Past
Commentaries
7/15/2022
Current Commentary
To My Friends, Clients & Observers:
It’s About Time
We are in a bear market. Actually, we’re in a triple bear market, something that has only occurred three times since 1950. There are bear markets in stocks, bonds and cash. A bear market in cash is defined when the T-Bill yields less than the inflation rate. Stocks and bonds are 20% off their highs; the 3 month T-Bill yields 2.4%; the CPI inflation for June is 10.6%, the Producer Price Index is 11.4%.
The stock market generally signals a recession 8 to 12 months in advance. When a recession is identified, after two quarters of GDP shrinkage, the market usually has bottomed. The NBER, the National Bureau of Economic Research is the agency that officially declares recessions. Usually that declaration comes 7 to 12 months after a recession begins. We’ve had bear markets without recessions. The difference between a bear market with recession and a bear market without recession is the length of time the bear lasts. And that is what concerns investors most because of the time value of money. It’s my opinion that we’re in the second of two quarters of shrinkage and hence we’re in a recession.
Adding significant inflation to recession causes stagflation, when nothing grows except prices. Earnings, wages and spending power all shrink. Inflation is a nightmare. Our objective is to build and protect purchasing power over time. Purchasing power is the real return on investment. The generally outstanding returns we had in 2021 have been diminished by the market decline but also by inflation which devalues real returns. We can look at historical charts and time the average duration of bear markets, but inflation is more durable, harder to control and harder to predict. Once inflation psychology sets in the only cure is a severe economic shutdown and reset. I don’t believe we have an inflation psychology yet and in fact this inflation may be transitory.
Mixed Signals
Let’s look at prices of three major components of the economy: 1) raw materials as in energy and commodities, 2) goods, and 3) services. They tend to peak and decline in that order. Energy prices and commodities have peaked and fallen; oil from $106 to $96; gold from $1949 a year ago to $1700, silver from $27 to $18; and copper and most other industrial commodities as well. Goods have not declined yet but they should, considering their raw material costs. Labor costs are not keeping up with inflation yet. There is no wage cost spiral – yet. Services usually peak 3 to 4 months after goods peak.
Falling commodity prices may reflect a recessionary slow down or they may reflect replenishing supply lines. In fact, there is evidence of increasing inventories in raw materials and finished goods which are leading to gluts which might cause a classic inventory recession. But increasing supply is a healthy antidote to inflation. I don’t foresee an inventory recession. Critical transaction technology, in addition to AI technology, is exponentially more powerful than it was 20 years ago.
Precious metals are the classic defense against inflation. They are not confirming. The dollar has reached parity with the euro and dollar strength is anti-inflationary.
Despite falling consumer confidence and gloomy consumer expectations, consumers are still spending aggressively, probably the effects of post-pandemic frustration and too much cash sloshing around. The consumer still generates 60% of GDP.
The unemployment rate of 3.6% is not an accurate indicator of economic strength. It has to be qualified by the participation rate. If all able-bodied workers who choose not to work were counted the unemployment rate would be over 9%. However, the size of the labor force is shrinking as the baby boom generation retires.
The yield curve is inverted and that is a strong predictor of recession. Treasury yields are 3.159% (2 year), 3.05% (5 year) and 2.93% (10 year). The Federal Reserve is committed to raising the Fed Funds rate another .75% next week, with more to follow in coming months. The Fed has also committed to a tighter money supply and a shrinking balance sheet. That remains to be seen. It will take generations to soak up so much excess money and generations of slower economic growth burdened by so much debt – created by an out-of-control political aristocracy immune to such concerns.
Inflation is the dragon that must be slain.
Earnings Earnings Earnings
Earnings reports for the second quarter are being released and they are not great so far. Of as much concern are the number of analysts’ downgrades and negative corporate guidance going forward.
It would be constructive if the U.S. suffered a short, sharp recession setting up a significant rebound in 2023. There are good values in great companies that we haven’t seen in years. The S&P 500 trades at 19.5 times earnings and a 1.66% dividend yield. I am concerned about the rest of the globe. Fully 40% of U.S. corporate earnings come from abroad. Corporate management has more powerful tools than ever before to increase productivity and profitability. Great companies find a way.
There is a trend in the market away from growth stocks to value stocks. That favors portfolios like ours that have value components of lower than market Price to Earnings and lower Price to Cash Flow.
There is an old saying that bears repeating. I can’t predict the direction of the next 10% move in the market but I can predict the direction of the next 100% move. It is up.
It’s just a matter of time.
Best regards.
Dennis M. O’Connor
