Taming the Bear: The Federal Reserve Needs to “Crack the Whip!”

We are now firmly in the twelfth month of this bear market across major asset classes, including stocks, bonds, crypto, and, most recently, housing! Like all bear markets, the declines have come in stages and phases based on economic data and what we consider misguided Federal Reserve commentary and policy. In the most recent decade, investors have become overly dependent on the Fed to alleviate whatever ails financial markets by simply lowering interest rates. The Federal Reserve has had a hard time breaking this habit, but it will be necessary for them to continue to raise rates if we are going to put an end to inflation and this broad-based bear market. Don't get us wrong, the end of this bear market is closer than most investors think – but, in some ways, it is being prolonged by a Federal Reserve that's afraid to "crack the whip!"

What do we mean by "crack the whip?" Can the end of the bear market be close? How will we transition your portfolio from our conservative posture if we head into a real economic and financial market recovery?

Inflation Let the Bear Loose!
All bear markets are rooted in some economic misalignment and are a natural part of the business cycle. This period is a result of an overly stimulated economy that led to excessive inflation on everything from food to lumber to wages. As we have expressed many times this year, excessive inflation can wreck an economy and the earning power of its citizens. The antidote for inflation is to increase interest rates, which slows economic growth and demand – thereby allowing supply to catch up and prices to fall.

The Fed Has Come to The Rescue by Purposely Slowing the Economy
There is no doubt that the Federal Reserve's current policy of raising rates has begun to work its magic. The economy has slowed, corporate profits have stumbled, stock prices have declined, and inflation is, in fact, falling. It will continue to do so if the Fed can maintain the discipline to forge onward and upward until inflation comes down to an acceptable and healthier level. The Fed's goal is to bring inflation to 2% from its current level of 7.7% (its highest level was over 9%). In our opinion, financial markets could have found their equilibrium level sooner had the Fed stopped "coddling" investors and financial markets with "sweet talk." For example, last week's soothing commentary that they may slow the pace of interest rates sent stocks soaring, only to find that since then that the economy is still growing way too fast to do so, which has caused stocks to give back all those gains and then some. This type of "sugarcoating" has been going on all year and has prolonged the bear market in asset classes. If the Fed wants to put an end to inflation and the bear market, they need to "crack the whip," stay disciplined about raising rates, and cease coddling investors’ expectations.

We Were Almost There – But We Shall Be Soon!
A few weeks ago – before the Fed once again wooed markets - stock prices got closer to the point of discounting the mild recession we foresee in 2023. At that point, most indexes were down 28-38% – a further 10%, and we would probably have reached the point of aligned valuation. However, the recent market rally has caused us to put aside our appetite to become more growth-oriented until the prices align with our view of a more contracted economy and lower levels of corporate profits over the next few quarters. Perhaps the next market decline will provide that invitation as corporate profits continue to sputter and unemployment ticks upward.

The Next Bull Market Will Start During the Recession

Bull markets usually start during recessions since stock prices discount where corporate profits are headed months into the future. Given this fascinating relationship between stock prices and the economy, we believe we may reach that point sometime in the first quarter of 2023. That's right! The new bull market is not far into the future – particularly if the Fed can focus and "crack the whip!"
In preparation for the new bull market, we have already made a list of great companies that we feel will be the best beneficiaries. This list will include companies from the tech, financial, industrial, energy, consumer, and communications sectors. Keep in mind that every new bull market is different than the last, and this one should prove that to be the case.

As Interest Rates Rise and Profit Growth Goes Lower – Lock in Yields with Longer Term Bonds
Over the next few months, we envision an environment where investor fears go from inflation to a possible recession. This environment often happens as the Fed's rate increases slow the economy to a halt. As inflation dissipates and the whiff of recession arrives, expect the market for interest rates to decline – in fact, it has already started to occur. We are near a window of opportunity where we would like to lock in some very attractive yields for the longer term by purchasing longer-term bonds for a part of your bond allocation. Though these bonds have longer maturity dates, they can be sold at any time we like. For a more in-depth review of the nature of fixed income and our approach to managing this important asset class, you can read this primer from our team: Fixed Income 101.

We hope you find this update helpful as the markets continue their volatile path toward the end of this bear market. Keep in mind that we are almost there and that our team stands prepared to catch the next bull market as it begins in 2023. Of course, when we start reinvesting towards growth, we will continue to employ our unique Active Risk Management process, which regulates the amount of your stock exposure, sector management, and uses carefully placed stop-loss orders.

Thank you for your continued confidence in our work, and Happy Holidays from all of us!

Your Team at MSR

If you know of friends or family that can benefit from a no-cost portfolio review, please do not hesitate to reach out.