As illustrated by the accompanying chart, every post-WWII bull market has experienced at least one separate correction (defined as a market decline of at least 10% but less than 20%) before ending in a bear market (a drop of 20% or more). But today, the S&P 500 is knocking on the door of a bear-market collapse without having yet experienced an isolated correction.
By the end of last year, the annual Consumer Price Inflation (CPI) rate soared to 7% and rose above 8.5% by March. So how did bond yields react to the biggest inflation surge in over 40 years? Since April 2021, the inflation rate has been greater than 4% and ended the year at 7%, yet the 10-year U.S. Treasury yield was only 1.5% as of December and is currently just 2.9%—the lower end of U.S. history. Indeed, looking back to 1872, today’s inflation rate is higher than 88% of the time, whereas the 10-year Treasury yield is still lower than about 80% of the time!
Consumers have enjoyed some positives in the last year, including a strong jobs market and rising wages. Overall, however, they have faced an increasing array of challenges that have dampened spirits. Fiscal stimulus has run dry, budgets have been pressured by a price upswing in nearly everything, interest rates are much higher, and despite elevated wages, the real wage rate has been declining. In addition, the headlines have turned increasingly dark: a protracted war in Ukraine, yet another COVID-variant upwelling, a potential policy mistake by the Federal Reserve, a stock market collapse, and widespread talk of an imminent recession.
Lately, “TECH” has truly become a “Four Letter Word.” After a prolonged leadership run that began long before the pandemic, and became dominant in early 2020, technology stocks have entered a bear market. The S&P 500 Technology index and Nasdaq 100 (the QQQ) are now off from record highs by over -20% and -22%, respectively. This has left many wondering whether the financial markets are again headed for a replay of the 2000 dot-com collapse.
As the following chart pictorial illustrates, several key ingredients that underlie pricing pressures are losing their inflationary force. These include the systemic impact of rising inflation expectations, the coincident contribution of higher commodity prices, and the leading influence of economic policies. There is also notable progress among several supply-chain problems, including a surge in the U.S. labor supply, improvement in international freight rates, a rollover in backlog orders, and evidence that companies are finally rebuilding inventories.
For stock investors, the most important issue surrounding the inflation environment is not how high it is nor how long it may stay above the Fed’s target rate. Rather, it is whether inflation is nearing a recovery peak: Even if it remains elevated for some time, if inflation is nearing a top, the stock market has historically produced satisfying results. That is, stocks have done well in periods following a peak in the inflation rate. Consequently, today, with inflation this extreme (and probably close to topping out), it’s time to buy!
We worry so much about the Federal Reserve. How far are they behind the curve? When will they start taking away the punch bowl? Is the fed funds rate alarmingly below the Taylor Rule? How fast will the Fed push interest rates higher? Will they opt for a 50 basis-pointer? Maybe multiple 50s? Could there be an intra-meeting hike? What is the terminal yield target? QT could be a killer! Do those dot-plots suggest a curve inversion? Oh my, even the Doves are Hawkish!
VIX® is the popular name for the Chicago Board Options Exchange CBOE Volatility Index®. It measures the stock market’s expectation of future volatility based on S&P 500 index options. When investors expect more instability, they perceive greater risk, and for that reason, the VIX is often referred to as the market’s “fear gauge.”
Theoretically, there is a supply and a demand, and they are brought together only by price. Obviously, both are important because when they get drastically out of whack, inflation rises or falls—or deflation develops. For this reason, it’s useful to separately monitor their developments in real-time. To fully appreciate the underlying source of inflation, one needs to acknowledge the status of “both” supply and demand. It could be too much demand or too little supply. Often, it’s a bit of both.
Bond yields across the curve have been exceeding the speed limit lately, zooming toward an unknown higher equilibrium. Since year-end, the 10-year Treasury yield has climbed from 1.5% to 2.6%; it has surged from 1.75% just since the end of February! With the Federal Reserve now joining bond vigilantes with their own “pedal-to-the-metal” toward monetary tightening, who knows how “fast” yields might continue to advance? For investors, this begs the question, “Does SPEED Kill… Stocks?” Although yield levels are still fairly low, if they rise fast enough, can equities withstand such a monetary shock?
As usual, this Friday’s employment report has plenty of intriguing plot lines. Could job creation surprisingly slow down just as recession fears are rising? Will another red-hot wage number add to inflationary woes? Could the unemployment rate really fall to the “mid-3s?” And what will all this mean for the Federal Reserve’s next meeting?
Economic excesses often create potential investment opportunities. When a key economic factor reaches a ridiculous level, it frequently proves profitable to expect a reversal: Recall the 10-year bond yield at 0.5% in mid-2020 (those who tilted investment bets toward rising-yield beneficiaries have since profited)—or the early-1981 extreme of 16%? Another example was 1995, when the U.S. dollar spiked to levels never seen before—nor since. In the 1990s, the labor participation rate peaked near 68% after having never risen above 60% prior to 1970. And, in the mid-1990s, following a decline of nearly 20% from its 1973 post-war high, the real-wage rate finally bottomed.
Putin’s war continues to create horrific human suffering and geopolitical turmoil, and the Federal Reserve has finally begun to raise interest rates as board members have quickly turned universally hawkish. As a result, the stock market has been volatile as traders assess whether correction lows have been successfully re-tested or if recent action is just a dead-cat bounce.
A barrage of reports suggests Main Street is being ravished by runaway inflation. Individuals are struggling to buy enough gas to get to work and to put food on the table. Companies can’t find workers or supplies, and higher resource costs are threatening profit margins. Consumer price inflation is now at its highest level in over 40 years, and media pundits, politicians, policy officials, titans of industry, and everyday consumers believe we are seeing a replay of the 1970s.
One way to judge if the stock-market correction is nearing its end is to look at how much “offense” has been hit relative to “defense.” Once aggressive investors have been adequately punished for their greedy overreach compared to the performance of more responsible investors, the correction has often run its course.
There is no historical precedent for the Fed’s balance sheet of nearly $9 trillion! Moreover, the current level of the M2 money supply—relative to nominal GDP—peaked near 95% in 2020 and is still close to 90%. By comparison, this ratio averaged 55% from 1950-2009 and, prior to 2020, was never above 73%.