October 2022 Stonemark Market Commentary

Don’t Be Fooled by the Latest Equity Comeback

The S&P 500 Index bounced 9.1% from the mid-October lows, spurred by hopes of a Federal Reserve (Fed) pivot, better-than-expected earnings and washed-out sentiment and positioning coming into the month. This rally has reignited the debate whether a durable bottom has already formed, or whether lower lows are still to come. Stonemark’s Investment Committee believes the bottoming process of the equity markets will take some time. Along the way, we believe there will be multiple head fakes for investors to sort out, including the current rally.

Countertrend rallies are not uncommon, with seven experienced during the tech wreck between 2000-2002, and eight seen during the Great Recession. The largest of these countertrend rallies were over 20% in each case, and the longest lasting of them ran for 101 trading days, or 4.5 months. So far, the current bear market has only seen five countertrend rallies, with the 17.4% pop over 44 days this summer being the longest and strongest among them.

There are several reasons we feel the current rally will ultimately fizzle out. First, we continue to believe that hopes of an early Fed pivot are overly optimistic. Policymakers appear poised to begin slowing the pace of interest rate hikes into year end and early 2023 (however, cuts remain on the distant horizon at this juncture) given strong services inflation which, even excluding shelter, is running at 8.2%. Furthermore, the unemployment rate currently sits at 50-year lows, providing continued support for more services spending through elevated wage gains. A premature U-turn in policy — possible only in a scenario of severe and rapid deterioration in the economy and financial markets — prior to creating more labor slack could perpetuate inflation risks into the future.

Source: CNBC SP 500 Index 90 Day chart

Secondly, interest rate increases take time to truly impact businesses and the market in a material manner. Since the beginning of the Federal Reserve’s rate hiking cycle earlier this year, the Federal Funds Rate has risen from nearly 0% all the way to almost 4%. We believe that the impacts of these rapid rate increases have not fully materialized in corporate earnings and consumer spending outside of select pockets of the market, such as real estate which has seen mortgage rates surge and new home purchases crater. The impact of these rate increases will begin to truly show next year, where earnings will have to be adjusted for increased capital costs and unilaterally weaker consumers.

Additionally, we are just beginning to witness layoffs occurring en masse, primarily concentrated within the technology sector. Behemoths like Amazon, Meta and Disney have indicated that they are beginning to trim their labor pool and slow hiring efforts, indicative of corporate belt tightening. As current economic conditions become further entrenched, companies outside of the technology sector are likely to begin their own layoffs and we feel that this will materially impact the market in a negative way.

Strong Rallies Are Common Within Bear Markets

Strong earnings in the first half of the reporting season have further bolstered the bulls, although 2023 expectations have drifted down by 2.8% over the month, according to FactSet, despite many companies electing to wait until next quarter to revise guidance. As hopes of a Fed pivot fade and further recessionary reality sets in regarding 2023 earnings, further downside movements are likely.

While the current rally may have been sparked by excess pessimism being unwound, it has a plausible chance of lasting longer and running further if typical post-midterm market behavior is a guide. Markets often rally following the midterm elections as uncertainty over control of Congress and the policy agenda abates. This has historically led to outsize returns in the quarters following the midterms.

Inflation Drives Everything

“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Milton Friedman

What Is M2 Money and Why Do We Care?

According to Investopedia, M2 is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, and other time deposits (in amounts less than $100,000). These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits.

We care about M2 because it is one of the best methods of determining inflationary pressures in the economy. The current rapid descent of M2 correlates well to the slight easing of inflation, as evidenced by last week’s CPI and this Tuesday’s PPI reports. M2 peaked in March of 2022 and the most recent data provided by the St. Louis Federal Reserve Bank indicates a beginning of the contraction of money supply and the contraction is accelerating. If Friedman was right, we should continue to see a significant deceleration in inflation:

Source: Board of Governors of the Federal Reserve System (US)

Markets Don’t Wait for Recession to Be Declared

Some investors may worry about the stock market sinking after a recession has officially been announced. But, history shows that markets incorporate expectations ahead of economic reports. The global financial crisis offers a lesson in the forward-looking nature of the stock market. The US recession spanned from December 2007 to May 2009, as indicated by the shaded area in the chart. But, the official “in recession” announcement came in December 2008—a year after the recession had started. By then, stock prices had already dropped more than 40%, reflecting expectations of how the slowing economy would affect company profits. Although the recession ended in May 2009, the “end of recession” announcement came 16 months later (September 2010). US stocks had started rebounding before the recession was over and climbed through the official announcement.

Data as of Oct. 31, 2022. Source: BLS, Federal Reserve, Census Bureau, ISM, BEA, American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg. The ClearBridge Recession Risk Dashboard was created in January 2016. References to the signals it would have sent in the years prior to January 2016 are based on how the underlying data was reflected in the component indicators at the time.

The dashboard above saw two signal changes this month, with Job Sentiment turning yellow and the Yield Curve moving to red given the inversion of the 10-year/3-month yield curve. Layoffs have accelerated with huge announcements from mega-tech companies such as Facebook (META), Amazon, Twitter, Zillow, DocuSign, Snapchat and many more. Undoubtedly, layoffs will accelerate in other sectors and trickle down into smaller companies as well. We are also focusing on the 10-year/3-month portion of the yield curve because it has not had a single false positive over the past eight recessions, providing an average of 11 months of lead time ahead of recessions ranging from five to 14 months. Last week’s inversion is a sobering economic reality in stark contrast to the recent market optimism.

Continue a Disciplined Approach

Although a durable recovery will eventually unfold, we expect market turbulence to continue through the coming quarters as investors face their first proper economic downturn in over a decade. While the current selloff is now 10 months old, it remains much shorter than the 16-month average that post-WWII bear markets have lasted. The bottoming process is a bumpy road that typically sees both ups and downs, requiring investor patience and discipline. We continue to believe that tilts toward defensive sectors and a bias for quality names will be beneficial for equity portfolio positioning over the intermediate term. The Stonemark Investment Committee is focusing on strong balance sheet companies that have high free cash flows, defensive postures, and disciplined C-suites and boards of directors.