Strategy and Positioning written by Steve Orr, Chief Investment Officer; and Essential Economics written by Mark Frears, Investment Advisor

As of market close November 10, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

5 Handle

Is a slightly lower inflation reading in October worth 5%? Lightly staffed desks and tons of one-day options last Thursday let the computers drive stock and bond prices north of 5% after the consumer price index release. Breath was solid — over 90% of the New York Stock Exchange listings finished higher, the second time since September. Advancing volume outstripped decliners more than three to one, a very solid day. Strategas reports that Thursday’s 5% rip higher was the 15th best one-day rally since 1950 for the S&P 500. For the week, NASDAQ tech rose 11% and Russell 2000 Small Cap rode the caboose to a respectable 4.8% gain.

What do those S&P 500 big rallies have in common? For starters, five days and three months later, returns are mixed, some higher, some lower. Of the top 25 best days since 1950, 21 occurred when the index was below its 200-day moving average — in other words, in a Bear market. The data support the time-worn saying that the biggest rallies come during Bears. 

Rolling over

Mark will have more details on the Consumer Price Index, but here are the highlights. What went down: health care, appliances, used cars and fuel. Still going up: housing, household supplies. A point we raised a couple of weeks back is that changes in shelter, or housing costs, take a minimum of six months to filter through to CPI. Housing costs started rising nearly a year before CPI did. And, on the downside, shelter costs are already falling around the country, but the CPI shelter costs index is still climbing. We expect the shelter index to turn lower and start pulling down CPI readings around March/April. 

Prices rising at a slower rate will help market sentiment. The scrooges in our group remind us that even though the rate of increases slows, prices are not going back to pre-shutdown levels. Over the next several years a strong case can be made that inflation will “stick” above the Fed’s magic 2% level. The Fed may have to settle for raising its “preferred” rate from 2% to 3% or more. What drivers would keep inflation high? Reshoring to more expensive production, fewer workers, and the fact that workers who are available are not as well educated at those entering the workforce 10 and 20 years ago. 

Higher costs

Excitement over a three-tenths drop in year-over-year inflation was not confined to stocks. Treasury bonds fell a quarter of a percent across the board. Twenty- and thirty-year bonds rose in price over three percent Thursday, helping ease the pain of 30% drops this year. Treasury Bills maturing in the next six months moved lower in yield by about a tenth of a percent. Why less? The Fed is committed to raising rates at the December 13-14 meeting. Current opinions in the futures pits show traders expect a half point increase in December and a quarter-point on February 1st. One month ago, the Treasury yield curve peaked at three years with a yield of 4.34%. Today it peaks at one year and 4.57%. The peak should continue to move closer in time as we reach the point where the Fed pauses or stops raising rates. Cash should be a good relative value until that point. We are mindful that some observers are already saying the Fed has gone too far. Unfortunately, that is knowable only in hindsight. 

The Bull case for bonds says regardless of how deep the recession is next year, the Fed has done enough damage to the economy, and we have likely seen the high in rates. This would make bonds attractive at 4% yields. We would remind our readers that coming rate increases will push short term rates to the 4% area over the next few months with very low-price risk relative to longer bonds. 

The Bear case says the Fed is not done until short-term rates are above inflation. Let’s see: Fed Funds target range is 3.75 % to 4% and CPI just posted 7.7%. No — not yet. The Bear view agrees slightly with the Bulls: most of the increases in interest rates are done, but not all. Steady employment numbers and rising wage growth are still trailing inflation but keep the Fed on offense longer than traders would like.

Another consequence of the decade of easy money is our rising debt burden. When interest rates were below 1%, Congress was happy to push the national debt load north of our country’s GDP. Now that rates have tripled off the lows, interest costs on the $31+ trillion federal debt are going up. About $3 trillion of U.S. Treasury debt matures in 2022 and another $5 trillion in 2023. That debt must be “rolled over,” which the Treasury does by issuing new securities. Additional debt is required to be issued each year that Congress runs a budget deficit. We wonder when federal interest costs will get the attention of Congress. 

Railroaded

The 1929 crash exposed how low margin requirements goosed speculative fever higher. Some stocks required only 10% of the purchase price, others up to 40%. Any big price move — say this year’s 20% drop — could (did) wipe out someone’s account. The Federal Reserve got the authority in the mid-1930s to set margin and it has been 50% for decades. 

Fast forward to the New Age of Crypto currencies. Over the last five years, electronic currencies and exchanges have captured the public’s fancy. Several innovations, such as the blockchain and wallet-to-wallet exchanges, ought to survive. One of the “innovations” that ought not, is low margin levels. FTX, a crypto exchange that entered bankruptcy proceedings late last week, fell victim to margin calls and runs, two age-old wealth killers. 

The crypto industry has yet to bow to any meaningful regulation here in the U.S. How do you create a panic or a run on the bank? With little to no regulation, manipulation to cause a run is easy. One way is to tell the world you are going to dump an illiquid asset. Binance, an offshore crypto exchange claiming 120 million registered users, announced it was selling a lot of FTX tokens. FTX Exchange and its brokerage, Alameda, also held a large number of tokens. Panic selling ensued, customers received margin calls and either sold to cover losses or were forced to put up more capital. The value of FTX and Alameda fell far enough that, lo and behold, Binance was able to play white knight and buy the companies. We will see if that scenario plays out. 

In the meantime, what’s old is now new — at least for some new crypto investors. For us, the FTX shenanigans are straight out of the Texas railroad wars in the late 1800s. Back then syndicates and shareholder groups waged proxy fights and bond price scams to force lines into receivership so they could pick up a route or leg between cities on the cheap. 

Curtain call 

Closing numbers for the third quarter earnings season please. 90% of the S&P 500 members have reported as of last Friday. FactSet reports that 69% posted a positive earnings surprise and 71% a positive revenue surprise. Earnings grew a sparkling 2.2% above the year ago quarter, or about 6% below inflation. Trailing inflation brings up two important points: 1) companies are no longer able to raise prices to keep up, and 2) sales are declining. This certainly meshes with what companies were saying on their calls. Most sectors are clearly cautious about the next several quarters and the word “recession” came up more often than not. 

Taking away the energy sector’s 140% gain, the rest of the 500’s earnings fell -5.3%. The largest decliners in earnings were Communications Services (Facebook -66% YTD, Google, AT&T ), Financials and Materials. The materials sector was plagued by reopening worries. Since September it has benefited from speculation about China reopening and is up 19% versus the S&P 500’s 11% return. Materials is a current holding in our sector rotation strategy. 

Analysts have heeded company outlooks and have marked down fourth quarter and 2023 first quarter estimates. This has the unwelcome effect of pushing forward price earnings ratios up from around 15 times to 17 times depending on which earnings estimate you prefer. Bear markets rarely bottom when P/Es are above historical averages. Fourth quarter season will begin on January 13th, which is fittingly a Friday.