not the same thing. The stock market is forward looking. The implication, for investors, is that when a recession hits the stock market tends to start rallying on the prospects of a better economy in the next 6-12 months.
Bottom Line: It will take some time but we have every reason to believe the stock market will return to positive returns and new all-time highs.
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Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market.All investing involves risks including the possible loss of principal invested. Past performance is not a guarantee of future results.
Index returns are not fund returns. An index is unmanaged and not available for investment.
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.
S&P Midcap 400 Index: The S&P Midcap 400 Index is a capitalization-weighted index measuring the performance of the mid-range sector of the U.S. stock market, and represents approximately 7% of the total market value of U.S. equities. Companies in the Index fall between the S&P 500 Index and the S&P SmallCap 600 Index in size: between $1-4 billion.
S&P Small-Cap 600 Index: The S&P SmallCap 600 Index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock’s weight in the index proportionate to its market value.
MSCI World Index: The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.
MSCI EAFE® Index: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
Bloomberg Barclays U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
NASDAQ Composite Index: The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market.
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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