By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
June 8, 2023
From the outset of this year, the S&P 500, as a barometer of the stock market, kicked off with a vigorous rise into February, then experienced a setback that gained momentum in March due to the crash of multiple banks. This was subsequently followed by a surge in the last week to the highest levels since the previous August. Given our defensive posture and elevated cash levels, we have not kept pace with our benchmarks but feel the penalty has only been a lost opportunity and not a loss of capital. The lost capital part in our minds lays ahead as we are not convinced a new bull market is underway but rather a seventh inning stretch of a bear market. This is why we maintain a heavily defensive position and are patiently awaiting a better opportunity to invest capital with less risk. Sometimes the best thing to do is nothing and wait patiently for that fat pitch.
“I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.” – Warren Buffett
In new bull markets, there is typically strong participation from almost every sector and industry, resulting in a collective rise of the majority of listed stocks. This can be likened to a "running of the bulls." However, this characteristic of broad participation is currently lacking in the stock market.
To illustrate, let us consider the performance of various indices. The S&P 500 Index, a widely followed market benchmark, has appreciated by 12% year-to-date (YTD) through June 5th. In contrast, the S&P 500 Equal Weighted Index, where all five hundred stocks hold equal influence, has only increased by 2% during the same period. Similarly, the well-known Dow Jones Industrial Average also showed a modest 2% gain. These figures indicate that the current market is highly selective, with the rally primarily driven by large technology stocks that carry significant weight in the S&P 500 Index.
This discrepancy highlights the limited breadth and depth of the current market rally, indicating that it lacks the widespread participation typically associated with the beginning of a new bull market.
Where’s The Beef?
In addition to the weak participation in the recent market rally, there are other factors that lead us to question the validity of a new bull market. One notable deviation from historical patterns is the stock market bottoming before the Federal Reserve begins cutting interest rates. When we analyze major bear market bottoms that occurred during recessionary periods, tracing back to the Great Depression, we observe a consistent pattern. In each instance, the stock market reached its lowest point during the recession itself, not before it. Often, this coincided with the last rate hike or occurred after the Federal Reserve had already implemented multiple interest rate cuts.
In contrast to the typical pattern, we hold the belief that the U.S. economy was not in a recession when the market hit its bottom last October. Even if a recession were to have occurred, we lack the crucial ingredient of Federal Reserve rate cuts that are typically associated with bear market bottoms. Instead, the Federal Reserve has actually raised interest rates on five occasions since then, and there are currently no indications of the Fed considering rate cuts in the near future. Given these circumstances, we question the presence of a catalyst for a market bottom.
Furthermore, the prospects for significant fiscal stimulus are low, as government spending is likely to be constrained by the debt ceiling deal negotiated by Congress. Instead of monetary stimulus, we continue to observe monetary tightening. The Federal Reserve is reducing its balance sheet and withdrawing liquidity from the financial markets, with the possibility of one more rate hike this year. The absence of both fiscal and monetary stimulus, historically powerful catalysts for economic turnarounds, raises the likelihood of a recession and reinforces our belief that the bear market that began in 2022 has merely been in hibernation and is likely to resume this summer.
We see the debt ceiling deal, which allows the U.S. Treasury to issue more debt, as a potential near-term catalyst for the bear market to resume its downward trajectory.
Beware the Tsunami
In the current situation, the increase in the debt ceiling and the subsequent issuance of a significant amount of debt by the U.S. Treasury (UST) may lead to a bearish scenario. This action is expected to have a negative impact on financial market liquidity, as a substantial portion of investor capital would be absorbed by the issuance of UST debt. As a result, this could potentially overshadow other investment opportunities and create concerns within the financial industry, as highlighted in the provided article.
Wall Street Fears $1 Trillion Aftershock From Debt Deal
Many on Wall Street predict lawmakers will ultimately reach an agreement, likely averting a devastating debt default, even if it goes down to the wire. But that doesn’t mean the economy will escape unscathed, not just from the bruising standoff but also as a result of the Treasury’s efforts to return to business as usual once it can ramp up borrowing...
The Treasury will need to scramble to replenish its dwindling cash buffer to maintain its ability to pay its obligations, through a deluge of Treasury-bill sales. Estimated at well over $1 trillion by the end of the third quarter, the supply burst would quickly drain liquidity from the banking sector, raise short-term funding rates and tighten the screws on the US economy just as it’s on the cusp of recession. By Bank of America Corp.’s estimate it would have the same economic impact as a quarter-point interest-rate hike…
“My bigger concern is that when the debt-limit gets resolved — and I think it will — you are going to have a very, very deep and sudden drain of liquidity,” said Bergmann, founder of New York-based Penso Advisors. “This is not something that’s very obvious, but it’s something that’s very real. And we’ve seen before that such a drop in liquidity really does negatively affect risk markets, such as equities and credit.”
Economic Debate Continues – Recession Coming or Soft Landing?
By analyzing the frequency of news articles mentioning the term "recession," we can gain valuable insights into the level of public concern regarding an economic downturn. Over the past decade, we observed a significant increase in article mentions during early 2020 when the economy experienced a brief recession. However, the number of articles discussing a recession quickly declined and reached the lowest levels in a decade by the end of 2021. In the spring of 2022, the count of recession-related articles began to rise sharply, reaching its peak in July of that year at levels slightly higher than during the actual recession in 2020. However, it is noteworthy that the fear of recession is waning, as the count of articles mentioning the term "recession" has now dropped to less than half of last year's peak.
“Those who do not remember the past are condemned to repeat it.” – George Santayana
This is why the economic consensus is predicting a soft landing, where the labor market remains stable without a significant increase in the unemployment rate. To understand whether we are heading towards a recession, it is helpful to study the history of US recessions and soft landings, observing the key indicators that lead to each outcome. The following are the key factors for a soft landing without a recession or rise in unemployment:
- Low inflation
- Mild increases in interest rates by the Federal Reserve
- Relaxed lending standards by banks
Conversely, the following markers indicate a higher likelihood of a recession:
- High inflation
- Aggressive interest rate hikes by the Federal Reserve
- Tightened lending standards by banks
Currently, we have all three key markers associated with recessions rather than soft landings, which is why we believe a recession is inevitable. Examining the consumer price index (CPI) as a measure of inflation since the 1920s, it is evident that elevated levels of inflation often precede recessions (indicated by red shaded bars in the graph). There have only been four instances where the inflation rate exceeded 5% without a recession, all of which were associated with a strong economy. These instances occurred during the 1930s when FDR stimulated the economy to recover from the Great Depression, twice in the 1940s during a thriving wartime economy, and in 1951 when the GDP growth exceeded 10%. In this current cycle, inflation reached nearly 10% last year while economic growth has slowed significantly to 1.6% in the first quarter of 2022. Historical patterns suggest that episodes of high inflation and low economic growth have consistently led to recessions.
An aggressive Federal Reserve hiking campaign is another common factor leading to a recession rather than a soft landing. Examining the Federal Funds Target Rate back to the early 1970s, where recessions are represented by red vertical bars and the two instances of soft landings are shown by green boxes, reveals some interesting patterns. The two examples of soft landings, where the US economy avoided a recession after Federal Reserve rate hikes, are characterized by small increases in interest rates, with the Fed raising rates by approximately three percentage points.
However, in the current cycle, the Federal Reserve has raised rates by five percentage points in a little over a year, making it the most aggressive hiking cycle since the era when Paul Volcker served as the head of the Fed in the late 1970s and early 1980s. The mild hiking cycle typically associated with soft landings is noticeably absent this time.
This observation highlights the significant deviation from the historical pattern and raises concerns about the potential impact of the aggressive rate hikes on the economy. The current hiking cycle, which surpasses the magnitude of previous soft landings, further supports the argument that we may be heading towards a recession rather than experiencing a soft landing.
The lending practices employed by bank loan officers also play a crucial role in shaping the nature of an economic downturn. The Federal Reserve conducts quarterly surveys of loan officers, inquiring about their lending practices and willingness to extend credit. One key indicator is the net percentage of loan officers willing to make consumer loans.
Looking at the graph displaying the net percentage of loan officers willing to make consumer loans, we can observe certain patterns. During the soft landing in the 1980s (first green box), there was a higher proportion of loan officers willing to extend credit compared to those unwilling. Similarly, during the soft landing in the middle of the 1990s, loan officers were balanced in their willingness to provide loans to consumers.
However, in the current cycle, we are witnessing the third-largest decrease in loan officer willingness to make consumer loans since the early 1980s. This significant decline raises the likelihood of a recession, as a deeply negative reading in this indicator has historically been associated with economic downturns. It suggests that consumers will face greater difficulty relying on debt to fuel their consumption spending, potentially leading to a contraction in the economy.
Taken together, the three factors highlighted—high inflation, aggressive Federal Reserve rate hikes, and reduced willingness of loan officers to make consumer loans—point to a more challenging economic landscape and increase the odds of a recession rather than a soft landing.
Outlook and Strategy
Our outlook remains cautious as we anticipate an inevitable economic recession. With this in mind, we maintain a defensive stance within our portfolios, opting to patiently wait for favorable market conditions instead of chasing short-term gains. As the effects of aggressive Federal Reserve rate hikes typically manifest with a lag of 12-24 months, we believe we have yet to experience the full impact of these measures, indicating that the toughest phase of the economic downturn may still lie ahead.
We anticipate a gradual deterioration of the economy throughout the summer and particularly towards the end of the year. This puts the financial markets in a precarious position, as a weakening economy will coincide with a significant liquidity drain resulting from the influx of US Treasury debt in the coming months. The combination of a deteriorating economic outlook and a loss of support for asset prices raises concerns about the potential for strong market returns. Consequently, our strategy focuses on defensive positioning to mitigate risk.
We will continue to exercise patience and wait for favorable investment opportunities, likening it to waiting for a "fat pitch" that presents itself to a disciplined investor with available cash. While holding cash has had its drawbacks over the past fifteen years during an era of extremely low interest rates, the current landscape of aggressive Fed rate hikes has elevated money market yields to around 5%, making cash a more attractive option. Once the anticipated opportunity arises, we will shift towards a neutral risk allocation in our portfolios. As the outlook improves further, we may consider increasing our risk exposure, including investments in stocks and commodities.
During this waiting period, we are devoting considerable time to constructing a shopping list of potential stock and bond investments. Bear markets often result in lower stock prices and higher dividend yields, as well as lower corporate bond prices and higher income yields, which can create compelling buying opportunities.
If you have any questions or would like to discuss our outlook and strategy in more detail, please feel free to reach out to us. We are here to provide further clarity and address any inquiries you may have.
Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.
Copyright © 2023 Chris Puplava