August 17th, 2022
Moving into the last 4 ½ months of the year we think it’s a good time provide you with an update and outlook for the rest of 2022. We are currently positioned very defensively and believe the recent four-week rally will not hold.
The federal reserve is aggressively tightening into a slowing economy while trying to fight the highest inflation in the last 40 years which was caused by extremely loose monetary policy during one of the strongest jobs markets of all time. This overheating of the economy coupled with COVID supply chain issues resulted in a buying euphoria of cars, houses, stocks, cryptocurrencies, luxury goods, SPACs, and COVID/meme stocks that lacked any fundamental value. Since the Fed started tightening interest rates and removing liquidity from the markets, we saw a significant deflation of these mini-bubbles and a slowdown in economic activity.
We wanted to share our thoughts on why we believe the recent rally in stocks is more likely a bear market rally during a very confusing economic environment. We say “confusing” economic environment because even when looking for historical comparisons it is hard to find a time in history like today where – interest rates are near all-time lows while having more job openings than people to fill them, combined with a near all-time high stock market and the highest inflation in the last four decades.
What follows is our analysis of why we believe there could be more turbulence ahead, hence our defensive positioning.
Inflation vs Unemployment
When analyzing Inflation (CPI) and the Unemployment Rate we can see that multiple times when inflation has accelerated, unemployment soon followed. As of right now the jobs market is still very strong but given the recent fall in economic activity, the idea of unemployment rising in the near future is a more probable scenario.
By the common recession definition of 2 consecutive quarters of negative GDP growth, the US is already in a recession. Looking back to the 1940s, every time this has happened the economy was either in a recession or heading into one.
Inflation vs Fed Funds Rate
Inflation has been the main concern for central banks around the world. Our fear is that even though inflation seems to have plateaued, it could remain elevated for some time or zigzag over the course of the next few years as it did in the 1970s. As per the chart below we can see that the Fed is very much behind the curve which was not the case in the last high inflation period of the 1970s. We believe most prices will remain high for the rest of the year and the Fed will continue to raise rates which could cause further damage to the economy.
The credit markets can be a great economic indicator, specifically the Yield Curve. In a normal economy, the Yield Curve is usually positive as bond holders of longer duration bonds receive a higher yield for their investment. Recently, the 10Year vs 2Year Treasury Yield Curve inverted. An inverted Yield Curve simply means that short-term maturity bonds are paying a higher yield than long-term maturity bonds which indicates that investors would prefer to hold short-term risk instead of long-term risk. This is because the more time money sits in a bond, the higher the risk of the investment failing and therefore one is compensated for allowing that risk. The inverted Yield Curve is not causative in nature. It does not create recessions, rather it is a representation of how market participants view the future of the U.S. economy. Even though it is not a panacea, the Yield Curve has had an impressive track record of warning investors of an impending recession.
Consumer Sentiment is slightly above its low reading of 50 reported in late June which was one of the lowest levels in history. Consumer Sentiment is important as it gauges the propensity for individuals to keep spending money in the economy.
A recent poll of CEO Confidence looking forward is at an extremely low level, usually seen during recessions. Small Business outlook on sales for the next three months is lower than the financial crisis in terms of pace of decline. On top of this, the newly passed Inflation Reduction Bill will also raise taxes on businesses which could create further pressure on companies.
Stock Market Valuations
The stock market is still at a very high valuation. The famous Buffett Indicator which is the ‘Market Cap to GDP’ is commonly defined as a measure of the total value of all publicly traded stocks in a country, divided by that country’s Gross Domestic Product. The current Market Capitalization of all publicly traded stocks is at an astounding 173% of GDP. To put in perspective, the mean value since the 1970s is 90%. Valuations are far higher than during the Dotcom Bubble and the Great Financial Crisis.
Bear Market Rallies
We take pride in our ability to stay calm in the face of market drawdowns and during periods of market euphoria. In our view, it is important for us to look at the facts and invest accordingly even if it means being wrong in the short-term. During the last two recessions of 2008 and 2000 there were 8 large bear market rallies with an average gain of 18% on the way to new lows. During the 2000 recession there were two rallies of more than 40% and one rally of more than 50%.
Much of the current rally has been driven by short-covering, this is even more evident when we see that stocks such as Carvana, Beyond Meat and Bed Bath and Beyond, which lack fundamentals, , have all rallied sharply during this recent market melt-up. This is the kind of activity that is usually prevalent during bear market rallies.
In closing, it is our job to look at factual data and make decisions based on where we think the market will be in 12-18 months from now. The Fed has been able to prop the market up throughout the last 13 years and in our view the result of such stimulation will carry consequences in the future.
Just as the economy during a recession can’t stay bad forever, it can’t also stay good forever. The markets, like everything else, move in cycles – cycles of expansion and contraction. At the moment, the path of least resistance is towards the beginning of a contraction cycle.
Although we hold a high degree of confidence in our full market analysis (which is much more in depth than the points discussed in this letter), we are also aware of the fact that the opposite is always a possibility, and we are committed to staying nimble and adaptive as new economic information unfolds.
The Harrington Alpha Team