The S&P 500 continued to move higher for the first half of the month before it topped out and began to move lower, ending the month in the red. The S&P 500 and the Dow were down over 4% while the NASDAQ was off 4.4%. Small caps (IWM) held up a bit better, only shedding 1.7%. As rates moved higher, the bond index (AGG) declined 2.85% for the month. Value (RPV) was down 1.2% while growth (RPG) declined 4.4%.
TWG growth, moderate and conservative portfolios were down 2.25%, 2% and 1.75% respectively for the month, aided by the cash allocation and overweight to value.
WHAT’S DRIVING THE MARKET – EXPECTATIONS
Financial markets do not always move on fundamentals or technical, and sometimes not using any logic at all! Often, the markets trend based on future expectations. Since the low made on June 16th, it is widely believed that the market advanced on the expectation that the Fed will pivot during the first half of 2023 and start to cut rates. Through this lens, the market got excited based on the prospect of a less hawkish fed. The narrative has been based on initial signs that inflation has likely peaked, as recent data has indicated and that inflation levels have begun to decline, albeit very gradually. With the expectation that the Fed is already impacting price stability, they will not need to raise rates as high as what the market expected earlier in the year. To us, this was a head scratcher.
If inflation moved down meaningfully over the past few months, then perhaps the trajectory would indicate that inflation would move closer to the Fed’s 2% target early in 2023. Realistically, however, that inflation has declined from 9.1% to 8.6% does not pave the way to get down below 6% by then.
Here at TWG, we never really thought that the market’s collective expectations made much sense. We just could not see how the Fed, or the market, could already be declaring victory in taming the highest increase in prices in decades. But somehow, some way, market participants believed they heard a much more dovish Fed chairman Powell during the July Fed Open Market Committee meeting presser. Sure, there would be no Fed meeting in August, and inflation data since July is leaning to the downside. Feet on the ground see gas prices continuing to decline week after week. But the battle against high inflation is not easily won, and often takes time for the economy to slow down enough to meaningfully reduce prices.
The big Fed event in August was the investor symposium in Jackson Hole, WY, on August 26th. There Fed Powell delivered a short and concise speech which dramatically changed the markets expectation of how much more work the Fed has committed to reign in the forces of higher prices. Plain and simple, along with references to the high inflationary environment of the 1970’s, Powell’s message was to clarify the misunderstanding that market participants were making from the July meeting – that it will take some time to bring inflation down to the committee’s target objective of 2%, and during that time and higher rates “will bring some pain to households and businesses.” The market dropped over 3% after his press conference and continued to decline during the final three days of the month after a wakeup call that the Fed means business by declaring this “higher for longer” mantra.
MARKET TECHNICALS
In our last note, we referenced the technical progress that was made since the June lows – namely that the S&P 500 moved higher than its 50-day moving average (MA) – a short term trend indicator (purple line in the below infographic). After the 50-day was surpassed, the market raced towards its 200-day MA, a longer-term trend line. The market almost touched this important technical level on August 16th, then quickly retreated. Thus, it appears that the 200-day MA (red line) is acting as overhead resistance. That the market was unable to take the 200-day MA is technically bearish – a reminder that we are still in a bear market. Furthermore, that the 200-day MA is still sloping downward and that the recent run up was not able to change this trend, suggests that the path of least resistance is still to the downside. How much lower the market could go down nobody knows, but it does warrant being cautious.
The other important pricing level we’re looking at is a point of past support and resistance is in the S&P 500 4,170 area. This is the price at which the first downdraft bottomed at this support level in March, and retested a week later before the market advanced to overtake the 50-day MA and rally into first quarter end. This double bottoming along with an advance above the 50-day MA looked like a credible level of support. Then, the next leg down began in April and bottomed in mid-May. The ensuing rally into June hit resistance in the 4,165-4,176 level three times before rolling over to make the current cycle lows in June. During the rally off the June lows the S&P not only moved above its 50-day moving average again, but also popped above this 4,170 area before rolling over again – a classic head and shoulder charging pattern, which is bearish. To us, this is a clear indication that the market is still working out the impacts of higher rates, higher inflation and a slowing economy. Thus, there is still no clear direction, and we are not out of the woods yet.
PORTFOLIO ADJUSTMENTS
Our work here never ends. Given that the pricing action in July and early August was decidedly up and to the right, we continued to incrementally add stock exposure to the TWG models. On August 2, we added exposure to the S&P equal weight fund (RSP), and added a little more on 8/8. Also, on 8/8 we shifted some value (RPV) to the S&P 500 (SPLG) and on 8/15 we added to VTV, our more conservative value fund as the market continued to advance. However, as the market peaked, and then fell hard on 8/16, we sold out of SPLG and trimmed RPV and VTV. The end result as we closed out the month was a sizable accumulation of cash, lowering the overall risk profile across the board.
Given the somewhat recent declines prior to the June low, our process was quicker to shed risk assets during the most recent drawdown. During the three days following the Fed induced sell-off, when we had reduced stock exposure, the market declined an additional 2.5%. Current cash levels are around 30% for TWG Growth, 37% for TWG moderate, and 36% for TWG conservative. These high cash levels almost exceed the cash levels we reached in mid June, and will serve to insulate your portfolios from further downside.
LOOKING AHEAD
As we enter the historically volatile month of September, we anticipate the market will continue its bear bull tug of war, with a likely increase in daily volume as Wall Street returns from summer break to re-sharpen their risk pencils.
The potential effect of every economic data point will be scrutinized in advance of the Fed’s mid-month policy meeting. The market is split between a .75% hike and a .50% hike. Another .75% hike will probably put the market on more defensive footing, and a .50% hike will likely raise expectations that the Fed is beginning to ease the pace of future rate hikes.
But the future rate increases (whether .25% or .50% into year-end) will most likely be data dependent, as the Fed has continuously stated. If we continue to see lower consumer price index readings, higher unemployment, slowing job and wage growth, softening housing prices, and additional cost cutting measures by corporate America, the market may start to anticipate an end to the Fed’s normalization of rates. However, we believe this is still far off.
It’s been six months since the Fed’s first rate increase, and subsequent increases are just starting to impact economic activity. Housing was the first area to reflect monetary tightening, as mortgage rates are quick to respond to increases in the Fed funds rate. The labor market is still extremely tight relative to historical levels, and the unemployment rate is still very low, though just starting to show some signs of tightening. Layoffs have started in less profitable sectors of the market, and employers are also starting to reduce the pace of hiring, which will soften the labor force further. The strength of the labor force is one area of concern, as demand will likely not wane enough to impact the inflationary forces if jobs continue to be plentiful and wage growth continues to escalate. Unfortunately, Powell was very clear in his Jackson Hole speech that unemployment will likely have to increase a couple percentage points to have a meaningful impact on inflation. This is part of the pain he referenced.
With earnings season in the rearview mirror, we will have to wait until October and November to see to what extent future earnings are re-rated in light of the tighter monetary conditions that are now starting to show up on corporate balance sheets. Thus, inflationary data will be the important news flow which will primarily impact the market in the month ahead.
As always, we hope this note provides some objective perspective on where we are, where we may go, and most importantly the actions we are taking to manage risk and return in a highly uncertain market environment.
