Tag Archives: economy

How High Is Too High?


The S&P 500 logged a stellar first quarter of 2024, rising just over 10% in 3 months. Moreover, it has gained more than 28% since the October low, just five months ago. It is likely that something will happen to trigger a sell-off from these levels. Trying to time a correction is not a good strategy. Sometimes momentum begets momentum. We could see another 10% rise before a reversal. The price of market returns is volatility. It might help to view part of the recent gains as “cushion” to offset a correction.

We’ve Come a Long Way

I am attempting to lean into rising risk by delaying new cash deployments and allocating new funds to value oriented positions. On the positive side, the Morningstar Market Valuation indicator suggests that the market is only 4% overvalued. That does not suggest a change in strategy, but I see significant parts of the S&P 500 trading at valuations that stretch my imagination.


Valuation and concentration risks are becoming elevated, but a correction is not inevitable in the near term. The key factor, as usual, is earnings and cash flow growth that provide fundamental support for market valuations. Another moderate risk factor would be fewer or delayed rate cuts. More impactful, but less likely factors include an inflation rebound or an earnings slowdown.

The overall outlook remains positive based on the four supporting themes including:

  1. Stable growth
  2. Falling inflation
  3. Impending Fed rate cuts
  4. AI enthusiasm

I will be watching these developments.

Past performance does not indicate future performance. Investing involves risk, including loss of investing principal.

And So the 4th Quarter Begins

The stock market fear gage, the VIX, is flashing extreme pessimism. If you follow the news flow, it is easy to see why. It’s a constant barrage of negativity. It’s important to note that crises and the stock market have coexisted for decades. Crises come and go, while the stock market has always been volatile, yet sustains a positive trend.

Near-term indications suggest that the market is challenged by the Fed interest rate policy but appears reasonably valued all things considered.

My favorite bottom-up indicator, the Morningstar Market Valuation chart, puts the US market at 91% of fair value on 9/30/23, suggesting slight undervaluation. On a deeper level, growth is slowing, but it is very debatable how much it will slow. For now, it appears that the answer is “not too much.”

Part of the reason the market pulled back from its recent high at the beginning of August is that the Fed signaled that it is likely to keep rates higher for longer. Higher yields translate into lower stock price multiples. Ultimately this will reverse when the Fed sees the threat of persistent inflation above target diminishing.

In the absence of an upside catalyst, I expect the market to remain rangebound (S&P 500 between 4,220–4,560) until either the positive scenario occurs with the economy’s slowing stops, the Fed becomes dovish, and disinflation proves successful. On the downside, if either of these factors deteriorates, the market could break to the downside.

This morning’s job report (Tuesday, October 3, 2023) sent interest rates higher. Accordingly, stocks dropped. The knee jerk reaction to a data point illustrates the market’s myopia in seeing the trees instead of peering through the forest. Every data point is extrapolated far into the future when we’re pretty sure that won’t be the case. That suggests the long-term outlook just went up by the amount of today’s decline.

A Chat GPT forest

I’ll also comment about Congressional dysfunction after this past weekend’s drama. A Government that can’t govern is not helpful given the fiscal state of this country. It can only create uncertainty in the Treasury market. Stocks will not go up with interest rates increasing from this level. Let’s hope Congress gets its act together sooner than later.

Last quarter I noted that the market “appears to be approaching fair value” after being up 15.91% in the first half of the year. The 3rd quarter pullback was not surprising.

The bottom line is that the S&P 500 went up 13.03% YTD through the 3rd quarter according to Morningstar. The 4th quarter should be interesting.

Investing involves risk, including loss of principal. Past performance is not indicative of future returns.

Recession Ahead?

Despite a banking crisis, rising interest rates, the indictment of a former president, et al., the S&P 500 finished the 1Q23 with a 7.03% gain. However, within the U.S. Market, growth stocks were up 14.79% and value was up only .18%, according to Morningstar. Despite this quarter’s gains, the Morningstar Market Valuation estimate puts the market at 92% of fair value.

The Fed kept interest rates too low for too long. There’s plenty of blame for both sides of the aisle in Congress too. While inefficiencies need to be purged from the system, politicians try to address the suffering at the individual level of those directly impacted when marginally profitable businesses are forced to close.

The banking problems that surfaced in March 2023 are one of the unintended consequences of Fed policy. Low interest rates incentivized banks to stretch for yield by buying long duration bonds that exposed their asset portfolios to excessive interest rate risk. When Silicon Valley Bank faltered, the whole banking system became suspect, and we saw a contagion effect with depositors pulling funds from similar banks. The Government intervened by extending FDIC insurance.

It is unreasonable to expect that 10+ years of easy money will not create some financial moral hazard. Now that we’re getting off the sauce, we’ll see who has been swimming naked. I expect continued volatility until the second half of the year. Getting past the peak interest rate question, lower inflation, the regional bank solvency question will likely result in better equity markets by the end of the year.

Patience

In my market outlook a year ago on January 3, 2022, I said, “I think a 20% correction would be reasonable… A 20% correction is not fun, but it is to be expected.” I’m not trying to say I told you so, but we need to maintain perspective after a very ugly year. Bonds went down too.

What now? Coming into 2022, the stock market looked about 7% overvalued. Now, it appears to be about 16% undervalued relative to Morningstar’s fair market value index. Since the end of 2010, only about 5% of the time does the market appear cheaper by this measure.

The broad landscape for investors is much healthier than it was a year ago. Valuations have come down. Interest rates are rewarding creditors for taking risk. Things are getting back to normal, and that’s good.

It might take another few quarters to see results, but the 2022 headwinds should turn into tailwinds later in 2023. The issues include slower economic growth, tightening monetary policy, hot inflation, and rising long-term interest rates. According to most projections, these issues should begin to resolve by the middle of this year.

Geopolitical risks around China, Russia, North Korea, and perhaps Iran, remain a threat to western civilization.

Heightened uncertainty makes the stock market go down and that creates an opportunity for long-term investors.

Investing involves risk, including loss of principal. Past performance is not indicative of future performance.

Closer to the Bottom than the Top

In January I said we should expect a 20% correction. I believe the Fed’s hawkish response to inflation has driven markets to over-shoot to the downside. I think the interest rate shock will slow the economy sufficiently to break the rapid rise in inflation and the Fed will pivot to a more dovish stance. We need positive real interest rates with low inflation, so stock prices can normalize. How long this take to play out is probably measured in quarters, not years.

Everyday millions of people vote on the value of companies by buying and selling. Many are influenced by the latest interview on CNBC. The only thing I know with certainty is that none of the pundits know what will happen. If watching the gut-wrenching volatility affects your happiness, you should probably spend your time watching something else. A quarterly review will tell you what you need to know.

Interest rates influence the value of stocks. Stocks are worth less with higher real interest rates than low rates. The artificially low rates we had until recently are the main reason stocks were overvalued in January.

There is a probable way out for stocks. Watch the following: Inflation will eventually recede, the Fed signals a pause, a Russia/Ukraine ceasefire occurs (which will happen at some point, even if it’s a Korean War-type solution where the war never actually ends and there’s a demilitarized zone). Then, China realizes that an economic collapse is worse than COVID and the U.K. accepts the reality that one can’t solve a problem partially caused by too much money via throwing more money at it (this already happened over the weekend – I wrote this on Friday afternoon and guess what, the markets are up about 3% mid-Monday afternoon). These things can happen, and they can happen fast. When they do, stocks should stage a massive, legitimate, well-rounded rebound.

Like Ian, I believe this storm shall pass.

Inveting involve risk, including loss of principal. Past results do not guarantee future results. The opinions expressed here are my own.

The Pause that Refreshes

The S&P 500 closed the 3rd quarter with a gain of about 14.7% YTD, despite recent volatility that brought it down about 5% off the highs. (International holdings continued to lag, causing diversified portfolios to generally come in a bit lower.) There are several issues creating enough headlines to spook the market, including inflation, the debt ceiling and potential Government shutdown, tax increases, supply chain disruptions, Fed tapering and the yield curve, and the continuing Covid pandemic. What could go wrong?

I could analyze each issue and explain why they might be more bark than bite, or why they are probably already factored into the market. However, I do have a real concern that the market will have to reckon with, valuation. The market is priced to perfection at about 20x 2022 earnings. Interest rates need to go up for long-term economic stability, and the market valuation math means the market valuation multiple needs to decline. The decline in valuation will not be absolute since it will be offset by presumably rising earnings. Theoretically the multiple could contract without a nominal decline in the market, given sufficient earnings growth, especially in an environment with a healthy dose of inflation. However, I expect interest rates will go up and the market will have an adjustment on the order of a 10% decline sometime within the next 6 – 12 months.

That would be a healthy part of normalization and allow for better long-term returns. Part of the past 3 years gains can be attributed to the Fed’s persistent stimulus. We may be beginning the pause that refreshes. The underlying economy is sound. Supply constraints are preferable to waning demand.

Investing involves risk, including possible loss of principal. Choose wisely.

The Underlying Strength of the Economy Is Unchanged

The underlying strength of the market has not changed. The pandemic is likely to end soon, perhaps by Memorial Day. Disbursement of the just passed $1.9 trillion stimulus is pending, with an additional likely $2.2 trillion coming with Biden’s just proposed American Jobs Plan to be spent over the next 10 years. Finally, the Fed remains committed to keeping rates low until they can persistently hit the inflation target of 2%.

With rising inflation concerns and a 4th COVID wave, crosscurrents made it a bumpy ride. At the end of the first quarter of 2021 the S&P 500 gained about 6.2%. I will spare you the economic scenario analysis and leave it at this. The long-term trend is up, but the short-term is impossible to know. I think the US equity markets are about 5% overvalued. Given the amount of stimulus and the fading pandemic, valuation is not a big concern.

Press On

Last year we wondered about the biggest risk to the markets. Was it the threat of persistent low-interest rates and the implied inflation threat, Government budget deficits, tax hikes, or valuations? Media and headlines covered pundits’ messages illustrating what could go wrong.

In retrospect, none of that mattered. The problem was something no one talked about because no one knew about it. A virus-induced pandemic ensued and led to a shutdown of large parts of the economy.

The important takeaway is that the greatest risk might be what you do not see coming. If you are not aware, it is hard to prepare. However, I will point out one more time that I covered the bases by listing plagues among several caveats to my sanguine outlook.

Like earthquakes in California, you know they will happen. You will not know when. In the stock market, we seem to have a big one, a 40 to 50% decline, about once every 10 years. We also average about two recessions every 10 years. Despite dramatic declines, the long-term trend continues up as billions of people around the world get up every morning to do something productive to improve their lives.

I do not know when the market will go down, but history shows that it always comes back. Most of the time recoveries occur within a few years if not months. Some risks are more apparent than others. But for whatever the reason for a correction, the important thing is to avoid selling into a distressed market.

Source Yahoo Finance, S&P 500 Total Return 1/1928 to 1/2021, Monthly, Log Scale

Planning requires anticipating how much money you are likely to need from your portfolio and reducing risk in part of your portfolio to reduce your potential need to sell in a distressed stock market.

Now what about 2021? The 5 key drivers of current market strength include Federal fiscal stimulus, vaccine rollout, divided government, dovish monetary policy, and no double-dip recession. Each of these factors favor continued gains, but none is certain. Near term, I can make the case that the market is on the expensive side. I do not think the options (cash, bonds, hard assets, real estate) are more attractive on a risk-adjusted basis.

As Calvin Coolidge observed, “Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.” I remain focused on long-term value creation.

With 2020 behind us, we’ll press on.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns.

Cross-Currents

The cross-currents of economic data are all over the place. The good news is that there is no clear indication of a recession. More specifically, indications are that the economy will continue in slow-growth mode of around 2%.

Personal consumption is about 70% of GDP and is currently the strongest component. Business investment and labor force growth are the keys to productivity, and this is the more worrisome factor. Political uncertainty discourages capital investment. Workers need better tools if they are to increase output. Labor supply, on the other hand, is constrained by birth rates, demographics, and immigration policy.

Trade war issues are contributing to weakness in manufacturing. While that could spill over into other areas, the weakness appears to be within the bounds of normal volatility. The best news on the trade front is that the pain does not discriminate. There are no winners. Consequently, trade wars are generally short-lived. The bad news is that neither China nor the U.S. has much incentive to compromise before the next Presidential election.

Finally, the Fed has worked itself into a position that raising interest rates appears to cause the stock market to decline. That’s logical since interest rates factor into stock valuation. However, the real issue is whether higher rates would dampen economic activity. I believe higher rates would be healthy and lead to a stronger economy. Any economic activity that would cease due to a 4 or 5% interest rate is probably an inefficient or unwise use of resources anyway. Getting to higher rates will cause market tantrums, but the end is nothing to fear.

Quarterly Update – 1Q19

The market peaked in early October, 2018, and came very close to the official 20% decline that defines an official “bear market.” The real issue is not the depth of the decline, but how long it takes to recover. After the market roared back (+13.06%) in the first quarter, we are nearly there.

Last quarter I shared a chart I use, that indicated the market was valued at 88% of fair value. Today, that reading is about 98%. There is a natural regression to fair value. We’re about where we are supposed to be, not cheap but not too expensive.

There has been a lot of talk in the media about the “yield curve” and what that means about recession risk. I wrote a blog post on the issue the day the curve inverted on March 22. Link here: https://www.daltonfin.com/2019/03/22/what-volatility-looks-like/.  Sure enough, the inversion was transient, with the 3-month T-Bill currently at 2.4% and the 10-year Treasury Note at 2.41%, virtually flat.

(Caution –  the next 2 paragraphs are on the wonky side)

The spread between the 10 and 2-Year Treasury is Worth Watching. When it goes negative, it is inverted.

The main problem with conventional yield curve analysis is that current conditions are a lot different from past circumstances, after 10 years of central bank intervention. The absolute level of interest rates has not been this low in any prior inversion analysis. To illustrate why this is important, consider an economy with no inflation. If the interest rate is the price of money, how much would you need to be paid to lend your money to the U.S. Federal Government? Now, add that rate to the expected inflation rate to get the level that the 3-month T-Bill should yield today in a normalized environment. Anything short of that is like a morphine drip to the economy. The Fed is trying to wean us, but that requires balancing the market’s tantrums (see December) which can become a self-fulfilling prophecy if a stock market decline causes a slow-down.

The Fed only controls the short end of the curve. The market controls the long end. When bond traders bet the Fed will cut rates, they buy the long end because interest rate changes compound and prices move inversely to rates. Increased demand on the long end causes long rates to fall. The greater concern is when the Fed starts cutting short rates. That signals trouble because they have more information than anyone else. What does the Fed do when they see trouble? They cut short rates to juice the economy. The problem is, there’s usually trouble on the horizon when that happens. The good news? That’s not the case today.

Volatility is the price of equity returns. We can manage risk if we understand your liquidity requirements. If we can anticipate distributions, we can reduce or eliminate the possibility of being forced to sell when the market is cheap. That’s what converts a temporary loss of capital a permanent loss.