After starting the month of May with increased selling pressure, the S&P 500 rallied over 6% during the last week to book its first positive month of the year, gaining 1.54 points, or .03%. The NASDAQ 100 (QQQ) was down 1.45%, and small caps (IWM) gained a fraction of a percent. Bonds were up 1% on the month. TWG Growth, Moderate and Conservative portfolios were up 1.6%, 1.45% and .6% respectively.
WHAT’S DRIVING THE MARKETS – INFLATION
Inflation is the main driver of the market, and for good reason. Inflation continues to challenge the Fed and their interest rate policy as they attempt to reduce demand to contain the rising cost of goods and services. April’s inflation reading indicated a slight cooling of the CPI (consumer price index), coming off the record levels of March, but hotter than what was forecasted.
During the May policy meeting, the Fed raised the Fed funds rate by the expected .50%, and indicated that they were not considering a .75% increase. Upon the Fed announcing their rate increase, the market rallied into the close. However, the very next day the market took a leg down, presumably on concerns that the Fed was not committed enough to aggressively fighting inflation. To us, this signals that the market is more concerned about persistently higher inflation than about the Fed funds rate. We believe this is warranted. As we’ve expressed in the past, higher inflation for a longer period of time will likely be more damaging to the economy than would aggressive rate increases designed to cool the economy. The market seems to agree.
At the end of the day, investing is about buying quality companies with the ability to grow earnings over time and return profit back to shareholders. If the market gets too “expensive” then market participants become less comfortable owning companies with low or no earnings (paying too much for a unit of profit). If the market becomes too “cheap” then participants are more likely to increase ownership of companies that can at least sustain earnings (getting more “value” out of stocks given their earnings).
These are difficult and volatile times, and we are very aware of the push and pull of inflation and interest rates on the economy, earnings, growth expectations and the impact on financial markets. Many interrelationships, some of which are explained below, create a dynamic different than prior periods of economic turbulence.
-To fight inflation, the Fed needs to cool demand. Its main tool to do this is raising rates to make it more expensive to borrow. This effects the housing market (more expensive to finance), corporate expansion and speculation (buying financial assets with borrowed money).
-If the Fed raises rates too much and chokes off growth, they may very well cause the economy to slip into a recession. They are trying to engineer a “soft landing” by curtailing demand enough to reduce inflation but not too much to choke off growth.
-Higher rates increase the discounting of future earnings, thereby making stock valuations more expensive than in the lower rate environment we’ve enjoyed for the past 10 years.
-If inflation persists, the Fed will likely need to continue to increase rates, thereby putting more pressure on stock valuations.
-If the Fed does not act aggressively enough, then inflation will likely remain persistently high, forcing individuals and businesses to pay more for just about everything. The effect of which is less disposable income to purchase discretionary items, and higher input costs for corporations which deflate their profit margins, and thus earnings.
-If estimated and realized earnings and profit margins deteriorate, then valuations will again become more expensive, likely requiring stock prices to decline further to keep valuations at reasonable levels.
-If inflation begins to recede, then the Fed will likely be able to back off on raising rates; a lower future rate expectations will decrease the discounting of future earnings and valuations will appear much more attractive, likely increasing interest in stock ownership.
A recession is not inevitable, and a soft landing is possible. Consumer savings are still elevated, and spending remains bullish. Jobs are plentiful and wages are still increasing. But if inflation remains elevated for too long, we may begin to observe a threat to the current levels of prosperity. This is why, in our opinion, the Fed needs to act aggressively to cool the deteriorating effects of persistent inflation.
There are many dynamics at play, and plenty of uncertainty to create ongoing volatility. However, the market has historically sorted out the uncertainty over time, and there are plenty of “green shoots” (mentioned in the prior paragraph) to keep economic activity humming along. The market typically overshoots to the upside AND the downside as it sorts out the impact of monetary and fiscal policy changes. Since the pandemic, the supply of money in our economy has expanded at an unprecedented pace, causing too many dollars to chase too few goods. The excess supply of money will need to be soaked up to temper the inflationary sources that are currently requiring a slowdown in demand to deal with elevated prices. This will take time and will require patience.
PORTFOLIO ADJUSTMENTS
During the month of May we have continued to reduce exposure to risk assets (stocks) and accumulate cash. We trimmed RSP (S&P equal weight) on 5/4 and again on 5/19, bringing this position to 82% of target. We also trimmed SPTM/VTSAX (total stock market index) on 5/2 and 5/6, bringing this position to 79% of target. Our value funds (RPV, VTV, FAB) remain at target, but would be the next positions to trim should the overall market in general, and value stock in particular, continue to deteriorate. TWG model portfolios generally have around 10% in cash which is assisting in not fully participating in market declines. Even with this cash position, the model portfolios kept pace with the month end rally. We are pleased with the risk mitigation efforts, and their expected impact on the bottom line – down less, up more (or as much). Model portfolios ended the month of May down around 10% YTD. YTD, the S&P is down 13% and the bond market is off 9%.
LOOKING AHEAD
A positive development during the month of May was that bonds provided the safety they are designed to provide. After being highly (and untypically) correlated to stocks during the first four months of the year, correlations during May were more typical – bonds were up when stock were down, thereby creating the ballast attributes that bonds are designed to provide. The S&P has yet to enter an official correction (closing day price 20% lower than the recent high), but did come very close on May 20 when the relief rally carried the S&P higher by 6.5% over the following week. It is these bounces off a low that are critical to participate in, and the reason our process will never fully evacuate risk assets. If inflation begins to recede and the Fed signals a slowdown in raising rates, the markets will likely shoot to the upside. Our current exposure will enable us to participate, and our process will quickly inject the sidelined cash back into the market. However, should last weeks rally only be a bear market bounce, then our current cash position will help reduce further drawdown.
If the Fed continues raising rates to reduce demand and cool inflation and if the market resumes its downward trend, then we stand ready to further reduce exposure to risk assets and systematically move more money to the sidelines. However this plays out, our process of navigating the storm will ebb and flow to reduce or increase risk accordingly. In our opinion, the Fed is just starting to raise rates, and likely has further to go – both in amount and duration. The impact of higher rates takes about 3-6 months to impact economic activity, so we believe volatility likely continues in the months ahead. The complexities surrounding the imbalances created by pandemic relief efforts, 10 years of low rates, excess money supply and demand, supply constraints and bottlenecks, the ongoing conflict in Ukraine and China’s zero COVID policy measures will take time to sort out. Brighter days will return, but it could be a while. So, while you enjoy the summer months with friends and family, know we are monitoring your investments on the daily, and will respond accordingly to whatever the market has in store for us moving forward.
