This Market Rally Could Be A Bear Trap!! Here’s why……

After a really tough first 6 months of the year, the stock market has been in rally mode, rising over 9% within the last 30 days.  It’s left investors anxious to participate in the rally to recapture the losses that were incurred in the first half of the year.  Our guidance to clients, while there are plenty of bobbing heads on TV talking about “buying the dip” and trying to call the “bottom” in the market, this could very well be what we call a “bear trap”.   A bear trap is a short-term rally that baits investors into thinking the market has bottomed only to find out that they fell for the trap, and experience big losses when the market retreats to new lows.

The 4th Bear Trap In 2022

 If the current rally ends up being a bear trap, it would actually be the 4th bear trap so far in 2022.   

The green boxes in the chart show when the rallies occurred and the magnitude.  Notice how the market moved to a new lower level after each rally, this is a common pattern when you are in a prolonged bear market environment.

So how do you know when the bear market is over and the new sustainable bull market rally has begun?  It’s actually pretty simple. Ask yourself, what were the issues that drove the market lower in the first place?  Next question, “Is the economy making MEANINGFUL progress to resolve those issues?” If the answer is yes, you may in fact be at the beginning of the rally off of the bottom; if the answer is no, you should resist the temptation to begin loading up on risk assets.

It's Not A Secret

 It’s not a secret to anyone that inflation is the main issue plaguing not just the U.S. economy but economies around the world.  Everyone is trying to call the “peak” but we did a whole video on why the peak doesn’t matter.

 The market cheered the July inflation report showing that headline year over year inflation dropped from 9.1% in June to 8.5% in July.   While progress is always a good thing, if the inflation rate keeps dropping by only 0.60% per month, we are going to be in a lot of trouble heading into 2023.  Why? As long as the inflation rate (the amount prices are going up) is higher than the wage growth rate (how much more people are making), it will continue to eat away at consumer spending which is the bedrock of the U.S. economy.  As of July, wages are growing at only 6.2% year over year.  That’s still a big gap until we get to that safety zone.

Understand The Math Behind The CPI Data

While it’s great that the CPI (Consumer Price Index) is dropping, the main CPI number that hits the headlines is the year-over-year change, comparing where prices were 12 months ago to the prices on those same goods today. Let me explain why that is an issue as we look at the CPI data going forward.   If I told you I will sell you my coffee mug today for $100, you would say “No way, that’s too expensive.”  But a year from now I try and sell you that same coffee mug for $102 and I tell you that the cost of this mug has only risen by 2% over the past year, does that make you more likely to buy it?  No, it doesn’t because the price was already too high to begin with.

In August 2021, inflation was already heating up.  The CPI headline number for August 2021 was 5.4%, already running above the Fed’s comfort level of 3%.  Similar to the example I just gave you above with the coffee mug, if the price of everything was ALREADY at elevated levels a year ago, and it went up another 8.5% on top of that elevated level, why is the market celebrating?

Probability of A 2023 Recession

Even though no single source of data is an accurate predicator as to whether or not we will end up in a recession in 2023, the chart that I am about to show you is being weighted heavily in the investment decisions that we are making for our clients.

Historically an “inverted” yield curve has been a fairly accurate predicator of a coming recession.  Without going into all of the details of what causes a yield curve inversion, in its simplest form, it’s the bond market basically telling the stock market that a recession could be on the horizon.  The chart below shows all of the yield curve inversions going back to 1970.  The red arrows are where the inversion happened and the gray shaded areas are where recession occurred.

Look at where we are right now on the far right-hand side of the chart. There is no question that the yield curve is currently inverted and not just by a little bit.  There are two main takeaways from this chart, first, there has been a yield curve inversion prior to every recession going back to 1970, an accurate data point.  Second, there is typically a 6 – 18 month delay between the time the yield curve inverts and when the recession actually begins.

Playing The Gap

I want to build off of that last point about the yield curve.  Investors will sometimes ask, “if there is historically a 6 – 18 month delay between the inversion and the recession, why would you not take advantage of the market rally and then go to cash before the recession hits?”  My answer, if someone could accurately do that on a consistent basis, I would be out of a job, because they would manage all of the money in the world. 

Recession Lessons

I have been in the investment industry since 2002.  I experienced the end of the tech bubble bust, the Great Recession of 2008/2009, Eurozone Crisis, and 2020 COVID recession. I have learned a number of valuable lessons with regard to managing money prior to and during those recessions that I’m going to share with you now:

1.  It’s very very difficult to time the market.  By the time most investors realize we are on the verge of a recession, the market losses have already piled up.

2. Something typically breaks during the recession that no one expects.  For example, in the 2008 Housing Crisis, on the surface it was just an issue with inflated housing prices, but it manifested into a leverage issue that almost took down our entire financial system.   The questions becomes if we end up in a recession in 2023, will something break that is not on the surface?

3. Do not underestimate the power of monetary and fiscal policy.

The Power of Monetary & Fiscal Policy

I want to spend some time elaborating on that third lesson.  The Fed is in control of monetary policy which allows them to use interest rates and bond activity to either speed up or slow down the growth rate of the economy.   The Fed’s primary tool is the Fed Funds Rate, when they want to stimulate the economy, they lower rates, and when they want to slow the economy down (like they are now), they raise rates.   

Fiscal policy uses tax policy to either stimulate or slow down the economy.  Similar to what happened during COVID, the government authorized stimulus payments, enhanced tax credits, and created new programs like the PPP to help the economy begin growing again.  

Many investors severely underestimate the power of monetary and fiscal stimulus. COVID was a perfect example.  The whole world economy came to a standstill for the first time in history, but the Fed stepped in, lowered rates to zero, injected liquidity into the system via bond purchases, and Congress injected close to $7 Trillion dollars in the U.S. economy via all of the stimulus policies.  Even though the stock market dropped by 34% within two months at the onset of the COVID crisis in 2020, the S&P 500 ended up posting a return of 16% in 2020. 

Now those same powerful forces that allowed the market to rally against unsurmountable odds are now working against the economy.  The Fed is raising rates and decreasing liquidity assistance.  Since the Fed has control over short term interest rates but not long-term rates, that is what causes the yield curve inversion.  Every time the Fed hikes interest rates, it takes time for the impact of those rate hikes to make their way through the economy. Some economists estimate that the delay between the rate hike and the full impact on the economy is 6 – 12 months.

The Fed Is Raising More Aggressively

The Fed right now is not just raising interest rates but raising them at a pace and magnitude that is greater than anything we have seen since the 1970’s.  A chart below shows historical data of the Fed Fund Rate going back to 2000. 

Look at 2004 and 2016, it looks like a staircase. Historically the Fed has raised rates in small steps of 0.25% - 0.50%. This gives the economy the time that it needs to digest the rate hikes.  If you look at where we are now in 2022, the line shoots up like a rocket because they have been raising rates in 0.75% increments and another hike of 0.50% - 0.75% is expected at the next Fed meeting in September.  When the Fed hikes rates bigger and faster than it ever has in recent history, it increases the chances that something could “break” unexpectedly 6 to 12 months from now.  

Don’t Fight The Fed

You will frequently hear the phrase “Don’t Fight The Fed”.   When you look back at history, when the Fed is lowering interest rates in an effort to jump start the economy, it usually works.  Conversely, when the Fed is raising rates to slow down the economy to fight inflation, it usually works but it’s a double edged sword.  While they may successfully slow down inflation, to do so, they have to slow down the economy, which is traditionally not great news for the stock market.

I have to credit Rob Mangold in our office with this next data point that was eye opening to me, when you look back in history, the Fed has NEVER been able to reduce the inflation rate by more than 2% without causing a recession.  Reminder, the inflation rate is at 8.5% right now and they are trying to get the year over year inflation rate back down to the 2% - 3% range.  That’s a reduction of a lot more than 2%.

Stimulus Packages Don’t Work

In the 1970’s, when we had hyperinflation, the government made the error of issuing stimulus payments and subsidies to taxpayers to help them pay the higher prices.  They discovered very quickly that it was a grave mistake. If there is inflation and the people have more money to spend, it allows them to keep paying those higher prices which creates MORE inflation. That is why in the late 70’s and early 80’s, interest rates rose well above 10%, and it was a horrible decade for the stock market.

In the U.S. we have become accustomed to recessions that are painful but short.  The COVID Recession and 2008/2009 Housing Crisis were both painful but short because the government stepped in, lowered interest rates, printed a bunch of money, and got the economy growing again. However, when inflation is the root cause of our pain, unless the government repeats their mistakes from the 1970’s, there is very little the government can do to help until the economy has contracted by enough to curb inflation. 

Is This The Anomaly?

Investors have to be very careful over the next 12 months.  If by some chance, the economy is able to escape a recession in 2023, based on the historical data, that would be an “anomaly” as opposed to the rule.   Over my 20 year career in the industry, I have heard the phrase “well this time it’s different because of X, Y, and Z” but I have found that it rarely is.  Invest wisely.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

2022 Market Outlook

There are trends that are developing in the U.S. economy that we have not seen for decades.  As inflation continues to rise at a rapid pace, we have to look back to the 1970’s as a reference point to determine how inflation could impact stocks, bonds, gold, and cash going into 2022.  The most common questions that we have received from clients over the past few weeks are:

Will the stock market rally continue into 2022?

• Will higher inflation derail the economy?

• How will the market react to the Fed increasing interest rates in 2022?

• A lesson from “The Nifty Fifty”

• How will the labor shortage and supply chain issues impact the markets in 2022?

I plan to address all of these questions and more as we present our market outlook for 2022.

 The Economy Will Continue to Strengthen

 It’s our expectation that we will see the U.S. economy gain strength in the first half of 2022.  Our economy is based primary on consumer spending and the consumer is charged with cash and ready to spend. The cash has come from record levels of government stimulus in 2020 and 2021, as well as rising wages across many sectors in the U.S. economy.  Debt levels are also at historic lows as well.  Due to the supply chain constraints, people could not spend the money, therefore they paid down their debt.  Per the chart below, debt payments as a percent of U.S. households’ disposable income is at the lowest level in over 40 years. 

Talk to any pool company and they will provide you with a clear picture of the pent- up demand.  Some pool installers are fully booked through 2022 and are taking deposits for pools for 2023. 

 Back Orders At Record Levels

 Many of the companies that we have spoken with across various industries have back orders at record levels. With back orders, the customer is already committed to buying a product from a company whether it’s a car, roof, gym equipment, etc., but they have yet to take delivery of that product.   When the product is delivered, they normally submit full payment, and the company realizes the revenue.  From an outlook standpoint, when companies have large back orders, it takes some of the risk off the table because it is not an “if the sales are going to be there to generate revenue” but rather “how quickly can the company deliver the product to their customers”.  

 Supply Chain Constraints

 The answer to the question “how quickly can they deliver?” relies heavily on how fast the global supply chain can get back online going into 2022.  People have been slower to return to the workforce than originally expected, which means less people at the ports to unload container ships, less truck drivers to transport the goods from the ports to the stores, and less employees in stores to stock shelves.  However, we see a number of new trends that should ease these constraints in 2022:

 Individuals needing to return to the workforce after depleting stimulus cash reserves

• Employer offering higher wages and sign on bonuses to attract employees

• A higher level of vaccination rates in children, easing childcare constraints, and allowing more parents to return to the workforce

 I think the economy has largely underestimated the impact of the childcare constraints on the ability for parents to return to the workforce.  If your child has a cough, even though a test may reveal that they don't have COVID, they may not be able to return to school for a few days, requiring a parent to take time off from work. 

 Relief At The Ports

 The two main ports in the U.S are the “twin ports” in Los Angeles and Long Beach; 40% of sea freight enters the U.S. through those two ports. Both have been working around the clock to unload ships and they are making significant progress.  Mario Cordero, executive director of the Port of Long Beach, stated that in mid- November there were 111 ships off the coast of California waiting to be unloaded and within two weeks that number was reduced to 61 ships.  However, it takes time for the goods to get off the ship, loaded onto a truck, and delivered to stores and businesses, but the trend is going in the right direction.

 Record Levels of Cash Injection

 Over the past 18 months, the U.S. Government has injected more cash into our economy than any other time in history.  To put this in perspective, let's compare the dollar amount of the bailout packages during the Great Recession of 2008 / 2009, to the level of cash injection over the past 18 months. In the illustration below on the left side you will see the TARP Program which was the government bailout for the banks and the housing market in 2008 / 2009. On the right, you will see all of the stimulus program that the government rolled out in 2020 / 2021 to battle COVID.

The total cost of TARP was $700 Billion.

 Over the past 18 months the government has injected almost $7 Trillion…………TRILLION……into the U.S. economy. That is 10 times the TARP program that was used to rescue the US economy in 2008/2009 when we almost lost the entire U.S. banking system.   

 To go one more step, below is a chart of the year over year change in the M2 money supply. This allows us to see how much cash is circulating within the U.S. economy compared to the prior year going all the way back to 1980.

Look at that mountain on the righthand side of the chart.  We have had recession in the past which has required the government to inject liquidity, which are illustrated by the grey areas in the chart, but nothing to the magnitude of what we have seen over the past 18 months.  Just a side note, this chart does not include the recent $1.2 Trillion dollar infrastructure bill that was already passed or the $1.75 Trillion Build Back Better bill that is deck.

 A lot of this cash that has been injected into the economy has not been spent yet because due to the supply chain constraints, consumers and business have not been able to spend it.  As the supply chain gets back online in 2022 and 2023, consumers and businesses will be able to put this cash to work which should be a boost to the U.S. economy.

 Inflation, Inflation, Inflation

 The great risk to the economy as we enter 2022 is undoubtedly rising inflation.  We have all seen prices rise rapidly for just about everything we buy: groceries, gas, travel, etc. The supply chain issues have made this problem worse because the less goods there are, the more expensive they become.  This leads us to the main question which is:

 “Will inflation subside once the supply chain gets back online or are these higher levels of inflation that we are seeing now just the beginning?”

 This is the question that everyone wants the answer to but it’s too early to tell.  The only thing that's going to provide us with the answer is time, so we are going to be watching these trends unfold week by week, month by month, as the data comes in during 2022.  In my opinion, there is an equal chance of both scenarios playing out.  Scenario one, the supply chain improves throughout 2022, increasing the supply of goods and services, which in turn stabilizes prices, and the risk of hyperinflation begins to fade.  Scenario two, either the supply chain does not heal fast enough, or wage growth continues to escalate, causing inflation rates to continue to rise, forcing the Fed’s hand to raise rates more quickly. 

 You have to remember that inflation only begins to do damage when prices rise to levels that consumers and businesses can no longer afford.  Given the historic levels of cash that have been injected into the economy, it’s our expectation that even with prices rising over the next 6 months, that may not curb the consumers ability or desire to purchase those same goods and services at higher prices.

 The Fed

 The Fed has two main objectives: 

1. Keep the economy at full employment

2. Keep inflation within its target range of 2% - 3%

 As you can see in the chart below, the CPI (Consumer Price Index) which is the Fed’s main measuring stick for inflation has risen well above the Fed’s 3% comfort zone and continues to rise.

 In November, it was reported that the year over year change in CPI (inflation) was 6.9%.  That’s a big number.  In response to these heightened levels of inflation, the Fed has increased its timeline for decreasing the amount of bonds that it is purchasing as well as escalating the timeline for their first interest rate hike.  With these changes, the Fed is intentionally tapping the brakes, so the economy does not overheat and give rise to hyperinflation like we saw in the 1970’s.  But it's important to understand that every time the Fed raises interest rates, it is working against economic growth because it makes lending more expensive.  Less lending normally means less spending.

 This change in the Fed stance is not necessarily an end all for the stock market rally.  Investors have to remember the Fed is raising rates because the economy is strong which has caused prices to rise.  Historically, as long as the Fed is able to raise rates at a measured pace, the economy and the market have time to digest those small increases, and the growth trend can continue.  It is when the Fed has to raise rates in large increments in a relatively short period of time, it creates more of an abrupt end to an economic expansion.   Think of it this way, if the interest rate on a 30-year mortgage go from 3.25% to 3.50% it’s not going to necessary derail the housing market. But if that 30-year mortgage rate goes from 3.25% to 5% in short period of time, that could cause a huge drop in housing prices because people will no longer be able to afford the mortgage payments to purchase a house at these elevate prices.   

 The Nifty Fifty

 Looking at that inflation chart that I showed you earlier, it’s been 30 years since the Core CPI index has been over 3%.  People that just started investing within the last 30 years have not seen the impact of inflation on stock, bonds, cash, and other asset classes. The last time the U.S. economy experienced higher inflation for a prolonged period of time was the 1970’s.  There are a lot of important investment lessons that we learned in the 1970’s but one of them that bears mentioning is the lesson of the “Nifty Fifty”. 

 The Nifty Fifty was the name given to a group of stocks in the 1970’s that were the darlings of the stock market.  Companies like McDonalds, Polaroid, Disney, IBM, Johnson & Johnson were names within the Nifty Fifty.  This group of stocks are similar to the FANGs that we have today which include Facebook, Amazon, Netflix, and Google. 

 Why the comparison?  Coming out of the 1960’s there was prolonged bull market rally, similar to the one we have today, these Nifty Fifty stocks were the growth engines of the market, and as such they traded at very high valuations (P/E ratios) compared to their peers in the stock market. Many of the Nifty Fifty stocks had P/E ratios above 50 times forward earnings.  To put that in perspective, right now the S&P 500 Index has a P/E of about 21x forward earnings. When higher inflation shows up, it traditionally has a larger negative impact on stocks that are trading at higher multiples compared to stock that have lower P/E ratios.  This is because higher interest rates erode the present value of those future earnings that are baked into the price of those stocks.   When higher inflation showed up in the 1970’s, many of stocks in the Nifty Fifty dropped by over 60%.  Investors need to remember, when the economy is good and inflation is low, the market tends to care less about valuations.  When inflation increase and/or the economy slows down, all of a sudden valuations will begin to matter again to investors.

 I’m making this point as a word of caution; the Nifty Fifty and the FANG have a lot of similarities.  Even though, at this point, I do not expect a hyper inflationary environment like the 70’s, a rise in inflation may have a similar impact on stocks trading at a higher valuation. Netflix current trades a PE of 55, Amazon (P/E 66), Microsoft (P/E 38).   The market looked at the Nifty Fifty similar to how I hear investors talk about the FANG stocks now, “how can they ever go down?”  Also from a psychological standpoint, investors often find it difficult to sell holdings that have made them a lot of money, and these FANG stocks have increase in value a lot over the past 10 years. There is also the tax hit that investors incur in taxable accounts when unrealize gains turn into realized gains.

 To be clear, this is not a recommendation for investors to go sell of their FANG stocks, it’s about understanding the trends that have played out in history, how those trends may compare to where we are now when assessing risk, opportunity, and the investment decisions that we may face in 2022.  

 2022 Outlook Summary

 Brining all of these variables together, we expect the first half the year to bring with it strong economic growth which should be a favorable environment for risk assets. But…….we don’t anticipate that it will be a smooth ride in 2022 for equity investors. As the Fed implements its anticipated interest rate hikes, there could be a number of selloffs throughout the year that will test the patience of investors. If inflation does not get out of control, those selloffs could be an opportunity for investors to put cash to work, as the market shakes off the scary headline risks and the growth trend continues. We expect the labor shortage and supply chain issues to improve in 2022, which should help to ease some of the inflation fears as prices begin to stabilize in 2022 and potentially drop going into 2023. 

 The second half of the year will depend largely on the trend of inflation.  If inflation runs hotter than expected, it could begin to have an impact on consumer spending as prices rise above what consumers are willing to pay, and it could force the Fed to increase the magnitude or frequency of rate hikes in 2022.  Either of those two items could potentially erase or decrease the gains the U.S. stock market may have achieved in the first half of the year.

 With higher levels of volatility almost a given for 2022, investor may have to resist the urge to sell out of their stock positions and retreat to bonds or cash knowing that an inflationary environment is an enemy of both high-quality bonds and cash.  Overall, investors will have to pay closer attention the economic and inflation data throughout the year to determine if pivots should be made in their investment strategy, especially as we enter the second half of the year.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.