Change is Upon Us. New Opportunities are Coming.
I hope everyone had an enjoyable summer and is enjoying the cooler fall months. There is a lot of news flowing these days and I’ve been working diligently in an effort to construct a clear view of the current financial puzzle. The difficulty is that the markets are like weather in that they are not completely predictable in timing and magnitude. To those in Florida, my best wishes to everyone impacted by Hurricane Ian.
During the third quarter of 2022, the S&P 500 Index was down 5.3%, the NASDAQ Index lost 4.1%, the Russell 2000 Growth Index gained 0.1%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) was down 6.2%.[1]
The stock market started the quarter very strong rebounding from the previous quarter’s losses and was accelerated by Federal Reserve (Fed) Chair Powell’s odd interest rate remark of “We’re right in the range of what we think is neutral.” The remark was taken positively by many that the Fed was done with interest rate hikes and tightening. Without a long explanation, in my opinion the remark was ridiculous and a disservice to investors.
The Fed uses many mechanisms to help ensure the financial system supports a healthy economy for U.S. households, communities, and businesses. It sets U.S. monetary policy to promote maximum employment and stable prices in the U.S. economy. In recent Fed commentary, they espoused that they want to see positive Real Interest Rates across the curve. This means that interest rates (nominal) less the rate of inflation are positive across the time horizon.
The current inflation rate published by the U.S. Bureau of Labor Statistics on Oct 13 was 6.6% on a core basis while the Federal Funds Effective Rate is ~2.5%. The Fed is conflicted. This fact and my finance and economic background is why I have a hard time believing many Fed comments at face value. Another example of an odd statement came on October 11th from the administration.
The White House commented that a ‘slight recession’ is possible but doesn’t anticipate it. There is a fine line in a gray area between promoting confidence and jeopardizing investor security.
Let’s look at a bit of history. The fourth quarter of Congressional mid-term years has typically shown positive returns in the past. In fact, according to the Presidential Cycle, while the second and third quarters of midterm years are historically weak, Q4 of midterms is the second strongest in the presidential cycle (with an average return of 6.6% since 1950), with the first quarter of the next year, ranking as the strongest of the presidential cycle, yielding a 7.4% average gain. Past returns are often taken as a future fact.
Do not fall for this. We’ll see if history repeats itself this year.
Here are a few metrics I’ve been looking at to understand how we stand today (September 16th, time periods):
Initial Jobless Claims – less than 2019-2021
Continuing Jobless Claims – less than 2019-2021
ASA Staffing Index – higher than 2019-2021
Weekly Retail Sales – higher than 2019-2020, lower than 2020
Box Office Receipts – 64% lower than 2019, higher than 2020, about the same as 2021
Rail Car Traffic (cars) – 7% lower than 2019, about the same as 2020-2021
Steel Production (net tons) – lower than 2019
Hotel Occupancy 70.0% vs 71.3% in 2019
TSA Checkpoint Data 2,070,440 vs 2,290,486 in 2019
Supply of Motor Gasoline in the US (Mbbl/d) 8,825 vs 9,346 in 2019
Global Commercial Flights 102,963 vs 120,816 in 2019
PMI > 50 (as of 10/3/22 it declined to 45.7 vs. last month’s 52.2)
Leverage less than 2001 and 2007
These statistics imply to me that currently, the state of the economy is not as bad as the headline news, so the performance of the stock market may be indicating a correction from an overvalued state and the strong possibility, in my opinion, of a recession.
In a worse scenario, as I wrote about in my last letter, a situation of Negflation may develop. That is my word for inflation coupled with negative economic growth. We are not there, but I’m watching. While inflation is down from its summer peak, it remains stubbornly high, and the economy is slowing.
Inflation was underscored by Friday’s Personal Income and Outlays report which showed Personal Consumption Expenditures (PCE) (the Fed’s preferred inflation gauge), rising a larger than expected 0.4% m/m vs. 0.2% expected, and 6.2% y/y vs. 6.1% expected. That’s below June’s 7.0% peak. But still too high. Core PCE was up 0.6% m/m vs. views for 0.5%, and 4.9% y/y vs. views for 4.8%.
The 6.2% inflation number causes a problem for the Fed saying they’re neutral with a 2.5% Fed Funds rate. To stop inflation, they will need to continue raising the rate which will likely put the economy in a recession, which will be a problem for the current administration and the mid-term elections.
I see three Fed outcomes:
- The Fed follows through with their inflation fighting rhetoric and continues to increase interest rates aggressively, thus causing a recession and a continued weak market.
- The Fed executes a near-term “pivot” and reverses their aggressive rhetoric to increase interest rates and the market explodes higher, but inflation worsens.
- The Fed takes a wait and see stance which does nothing but buys them time, at the expense of the American public. The market remains skittish and vacillates on any hint of Fed direction.
If the Fed raises rates too fast compared to other Central Banks, it may cause currency to move out of foreign countries to the US to capture a higher yield and relative safety. This currency movement leaves other countries at a disadvantage since their currencies weaken compared to the US and their purchasing power for US denominated goods is less.
Due to the high interest rates in the U.S., one outcome is the evisceration of emerging market economies. Emerging markets generally have undesirable currencies due to their lack of stability and are required to transact business in now more expensive U.S. dollars. Emerging markets are not the only markets hurting. Most other nations are also affected by the dollar strength since oil contracts around the world are executed in the U.S. dollar.
The EU will be keenly affected this winter since until recently, they purchased Russian oil for 45 percent of its imports and around 40 percent of its consumption.
While the U.K. and EU are already in a recession, as reported by a S&P Global report, their currencies are crashing compared to the dollar. The British pound two years ago was 1.4 pounds to 1 U.S. dollar, not it’s 1.1:1 and the Euro during the same period was 1.2:1. Now it’s slightly less than the dollar. The impact to U.S. multinational sales abroad is not widely publicized as of now, but it is hard to make a case of increased sales abroad. I’m staying away from investments which rely heavily on foreign sales. Also, foreign travel to U.S. destinations may suffer due to weakened purchasing power abroad.
Positives:
- The markets have begun to price in the possibility of a recession – we are one step closer to getting out of this turmoil
- Money market levels are high, and cash may enter the market
- The Administration has an open door to relax its anti-oil policies which would greatly help the stock market
Negatives:
- Liquidity is lessening
- The Fed maintaining their aggressive inflation-fighting rhetoric causing an excessive economic slowdown
- Uncertainty about the fall elections
- A prolonged recession develops, which curbs investor enthusiasm
Note that the Russell 2000 Growth Index, a small company proxy, eked out a gain in the last quarter.
As investors hunker down for the possibility of a recession, traditional value stocks which have been out of favor for some time, compared to Big Tech names, may resurface as Wall Street darlings.
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
Copyright Martin L. Yokosawa. All Rights Reserved
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.