Remember back when stocks were making new highs, there were new buy signals flashing, and ‘everyone’ was thinking (out loud) that the worst of the bear market was over — in other words about a month ago!? In our eLetter at the time I mentioned that although things were looking up, I was concerned that inflation might be with us for a while. And that the battle between bulls and bears might remain a high-profile issue longer than we would like. Essentially, my thoughts were that we might be approaching a long, slow slog. You may also recall that I mentioned that, while many of our readers were thinking that this period of stress was about to be over, I had wished that everyone forgot about the ‘short bear market’ of 2020 — because a reliance on a belief that bear markets are commonly ‘short’ may turn out to be short-sighted. Unless you had been around during the early 2000’s or perhaps 2008 you might not know what a prolonged bear market actually feels like.
So, because I tend to err on the side of the glass being more than half full, I thought I’d take a few minutes today to examine both sides of the bull v bear debate and why it appears to me that the current environment might possibly be with us for a while.
My suspicions are that everyone who owns a computer (or TV) already knows the negative argument: Inflation has been sticky and does NOT appear to be ‘transitory’. (It could have been had ‘policy’ not intervened.) Therefore, the Fed must remain aggressive and that means continually raising rates more than we (we ALL) were expecting (despite the global economy which appears to be getting weaker.) And so, our furry compatriots would suggest that the Fed will throw the economy through the windshield as it pounces on the brakes. In turn, earnings guesses for Q4 and all of 2023 are most likely too high and must retreat. This will result in stock valuations and multiples also being too high, and thus coming down. Ugh!
My personal concern (at least at 2AM) is that inflation actually will remain with us for a ‘longer’ period of time. Here’s why: The two largest contributors to inflation are wages and shelter. And I contend, that no matter what the Fed says or does, these are unlikely to pull back any time soon. Shelter may well be the most troublesome part because the demand side is truly outrunning supply. And that’s the big deal. The causes of the surge in housing and rent costs, as well as salaries have been related to changes in consumer behavior that the Fed just cannot control at least not without producing havoc on the economy.
It is true that house prices are coming down but the effects on rentals, thus far, have been de minimis. And housing demand remains high despite mortgage rates (which are more than double the December rates). This is especially so in areas that don’t have a Phoenix summer or a Chicago winter. The continuing demand is keeping prices high (for now). The higher rates mean that home affordability has gotten tougher, which, of course, creates demand for apartment rentals. And this (as you may have surmised) means prices for rentals remain buoyant. And, according to stats I’m reading, rental prices are continuing to rise. Why? Because, as we said, it’s to do with demand staying ahead of supply. Funny how that works.
For the math-inclined, keep in mind that somewhere around 40% of ‘Core CPI’ is attributed to ‘shelter’ — which means that a big chunk of inflation may be likely to stay ‘sticky’.
And then there’s wages. Thanks, Covid! This is where employees quit one job to move to another higher paying gig. And how do companies retain workers? (Yup!) By paying them more. This merry-go-round continues unless the Fed can DESTROY demand for housing and the other stuff that we all tend to buy.
The thinking is that Jay and the central bankers can raise rates high enough, and thus reduce the demand for …………… just about everything, I guess. The plan is to create enough weakness among buyers of stuff to cause a pullback on the advancing prices and the job-hopping movement. And this, according to plan, will be done without crunching the economy too badly. I wish them lots of luck! Their track record, other than once in the mid 90’s hasn’t been too good. Looks like a meaningful recession has resulted each time the Fed has tried to raise rates in the past.
So, I’m uncomfortable about the market environment clearing anytime soon. There is normally a lag between the time rates are raised and the economy picks up. My fear is that by the time the Fed has created enough demand destruction, it may be too late for the hoped for ‘soft landing’
And how does it end?
On the one hand, perhaps the Fed can move that camel through the eye of the needle, and inflation goes away without an accompanying ugly time. That would be ideal. It would mean we’ve seen the worst of this bear. Perhaps the glass is actually half full!
Or, on the other hand, the alternative would include some additional downside for markets. Running some typical market multiples math, I’d guess that a move down to 3200 or so on the S&P Index might get us in ‘average’ ranges for historical bear market drops. UGH UGH!
The bottom line is that there may not be a quick fix unless there is a really positive surprise such as Russia pulling out of Ukraine, Covid stops in China, supply chains get fixed, the Fed loosens up. Hey! All of those COULD happen. But we shall see.
As I see it, this is a good time to keep an open mind, be way more conservative than normal, and stay flexible.
Ron’s Market Minute — Correlations
Well, here we are — at the end of the worst week of the worst month of the worst year that I spoke about last week. And markets didn’t surprise by heading down, although the magnitude of this week’s drop is a bit surprising.
Although we have avoided traditional stock holdings for most of this year, until this week a few sectors have been actually looking quite good and holding up. These included dirty energy, clean energy, and utilities. And although they are longer term positive, their technicals have joined the rest of the stock-based areas in their downward move.
In a traditional bear market as values drop, correlation tends to go UP. And that’s what’s happening this week. Correlation is the degree to which individual sectors look a lot like the S&P Index: going up as it goes up, and down as it goes down. In a bear market, something that has LOW correlations is good — something that goes UP as markets go DOWN. (Or at least goes down less than markets). In these few areas that I mentioned, prices have been much stronger than the prices in the S&P Index. Stronger is good, and we like that. However, as the indexes continue to fall, it just means that the strong sectors are now dropping LESS than the indexes. Although we have been peeling back exposure to even these areas, and at the moment they are continuing to drop less than markets, it doesn’t feel great to tout that they are dropping less, but still dropping.
I suspect that today’s selling may flop over to next week. Richard Russell (of the Dow Theory Letters fame) used to say that the winner in a bear market is the one who loses the least. Still, the ‘better losers’ are not immune to the bear: the correlations rise as a bear environment increases risk for all stock-related holdings and the chance of finding winners is greatly reduced.
That said, we have now reached a technical point where in these areas as well as markets in general have become ‘oversold’. Prices have come down far and fast and as that happens some buyers eventually come out of woodwork and decide that it could be worse, but probably a lot (or most) of the damage is done and begin to buy. With all of the AI machine robots running similar programs, that MAY cause the next up-market rally.
We remain extremely defensive.
Ronald P. Denk, CFP®
Denk Strategic Wealth Partners
10000 N. 31st Avenue, Suite D406A
Phoenix, AZ 85051
Phone (602) 252-8700
Fax (602) 252-8701
Toll-Free (877) The-Denk