Understanding the Uncertainties

Understanding the Uncertainties

September has proven to be a difficult month, like many times in the past.  The market decline in the month almost felt like a self-fulfilling prophecy.  The Dow, S&P 500, and NASDAQ were down 5.7%, 5.24%, and 6.2% respectively, leaving the quarter relatively flat.

The month was marked with numerous uncertainties, not the least of which were fiscal policy issues.  A potential government shutdown (which just got resolved), the debt ceiling, the $1 trillion infrastructure bill, and the $3.5 trillion reconciliation bill are uncertainties that are still present.

Moreover, the crackdown in China, the COVID-19 Delta variant’s impact on growth, confirmed supply chain disruptions, and other international tensions added to the unpredictability.

At the same time, the Federal Reserve did provide some clarity on the direction of monetary policy with respect to tapering.  It appears that at the November 3rd meeting, the Fed will lay out how it is going to reduce the $120 billion monthly bond purchases, with the expectation of ending those purchases by mid-2022.

Additionally, to some investors, the lingering relatively high inflation expectation for the rest of the year is worrisome.

These market uncertainties appear to have triggered technically driven market action.

For individual stocks and the indices, when prices of the index fall below the 50-day and 200-day moving averages, selling is usually intensified. Add stocks falling below the Bollinger Band (a statistical chart characterizing price and volatility over time) and additional downward pressure develops.  Moreover, the momentum algorithms and robo-investing are models that automatically execute trades based in part on technical momentum factors.

It is interesting to note that the first day of October was marked by unusual volatility and price action in the market indicators (Dow, S&P 500 & NASDAQ).  In seconds, the indices gaped down sharply.  That kind of market action could easily trigger stop losses and be part of margin calls.

These structural deformities (as I call them) do little to the underlying fundamentals.

Against this backdrop, the U.S. economy has performed and continues to perform remarkably well.  Real GDP for the second quarter recorded a 6.7% seasonally adjusted annual rate (SAAR) of growth, along with profits rising 10+%.  Also, net cash flow (with inventory valuation adjustment) rose 8% quarter-over-quarter (SAAR), up 40% from the depressed second quarter of 2020.  For the third quarter, real GDP estimates range from 3-5%, with expanding profitability and cash flow.  Consequently, the multiple of earnings has been declining, creating a more favorable value proposition.

The more disaggregated data shows continued economic strength.  For the month of August, forward looking indices exhibited continued upward momentum.  For example, Markit US Manufacturing Purchasing Managers Index (PMI) was 60.7, ISM US Manufacturing PMI was 61.1, and ISM New Orders was 66.7.  Numbers in excess of 50 suggest economic expansion.  A number in the 60s is very strong.

Moreover, personal spending in August vs. July was up 0.8% and inflation adjusted spending was up 0.4%.  At the same time, the consumer savings rate was 9.3%.  This historically high rate would suggest the consumer has plenty of fire power.  The element that is weighing on many minds is the inflation rate.  In August, the Personal Consumer Expenditures (PCE) deflator – the indicator the Fed uses – rose 0.3% month-over-month and is up 3.6% year-over-year.

From a monetary policy perspective, liquidity continues to be injected into the financial system.  Even if the Fed reduces the current bond purchases ($120 billion monthly) by $15 billion a month until June of 2022, this reduction still implies an additional $540 billion in bond purchases.  Moreover, the $1.5 trillion in reverse repurchase agreements (R Repos) also becomes a source of funds.

The monetary authorities recognize that the inflation rate is well above their target and expect it to remain there for the balance of the year, and then trend downward.  Supply chain disruptions continue to be an important factor affecting inflation and it appears that the impact will be felt well into 2022.

For long-term investors, the real culprit that produces a “bear” market is a recession.  The state of the economy as outlined above shows no recession in sight.  In fact, the continued expansion in liquidity and the near zero interest rates tend to push recession risk further into the future.  Absent a recession, stocks should remain a preferred asset class.