I find it hard to sort out what is really going on in the market from all the noise unless I systematically work through it. There’s the war in the Ukraine, gasoline prices over $5.00 per gallon, the Fed being behind on the yield curve and the economy is probably already in recession. When I step back, the news is pretty negative and forecasters seem to be competing to report the worst possible outcome. The S&P 500 is down 20.6% in the first half, the worst six months since 1970, while the NASDAQ, home to many of the technology companies, is off 29.5%, the worst first half on record. Furthermore, stock market sentiment is worse than what we saw at the COVID bottom in 2020 or the bottom of the Great Financial Crisis in 2009. You can usually take some comfort from this type of peak sentiment and what may be the most anticipated recession on record. For a bounce, you probably don’t need things to reverse. They just don’t have to be as bad as expected. But, for a bottom, there has to be a change for the better and when I look at some of the longer term trends, I don’t see it. But let me take you through both scenarios. And, the best way to do this is to focus on a couple of time-tested principles of liquidity and regressions to the mean.

Liquidity

We’ve always contended that liquidity will trump economic statistics when it comes to predicting the stock market. Recessions end after stock market bottoms once the Central Banks start to loosen monetary policy. Unfortunately, the inverse is also true. The Federal Reserve has embarked on a tightening cycle, which is being reflected in the market’s averages even though the economic statistics and earnings estimates are still hanging in there. If you want to understand the market, I’m reminded of an old President Clinton campaign slogan, ‘It’s the economy, stupid’. It was a reminder to his entire campaign staff that there was a singular issue to focus on. For the current market, I’d revise the message to ‘ It’s valuation stupid’. Companies, in many cases are reporting good earnings and analysts’
estimates are still rising, but the stocks are going down. Investors are frustrated with the declines and believe it’s an over reaction. But, I can tell you, having lived through the ‘70’s, you might be surprised at how far price earnings valuations can fall if liquidity doesn’t improve.

Obviously, the key to this issue is held by the Federal Reserve and other Central Banks. So, it’s worth understanding how they operate and then I’ll give you my best guess on how this all plays out. The Fed has two methods of implementing monetary policy. The first is through stated intentions or moral suasion. This is done through ‘forward guidance’ when it indicates future policy moves. It is intended to get a reaction from the financial markets and to have the markets do some of its work. It is pretty apparent in this cycle as 10 Year Treasury bond yields have moved up from last year’s lows of about one half of one percent to a recent high of almost 3.5%. It’s caused mortgage rates to escalate and is shutting down new home acquisitions. Yet, the Fed’s actual implementation of tighter monetary policy has only just begun. Rates were raised a mere 25bps in March, another 50bps in May and finally 75bps in June. That gets us to 1.5% – 1.75%, not a particularly high bar. But Chairman Powell’s rhetoric is pretty hawkish and his hero is now previous Fed Chair Volcker who took government interest rates to 18% to cap
the inflation cycle of the ‘70‘s. Forecasters now expect him to be more aggressive and anticipate two more bumps in the Fed funds rate of 75pbs in each of July and September, which will get the rate between 3.0%-3.25%. Whether this is actually being more hawkish or just shorting the cycle and getting to the same objective sooner remains to be seen.

In my opinion, Powell is no Volcker and has some other unstated objectives in mind. He has pivoted from stated policy several times in the past. Remember, his original goal was focused on employment and being willing to accept higher than normal inflation for a period of time to balance the extended period of low inflation. Now, his focus is on rising prices and bringing them under control at the expense of employment, and he acknowledges the possibility of a hard economic landing. Not what the market wants to hear. In my opinion, he has probably been intentionally aggressive to give himself some maneuvering room. Hike more now to cut expectations later. I think inflation is on the verge of moderating, but secular trends will leave it higher than acceptable. I’ll come to these shortly. Nonetheless, it will leave the Fed compromised. Do they push further to bring inflation down to target (Volcker)? They can only affect demand and employment, not supply. Or, do they declare a victory at higher than normal inflation levels to save jobs? My bet is that Powell pivots and backs away from aggressive tightening.

As I said earlier, things don’t have to get better to cause a market rally. They only need to be not as bad as expected. Inflation coming off the peak and Powell taking his foot off the monetary breaks would constitute the conditions for a bounce. Furthermore, this would not be inconsistent with other Fed tightening cycles where the central bankers backed off to preserve growth and employment. My challenging the government’s resolve already has a real case example. The European Central Bank (ECB), even before they have started to raise interest rates, has had to relent on Quantitative Tightening by providing a new, yet to be unveiled, bond buying program to prevent government bond spreads from widening and impairing the borrowing ability of certain countries such as Italy. The ECB feels that it needs to continue to intervene.

Furthermore, I think there are some things that the Fed isn’t telling us. First, it will require significantly higher interest rates to cause the kind of demand destruction that is required to bring demand and inflation down to their stated goal. Second, I think they are willing to suffer stagflation to save jobs and avoid a serious economic downturn and bear market in an over leveraged economy. Financial Repression could be the undeclared goal to deal with the bloated size of government debt to GDP. This has been practiced in the past, most recently after WWII, to reduce the debt burden by holding interest rates below inflation to create a high nominal economic growth rate, but one that is low after accounting for inflation. When revenues and wages go up they are taxed, but bonds, after inflation, get devalued. In the 70’s nominal GDP kept climbing from the economic peak of the cycle in November, 1973, to its trough in March, 1975. But in real terms from peak to trough GPD dropped by 3.1%.

Regressions to the Mean

Most of the market’s decline can be attributed to the rise of interest rates, which causes an increase in risk premiums and higher discount rates. That’s analyst-talk for lower valuations. Price earnings ratios, a measure of valuation, have collapsed for the S&P 500 from about 22.5X at the beginning of the year to roughly 16X. That’s a 27% decline, and it is even worse for some of the big cap growth companies such as Amazon and Facebook.

This isn’t unusual for a market correction. What is generally required for a Bear Market is a recession and earnings deterioration. So far, you’re seeing softening economic data but not a collapse and no declines in earnings estimates. If a downturn isn’t coming, this market is a buy as a recession is now being factored in.

My problem is that I see a number of secular issues and trends that are regressing back to the mean, which I find troubling and will result in an extended headwind for the market. Let me take you through them.

1) Profit margins are still near all time highs. They reached current levels in the 1960’s and then were eroded from roughly 12% to 7% by the 1980’s as companies couldn’t pass through cost increases.

2) Risk. Low interest rates have required investors to take on more risk to achieve the same return objective. Investors have moved out of their safe GIC’s into longer dated bonds. Or they have moved from government bonds to corporates and even out of fixed income to equities. But to get a reasonable rate of return one has had to take on more risk. And some of this is benign. Even if you stayed with bonds, which did well in a declining interest rate environment you might not have appreciated that as the coupon rate approaches zero, the volatility risk gets transferred to the principal amount of the bond. The first quarter of this year saw the worst bond market on record even though interest rates went up only modestly. As investors come to grips with this new volatility and experience some negative results, they may be inclined to step back a little and look for safer returns and move away from equities.

3) Credit Spreads. One of the hallmarks of a Bear Market and distressed conditions in the financial markets is a widening in the interest rate spreads between government issues and those issued by corporations. These spreads have started to widen, but have not reached levels seen in past recessions. If the economy slides, this will be another negative factor for the market.

4) Earnings. As I said, earnings forecasts are still close to their highs and don’t reflect the worsening economic conditions. Consequently, valuations may be understating how much lower this market could go. Second quarter earnings releases could give us some insights as managements will get a chance to provide earning and business guidance for the balance of the year. But, I would be surprised if the current estimates hold up.

5) Liquidity. From 2009 until recently, we have seen an unprecedented amount of liquidity pumped into the system. Initially, it did not make its way to Main Street, but instead flooded into the financial markets resulting in an extended bull market in stocks and bonds. Recently, that excess funding has found its way into residential real estate. The Fed is now embarking on Quantitative Tightening that will remove $1.14 trillion dollars from the system over the next twelve months. We’ll see if they actually follow through, but if liquidity is key to a bull market, this is not a good sign and in my opinion will effect Wall Street more than Main Street not unlike what we saw in the 70’s.

Secular Inflation

There are other trends that I see reversing that are more specific to inflation. If I’m right on these, they support the case of stagflation.

1) Wages. Labour’s share of GDP has historically averaged about 66% and it has dropped to around 59% and they want it back. Demographics say we have run out of workers with almost two job openings for every unemployed person. With baby boomers retiring, we face a continued shortage of workers.

2) Housing. Over the last couple of years, the price of a median home has appreciated roughly 33%. With higher mortgage rates, home ownership is out of reach for many and they have turned to the rental market, which has seen the rent for a one bedroom apartment rise by 20%. This is getting fed back into homeowner’s equivalent rent which is about 42% of the Consumer’s Price Index (CPI).

3) Energy. The price of oil has been aggravated by the Russian- Ukraine War but is hardly the underlying cause. It is due to a colossal miscalculation of governments and environmentalists in transitioning from carbon-based fuels to renewables.

4) Globalization. China has provided the antidote of cheap labour and cheap goods that has offset loose monetary policy for years. Now trade wars and unreliable foreign sourcing and security issues are causing manufacturers to re-examine their supply chains. It’s resulting in manufacturing moving out of China and in some cases returning to North America while others are adjusting their inventory levels from just-in-time to just-in-case. Either way costs are going up.

5) Regulation. I haven’t mentioned this one before but regulation, besides monetary and fiscal policy, is one of the ways the government can control the economy and the role of regulation is reversing. Deregulation, tax cuts and free trade are good for corporate profits and bullish for the stock market.

Policies that promote income redistribution, higher taxes, industrial re-regulation, organized labour and
protectionism are bad for economic growth and stock prices. (Please accept these as over-generalizations as even I would argue that the capitalist system has some excesses that need to be addressed.

Pro-growth government policies dominated by supply side reforms, free market capitalism and globalization from 1980 to 2010 are beginning to reverse. The Trump Administration started the process with a trade war with China. Biden wants to tax and spend while pursuing an aggressive green agenda and continuing trade protectionism. As an example, it is estimated that California’s new restrictions on driver classification will take tens of thousands of truck drivers off the road according to the Wall Street Journal. Meanwhile, President Xi is aggressively regulating China’s platform companies, centralizing power, marginalizing private business and pursuing ‘common prosperity’ by forcing the rich to pay more.

Global geopolitical tensions are rising. Europe is already in a war. China – US tensions continue to rise and Western Europe is re-arming while Japan plans to spend more on defense.

Unfortunately, I don’t see any easy solutions for some of these issues and I don’t think they will favour the financial markets.

Stock Market

When I look at some of my individual portfolio holdings, I’m impressed by how cheap they are. On a one-off basis, there are a number of companies that I’d buy because they seem too undervalued, and eventually that’s what will put in a market bottom. But liquidity and valuation may be the headwinds for a general market advance.

The market has already discounted higher interest rates and is now discounting a recession, which my secular factors would suggest is likely. Nonetheless, a lot of damage has been done to the market. If the trends are cyclical, then we’re probably getting close to a bottom on a stock-by-stock basis. We’re oversold and due for a rally, which could be triggered by some relenting of inflation and the Fed backing off from its aggressive posture, my not as bad as expected scenario.

However, if we do enter a recession there will probably be another leg down as earnings get revised. If it results in stagflation, the earnings drawdown may not be as great, but higher interest rates and limited liquidity will continue to erode valuations as we saw in the 70’s. Back then, we endured a decade long bear market where stocks made little progress, but earnings expectations were met most every quarter. From 1970 to 1989 corporate profits grew 4.7 fold, which equals an 8.4% annualized rate in a period of high inflation and rising inflation. From 2000 to 2019, corporate profits expanded 3 fold, equal to 6.1% annualized in a period of low inflation. Inflation in the 70’s depressed PE ratios as the average multiple for the S&P was only 12X. Multiples expanded by 85% since 2010 even though the US economic growth had been weaker than the previous decade.

Another differentiating factor is what we refer to as the Fed Put. This has been the Central Bank’s response to falling or troubled financial markets. In the last two decades, the Fed has been able to dramatically lower interest rates and provide liquidity at any sign of trouble because inflation was in a secular decline. In the 70’s, there was no such option and the Fed in fact raised rates even during economic slowdowns to fight inflation. Similarly today, it is highly unlikely that Powell could justify a reversal of his tight monetary policy because of a weak stock market. It will no doubt require a financial accident to cause a sudden reduction in rates.

So, there’s a realistic case for a bounce, but a bottom may be a bit more elusive and when it does come a new bull market will require a pivot to monetary easing.

In the meantime, remember this market is all about valuation and liquidity. With unemployment at 3.6% headed to 4.2% (Fed’s est.), we’re not likely to have much of a recession. Earnings, however, could suffer from margin compression as this monetary policy cycle hurts Wall Street more than Main Street.