Wesley Chapel, FL
As I said (again) in last month’s commentary, it still feels like a bear market to me.
The SPY Exchange Traded Fund (which tracks the S&P 500 Index) managed to finish May with a small gain of 0.23% after being down 7.64% at its lowest point on May 20th.
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SPY was down 20.34% in 2022 at its lows in May.
SOURCE: Tradingview.com
The SPY was down 20.34% from its highest closing value (achieved on January 3rd) during the day on May 20th, in bear market territory before subsequently rallying 9.67% to its recent high on June 2nd.
As of today, the SPY still hasn’t closed 20% lower than its highest close, so depending on who you ask and how you measure, one could argue that we still haven’t technically entered a bear market. But depending on how the rest of the day goes, we might get there today.
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SPY was up 9.67% from the lows to its recent high.
SOURCE: Tradingview.com
So far, June has not been kind to the markets and as of this writing, the market is down about 21% from its highs – solidly in bear market territory. If the market closes below $382.16, we will have finally entered a technical bear market. Even if that doesn’t happen today, I still think it is very likely to happen before we see a new all-time high.
But you just never know.
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SPY was down 21.52% in 2022 at its lows earlier today.
SOURCE: Tradingview.com
As I have also tried to make clear in my recent commentaries, there is no reason to get all worked up about a bear market rally or bounce. The most recent bounce that took the SPY up 9.67% from May 20th to June second is no different. As we now know that bounce was nothing more than an opportunity to sell more stocks before the market dropped to a new low.
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SPY has erased 100% of its 2021 gains.
SOURCE: Tradingview.com
The primary reason that the market has made a fresh low today is because of the latest inflation reading (as measured by the Consumer Price Index or CPI) that was published by the Bureau of Labor Statistics (BLS) on Friday morning.
After cooling off slightly in May, inflation has returned to its highest level since the 1980’s. To recap, CPI previously peaked at 8.5% in March before declining slightly in April to 8.3%. The most recent report released on Friday morning, covering the month of May, showed a year-over-year change of 8.6%.
I really sort of thought that the 8.5% CPI print from March was going to be the high for this cycle. So, I was wrong about that. But that is ok. I still think (because the evidence shows) that the rate of change for inflation is slowing. After such a big move higher, the top should be more of a process than an event anyway. Just like the bottoming of the stock market should be more of a process than an event, too.
The stock market clearly expected inflation to continue falling in May. The estimates were for CPI to come in at 8.2%. So, a return to multi-decade highs sort of implies that the Federal Reserve Bank (FED) does not have control of the situation and they may need to act more aggressively to bring inflation down.
On Thursday of last week, the market was expecting (and the FED has set the expectation for) a rate hike of 0.50% at their upcoming meeting which concludes on Wednesday, June 15th. That would take the current overnight lending rate (Fed Funds Rate) to a target of 1.25% from the current 0.75%.
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You read that right. Interest rates currently still start with a zero. The overnight rate is closer to zero than it is to the “neutral” rate which the FED in March said was around 2.50%. The neutral rate is the rate that neither stimulates nor restricts economic activity. It is largely subjective but let’s say I agree with them.
So, if the FED hikes interest rates by 0.50% as expected, the rate will still be closer to zero than neutral. And even if the FED raises by more than 0.50%, say, by 0.75% or even 1.00%... the new overnight rate will still be “stimulating” an already overheated economy, instead of restricting it.
This is madness, friends. Total madness.
Since CPI was reported on Friday, expectations for this week have begun to imply a hike of 0.75%. So, we will find out in a couple days.
As I have said in these commentaries before, the FED has put itself and our country into a very difficult position. I do not see a way forward without some real pain.
On one hand, if the FED continues its accommodative easy money policies, inflation will remain persistently high and might even go higher, hurting the lowest income households the most. On the other hand, if they act decisively to restrict economic activity with aggressively higher interest rates, the stock market will continue to fall, hurting the wealthiest households the most.
If you are wondering what I think they should do, I think they should act to immediately raise interest rates past the neutral rate sending the stock and bond markets much lower very quickly. Many unprofitable (zombie) companies would go bankrupt, and the employees of those companies would lose their jobs sending unemployment higher.
I don’t say this lightly. I don’t desire for anyone to lose their job, or their home, or their retirement savings. And as Brad Pitt’s character famously said in the movie about the Great Financial Crisis called “The Big Short,”
“For every 1% increase in unemployment 40,000 people die.”
Some time ago I researched the quote for accuracy and found it to largely be plausible. I couldn’t prove or disprove it, but it seems like a reasonable statistic.
But I have a feeling that if the FED doesn’t act to aggressively get inflation under control, prices will rise to a point where the poorest Americans won’t be able to afford to put food on their tables anyway.
Again, this is not capitalism’s fault. This is the government’s fault.
What did they think would happen when they panicked and closed the entire economy down for a year (or more)?
What did they think would happen when they just printed trillions of dollars and gave it away?
It boils down to one simple fact. Our economy can’t afford our government.
Even without restrictive interest rates, some of the biggest companies in the world are already starting to layoff employees and freeze hiring. Many companies are already reducing their expectations for sales and profitability this year.
This is no surprise. We are just about halfway through the year now and companies are beginning to get an idea of whether they can realistically achieve the expectations they set for themselves and investors in their quarterly earnings calls at the beginning of the year.
If a company knows that they won’t be able to achieve the guidance they offered earlier in the year and fail to update their shareholders on the situation, they run the risk of getting sued. Beyond that risk, nobody likes surprise missed earnings on Wall Street. If a company surprises by missing their expected sales and profitability for a year their stock can drop by even more than if they slashed their guidance mid-way through the year.
So, now that we are into June, many companies can see the writing on the wall, and they know they are going to miss full year expectations. And several companies have already cut their expectations for 2022.
Recently (on May 18th) shares of national retailer Target (TGT) dropped 26% in one day after the company reported lower sales and profits than they and analysts on Wall Street were expecting. It also reported higher costs and changes in consumer behavior. Then, just a couple weeks later (on June 7th) the company cut its guidance again and reported a massive increase in inventories.
Shares of Walmart (WMT) made similar moves (down about 20% in a few days from 5/16-5/19) on similar results.
Even Microsoft (MSFT) has slowed hiring and cut guidance.
If these, the biggest and best companies in the world and in their industries are having this much trouble, how do you think it is going for the rest of them? Not good is my guess. And we will likely begin to find out just how bad the expectations have gotten when earnings season starts in July. At this point, company management will have little excuse for not updating investors on their outlook. And I find it hard to believe that many will be on pace to meet, let alone exceed their current estimates.
Second quarter earnings season unofficially begins on July 14th when JP Morgan (JPM) reports results.
As of May 31st, the forward price to earnings ratio (Fwd P/E) for the S&P 500 was 17.3x. For those who don’t know, you get the Fwd P/E ratio by dividing the current price of something by the expected profits over the next twelve months.
So, if you were going to buy an ice cream shop, for example, at a price of $100,000 and you expected it to generate profits (after paying all expenses) of $833 each month for the next twelve months for a total of $10,000 for the year, the P/E ratio would be 10: 100,000/10,000.
If the price was $100,000 and you only expected it to generate $416/mo of profit for a total of $5,000 for the year, then the P/E ratio would go up to 20: 100,000/5,000.
The P/E effectively tells you how many years it would take for the profits to cover the purchase price. As you can see, a higher P/E means more expensive and a lower P/E is less expensive, all else being equal.
The average Fwd P/E for the S&P 500 Index over the past 25 years is 16.85x. So, 17.3x isn’t too expensive, really. And with interest rates so low compared to historical levels, 17.3x really does seem cheap. But here is the problem. Those earnings estimates for the next twelve months are falling. As companies update their guidance for the current environment in July, Wall Street analysts will be forced to lower their estimates and therefore the “E” part of the Fwd P/E equation will drop.
Lowering the “E” part of the equation will force the ratio to go higher… absent a correlating drop in the “P” part of the equation. This will make stocks look more expensive, just like in our ice cream shop example above.
Going back to the ice cream shop example, if we only wanted to pay 10 times earnings (10X) for the shop, and we only expected the shop to have profits of $5,000/yr, the price would have to fall from $100,000 to $50,000 for us to be willing to buy it.
The same thing happens in the stock market. As analyst estimates fall, P/E ratios will rise, and buyers who thought they were getting a good deal at 17.3X will find out they paid too much. Other potential buyers will walk away and wait for prices (and therefore the P/E ratios) to come back down.
Ultimately, the takeaway is that lower estimates (and higher rates) lead to lower prices in the stock and bond markets.
For now, cash is king.
I know cash is boring. I know it doesn’t keep pace with inflation. But it sure beats losing 20%, or 30%, or more…
The key to surviving a bear market is to avoid major losses. As Nicholas Nassim Taleb said in Antifragile:
“The learning of life is about what to avoid.”
As I mentioned in a recent commentary, most advisors will never hold cash. For most people in this business, it is always a good time to buy stocks… no matter the economic environment. If stocks are going up, they say it’s a good time to buy because of momentum, if stocks are going down, they say it is a good time to buy because stocks are cheaper than they were before. When stocks are down big, they say it’s a good time to buy because stocks are on sale!
If these people can identify good times to buy, how come they can never identify good times to sell, or to just sit on the sidelines and wait patiently?
In his book “Antifragile,” Taleb goes on to say:
“Charlatans are recognizable in that they will give you positive advice, and only positive advice, exploiting our gullibility and sucker-proneness… Yet in practice it is the negative that’s used by the pros, those selected by evolution… people become rich by not going bust (particularly when others do).”
A highly respected analyst by the name of Dan Ferris recently quoted Taleb and that is where I picked this up. Taleb (like Ferris to me) is a legend in the investment community. Dan went on to say:
“Unprofitable companies’ stock prices can soar sometimes. But reality always catches up with them… Eventually, investors realize they’re not making any money. And in turn, the unprofitable company’s stock blows up.
When too many people fail to avoid a mistake, it can look like a success… until reality catches up with them. Ask anybody who bought Pets.com, Webvan.com, eToys.com, or numerous other companies that never earned a dime during the dot-com boom.”
Now is not the time to “buy the dip” or aggressively invest in anything. Now is the time for patience, and a lot of cash.
For those of you who are retired, this is even more important. You should always maintain a substantial cash reserve. If you can afford it, we recommend holding three years of discretionary spending in cash. We don’t even recommend keeping that in an account with us where we get to earn a fee.
Bear markets usually don’t last 3 years. And even if they do, there is usually something to sell along the way to replenish that reserve as necessary.
But the worst thing you can do (we call it financial suicide) is to “choose a withdrawal rate” and take a systematic withdrawal every month from your declining investments. This is what the vast majority of retired folks do at the recommendation of their advisor.
Four percent is a common withdrawal rate even though many studies have been done to show that there is no reason to believe it will work out in the long run. In fact, I think some of these studies were done with the intention to scare people into taking even less from their investments so that these advisors could keep more assets under their management for even longer.
The investment management industry basically sets it up this way:
“Dear client, please save as much as you can while you are working. Invest it with me and I will allocate your capital to a pie chart of funds (that I don’t manage) based on your risk tolerance.
From there, I will never sell anything to get you out of the way of the bear markets that are sure to come along. And when you question me about why you are down (or not up enough) I will blame you for having a high (or low) risk tolerance score.
I will never tell you it is a bad time to invest because it will always be a good time (for me) for you to invest. I get to charge my fee either way. I will tell you about “dollar cost averaging” and how if you buy some at the highs and some at the lows, it works out to a lower average price over time.
Instead of managing your money, I will manage your emotions and expectations and tell you that you ‘can’t time the market.’
And when you finally want to retire, just tell me how little you can afford to get by on each month. I will show you studies that will scare you into finding a way to survive on even less.
Then, we’ll send that amount to you after selling off your investments each month. This way, I will get to keep as much of your money under my “management” for as long as possible, thus earning a higher fee.”
If you aren’t already a client of Elevate and this sounds all too familiar, please call or email us TODAY!
There are a ton of things broken with this model that I don’t have time to get into, but the major issue is that taking a systematic withdrawal amounts to dollar cost averaging in reverse. You still get the lowest average price, but this time you are the seller… not the buyer. That is why at Elevate, we call it financial suicide. You want to sell at the highest price… not the lowest.
Once you are retired, you are an active investor whether you like it or not. You must time the market. You must prepare for bear markets by holding a cash reserve. There is nothing worse than having to sell twice as many shares to generate the same level of income. If you are forced into that situation due to poor planning, the shares you sell to put food on the table are no longer in your account when the bear market finally ends and the market bounces. The problem just compounds.
If a bear market happens early on in your retirement (called sequence of returns risk) and you are forced to sell more shares while the market is down, it can totally blow up your retirement and send you back to work in your eighties, or to live in your child’s basement – or both…
Once retired, the risk is running out of money before death. You must have an income plan. And as another of my most respected investors, Dr. David Eifrig, has articulated perfectly:
“If your retirement income plan depends on an accurate prediction of markets, you are doing it wrong.”
If you have been to our office, you have probably seen that quote hanging on the wall in our conference room.
In closing, now is the time to sit tight. Until the FED backs off from their hawkish rhetoric there is no reason to be aggressively buying stocks or bonds. The traditional 60/40 stock/bond pie chart prison model is down 20%+ in 2022. And, since I started writing this commentary, the market has closed for the day and the S&P 500 is officially in a bear market on a closing basis. The time will come to buy stocks again. But that time is not now.
We will hold our best positions for as long as we can, but if they close below our predetermined trailing stop levels, we will raise even more cash.
We will also keep building our “shopping list” so we are ready to pounce when the situation changes.
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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