Dear Clients and Friends,
Our communications to you often occur in connection with periods of downward market volatility as we seek to provide perspective on such events. In a pleasant change, we think the recent sharp market rebound also merits some commentary which we offer below.
In June, the inflation spike to 9.1% for the CPI coupled with some weakening economic data heightened fears that the economy would become a casualty in the Fed’s battle against inflation, with a recession in the offing. The S&P hit a 2022 low of 3637 on June 17. Since then, equities have staged a strong rally with the S&P advancing 17% and the NASDAQ rising 23% from their respective June intra-day lows. Bond prices have also recovered with the 10-year treasury yield declining to 2.85% from its June peak of 3.48%.
In our view, the three key factors underlying this rally have been as follows:
- In June, investor sentiment and institutional equity exposures were both at extreme lows providing an excellent set-up for a rebound.
- Gasoline prices peaked in June and began falling along with prices for many commodities and at least some goods and services. This created an expectation that July inflation data would show a decline, an expectation that was fulfilled with the release of those data on August 10.
- The Q2 earnings report season which began in mid-July exceeded expectations both as to Q2 earnings and forward guidance. S&P 500 earnings grew 9.2% year-over year. The ratio of companies issuing negative forward guidance compared to those issuing positive guidance was 1.1, an improvement from a 1.8 ratio in the prior quarter.
As to where we go from here, there have been 19 instances since WWII in which markets dropped 15% or more and then regained over 50% of the decline as we have now done. In only one of these instances did the market go on to make a new low. In 40% of cases the market was already in a new bull market.
Another optimistic signal comes from the pattern of insider buying and selling. The Sentiment Trader tracks the ratio of insider buying/selling which recently hit the fourth highest level in the last decade. Past periods marked by the current level have proved to be good buying opportunities.
However, sanguine indicators such as the foregoing need to be weighed against the recognition that market direction will most likely be shaped by how hard and how long the Fed will need to push its fight against inflation. Economic data tends to be “noisy,” and July’s one month dip does not a trend make. The Atlanta Fed maintains an index of “sticky” price components of inflation that are less variable than other more changeable components. This index rose to a new high in July.
Moreover, housing – which accounts for over a third of the CPI – presents a significant challenge for the Fed. “Owner-equivalent rent” (the CPI’s measure of housing costs), lags home prices by 12-18 months. This measure also hit a new high in July. Even if home prices stop rising, we will likely still have at least a year of increases in the CPI’s housing component.
As to recession risks, the relevant data are unusually divergent. While multiple data can be found to support the recession scenario, other data can be marshalled to support the view that the “soft landing” the Fed hopes for remains plausible. We remain on the fence as to prospects for recession, but share the view that any recession is likely to be of a more mild variety.
In viewing the recent market activity, we are reminded of the old saw that “things are never as bad as they seem nor as good as they appear.” We think the former applies to June and its lows, and we are optimistic that month will prove to be the bottom of the market decline.
However, we suspect that the “nor as good as they appear” part could prove applicable to the current market and the more than 15%-20% over the last six weeks. Near-term we plan to hold a little more cash than usual, but we see no reason for change to our constructive longer-term outlook or our portfolio strategies. Trades you may see in your accounts will mainly reflect some adjustments to our fixed income and international holdings and some tax-loss selling which we plan to undertake over the next few months.
As always, please do not hesitate to reach out to discuss how the view above effect your personal portfolio or financial plan.
Kevin O’Grady and Kevin Barlow
1BCA Research, “Concluding 2022 Q2 Earnings Season,” August 10, 2022
2John Authers, “Curb Your enthusiasm on the Good Inflation News,” August 10, 2022
3John Authers, “Markets Get Cold Feet Even as More Good News Rolls In,”
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