Shades of 1994?

By Crest Capital Advisors on June 17, 2022

Dow: (4.97%) to 29,888.78
S&P 500: (5.79%) to 3,674.84
Nasdaq: (4.78%) to 10,798.35
Russell 2000: (7.48%) to 1,665.69
10 Year Yield: 3.23%
Outperformers: None
Underperformers: Energy (17.16%), Utilities (9.17%), Materials (8.28%), Industrials (5.82%)

US equities were sharply lower this week as the S&P 500 had its worst weekly performance since March 2020. All sectors were down by at least 4%, while Energy was the biggest decliner, down over 17% for the week, the sector’s worst performance since March 2020. Along with the decline in the energy sector, WTI crude ended the week down 10.4%. The risk-off sentiment was driven by factors around this week’s Fed action, particularly due to rising skepticism of the Fed’s ability to engineer a soft landing.

On the positive side, the latest batch of China’s economic data was better, including a return to positive industrial production growth while retail sales were better than feared. Several economists said that the May data confirmed China’s growth has bottomed and should improve in the months ahead given a recalibrated Covid-zero policy, a Beijing/PBoC stimulus tailwind, and accelerating consumption in wealthier cities.

It’s been 28 years since the Fed last hiked rates by 75 basis points to get ‘inflation under control’. This was way back in 1994 when then Fed President Alan Greenspan embarked upon an aggressive tightening path. The result was bond yields spiked (same as today) and bonds experienced their worst year in terms of percentage declines since the Great Depression era (Today’s declines are even worse). The stock market reacted by selling off (not nearly to the degree we are seeing today) and experiencing a very difficult grind over a prolonged period. In that era, the average stock was down much worse than the headline index (same condition as today). But, once the Fed finally signaled an end to the hiking, and importantly bond yields started to turn lower, the stock market took off again. By early 2005, stocks had reached new highs and they never really looked back for another 5 years.

The chart below shows the stock and bond market performance over that era. We would welcome a repeat of that era as we are likely much closer to the peak in yields for this cycle than many anticipate.

Patience Is a Virtue

When it comes to bear markets, we all want it to be over yesterday and the recovery in asset values to occur quickly. We’ve been through enough cycles in our 30+ year careers that we know this too shall pass. In the meantime, some perspective for your consideration:
The bottoming process will take time, especially when you factor in today’s inflation narrative.

So, how do you trade that? You don’t — you invest in it. It’s more important than ever to understand the difference in these times. Both retail and institutional sentiment is still very bearish, which we think are actually contrarian indicators. What everyone watching really needs to pay attention to is what insiders are doing and where the smart money is going.

Insiders are indeed buying their own stocks at levels we haven’t seen since the start of the pandemic — something we’re constantly monitoring — and this past month was the first month since March 2020 where there was more insider buys than sales.

Inflation, Inflation, Inflation

In the investing business, it’s said that there is no difference between being early and being wrong. We still have 11 reasons why inflation will slow, but obviously – with the recent May Consumer Price Index (CPI) report (which spurred the Fed to get even more aggressive, catalyzing yet another leg lower in the stock market) – we were early in forecasting this weakness. The reasons for CPI weakness ahead, however, stands. Consider the following:

1. Surging real retail, ex-auto inventories, along with stagnant sales. We’ve now seen 6 months in a row of double digit inventory gains. Last month’s reading was revised up from 2 to 2.4% which represents a 4-decade high!! Despite all that, apparel prices, for example, rose 0.7% month-over-month in the latest CPI report.
2. More domestic production, easing supply chains, and surging imports. Still, core goods prices rose 0.7% month-over-month.
3. Declining real disposable personal income should dampen core service inflation. Instead, it soared 0.6% month-over-month.
4. Declining profits are already slowing average hourly earnings, so core inflation should slow…just hasn’t shown up in the data yet.
5. Used car prices are in an unsustainable trend. But in the latest CPI report In May, they surged 1.8% month-over-month.
6. Extreme housing weakness will slow shelter inflation – but that won’t be visible in the CPI until next year. In May, shelters rose a record 0.6% month-over-month.
7. Plunging M2 growth (we discussed this last week) and declining Federal outlays also ought to weigh on core inflation. But perhaps the lagged impact of the massive stimulus is still taking time to dissipate, thereby holding inflation higher last month.
8. The stronger US Dollar may be holding inflation down slightly, but not enough to make a difference right now.
9. Growing labor supply is contributing to slowing wage inflation, but not enough to slow core inflation just yet.
10. A global economic slowdown is underway, but apparently not slow enough to curb commodity prices just yet, and therefore headline inflation.
11. Solid productivity growth. Well, near term, it has actually weakened, helping keep the core higher, longer. But longer-term we expect it to accelerate.

All those inflation headwinds are still in place, so yes, we still expect inflation to slow significantly. But timing is everything. And our timing was early. As we’re often reminded … there’s no difference between being early, and being wrong.

That said, we have seen notable improvement already in the Fed’s favored measure of inflation, the Personal Consumption Expenditure, or PCE, reports. The chart below shows the core reading for the last 12 months with the green bars showing the latest (2) reports which have been incrementally better. Don’t get us wrong, the reading for Core PCE is still too high for the Fed’s liking, but it is indeed heading in the right direction. Now we just need the market to start pricing this in and the Fed to start acknowledging it in their forward guidance.

Multiple Contraction

This year’s market decline has been all about multiple compression…that is, investors are willing to pay substantially less for the same stream of earnings than they were last year. Actual S&P 500 earnings have grown by 8.8%.

The chart below puts the multiple declines in perspective. While not quite at prior period market bottoms, we are very close and we are certainly below the average valuation of the past decade.

Buy The Dip?

Warren Buffett, one of the greatest investors of all time, is credited with many great investment axioms. Perhaps the one most relevant to today is as follows….” be fearful when others are greedy, and greedy when others are fearful.” Today is definitely a period of extreme fear…and it’s prevalent across all types of investors…from institutional, to retail, to CEOs, to average consumers.

The chart below (orange bars) shows the S&P 500 return on average over the next year when buying after a 20% drop (as we have today). The blue bar shows the average return overall. As you can see, and particularly over the next 12 months, the return nearly doubles from the average if one buys after a drawdown. Financial assets are the one area that we consistently resist buying when on sale. Perhaps we should try even harder to overcome.

Here’s another chart quantifying the level of bearish sentiment in the market today. Note that we have reached levels equivalent to or even lower in every major market bottom that has occurred over the past 11 years. These prior periods all proved to be great buying opportunities.

The biggest hesitation to buying the dip of course is that we never really know when the final bottom will occur. We know the market has corrected significantly, we know it’s massively on sale here, but there is nothing that says it can’t get worse. Making matters more challenging, there are no shortage of “expert’ opinions on the financial channel telling us how bad it is out there and why it’s going to be worse. But does it really matter if we don’t peg the absolute lows?

On Oct. 1, 2008, Lehman Brothers had been bankrupt for two weeks, Congress was objecting to the bank bailout, the S&P 500 was already down by about 25% and any number of horrors seemed possible. It’s a good comparison to where we are today. Had you bought then, you’d have had to withstand a loss of more than 40% over five terrifying months. But you would have been made whole by the end of 2009. And by the top of the market at the end of last year, you’d be sitting on a 440% total return. Even now, you would have more than quadrupled your money. And that was after buying when capitalism’s survival seemed more imperiled than at any time since the end of the Second World War, and after totally failing to time the bottom!

And finally, the below chart remains one of the most compelling from a contrarian perspective. With this week’s sell-off, the average stock in the S&P 500 index is now down -31% from its 52-week high. This certainly is an outlier reading and historically has shown to be a great time to put money to work.

T.I.N.A No More?

Over the years, we’ve discussed the “T.I.N.A.” investment mantra…which stands for There Is No Alternative…as a primary catalyst behind investors buying stocks and other risk assets in lieu of holding cash and fixed income. The reason of course was with the Fed suppressing interest rates for years on end, investors seeking yield had nowhere else to turn but to risky assets.

This post Great Financial Crisis/Quantitative Easing phenomena is reflected in the chart below as the percentage of stocks with a dividend yield greater than that of the US 10-year treasury bond was consistently steady around the 50% range. Well, fast forward to today, and with the 10-year treasury yield spiking from 1.40% to 3.5% in 5 ½ months, the percentage of S&P 500 stocks with a yield greater than the 10-year treasury has now plummeted to 11%! Maybe there is an alternative?

Paging Jerome Powell

Hey Jerome, is this (see chart below) the consumer you believe is in such a strong financial position? The red line in the chart below shows the “personal savings rate”. Note how it went up dramatically during Covid (thanks to transfer payments) and has now given all of it (and then some) back. The consumer savings rate is extremely low today. On top of that chart (the blue line) is consumer credit. As you can see, it has hooked up substantially (new pre-Covid highs) at the same time the savings rate has plummeted. This may be a sign that consumers are having to lever up to deal with inflation.

Crazy Stat(s) of the Week

Here are this week’s crazy stats:

• With the declines in the latest week, the S&P 500 has wiped out all of last year’s gains.

• US Treasuries (or ‘bonds’ more broadly) are experiencing a historic drawdown. Prior to this year, the largest intra-year drawdown for Treasuries was -6.7%. This year we’ve extended into double digit declines.

• According to PitchBook data, more than 140 venture capital backed companies that went public in the US since 2020 have market capitalizations that are now less than the amount of venture funding they raised! Re-read that again…not less than the VC’s valued the company, less than the amount of money they raised over the company’s existence! WeWork sports the largest difference between VC $’s raised and current market value: The company took in nearly $9.9 billion of investment capital and now trades at a market cap of $3.7 billion!

Quote of the Week

“We got the CPI data and also some data on inflation expectations late last week, … and we thought this is the appropriate thing to do.”

-Jerome Powell (During Q&A on this week’s 75 bp rate increase)

(Editors Note: Does this sound like winging it to you?! Because it sure does to us. Remember, these “Fed heads” are not infallible and they are certainly not accurate predictors of future outcomes! Transitory anyone?)

Calendar of Events to Watch for the Week of June 20th

It will be a short week ahead with markets closed on Monday for the Juneteenth National Independence Day Holiday. Earnings remain extremely slow with just a few notable housing and consumer-related names on deck. On the US economic calendar, the highlights will be data readings on Existing Home Sales on Tuesday and Manufacturing/Services PMIs on Thursday. On the monetary policy front, the various Fed speakers will be closely watched for any signs of the policy path after this week’s ‘surprise’ 75 basis point rate hike.

Monday 6/20 – US Markets will be closed in observance of the Juneteenth holiday.

Tuesday 6/21 – Existing Home Sales for May will be scrutinized with the big run-up in mortgage rates this year. Economists are expecting a month-over-month decline of about -4.5%.

Wednesday 6/22 – No major US economic reports. Canadian Consumer Price Index (CPI) data will be released with economists expecting a hot 1.0% month-over-month increase and 7.2% year-over-year rate.

Thursday 6/23 – The Markit PMI Manufacturing and Services data for June will be out with economists expecting a modest decline in Manufacturing (from 57.0 to 56.3) and a slight uptick in the Services reading (from 53.4 to 53.9). Our guess is this data-set may disappoint to the downside to reflect slowing economic momentum.

Friday 6/24 – US New home sales for May are expected to be in-line/flat with the prior month at 590k units.

Source: FactSet