The Manley Macro Memo
- In January, the S&P 500 had its worst month since the pandemic crash of March 2020 because inflation surged to a forty-year high, and the Federal Reserve announced they were prepared to tighten monetary policy more aggressively if inflation persists. Although the S&P 500 is in a mild correction (dropped 9.8% off its January 4th all-time high close), most stocks have declined more than 20% and are in a bear market.
- The economy remained robust in January. Nonfarm payrolls grew by 467k, which was significantly better than Wall Street's expectation, and the unemployment rate was 4%. Additionally, retail sales increased by the most in 10 months and reached a record high. The strong economy, supply chain issues, and the massive increase in money supply led to a 7.5% increase in the consumer price index (CPI), which was the largest year-over-year gain since February 1982. Inflation's surge to a 40 year high contributed to consumer sentiment falling to a 10-year low.
- The Fed's hawkish pivot caused stocks to decline in January. The Fed announced that they were prepared to tighten monetary policy, yet they have not removed any of their emergency measures -- they only reduced the amount of stimulus they are providing. We believe that the Fed made a significant monetary mistake by failing to act. The economy is near full employment, and inflation has been greater than 5% for nine consecutive months, yet the Fed keeps interest rates at 0% and continues to "print" money to buy bonds. Their profligate policy created asset bubbles, wealth inequality, and the highest inflation rate in 40 years. In our view, the Fed backed themselves into a corner by not acting. If they gradually tighten monetary policy to support the inflated stock market, inflation will remain elevated, and "Main Street" will continue to suffer. If they aggressively tighten monetary policy to tame inflation, stocks will crash, and "Wall Street" will suffer.
- Since monetary policy acts with a 12-month lag, inflation will remain elevated. We expect the economy to slow due to inflation, higher interest rates, and a substantial drop in fiscal spending. In this economic environment, we continue to see a significant opportunity to invest in the inexpensive value sectors of the market while avoiding the mega-cap tech stocks that dominate the S&P 500. Finally, we believe that the risk of a significant market decline is high because of the Fed's monetary mistake, market structure issues, a potential energy crisis due to years of underinvestment, and Russia's aggression in Ukraine.
The stock market began the new year on a sour note. In January, stocks dropped sharply as inflation surged to a 40-year high, and investors worried about the Fed's hawkish pivot. The S&P 500 declined by 5.3%, while the small-cap Russell 2000 decreased by 9.5% in January. The foreign markets were mixed, the MSCI EAFE index of international stocks declined by 3.6%, and the MSCI Emerging market index was flat.
Despite the "risk-off" environment, the "safe havens" performed poorly -- the U.S. long-bond and gold fell by 3.9% and 1.7%, respectively. The U.S. 10-year bond yield increased by 0.26% to 1.77%, while the yield curve (2-year to 10-year) flattened by 0.18% to 0.61%. Oil jumped by 17.2% as the Omicron variant threat receded and geopolitical risk increased in Ukraine.
In this "risk-off" market environment, all of the sectors of the S&P 500 declined, except for energy and financials. Also, higher interest rates and inflation caused the value sector to significantly outperform the growth sector by 6.3% (the Russell 1000 Value index declined by 2.4%, while the Russell 1000 Growth sank by 8.7%).
As discussed last month, despite the Covid pandemic, the associated economic shutdowns, and inflation at a 40 year high, the S&P 500 appreciated by more than 100% over the past three years, and most valuation measures have never been higher.
We believe that the Fed's profligate monetary policy created asset bubbles, wealth inequality, a record debt burden, and an inflation rate at a 40 year high. The Fed's monetary mistake has elevated financial and economic risks. We believe that the stock market is vulnerable to a significant decline as financial conditions tighten and the asset bubbles deflate.
To stabilize the economy during the pandemic, the Fed cut interest rates to 0% and "printed" $120 billion each month to buy bonds. In this environment of artificially low-interest rates and massive liquidity, the stock market received record inflows due to the historic level of shareholder buybacks, M&A, and retail investment.
By keeping interest rates too low for too long, the Fed incentivized corporations to "buy not build." Instead of investing in productive assets, corporations borrowed to buyback their shares and/or acquire other companies. Artificially low-interest rates, not inexpensive stocks or great fundamentals, led to a record level of share buybacks and M&A.
Chart 1: Artificially low-interest rates gave corporations the incentive to "buy not build," so corporate buybacks and M&A surged to a record level in 2021.
We believe the impact of these record inflows was magnified because of the dominance of passive investing. Since more than 50% of stocks are held passively (not for fundamental reasons), the supply of available stock for trading is reduced, which can exaggerate the impact of fund flows on the underlying stocks.
In our view, the S&P 500 became detached from the fundamentals because of the unprecedented amount of liquidity in the financial system and the dominance of passive investing. We are concerned that the factors that drove stocks to a record valuation level can rapidly reverse as financial conditions tighten due to the inflationary surge.
Chart 2: Liquidity, not fundamentals, drove the equity market to a record valuation. Warren Buffet stated, "Market Value to GDP is probably the best single measure of where valuations stand at any given moment." Unfortunately, valuation has never been higher, and liquidity is waning.
Inflation has been greater than 5% for nine consecutive months, and the economy is near full employment, yet the Fed keeps short-term interest rates at 0%, and they will print another $20 billion to buy bonds between February 15th to March 10th. Recently, former U.S. Treasury Secretary Lawrence Summers told Bloomberg, "It is nothing short of preposterous that in an economy with 7.5% inflation, that in an economy with the tightest labor market we've seen in two generations, that the central bank is still as we speak growing its balance sheet."
The Fed is clearly behind the curve and has committed a significant monetary mistake by failing to tighten monetary policy. Financial risk and economic uncertainty are elevated because they failed to act.
Chart 3: Inflation has remained above 5% for the past nine months, and the Fed has not tightened monetary policy; they only reduced the level of stimulus. Since monetary policy acts with a 12-to 24-month lag, we do not expect inflation to recede until the Fed aggressively tightens monetary policy. Historically, inflation greater than 5% leads to recession.
The Fed has backed itself into a corner by not removing its emergency measures. To fight inflation, they must aggressively tighten monetary conditions, but that would lead to a bear market and most likely a recession. If they attempt to support the overvalued stock market and gradually tighten policy, inflation will remain elevated, and "Main Street" will continue to suffer.
Chart 4: While the Dow Jones Industrial Average remains elevated and nearly immune to high inflation, consumer sentiment has plunged. Sharp drops in consumer confidence typically presage recessions.
Although the Fed has not tightened monetary policy, higher interest rates have reduced liquidity, which has led to a bear market for most stocks. Of the 25 major indexes that we follow, only energy and financials are above their 200-day moving average, and most indexes have declined over the past six months. Also, while the S&P 500 is less than 10% off its all-time high, most stocks are below their 200-day moving average and in a bear market.
Chart 5: The S&P 500 is less than 10% off its all-time high, yet most stocks are in a bear market. Currently, 63% of NYSE and 75% of NASDAQ stocks are below their 200-day moving average and in a bear market.
Most stocks are already in a bear market, and we believe the S&P 500 is vulnerable to a significant decline this year. In fact, large corrections are typical in midterm election years. According to Bank of America Securities, the average decline in a midterm election year is 20.8%, and 43% of midterm election years had declines greater than 20%.
The magnitude of a bear market decline usually depends on whether the economy enters recession. Currently, market-based economic indicators (the yield curve and credit spreads) do not indicate that we are headed toward a recession at this time. Unfortunately, 11 of the past 12 Fed tightening cycles since 1950 have led to recession.
Chart 6: Market corrections are typically less than 20% if a recession does not occur. While most Fed tightening cycles lead to recession, market-based indicators are not forecasting a recession at his time.
The Fed's emergency monetary measures created a financial asset bubble, wealth inequality, a record debt level, and an inflationary surge. Higher interest rates are reducing market liquidity, and the financial asset bubble is deflating. This March, the Fed will tighten monetary policy, further reducing liquidity and pressuring stocks. While bear markets without a recession are typically around 20%, we are concerned that market structure issues -- passive funds and quant strategies that buy or sell based on flows, trends, and volatility -- could magnify the bear market as it augmented the previous bull market.
Our Model Portfolio:
The benchmark for our model portfolio is the Traditional Blend — 60% equity, 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, we risk-weight our positions to manage volatility.
We are positioned for an inflationary economic environment and slowing growth. We are concerned that the accelerating inflation has led to a bear market and potentially an economic recession. We are focused on preserving capital and reducing volatility in this risky and uncertain environment. We remain underweight equities, fixed income duration, and overweight commodities and gold relative to our benchmark.
Our portfolio's risk level (annualized volatility) is 12.6%, which is significantly less than our 60/40 benchmark.
Current Risk-Weighted Model Portfolio:
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Our short-term (three-months) outlook is neutral:
The S&P 500 dropped by 12.4% from its all-time high in January. In early February, oversold stocks rallied and retraced 62% of the previous decline. Currently, market breadth is negative, volatility is elevated, and most stocks are in a bear market. We believe the S&P 500 offers a poor short-term risk-reward and expect a decline below the January low as market liquidity deteriorates and investors become more risk-averse. We will become more constructive in the short term when investors are fearful, stocks are oversold, and market breadth begins to improve.
Our long-term (more than four years) outlook is neutral:
We believe that the S&P 500 offers a poor risk-reward because it is extremely overvalued. Also, we are concerned about the long-term unintended consequence of the unprecedented monetary and fiscal policy that was used to combat the pandemic. Artificially low-interest rates and historic peacetime deficits have led to a record debt burden, which will become problematic as the economy grows, and interest rates normalize. We continue to see a significant opportunity to invest in the value sectors of the market while avoiding the mega-cap tech stocks and the S&P 500. While we expect to profit from the reflationary rotation into the cyclical stocks, longer-term, we remain concerned about the impact rising interest rates will have on profitability and stock valuations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.
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Disclaimer: The material in this newsletter is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.
J. Lawrence Manley, Jr., CFA
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