The Manley Macro Memo
Don't Fight the FED!
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EXECUTIVE SUMMARY
After a sharp summer rally, the bear market resumed in mid-August. Stocks declined as inflation remained elevated, and Federal Reserve Chair Powell stated, "While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses." The Fed's hawkish message indicated that the dovish policy pivot Wall Street expected next year was unlikely.
In our view, the first leg of the bear market, which was driven by declining valuations, ended on June 16th, when stocks were extremely oversold, and investors were fearful. Then, non-fundamental factors and the false "Fed Pivot" narrative fueled a sharp eight-week bear market rally that ended on August 16th. Currently, stocks are in the second leg of the bear market, driven by a weakening economy and declining corporate profits.
Despite inflation at a 40-year high and the Fed aggressively hiking interest rates to slow the economy, Wall Street expects corporate profits to grow by 14.4% next year. While Wall Street is bullish about 2023, market-based indicators show that a recession is likely next year. Since corporate profits have a median decline of 17% during recessions, we believe that stocks are vulnerable as earnings estimates are revised lower.
Stocks remain overvalued, earnings expectations appear unrealistic, and the Fed sharply raised interest rates from 0% to 3.25% in six months to slow the economy. In this high-risk environment, we remain underweight equities relative to our benchmark, and we are invested in defensive sectors of the market (utilities, staples, healthcare, and value) and long the safe havens (gold and long-term U.S. Treasury bonds). We continue to believe the S&P 500 will fall by another 14% to 3200 and bottom near the mid-term election, as the corporate earnings disappoint and the economy heads toward recession. In this high-risk period, we will continue to focus on preserving capital and managing risk until market volatility declines, the economy stabilizes, and the stocks offer a better risk reward.
Market Review:
After a strong summer rally, the bear market resumed in mid-August. The S&P 500 declined by 24.5% between January and mid-June as rising interest rates drove stock market valuations lower. Over the following eight weeks, the oversold market rallied by 18.9% because of short-covering, passive inflows, gamma trades, and buying by quantitative trend and volatility strategies. As the markets rallied due to these non-fundamental factors, investors crafted a narrative that inflation had peaked, and the Fed was poised to pivot to an easing cycle by the middle of next year.
Unfortunately, Fed Chair Powell refuted this narrative during his August 26th speech at the Jackson Hole Economic Symposium. Powell said the Fed would accept a recession as the price of fighting inflation. He also highlighted that the Fed pivoted too soon in the 1970s, and that accelerated and extended the inflation problem in the early 1980s. Powell bluntly stated, "While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain." Stocks resumed their bear market on the belief that there was no Fed pivot on the horizon and that a recession may be necessary to tame inflation.
In August, the S&P 500 fell by 4.2%, while the small-cap Russell 2000 and the NASDAQ Composite dropped by 5.2% and 2.0%, respectively. The foreign markets also performed poorly -- the MSCI EAFE index of international stocks declined by 6.1%, while the MSCI Emerging market index dropped by 1.3%.
The value sector of the market outperformed the growth sector by 1.7% in August (the Russell 1000 Value index declined by 3.0%, while the Russell 1000 Growth fell by 4.7%). Year-to-date, the value sector outperformed the growth sector by 12.6.0% (the Russell 1000 Value index dropped by 9.95%, while the Russell 1000 Growth fell by 22.6%). We expect value stocks to continue outperforming growth until the bear market ends.
Despite the "risk-off" environment, the "safe havens" performed poorly – the U.S. long-bond declined by 4.6%, while gold fell by 2.8%. The U.S. 10-year bond yield increased by 0.49% to yield 3.13%, while the 2-year U.S. Treasury note rallied by 0.56% to yield 3.45%. The yield curve (the spread between the 2-year to 10-year) rose by 0.07% to negative 0.32%. A negative yield curve – short-term rates yield more than long-term rates – is a reliable indicator of economic weakness. Recessions typically occur within twelve months of an inverted yield curve.
In our view, the first leg of the bear market ended on June 16th because stocks were extremely oversold, and investors were fearful. Then, non-fundamental factors and a false narrative fueled a sharp eight-week bear market rally that ended on August 16th. Currently, stocks are in the second leg of the bear market, driven by a weakening economy and declining corporate profits. The decline accelerated in September as core inflation surprisingly increased, and the Fed raised interest rates by 0.75% to yield 3.25% and indicated that short-term rates would reach 4.4% by the end of this year. The S&P 500 is near its June low, and we expect that low to be breached in early October. We continue to believe the S&P 500 will decline by another 14% to 3200 and bottom near the mid-term election.
Financial Market Review
Our Model Portfolio:
The benchmark for our model portfolio is the Traditional Blend — 60% equity and 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, to manage risk, we volatility-weight our positions and set a volatility target equal to our benchmark's historic risk level. When volatility increases, our asset allocation dynamically reduces our equity risk exposure.
Our model portfolio performed well relative to our 60/40 benchmark because of our defensive investment posture, which was underweight stocks and invested in the market's defensive sectors (healthcare, consumer staples, utilities) and the safe havens (gold and U.S. Treasury bonds). We are disappointed that the safe havens (gold and U.S. long-term treasury bonds) have performed poorly instead of protecting our portfolio during the market decline. Additionally, our inflation hedges (energy stocks and the Goldman Sachs Commodity Index) have recently hurt the portfolio, as slowing global growth has led to sharp declines in the commodity markets. Currently, the market is very oversold, and we expect a rally into the end of the third quarter. As the market rallies, we expect to reduce our risk exposure to focus on preserving capital during the next leg of the bear market.
In sum, stocks are near their June lows, and we have very performed well on a relative basis, but the poor performance of the safe havens has driven our absolute performance near our threshold. Although we still expect the safe havens to perform well when investors shift their focus from high inflation to a pending recession, we believe it's prudent to further reduce our risk exposure during the next market rally. While we expect the next six weeks will be volatile, we believe there will be an excellent intermediate-term buying opportunity near the mid-term election.
Current Risk-Weighted Model Portfolio:
Our portfolio's risk level (annualized volatility) is 13.2%, which is significantly less than our benchmark's risk level of 24.2%.
Market Discussion:
Currently, inflation is at a 40-year high, stocks and bonds are in a bear market, and existing home sales have declined for six consecutive months because mortgage rates have spiked above 6%. These economic problems are the unintended consequences of the Fed and the government's response to the Covid pandemic. The Federal Reserve and the U.S. Government injected unprecedented monetary and fiscal stimulus into the economy to stabilize the economy during the pandemic lockdowns.
When the economy recovered (the Covid recession officially lasted two months and ended in April of 2020), the Fed maintained its emergency measures despite financial asset bubbles and surging inflation. Finally, in March of 2022 -- when inflation reached 8.5%, and economic recovery was nearly two years old -- the Fed raised interest rates to 0.25% and ended its Quantitative Easing Program that "printed" $120 billion each month to buy government bonds.
Because the Fed misdiagnosed the inflation problem as "transitory" and failed to normalize monetary policy, the Fed is now aggressively hiking interest rates and slowing the economy to tame inflation. Unfortunately, the Fed's current hiking cycle will have unintended consequences, just as its easy money policies led to asset bubbles and drove inflation to a 40-year high.
The stock market remains in a bear market that began in January. The first leg of the bear market was due to declining valuations fueled by sharply rising interest rates. Between January and the middle of June, the S&P 500's P/E multiple fell by 25.9% (the P/E fell from 21.9 to 16.9, while earnings estimates increased slightly) as the 2-year U.S. Treasury note jumped from 0.77% to 3.14%. We believe that the second leg of the bear market -- which began on August 16th – will be driven by disappointing earnings and an economy headed toward a recession.
The Fed failed to normalize interest despite a robust economic recovery and rising inflation. Now, to combat inflation, they are taking measures (aggressively raising interest rates and reducing the size of the balance sheet) to slow the economy. Unfortunately, most Fed hiking cycles have led to recession, especially when inflation was above 5%.
On September 21st, the Federal Reserve hiked interest rates by 0.75% for the third consecutive time. At the press conference, Fed Chair Powell said, "No one knows whether this process will lead to a recession or if so, how significant that recession would be. The chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer. Nonetheless, we're committed to getting inflation back down to 2%." Powell is correct, it is impossible to know the impact of deflating asset bubbles and higher interest rates on our leveraged economy. Also, there is significant economic uncertainty because the Fed relies on lagging economic indicators (inflation and employment) to set policy that acts with an approximate twelve-month lag.
Given the Fed's abysmal track record, and the financial excesses created by its profligate monetary policy, we believe the debate should be about how severe the recession will be, not whether or not the Fed will achieve a "soft-landing." While Chair Powell is uncertain if their monetary policy will lead to a recession, market-based indicators suggest that a recession is imminent:
The yield curve's slope is probably the most accurate economic indicator, and every post-WWII recession has been preceded by an inverted yield curve (short-term interest rates yield more than long-term interest rates). A recession is probable in 2023 since yield curve inversions typically precede recessions by 6 to 18 months.
Another accurate indicator of the economy is the Conference Board's Leading Economic Index. The LEI has declined for six consecutive months and is currently forecasting a recession. According to famed economist David Rosenburg, the LEI has a perfect record of forecasting recessions since 1959.
Commodity prices have declined sharply over the last three months. Falling commodity prices indicate a drop in global demand and often presages a recession.
While Chairman Powell is uncertain about the impact of his monetary policy, and market-based indicators show that a recession is probable, Wall Street analysts believe the Fed will orchestrate a soft-landing, and earnings will grow by a robust 14.4% in 2023. We believe the next leg down in the bear market will be driven by disappointing earnings and Wall Street revising its forecast lower. We believe corporate profits will decline next year. In fact, according to Bank of America Securities, the median decline for corporate earnings during a recession is 17%.
While Fed Chair Powell indicated that their monetary policy would cause some economic pain, Wall Street analysts forecast that the S&P 500's operating earnings will grow by 14.4%.
Source: S&P Global
Intermediate-term Outlook
We believe the second leg of the bear market began on August 16th, and disappointing Q3 earnings and lower guidance will fuel the next leg lower. We expect the S&P 500 to decline to 3200 and bottom near the mid-term election. An S&P 500 drop to 3200 would be a 33.6% bear market decline, which historically is approximately the median bear market. Additionally, a slide to 3200 would retrace 62% of the post-pandemic bull market, and the S&P 500 would sell at 15.6 trailing earnings, which is an average valuation level. We hope the market will be oversold and poised for a year-end rally as we approach the mid-term election. Historically, post-mid-term election rallies have had robust median returns greater than 7%.
In the short-term, markets are driven by emotions (fear and greed), and non-fundamental flows can accelerate these trends – i.e., passive investments (monthly 401k contributions, target date funds, and corporate buybacks), and quantitative funds (trend following, volatility targeting, risk parity, and delta hedging option exposure). We believe that these non-fundamental flows have changed the market's structure and made it more suspectable to sharp rallies and declines, which are ultimately noise and not discounting a change in the fundamentals. Currently, the market is very oversold, and investors are fearful – these conditions typically lead to sharp countertrend rallies. We plan to utilize any market strength to reduce our risk exposure further.
As the Fed tightens financial conditions and the credit cycle turns down, we expect the S&P 500 to fall to 3200 this fall. A decline to 3200 would retrace 61.8% of the previous bull market and be in line with the average bear market decline of 34%. At this level, the S&P would sell at a reasonable 15.6 times peak earnings.
IN SUM:
We believe we are in the second leg of the bear market that will be fueled by disappointing earnings and an economy headed toward a recession. We estimate the S&P 500 will fall to 3200, which is in line with the average bear market decline of 34%. Also, the S&P 500 would sell at a reasonable 15.6 times peak EPS.
In this recessionary environment (declining growth and inflation), we believe the market's defensive sectors (healthcare, staples, utilities, and value) will outperform. Also, as investors shift their focus from inflationary to recessionary fears, we expect long-term treasury bonds and gold to help hedge the portfolio's equity exposure.
In this high-risk environment, we remain focused on preserving capital until market volatility wanes, the economy stabilizes, and stocks offer favorable risk-reward.
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Disclaimer: The material in this newsletter is for educational purposes only and should not be considered 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.