What’s the Deal?

The lament of investors is not knowing what is going on. I refer to it as “What’s the deal?”. If you have some sense of where markets are going, you can develop a strategy for coping with the changes.

There are so many disconnects in the markets, currently, it is difficult to develop a strategy. In hindsight, it is clear that the huge payments the government made to its citizens in 2021 created an inflation bubble that now must be delt with. The U.S. government has little real control in bringing down inflation. The Federal Reserve, Fed, can raise interest rates and thereby slow down the economy, and thereby consumer spending. The Fed is vigorously raising rates to restrict inflation.

A Look at What’s Happening

Inflation is increasing prices at a rate not seen since the early 1980’s. The war in Ukraine has placed enormous pressure on fossil energy supplies in the western countries. There are many job openings but not a sufficient number of people to fill what’s needed. Unemployment is at an all time low. Both stocks and bonds are down by double digits. The political environment is hostile.

Is there Hope

With all the negativity that appears before us can we see a glimmer of hope? I believe the answer is yes! The past three months have been brutal on just about every asset class. The Wall Street Journal, on July 5^th, reported on the decline in prices for raw materials. On July 6^th, the price of a barrel of oil dropped below $100, at $98.36. The price of building materials declined in the quarter by 22%, lumber by 31%, cotton down 27%, corn off 17%, wheat down 12% and it goes on. Mortgage interest rates are going back down, as fewer people are refinancing or buying housing. The price earnings ratio estimate of the S&P 500 is now16.69 vs. 22.65 a year ago. The dividend yield on the S&P 500 is now 1.71 vs. 1.35 a year ago. This would appear to indicate stronger value in stocks. As interest rates on bonds have gone up, lowering the value of bonds, the current yields are very attractive.

I believe what all of this is telling us is that prices are beginning to come down. When the Fed raises rates, it takes 60 to 90 days to go through the economy. This might suggest that the Fed interest rate increases are having the desired effect, and the most recent 0.75% increase isn’t really in the economy yet.

Where Might we be Headed?

All signs seem to be pointing to a recession. In April we had an inverted yield curve. This happens when the 2-year Treasury is paying a higher interest rate than the 10-year Treasury. Based on the past, it would indicate that a recession is likely in 9 to 12 months. That would be January to March of 2023. It would appear that the stock market has already priced in a recession. The stock market tends to look out six to twelve months in pricing. If this is the case, we may be seeing a near bottom in the stock market and a lowering of interest rates on bonds. If this is the case, then it could be a positive for investors during the balance of the year.

The negative side of this would be, the expectation that unemployment will go up and the economy will stagnate. The level of such disruption will be in the hands of the Fed.

Numbers Review

The S&P 500 index ended the quarter at 3785 compared with 4530 at the end of the last quarter, down 15.7%., and down 20.6% for the year. The S&P Mid Cap index ended the quarter at 2269, down from 2694 at the end of the last quarter, or 15%, and 20.2% year to date. The S&P Small Cap index ended at 1128 compared with 1319 at the end of the first quarter, down 13.6%, and 19.5% year to date. The MSCI ex USA index for foreign stocks declined to 276 from 324, for a loss of 19.7% year to date. The 10-year Treasury was 3.09% down from 2.53% at the end of the last quarter.  The Bloomberg Barclays US Aggregate Bond Index yield went from 1.75%, at year end, to 3.74%, for a decline in the value of bonds of 10.3% year to date.

Conclusion

With stocks down around 20% and bonds down about 10%, year to date, we are in an unusual place in history. There are some indications that the downturn in markets may be waning. Both in the month of April and again in June we saw major selling of stocks, particularly tech stocks. There is quite a bit of volatility, which I credit to investors still trying to figure out “What’s the deal?” This may become clearer, and with clarity the markets usually respond in a positive manner. When markets move up, they can do so within a matter of days, so it pays to stay invested. To say the least, this has been a difficult time to be an investor.

Ed Mallon

¹ Markets Digest, Wall Street Journal, July 1, 2022 

² Business & Finance, Wall Street Journal, July 7, 2022 

³ Exchange, Wall Street Journal, July 2-3, 2022