Wesley Chapel, FL

Investors,

What a change the rolling over of the calendar to 2022, has brought to the markets…

“I personally expect a major downside event in 2022. Maybe even in the first quarter. Maybe we are even seeing it start to happen already.”

The market started the year with a wobble, and then on January 12th the United States Bureau of Labor and Statistics (BLS) released inflation numbers for December 2021 which showed that the prices consumers pay to consume goods and services (Consumer Price Index or CPI) rose by 7% from the prior year in December 2020. This was the highest annual percent change recorded since 1981.

Month over month inflation
SOURCE: BLS.gov

Yesterday, the BLS released inflation numbers for January 2022. This time the CPI showed an annual increase of 7.5% from last year in January. This probably doesn’t surprise anyone… It is no secret that prices are high and rising.

But once again, the BLS data showed that the monthly increase has slowed from the peak seen in October 2021. Check out the nearby chart of monthly CPI.

Another nearby chart shows the annual CPI for each month going back to the year 2000. To be clear, each year there are 12 annual CPI reports. Each month reports the index’s percent change from the same month the prior year. If you look closely, you will notice that inflation really started to pick up in April of 2021 at 4.2%. The last time we saw a print that high was back in September, 2008 during the Financial Crisis when the CPI hit 4.9%. One year later, that 4.9% became the base number and the CPI came it at -1.3%, showing that prices had actually decreased from September 2008 to September 2009.

In fact, if you look even more closely at the same chart with highlights nearby, you will see that any time CPI hit 4% it has never printed a higher number one year later. None are even close. That is what you call base effects.

So, while inflation can stay high, and even keep increasing, the rate of change is already slowing when you look at monthly data, and is very likely to slow as we get into April and “base effects” kick in.

The Federal Reserve has two mandates:

Maintain stable prices
Maximize employment

There is actually a third mandate to maintain moderate long-term interest rates, but nobody ever talks about that one. Many (including me) argue that yet another very real but totally unofficial mandate is to make the stock market go up or at least prevent it from going down too much. This is where we get the term “FED Put.” We most recently saw this in action during the COVID crash. But the idea has been around since at least 1987 when then FED Chairman Alan Greenspan lowered interest rates to help companies recover from the Black Monday stock market crash.

Unemployment and Wages
SOURCE: JP Morgan

The most recent data, again from the BLS showed that the unemployment rate in January was 4.0%. This is well under the 50-year average of 6.3%. You can see the nearby chart of the unemployment rate and wage growth that the wage growth rate is actually outpacing the unemployment rate – a rare occurrence. Over the past 50 years, the blue line has very rarely been above the gray line, and not for any sustained amount of time since the 1970’s.

Interestingly, this situation gives the FED what amounts to “permission” to tighten monetary policy by taking actions to increase interest rates. These actions will involve a combination of (finally) ceasing the operations related to buying bonds in the open market, threatening to raise overnight lending rates (which banks charge each other and then flow through to everyone), actually raising the overnight lending rates, and then ultimately maybe even selling some of the bonds they have bought over the past several years.

Each of these actions will make it harder for companies to stay in business and will ultimately lead to workers getting laid off, and if we are lucky, it will even lead to some companies to fail and file for bankruptcy.

But here is the thing… unemployed people vote. And they tend to vote against the current folks in office. So, there are political motivations to maintain accommodative policies forever and ever and ever and ever… which is how we got to where we are in the markets today, where it is nearly impossible to find companies trading at anything that seems like an even remotely fair price – let alone a good or deep value. Too many companies today (even publicly traded companies) earn no profits at all. Where analysts used to look for value stocks and compare companies based on price-to-earnings ratios, we now have to look at price-to-sales ratios because most (not all) companies do have sales, but so many companies don’t have any earnings to compare or consider.

On the other hand, many of the current administration’s supporters are feeling the squeeze from costs rising much faster than their wages. The insidious thing about inflation is that it is an invisible tax that disproportionately impacts the poorest Americans.

I read this once somewhere and it stuck with me:

“When people vote, they don’t often get what they expect – they get what they deserve.”

Many voters (not all, as many just wanted to be rid of the previous guy in the White House) decide based on policies that they perceive will financially enrich their lives. The appeal of free college, and free healthcare, and taxing the rich and money for social programs, is very real for the poorest voters.

Unfortunately for them, what ultimately ends up happening is that wealthy Americans figure out ways to not pay as much tax as expected (some even leave altogether and pay nothing especially at the state level), and the government ends up printing money out of thin air to pay for all their promises. This is where the inflation comes from. It isn’t inflation of prices… it is inflation of the money supply. Too much money chasing too few goods and services are what make the prices go up, and once it gets started it is very hard to get under control.

Some of the biggest price increases come in the form of homes, and stocks. The big problem there is that the stock market is largely owned by the wealthy and not the poor folks who need the “free” social programs. The same goes for real estate. Sure, a little more than half (64%) of Americans own their homes, but that is down from 69% back in 2004 (before the FED started buying assets via their Quantitative Easing programs.) And that is just homes. That doesn’t include any commercial real estate or second, third and fourth homes.

The only way to beat inflation is to own assets (businesses/stocks and real estate) before the money printing happens. And unfortunately, most people don’t and so income inequality just worsens as you can see in the nearby charts.

I am not trying to beat up on the democrats here either. According to Pantera Capital, we printed more money in June of 2020 under then-President Trump (a republican), than we did in the first 200 years of our country’s existence. Again, voters don’t often get what they expect, they get what they deserve, as the saying goes. It works the same regardless of the winning party.

The point that I am trying to make here is that President Biden is actually in favor of the FED raising rates to combat inflation whereas President Trump was very unhappy with the FED for raising rates in 2018. It is quite rare for a President on either side of the aisle to advocate for higher interest rates and tighter monetary policy as it generally leads to higher rates of unemployment. On top of that, it makes new homes harder to afford due to higher monthly payments, unless home prices come down enough to offset those higher payments. However, if home prices fall enough it hurts the 64% of people who own their homes already.

It is a tough spot for our country to be in, and “easy money” is what got us here. All we did was delay the economic pain that should have felt in 2008-09 and then again in 2020. Eventually, my bet is that it all catches up with us. It is just a matter of when.

At any rate, the FED may not have to do much in the way of tightening policy or raising rates. I do believe they will raise rates at their meeting on March 15-16th and maybe again at their meeting in May which takes place the 3rd-4th.

But then we will get CPI data on May 11th which will report the 12-month period from April 2021 to April 2022… and as I outlined above, it would be historically unprecedented to see inflation any higher than 4.2%. This would be enough for the FED to say that “inflation is moderating” and take a “wait and see” approach to further increases. This is especially so if the market is still languishing at that time. More evidence that inflation is already moderating can be found in the Manheim Auto Price Index which showed that prices from December ’21 to January ’22 were flat for the first time in a long time. Car prices have been one of the prime contributors to the overall inflation picture over the past year, so seeing those level off is a good sign that we may have already seen peak inflation for this cycle.

The FED can actually stimulate economic activity by after threatening to raise rates by a lot, simply backing off from the worst-case scenario and raising them by less, more slowly, or not at all.

Performance

The S&P 500 Index (SPX) finished January with a loss of 5.26%. That is better than just a few days earlier on the 27th when the index was down 9.22% at the end trading. But still, this decline didn’t even qualify as a “correction,” which requires a drop of 10% or more from highs.

So, we haven’t yet seen a “real” drop, let alone a “major downside event” as I have written that I expect. We may just be getting started.

In fact, this post titled “Still Extreme Levels of Ridiculousness” from Jesse Felder sums it up very well:

“Despite the strong two-day rally to finish the month, January was the worst start to the year for the Nasdaq (down 19% peak to trough) since 2008. And if not for that two-day rally, it would have been the worst start for the Nasdaq ever – and ever, as they say, is a very long time. As a result, you might have thought that the decline would have made some progress in normalizing valuations, but you would have been wrong.”

When the SPX was at its lowest point on 1/27, our Value Strategy was down less than 4%. Our Growth Strategy was down less than the market at the lows, too. The best part is that both strategies were sitting on a lot of cash and that is still the case, today.

Even though markets have rebounded from the lows, they have not yet broken out to a point where I would say we are “all clear” to aggressively buy back into stocks. The markets can (and probably should) drop further from here. But if they don’t, we will very quickly put money back to work.

SPY during COVID crash
SOURCE: tradingview.com

During the COVID crash, the SPY (the ETF that tracks the S&P 500) initially dropped about 12.5% from the highs before rebounding 5.5% and even rising above the 200-day moving average, before dropping another 29% where the FED came to the rescue and we reached the lows. See the chart nearby.

History doesn’t always repeat, but it often rhymes… If you look at the chart of the SPY today, you will see that it also dropped, then rebounded back above the 200-day moving average (light blue line) before dropping once more. Today, the market dropped and finished below the 200-day moving average on news that Russia will likely invade Ukraine.

There can be no assurance that the market will continue to sell off. But we are prepared no matter which direction the market goes from here.

I see our most important job as protecting your hard-earned capital. Sure, I want to make money too, but I only invest aggressively when the odds are in our favor. Today, the odds are not in our favor and so I remain cautious. I am willing to sacrifice some of the upside rebound to protect against the downside potential.

Outlook

Keeping it short and to the point, I expect a lot more volatility than we have experienced recently. It isn’t abnormal. What was abnormal was 2021. Corrections are normal. Bear markets (drops of 20% or more) are normal. They are just part of the cycle.

When we humans try to prevent the cycle from playing out by bailing the economy out of bad situations with monetary interventions, all we do is delay the inevitable. And maybe that is ok. Maybe that is the best thing to do. I somehow doubt it, but that question is outside the scope of this commentary.

I expect inflation to moderate.

I expect the FED to raise rates at a slower pace than they are currently discussing.

I expect more downside this year even if it isn’t in the short term.

And I expect the market to finish the year with a gain, overall!

This is why we don’t predict; we prepare.

One last thing:

My S&P 500 prediction for this year is 5,195. We received 56 predictions from clients and others. The average prediction was 4,888.33 – a gain of 2.6%. There were 17 predictions that the market would be down for the year. The average of those down-market predictions was 4,234.33 – a loss of 11.1%.

Good luck to those who entered! I look forward to sending prizes to the winners in January 2023!

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

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor

Legal Information and Disclosures
This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.