Bob’s Journal for 6/2/22

How Investment Markets Have Changed

Over the last four decades, investors came to believe certain relationships and trends in the markets were inviolate and permanent.

Investment rules and strategies were developed around these relationships. It’s time to reconsider those beliefs.

Historic bull markets in stocks and bonds began in 1982. The Federal Reserve changed its policies and goals at the same time to become a major factor in the bull markets.

We’re in a different economic environment now, and the Fed is changing its policies and goals to reflect that. We don’t know how long this new environment will last, but investors need to follow the Fed and understand what it is doing.

In the early 1980s, Fed Chairman Paul Volcker and his fellow central bank leaders broke the inflation of the 1960s and 1970s. That ushered in a period during which inflation and interest rates steadily declined.

Stock prices rose at a faster rate than economic growth due to declining interest rates and profit margins growing at a rapid rate. Profit margins were helped by lower taxes, globalization that led to lower prices for labor and commodities, and other trends.

All those trends are ending or have reached their limits. Here are some rules and strategies that worked well the last few decades but need to be reconsidered in this new environment.

Stocks and bonds are uncorrelated. There’s no law of the markets that proves stock and bond prices have to move in opposite directions. They’ve done that most of the time for the last 20 years or so, but they haven’t always and don’t have to do so.

In fact, stocks and bonds have been moving in the same direction for more than six months. They did the same thing in the 1960s and 1970s, the last time we had high inflation.

The Fed’s going to have to raise interest rates until inflation is down to a level with which the leaders there are comfortable. That will be bad for both stocks and bonds.

Buy on the dips. A great timing strategy since at least the end of the financial crisis has been to buy more stocks whenever market indexes decline.

The strategy worked because the Fed wasn’t worried about inflation. When the economy or stock market became weak, the Fed could increase monetary stimulus to help push stock prices higher.

Those days are gone, at least for a while. High inflation is embedded. The Fed can’t ease monetary policy to help stock prices until inflation declines, or central bank officials become more worried about a recession than inflation.

Buy growth stocks, especially of U.S. companies. The best assets to own since the end of the financial crisis have been U.S. stocks and especially the stocks of large growth companies. Technology and consumer discretionary company stocks have been especially rewarding.

The trend reversed beginning in late 2021. This year, U.S. growth stocks are among the worst places to be invested.

The valuations in those stocks were dependent on low interest rates and continued liquidity from the Fed. The stocks are being repriced to reflect that the Fed is withdrawing liquidity from the economy and letting interest rates rise.

If the Fed has to let economic growth slow or even decline to rein in inflation, those stocks will be repriced to reflect lower revenue and margins.

Avoid commodities. Commodities have been in a bear market for most of the last 20 years. That reflected the low inflation during the period.

But commodities perform much better than stocks and bonds during periods of high inflation. Over the last year, commodity prices rebounded, delivering high returns while stocks and bonds delivered losses.

The old rules and strategies won’t work as long as inflation is high. Investors have to decide if this is the time to recognize we’re in a new economic environment or bet that inflation will be tamed in a short time.

Know What the Markets are Expecting

Top investors don’t earn high returns by forecasting what will happen in the economy and markets.

They go a step further and anticipate what will happen in the economy and markets that isn’t already reflected in market prices. An investor gains nothing by anticipating what most other investors expect because that already will be reflected in market prices.

This is an important lesson for today.

Stock prices have declined significantly from their highs of 2021. But today’s prices don’t appear to reflect slower economic growth and definitely don’t reflect a decline in growth.

Instead, the decline in stock prices closely matches the rise in market interest rates. Interest rates are one factor investors use to determine stock prices. Changes in the return on risk-free assets (the interest rates on treasury bonds) cause price changes in riskier assets, such as stocks.

The percentage decline in the stock indexes is about the same as the rise in the yield on 10-year treasury bonds. In other words, the decline in stock prices so far is only a re-pricing based on interest rate changes.

Today’s lower stock prices don’t anticipate slower economic growth, lower profit margins, lower revenues and lower cash flows.

Other market prices indicate investors expect inflation probably has peaked and soon will return to a level with which the Fed is comfortable. Interest rates aren’t expected to rise much more.

These expectations appear too optimistic to me. Though inflation probably has peaked, the labor and supply shortages will keep a floor on inflation for many goods and services. It will be difficult for inflation to return to the Fed’s target level without a decline in demand.

I expect interest rates will increase until economic growth declines, reducing the demand for goods and services. That’s why I expect stocks and bonds still have difficult times ahead while commodities and other inflation hedges are better places to be invested.

China and the United States Can’t Make a Deal

Stocks of publicly listed, China-based companies were caught last year in a conflict between U.S. financial regulators and Chinese officials. If things don’t change, the conflict won’t be resolved, and the companies will leave U.S. stock exchanges.

The conflict involves a law enacted in the wake of the accounting scandals of the 1990s and early 2000s. The law mandated audit inspections by the Securities and Exchange Commission (SEC) of all publicly traded firms in the United States beginning in 2002. In 2020, the law was amended to state that companies would be de-listed from U.S. exchanges if they didn’t comply with the inspections.

The sticking point is that China doesn’t want the records of companies based in China to be examined by U.S. regulators. The law requires U.S. regulators to be allowed to interview local accountants that audit companies and review their audit papers. China won’t allow those actions, citing its confidentiality laws, plus national security concerns.

So far, regulators from both countries haven’t been able to reach a deal on the inspections.

If no deal is reached, close to 300 China-based companies could be removed from U.S. stock exchanges as early as 2023, including well-known names such as Alibaba and Baidu. A few companies already voluntarily de-listed from U.S. changes.

U.S. officials have said significant issues have to be resolved before a deal can be reached, while Chinese officials say they are confident they’ll have an agreement. If an agreement is reached, the next test will be whether compliance with the agreement matches the expectations of the SEC.

The Data

Home prices increased 2.4% in March and 21.2% over 12 months ending in March, according to the S&P Corelogic Case-Shiller Home Price Index.

The 12-month gain is the highest in the 35 years of data compiled for the index, exceeding the previous record set with February’s report.

The Federal Housing Finance Agency (FHFA) reported a 1.5% gain in its House Price Index in March and a 19.0% increase over 12 months. The 12-month increase is down a little from February’s 19.3% increase.

Pending home sales declined 3.9% in April from March’s level. That’s the sixth consecutive month that sales declined from the previous month’s level.

Over 12 months, pending home sales are down 9.1%.

The declining sales and higher prices both are the result primarily of a low supply of homes available for sale.

The Fed’s preferred measure of inflation, the PCE Price Index, increased 0.2% in April from March’s level. The index increased 6.3% over the 12 months ending in April. That’s lower than the 6.6% 12-month increase recorded in March, which was the highest level since January 1982. April also is the first time the 12-month number has been lower than in the previous month since late 2020.

Excluding food and energy, the core PCE Price Index increased 0.3% in April, the same as in March and February. The core PCE Price Index rose 4.9% over 12 months, down from the 5.2% 12-month increase reported at the end of March.

The Consumer Price Index (CPI), which was reported a few weeks ago, increased 8.3% over 12 months as of April. The gap between the CPI and the PCE Price Index is the largest since 1981. That reflects major differences in how the two indexes measure inflation.

Household spending increased 0.9% in April. That’s down from the revised 1.4% increase in March. After adjusting for inflation, spending increased 0.7%. Spending has increased for four consecutive months.

But households spent more than they earned. Personal income increased only 0.4% in April. After adjusting for inflation, personal income was unchanged.

Households maintained their spending by tapping into savings. In March, the savings rate fell to 6.2%, then the lowest level in nine years. But in April the savings rate declined again to 4.4%, the lowest level in 14 years.

The Kansas City Fed Manufacturing Index held fairly steady, coming in at 23 for May, after reporting 25 for April.

Manufacturing activity in Texas was mixed, according to the Dallas Fed Manufacturing Survey.

The General Activity Index derived from the survey fell to a negative 7.3 in May from a positive 1.1 in April. But the Production Index increased to 18.8 in May from 10.8 in April.

New unemployment claims declined by 8,000 to 210,000 in the latest week.

Continuing claims increased a little to 1.35 million. They remain near their lowest level since 1969.

The second estimate for first-quarter gross domestic product (GDP) was revised to a slightly lower decline than in the first estimate. The latest estimate was for a 1.5% annualized decline in GDP in the first quarter, compared to a 1.4% annualized decline in the first estimate.

The Consumer Sentiment Index for April, offered by the University of Michigan, was 58.4. That’s down from the 59.1 level reported in mid-April and well below the 65.2 level reported at the end of March. The index was 82.9 12 months earlier.

The decline in the index was due to declines in sentiment regarding both current economic conditions and expectations for the future. Consumers are concerned about the future of the economy but say they aren’t as concerned about their own personal finances.

The Consumer Confidence Index from The Conference Board declined to 106.4 in May from 108.6 in April.

The Chicago Purchasing Managers Index increased in May to 60.3 from 56.4 in April. That indicates manufacturing growth accelerated in the Chicago region from April to May.

The Markets

The S&P 500 rose 4.62% for the week ended with last Friday’s close. The Dow Jones Industrial Average gained 4.15%. The Russell 2000 increased 5.29%. The All-Country World Index (excluding U.S. stocks) added 2.01%. Emerging market equities improved by 1.45%.

Long-term treasuries rose 2.16% for the week. Investment-grade bonds increased 2.92%. Treasury Inflation-Protected Securities (TIPS) added 1.36%. High-yield bonds gained 4.47%.

In the currency arena, the U.S. dollar declined 0.48%.

Energy-based commodities increased 2.73%. Broader-based commodities rose 1.39%. Gold was unchanged.

Bob’s News & Updates

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