The Manley Macro Memo
Is the Financial Bear Market in Stocks and Bonds Almost Over?
Executive Summary
After a difficult Q1, the selloff in the financial markets accelerated in April because of the extended war in Ukraine, the supply chain issues related to the lockdowns in China, and the Fed's "promise" to raise interest rates quickly to curb inflation. Additionally, stocks suffered in April as disappointing earnings from Netflix and Amazon indicated that surging inflation could be hurting consumers.
In April, the economic news was dour. Inflation remained elevated at 8.3%, but Q1 GDP fell by 1.4%, surprising economists that forecasted a 1% gain. Monetary policy remains loose, yet growth is already slowing. It is not surprising that surging inflation, higher interest rates, and a significant drop in fiscal spending led to a period of Stagflation (elevated inflation and declining economic growth).
Stocks are in a severe bear market, and the bond market is on pace to have its worst year in history. Investors have lost trillions of dollars due to the sharp declines in stocks, bonds, and crypto, yet the Fed's monetary policy remains stimulative. Fed funds are set to only 1%, which is 7.3% less than inflation, and the Fed will not start selling bonds to reduce its bloated balance sheet until next month. As the Fed tightens financial conditions this summer, we expect the credit cycle will turn down, economic growth will slow, and stocks will have another bear market leg lower.
The S&P 500 has declined by 20% peak-to-trough because rising long-term interest rates drove stock valuations from overvalued to an average value. Despite inflation at a 40-year high, geopolitical uncertainty, and a Fed significantly behind the inflation-fighting curve, Wall Street expects 10% earnings growth for the S&P 500 this year. We believe earnings expectations are unrealistic, especially since profit margins are at a record high and poised to regress to the mean. This week Walmart and Target missed earnings estimates because rising costs hurt their profit margins, and both stocks had their largest single-day decline since 1987. If Walmart – the best operator in the consumer space – couldn't maintain its margins, it is unlikely that the average operators will be successful.
Our portfolio has 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 limited credit risk. Further, since market volatility is significantly elevated, our equity exposure is reduced relative to our benchmark. In this high-risk period, we will continue to focus on preserving capital and managing risk until there is more certainty and the market offers a better risk-reward.
April Review:
After a difficult Q1, the selloff in the financial markets accelerated in April because of the extended war in Ukraine, the supply chain issues related to the lockdowns in China, and the Fed's "promise" to raise interest rates quickly to curb inflation. Additionally, stocks suffered in April as disappointing earnings from Netflix and Amazon indicated that surging inflation could be hurting consumers.
The S&P 500 declined by 8.8% in April, while the small-cap Russell 2000 fell 9.9%. The NASDAQ Composite plunged by 13.3% in April, its worst month since October 2008. The foreign markets also faltered -- the MSCI EAFE index of international stocks and the MSCI Emerging market index declined by 6.7% and 6.1%, respectively.
Higher interest rates helped the value sector of the market to outperform the growth sector by 6.5% in April (the Russell 1000 Value index declined by 5.7%, while the Russell 1000 Growth sank by 12.2%). We expect this trend will continue until inflation and interest rates peak.
The bond market had its worst month since December 2009 because the Fed indicated it would likely increase interest rates by 0.50% increments at its May, June, and July meetings. Based on the Fed's guidance, the market expects short-term interest to be 3.0% by next February (eight weeks ago, the Fed had short-term interest rates set at 0.25%).
The U.S. 10-year bond yield increased by 0.56% to 2.88%, while the 2-year U.S. Treasury note jumped by 0.42% to yield 2.70%. The yield curve (the spread between the 2-year to 10-year) rose by 0.15% to only 0.19%. During the "risk-off" environment, the "safe havens" performed poorly -- U.S. long-bond fell by 9.4%, while gold declined by 2.1%.
This year, the S&P 500 and the U.S. Aggregate bond market have declined by more than 10%. According to the Wall Street Journal, this is the largest simultaneous drop since 1976, and the only other time both indexes declined was in 1994, when the S&P 500 fell 1.5%, and bonds dropped by 2.9%.
This year has been challenging for investors with balanced portfolios like the Traditional Blend (60% stock, 40% bond). Stocks and bonds are usually negatively correlated, so bonds rise and act as a ballast for balanced portfolios when stocks fall. Unfortunately, inflation has temporarily caused stocks and bonds to decline together. Only commodities and gold have provided a positive return this year.
Sector Review:
Surging interest rates and fear of shortages due to the Ukraine war and the lockdowns in China led to a very broad selloff in April. Consumer Staples were the only sector of the S&P that had a positive return. The most significant declines were in the sectors with high valuations and the most exposure to the overvalued mega-cap stocks: Communications (14.1%), Consumer Discretionary (11.9%), and Technology (10.9%).
Market Discussion:
The Federal Reserve and U.S. Government unleashed unprecedented monetary and fiscal stimulus to stabilize the economy during the pandemic. Unfortunately, these policies, coupled with supply chain issues and a reduction in energy production due to underinvestment because of ESG concerns, created financial asset bubbles and drove inflation to a 40-year high.
Last year the Fed claimed that inflation was "transitory," the bond market agreed, and interest rates hardly rose. On December 1st, inflation was 7.1%, yet the 2-year U.S. Treasury note yielded only 0.56%, and the S&P 500 sold at a P/E of 21.5 times 12-month forward earnings.
The Fed's analysis was wrong, and inflation was not transitory. It was primarily driven by their profligate policy of negative real interest rates (short-term interest rates set less than inflation) and their QE program that printed $120 billion each month to buy Treasury and mortgage bonds.
This year inflation continued to accelerate, and it was clear that the Fed would need to act aggressively because it had not even begun tightening monetary policy. Bond investors panicked, and interest rates had one of their sharpest increases in history. The 2-year U.S. Treasury bond increased from 0.73% to 2.74% in four months.
The 2-year U.S. Treasury bond increased by 2.0% in four months as investors realized the Fed was behind the curve fighting inflation.
The bond market is on pace to have its worst year on record, and the sharp increase in interest rates has led to a broad-based bear market for stocks.
Year to date market performance through May 18th:
Interest rates and earnings are the main drivers of stock prices. Since companies are worth the present value of their future cash flows when interest rates rise, the company's value declines. This year's sharp increase in interest rates created a bear market by driving stock valuations from overvalued to fairly valued. As the table above shows, the most significant year-to-date declines occurred in the market sectors with the highest valuations.
Over the past 20-years, the S&P 500 was valued at 15.5 times 12-month forward earnings. After the March 2020 pandemic market low, the Fed set short-term interest rates at 0% and printed nearly $5 trillion to buy financial assets. The Fed's profligate monetary policy drove stocks to a record valuation level. Despite inflation near 8% in January, the S&P 500 was valued at 21.5 times 12-month forward earnings (a 38% premium to the 20-year average P/E). As the Fed turned hawkish and interest rates sharply rose, the S&P 500's valuation fell to 16.6 times 12-month forward earnings.
Over the past 20-years, inflation averaged 2.1%, the 10-year U.S. Treasury bond yielded 2.94%, and the S&P 500 was valued at 15.5 times 12-month forward earnings. Today, inflation is 8.3%, the 10-year U.S. Treasury bond yields 2.88%, and stocks sell at 16.6 times forward earnings. Despite the bear market in stocks and bonds, valuations still appear rich considering the economic uncertainty and geopolitical risk.
The Fed's monetary mistakes led to financial asset bubbles and inflation at a forty-year high. The Fed's preliminary actions to fight inflation are deflating the asset bubbles they created. Despite a severe bear market and economic uncertainty, stocks are not yet undervalued.
The sharp rise in interest rates led to a contraction in market valuation (overvalued to fairly valued), which drove the first leg of the bear market. To fight inflation, the Fed has indicated that it will aggressively raise interest rates to a neutral level of around 3% by early next year. The Fed is raising interest rates and tightening financial conditions to slow economic growth and reduce inflation.
While the Fed is hopeful that its actions to reduce inflation will not lead to a recession, history shows that a "soft-landing" is unlikely since most Fed tightening cycles led to recession. Its most successful "soft landing" occurred during the 1994 tightening cycle.
In February 1994, the inflation was 2.5%, and the Fed raised short-term interest rates by 0.25% to 3.25%. By February 1995, the Fed had increased short-term interest rates to 6.0%, and inflation peaked at 3.1% before heading lower. The Fed tamed inflation and avoided a recession because they acted preemptively (before inflation was out of control), and they increased real rates from 0.50% to nearly 3.0%.
The current relationship between short-term interest rates and inflation is nearly the mirror opposite of 1994. When the Fed first hiked interest rates to 0.50% on March 16th, inflation was 7.9%, and real rates were negative 7.4%. We believe a "soft-landing" is unlikely because the Fed failed to act preemptively, and inflation surged to a level that historically led to recession.
Inflation has been above 5 percent for nearly a year. Historically, only a recession tames inflation once it reaches this level.
The Fed will raise interest rates and sell bonds to shrink its bloated balance sheet to fight inflation. These actions, by design, will slow economic growth and, as history shows, probably lead to a recession. Despite the Fed's explicit statement that it will attempt to slow the economy, Wall Street analysts are forecasting robust earnings growth of 10.1% this year. Although interest rates have risen, and labor, transportation, and commodity costs have surged, analysts have not reduced their earnings expectations for 2022.
We believe that inflation, higher interest rates, and plunging consumer confidence will adversely impact the economy and corporate profits. Also, the trillions of dollars lost in the stock, bond, and crypto markets over the past six months are creating a negative wealth effect on the economy that is difficult to measure.
We believe the next leg in the bear market will be driven by analysts reducing their earning expectations and stocks discounting a profit recession. This week, analysts were shocked to learn that Wal-Mart and Target reported disappointing earnings due to inflation's negative impact on their profit margins. Both stocks had their most significant single-day drops since the 1987 crash. What will happen to average operators if Wal Mart's profitability (the best operator in the consumer space) was adversely impacted by inflation?
Despite surging costs and higher interest rates, Wall Street expects 10.1% profit growth this year. We believe the analysts are wrong and profits will significantly disappoint.
During the first leg of the bear market, the S&P 500 fell 20% due to valuation compression. We believe that declining earnings expectations will drive the next leg of the bear market as the credit cycle turns down and the economy heads toward recession.
We estimate that the second leg of the bear market will drive the S&P 500 to 3200 by this fall, which is a 34% peak-to-trough decline and in line with the average bear market since WWII. Additionally, at 3200, the S&P 500 would sell at about 16 times peak GAAP earnings and retrace 61.8% of the bull market from the Pandemic low.
As the Fed tightens financial conditions and the credit cycle turns down, we expect the S&P 500 to fall to 3200. 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%.
Summary:
Stocks are in a bear market because inflation and the sharp increase in interest rates caused valuation levels to fall from overvalued to fairly valued. Currently, inflation is 8.3%, and the Fed has indicated that they will raise interest rates and tighten financial conditions to slow growth and reduce inflation. Although most Fed tightening cycles led to a recession, Wall Street is forecasting robust 10.1% earnings growth. Recent earnings reports from Amazon, Walmart, Target, and Cisco indicate that 10% growth is unlikely.
Higher interest rates and declining valuations drove the first leg of the bear market. The second leg of the bear market will be driven by declining earnings expectations caused by a declining credit cycle and a slowing economy. 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, 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.
Last year, the Fed failed to remove its emergency monetary measures (used to stabilize the economy during the pandemic) because it believed inflation was "transitory." We thought their monetary mistake would lead to accelerating economic growth and an inflationary surge, so we eliminated interest-sensitive securities and added value and energy stocks, commodities, gold, and TIPs (U.S. Treasury Inflation-Protected Securities) to perform well in a reflationary period (accelerating growth and inflation).
We believe the economic growth rate has peaked (Q1 GDP was negative) due to the inflation burden, higher interest rates, and low consumer confidence, yet the Fed is embarking on its most aggressive tightening cycle in 40 years. History shows that most Fed tightening cycles led to recession, especially when the Fed waited for inflation to surge before acting.
Our portfolio is positioned for a stagflationary economic environment (slowing growth and elevated inflation). To perform well in this economic environment, we have invested in the market's defensive (not economically sensitive) sectors – utilities, consumer staples, and healthcare. Also, we added initial positions in the U.S. Treasury bonds that should act as a safe haven in a period of slowing economic growth. Our investments in energy stocks, commodities, gold, and TIPS should continue to perform well with elevated inflation.
In this high-risk environment, we will continue to focus on preserving capital until inflation subsides and the market offers a better risk-reward. To manage risk, we build a diversified and economically balanced portfolio to perform well in all economic environments (growth, inflation, recession). Next, we determine which economic environment we are in, and we tilt the portfolio to investments that perform best in that environment.
Finally, we employ a volatility target equal to our benchmark's historic level of volatility. When volatility (risk) rises, the portfolio's risk exposure is automatically reduced. Our benchmark has a 60% allocation to stock, and historically it has 0.58% of daily equity risk. Since market volatility is extremely elevated (60/40 blend currently has daily equity volatility of 1.32%), our equity exposure is reduced to 29.5% to maintain our desired daily risk exposure.
In sum, stocks are in a bear market, and volatility remains elevated. We remain focused on preserving capital in this risky and uncertain environment and remain underweight equities 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.
Our portfolio's risk level (annualized volatility) is 15.6%, which is less than our 60/40 benchmark.
Current Risk-Weighted Model Portfolio:
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.