Rearview to Windshield, July 2022

by | Jul 5, 2022 | Blog, Market Updates

Developments Over the Past Month


The U.S. Officially Entered into a Bear Market: The S&P 500 has officially entered a bear market, marking the 27th bear market since 1929 (20%+ peak-to-trough decline without a 20% rally). Historically, bear markets have resulted in a 35% avg. drawdown. Finally, the S&P 500 is on track for worst quarterly performance since height of pandemic fears, worst 1H since 1970.



Keeping the Same Title as Last Month: The Beatings Will Continue Until Morale Improves: Markets have been held hostage by fears of an inflation-fighting Fed-induced recession. Those concerns have been front and center for most of the year. Markets have done an efficient job of pricing in many, if not all those concerns. On the other side of the debate, it would not take many things to break right to infuse a more positive attitude into the narrative. 1) China reopens and gets back to clearing supply chains and picks up demand for global goods and services. 2) Inflation starts to roll over. We are seeing signs of that in the Regional Fed updates on the prices paid lines and in many commodity prices. 3) The war in Ukraine ends. All of these are credible possibilities, and any one of them would be positive for both the economy and markets.


The Beginning of Quantitative Tightening: We are beginning a new regime as the Fed moves to reduce the size of its balance sheet which has grown to nearly $9 Trillion. Since March 2020, the Fed has made more than $4T in bond purchases. Now, to fight inflation, the Fed will begin to let some of their bonds mature (without replacing them). According to the central bank, roll offs will ramp up to $95 billion in September including a $60 billion reduction in U.S. Treasuries (“UST”) and a $35 billion reduction in Mortgage-Backed Securities (“MBS”). The first three months, however, will begin at half that pace, $47.5 billion, comprised of $30 billion UST and $17.5 billion MBS. That compares to a peak roll off $50 billion a month when the Fed performed the exercise starting back in 2017. The Fed started this process in June.


Where is The Fed Put?: We continue to believe that the Fed Put is much lower right now, as FOMC Chairman Jerome Powell has stated that the Fed is going to keep raising until we have a recession unless inflation meaningfully improves. The cause of the decline is equally important. The Fed has a long history of easing policy in response to earnings drops, but there isn’t much evidence that it responds to multiple compression. The fact that inflation is higher than at any time since the genesis of the Fed Put and that stocks have appreciated a lot over the past two years suggest the strike is well below current prices. Similarly, the recent decline in stock prices owes exclusively to lower multiples; it would take another leg down induced by a drop in earnings to impress the Fed.


Rate Hikes: The Fed is “unexpectedly” hikes 75 basis points in June, as the May CPI reading came in much structurally higher-than-expected. Now, the market is pricing in a 50-75 basis point hike in July, with September leaning towards a 50 basis point hike. But after that the outlook is bit cloudier. The market has fully priced-in 10 rates hikes in 2022 (to the 2.50-2.75% range) and one more in 2023 which would be the fasted pace of hikes since 1989. We expect Powell’s tone to remain hawkish at future press conference. Finally, financial conditions have already tightened significantly, for example the pop in mortgage rates is harming housing affordability and with further Fed tightening there will be more casualties to slow the economy further.


“Phantom Earnings” Moving Forward: Overall, 2022 consensus EPS are up modestly, but what is most noteworthy is how this earnings trend has skewed between indexes with small cap and value indexes seeing much more significant positive earnings revisions, while growth and larger cap indexes, more negative. While consensus 2022 EPS rose 1% since April 1, it was entirely driven by Energy (-0.2% ex-Energy). Over this past retail earnings season in middle May, we started to see a shift if spending habits by the consumer, spooking the market.


The U.S. Consumer: US consumer confidence dropped in June to the lowest in more than a year as inflation continues to dampen Americans’ economic views. The Consumer Confidence Index – a measure of expectations – which reflects consumers’ six-month outlook – dropped to the lowest in nearly a decade as Americans grew more downbeat about the outlook for the economy, labor market, and incomes. Consumer spending is about 70% of the US economy. If people start spending a lot less, then businesses lay off workers, which leads to even less consumer spending. As a result, unemployment could rise a lot.


S&P Valuation: The S&P 500 is trading back at 16.5x or 1 turn higher than where it was trading at the prior week’s lows… this seems hard to justify given the growing concern about earnings. As a result, we continue to believe any near-term rally is nothing more than a bear market bounce with lower lows ahead.


Earnings: 2022 S&P 500 operating earnings = $229. 2023 = $251. 2021 = $209. 2020 = $142. 2019 = $165.


Valuations: S&P 500 Fwd. P/E: 16.5x, EAFE: 11.7x, EM: 10.7x, R1V: 13.0x, R1G: 21.7x, and R2K: 11.2x.  



Talking Points – July 2022


  • Yield Curve: The yield curve officially inverted at the end of March. an inversion of the 10/2 spread does not mean a recession is imminent. Historically speaking, stocks rally for about a year after a 10s-2s inversion, with an average return around 15% (heads up, this is a different range than shown in a below chart). So, a curve inversion is not a reason to sell—it’s a signal that the time on the bull market and economic expansion is now limited, and to prepare for both to end.


  • Build Back Better: Though it wasn’t passed in 2021, President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. In our opinion, this is a big experiment. We’ll wait to see how the Build Back Better plan and taxes pan out. It appears that this dramatic change in societal direction has proved to be difficult for some moderate Democrats to get on board, i.e., Manchin.


  • We continue to watch forward EPS expectations fort he market as it starts to grapple with higher-than-expected inflation curtailing margins. 


  • Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.



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