The Beatings Will Continue Until Morale Improves

By Crest Capital Advisors on September 23, 2022

Dow: (4.00%) to 29,590.41
S&P 500: (4.65%) to 3,693.23
Nasdaq: (5.07%) to 10,867.93
Russell 2000: (6.60%) to 1,679.59
10-Year Yield: 3.69%
Outperformers: No positive sectors for the week.
Underperformers: Energy (9.00%), Consumer Discretionary (7.02%), REITs (6.42%)

The Beatings Will Continue Until Morale Improves

US stocks were lower across the board this week, with the major averages posting a fifth decline in the past six weeks. The S&P 500 was down by more than 4% for the third week over the same period, while the Nasdaq was off by more than 5% for a second-straight week. All sectors were down by at least 2% while energy was the big decliner, off by 9%. Not to be outdone, there were similar pain thresholds in bonds as US real yields hit the highest levels since 2011.

The driver of asset prices this week was entirely centered around the Fed and its latest policy announcement where the Fed conveyed to markets in no uncertain terms its one-track focus is raising rates to bring down inflation, regardless of the economic cost. The obvious fear here is the act of taming inflation will come with significant collateral damage to businesses and households…also known as a “hard-landing”. Would they actually destroy the village in order to save it? The answer at face value would seem to be ‘yes’.

But, if we’re going to have a hard landing, then by definition we have to have lower long-term interest rates and inflation. So, watch yields for a tell of the market’s belief in the hard landing scenario. For now, yields are holding, and still pushing higher. That is not the set-up for an imminent economic collapse (aka “hard landing”). And if spiraling inflation is the fear, then falling commodity prices (as we are seeing today) are also incongruent with that scenario. The bottom line is the selling pressure we see this week has more of the hallmarks of a “just get me out of all assets”, rather than pricing in a specific view of a future economic outcome. The selling this week was liquidity driven with traders placing a premium on reducing exposures everywhere. Trading volume was elevated, it had a liquidation feel overall.

While we submit that the economy is still in decent shape today, and the year-to-date rate hikes were probably necessary, we have to note a huge number of inconsistencies in what Jerome Powell is focused on, and what we are all seeing in real-time in the financial markets. There is a risk the Fed is that obtuse. Or, it could be they simply want to maintain a level of rhetoric tougher than actual actions, in effect moving markets so they don’t have to. For more on our views as it relates to the Fed, what they just did, and what we feel they should be focused on; check out our post-mortem analysis below. If you are the type that wants the bullet points instead, you can read these two quotes and come away with the main crux of our opinion.

“They know nothing”
-Jim Cramer, circa 2008 in reference to the Federal Reserve

“Calling it poor monetary policy would be an understatement.”
-Professor Jeremy Siegel, 9/23/2022 in reference to the Federal Reserve

FOMC Post Mortem

After Powell’s Jackson Hole speech in late August and the ‘not-as-cool-as-expected’ CPI report in the week prior, markets had moved to expect a hawkish Fed at this week’s meeting. After all, we just re-priced the stock market ~5% lower last week alone and the market implied Fed fund futures had moved to a 100% certainty of at least a 75 bp rate hike, with some probability assigned to an even higher full 1% move! So “hawkish” was the expectation heading into the meeting. And yet somehow, Jerome Powell managed to come in swinging even stronger than markets had anticipated, in a sense out hawking the hawks. The result was an immediate meltdown for stocks and a surge in bond yields and the US Dollar that has thus far carried us into the weekend.

During his press conference, Powell went out of his way to talk tough, metaphorically beating his chest and flashing his newfound inflation fighter credentials. He made sure to put emphasis (not that computer algorithms can interpret tone) on every hawkish turn of phrase just to show us all how tough he is.

Phrases like; “strongly committed”, “significantly reducing the size of the balance sheet”, requiring “compelling evidence”, “forceful steps”, and “the historical record cautions strongly against prematurely changing policy course”. Summing it up, prior to taking questions, he stated the following: “My main message has not changed at all since Jackson Hole….We will keep at it until the job is done.”

Taken together, the press conference was enough to convince us the Fed is overly focused on fighting yesterday’s war against inflation. Powell wants to be seen as this generation’s Paul Volker, the 6’8 Fed President that is credited with slaying the inflation dragon of the late 1970s and early 1980s. But conditions today are far different than they were in that era, and this lack of acknowledgment is concerning.

Powell acknowledged that Fed interest rate policy has “long and variable lags” in terms of its impact on the economy, yet he is focused on data that is also fraught with long and variable lags! (40% of core CPI is housing, and the housing component has a notoriously long lead time before it shows up in the data. The high readings we are seeing today are artifacts of 2021 and are not indicative of real-time activity!)

In Powell’s press conference, there was very little, if any, focus on actual on-the-ground/real-time data. We are a market-driven economy and market rates are telling us the economy is slowing tremendously and financial conditions are as tight as they have been since the GFC in 2008-9! (See chart below)

So again, we rhetorically ask, what is the Fed looking at?!

Real rates, money supply, stocks, yields, the dollar, commodities…they are all pushing towards extremes and showing significant signs of stress.

Oil prices in particular are back to January levels…that’s before Russia invaded Ukraine!

The money supply (M2) is in free-fall and next week will show another data point in that trend lower. Inflation is the price of money, and if money is in freefall, so too will inflation.

Housing prices have rolled over. Mortgage rates have doubled. We’ve had the biggest decline in the home builders index in history, greater than during the GFC!

In real-time, the economy has slowed massively. And, the Fed acknowledges its policy has “long and variable lags”. And yet, the Fed promises to keep at it until the lagged data (CPI) goes sufficiently low enough. So, they are focused on 3-month annualized core inflation, data that is by definition backward-looking, and the rest of us look at market-oriented data.

On the bright side, Powell and the Fed will eventually see the light. And when they do, they will adapt. It took them forever to see the light that inflation was not in fact transitory. None of their November 2021 predictions came true. None of their dot plots. None of their forecasts. We highly doubt any of their 2023 predictions will come true either. They may be forced to lower rates much sooner than they think.

At the end of the day, Powell is afraid he will be perceived as another Arthur Burns (Arthur Burns headed up the Fed during the 1970’s inflation outbreak). The problem we see is he may just be remembered as the one Jerome Powell. Tone deaf to markets and compounding one mistake to another.

In short, we see the Fed attempting to cover for its prior mistake (transitory inflation) with what may be an even larger policy mistake (causing a recession).

In the words of Professor Siegel, calling it bad monetary policy would be an understatement.

Finally, let’s lighten it up with the following clip, courtesy of Ross from the TV show Friends….Jerome, we think he may be speaking to you!

Friends – Ross Pivot

The Fed’s Crystal Ball is Broken

The chart below shows the tracking of the Fed’s infamous “dot plot” over the past few years and it’s an absolute joke of a forecasting record. Why the market places so much emphasis on the Fed’s outlook at a single point in time is beyond us. This should be a time for humility, an acknowledgment by the Fed that they can’t entirely predict the future after getting the inflationary surge so, so wrong last year. But that does not seem to be the case as the Fed is communicating as though they know exactly what is going to happen in 2023 and into 2024. They most certainly DO NOT.

In September 2021, just one year ago, the Fed told us the median dot plot for the Fed funds rate at year-end 2022 was a mere 0.26%. Laughable! We’re already at 3.25% and if we are to believe today’s dot plot, it’s going to 4.44%! That’s a far cry from the 0.26% they predicted a year ago. So why should we take the Fed and their dots at their word when they forecast fed funds will be 4.63% at year-end 2023!?

“Data Dependent”

If we were data dependent, as the Fed suggests it is, we’d be looking at this data: Housing activity is plummeting. The new home sales pace is back to 2015 levels. (see chart below) Mission accomplished to cooling the housing market. It may not look like it when viewed through the prism of backward-looking data sets, but out in the real world, it has cooled considerably.

And, building permits over the last four months are now down close to 17%. The last three times we saw that kind of weakness, we were in a recession or headed into one.

30 yr fixed rate mortgages are quickly approaching the highs of the last 20 years.

Shipping costs have fallen substantially. We’re still a bit above pre-pandemic levels, but it’s quickly approaching the lows for this data series. Freight rates overall continue to accelerate lower with a 9.51% drop this week. As we near the quarter end, this is currently the largest quarterly percentage drop since 2011.

And, we can’t forget about the much feared ‘stickiness’ of inflation as expressed via forward-looking market expectations. A quick glance at the market-implied inflation rates 2 and 5 years out shows a considerable decline back towards the Fed’s 2% target level.

Speaking of Morale

Investor Sentiment (morale) is a disaster. The chart below shows the bearish sentiment has now reached a new high for 2022, just below all-time record levels achieved both in 2008-9 and back in 1990. In 1990, things got this bad…and the market bottomed within 2 months. In late 2008, sentiment reached similar extremes to what we have today, and the market ultimately bottomed a few months later. So, while things could get worse, we are closer to the end than to the beginning, at least by historical standards.

Perspective

Take a look at the chart below. The upper chart shows the growth of $10k invested in the S&P 500 in 1950. You’ll note it compounds to a value of approximately $2.32m today! The bottom chart shows the peak-to-trough declines that occurred along the way of generating that amazing compound growth. The ride was anything but smooth. Bottomline, if you can’t handle the stress of the bottom chart, then you can’t (or won’t) get the benefits of the upper chart. Investing is not easy. 2022 has been a master class in dealing with market adversity and we can’t be certain of when the tide will finally turn. But here’s what we do know. The 2022 environment will change, and we will eventually emerge to better times ahead. Stocks, as they have always done in the past, will find a way to new all-time highs again. We all just need to be patient and maintain perspective. Now is not the time to let near-term fears prevent us from obtaining long-term wealth

We’ve had fifteen bear markets since 1950, with an average decline of 30%, lasting just under a year to reach the bottom. After a few short-lived bear markets (2011, 2018, and 2020), the current bear market is getting closer to the historical averages.

The bad news about declines in the stock market is you never know how long they will last. The good thing is they offer an opportunity to buy at lower prices.

It’s tempting to believe you could sidestep these losses, receiving all the upside without any of the downside. But no one has shown the ability to do so in a repeatable fashion.

Avoiding volatility may sound good in theory, but volatility is the price admission for superior long-term returns.

Overlooked

In 2022, particularly if you are one to watch the financial channels, the only thing anyone wants to talk about is inflation, the Fed, and how high-interest rates are going to crush the economy. Any other narrative is ridiculed or dismissed. There once was a time when the election cycle mattered to markets, and it has historically generated predictable and repeatable market responses. Assuming the election narrative can assert itself into the current malaise at some point in the next month or so, the historical trend would suggest we are reaching the nadir of the market decline (typically around October of each mid-term election year) and about to turn the corner into year-end. (Also interesting to note the initial low of each mid-term election year tends to happen around June.)

Economic Funnies

Wall Street in 2022….

Crazy Stat(s) of the Week

Here are this week’s crazy stat(s):

• Boom and bust for Tech sector breadth. A month ago, 96% of the S&P 500 Tech members were trading above their 50-day moving average and everyone wanted to buy them. Today it’s just 3% and everyone hates them! (see the chart below for an illustration of the extreme move) Once again markets confound the consensus. Will it work again at current levels?

• As of Thursday’s close (9/22/2022), the S&P 500 marked its 29th decline of the year of between 1% and 2%. That’s the most we’ve seen since 2008 which had 34 occurrences.

Quote of the Week

“[Jerome] Powell’s quote that ‘monetary aggregates don’t play a role in formulation of policy’…it’s like the Pope saying he doesn’t read the Bible!”

-Ed Hyman, Evercore ISI

Bonus Quote of the Week

“In good times, skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. The things that terrify other people will probably terrify you too, but to be successful, an investor has to be a stalwart. After all, most of the time the world doesn’t end, and if you invest when everyone else thinks it will, you’re apt to get some bargains.”!”

-Howard Marks, Oaktree Asset Management

Calendar of Events to Watch for the Week of September 26th

Another light earnings week ahead as we move into final quarter-end reports. More importantly, is whether we get any pre-announcements leading into Q3 earnings next month. On the economic calendar, the highlight of the week will be Friday’s Personal Consumption Expenditure (PCE) report. Jerome Powell specifically referenced the Core PCE as something the Fed is watching closely and wants to see cool considerably. While the hawkish rhetoric has done its damage, markets will nevertheless be focused on any news that could change the trajectory of the current expected policy path.

Monday 9/26– The Dallas Fed Index for September is expected to contract with a reading of -4.0, a slight improvement from August’s -12.9 level.

Tuesday 9/27 – US Durable Goods for August are expected to be flat at 0.0% month-over-month. US New Home sales for August are expected to contract about -4.1% from last month’s report. The September Richmond Fed Index is expected to contract once again at -3.0 v last month’s -8.0 pace.

Wednesday 9/28 – US Pending Home Sales for August are expected to be roughly unchanged month-over-month.

Thursday 9/29 – US Final GDP for Q2 is expected unchanged at -0.60% quarter-over-quarter.

Friday 9/30 – The most important report of the week will be the August Personal Consumption Expenditure (PCE) report with economists expecting a 0.4% month-over-month increase for the Core (Ex-food/energy) and a 4.8% year-over-year rate. The Core PCE was specifically called out by Jerome Powell as something the Fed is acutely focused on.

Source: FactSet