Financial markets have no clear direction, trapped in No-Man’s Land until at least the next Federal Reserve meeting on May 3rd. Depending on the economic data points of the day, stocks are gyrating up and down within a narrow band without clear direction or conviction. Such is a time when opinions and predictions bounce markets until enough data exists to prove one right or wrong. There are several directions for future economic and market performance that need to clear up.
The First Compass is monetary policy – driven by the Fed moving interest rates and the supply of money. It is expected that rates will be raised another ¼ percent in May, and then a pause announced as the toll previous increases are having on the economy becomes clearer in the data. This includes inflationary pressures receding, employment growth cooling, and the availability of credit shrinking. Tighter financial conditions weigh on small businesses, who employ 2/3 of all workers. The possibility of recession has increased, and slower corporate earnings – the primary basis for stock valuations – are expected.
Secondly, virtually every recession indicator is flashing red, from manufacturing data, commodity prices, and a very inverted yield curve. But consumers will determine if a recession occurs and how severe it might be. Will consumers keep spending while bank credit is reduced, the economy slows down, confidence is eroded, and a true recession occurs? No one knows. So, today we are stuck in No Man’s Land.
There are clear signs that once the corner does turn, the recovery in stock prices could be fairly swift. While this all sounds ominous, the reality is that a possible recession should be shallow and short. Despite potentially slower short-term earnings, corporate and household balance sheets remain quite strong. Assuming this persists, any damage due to recession may not foster further reduction in stock prices. Earnings also historically prove stronger than pessimists fear. Finally, investor sentiment and positioning is downright despondent. Troughs in sentiment tend to precede strong equity returns. We are currently in the 16th consecutive month of negative market sentiment. The Great Financial Crisis had a span of 18 months. With the second longest period of negative sentiment in place, and cash accounts flush with $3-$4 trillion to invest, there will likely be great demand for equities when sentiment turns.
Barring a major unforeseen event, we expect a turnaround later this year as markets “look through” to next year. In the ten prior periods when markets were up in the first quarter after a negative year, the year finished higher in all of them. Further, 15 out of the last 16 periods produced positive annual returns in years when the market was up greater than 5% in the first quarter. We believe the stage is set for the market to accelerate into year-end once earnings and consumer strength pictures clear up.
So, what parts of the market are best positioned for growth?
Enjoy today and tomorrow, and let us do the worrying!
One economic conversation last year centered on whether Federal Reserve rate increases would cause a hard or soft landing, with a hard landing increasing unemployment, and a soft landing perhaps avoiding a recession altogether. Lately, a third scenario is receiving attention – the “no landing” scenario.
In the “no landing” scenario, inflation remains high despite the Fed’s rate hikes. This theory points to the persistently strong labor market and continued consumer spending. If this happens, the Fed would likely keep raising rates. The uncertainty reintroduced by this scenario could echo 2022, where both stocks and bonds declined in value together.
The 60/40 portfolio was down over 16% in 2022 1. If you’re in retirement and withdrawing money from your portfolio for living expenses, down years like 2022 are problematic. To maintain the 60/40 allocation, you must sell some of everything when everything Is down. If you’re taking fixed monthly amounts, the percentage that you are withdrawing is increasing each month as assets decline in value.
This typically makes it difficult for retirees to maintain their lifestyle, even after markets recover. As an alternative, consider our needs-based approach to asset allocation. Integras Partners helps clients identify spending needs and goals and tailors investments accordingly. We allocate a portion of portfolios to short-term needs using fairly conservative investments. This allows longer-term assets to remain invested for growth, providing extra time, if needed, to recover from downturns.
1 Proxied by the Vanguard Balanced Index Fund (VBIAX)
Enjoy today and tomorrow, and let us do the worrying!
From an investment perspective, we at Integras Partners are glad to see 2022 in the rearview mirror. With multiple crosscurrents impacting investors’ ability to discern earnings and growth prospects, markets suffered a meaningful decline without settling on whether the worst is behind us. We expect uncertainty to stay with us for several months as future economic data comes in.
We continue to see two phases of this market decline, each phase driven by a component of stock pricing. First is the earning (or profit) potential of a company and second, how much investors are willing to pay for those unknown earnings. This concept also applies to other asset classes such as bonds and real estate. The first phase of decline happened in 2022 from the latter component, valuations coming down, which was fueled by higher interest rates. The second phase, which has yet to materialize, corresponds with decreasing earnings potential due to slower economic growth. This is what the market is currently struggling with – the uncertainty of how economic conditions will affect earnings and growth potential – the uncertainty of recession.
Whether the second phase occurs is unknown, but the damage done in the first was significant. High growth stocks were down 30%-60%, 20-year US treasuries fell 31%, growth underperformed value by an amazing 25%, and the list goes on. For the major averages, the S&P 500 ended down 18.1%, the small cap Russell 2000 down 20.4%, and the international EAFE index down almost 14.5%. Even the investment grade bond index was down 13%. The only places to hide were energy, utilities, consumer staples and cash. Virtually everything else ended in negative territory.
The list of conflicting indicators as to how the market may perform over the next 12 months is too extensive to complete the picture here, but we offer a few.
In the optimist’s corner…
Investor sentiment is terrible and positioning is quite defensive – indicating the environment is ripe for positive surprises. Earnings have held up well, economic growth is still positive, and employment is strong. Inflation has peaked, gas prices are down, Dollar strength has peaked, high-yield bond spreads are stable, and we are nearing the end of the Fed tightening cycle.
In the pessimist’s corner…
We are still in a bear market, technical patterns remain negative, and valuations are still too high. Leading economic indicators are the weakest since 2009, the bond market is priced for recession (since the 1960’s we’ve never avoided recession with the yield curve this inverted), the Fed is still raising interest rates, and the stock market has never bottomed before the Fed stops raising interest rates.
Until the recession question is answered, volatility will remain elevated, and no clear market direction will be established.
We believe recession depends on two key components – inflation and employment, and Timing is Everything.
Enjoy today and tomorrow, and let us do the worrying!
Until the looming recession question is answered, volatility will remain elevated, and no clear market direction will be established.
Recession depends on two key components – inflation and employment. If inflation falls enough for the Fed to stop raising rates BEFORE employment strength is wiped out, then we may escape recession. If not, recession is all but guaranteed and the question becomes one of severity. The market is currently struggling with this uncertainty – will economic conditions affect earnings and growth potential? We have repeatedly written over the past year to expect a recession. Even with inflation falling, there is still a way to go towards the Fed’s 2% goal, and the Fed has been vocal in its willingness to overshoot. To date, employment has held up very well in the face of higher interest rates. People with money to spend keeps the economy growing. But that is also part of the problem – people keep spending and contributing to inflationary forces. Making the Fed’s job even more difficult, consumer spending has moved away from goods towards services. Goods inflation has come down markedly in the past 6 months, but services (restaurants, travel, sporting events, concerts, etc.) has continued to rise. It is much harder for the Fed to tamp down services inflation while people have jobs. Additionally, there is still $4 trillion of excess savings in consumers’ bank accounts, so they could continue spending for a while even with no job.
However, we do not expect a protracted and deep recession. The financial system is much more stable and liquid than a decade ago, corporate, and personal balance sheets are in very good shape, and employment demand is likely to remain (relatively) strong. Therefore, we are in the mild recession camp.
The market already suffered a meaningful decline in 2022. How much farther could the market decline should a mild recession occur? With valuations far lower than a year ago, the downside from here could be limited. Perhaps we have already seen the bottom for this cycle. However, the typical P/E ratio for a recessionary market is closer to 14-15 times earnings (we are currently at 18). Along with potentially weaker earnings, this implies we could move lower in the coming months. If earnings don’t dissolve meaningfully, we think 3,500-3,600 on the S&P 500 may be the bottom. That represents a roughly 10% decline from today’s levels.
The bottom line is to expect volatility to remain elevated at least until the Fed stops raising interest rates. Then the market can more easily assess future earnings prospects, and the stage should be set for a rebound in financial markets.
Enjoy today and tomorrow, and let us do the worrying!
Inflation concerns and policy responses, including interest rate hikes, led to a painful year for markets. For much of the year, investors struggled with whether to believe that the Fed would follow through with aggressive hikes, causing relief rallies that did not hold. Because of this uncertainty, we took a “one foot in, one foot out” approach for our clients, reducing equity exposure but remaining partially invested should a Fed pivot occur. This was not the first tactical reduction that we made. In the Fall of 2021, we reduced equity exposure in our longer-term growth strategies in favor of private real estate offerings, recognizing extreme equity valuations and doubt over future earnings continuing to support those valuations.
Tactical strategy adjustments are one way that we protect our clients’ lifestyles. Our needs-based approach to asset allocation is another. We identify client spending needs and goals and tailor investments accordingly. We dedicate a portion of investments to short-term needs using relatively conservative, liquid investments. Drawing from that portion of the portfolio allows longer term assets to remain invested for growth, with the time needed to recover from market downturns.
We remain tactically defensive due to recession uncertainty, but we believe market recovery will begin this year. Markets are laying bets on both sides, but we note a slight positive change in the mood vs just a few short months ago. Still, we must remain cognizant of the near-term risks before redeploying defensive capital into more aggressive assets.
Given the discounts that are in place today, once a recovery begins, the next year or two should see relatively outsized investment returns. As long-term investors, we are positioned to take advantage of this rebound. Extreme moves in markets (both up and down) like we have witnessed recently occur during turning points. There will be more volatility, but we have told our clients to expect additions to equity exposure during the early part of the year, primarily in international and small-caps, along with small positions in beaten-up industries and those poised for future growth.
As stewards of our client’s investment capital, we know how concerning the past year has been. Having adequate reserves on hand during times like these enables them to continue living their lifestyles while waiting for the tide to come in. This is why our financial planning and investment process is especially valuable.
We aim to allow you to sleep at night knowing you can live life and let us worry about how to sustain it.
Enjoy today and tomorrow, and let us do the worrying!
Broad asset allocation based on “risk scores” assumes more risk than aligning investments to fund specific goals. So, we take little risk with money you need soon, allowing the benefits of increased risk to mature over extended horizons. The longer investments have the greater the certainty of expected returns. Plus, you don’t have to worry about short-term market gyrations.
Set an appointment if you want to speak with us about how we might help you.
