It’s Messy Out There, But We’ll Get Through It

July 8, 2022 by Martin L. Yokosawa

I hope you are having a wonderful summer and enjoying time with family and friends.

The last quarter has been tough at the gas pump and for portfolios, but we have seen this before.

We are not out of the woods yet, but there are clearer skies coming.

During the second quarter of 2022, the S&P 500 Index was down 16.4%, the NASDAQ Index lost 22.4%, the Russell 2000 Growth Index was down 19.4%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) was down 4.8%.^[1] Stock market participants began to “price-in” the effects of inflation, the Federal Reserve’s 0.75% rate hike, and the reality that the possibility of a recession is approaching. As I have been writing and positioning for this reality, we have missed the brunt of the decline.

Recently, on a day when the market was down 3%, an astute client posed the question “are we there yet.” My response was:

Due to the movement of so many market variables and their interpretation by all investors, large and small, it is impossible to peg if the current correction is over. My experience leads me to believe we are about halfway through the market turmoil. As I have written before, the stock market is a discounting machine and stock market levels are driven by the earnings of the stocks in the index…Based on current earnings expectations, I believe the major market indices are fairly valued, not cheap. This means some of the massive money market holdings could begin to enter the market and move it higher or earnings revisions could be lowered due to higher interest rates and recession fears causing lower prices.

My buy list is growing and I’m waiting for the next round of earnings to be reported to confirm which ones to buy. This will be a busy summer for me. In any case, many smaller companies look attractive and can move faster in dealing with changing economics.

There are two main points to be gleaned from this question. The first is that I don’t feel that investors have fully recognized the impact of inflation and a possible recession on future corporate earnings. The second is that, even though the question was asked by a seasoned investor, there wasn’t a high degree of distress indicating investor capitulation, an action which typically marks a market bottom.

In the past I have noticed that investors capitulate at the wrong moment, usually being prompted by bleak media headlines. Many times, it’s at a point half-way through a recession or difficult economic climate.

There are many recession definitions, but the common theme is negative economic growth. What few address is the magnitude and the length of a recession. For investors considering if they should add money to the market, there is a big difference between a slow prolonged quarterly economic deterioration versus a couple painful ones with prospects for a recovery. At Torii^® Asset Management we ignore the headlines and concentrate on economics and the companies which can prove earnings and have potential to grow going forward. Don’t get tied up in media headlines.

In the news, headlines are about inflation, recession, and deflation. What if we have Negflation? Don’t worry if you haven’t heard of it and don’t bother looking it up since I coined it earlier this year to explain something I’m watching closely for. My definition of negflation is decreasing economic activity while general prices are rising. The world hasn’t experienced it, but I’m studying the idea and how to react to it if it emerges. I’m only looking ahead and not forecasting it.

This thought may be scrutinized today, just as the concept of negative oil prices. On April 20, 2020, the front-month May 2020 WTI crude contract settled at negative $37.63 a barrel on the New York Mercantile Exchange. Negflation would be serious as business and consumer pocketbook balances decline in the face of higher prices. In addition, markets do not like uncertainty, which may compound the problem of decreasing purchasing power which I discussed in my last review.

One scenario which could possibly prompt negflation is a super-spike in crude oil prices. And, on July 5^th, a Reuters headline read “Russia’s Medvedev says oil could top $300-$400 if Japan’s price cap idea implemented.” Remember, crude oil is not only used as fuel, but in the production of plastics, cosmetics, and textiles. Think synthetic clothing and footwear, toothbrushes, plastic drinking cups, measuring cups, even hula hoops. If the general level of prices increases at a rate significantly faster than business and personal income, economic activity would surely fall.

Again, I’m looking at this potential problem in case it unexpectedly occurs, just to be ready.

Here’s how I see things today:

The pace of Federal Reserve interest rate increases has likely topped
The market will remain volatile with a summer relief rally and retrace into the fall elections
For safe money, it is a good time to begin buying some high-quality short-term fixed income

Positives:

The steep rise in U.S. Treasury yields has abated and relieves some pressure on the stock market
Money market levels are high and some of that cash may enter the market
Current global tensions may relax
The Administration has an open door to relax its anti-oil policies which would greatly help the stock market

Negatives:

Potential downward revisions in earnings expectations due to recession fears
Fed becomes too aggressive with their inflation fighting policies causing an excessive economic slowdown
Uncertainty about the fall elections
A prolonged recession ensues which curbs investor enthusiasm

There are a lot of moving parts in the financial system, nothing catastrophic, but it is impossible to fully commit to any one area due to the turmoil. The key to getting a better understanding of the situation will be from listening to the quarterly earnings calls and listening to management’s commentary and how it has changed over previous quarters.

This market commentary is provided by Martin Yokosawa and Jeff Batterson at Torii® Asset Management. We would like to get your advice on how to make these letters as valuable as possible. If you have any suggestions, please email us at jb@toriiassetmanagement.com. You can also learn more about Torii® Asset Management and view past letters at www.toriiassetmanagement.com.

Can you do us a small favor? Go online right now and share this letter with someone you know who would be interested.

Very truly yours,

Martin L. Yokosawa

Torii^® Asset Management, Inc. Landolt Securities, Inc.

9S040 Stearman Drive, Naperville, IL. 60564

Securities processed by and investment advice provided through Landolt Securities, Inc. Member: FINRA/SIPC

Torii^® Asset Management, Inc. and Landolt Securities, Inc. are not affiliated companies.

[1] These returns are priced based and exclusive of dividend reinvestment.