Perspective : The Download: 3Q 2022

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Inflation fear and capital markets

Capital markets have double dipped, and the S&P 500® Index has hit a new 2022 low based on the same old fears. This decline is taking longer than most people want to tolerate, and a double dip is so deflating. It leaves investors with the feeling that whatever ails the markets now appears permanent.

Having been a student of capital markets for 30 years now, I am humbled. This is an industry where the more I learn, the more I know what I do not know. That being said, it seems to me that historical capital market performance has clearly rewarded investors over the long run, and it only rarely offers investors a significant “sale” as represented by a Bear Market in the S&P 500. If only I could have taken advantage of all these downturns. This simple knowledge would have been all I needed to know to succeed as an investor.

In my opinion, the negative positioning in the markets is because inflation is running hot. The inflation fear is that the Fed will over tighten, interest rates will rise too much, the consumer will collapse, and earnings crater. This shouldn’t be a surprise to any investors, as this has been the narrative now for over a year.

As far as risks go, inflation is a risk we have seen before with an identifiable solution. Inflation has been a frequent risk throughout history. I think inflation is not a black swan, and by now investors should not perceive this to be a fat tail event. Nor do I think anything is “broken” – like the financial system was during 2008. As far as risks go, this is not that abnormal. But it is just about to get worse, right? History would say, maybe. I would say, that is one of the things that I know I don’t know. Nor does anyone else.

If you peruse any source of media, there seems to be a lot of people who think they know. The more negative the scenario, the smarter they think they sound. I guess this is the business of pontificators and talking heads, and nothing sells clicks and eyeballs like fear. By now, we should all understand that the media thrives on chaos. Is any of this information chaos helping anyone?

To this point, the University of Michigan Consumer Sentiment Survey recently showed that consumers think that the economy was about the worst in history! Say what? This strikes me as being quite a negative stance.  Is it the barrage of negative information that consumers are trying to absorb that leads to this opinion?

Source: http://www.sca.isr.umich.edu/files/chicsh.pdf

Back to my question: Is any of this information overload helping investors? Yes, absolutely. When investors are scared and when pessimism sounds smart, those few investors with fortitude to see the obvious can be rewarded. The above chart screams to me. Historically the lows of pessimism have been met with apparent buying opportunities. What do 1974, 1980, 1990, 2008 all have in common? They are those rare times when the stock market has presented possibilities for investing in markets where declines subsequently recovered.

Tell me something good, please!

On the flip side of the current tide of pessimism, an optimist might note that the U.S. unemployment rate is near the lowest in history, and wage growth is the highest on record. Consumers and businesses appear healthy, and the world’s economy is far more profitable (more service oriented) than in the 1970s. So far, the “predicted” economic and earnings debacle has yet to occur. The near unanimous prediction of serious damage has resulted in stock prices at low valuation levels, we believe implying that higher future expected returns for stocks are reasonable from these price levels.

Forward Price-to-Earnings (P/E) ratios for U.S. stocks near historic lows

Recession – “The stock market has predicted nine of the past five recessions.” – Paul Samuelson[1]

This may be the most expected recession in history. The moment we have all been waiting for. After both stock and bond markets have already experienced sizable losses, inflation is only now impacting earnings and the economy. This relationship is chapter and verse in the annals of stock market history. The capital markets generally lead the economy, not the other way around. The capital markets lose money first, then the actual economic damage occurs. However, the Atlanta Fed doesn’t seem to see a contraction in GDP, their models imply quite the opposite.

No recession yet – The Atlanta Fed seems to think that GDP will be +2.9% in the third quarter.

Source: https://www.atlantafed.org/cqer/research/gdpnow

Inflation

While it appears that inflation is currently persistent, history tells a different story.  Most prior inflation regimes U.S. have not lasted much longer than 3 years. I think this is likely because inflation leads to a Fed response, falling asset prices, and a slower economy, all of which have historically been deflationary forces. One scenario that should be considered is that central banks may very well be successful with their rate hike campaigns.

The cure for inflation is inflation – Most inflation regimes have not lasted longer than 3 years

Did I lose you there? Does the pontification that inflation will just fade away and that the invisible hand of the market will make everything OK sound a little too simple and naïve? We are accustomed to more excitement from our media sources, but reality can be boring. Want something to really worry about again, wait until the housing market collapses. See what I did there, I grabbed your attention back.

You can’t be an investor without worry, there is and has always been a worst-case scenario.  Optimism sounds simple and naïve, while fears shoot straight to the amygdala.

Is this a buying opportunity or are conditions just about to get worse? As I have already stated, I know that I don’t know. The answer can be both. In the short run, it certainly appears that investors believe that outcomes are about to get worse. In the long run though, historically the stock market has recovered, and rarely are stock prices on “sale”. That’s what I think I know.

[1] Paul Anthony Samuelson was an American economist, who was the first American to win the Nobel Memorial Prize in Economic Sciences.

[2] U.S. Bureau of Labor Statistics, Consumer Price Index

[3] Federal Funds Effective Rate (FEDFUNDS) | FRED | St. Louis Fed (stlouisfed.org)

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Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

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ASSET CLASS INDEX INDEX DESCRIPTION
U.S. Large Cap Equity S&P 500 Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ

 

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