Broker Check

Two Roads Diverged in a Yellow Wood

June 01, 2022

And which path the market will take is unknown.  The chief investment strategist of a large broker-dealer addressed a crowd of industry professionals at a major annual investment management conference, back when these types of events took place in person.  She said to the group that the data supported a case for stocks to advance, and the data supported a case for stocks to decline.  She said that either case appeared to be equally compelling.  This was 2016, if memory serves.

Similarly, today, investment bank forecasts for the future of the S&P 500 vastly diverge.  Some disagreement is natural.  But widely differing opinions are not common.  The S&P 500 is currently around 4,000.  Oppenheimer estimates that the S&P 500 will reach 5,300.  Bank of America/ Merrill Lynch says 3,500.  Reading the tea leaves has not been this difficult for some time.

The present situation is especially challenging because the path the market takes will be less driven by the health of the economy, which normally it is, and more driven by the actions of the Federal Reserve in its quest to “restore price stability”, in the words of Chairman Powell. 

Fed Strategy

The Federal Reserve has two mandates: controlling inflation and creating the conditions for a healthy employment market.  The Fed’s price stability (inflation) target is approximately 2%.  The current rate of inflation is 6.6%, as measured by CPE (Consumer Price Expenditure, the Fed’s preferred gauge).  The main tools for lowering inflation are: 1) jawboning/ communication and 2) increasing the cost of borrowing through the benchmark short-term lending rate.  The objective is to create enough financial unease that consumers and businesses spend less money overall.  Reduced consumer and corporate spending builds inventories, which lowers production and prices. 

Early Results: The Treasury Market, et al

The Fed has been very successful creating financial unease. The clearest example is the performance of the US Treasury market.  Thanks to the Fed’s rapid policy change, the first four months of the year produced the worst Treasury market returns since 1788, the year the US Constitution was ratified. Treasury returns have been better over any four-month period in history than they have been this year through April.  We’ve seen far too many “once in a lifetime” market milestones over the past two years, but this one is the most significant.

There are other examples of the Fed’s effectiveness signaling and implementing an aggressive rate-hike strategy.  US home sales (volume, not prices) have declined 30% this year through April as increased mortgage rates cause buyers to reassess their plans.  Home sales numbers in April of this year were the same level as April of 2020 and February 2008.  Consumer sentiment surveys are plumbing depths not seen since the 1980s, and in some cases, since the 1940s.  Earnings calls from consumer bellwethers Walmart, Target and Amazon all surprised the market with down-beat sales and accumulating inventories of unsold goods.  Walmart noted that while sales grew 3%, the mix has shifted from merchandise to groceries and white-label (generic) consumer staples.  These firms have earned the respect of Wall Street for their superb supply chain management, and all were caught flat-footed by swiftly changing consumer preferences.

The preceding data seems dire, but dire is the Fed’s goal.  Historically, Fed-induced slowdowns were a common response to growing rates of inflation.  It may feel dramatic and severe this time because the US hasn’t gone through a rapid, rate-induced slow-down since 1994 when the Fed successfully engineered a soft landing. 

More on Inflation

The Optimistic Case:  If you’re a regular reader of our publications, get ready to roll your eyes, as we’ve said this many times before.  It does appear that inflation is beginning to break lower according to PMI data.  Delivery times at the wholesale level have improved for five months running.  Manufacturing output has increased for the past nine months, and manufacturing work backlogs have decreased by 14% since September of 2021.  Readings still show an imbalance between supply and demand, but the trend is moving in the right direction.

We learned from the earnings reports of the big box stores listed above that consumer demand for large items is quickly declining and inventories are building.  This should lead to modest price cuts as Walmart, Target, and Amazon work to clear out their warehouses.  When a big player like Walmart cuts prices, you can expect competitors to follow suit.  The prices of consumer goods guided inflation numbers higher last Spring; they may lead inflation lower this summer.

Finally, it is important to note that the US dollar has appreciated significantly this year, hitting a 20-year high on a trade-weighted basis.  Half of US consumer goods are imported, and the strong dollar has reduced import prices by 6% year to date.  Between improving supply chains, reduced demand, and cheaper imports, it does appear that “peak inflation” is finally behind us. 

The Pessimistic Case:  Every time the data suggests a break lower, another COVID variant materializes, or a war starts.  From the pricing of capital market instruments, we know that the market expects inflation to remain near 8% through the summer before falling to around 3% in April of 2023.  This assumption is priced into both the equity and bond markets.  If inflation were to fall faster than expected, then we may see a strong rally in both stocks and bonds.  If the opposite proves true, we can expect more pressure from the Fed and a negative impact on capital markets.

Pause for Interim Summary

The Fed wants to get inflation down to its stated target run rate of around 2%.  It does this by talking about raising short term interest rates, then raising short term interest rates.  There appear to be signs that this strategy is working.  Consumers are spending less on discretionary purchases of goods, leading to accumulating inventories and presumably, eventual price declines.  A strengthening US dollar has helped lower prices of imported goods.  Still, spending on discretionary services, such as airfares and hotels, remains strong.  The market assumes that inflation persists through the third quarter of this year before moderating to the Fed’s target rate by the middle of next year.


As we argued in last month’s newsletter, the US is in a debt trap.  This means that due to the high and growing levels of debt (and wealth inequality) the US cannot handle higher interest rates without seeing an economic slowdown.  The magical “neutral” interest rate that balances supply and demand within the economy is lower than commonly estimated and has declined over time as debt levels have risen.

This conclusion is not a commonly held belief (although it was in the aftermath of the 2008 financial crisis), even though overall debt levels in the US economy have returned to all-time highs.  The debt trap argument is still being made by some of the most respected voices in the industry, such as Jeremy Grantham, Lacy Hunt, Bob Ferrell, Oliver Blanchard, Charles Goodhart, Matt King and Tobias Levkovich before his passing last October.

This hypothesis matters because if true, the Fed will likely stop increasing short-term rates this fall, and possibly cut rates in 2023.  This more optimistic scenario is dependent upon inflation falling to levels acceptable to the Fed.  Something to keep an eye on.

Capital Markets

As of May 31st, the last trading day of the month, the S&P 500 (SPY) is down -12.79% for the year.  The technology heavy NASDAQ (QQQ) is down -22.33%.  US small cap stocks (IWM) are down -16.59%.  The international large cap market (EFA) is down -11.10%.  The bond market (AGG) is down -8.83%.

The bond market is ripe for a recovery.  Our call last month, that the 10-Year Treasury would stay around 3%, has thus far been correct.  After brief trip to 3.25%, yields have fallen to 2.8%.  This occurred as the Japanese sold a record number of Treasuries, for reasons we won’t bore you with here.  The bond market is showing signs of a recovery

The equity market outlook is not as encouraging in the immediate term, though not nearly as bad as the most bearish estimates – and regardless of short-term rallies such as experienced during the week beginning Monday May 23rd.  Our “base case” is that the market trades sideways, with pronounced volatility, until there is a clear break lower in inflation readings and growth rates gather positive momentum.  Several high-profile firms experienced significant equity declines on marginal earnings misses, indicating that investor sentiment has shifted from the blind optimism that prevailed last year to “show me proof” today.  Changing this bearish sentiment requires better than expected economic data that may take time to accumulate.

On the bright side, P/E valuations for the S&P 500 and NASDAQ are at their ten-year averages. This suggests markets are neither rich, nor cheap, relative to recent history.  Analysts are still anticipating 10% earnings growth for the year, which will likely prove to be optimistic.  We will retain our defensive positioning and refrain from “buying the dip” until the Fed signals a change in their plans.

Investment Management

We were fortunate enough to have reduced risk in our managed portfolios at the beginning of the year through the sale of Emerging Markets, International Small Cap and high-growth US equities. That process has continued in May as certain opportunities have materialized.

In non-retirement plan accounts in custody at Charles Schwab & Co., we added a municipal bond fund from Goldman Sachs. This trade was funded from the sale of Guggenheim Total Return Bond fund, which was sold at a tax loss.  Municipal bonds provide tax-free income, which is attractive only in a taxable account.  The tax equivalent yield (your yield after adjusting for taxes) for intermediate municipal bonds exceeded 5% in May for those in the 32% marginal tax bracket.  This level has only been reached three times in the past 15 years (’08, ’13 and ’20), and has provided strong subsequent returns.  The higher yields in the municipal bond market are due to the general disarray of the overall bond market.  The issuers of municipal bonds are in great financial shape (check your property taxes for confirmation of that fact) suggesting the increase in yield is not due to an increase in credit risk.

Glenmede, a large cap US growth fund, was sold and replaced with a similar fund from investment house MFS, for tax purposes.  The new fund is marginally more conservative and pursues the same quality growth mandate of Glenmede.   However, given the price decline of the Glenmede fund, we felt it was important to realize the tax loss.

Finally, 50% of JPMorgan Small Cap was sold and replaced with a value-oriented ETF from Vanguard.  The replacement fund invests in firms that have lower valuations than the overall market, but also screens for quality in the form of cash flows and earnings.  We anticipate that this new addition will reduce portfolio volatility and capture sufficient upside in the intermediate term.

Don’t Panic

Going back to the 1950s, even earlier than the period covered by the chart below, the US economy has experienced 11 recessions and 12 bear markets.  Since 2000, we have experienced three recessions and five bear markets.  It is easy to succumb to anxiety and the irrational fear that this time things are different, that this time we won’t recover.  But we have recovered.  Every time.  The trend is always up, and to the right.

The consequences of current market conditions depend on your situation.  For clients adding to their accounts, a longer recovery means better future returns on your contributions.  If you fall into this camp, you’re buying stocks and bonds at a discount, and your perseverance will be rewarded over the longer term.  For those clients withdrawing funds on a regular basis, the picture is more nuanced.

If you are in, or approaching retirement, we fully understand your concerns.  Bear markets test your resolve.  All the long-term charts showing the equity market’s steady rise over the long haul have little meaning when account values are down for two straight months.  However, this scenario is to be expected and is incorporated into our forecasting.  Our planning software stress-tests your portfolio and assumes that our clients retire into a market twice as bad as what we’ve experienced year to date, followed by a 15% decline the following year.  We plan for our clients to retire into a financial crisis because it’s a possibility, however unlikely, and we owe it to our clients to prepare for the worst.

We’ll leave you with this.  One of the many tag lines within the investment management industry is “Don’t fight the Fed.”  Let’s consider this to be wise counsel.  The Fed is intent on bringing supply and demand into balance by increasing the cost of money.  The follow-on effects of interest rate increases can, and often do, include capital market contractions, as we are experiencing now.  Remember, inflation is too much demand chasing too few goods.  Technically, the Fed is targeting the velocity of money, and debt.  Explanations of these concepts are highly technical and beyond the scope of this discussion.  Simply put, the Fed wants us to spend less.  There may be wisdom in doing as the Fed asks.  It both helps preserve your personal assets, especially important when investment and retirement.

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