Federal Reserve Chair Powell is a puppet master who plays a world class economist by day and works overtime as a financial bartender, speaking the language of Wall Street gibberish to cajole his customers. For the past few months, the Fed has spoken in tongue with a harsh message to its Wall Street minions who promptly decoded his tough talk as being Dovish. Powell has emphatically declared he will not hesitate to push interest rates higher until the battle to bring inflation down has been won, even if he causes a recession. The problem is that investors are whistling past the inflation graveyard and assume his renewed Hawkish – get tough – tone will have a brief shelf life. Since the June – July equity market lows, when inflation peaked, investors have rushed in to support any swoon in prices due to negative news. Stock and Bond speculators are discounting reduced corporate earnings and expecting an easier monetary stance by the Fed in the new year. Even though only modest monthly CPI numbers will be falling off the 12-month average until Q1 of 2023, the consensus feels that prices will fall more quickly than the Fed implies and thus expects rate hikes to start tapering next month. The Fed continues to raise short-term rates while Bond investors front run the Fed, pushing long-rates lower over the past 3 months. The Financial Conditions Index measuring economic and financial stress in the system correlates extremely well with the stock market. The enormous downtrend from the Pandemic nadir in March 2020 to late 2021 reflected looser financial conditions, providing a confident backdrop for soaring equity prices. When stocks moved to new highs in November of 2021, financial conditions were already edging negatively higher, warning of pending financial stress. This stress index turned Bearishly higher in 2022 in lockstep with falling stock values. Even during the Summer rally, we had forecasted from June to August, financial conditions did improve modestly as Bond investors pushed interest rates lower, against the wishes of the Fed.
A more advanced look at financial conditions is provided by the Chicago Federal Reserve with its ANFC Index. The Bear market lows to date in June coincided with dangerously tight readings above the zero line in this index. Even the strong 19% Summer rally in stocks until the August peak mirrored the small decline or loosening of conditions in ANFCI shown below. Over the past few weeks this stress index bumped higher again with an ANFCI trend that is approaching elevated risk levels once again. Above the zero line will likely coincide with a retest of the June lows or lower. We’ll see how a 75-point hike on September 20th affects this index.
However, a bright spot is that sentiment has been extremely negative due to inflation and Recession concerns. Historically, when expectations become this dire it means sideline cash levels are higher than normal and it will take ever greater surprises or exogenous events to send valuations to decisive new lows. The small investor and money managers have taken enough of a defensive portfolio posture to provide significant buying power once it becomes obvious that inflation is in sharp decline. Rarely do stock prices fall to decisive new lows without an intervening rally when sentiment is this Bearish.
This isn’t a tranquil environment to forecast, which is reflected by what appears to us to be a record split between respected institutional analysts with many expecting a 20% rally by year end and many others forecasting a 20% panic lower. Lower valuations can be justified by exceedingly high inflation and a Fed determined to slow the economy. Yet a great deal of negative forecasts is priced into current values and job openings remain near record levels due to strong backlogs. So, the economy can handle a lengthy but modest economic contraction and the lagging downward earning revisions without necessarily causing severe pain, as long as inflation declines steadily over the next year towards a 2% handle. Compounding the variable forecasting is a potential war with China over Taiwan, a protracted China Covid lockdown, a winter spike in energy prices from shrinking Russian supplies on the world market and a rush of mid-term voter inspired spending bills that will easily surpass $1 trillion. Despite these variables, we are most encouraged for stock investors as we move past potential seasonal weakness in September and October, due primarily to continued record labor and energy supply shortages along with oversold sentiment displayed by individuals, money managers and major institutions. With our outlook for about $217 in SP earnings for 2022, the SP can fall as low as the 3200’s or stay above the 3600’s that has already been achieved. If stock indices remain above their June lows into October, then we will be looking to redeploy more of our 52% cash position back into stocks. Shorter term, we expect to use any dip to the June lows or lower to add selectively to the portfolio.