The Pivot: Yesterday, Today & Tomorrow

The Pivot: Yesterday, Today & Tomorrow

The precipitous decline in the financial markets over the last seven months has been confounding on several fronts.  However, one aspect has been very clear; the speculative excesses that have permeated the equity market over the last several years have been and are being purged.  The “dream stocks” that had no road to profitability and a relentless need for cash collapsed.  They relied on private equity and the IPO market which dried up as the Federal Reserve began to change policy.  Many of the public dream stocks have fallen 80-90%.  The SPACs (special purpose acquisition companies) that offered ridiculous promises when going public have been crushed (and justifiably so).  The IPO market has shrunk dramatically and the standards for going public have risen dramatically.  Many of the startups in private equity’s hands will fail or be dramatically reconfigured.  Also, the investment banking firms will feel the earnings effect of diminished IPO activity, hoping that trading and traditional banking will provide the earnings offset.

The “meme” stocks that captured the imagination of the individual investors and traders created a frenzy, even drawing in institutional investors and hedge funds.  Media coverage helped feed the frenetic activity.  Many hedge funds were caught on the wrong side of the trade, and day trading turned into a losing proposition.   Many of the meme players either have begun to appreciate what investing is all about or have exited the game and will not return.

The purging did not just impact stocks (and to some extent bonds).  The highly touted bitcoin revolution has experienced significant declines and infrastructure failures that are still ongoing.  The notion that bitcoin would save the world and should be in retirement accounts received so much credibility that some Wall Street firms are offering bitcoin and others are considering making such an option available.  NFTs (non-fungible tokens) are even getting traction, but reality is setting in.  Promotional products where there is a clear lack of understanding are punishing investors.  In my judgment, one rule of investing is “Don’t buy anything you don’t understand.”  Sometimes the best decisions you make are the ones you don’t make.  Many celebrities and professional ballplayers that promoted crypto or only wanted payment in crypto should be having second thoughts.  Particularly, in this very unstable world, the dollar is still king.

The speculative phase and then collapse is characteristic of every bull market/bear market cycle.  What is difficult to assess is the degree of leverage (borrowing) that the bull market generated and the magnitude, time, and nature of the deleveraging process.  In these downdrafts, the market often exceeds what the fundamentals will ultimately justify.

Some people would argue that parts of the equity market have literally collapsed and ceased to function, thus raising the specter of declining liquidity and growing financial instability.

In the face of all this distressing market activity, it might prove prudent to step back and attempt to assess where we are in the economy, the geopolitical environment, and the status of public policy.  Has inflation peaked?  Are we entering a recession?  Is the Fed going too far?

At the present time, a number of factors do suggest that we are not entering a recession, but some variables indicate that economic growth is weakening, falling to the 0.5 to 1.5% range.  Yield spreads and the yield curve, which typically lead a recession by 12-24 months, have not provided such indications.  The ISM survey for manufacturing and services has not yet pointed to a contraction, but the manufacturing component has declined significantly.

Nominal interest rates are still below the inflation rate, a sign that recession is further in the future.  The consumer’s balance sheet is strong and job openings are high, something the Fed highlights.  However, signs of slowing are emerging.  The savings rate has fallen sharply from 14% to 6.6% in Q1 and even lower the last 3 months.  With inflation eating into wage gains and no fiscal stimulus, the savings rate is likely to fall even further.

In May, retail sales fell, both in nominal and real terms, thus suggesting that consumer spending in Q2 slowed appreciably.  The consumer appears to be adjusting to the burden of high energy and food costs by changing the basket of goods he or she purchases.

Housing is churning! In response to the rise in mortgage rates to 6.28%, up from 3% a year ago, activity in the housing sector has slowed, with permits and starts down sharply.  Compass and Redfin are laying off thousands of employees.  The housing market, which is the only asset class that has not corrected, seems poised to change.  Rising prices, rising interest rates, and essentially declining affordability puts that market in a vulnerable position.

The psychology among sellers in a rising housing market has been to wait because prices are going up, thus leading to a lack of supply.  However, buyers appear to be reaching the point of exhaustion.  Multiple bids and buying homes “sight unseen” appear to be coming to an end.  Once sellers realize that their neighbors, who were also waiting to put their house on the market, have done so, they decide not to wait.  As in the stock, bond, and commodities markets, once the selling psychology changes, the market corrects.

If these changes in housing psychology are in fact happening, the monetary authorities will welcome such a change.  Housing prices have been a big inflationary component in the CPI, something to which Powell referred in his recent press conference.

The Fed increased the federal funds rate by 75 basis points at the June FOMC meeting and indicated there would likely be multiple increases for the rest of the year into 2023, with a federal funds target of 3.4% at the end of 2022 and into 2023.  These actions were prompted in part by the May Consumer Price Index (CPI) report and, more importantly, the University of Michigan Surveys of Consumers.  When they reported that consumers expect future inflation to rise over the next 5-10 years, after maintaining a stable outlook for many months, that triggered a move to increase the rate from 50 to 75 basis points.

The geopolitical environment continues to complicate Fed policy.  The biggest culprits in the inflation picture are food and energy prices, both of which are essentially out of the Fed’s control.  Yet they are eating into the consumer’s pocketbook and mindset.  The war in Ukraine and the shutoff of Russian crude and natural gas are big factors, as well as supply chain issues.

At the recent FOMC meeting in June, the Fed laid out an aggressive plan to confirm its commitment to curb inflation.  It then focused upon the economy’s strength and its ability to absorb the rate increases as the Fed moved the rates to a more normal level.  Its forecasts for unemployment at the end of 2022, 2023, and 2024 – a little above 4% from the current 3.6% – seem to us very unrealistic and politically sensitive.  A larger increase in unemployment would not be greeted favorably.

The slowdown in economic activity is here.  An inventory cycle has emerged where excess goods were stacking up at the retailers – Walmart and Target to name two.  Price concessions seem likely as the consumer becomes more discerning.  Further, companies are beginning to rationalize their assets.  For example, tech companies are slowing hiring.  Amazon is trying to unload excess warehouse space.

In my opinion, the interest rate scenario that the Fed has laid out does not fit with the underlying economy.  Over the next several months, greater evidence of a slowing economy should emerge and expectations on the rate path may change.  Change is not uncommon.  It was not that long ago where inflation was viewed as transitory and rate expectations were for no increases in 2022.

Ukraine (food), the Russian sanctions (energy), the supply chain, and most importantly Fed policy, set in motion the market declines that have been traumatic in some segments of the market.

Capitulation is a word used by market pundits that defines the end of a bear market:  wholesale selling without regard to value.  The downward pressure on the market for months and the number of weeks the averages have fallen – breaking records – suggest capitulation has been underway for some time.  The declines have spread to virtually all sectors of the market – there is no place to hide (another characteristic of the bottoming phase).  Investor sentiment is at record lows – a contrary indicator – and cash positions among individuals and corporations are at record high levels – another good indicator.

Within the market, changes are emerging.  Dividend increases are rising and many are above their normal pattern.  Stock buybacks have accelerated.  There have been some major moves.  For example, Restoration Hardware announced a buyback that would reduce its capitalization by 25%.  Science Application International Corp. announced a 16% capitalization reduction through buybacks.

Most certainly, the market can go lower.  Fear can carry things to extremes.  However, we appear to be probing the bottom when some growth stocks are looking more like value stocks.

The rise in interest rates and the increases that are expected do not seem to justify the compression in P/E multiples.

With inflation in such focus, any change will get intense scrutiny.  Already some signs are emerging.  Lumber prices have fallen sharply (60%).  Freight rates (FBX) are down 34% year-to-date and 55% since the peak last September.  The inventory cycle is already bringing price concessions.  Raw industrial material prices have also begun to fall.  The housing market has slowed.  The signs are small, but signs nonetheless.  Further, China is struggling to increase economic growth in the face of COVID.  Meeting its 5.5% GDP growth target and beating the U.S. is unlikely, unless its economy opens more quickly.  The October National Congress is an important motivator for Chairman Xi.

Directional change is coming, and there will be a need for the next pivot.  It is just a question of when.