The Manley Macro Memo
Stocks are overvalued and vulnerable to significant decline as monetary conditions tighten and the bear market accelerates.
Financial markets declined sharply during the first quarter of 2022 because of soaring inflation, the Fed's hawkish pivot, and Russia's invasion of Ukraine. While stocks had their first quarterly loss since the pandemic bear market, the Bloomberg U.S. Treasury Index fell by 5.6%, which was the worst quarter on record (during the first quarter of 1980, the index fell 5.5%). We believe that stocks and bonds offer a poor risk-reward and are in a bear market.
The economy remained strong in March. The unemployment rate dropped to 3.6%, which was nearly the lowest level since the 1970s. Unfortunately, inflation grew at 8.5%, which was the largest increase since 1981. We believe that inflation, higher interest rates, and a significant drop in fiscal spending will reduce economic growth and increase the probability of a recession. Historically, when inflation reaches 5%, the economy is already in recession.
In March, the Fed ended its bond-buying program and increased short-term interest rates to 0.50%. The Fed indicated that they were prepared to take aggressive actions to reduce inflation, and they would "sell" $95 billion of their Treasury and mortgage bond holdings each month. Additionally, Fed Chair Powell suggested that "there's something in the idea of front-end loading" the interest rate hikes to get inflation back to 2%. Last year, the Fed failed to remove its emergency measures despite a strong economy and surging inflation. Now, the Fed is planning to aggressively tighten policy into an economic slowdown. Nearly all Fed tightening cycles led to recession; unfortunately, it appears that we are headed in that direction.
Over the past few months, we transitioned our portfolio from a reflationary bias (one that benefits from strong growth and rising inflation) to a stagflationary bias, which benefits from slowing growth and elevated inflation. We see a significant opportunity to invest in the value and defensive sectors of the market while avoiding the mega-cap tech stocks that dominate the S&P 500. Additionally, we are overweight gold and commodities, and our fixed income allocation has a limited duration or credit risk
While most stocks are down more than 20% and in a bear market, the S&P 500 has only declined by 14.6% from peak to trough. In our view, the S&P has benefitted from market structure issues (corporate buybacks, 401k contribution, and the proliferation of ETFs), not favorable fundamentals. The S&P 500 is significantly overvalued and vulnerable as monetary conditions tighten and the bear market accelerates. In this high-risk period, we will continue to focus on preserving capital and managing risk until the market offers a better risk reward.
First Quarter Review:
Financial markets declined sharply during the first quarter of 2022 because of soaring inflation, the Fed's hawkish pivot, and Russia's invasion of Ukraine. While stocks had their first quarterly loss since the Q1 2020 pandemic bear market, the Bloomberg U.S. Treasury Index fell by 5.6%, which was the worst quarter on record (during the first quarter of 1980, the index fell 5.5%).
The S&P 500 declined by 4.95% for the first quarter, while the small-cap Russell 2000 and Nasdaq 100 fell 7.5% and 8.8%, respectively. The foreign markets also performed poorly -- the MSCI EAFE index of international stocks and the MSCI Emerging market index declined by 6.5% and 7.6%, respectively.
During the "risk-off" environment, the "safe havens" were mixed in Q1 -- U.S. long-bond fell by 10.6%, while gold jumped by 5.7%. The U.S. 10-year bond yield increased by 0.81% to 2.32%, while the 2-year U.S. Treasury note jumped by 1.6% to yield 2.28%. This yield curve collapse (the spread between the 2-year to 10-year fell by 0.78% to only 0.04%) indicates an economic slowdown or recession is on the horizon. Finally, oil rallied by 33% in the first quarter due to the strong economic growth and the threat of energy sanctions on Russia, which produces more than 10% of the world's oil.
Higher interest rates and surging inflation helped the value sector of the market to outperform the growth sector by 8.3% in Q1 (the Russell 1000 Value index declined by 0.7%, while the Russell 1000 Growth sank by 9.0%). We expect this trend will continue until inflation and interest rates peak.
After a sharp decline to begin 2022, the market rallied in March despite surging inflation and the war escalation in Ukraine. This rally was not unexpected. We believe the oversold market benefitted from temporary market flow issues – options expiration, quarterly rebalancing, and passive investment flows (401k contributions and corporate buybacks).
In March, all of the S&P 500's sectors were positive except the financials. The leading sectors were a mix of defensive (Utilities, REITs, and Healthcare) and inflation/commodity-related (Energy and Materials).
March Market Performance:
In our view, inflation's surge to its highest level in forty years and the Fed's hawkish pivot caused an equity bear market and has elevated the risk of recession. While most stocks and major indexes have declined by more than 20%, the S&P 500 had a peak-to-trough decline of only 14.6%.
We believe the S&P 500 is detached from the fundamentals because it benefits from the excess liquidity created by the Fed, the dominance of ETFs, and passive inflows (corporate buybacks and monthly 401k contributions). Currently, the S&P 500 offers a very poor risk-reward and is vulnerable to a sharp decline as the Fed begins to aggressively remove liquidity starting in May.
To stabilize the economy during the pandemic, the Federal Reserve cut interest rates to 0% and printed more than $4.8 trillion (equal to 20% of GDP) to buy U.S. Treasury and mortgage bonds. Despite a strong economy, labor shortages, and inflation significantly above their 2% target, the Fed continued its profligate monetary policy because they estimated that inflation was "transitory." The Fed was wrong, and its failure to remove its emergency measures led to financial asset bubbles and drove inflation to the highest level in forty years.
This year, the Fed finally realized it was behind the inflation-fighting curve, so it ended its bond-buying program and raised interest rates to 0.50% in March. Also, the Fed stated they were prepared to take more aggressive steps to fight inflation. As discussed last month, when tightening monetary policy, the Fed maintains a nearly perfect record -- the last ten tightening cycles led to nine recessions.
Most Fed tightening cycles led to recession.
While history shows that most Fed tightening cycles led to recession, it is interesting to note that since 1960, the economy was already in recession once inflation reached 5% -- inflation surged to 8.5% in March.
Since 1960, the economy has been in recession whenever inflation was 5% or more.
Most stocks have declined more than 20% and are in a bear market. The magnitude of a bear market decline usually depends on whether the economy enters a recession. If a recession doesn't occur, the typical decline is less than 20%, while the average bear market decline during a recession is around 35%.
While no one can consistently forecast the economy or predict recessions, we believe that history shows that recessionary risks are elevated. Despite the elevated risk of recession, the S&P 500 and investment-grade corporate bond market remain priced as if we were in a "goldilocks" economic environment (strong growth and mild inflation).
Currently, the S&P 500 sells at 21.8 times its 12-month trailing earnings, which is 36% greater than its long-term average P/E of 16. Also, Baa investment-grade bonds continue to sell at a premium valuation. Historically, Baa bonds yield 2.3% more than 10-year U.S. Treasury bonds, while today, the Baa credit spread is only 1.9%
Despite the worst inflation in 40-years, stocks valuations are more than 35% above their historical average
Although the bond market had its worst quarter in thirty years, corporate bond spreads are 0.40% below their long-term average and show no sign of risk aversion.
Stocks and bonds remain overvalued despite the significant economic uncertainty due to surging inflation and the hawkish Fed. This overvaluation indicates that investors are complacent, and too much excess liquidity is in the system. As the Fed raises interest rates and sells $95 billion of its bond holdings each month, we think stocks and corporate bonds will decline sharply as their valuations regress to the mean.
The Fed has indicated that it will finally take aggressive steps to fight inflation. Typically, when inflation is greater than 5%, the Fed makes a monetary mistake that leads to a recession and a greater than 35% stock market decline. In our view, stocks and bonds are extremely overvalued because of the Fed's excess liquidity during the pandemic. As the Fed removes liquidity, we believe that financial assets will be vulnerable to a significant bear market. In this high-risk environment, we are focused on preserving capital until there is less uncertainty and the market offers a favorable risk-reward.
Our Model Portfolio:
The benchmark for our model portfolio is the Traditional Blend — 60% equity, 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, we risk-weight our positions to manage volatility.
Last year, we believed that the massive monetary and fiscal stimulus would lead to a reflationary environment (strong growth and rising inflation) where value stocks, commodities, floating loans, and TIPS would prosper. We expect the inflation burden, rising interest rates, and the $1.3 trillion (6% of GDP) reduction in fiscal spending will slow economic growth this year and lead to a stagflationary economic environment (slowing growth and elevated inflation).
To perform well in this economic environment, we eliminated our investment in the financial sector due to the flattening yield curve. Also, we made investments in gold mining stocks, utilities, and consumer staples. Additionally, we expect to opportunistically make investments in the healthcare, and REIT sectors of the S&P 500, which should perform well in a period of slowing economic growth.
In sum, stocks are highly overvalued, inflation is surging, and volatility remains elevated. We are focused on preserving capital in this risky and uncertain environment and remain underweight equities, fixed income duration, and overweight commodities and gold relative to our benchmark. We maintain a large cash balance, which reduces the portfolio's risk level and gives us the buying power to make future investments at better prices.
Current Risk-Weighted Model Portfolio:
Our portfolio's risk level (annualized volatility) is 13.8%, which is less than our 60/40 benchmark.
Disclaimer: The material in this newsletter is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.