Market Pulse: Mid-Year Update

Unfortunately, the celebration of the Fed’s “courage” lasted less than a day and the declines resumed. The Fed thought they could allay investors’ fears about inflation by raising 75 basis points but instead, all they did was raise other fears, now of the Fed doing too much rather than too little. The 10-year Treasury was trading right around 3% but jumped to almost 3.5% by the time of the FOMC meeting. Rates did fall back the rest of the week and closed around 3.24% but the damage was already done. Mortgage rates jumped to nearly 6.25% at one point last week and the housing market is downshifting rapidly. As I said last week, a cooling of the housing market is necessary but slamming on the brakes of an economy is generally not a good idea, as I thought we learned during the COVID fiasco. If rates come back down – and with the economic data continuing to weaken that seems likely – we may avoid a collapse in the housing market but it will be a close call – we need to get some good news on inflation soon.

We seem to have reached the indiscriminate selling part of the bear market. We have maintained a defensive equity posture and a cash cushion (10-15%) dating back to last year and that continues to be the case. But, to take one example of babies and bath water, the Select Dividend ETF (DVY, we own) fell from a nearly 8% gain YTD on June 7th to a 6% loss by last Friday. I suppose it is somewhat interest rate sensitive with 26% in utilities but the fundamentals didn’t really change much, if any, over that two-week period. The index now trades for 12.5 times earnings but it wasn’t expensive before the selloff. The S&P 500 value index (IVE, we own) had similar performance, falling from a 3% loss to a 14% loss over the same time frame. The largest holding in the index is Berkshire Hathaway which went from +5% to -10%. I suppose if you’re going to bail on Berkshire Hathaway, you can justify selling just about anything.

Our portfolios are still outperforming on the year but losses have now reached double-digits (depending on timing, risk tolerance, etc.; the 60/40 stock/bond portfolio is down 19%) and I am reviewing all of our indicators to see if there is more we should do. It has been a challenging year, to say the least, but we have continued to follow our process. But losing less than everyone else, while admirable, is not our goal. We aim to make money every year – even knowing that is likely an unattainable ideal in the long run – and we still have half a year to go. I think it would be helpful to review where we are and how we got here.

Interest Rates/Fixed Income

We came into this year expecting the economy to slow. That wasn’t exactly a courageous bet since the growth rate last year was goosed by Biden’s American Recovery Act and an accommodative Fed; neither of those items seemed likely to repeat. Biden’s legislative agenda died in West Virginia. The Fed should have started its tightening last year and everyone knew that except perhaps the folks who run the Fed. Of course, we don’t give the Fed so much credit around here but everybody else does and that is what matters to markets, at least in the short term. So, a slowing economy and a tightening Fed was the outlook at the beginning of the year. But we faced a bit of a dilemma because it was also obvious (at least to me) that interest rates were going to rise. Our normal response to slowing growth would be to extend the duration of our bond portfolio and if it reached recession proportions, actually reduce risk assets and add more bonds. But if rates are rising that plan is off the table.

Being wrong on duration this year has been painful and the wronger you were, the more it felt just like owning stocks. This is why it takes extraordinary conditions for us to buy the very long end.

Commodities and Gold

Rising rates also affected our commodity and gold exposure. We expected real rates to rise and in the past, that has not been a positive environment for commodities. 10-year TIPS rates are up from -1.04% at the beginning of the year to 0.67% Friday. That 171 basis point rise is about the same as the nominal 10-year (176 basis points) but is arguably much more important. Positive real rates are actually a positive sign for quality long-term growth but it will have to rise more and stay that way for it to really impact the economy. And, in general, what is good for growth is bad for gold.

Equities

We also came to the conclusion last year that the S&P 500, and especially the growth part of that index, was essentially uninvestable. From meme stocks to SPACs to technology stocks to crypto, speculative fever gripped investors last year to a degree I hadn’t seen since the turn of the century dot com boom and bust. I knew there would be a comeuppance but when was a question I couldn’t answer. By the fourth quarter though, we had eliminated our S&P 500 exposure in favor of more defensive positions in Dividend stocks and US and International value stocks. We had and have no exposure to the S&P 500 growth index or NASDAQ index. By the way, we have never recommended any crypto investments and despite the ongoing crash, are not likely to soon.

Similar results were seen in small-cap stocks where dividend and value indexes outperformed the growth index:

Our allocations to small cap are generally pretty small but we are currently smaller at 75% of our strategic allocation. Strong dollar environments tend to favor small caps over large but with a slowing domestic economy, I didn’t want to make an oversized bet on that. In this case, small-cap and large-cap returns have been quite similar (-25.4% and -22.4% respectively).

Real Estate

Real estate (REITs) has performed in line with large-cap stocks this year. For most of the year, we have maintained an allocation that is 50% of our strategic allocation. We raised that to 75% when we extended the duration of our bond portfolio. REITs are rate sensitive and performance should improve if rates come back down.

REITs also perform well in inflationary environments and that might argue for a full allocation. However, truly inflationary environments are marked by a weak dollar which isn’t true today. Interest rates are probably the more important driver of REIT returns going forward.

International Equities

One of the strangest outcomes in this year of strange outcomes is the outperformance of international equities over US. This is wholly unexpected in a strong dollar environment but even EM equities are outperforming the US this year. We own a small position in Japan and despite the plunge in the Yen (-14.7% YTD), the Japan ETF has managed to slightly outperform the S&P 500. With commodity prices on the upswing, Latin American stocks have led, still positive on the year. That, despite the continuing political swing to the left (Colombia joined the trend yesterday) that may continue in Brazil later this year. Two things come to mind here that investors should take to heart. First of all, the economy is not the market and the market is not the economy.

Everyone knows about China’s ongoing economic difficulties and yet its stocks have done better than the US this year. Second, don’t let your politics dictate your investment choices. The leftward swing in LA politics is probably not a long-term positive but it hasn’t stopped those markets from outperforming.

Outlook

Economy

I have maintained for some time now that once the COVID distortions in the economy are gone, the US economy would settle back to its previous growth trend of around 2%/year. That is based merely on the observation that GDP grew 2.1%/year for the decade prior to COVID and we did nothing during COVID to change that trajectory. Economic growth can be boiled down to just two things: productivity growth and workforce growth. Either workers become more productive and output grows or you add more labor and output grows. Did we do anything to enhance productivity during COVID? Well, there were changes due to COVID – work from home, etc. – but whether those things turn out to be positive for productivity is still an open question.

As a percentage of the population we are still a full 1% below the pre-COVID level:

So, with low productivity growth and weak workforce growth, I just don’t think it is realistic to expect something other than what prevailed prior to COVID. If anything, since we added a lot of government debt during the pandemic, we might even assume growth will be somewhat less than the pre-COVID trend. On the other hand, I think that is mitigated by the fact that a lot of the government debt added was merely a shift from household balance sheets to the government’s balance sheet. The savings rate has fallen this year but that doesn’t mean, contrary to a lot of commentary out there, that people are spending the huge pile of savings they accumulated during COVID (flow vs stock).

Last year’s 5.7% GDP growth rate was not sustainable, fed as it was from Biden’s spending plan and an accommodative Fed. Growth had to slow this year and it is. What is remarkable so far though is how little evidence we have of that. Real retail sales have been running well above trend and should come down but they remain elevated:

If retail sales are going to fall back to trend – and I think that makes sense – the question is how. Will it be a rapid drop or gradual? More importantly, how will this affect overall consumption? Will a rise in services spending offset some of the – potential – drop in goods spending? Will it be sufficient to keep overall real consumption growing on trend?

Example: The ISM surveys have come off their highs but are still well above levels associated with recession. And neither of these is a primary input to our portfolio process because they produce too many false signals.

The regional Fed manufacturing surveys also show the slowdown. Like the ISM, these surveys often turn negative without a recession. A negative reading just means things are slowing. We don’t use this as a primary indicator either because of the high number of false signals:

I don’t know how this slowdown will be resolved. There is very little data available right now that points to recession at all, much less something catastrophic like 2008. Yes, credit spreads could keep getting wider, the ISM surveys could get worse, the regional Fed surveys could deteriorate, and retail sales could fall off a cliff while consumers also pull back on travel and other services spending. But we don’t make big portfolio changes based on extrapolating a present trend to its worst-case scenario. We came into this year with our portfolios defensively positioned and we still are. To get even more defensive would require evidence that the economy is doing something more than just slowing from an unsustainable growth rate.

Markets

Market sentiment is at extremes in almost all asset classes.

It is profoundly negative about stocks and real estate and, despite a selloff last week, still profoundly positive for commodities. I suspect we are at or near turning points for both but that doesn’t mean either trend is over. The S&P 500 could easily rise by 15 to 20% from these levels and still be in a downtrend (below the 200-day moving average). Commodities could do the opposite and still be in an uptrend. That’s how far away from the long-term trends we are right now.

I would also point out that the very long-term trend of the S&P 500 is still up even after this large selloff. The only times we’ve been more oversold was in 2002 and 2008 and in both of those cases the index traded below its 50-month moving average (which it did briefly in 2020 but didn’t close a month down there). If this isn’t another 50% bear market – and those are rare despite us having had two in the last 20 years – then the bottom is probably here or very close.

A rally in bonds – a fall in rates – should also be positive for REITs and the dividend stocks (26% utilities).

The bigger question is what a fall in rates would do to commodities, gold, and the dollar. It will be important to see how real rates react relative to nominal rates and how inflation expectations change. Ideally, we’d see a fall in nominal bond yields and steady real rates resulting in a fall in inflation expectations.

But ideal may be too much to ask and if real rates start to fall in the context of an economic slowdown, gold should outperform general commodities. As for the dollar, its course is more likely to be determined by what is going on outside the US but in general, a slowdown here relative to the rest of the world would be negative for the buck.

The course of the dollar will largely determine if and how we might change our equity allocations. Right now, we have some international value exposure but the rest is defensive US equity. If the economy cools but doesn’t fall apart, we may need to shift to more offense and valuations would point to increased mid or small-cap exposure. The S&P 500 and its growth piece are still expensive, if a lot cheaper than they were, but I would be reluctant to make any long-term commitments to those areas unless we believe earnings will accelerate sharply (which we don’t at present). International stocks are still cheaper than the US and it really doesn’t matter what part of the world you look at. EAFE is 12 times earnings, Asia ex-Japan is 14 times, Japan is 12 times and global stocks are 15 times. The value versions of those are even cheaper.

For now, we are not making any big moves because we don’t have sufficient evidence to do so. We remain defensive because the economy is slowing but we also think inflation is peaking (example: Philly Fed manufacturing prices paid component is down 20% over the last 3 months). We are likely to soon extend the duration of our bond portfolio again to take advantage of what we think could be a significant rally in bonds. I would expect too that better inflation data and softer economic data should put the Fed on a less aggressive path. But Powell seems uniquely clueless in the recent string of lousy Fed Chairmen so who knows? If the market starts to price out some of the currently expected rate hikes, I would also expect a positive response from stocks. Whether that is a temporary reprieve, the calm before the recession storm, or a new bull market I can’t say yet.

The rising dollar, rising rate environment continues although the ascent of both slowed at the end of last week. This means nothing of course; it was just a couple of days. The trend for both is still solidly up and both could pull back considerably and still be considered as such. A first downside target for the 10-year yield is about 2.94%, second down to the May low at 2.71% and a third at 2.25%. For the dollar, first downside target would be 102.6, second @ 98. Anything below that would end the intermediate uptrend.

Obviously, there was no place to hide last week but that isn’t even interesting. What is, is that growth stocks outperformed value for the week and since late May. It isn’t enough yet to change the trend but it is potentially a positive sign if the things that were hit hardest are starting to do relatively better. China was again an outperformer but still down on the week.