Investment Insights 

 — Steve Orr 

Trend

The third quarter is in the books, so let’s check the ledgers. The Dow Industrials fared best among the major stock indices, only declining about -2%. The S&P 500 held up well versus its mid- and small-cap brethren, losing -3.2% versus their -4% and -4.9% declines. Most of the non-U.S. indices fell during the quarter around 4%. 

U.S. interest rates gave stocks a run for the bottom during the quarter. We’ll address the reasons in a moment. Rising interest rates meant long-maturity Treasuries took it on the chin. The 20-year area of the Treasury yield curve lost around 13 percent, contributing to the Bloomberg Barclays Aggregate’s drop of 3%. Crude oil sprinted 28% higher, thanks to tighter supplies, and gold defied its inflation-believers with a -4% return. 

Like it or not, “the trend is your friend” goes the old Wall Street saying. Long-term stocks are still in a Bull. Since peaking at the end of July, stocks have drifted lower and now sit on their uptrend line from last October’s low, so the intermediate term is still a Bull market. For the short-term trend, the technicals and fundamentals are not in the Bull’s favor. 

Combined

Usually, we keep a mental ledger of what issues are helping or hurting assets. Stocks sometimes share a few concerns with interest rates and commodities. Today, our lists are combined. All asset classes have the same walls of worry to climb and few ladders to help them over. 

On the positive side of the ledger, we have employment and a healthy consumer, sort of. As humans, we can suffer from recency bias, or the tendency to think things will continue to stay the same. Must be tough for Yankees fans. This Friday’s preliminary report for August employment will likely show gains of around 150,000 net new jobs. A “normal” number but in the context of Congressional-spending fueled growth, it’s a drop of about half from a year ago. 

Consumers are on the same path. Expectations and spending are on a downward path toward historical norms. Dana Peterson, the chief economist at The Conference Board, stated after last week’s Consumer Sentiment report, “Expectations for the next six months tumbled back below the recession threshold of 80, reflecting less confidence about future business conditions, job availability, and incomes.” Yes, inflation caused consumers to pull in their horns, but stimulus money was bound to run out sooner or later. Regardless of your viewpoint, the economy is sequentially slowing. Our concern is whether the slowdown will drag into a multiple quarter recession. 

Pumpkin spice

After August and September drawdowns, we are ready for some positive returns. When the S&P 500 rises by 10% or more through September, the fourth quarter usually finishes in positive territory. 

The trusty Stock Trader’s Almanac tells us that good stock market returns in October have helped end 13 Bear markets since World War II. Since we are not in a Bear, just a “disliked Bull,” that is good news. Pre-election year October performance history for stocks is skewed lower by 1987. Regardless, October is the second-best month for the Dow Industrials and fourth best for the S&P 500. 

Knowing a positive year is in the cards would spice up investor moods going into earnings season that starts, gulp, on Friday the 13th. Stock performance does follow a seasonal pattern and, historically, this is the best quarter of the year, and the second best in the presidential cycle. However, we are reluctant to increase allocations to risk assets at this point. 

The August low of 4,335 would be a chart point that would get our attention. Closing the chart window at 4,400 would be even better. Those few fourth quarters after a 10% rally where returns languished or fell happened when the Fed was tightening financial conditions and/or raising rates. 

Signs 

What are the signs on the negative side of the ledger? First and foremost are central bank rate increases. The emotional reaction of an economist (we think) is that the Fed cannot just take short-term rates from zero to 5.25% and not break something in the economy. After all, we have plenty of history where the Fed has done just that. Our rational side tells us that patience is needed to see the full effects of this rate cycle. We think the Fed is close to pausing for the election cycle. Data over the next several months should tell us if there is one more increase in December or January. 

Higher short-term rates pushed the yield curve to invert in the middle of last year. The average time to recession from the start of an inversion is around 300 days. We would point out that four of the last nine recessions started two or more years after the curve inverted. The Leading Economic Index, which counts the yield curve as one of its components, has sat in negative territory for 17 months. 

Speaking of longer-term interest rates, they are now their highest in 20 years. The new 40-year cycle of higher interest rates started in late 2020. Mortgage rates approaching 7.75% are crimping home sales. We have yet to find a Wall Street economist forecasting 5% 10-year Treasuries, but our charts suggest 5.15%, last seen in 2006-07, is the next major resistance area. Few people in our business remember a 5-handle 10-year yield as normal. If our economy trundles along at 2% real growth and 4% unemployment, they might want to adjust their thinking. 

Supply and demand puts many a freshman to sleep in economics class. But the beginner Says Law graphs do get the dynamics right. Having fewer buyers  —think central banks and foreign governments—pressures bond prices lower. Congress avoiding shutdown by agreeing to continue spending means the supply of bonds will rise later this year. We expect interest rates will slow down their rise for a few weeks thanks to how the Treasury issues debt. But fear (not “fear not”) there will be more supply on the horizon. 

Next, how about inflation listed by months? From the April 6 low of 3.31%, the 10-year Treasury is now 1.25% higher. That is an average of 0.2% per month. Crude oil is 30% higher over the quarter and the U.S. dollar has climbed 5% over the last two months. Please note that when all three of these assets rise at the same time, the economy slows meaningfully over the next year.

Strikes and work stoppages may not impact inflation in the next few months, but over the life of a union contract the wage increases do pressure inflation higher.