Stock market decline (SPY) continues at an accelerated pace after the FOMC, where the main message seems to be that 75 basis point rate hikes are the new status quo until inflation falls materially. Given that the August CPI saw an acceleration in the core monthly CPI, we are a long way from that. And while the Fed is aggressive, we are seeing more signs of damage to the economic and earnings outlook. In today’s commentary, I want to focus on the deteriorating outlook and our current strategy. We then provide an overview of some relevant market topics. Read on below for more information….
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(Enjoy this updated version of my weekly commentary originally published September 23)rd2022 in the Newsletter POWR Shares Under $10).
For the past week, the S&P 500 (SPY) fell by 3.6%. We are now less than 5% above the mid-June lows that once looked like a potential market bottom.
As I shared in the trade warning, I no longer see that “bottom” as a hold and see lower lows. This is mainly because inflation, earnings and the economic outlook have deteriorated further and are in the worst place than in June.
Let’s be clear: the inflation problem is solved.
It’s just a matter of whether a recession will be the price to pay. In July and August you could argue that this was possible based on the resilience and positive behavior of the economy in the leading inflation indicators.
Now we see more evidence that the economy is rolling over, while it is clear that the ‘stickier’ components of inflation are rising fast enough to offset the massive deflation in the more volatile components.
This is bad for several reasons and a primary reason I changed my mind. In hindsight it was remarkable that earnings growth and job growth could continue with a headwind of higher rates, I am not so optimistic that this will repeat itself in the next 3 to 6 months.
We are likely to experience more weakness, which will be compounded by the Fed’s near-maximum aggressive stance. And the inflation data makes it clear that this aggressive stance is not going to change anytime soon.
Turning to the general stock market, we will see short-term interest rates remain higher, which will push multiples downward.
At the same time, revenues should fall. This is a deadly double dose for the stock market and is a common ingredient in some of the most brutal bear markets in history.
Strategy
We have significantly reduced the portfolio. These bear markets are determined by liquidity leaving the markets and going to places with guaranteed returns. This is especially true when the 2Y returns more than 4%.
As noted in the past, this is the biggest drawback of investing in low-priced stocks. These stocks are very sensitive to liquidity fluctuations and can fall sharply if there are no bids in the market.
I wouldn’t be surprised if this leg end was in some sort of dramatic capitulation-esque move with a huge spike in the Vix. I think this would present a buying opportunity in the near term, but the primary trend remains lower until there is some relief on the inflation front.
Market topics
Now let’s look at a major stock market (SPY) subjects…
Treasuries: As described above, we see extraordinary movements in Treasuries. What is interesting to me is the 2Y is at 4% while the 10Y is at 3.6%. This is a pretty steep inversion and historically a reliable sign that a recession is imminent.
The 10Y at 3.6% and the lack of strength in gold and silver also show that the market sees longer-term inflation normalizing around the 2% level, as returns simply don’t make sense if inflation is structurally higher.
Q2+Q3 earnings summary/look ahead: At the start of the year, analysts expected 8% earnings growth in the second quarter. After the first quarter, this was reduced to 3% earnings growth and the quarter ended with 6% growth.
It should be noted that profit excluding energy fell by 4%. For the third quarter, analysts predict earnings growth of 3%, which is a serious markdown from the 8% a quarter ago.
FOMC Meeting: There was nothing really positive about the FOMC, although it wasn’t a surprise. The Fed doesn’t have many options but to keep rising at this rate until inflation falls.
It’s really a matter of which will break first – inflation or the economy. Recent developments argue in favor of the latter.
Midterm elections: Going into the year, the consensus was for a “red wave,” given the low approval ratings for Democrats and President Biden.
This changed as a result of some poor candidate picks on the Republican side and an energetic Democratic base following the Dobbs decision that gave Democrats some momentum.
Now we see this momentum fading and it is increasingly likely that Republicans will at least win back the House. Furthermore, they have a better chance of winning the Senate than the Democrats of winning the House.
For the market, a stalemate is good, especially in an inflationary environment, because it means lower spending. In fact, a Republican-controlled house would mean no new substantial legislation for the remainder of Biden’s first term.
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All the best!
Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Shares Under the $10 Newsletter
SPY shares closed at $367.95 on Friday, down $-6.27 (-1.68%). Year-to-date, the SPY is down -21.63%, versus a % increase in the benchmark S&P 500 index over the same period.
About the author: Jaimini Desai
Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR growth and POWR Shares Below $10 newsletters. Read more about Jaimini’s background, along with links to his most recent articles.
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