After a surprisingly strong start to the year, the market rolled over in February. The S&P 500 and bond index (AGG) declined 2.5%, the NASDAQ declined .5%, the DOW lost 3.9%. Value/RPV shed 5.5%.
What Moved the Markets – Strong Economy and High Inflation
The February 3rd release of the January jobs report was stronger than expected. The large addition of workers to the labor force is inflationary in nature. The market sold off on that data point, implying that the Fed will need to keep raising rates to cool the hot labor market, which has been the one area where inflation has not abated.
This data point has continued to the recent trend that good economic news is bad news from a rate perspective. However, it is very difficult for us to see a recession in the near term when the unemployment rate is so low, and companies continue to add employees in the aggregate.
Additional February data points show a stronger economy and hotter prints than what the Fed would desire from their efforts to bring inflation down. January retail sales rose by 3%, much higher than the 1.8% expectation. CPI rose .5% in January, and annually dropped to 6.4%, less than the 6.2% expectation. PPI increased by .7%, more than the .4% expectation. Is this a one-off month, or a change in trend to one where inflation is fading less quickly than expected? Fourth quarter GDP was revised higher, implying more strength in the economy than was previously indicated.
All of these signs would imply that the Fed may have to raise rates more than what the market has been pricing in. Higher rates for longer would also imply that the proverbial “pivot” or even a pause, is further away than what has been priced into the market. Once again, the perception of how far the Fed may go seemingly changes monthly, adding more confusion and uncertainty to the mix. This uncertainty typically heightens volatility, which we are clearly seeing on a day-to-day, month-to-month basis. Simply put, there is more work to be done on the inflation front, which leads to less visibility about the future and where the market may be headed in the short term.
TECHNICAL INDICATORS
Viewed through a technical lens (see infographic below), the S&P 500 started the year not only moving above its 50 day moving average (purple line) but also moved and stayed above its 200 day MA (red line). The 200 day MA has also started to flatten out, suggesting the long term downtrend could be receeding. The S&P 500 in January also notched a series of higher highs and higher lows, supporting a higher trending 50 day MA and suggesting a short term continuation higher. Lastly on the positive side is what’s called a “golden cross”, where the 50 day MA crosses above the 200 day MA – a positive technical indicator. However, the pricing action in February may have changed course. As you can see from the infographic below, February pricing action resulted in a series of lower highs and lower lows – a reversal from the technical trends observed in January. The S&P is still priced above its 200 day MA, which, in our opinion, needs to hold in order for this curent uptrend to contnue. The 200 day MA will likley be a near term battle ground that could determine the forward trend, at least from a technical perspective. 
PORTFOLIO ADJUSTMENTS:
Being close to fully invested because of the positive pricing movement during January, there was very little trading activity.
On February 2nd, we adjusted our bond exposure and sold 50% of VARBX (alternative investments) and purchased PFFA – a preferred income fund.
On February 28th, we sold our small S&P 500 position, SPLG, and moved to cash.
Given the declines in RPV/value in February, we would not be surprised to see a reduction in this position (which is our largest) and allocate any sale proceeds to other areas of the market, such as growth or mid-caps –both of which have exhibited relative strength since mid-January (as long as the trend continues).
LOOKING AHEAD
We are at a perplexing juncture in this economic cycle and the market can go either way. There is simply no clear direction or trend that seems durable given the deluge of conflicting data and underlying strength in the economy. This strength, and the ongoing spending by consumers, is quite resilient, but it is unlikely to last indefinitely. As we’ve stated numerous times in the past, the longer it takes for inflation to recede back to the Fed’s 2% target the more likely a recession will emerge. Savings rates continue to decline, but there is still a lot of excess money sloshing through the economy. It seems that the stimulative measures that were taken during the pandemic continue to support consumer spending and overall economic activity.
Think about this: money spent by one is money earned by another. Given this concept, we suspect that the spending down of stimulus checks and heightened savings resulting from the pandemic will stick around for longer than most have thought, with excess capital simply changing from one hand to another. Almost like musical chairs. So, either inflation has to head down fast so that rates can moderate before the last seat is taken, or inflation remains so stubbornly high that the Fed is forced to raise rates much higher than anyone would have thought. The latter scenario, in our opinion, will likely lead to a policy error and cause the economy to contract.
We will continue to follow our process to manage risk and are reassured that having an objective evaluation process will assist us in handling whatever the near-term situation brings.
We wish you well.
