December 17, 2022

Wesley Chapel, FL

The S&P 500 continued to claw back some losses in November, finishing the month up 5.56%. This was the 5th calendar month of the year with a positive return, but the index was still down 14.17% for 2022 when the month ended.

A little more than halfway through December the market has given back all of its gains from last month and is presently down 19.30% for the year. The SPY ETF that tracks the S&P 500 index was down 6.63% in the past four days alone despite “Wall Street” getting exactly what it wanted as an early Christmas gift –CPI (inflation) came in lower than expected and the Federal Reserve Bank (FED) slowed the pace of its rate hikes.

For those of you who regularly read this commentary and especially if you also tune in to the weekly Elevate Market Chat on YouTube, you know that I am not surprised by the market’s reaction to getting exactly what it wanted.

If you don’t know what the Elevate Market Chat is all about, I strongly encourage you to check it out and then subscribe to our YouTube channel if you like what you see/hear. This is by far the best way to keep up with my current thoughts on the markets, economics and policy implications. And, as a bonus you get to see what Kyle thinks too… He’s got way more letters after his name than me!

Subscribing should notify you each time we post a new recording, usually in the afternoon on Thursdays. You can click here to subscribe to the YouTube channel and watch our recent chats.

Moving along…

I said in last month’s Market Commentary:

“’surprises’ of lower-than-expected inflation give the market (a very poor) reason to believe that the Federal Reserve Bank (FED) will “pivot” from raising interest rates to cutting interest rates soon.

That belief never materialized last time around and I don’t think it will this time either.”

Now, we can see how that “prediction” worked out.

Last week, the US Bureau of Labor Statistics (BLS) reported inflation via its release of the Consumer Price Index (CPI) for the month of November on Tuesday the 13th. The market was expecting the number to be 7.3%, down from 7.7% in October and it came in at 7.1%, “surprisingly” below expectations.

That same day was the beginning of the FED’s eighth and final regularly scheduled meeting of 2022. These meetings are two days long and conclude with the FED’s decision on whether to change its “policy rate,” also known as the “Fed Funds Rate.”

“Mr. Market,” an allegorical character created in 1949 by Benjamin Graham (Warren Buffett’s mentor) to personify “the market,” has consistently (and mistakenly) tried this year to simplify the current economic situation to be as follows:

Inflation slows > FED cuts interest rates > stocks (and bonds) go up

Don’t let anyone fool you about what the word “pivot” means in the context of FED policy. To be crystal clear, pivot does not mean “pause.” It does not mean “hike by less.” Pivot very plainly means to go from hiking (raising) the Fed Funds Rate to cutting (lowering) it. Its that simple.

Mr. Market by the way, is at least partly described by these attributes:

Is emotional, euphoric, moody.
Is often irrational.
Is there to serve you, not to guide you.

Said another way, Mr. Market is manic-depressive, and I think it is worth a few minutes to try to get to know “him.” (For what its worth, Kyle thinks I should cut some of the quotes out from below, but I already did and I like all these too much!)

“The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him - but only to the extent that it serves your interests."
-Benjamin Graham

“Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to.”
-Benjamin Graham

"If you look to 'Mr. Market' for advice, or if you imbue him with wisdom, you are destined to fail."
-Seth Klarman

“Don’t take advice from Mr. Market, who again and again is a wonderful creator of opportunities but whose advice should never, ever be followed.”
-Seth Klarman

"Successful investors must possess the mindset to take advantage of Mr. Market's bipolarity, and even come to appreciate it."
-Seth Klarman

"Mr. Market's predictably irrational proclivities can become our edge. He's a terrible master but a worthy servant."
-Frank Martin

"Benjamin Graham said if you don't have an intimate knowledge of the chronic behavioural anomalies of ‘Mr. Market’, the imaginary manic/depressive, who personifies the emotional impetus behind the actions of the ‘crowd’, you're doomed to mediocrity or worse."
-Frank Martin

“Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.”
-Warren Buffett

“Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, ‘If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.’"
-Warren Buffett

“Of course the best part of it all was his [Ben Graham’s] concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, ‘I’ll sell you some of my interest for way less than you think its worth.’ And other days, “Mr. Market” comes by and says, ‘I’ll buy your interest at a price that’s way higher than you think its worth.’ And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct.”
-Charlie Munger

So, now that you know a little bit (more) about who Mr. Market is and how he behaves, it may not surprise you to learn that he got this one wrong, again…

Not only did the FED not pivot to cutting interest rates despite inflation slowing yet again, instead the FED once again raised its policy rate, this time by 0.50% or 50 basis points (bps) to a range of 4.25% - 4.50%.

To be fair, the FED did slow the pace at which it has been raising interest rates from 0.75%, but slowing the pace, pausing, and pivoting, are all very different things with very different implications.

End of the day, the FED is still hiking rates. Hiking rates is “hawkish.” And a hawkish FED is “bearish” for stocks and bonds. Mr. Market clearly loves animal allegory too.

I have once again updated my projections for CPI and the Fed Funds Rate using the recently reported data, but those data led to no change to the timing of when the “Real” Fed Funds Rate will turn positive. Remember, any time you see a “real” rate it means that some rate is having an inflation rate subtracted from it.

For example, if we take the current Fed Funds Rate of 4.5% and subtract the current CPI rate of 7.1%, we get a Real Fed Funds Rate of -2.6%.

Historically, the FED has never stopped (or paused) hiking rates with a negative Real Fed Funds Rate, let alone pivoted to cutting rates. So, it seems like we have at least a little ways to go. You don’t just have to take my word for it either, Chairman of the FED, Jerome Powell said during his press conference on Wednesday after the recent meeting, “We still have some ways to go.”

He went on to say in response to a question about whether the FED might (pivot to) cut rates in 2023, “I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way… Restoring price stability will likely require maintaining a restrictive policy stance for some time.”

You can’t make it up. None of this is new, yet the financial media and Mr. Market in general just can’t seem to wrap their collective and shared brain around the fact that there are no rate cuts coming. At least not any time soon. Powell has been saying the exact same thing since at least August when the FED had their annual meeting in Jackson Hole, WY. I wrote about that in my September commentary.

Nothing has really changed since then. At least not materially.

And that leads me to my outlook for next year. I am increasingly concerned that the market will follow up this year of losses with another year of losses for stocks and bonds. Nobody seems to think it is possible that the market could be down two years in a row. Most everyone I talk to, hear from, or read about seems to expect the market to bounce back in 2023… but those expectations don’t really come with much compelling evidence.

Sure, I think the market will bounce back at some point and in the long-run, there is still no better place to invest and compound your wealth than the United States stock market. But stocks most certainly do not have to bounce back next year – just like they didn’t this year.

There are two more factors that I think are very important to determining the most likely path of markets in the coming year. First is the yield curve and second is the FED’s balance sheet. So, lets change gears…

I wrote about the yield curve back in my April commentary. To summarize, long-term interest rates should be higher than short-term interest rates. That is a normal environment and reflects a normal, upward sloping yield curve. When short-term interest rates are higher than long-term interest rates, the yield curve is said to be inverted, and is quite abnormal.

An inverted yield curve reflects economic risks being higher in the short-term than in the long-term. Another way to say is that if we make it through these short-term challenges the long-term outlook will improve.

One way (there are many) to measure the yield curve is to calculate the spread between a short-term interest rate and a long-term interest rate. The most popular spread to study is the 10-year US Treasury yield minus the 2-year US Treasury yield. It is normally a positive number and reflects a normal, positive sloping yield curve. The shorthand reference for this spread is the “10’s minus 2’s.”

When the spread turns negative, a rare occurrence, it signals an unhealthy economy with more risk in the short-term than the long term. Today, the 2-year US Treasury yield is 4.185%. That means you can earn 4.185%/yr for lending the United States government money for 2 years. Meanwhile the 10-year US Treasury yield is 3.490%. So, a loan to the same borrower for 8 years longer only yields 3.490%/yr.

Taking the 10-yr 3.490% yield and subtracting the 2-yr 4.185% yield, we get -0.695%, a negative number which implies an inverted yield curve. On December 7th, the spread was even worse at -0.84% which was its lowest level since 1981.

Why do we care? Well, pretty much every single time the 10’s minus 2’s spread goes negative a recession follows within the next 18 months, or so. Take a look at the chart below.

With the 10’s minus 2’s spread going negative back in July 2022, the clock is ticking. It’s always possible that no recession will follow this time… but from my perspective, we are probably already in a recession.

During a recession, stocks don’t tend to do well. One study shows that in the 11 recessions since 1950, the average market bottom comes after 169 days with the S&P 500 down 21%.

What normally ends a recession? The FED cutting rates to stimulate economic activity. I think we are a long way from that happening based on recent comments from Chairman Powell.

And so far, I haven’t even mentioned the FED’s balance sheet. The meteoric rise in the stock market has coincided with a consistent accumulation of treasuries and other toxic assets by the FED. These actions have pushed and kept interest rates artificially low and caused prices of stocks and bonds to soar… but they also caused the inflation we are now seeing persist throughout both the US and global economy.

The last (and only) time the FED tried to reduce the size of its balance sheet, not even by actively selling its holdings but just by simply not reinvesting cash from maturing bonds, was back in 2018. That was also the last calendar year that the S&P 500 was down. Coincidence? I think not. And the only reason it started to rise just before the year ended was because the pain got too bad and the FED began discussing its plans to stop letting assets “roll off” the balance sheet in the coming year.

If you remember, then-President Donald Trump was an extremely vocal critic of the FED policy to reduce the balance sheet known as “Quantitative Tightening,” or QT, which is the inverse of adding assets to the balance sheet through “Quantitative Easing,” or QE.

In a June 2019 article, CNBC wrote:

“Trump has said several times that the Dow Jones Industrial Average, which has performed strongly since Trump’s election in 2016, would be 10,000 points higher had there been no QT. He also told Fox that he thinks GDP growth would be close to 5% rather than the 2.9% seen in 2018 and a slower pace that is expected this year.”

I don’t share this to be critical of Trump but to give you an idea of what QT does to the stock market. I personally wish the FED would stay out of the market manipulation game and let the business cycle take its natural course – which includes expansions and contractions. I don’t think they know what rates ought to be any more than anyone else. It’s total guess work and their manipulation related to QE and cutting rates to zero are exactly why we have the inflation problem we have today.

As I have said before, and I am sure I will say again, “the FED acts as both arsonist and firefighter.” Its obnoxious.

I think one other thing that I mentioned last month is worth reiterating here, and maybe will be again in future commentaries:

Is it possible that the market may have already bottomed? Sure. But I think it is unlikely.
The facts that override this view are at least 3-fold:

1.       Global growth is slowing
2.       Monetary conditions are tightening
3.       Inflation remains persistently high

For now, the name of the game is caution and patience. There is no reason to aggressively buy stocks unless you want to essentially gamble. US Treasuries that mature in less than 1 year yield 4%+. The US Dollar is a good place to be while we wait for more clarity around the economic environment.

One last thing before I go, I will be dusting off our 2022 year-end stock market predictions and sending prizes to the top 3 once the year is over! For new clients, we do this for fun every year but it is not how we manage portfolios where we prepare, we don’t predict.

In my January commentary I will ask for your guesses for where the S&P 500 will finish in 2023. We like to get those in by the time I write and post my February commentary so be ready to submit your predictions!

Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed in November.

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

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor

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