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

As of market close August 12, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Not yet

The S&P 500 put up an impressive 3.3% run last week, its sixth in the last eight weeks. The summer is moving quickly (thankfully), and we are now two months on from the 3,666 low. Long-time Wall Street economist Ed Yardeni pointed out the eerie coincidence of the 2008-09 Financial Crisis low: 666, now 3,666. Below we look at recent action to see if 3,666 could be this cycle’s low. 

Only China’s market was down for the week. Every developed market rose at least 1% except the poor Swiss. Over the last month the story is the same. In line with our indicators, the U.S. has led the performance parade. The countertrend rally has certainly calmed some traders, but as we mentioned last week, the first-half drop and rebound are typical Bear cycle occurrences. 

Longer term interest rates are nearly one-half of a percent lower than their mid-June peak. Short rates are following the Fed’s orders and holding near their recent highs. The two-year Treasury touched 3.25% late last week, a sign that traders expect more rate increases from the Fed. 

Plan B 

We are rarely fans of the consensus view. Our philosophy, born of hard knocks, humility and research, is to take what the market is giving us and make sure we are correctly positioned for the intermediate and long-term trends. Our indicators and research point to another leg down in the short term for stocks as softer economic data rolls in from here and abroad. Past the fall, we still believe there will be a mild recession into the spring, followed by accelerating earnings and a rebound. That is short-term caution, and we find more commentators and media coming to our view. 

We fear that means the market “herd” is coming around to our view. When you are part of the herd you become average or get average returns. In the herd, several things can happen: 1) a stampede and you get run over, 2) grumbling at the gates of the slaughterhouse, or 3) crowding into narrow trades that suddenly turn sour. There is no doubt that the economy ran slower through the middle of the year. Recent statements from Fed members affirm that the Fed will continue raising rates until inflation squeals. A Fed Funds overnight rate of 4% is just three one-half percent increases away and we have three meetings left this year. 

Herd path?

It is very possible that a 4% overnight rate combined with a smaller Fed balance sheet could have the economic effect of a 4.5% to 5% interest rate. If food and rent prices roll over in the first quarter of next year, then we could see a path for inflation to moderate to 6% levels in January. By May they could touch 4% and monetary policy would be roughly neutral (Fed Funds – inflation = 0). What would that mean for company earnings and thus stock prices? Third and fourth quarter of this year would see inventory reduction sales and losses taken on inventories in some industries. Walmart reports this coming Wednesday and analysts expect inventory levels to be a top concern. 

In 2023 earnings could rebound thanks to less fear of rate changes and recovery from a mild slowdown. We assigned a high probability to that outcome, but now that the herd is at our slowdown corral, we wonder about Plan B, or some lesser probable outcome. 

What if

The market gave a rally, and nobody came? Commodity trading firms appear to be light on stocks and should be buying. It is summer and most of the tape action last week seemed to be short covering. Most indices are racing up toward their 200-day moving average. Trend and breadth indicators have moved quickly toward overbought ranges. Next week is options expiration Friday. There is plenty of dealer hedging yet to go. So, for the first time in months, there may be positive demand for stocks. 

Credit spreads and growth stocks have had a very good run since mid-June. U.S. corporate bonds, as measured by the ICE BofA Corporate Master, have risen over 3.5%. High Yield is up over 6%. These are bellwethers that usually show stress before economic data turns down. Well, it is true that both hit the skids very quickly earlier this year, -15% and -13% respectively, from the start of the year through June 16. Are rates markets telling us, yes, higher rates ahead but companies can handle it? Possibly. 

Positive job growth and easing of pump prices have consumers feeling slightly better than they did in May. Manufacturing surveys have come off their highs but remain in expansion territory. We had assigned a reasonable probability to the economy sliding down so far that the Fed would have to pause. A better Plan B would have the Fed pause in the spring because the economy is already beginning to recover and find its way around inflation.