Big Picture Review
Many of the challenges the market faced in the first quarter were exacerbated in the second quarter. The pandemic-induced roadblocks that constrained supply at the end of last year continued to weigh on the economy. Ironically, stimulus in the form of government distributions and tax relief spurred demand that exacerbated the bottlenecks. Moreover, the war in Ukraine which began in February, grinded on into the summer months with neither side able to claim victory yet pressuring the prices of energy, food and other commodities. The consumer price index (CPI) rose 9.1% in June from a year ago according to data released by the Bureau of Labor Statistics. That was the highest increase since December 1981. According to AAA, June 14 recorded the highest ever average price (since collecting data beginning in 2000) for a gallon of gasoline in the U.S. at $5.016 for regular unleaded. Excluding food and energy, consumer prices rose 5.9% in June presenting a challenging headwind for the domestic environment. Shelter costs, which include housing trends and comprise one-third of the index, rose at the fastest monthly pace since March 2004 and the quickest 12-month pace in 31 years.
The Federal Reserve clearly has a lot of work to do. In response, the Federal Open Market Committee continued and accelerated the pace of interest rate hikes. In March, the Fed began tightening with a 25 basis point (0.25%) hike. In May, they upped the amount to 50 basis points. Last month, in the most aggressive boost since 1994, the Fed instituted a 75 basis point rise taking its target federal funds to 1.50%-1.75%. According to their projections, rate increases are expected to continue through the remainder of 2022 and into 2023. As a result, officials significantly cut their outlook for 2022 economic growth, now anticipating a 1.7% gain, down from the March projection of a 2.8% rise. The Fed uses Personal Consumption Expenditure (PCE) price index as its preferred inflation gauge because it is more detailed than the CPI. In May, the PCE index rose 6.3% annually and 4.7% excluding food and energy. The Fed is projecting it to end the year with an annual rise of 5.2% and 4.9% core figure—higher than their March projections but lower than the most current release.
The biggest challenge the Fed faces is psychology. What Chairman Powell and his colleagues fear the most is that inflationary expectations will become entrenched by households and businesses. If higher prices are presumed, then it is likely to become self-fulfilling. However, the higher rates go, the greater likelihood of a recession because it is a blunt instrument that has a profound effect on a number of economic activities—from house buying to car shopping to capital goods investments. The trillion dollar question is: does the Fed fear inflation more than it fears a recession? The answer so far has tilted toward inflation as the bigger demon. “Is there a risk that we would go too far? Certainly there’s a risk, but I wouldn’t agree that’s the biggest risk to the economy. The biggest mistake to make…would be to fail to restore price stability,” said Powell at a central-banking forum in Portugal last month.
Central bankers such as Powell believe that inflation is the bigger threat because once it becomes status quo, it would require the Fed to increase rates more than otherwise to shatter that mind-set. That is exactly what happened in the late 1970s and early 1980s when then Fed Chairman Paul Volcker ratcheted benchmark rates close to 20% to squash price hikes caused primarily by high oil prices. The Fed does not want to have to put the economy through shock therapy again. The U.S. central bank has two mandates: stable prices and full employment. It says nothing about a recession or keeping investors happy. If the Fed’s goal is to have inflation expectations stable, or “anchored,” around 2% then it has a long ways to go and it is safe to assume that the hikes will continue until otherwise notified.
How high might rates go? The Fed’s Summary of Economic Projections shows the federal funds rate central tendency to end 2023 between 3.6%-4.1% or more than double the current range. However, in contrast, futures markets are settling at a median around 2.6%. Why the discrepancy? Traders are believing that a recession will occur sometime over the next 18 months thereby halting the Fed’s rate hike trajectory. Clearly, a Catch-22 situation is at work. If the Fed is indeed successful with its plan, it will slow the economy as anticipated. But in slowing growth, the hikes have been so sharp it will likely have to inject liquidity through rate cuts to keep it from stalling too much. But do not get attached to these prognostications because they can change on a dime. The markets were expecting slow and steady 25 basis points hikes for the first half of 2022 at the start of the year. Things have certainly changed.
It will take time for any rate escalations to make their way into various industries. Aggregate demand does not change as quickly as rates do. In fact, that insight is a key reason why a recession, should it come to pass, is unlikely to be overly severe. While recessions are not joyous events, they are not all end-of-the-world occurrences as they are often painted to be. The official arbiter of U.S. recessions, the National Bureau of Economic Research (NBER), defines a recession as “a significant decline in economic activity spread across the economy, normally visible in production, employment, and other indicators.” There was a recession in 2001 according to NBER even though GDP did not contract for two consecutive quarters, as is often the threshold used. The 2020 recession started February 1 and was over by April 30, barely lasting three months. The committee makes a judgement call based on a wide variety of indicators which underlies the possibility that recessions can look very different from each other.
This one may look unique for a variety of reasons. The labor market looks strong. The June payroll figures from the Labor Department showed a gain of 372,000 jobs and a national unemployment rate of 3.6% which is a hair above the half-century low reached in early 2020. The U.S. has more than 11 million unfilled job openings in six of the past seven months, four million more monthly openings than was typical before Covid-19 hit in early 2020. The size of the labor force is being affected by baby boomers retiring meaning even those who do get laid off should have options to collect a regular paycheck again soon.
Also, from early 2020 to the end of 2021, U.S. households built up $2.7 trillion in extra savings according to Moody’s Analytics. Through various stimulus programs, the government distributed over $5 trillion to households, businesses and state and local governments. That cash cushion means that even as output slows, spending can remain somewhat solid. At the end of March, according to JPMorgan Chase Institute, the bank’s in-house think tank, balances of families with the lowest incomes were 65% above 2019 levels. The industries emblematic of this strata-retail, hospitality, leisure—saw strong wage growth as the economy opened following the Omicron wave late last year suggesting their need to dip into savings was minimal. Does this savings cash find its way into financial markets? Potentially, but with the crash of fads like SPAC IPOs and the fading of crypto currencies, retail investors are likely to focus on paying the bills rather than gambling.
As we wrote last quarter: “The point is whether (a recession) happens later in 2022 or 2023 or not until 2024, there is a recession in our future. The business cycle has not been annulled. What really matters is what how long will it last, have the associated causes been identified and addressed and, most importantly to us, what opportunities have been uncovered because of it.” The NBER has been calling recessions since 1857. The only thing we can know for sure is that all of the previous ones have ended when the cycle of growth began anew. Should we see a slowdown develop in the coming quarters, we will be looking forward to the day that one ends too.
Market Analysis & Outlook
The results for the second quarter for the world’s major bourses reflected the changed nature of the investment environment. The days of “easy money” were long gone and replaced by uncertainty and nervousness imposed by the shift in tone of the Federal Reserve. The S&P 500 suffered its worst first half of a year since 1970 falling 21%. Just a year ago, that index was sporting a 14% gain through June. For the second quarter of 2022, declines of at least 10% were posted by 323 companies and 84 were down at least 25%. Year-to-date, 189 firms were down at least 25% in the index. For 2021, 434 stocks gained an average of 34% emphasizing how drastically things have turned. Similar to the first quarter, foreign bourses also had a difficult period. For the second quarter in local currencies, NIKKEI (Japan) -5%, CAC-40 (France) -11%, DAX (Germany) -11%, BOVESPA (Brazil) -18%. The tech-heavy Nasdaq Composite fell 30% during the first six months of the year as this former high-flying group fell victim to the jump in rates which spurred traders to sell the generally higher multiple names of which the Nasdaq has many. That sharp rise in rates continued to plague the bond market, too. The Bloomberg US Aggregate index was down 10% year-to-date and the Municipal Bond index fell 9%.
For investors who were accustom to quarter after quarter and year after year of gains, it has been a period of adjustment. But the cycle of investing will always involve periods of challenging markets, negative returns and undefined futures. With the right financial plan and appropriate patience, such interludes can eventually become wonderful windows of opportunity. Having a diversified, balanced portfolio has proven so far to provide some defensive characteristics in a volatile market. While we have experienced declines in various names like many other investors, our lower beta holdings have avoided the worst of the large daily swings.
Many investors still want to know: is it safe yet? The average length of time it took for the S&P 500 to recover from the low of the bear market (as defined by a decline of 20% or more from the most recent high) to reach a new all-time closing high was about two years. The quickest recovery took just over three months (in 1982) while the longest took nearly six years (1974-1980). So, it depends. And trying to figure out how long this one will last is close to impossible to tell, and time is better spent elsewhere. Why? Because time in the market has historically proven to be more important than timing the market. An investor could have begun trading on February 19, 2020, the peak for stocks before the pandemic and still had more money at the end of the most recent quarter which included the March 2020 bear market and seventeen days after the most recent bear market began in 2022. It is obvious that an investor who just started investing at the beginning of the year would be sitting on weighty losses, but the one who may have thought they poorly timed their February 2020 investment would be looking at gains. One can choose any day in that period or choose one four months from now but our conclusion will be the same—have the right financial plan and appropriate patience and history shows there is a high likelihood one will accrue value over time through bull markets, bear markets and everything in between. Admittedly, there could be some white-knuckle days investors have to endure, but the right allocation can contribute to the sleep-at-night factor. We recently came across an insightful quote from Jason Zweig, author of The Intelligent Investor in The Wall Street Journal: “…the folly of trying to figure out when stocks have hit bottom. So you should distinguish what you can control from what you can’t. Instead of wasting your time trying to read the market’s tea leaves, take charge of the risks you run, the taxes you incur and your investing time horizon.” Wise advice.
There are other factors we closely track which gives us confidence that what we are witnessing in the markets has so far been orderly and rational while undeniably unpleasant. The Cboe Volatility Index, known as the VIX, is a barometer of investor expectations for stock market turbulence over the next 30 days based on prices for options on the S&P 500. A higher figure coincides with higher volatility as more traders buy puts to protect positions that may decline. The VIX hit an all-time closing high of 82.7 in March 2020 in response to the onset of the pandemic on U.S. shores. That peak surpassed the prior high of 80.7 reached in the fall of 2008 during the depths of the global financial crisis. Even among the triple threat of threat of sticky inflation, Fed hikes and recessionary risks, the highest closing level this year was 36.5 and that was back in March. There have been a few spikes in May and June which have reached the lower 30s but nothing compared to record levels even though it remains elevated compared to its average of around 20 since 1993. Historically, the VIX surges to a peak before bear-market bottoms. With more than half of the globe having at least one Covid-19 vaccination shot, the threat from the pandemic has waned albeit not disappeared completely with various less lethal but more contagious variants still spreading. And, unlike 2008-2009, the financial system in the U.S. is not threatened by excessive leverage and poorly capitalized institutions. What might cause a spike this time around is a recession on the heels of shrinking corporate earnings estimates and margin compression, which we will address later. Investors seem resigned to the fact that the next few months will be a slog without a clear resolution on inflation peaking or the sharpness of rate hikes on tap until later in the year.
For those who adamantly must seek some comfort from various indicators, other technical factors have not confirmed a market bottom yet but we could be close. The 14-day relative strength index (RSI) has stayed above 30 since late January. Market downturns in 2011, 2018 and 2020 all ended with the 14-day RSI below 20 in each instance. We have seen the percentage of S&P 500 stocks trading below their 50-day moving average drop below 5% in mid-June signaling a least the early stages of a major low are forming. Nonetheless, even with 26 trading days year-to-date moving at least 2% or down in the S&P 500 (compared to seven all of last year), it is hard to point to that gut-wrenching, soul-crushing, hope-killing selling day that marks peak fear. On June 10, the Cboe put-to-call ratio hit 0.89, its highest level since March 2020 and higher meaning a worse market situation. That figure hit 1.28 in March 2020 and 1.35 when Bear Stearns collapsed in 2008. Instead of the V-shaped bottoms that marked selloffs in December 2018 or March 2020, the future could hold more of a steady, water-torture decline that occurred with the dot-com bubble burst. It may take a number of weeks or months to truly determine if there has been a real shift in how investors view the market.
What we believe is that the Fed will not pivot until inflation improves significantly. That means that rallies in the market will be capped because traders will have in the backs of their mind that the age of accommodation is over. It will not be a surprise to get bull rallies inside a bear market because sometimes valuations just seem too tempting to pass up. How will that be different from a true beginning of a sustainable rally? Greed. Up days in the market will be very powerful marked not only by lots of participation by various sectors but higher-than-normal volume spikes. Additionally, there will likely be some sort of confirmation from the fixed income markets punctuated by thinner spreads between risky and riskier borrowers and a yield curve which is upward sloping at all the major maturities.
As we mentioned before, sitting on the sideline waiting for such a day to occur is unwise. Not only would an investor be missing out on a stream of dividends from equities or interest payments from bonds in such a scenario, but they would also likely miss out on the sharpest upside returns which usually happen in a handful of those first few rally days. Some might argue that sitting in cash helps avoid missing the absolute bottom in the markets. But since nobody knows when that is in advance, that just raises the probability of missing the start of the next bull market. Being nervous in tumultuous markets is just a symbol of being human. Responding with panic, however, is a sign of not having the right plan.
With second quarter earnings season marking the summer months, investors would be wise to listen closely to management guidance. Wall Street has a spotty history of calculating how inflation and recessions weigh on earnings. Operating margins for the S&P 500 have climbed from around 13.5% in the middle of 2020 to 17.0% by the end of the first quarter this year. That is an incredible rise considering the pre-pandemic peak was a little over 16% in the middle of 2018. Since then, pandemic forces have combined to not only snarl supply-chains but also severely impact the cost of labor. Compensation costs is the single most expensive line item for the majority of companies. From a labor force participation rate of 63.4% in February 2020, that figure has dropped to 62.2% as of June 2022. That 1.2% difference represents millions of people who are no longer in the workforce. With supply constrained, it takes higher wages to attract those still willing to work and that directly affects the bottom line and, hence, the residual earnings left for shareholders.
According to Wall Street analysts, S&P 500 earnings are expected to rise 10.4% by the end of this year versus 2021 followed by a slightly lower 8.5% rise next year. While the prospects for a recession, its potential depth and possible severity remain unknown, it is unlikely that earnings in a rising rate environment are going to be accelerating by double digits. What is even more head-scratching is that the 2022 estimate has risen since the end of 2021. Our conclusion is that estimates are too lofty at this stage because of the pressure on margins. Those companies who can pass along rising costs will be best positioned, assuming they do not lose market share as a result. So far, with households still feeling plush from stimulus checks, inflation has not had a huge bite in consumers’ wallets…yet.
We often get the question, what are we doing or will be doing differently if a recession happens? While we are constantly analyzing market currents and how they will affect our holdings, there is not a substitute for quality management, dominant positions versus competitors, sturdy balance sheets and stable cash flows. An economic slowdown six months from now is not going to change our investment theses because our investment theses are not solely based on the economic temperature. Every company must deal with whatever direction the winds are blowing and that risk cannot be diversified away. If you are invested in the market, you must deal with such a risk. Our newest investment to the SGK Core, Zoetis, is not immune from the spending patterns of households or businesses, but they do produce products and services which are crucial and oftentimes life-saving thereby leading to spot near the top in the spending pecking order. Even if a firm is in a more economically sensitive sector like our bank holding JPMorgan, we are shareholders because of its strong position in mergers & acquisitions, its stellar wealth management division and its massive and profitable credit card portfolio among other reasons.
As long-time clients will attest—many of our commentaries repeat themes over and over: Volatility creates opportunity. Waiting for a catalyst or rebound will often result in the purchase of fully valued security. Value is never out of style, but it does not work all of the time. Taxable gains are the cost of being right. One cannot consistently time the absolute bottom any easier than timing the market top. Think like a contrarian because patience is a virtue.
For us, these axioms are virtually instinctual. It does not mean we are infallible because nobody is. We focus on fundamentals because they are manifest, quantifiable and repeatable. Using the available public information and our collective investment experience, we try to build portfolios that will provide long-term growth and cash flow. Jointly, our equity core holdings yield more than the S&P, are trading at a discount to the market based on expected earnings and cash flow and have less beta (volatility). Our bond holdings emphasize credit quality and laddering maturities enable us to identify occasions to re-invest at periodic intervals. The markets will continue to go through this period of transitioning and uncertainty which makes dividend income and bond interest extra precious. We will continue to monitor and evaluate the various trends and themes which permeate the markets for the rest of 2022 fully aware that each quarter brings new trials and opportunities.
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