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The S&P 500 finished August down 9.62% (using the SPY ETF as a proxy) for the month. That marks the sixth losing month of 2022. The market also made fresh lows for the year as I have been expecting and writing about for months.

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SPY Chart
*SOURCE:* *Tradingview.com*

It turns out the rise in the market from the lows on June 17th to the highs on August 16th, which took the SPY more than 19% higher, was nothing more than a bear market rally.

As of yesterday, and then again today - the SPY made yet another new low for the year.

So much for the calls on the Cartoon Network (aka CNBC) that the bear market was over, and the FED was going to pivot to cutting interest rates from raising them.

Oddly enough, the geniuses on financial media and most of the pie chart sales reps from big financial companies are still talking about the FED pivoting. More like they are praying for the FED to pivot and stop the bleeding.

Remember I also wrote about these types (for whom it is always a good time to buy) in my June and July commentaries.

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At Elevate, we have consistently stayed bearish and heavily overweight cash. When clients and prospects bring us new money to invest, we explain to them that this is not the time to aggressively be investing in stocks or bonds. Yes, there are some stocks that we still own and have held up comparatively very well this year. We have maintained a long position in energy stocks that is actually up for the year.

The fact that we are in a sustained bear market doesn’t mean we shouldn’t invest some capital along the way. But we do so cautiously and with a lot of cash on the sidelines.

Recently, we even decided to invest money into an inverse fund (in our Growth Strategy) that goes up when the S&P 500 goes down because we didn’t think the market was done dropping. So far, that has worked out well. I only wish we’d done it sooner!

Another change we have made is to start buying US Treasuries that mature in less than one year. We have added 3-month and 6-month US Treasuries to both the Growth and Value Strategies which carry handsome yields – higher than we have seen in many years.

Those maturity dates are strategic.

The bear market wont last forever.

It feels like many people are finally getting discouraged. That is a normal part of the sentiment cycle. Usually, when people finally begin to give up and feel like the market is never going to go up again, we are nearing a low point, dare I even say a “bottom.”

As long-time readers know, we don’t pick bottoms around here. The market is down enough that we don’t need to pick the exact bottom to know that we will make a lot of money buying and holding stocks when this bear market is over, and the next bull market begins.

That said, it does make some sense to get an idea of when we think that transition is likely to take place and then update that thinking as we obtain new information.

Last month I shared a list of 14 points from Chairman (of the Federal Reserve Bank) Powell’s Jackson Hole speech given on August 26th, 2022. I encourage you to go back and read them because all of them are still in play.

I believe this speech is the primary lens through which to view the markets, for now. Nothing has changed since.

The FED sets the overnight lending or FED Funds rate in a range (usually 25 basis points or 0.25% wide) not at a specific level. The FED has signaled an intention to get the top end of that range in the overnight lending rate to 4.50% by the end of the year.

As of the end of the FED’s most recent meeting on September 21st, the top end of the range for the FED Funds rate is 3.25%. So today, the target range for the FED Funds rate is 3.00% - 3.25%. Most people in the financial media just quote this as 3.25%, using the top end of the range as “the rate.”

Interestingly, when financial media quoted the rate as 0% for much of the past several years it was actually in a range from 0% to 0.25%. So, they switched from quoting the low-end of the range when rates were extremely low to the top end of the range as rates rise. Whatever they can do for maximum impact in their headlines…

Anyway, for the sake of brevity and comparison, I will stick to using the top end of the range for this commentary.

As I was saying, the current rate is 3.25% and the expectation is for the rate to be 4.50% by the end of the year. The FED has two more meetings in 2023 at which to raise rates (absent an emergency policy change between meetings which is exceedingly rare.) There are no meetings in October. That leaves one meeting on November 1-2. And then the final meeting of the year on December 13-14.

It doesn’t take a math whiz to figure out that they need to hike by 1.25% across the two meetings to achieve the 4.50% level by year end.

The market currently expects the FED to hike by 0.75% (again, for the fourth meeting in a row) on November 2nd and then for them to hike by 0.50% on December 14th. I largely agree with this expectation.

From there, things get a little trickier.

One thing to know is that the FED has never stopped a rate-hike cycle with the real FED Funds rate being negative. That doesn’t necessarily mean they never will… but history says it is unlikely that they will stop before pushing the real FED Funds rate into positive territory, or at least to 0%.

Any time you see the words “real rate” together they indicate that some inflation rate is being subtracted from some other rate. In this case, we use the full annual (or year-over-year) rate of change in the Consumer Price Index (CPI) which was most recently reported at 8.3%.

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*SOURCE:* *tradingeconomics.com*

Today, the real FED Funds rate is -5.05%. That is determined by taking the current FED Funds rate of 3.25% and subtracting the most recently reported CPI rate (from September 13th for the year ending August 31st) of 8.3%.

3.25% - 8.3% = -5.05%

In other words, the FED Funds rate would have to be 8.3% today, for the real FED Funds rate to not be negative. That’s not going to happen.

What is likely to happen from here is a combination of two things until the real rate goes positive:

CPI falls
FED Funds rate rises

So, to get an idea of when the real rate might go positive, we need to forecast these two items.

We know when the FED will meet. And we know that CPI gets reported each month.

To make our projections we use estimates of month-over-month (MoM) CPI to project the year-over-year (YOY) CPI each month going forward.

And we use commentary from members of the FED to project the FED Funds rate at each of their meeting dates.

Then we “stress test” those projections in either direction. For example, what if the FED hiked more aggressively and CPI rose more slowly, or even declined? What if CPI accelerated more aggressively and the FED hiked more slowly?

The overarching idea here is that the market will finally stop going down when it begins to believe that the FED will stop raising interest rates. The market will go up even more if it believes that the FED will actually begin to cut interest rates – stimulating the economy and the markets.

Since the FED will probably hike until the real FED Funds rate is no longer negative it is a good idea to get a sense of when that might reasonably happen so that we can plan accordingly.

Once we have a projection of the earliest time that the FED Funds rate will go positive, we can look for US Treasuries that mature during that time frame so that we get our principal and interest back and potentially put those dollars back to work in the stock market. That is why the Treasuries we have bought so far mature by the end of March.

I explain all this so that you can get an idea of what you will see in the next few images which I encourage you to click and study.

Below, you will find three scenarios that show various rates for YoY CPI based on varying MoM CPI rates along with projected FED Funds rates.

The first scenario is my base-case. MoM CPI has averaged 0.20% since 2010. So, that seems like as good a rate to use for projections, as any. That doesn’t mean that CPI will be 0.20% every month starting now and for the rest of time. In fact, that is almost guaranteed NOT to happen. But if MoM CPI averages about 0.20% for the next several months, YoY CPI will mostly come in where projected in the scenario.

It is important to remember that I will adjust these projections continuously based on new information coming in and new commentary from members of the FED.

The main takeaway of the base-case scenario is that the FED Funds rate goes positive in March 2023 after the FED hikes by 0.25%. Technically, we wouldn’t know that the real FED Funds rate went positive until the CPI was reported for March the following month, in April 2023.

But also, by then, assuming the scenario played out this way, the FED would already be signaling through their commentary that the hike cycle was nearing an end. And that sort of commentary would potentially stop the market from going lower, if not cause it to rise, all by itself.

Again, the important point here is that in my base-case I currently expect that the FED could make their final hike of this cycle in March 2023.

From there, we want to know what is the “best” case scenario and what is the “worst” case scenario. Best and worst carry a lot of baggage. To be clear, I don’t mean that the best-case scenario couldn’t possibly get any better or that the worst-case scenario couldn’t possibly get any worse… I guess the best way to say is that these are the best and worst reasonable scenarios I am willing to publish!

Another bit of baggage is whether it is actually good or bad that the FED stops or continues hiking but that is outside of the scope of this commentary.

Maybe it would be better to think of them as the “earliest” case scenario and “latest” case scenario. But even that doesn’t work because it could always take more or less time than I expect depending on a multitude of factors.

At any rate, the earliest I can see the FED making their final hike of the cycle is January 2023, and the latest I can see is May 2023.

The earliest-case scenario would require MoM CPI to decline by 0.10% per month from now until January. The big problem with this scenario is that if MoM CPI actually declines by 0.10% for long enough, we would end up seeing YoY CPI begin to decline in June of 2023. That means deflation.

The FED will never let that happen.

The economy doesn’t function when prices across the economy are falling. In that type of economy people are incentivized to hold off on purchases because anything they want to buy would be cheaper next month. The only other time that happened in recent history was during the Great Financial Crisis of 2008-09. Nobody wants that.

You can see why the FED targets an annual rate of inflation around 2% and not -2%.

In the latest-case scenario we see MoM CPI growing at 0.33% and a YoY CPI of 4%. The “sticky” items in the inflation calculations are currently rising at a little over 4% per year. So, to me, it seems likely that this inflation will “stick” around for a while even if the more volatile items like Energy flatten out or even drop slightly.

In this scenario we see YoY CPI flattening out at 4% by August 2023. This is double the FED’s stated target, so more than likely if this were to occur, the FED would again resume hiking rates at some point to bring that down. But 4% with a positive Real FED Funds rate is a vast improvement for the economy compared to where we are today with CPI at 8.3% and a negative FED Funds rate.

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*SOURCE:* *JP Morgan Guide to the Markets*

Could it be a lot better or a lot worse than any of these scenarios? Sure. How likely is it? I don’t know. I think it is probably far more likely that inflation stays higher for longer and my “worst-case” is not bad enough, than for it to actually drop faster than 0.10% each month.

Make no mistake – our economy is in a very precarious position and there is no easy way out of this. The FED created this situation and now they are trying to fix it. It is very hard to trust that they have any clue how it will go. We are all part of a great experiment and there is no telling how it will play out.

But we can’t just sit around and wait for the “all clear” signal. We have to do the work and allocate our capital somewhere. The best way to do that is with reasonable analysis based on the best information available at the time – and then to update the analysis continuously.

Tomorrow morning, we will get the CPI report for September, and I will update our projections accordingly. The market will react violently almost regardless of what is reported. The market is expecting CPI to come in at 8.1% compared to 8.3% reported for August. If the reported number is lower than 8.1% the market will rally, perhaps by a few percent. But remember, with the FED Funds rate at only 3.25% CPI would have to come in at 3.25% in order for the FED to not hike next month and again in December. I think we can pretty much rule that out.

So, even if CPI is reported at 8%, or 7%, or even 6%, the FED is still going to be hiking rates in November and December. Once the market realizes that over the subsequent few days any sort of short-term rally will probably fade.

Remember, we just saw a two-month bear market rally that rose almost 20% before dropping to fresh lows. So, a few percent of upside on a lower than expected CPI report is nothing to get too excited about.

Don’t get me wrong. I’d like to see CPI fall as much as anyone. But 7% inflation is still extremely high relative to history and relative to the FED’s target.

One other thing on the horizon is the 3rd quarter GDP report which is coming later this month. Even though projections have improved recently, and GDP is expected (for now) to be positive for the first time in two quarters – I personally have my doubts.

The bottom line is that the FED is hiking rates in an economy that is probably in a recession with extremely high (and hopefully falling) inflation.

We are by no means out of the woods yet. We are stuck in a painful bear market and there could be even more pain to come.

But this bear market will not last forever and when it finally ends, we will want to have plenty of cash to put to work in the best long-term wealth generating investment that the world has ever known: the United States Stock Market.

Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets in September.

Until next time, I thank God for each of you, and I thank each of you for reading this commentary.

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor

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