Market Update October 3, 2022

Photo by Nathan Anderson on Unsplash

Economic data included no revisions in the still-negative Q2 U.S. GDP report. Durable goods fell back, as did home prices in several national indexes. Consumer confidence measures were mixed, while jobless claims improved.

Global equity markets fell back again, as investor moods were dampened by continued corporate negativity and higher interest rates, with financial concerns in the U.K. a key catalyst. Bonds declined as yields rose across much of the treasury curve. Commodities were mixed with crude oil prices ending slightly higher for the week.

U.S. stocks fell back again last week, and September ended negatively—true to historical form, unfortunately. In addition to financial turmoil in England (discussed below) carrying over to other developed nations, explosions that damaged the Nord Stream European gas pipeline, and a hurricane making landfall in Florida added the potential for disruptions. By sector, only energy ended with a gain (2%), while utilities suffered the most (-9%), on higher interest rates and perceived hurricane effects. Real estate also lost -4%, in keeping with most other sectors. Negative feedback from Apple and Nike in regard to upcoming global slowing were closely-responded to by investors.

The Dow finally reached -20% bear market territory last week, to join the S&P and NASDAQ, although that index is generally irrelevant from the standpoint of broader stocks (better measured by the S&P). But, it tends to be mentioned in the mainstream media frequently due to its century-plus historical legacy. Interestingly, the VIX index (which is the implied standard deviation on the S&P 500 based on options pricing) has risen relatively gradually. After trading between 20-30 most of the past few months, it’s again approaching 35. On the positive side, from a contrarian standpoint, high VIX levels have provided decent equity buying opportunities over the following 12- and 24-month periods. This is not saying this fall’s volatility has ended—both October outright and the lead-up to mid-term elections have provided historical uncertainty. However, the three months of Q4 have been historically the most positive for equities.

From the S&P 500 peak of 4797 on Jan. 3, prices are now down -25%. This is right about the median market decline level seen before recessions since World War II. So, the perpetual question being asked by markets is: where is the bottom? As usual, markets are trying to sort out a variety of potential scenarios. Investor sentiment, inflation, and geopolitics may still carry the near-term, but earnings become more important on a multi-quarter basis. With the economy in transition, markets are sorting out a variety of more realistic to less realistic scenarios. These are just examples to show how the inputs involved change the assumptions

§  In a sample hypothetical worst case, 2022 estimated S&P earnings of $225 fall by -10% in 2023 to $203. Applying a deep recession-like 12x P/E ratio results in an index level of ~2430. (This would be a total peak-to-trough drop of -49%, and a further decline of -32% from Friday’s close.) As that total drawdown severity is nearly on par with the 2008 financial crisis (over -50%), this appears extreme, more in line with a multi-decade structural bear market. For what it’s worth, it isn’t in the base case of most mainstream strategists. However, these types of calculations are instructive, particularly in light of periodic financial advertisements on the sensational side claiming: ‘Stocks set to fall by 90%!’

§  In a middle-of-the-road scenario, conservatively implying 0% earnings growth for 2023 (which assumes a recessionary earnings drop as well as recovery), and a reversion to a long-term average 15x P/E, results in a level of 3375. This is -6% below Friday’s close, and a -30% total drop from peak. So, this path would be slightly worse than the median historical precedent.

§  In a better-case scenario, using FactSet’s median estimate of 8% earnings growth for 2023 (to ~$243), and a still-optimistic 16x-17x P/E, the S&P target rises to ~4000. This is 12% above the current level, although still down -16% from the peak. Assuming we enter recession, markets could start to look further out into 2024, with stock pricing based on implied earnings recovery post-recession. This could push prices higher in advance of the actual fundamental improvement, which wouldn’t be all that unusual.

Foreign stocks in Europe and the U.K. fared better than domestic stocks, helped by a weaker dollar, while emerging markets fared worse, although results were country-specific. The episode in the U.K. was an unusual wrinkle during the week. To combat economic slowing and high energy prices, the new Truss administration announced a substantial fiscal expansion with energy subsidies and tax cuts (although spending was not reduced in kind, increasing the fiscal deficit sharply). This was rebuked by the IMF, and resulted in a dramatic weakening of the pound and debt sell-off as interest rates rose sharply, causing nearly a -25% drop in long-term bond prices in short order. This was made even more real for potential British homebuyers, as mortgage lenders withdrew from the market due to a lack of clarity about rates, and not wanting to be left holding the bag. Pension plan asset-liability conditions had also deteriorated quickly and severely, which prompted government action. This included the Bank of England announcing temporary asset purchases of long-dated bonds (which pulled yields back down by a about a percent within a trading day, almost reversing the prior price decline). In keeping with this policy, the October beginning of U.K. quantitative tightening has been postponed a month. While the government was praised for the short-term response to restore stability, it has been criticized for the ill-planned fiscal plan that started the whole debacle. The Bloomberg European Financial Conditions Index fell to -3.5 standard deviations below normal, in line somewhere between Covid and the Eurocrisis (the U.S. index fell to -1.5 standard deviations below normal, last seen in early 2019).

If this sounds circular and confusing, those events reflect the new reality of the global central bank tightrope. This is a hoped-for balance between wanting rates higher to fight inflation, but not enough all at once to disrupt financial funding markets and market expectations. The Russia-Ukraine conflict is directly related to this, with government pressure to assist citizens being the result of slower economic growth, due to higher energy prices, starting with Russian energy dependence and cut-off of regional supply. By contrast, the U.S. has the benefit of sponsoring the world’s reserve currency, as well as the largest and most liquid treasury bond market, which has lowered the risk of similar events on this side of the pond. The U.S. is also far more energy self-sufficient, with no reliance on Russia; in fact, American LNG has been shipped to Europe to quickly shore up their winter supplies, albeit the ocean being a cumbersome transportation method. This does highlight the difficulty in making the transition between quantitative easing (which England has essentially implemented again for now) and quantitative tightening (which is the removal of such market-stabilizing purchases). For the U.K. and possibly other developed nations, a possible scenario is that this removal of 15 years’ worth of monetary easing may end up being more gradual, and thus take far longer, than initially expected to reduce the chances of such surprises.

U.S. bonds fell back again as interest rates continued higher. Government outperformed corporates, with the bellwether 10-year treasury temporarily reaching 4% for the first time since 2008, as longer bonds have ticked upward to reflect the new assumptions of a higher Federal Reserve terminal rate. However, in keeping with sentiment from the Bank of England’s actions, long treasuries fell back by over a quarter-percent—the largest single-day change since 2009—as investors sought out the safety of these bonds. This higher rate level has also increased the curve inversion between the 10y-2y, while the 10y-3m segment remains positive. These differences reflect the differing economic signals pointing to either recession or no recession. Foreign bonds fell back most notably in emerging market debt, which declined several percent as credit spreads widened.

Commodities were mixed on the week, with gains in energy and precious metals offset by a minor decline in industrial metals. The price of crude oil rose roughly a percent on net to just over $79/barrel, despite a back-and-forth week. OPEC has considered production cuts, which were balanced with recession concerns that have steadily lowered expectations for energy demand.

Period ending 9/30/20221 Week (%)YTD (%)DJIA-2.92-19.72S&P 500-2.88-23.87NASDAQ-2.68-32.00Russell 2000-0.82-25.10MSCI-EAFE-1.35-27.09MSCI-EM-3.26-27.16Bloomberg U.S. Aggregate-0.99-14.61

U.S. Treasury Yields3 Mo.2 Yr.5 Yr.10 Yr.30 Yr.12/31/20210.060.731.261.521.909/23/20223.244.203.963.693.619/30/20223.334.224.063.833.79

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.