As the bear market has progressed throughout the year – with intermittent rallies of strength – most investors are focused on “what will it take” to put an end to this gloomy period for financial assets. In this brief strategy update, we thought we would share our thoughts on this important topic. What indicators, statistics, and data does our team need to see “line up” to become more constructive and growth-oriented in our strategy? Let’s take a look at five important factors coming our way throughout the next weeks and months.
1) Inflation Peaks and Meaningfully Heads South
The Federal Reserve continues fighting a battle to slow the economy enough to wipe out excessively high inflation – the latest print in July was 8.5%. Their goal is to reduce inflation to the pre-pandemic low of 2%, which will be quite a feat! So far, it looks as if inflation has peaked, and the Fed is beginning to win the battle. We can see this across commodity prices – namely gas prices – and housing. However, wage inflation continues to spiral upward along with other key core inflation data. We need to see this data weaken to be assured inflation and the Fed’s battle is closer to the end than the beginning. There are several key data points coming up in the next few weeks. As a rule of thumb, the Fed usually stops raising rates when the Fed Funds rate (currently, 2.75%) equals the inflation rate (currently, 8.5%).
2) Slow Growth vs. Recession Reality
The danger of the Fed trying to slow the economy just enough to wipe out inflation is that they run the risk of pushing the economy into a full-fledged recession. Although the poor performance of stocks and bonds as of late may already reflect a slower economic future, prices would have to fall much further to reflect a real recession. Think, stock indexes down 40 to 50% as opposed to the 25% as recently seen in early summer. This is a significant risk that investors should be cognizant of as we head towards the fourth quarter of the year. As with inflation data, there are several key indicators and data points we will be watching closely to make an informed judgment call, which include GDP, ISM manufacturing, and capacity utilization. If the Fed can engineer a soft landing for the economy, financial markets will roar. We will have more clarity on this in the coming weeks and months.
3) Equity Market Valuations and the Illusion of PE Ratios
We find the price of stocks and bonds out of line with the underlying fundamentals of the economy. The global stock market trades at a forward price-earnings (PE) ratio of 17, which is not what we would consider attractive heading into a slowing economy. This is even more uneven in sectors like technology that currently trade at higher PE multiples than the broader indexes. This data is even more concerning when we face corporate earnings reports which start in a few weeks. Given the weakening economy, it is expected that earnings reports, guidance, and estimates may all be lowered. If the “E” of the PE ratio falls as we head into the fourth quarter, valuations will rise even further, making stocks less attractive and may cause another leg down in this bear market. As we have said before, today’s PE ratio may be an illusion if the earnings come in much less than expected in a few weeks. We will be watching earnings reports carefully to better assess if stock prices have become more appealing.
4) The Volatility Index and Investor Sentiment
There are several key indicators, such as the VIX, which measures volatility, and market psychology indicators, such as the Put/Call ratio, that we watch closely to determine if stock prices are attractive. Given the big bear market rally in July and the recent return of “meme” stock investing, these indicators remain unattractive for re-entering the stock market in earnest. We prefer to see this data improve and will be watching it closely.
5) Geopolitical Improvement
The war in Ukraine, energy and food crises in Europe, the concerns in Taiwan, and the rolling lockdowns in China are all negative pressures on global equities. An improvement in any of these issues would be a plus for global markets, and we will watch each carefully in the coming weeks and months.
Given the less-than-constructive economy, inflation, and geopolitics, we have been significantly underweight stock exposure throughout most of the year. However, many of these factors will eventually improve and most likely be faster than investors think. In that regard, we have already built our “bull market” portfolio of global stocks and other “risk-on” tools to benefit from the next new business cycle and bull market. It is around the corner… but we are not quite sure how close that corner is just yet. However, when it does come, we stand ready to re-invest and enjoy the next profitable cycle. In the meantime, there are currently some great opportunities in the bond market to keep your cash working for you with attractive yields. If you have cash or nonperforming assets outside of our management, let’s discuss how we can productively put this to work for you.
We hope this short update finds you well and that you enjoyed the Labor Day weekend. If you would like to discuss your portfolio or have experienced any changes in your financial affairs, please let us know. As always, thank you for your vote of confidence in our work.
Your Team at MSR
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