Destructive Instincts and the Antidotes
Destructive Instincts and the Antidotes
The number of frightening headlines and fearful investors continues to mount to historic levels. And while it’s natural to believe that such things are evidence that the tough times will last indefinitely, history and a deeper look at current inflation data paint a much different picture.
Five Things You Should Know
- Equity Markets – were lower this week with U.S. stocks (S&P 500) down -4.52% while international stocks (EAFE) fell -6.05%.
- Fixed Income Markets – were lower with investment grade bonds (AGG) down -1.63% while high yield bonds (JNK) fell -2.79%.
- Central Bank Activity – While the Fed’s decision to raise rates for the 5th consecutive meeting by 75 basis points was not a surprise, the Fed’s upward revision of their expected dot plot sent risk markets lower this week as investors digest the consequences of lingering inflation. Meanwhile the Bank of England also raised rates for the 7th time in less than a year, with borrowing costs for businesses and consumers now in-line with levels not seen since 2008.
- Housing Reversal – Another victim of inflation has seen the recently booming housing market begin to shift lower with prices falling from their peak levels. Mortgage rates have now risen for a fifth consecutive week with the average 30-year fixed loan currently sitting around 6.3%.
- Key Insight – [VIDEO & ARTICLE] The number of frightening headlines and fearful investors continues to mount to historic levels. And while it’s natural to believe that such things are evidence that the tough times will last indefinitely, history and a deeper look at current inflation data paint a much different picture.
Insights for Investors
“Clear thinking requires courage rather than intelligence.” – Psychiatrist Thomas Szasz
The Fed Announcement
Wednesday brought the much-anticipated latest announcement from the Fed and while their actual move, another 75 basis point hike, was expected, the real issue was trying to “decode” Chairman Powell’s comments for what may lie ahead.
If the stock market’s initial response is any indication, the market doesn’t have much confidence in the Fed’s ability to engineer a soft landing. Powell’s comments to the effect that “…my colleagues and I are strongly committed to bringing inflation back down to our 2% goal” and, “We can't fail to do that. I mean, if we were to fail to do that, that would be the thing that would be most painful for the people that we serve”, were for the moment interpreted as “hawkish” but in all honesty such comments shouldn’t have surprised anyone and hardly lock the Fed into any particular path if the data changes.
Where this all ends will be about what happens to the rate of inflation over the next 6 months and deciphering that picture, while not a certainty, is far clearer than trying to read into purposefully generic statements.
Furthermore, as economists like Scott Grannis and Brian Wesbury continue to point out, the Fed sadly continues to ignore the most effective, and least economically disruptive, path to fighting inflation – reducing monetary supply.
As Wesbury put it, “Our biggest concern over today’s Fed activities has nothing to do with what they published or said, but rather what they continue to ignore. The M2 money supply is and has been the biggest factor on inflation, yet Powell and the committee statement didn’t mention it once … The bottom line is that it’s good the Fed has prioritized the fight against inflation, but it remains overly optimistic in how quickly it will get inflation back under control, especially as the tools they have to tame inflation are like using a drill to hammer a nail. Follow the growth of M2 – which has thankfully slowed and must remain low for the foreseeable future – for guidance on the path forward from here.”
The Current Outlook for Inflation
The evidence and trends related to inflation paint a much different picture than the hyperbolic headlines on the topic.
JPMorgan remains optimistic the worst of inflation is behind us stating, “By the end of the summer, investors had adopted a view that inflation would decelerate at a healthy pace into the end of the year. While headline CPI did decelerate to 8.3% y/y in August on the back of a 5% decline in energy prices, the report disappointed on a month-over-month basis as inflation rose 0.1% m/m versus expectations for a sequential decline. While some of the disappointment in the head- line figure stemmed from food prices rising 0.8% during the month, the core figures were a bit unsettling, rising 0.6% in August and 6.3% y/y. In the details, inflation in core services outpaced inflation in core goods, and shelter costs continued to move higher. Despite this disappointing report, we see reason to expect that prices will continue to cool in the coming months. As shown in this week’s chart, food, energy and other commodities prices had been growing faster than the headline number itself but are finally starting to come down. This is key, as together these items account for 40% of the CPI basket. Looking ahead, we expect commodity disinflation to spill over to other categories. This notion was reinforced by the 0.1% m/m decline in producer prices, which should eventually feed into lower CPI.” (See accompanying chart).
As to the recent worries around “sticky inflation”, Alpine Macro is firmly in the camp of those expecting inflation to moderate more quickly than current expectations. They commented, “A key component that has held core CPI inflation high is the shelter index, which is still rising at a 6.3% annual rate. Many are concerned that rental costs are much stickier than other CPI components and could hold the entire inflation rate high, therefore torpedoing the equity market anew. This is possible, but if it does, it would only do so temporarily … rental inflation has not only been highly volatile but also closely correlated with the housing market. With the residential market beginning to cool quickly, rental inflation will likely peak soon.” (See also JPM chart above).
Analyst Thomas Lott pointed out the common mistake most (including the Fed) seem to be making in evaluating where inflation actually sits today stating, “Here is the problem (as we see it). The Fed is only halfway to its likely 4% Fed Funds rate, on the premise of high CPI data. But while year-over-year inflation looks high, that is entirely backward-looking data. The month-over-month data looks extremely benign. CPI, including the very important food and energy categories, was only up 0.1% in August. And it was up 0.0% in July.”
He also, like those above, highlighted the importance of the “shelter” component in inflation data, and the fact that both home prices and rents are beginning to roll over as we speak. He concludes, “Based on what we see, the odds of the CPI falling rapidly, especially in Q4/early 2023, are quite high.”
What could it mean for Markets?
The biggest challenge for investors at such times is just how bad these types of markets feel. And to be clear, I am not making light of that at all, but rather acknowledging a very real challenge we all face. Just this week a colleague came to me to talk and commented how “hard” of a year it’s been dealing with these markets.
As the chart below, which shows that we are on pace for the most daily drops of 1% or more shows, even if not the worst year from a performance perspective, this is a historically challenging year in its own way.
And investors’ sentiment is struggling as a consequence. For just the third time-period in the history of the AAII Sentiment Survey, “bearish” investors are registering over 60%. During such times, most investors “feel” like it will never get better, but it does.
Step 1 - Acknowledge the pain and challenges it presents is an important part of avoiding making avoiding emotionally charged decisions. I love the quote above and think of it often as it relates to making sound investment decisions.
Making money as an investor isn’t about knowing the future or being the proverbial “smartest person in the room” as much as it is about having the courage to stay disciplined and not panic during tough markets.
Step 2 – Understand history. A look back at the other periods of dire sentiment show the outlook is far better than it feels. The following chart shows that the average six and twelve month returns after such sentiment levels are breached are +19.54% and +33.20%, respectively. Both years (1990 and 2008) where the market dropped -20% and hit 60% bearish levels saw calendar year returns of 20%+ the following year (see Feast or Famine chart below).
There is also good reason to believe even if markets have some more volatility ahead, that the bulk of it may be behind us.
Tom Essaye summarized the current state of things this way stating, “So, did the outlook for stocks get that much worse this past week? No, it didn’t. At the September Market Multiple Table we stated we believed the “fair value” of the S&P 500 to be between 3,680-3,910, with a midpoint of 3,795. Nothing has occurred that would make us change that estimation. Instead, the market has been forced to confront the reality that, while there have been some positives since the June lows (peak in inflation, more resilient corporate earnings), the major problems with this market, Fed rate hikes and very high inflation, have not been fixed. As such, we must be skeptical of any sizeable rallies that come without legitimate improvement in those two issues.
Other quantitative indicators suggest we may be nearing the type of point of max bearishness that signals a bottoming out process.
Yahoo Finance commentator Saqib Ahmed noted that “Futures tied to Wall Street’s fear gauge are close to sending a signal of growing fear that has sometimes preceded past stock market rebounds … October VIX futures were trading only 0.20 points lower than November futures, the slimmest margin since mid-June, when the S&P 500 marked a bottom.” (See accompanying chart).
While commentator Michael Msika noted, “…the extreme bearish positioning could also prove to be a source of support for stocks. Fund managers are the most underweight equities they’ve ever been, while cash levels are at their highest level on record, according to Bank of America Corp’s latest monthly survey.
Another gauge, CFTC’s S&P 500 net non-commercial futures, also shows an extremely negative view, having reached levels last seen during the downturns of 2008, 2011, 2015 and 2020. Such bleak sentiment is often seen as a contrarian indicator, flagging a rebound.”
A quick look at the “red dots” below reveals that such periods of bleak sentiment have corresponded far more often with market bottoms rather than the beginning of some new horror as is often feared in the moment.
The Challenge
A great challenge in life, and in investing, is confusing the path with the destination. We set not only a goal, but an expectation of how we are supposed to get there. When things go differently than we expect we a) get emotional, and b) incorrectly assume our goal is automatically affected – neither is necessarily true.
We invest money and we hope/believe the market will/must go up at a certain rate over a set period or all is doomed, and we fear that market declines will continue indefinitely.
The reality, as the chart show below, is that markets are anything but predictable, normal, or steady.
“Average” (blue box below) almost NEVER happens. Rather, what defines markets are seemingly erratic behavior summarized by AMG as, “Feast or Famine” that for the uneducated or undisciplined investor will continually try to pull them between actions induced by greed and fear in a way that almost assuredly would be destructive to their ultimate goal.
Markets don’t “work” all the time, but over time.
Let Mr. Market be manic, his behavior is beyond your control. All you need to control is your response, and ability to see over the valley to what inevitably lies ahead.
In Summary
None of this is meant to predict – our process is not based on making predictions. It’s a natural human instinct to want to control and to “know”, but it’s simply not how life or markets work much of the time.
The Fed’s inability to effectively (and constructively) communicate along with its continued failure to address the real culprit (monetary supply) behind current inflation levels is frustrating at best and somewhat “frightening” at worst.
However, if you can shift your attention from all the narrative driven “hot takes” on what the Fed may do next, to the actual data you’ll find solid reasons for optimism. From improvements in the subcomponents of inflation, to historic market movements after similar levels of sentiment and positioning, there is a lot of evidence that suggest there are great opportunities for investors with some patience.
Furthermore, we’d also encourage you to also broaden your focus, at least in part, from simply watching the stock market to see some of the opportunities finally presenting themselves in a number of areas within the fixed income market. The bond market doesn’t demand near the allocation of TV time as stocks, but for many investors they may demand more of a portfolio allocation than has been justified in recent years.
Have a wonderful weekend,
Tim and the team at TEN Capital
Data, Just the Data
Data points this week included:
- U.S. Jobless Claims – rose by 5K to a claimant count of 213K for the week ending September 17th. The reading was below the market estimate of 218K, and puts it above last week’s revised value of the lowest since May. The four-week moving average fell by 6K to 216K.
- U.S. Housing Starts & Permits – jumped significantly by 12.2% MoM coming to an annualized rate of 1.575M units for the month of August. This handily beat expectations of a 1.445M increase. This is the largest expansion since March 2021, but the high prices, increasing mortgage rates, and elevated material costs are still weighing on home buyers. Single-family starts increased 3.4%, and multi-family units rose 28.6%. Building permits (proxy for future construction) did fall (10%) and is the biggest drop since April 2020.
- U.S. Existing Home Sales – contracted slightly by (0.4%) MoM to an annual rate of 4.8M in August, marking the lowest reading since May 2020. This is the seventh consecutive month where sales have fallen. Median existing home prices are up 7.7% from a year ago to $389.5K and inventory has moved to an equivalent of 3.2 months.
- U.S. PMI Composite Flash – bumped up to 49.3 from 44.6 in September marking a decline in business activity but seems to be softening. Service output fell at a softer rate as well as manufacturers saw a decline in production. New orders declined, but employment slightly bumped up. Business confidence has risen to a four-month high.
- U.K. PMI Composite Flash – fell to 48.4 from 49.6 for the month of September. This was the quickest contraction since 2021 as high costs and a weak economic outlook are weighing on output. Employment rose despite job creation remaining flat. Input costs and output charges rose slightly but remain at the highest levels ever seen.
- Eurozone PMI Composite Flash – slightly dipped to 48.2 in September after a previous month decline to 48.9. This marks the third-consecutive month of a contraction with services falling from 49.8 to 48.9 and manufacturing down from 49.6 to 48.5. New orders fell, with input costs rising rapidly. Business expectations have fallen to their lowest reading since May 2020.