April 13, 2022

Wesley Chapel, FL

Bottoming in stocks, or in the stock market overall is normally a process, not an event. The COVID bear market bottom was unique with the FED coming to the rescue with trillions of cash and accommodative policies.

Dare I say it? This time is different!

Today the FED is removing its accommodative policies (albeit slowly) and instead of coming to the rescue with more cash to buy bonds as they did during COVID, they are looking at selling some of the bonds they accumulated during the past Quantitative Easing (QE) cycles.

The S&P 500 (the market) is still in a technical correction (a drop of 10% or more) and will remain there until it makes a new all-time high.

As I said last month:

“Bear markets, corrections and recessions are a few of the events that can only be seen through the rearview mirror or by looking backward. You can’t see them through the windshield, or by looking forward.”

Economic recession is a hot topic these days. Most market participants (myself included) and certainly the financial media tend to think of a recession as two consecutive quarters of declining Gross Domestic Product (GDP). It is technically a little more nuanced than that.

The National Bureau of Economic Research (NBER) is responsible for officially declaring recessions has this (among other things) to say:

“Q: The financial press often states the definition of a recession as two consecutive quarters of decline in real GDP. How does that relate to the NBER's recession dates?

A: Most of the recessions identified by our procedures do consist of two or more consecutive quarters of declining real GDP, but not all of them. In 2001, for example, the recession did not include two consecutive quarters of decline in real GDP. In the recession from the peak in December 2007 to the trough in June 2009, real GDP declined in the first, third, and fourth quarters of 2008 and in the first and second quarters of 2009. Real GDI declined for the final three quarters of 2001 and for five of the six quarters in the 2007–2009 recession.

Q: Why doesn't the committee accept the two-quarter definition?

First, we do not identify economic activity solely with real GDP, but consider a range of indicators. Second, we consider the depth of the decline in economic activity. The NBER definition includes the phrase, “a significant decline in economic activity." Thus real GDP could decline by relatively small amounts in two consecutive quarters without warranting the determination that a peak had occurred. Third, our main focus is on the monthly chronology, which requires consideration of monthly indicators. Fourth, in examining the behavior of production on a quarterly basis, where real GDP data are available, we give equal weight to real GDI. The difference between GDP and GDI—called the “statistical discrepancy”—was particularly important in the recessions of 2001 and 2007–2009.”

What is GDP? The Bureau of Economic Analysis (BEA) defines it this way:

A comprehensive measure of U.S. economic activity. GDP measures the value of the final goods and services produced in the United States (without double counting the intermediate goods and services used up to produce them). Changes in GDP are the most popular indicator of the nation's overall economic health.

At any rate, what I said remains true – we won’t know that a recession has begun until we have been in it for some time. Maybe for several months.

The main reason everyone is concerned about a recession right now is that the yield curve recently inverted. That’s a lot of jargon, I know. Let me try to quickly and simply explain.

Normally, if you want to borrow money for a relatively short period of time you will have to pay a lower interest rate than if you want to borrow money for a long period of time, all else equal. Imagine if a friend asked you to borrow money overnight, or for a week… you might not charge them any interest at all. But, if they wanted to borrow money for a year, or a decade… you might decide to charge an interest rate. The higher rate they are willing to pay, the more likely you are to loan the money.

This is how banks make money. They borrow money from you (yes you) at the lowest rate possible and then turn around and loan that money out at the highest rate possible, and they keep the difference. How do they borrow money from you? That is what your checking account is – a loan to the bank. And how much are they paying you in interest? Not much. Since you can (in theory) go get all the money out of your checking account any time you want this is an extremely short-term arrangement.

Due to the fractional reserve system, even though the bank can lend $9 of every $10 in your account – they still get to show the balance in your account as $10. This is a lot like creating money out of thin air. Check out this one-minute video to get a better idea how it works.

The bank then lends your money (and then some) to other people in the form of mortgage loans which recently hit 4.7%. I will come back to mortgage rates in a minute, but the point here is that banks are paying us close to 0% on our checking accounts, and meanwhile charging 4.7% on mortgage loans - and they keep the “spread.”

The main point there is that in normal conditions in a healthy economy, short-term interest rates are lower than relatively longer-term interest rates. This means that normally, the interest rate on a 2-year government bond is lower than the rate on a 10-year government bond.

Click to enlarge
Normal (upward sloping) yield curve

For example, on December 31, 2021 the rate on the 2-year US Treasury Bond (this is the rate the government pays to bondholders to borrow money for 2 years) was 0.74%. On the same date the rate on the 10-year US Treasury Bond was 1.51%. The yield curve was sloping upward if you plot these on a chart (which you can find nearby.

Fast forward to April 1, 2022 the rate on the 2-year US Treasury Bond was 2.46% and the rate on the 10-year US Treasury Bond was 2.39%. The yield curve was inverted. Even if only slightly inverted, how much do you think it takes to get banks to stop lending when they have to pay more to borrow funds than they can earn by lending those funds out? The answer is “not much.”

In fact, as the yield curve flattens, it tends to stifle economic activity, overall. One way to think of it is: the steeper the yield curve the healthier the economy. This is probably a fair statement for my purposes in this commentary. It follows that the flatter the yield curve, the less healthy the economy. An inversion is an anomaly that is indicative of a very unhealthy economy, no matter how inverted it is. Even a little is unhealthy.

There is a pretty standard way to track the steepness of the yield curve and it is to simply take the 10-year US Treasury rate and subtract the 2-year US Treasury rate. This is commonly referred to as the “10’s minus 2’s.” If the result is a positive number the yield curve is sloping upward. The bigger the resulting number the steeper the curve.

However, if you are left with a negative number the yield curve is inverted.

Back on December 31, 2021 the “10’s minus 2’s” was 0.77. By April 1, 2022 the “10’s minus 2’s” was -0.07%. You may also hear this referred to as a yield “spread.” Spread and curve are used pretty interchangeably in this context even though they aren’t always the same meaning in other contexts.

There are lots of other bond durations (than 2-years and 10-years) that economists measure. There are durations of 3 months, 5 years, 7 years, 30 years, etc… and we can do the same math to get the spread for each of these different maturities. Most yield curves (or spreads) were still sloping upward on April 1st, but the “10’s minus 2’s” is the “granddaddy” of them all…

10’s minus 2’s spread with recessions indicated by shaded areas.
Click to enlarge
Source: Federal Reserve Bank of St. Louis

And when the “10’s minus 2’s” inverts, or goes negative, it is highly likely that a recession will occur… within 18 months.

The key phrases in that last sentence are: “within 18 months,” and “highly likely.”

Highly likely does not mean certainly!
Within 18 months does not mean tomorrow, or the next day!

So, the yield curve inverting is not a good reason to sell your stocks immediately to go to cash. Notice in the chart of “10’s minus 2’s” from the Federal Reserve Bank of St. Louis nearby that the inverted yield curve didn’t lead to recessions (shaded areas) overnight. And you wouldn’t want to go to bonds in a rising interest rate environment like that in which we currently find ourselves.

Another item for the “reasons to be bearish” bucket. Surging energy prices also tend to precede recessions…
Click to enlarge

All that said, I don’t dismiss the inversion. It gets added to the “reasons to be bearish” bucket.

Lets move on briefly to mortgage rates which I mentioned earlier are currently at 4.7%. I noted in my February commentary I mentioned that rising interest rates were going to have an impact on the housing situation - and not in a good way. At that time, a fixed 30-year mortgage was about 3.7%. Today, rates are 1% higher on an absolute basis but that also means they have increased by 27% on a relative basis. That is a crazy move.

U.S. 30-year mortgage rates since 1987
*Source: Tradingview.com*

Until recently, mortgage rates had been trending down since 1987. That trend is officially broken (at least for now.). See the (scary) long-term chart nearby. Any time a chart breaks a trend that has been in place for that long - look out. There could be a lot of momentum for a move even further in the opposite direction - in this case that means for mortgage rates to go even higher.

I see this as probably the scariest chart in the entire economy right now. Why? Well, think about it this way. If you could afford a $3,000/mo mortgage payment (just principal and interest) and had unlimited capital for a 20% down payment:

at 3.7% you could afford to pay $814,000 for a home. You’d put down $162,800 and your monthly mortgage payment would be about $3,000.
at 4.7% your monthly mortgage payment would be 12.7% higher at around $3,380.
if you needed to keep your mortgage payment at $3,000 the price of the home would have to drop by 11% to $723,000 for you to be able to afford it.

U.S. Home Construction Fund (ITB)
*Source: Tradingview.com*

This is just one way to illustrate how higher interest rates lead to lower prices over time. We haven’t yet seen home prices begin to fall, but if rates continue to rise I think that will be the natural outcome as sellers will be forced to reduce their asking prices to attract the same buyer who can’t afford the payment at higher rates. It does seem that the parabolic rise in home prices has started to slow. And homebuilder stocks are feeling the pain. See the nearby chart of the U.S. Home Construction Fund (ITB).

Full disclosure, we weren’t immune to this drop as we held the homebuilder D.R. Horton (DHI) in our Growth Strategy at the start of the year. Thankfully, due to following our predetermined stop-loss, we got out before it continued another 11% lower (so far). If mortgage rates continue to rise, home builders should continue to fall.

Click to enlarge
Month over month CPI
Source: bls.gov

Inflation
Another hot topic is inflation. I have spent a fair amount of time sharing my thoughts on inflation in the past couple commentaries (February and March) so I will (try to) keep it short here. The Bureau of Labor Statistics (BLS) released their monthly Consumer Price Index (CPI) yesterday. And inflation came in hot again. It was the highest number in four decades and the month over month CPI reaccelerated from 0.8% to 1.2% (on a seasonally adjusted basis). This isn’t too surprising given the conflict in Ukraine and related sanctions on Russia which have caused energy prices to jump. Remember, Russia didn’t invade until February 20th. So, with only 8 days remaining in February the impact for the monthly CPI was somewhat limited.

If you remove the impacts of energy and food prices, Core CPI was only up 0.4% month over month. This represents a slowing of monthly inflation from 0.7% for the past two months (Jan and Feb).

So, the inflation picture is mixed on a rate of change basis. The way I track the numbers (quarterly to align with GDP which is only reported quarterly) actually shows a slowing down of the year over year (YoY) rate of change in CPI during the first quarter of 2022 from the fourth quarter of 2021.

The nearby chart shows that YoY inflation in Q4 2021 was 6.7% which was 24.2% higher than YoY CPI in Q3 2021. So, in order to maintain the rate of change (or acceleration) CPI would have needed to be 24.2% higher than 6.7% in Q1 2022. Which means CPI needed to average 8.3% in Q1 2022. It came in at only 8.0% and represented a slowing in the “2nd derivative” of -19.5%.

Soon we will get new data for GDP rate of change in Q1 2022, and if it doesn’t come in at 20.7% it will also show a slowing rate of change in the “second derivative” column. The chances of GDP achieving 20.7% are virtually zero.

There are (at least) two reasons I go through all this:

When both CPI and GDP are slowing in rate of change terms, you can be virtually certain that the economy is in a recession.
When both CPI and GDP are slowing, you can usually count on the FED to take an accommodative position regarding monetary policy to get us out of that recession.

Now that is an interesting position to be in. The FED has painted itself (and our country) into a corner. Either they tighten (raise rates) monetary policy into a slowing economy (GDP and CPI) which will make a recession worse, probably leading to massive unemployment and social unrest. Or, they act to save the stock market by easing monetary policy (cutting rates or printing money to buy more bonds) and leading to ever higher inflation and a worse economy in the long run.

All I can say is this: don’t count on the FED to deliver magical outcomes. The position we are in is largely the fault of the FED. Keep in mind this is the same group that called inflation “transitory” for a year and even after they finally admitted it wasn’t transitory, they continued stimulating an already overheated inflation picture all the way until last month when the finally stopped buying bonds as a part of their Quantitative Easing (QE4) program.

As Jim Grant famously quipped all the way back in 2015, “the FED is acting as both arsonist and fireman.” They have no idea what is going on or what to do about it.

SPY price chart
Click to enlarge
*Source: tradingview.com*

Moving on…
The S&P 500 has technically broken out of the cycle of lower highs and lower lows I outlined in my last commentary. But given all the items I just outlined above, I am not really feeling that the odds are in our favor to be aggressively buying stocks.

If you look at the nearby chart of SPY (the S&P 500 index fund) you will see that the market rallied a long way from the lows and actually made both a higher high and a higher low above the 200 day moving average (DMA) indicated by the light blue line. But since then, the market has sold off once more and dipped back below the 200-DMA (light blue line).

Trading under the 200-DMA with the economic backdrop I have outlined in this commentary is not the time to be getting aggressive.

So, we have remained cautious. We are staying long our best ideas but closing positions that hit our predetermined stop loss levels. I am constantly looking for opportunities to put our cash back to work in the markets, but good values are very hard to find and growth stocks have not regained their upward momentum. The way I see it, patience is the key.

The S&P 500 (SPX) and Nasdaq (COMP) were both up about 3.5% for the month of March. Also as of the end of March both indexes were still down for the year (-4.95% for the SPX and -9.10% for the COMP.) So far in April, both indexes have given back those March gains.

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In summary…
There is a lot to cover and I could keep writing… But I know your time is important.

The bottom line is that the government in various ways has led directly to the current economic environment through all sorts of interventions. Looking for them to intervene again to “save us” from declining stock values may be warranted, but it will only delay the inevitable. The capitalist economy is cyclical. It expands, then it contracts, but overall it tends to get better over time, pulling more and more people out of poverty and leading to the best quality of life ever seen in the history of humanity.

There is no other economic structure that compares.

What I think we need is for the government to stay out of the economy, and let “nature” take its course. Recessions are not the end of the world, they are a time to hold some extra cash and be very picky about the stocks you select.

For now, there are a lot of reasons to be bearish or pessimistic, as I have outlined. But the best place to be invested for the long-run is still stocks in the United States and the best currency to hold is still United States dollars.

That doesn’t mean you have to be “all in” or “all out” of either of them. But a combination with more cash than normal makes the most sense to me, right now.

No matter what comes next, I will continue to follow our rules that have consistently helped us to protect capital when the odds were not in our favor, and capture upside when the situation is more favorable.

Our latest “Market Chat” from Thursday, April 7th.

One last thing…
If you want to hear my thoughts more frequently, you can tune into our new YouTube channel where Kyle Lottman, CFA, CPA, CMT and I are discussing markets weekly. We record the conversations on Thursdays and get them posted shortly after. We are trying to keep them to 30 minutes, but there is a lot to discuss these days. We go through a lot of charts and technicals, but we also cover fundamental economics. We hope you will tune in and find the content useful and relevant.

As always, 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 Advisors

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