Adversity and Opportunity are Neighbors

The Wall Street rollercoaster has been an intense ride for investors. This week brought the deepest dive of the slide. The Market is rattled by the pressures of relentless inflation and the growing probability of recession. The S&P 500 officially entered Bear Market territory, loosely defined as a 20% decline from its record high reached at the start of the year. The Tech-heavy NASDAQ is down 30+%. The rout this week even hit Energy stocks, by far the best performing sector, driven by spiking Oil prices. Treasury Bonds got hit too, early in the week, as yields jumped to levels not seen in a decade. The 10-Year Treasury hit 3.5% this week. It started the year at 1.5%. Importantly, yields backed off those elevated levels, with the Bond Market rallying into the weekend. This sell-off came ahead of the June Fed meeting. It continued after it. The volatility index above 30 is like hurricane winds for stocks. It’s hurricane season on Wall Street.

“What we need to see is clear and convincing evidence that inflation pressures are abating, and inflation is coming down. And if we don’t see that, then we’ll have to consider moving more aggressively.” Fed Chair Powell said those words a month ago. Clearly, they didn’t see the evidence this week. America’s Central Bank raised interest rates by 75 basis points (0.75%). This was strategically leaked just days in advance. It also prepared the Market for more hikes at this rate if price rises don’t subside. The Fed just launched its largest interest rate hike campaign in 3 decades, finally taking this inflation seriously. The Market has been forcing the Fed’s hand all year. The Fed has been slow to move. This week they took a big leap. The Fed has become more synchronized with what the Market has priced in. But the Market does not believe in the Fed’s ability to tighten so aggressively and still avoid a hard landing. A recession is getting priced in. 

The Federal Reserve is in a no-win situation. It’s important to understand that they put themselves here by not acting earlier when bubbles were building in 2021. There’s no question that zero interest rates and Trillions of Dollars of Fed asset purchases stemmed the Covid crisis in 2020. But keeping the emergency policy in place for so long encouraged bad behavior and led to the asset bubbles. While there continue to be concerns the Fed is not moving fast enough, the fact is our central bank is tightening into an economic slowdown. Achieving a soft landing will be beyond a challenge. The last time the Fed raised rates by 0.75 percentage points was in 1994. Back then, the central bank rapidly raised rates to stave off a potential rise in inflation. Today we already have it. Taming inflation runs the risk of wounding the Economy. The Fed just hiked interest rates with stocks in a Bear Market for what appears to be the first time ever. Saying the Fed is in a tough spot is a complete and total understatement.

The American Consumer is feeling the pressure. Retail sales contracted for the first time this year. The only increases were found in food and gasoline purchases. Pretty much everything else declined in May. That’s inflation at play. Dollars are getting sucked into the gas pump, away from other discretionary items. Even importers had to cut prices for the first time in years as demand for stuff has shrunk. Layoffs are on the rise. Companies are sending employees packing with increasing frequency. Asked about the impact on jobs at this week’s press conference, Powell responded, “We don’t seek to put people out of work.” But job losses will be an inevitable result. Americans are tightening their wallets again. That puts cold water on a strong economy. 

Affordability in America has evaporated. Gas hit $5 across the country and $7 in California for the first time ever. Mortgage rates hit 6%. That is cooling what can only be described as a crazy, white-hot Housing Market. Mortgage applications fell 33%. New house sales are down 43%. Housing starts declined 14% in a month. Philadelphia Fed manufacturing index contracted for the first time since May of 2020These are big declines. These declines occurred even before this recent spike in gas prices and rates. It’s pricey out there.

The war in Ukraine has definitely exacerbated the situation. But inflation was already a problem. The Consumer Price Index (CPI) has been rising since March of 2021. That is a full year before the Russian invasion. If you recall, Chair Powell “retired” the use of the word “transitory” last November, which was several months before the onset of the war and the severe sanctions that followed. We are fighting a new war and inflation is the enemy again.

Price inflation continues to outstrip wage inflation. The Economy doesn’t work when prices for goods and services increase at a faster rate than incomes. There’s only so much the Fed can do. Their tools are designed to curb demand. The Fed can’t control supplies. It can’t produce more Oil or grow more food. It can’t manufacture cars. It can’t make electronic devices or toys. It clearly can’t relieve the ever-present strains in the global supply chains. So, the Fed will continue to raise rates and tighten monetary policy. Mortgage rates will continue to go up, as well as car loans and credit cards, making it much more expensive to borrow cash. 

It’s not just the Fed. The Bank of England and the Swiss National Bank hiked rates too. So did the central banks in Taiwan and Brazil. Inflation is a global issue. Tighter money is their solution. More on the Swiss below. 

In many ways, this is an unprecedented slowing cycle we currently face. There are definitely elements of previous cycles, such as the inflation and stagflation from the 1970s and 80s, which were driven by high oil and gas prices. Then you add in the asset bubble bursting in Growth stocks, Housing and cryptocurrencies reminiscent of the Dot-com days. Our bloated Federal debt and dysfunctional government continue to weigh heavy on the American Economy. Throw in the global pandemic and we’ve got an unprecedented set of pressures plaguing us simultaneously. This is serious stuff. It’s been building for a while.

Paul Volcker achieved legendary status as the Fed Chair that whipped inflation. Paul Volcker is revered today. He was hated in the 1980s. Volcker had guts. He did what he thought was right, not what was popular. He made the hard call, inflicting serious pain to the US Economy in order to whip inflation. No pain, no gain used to be a battle cry. Nothing worthwhile is ever quick or easy. You don’t hear those words much these days. Jerome Powell is not Paul Volcker.

Historically, the Fed cuts interest rates in this type of environment, not hike. They try to provide stimulus and reprieve from the economic pain. At zero rates, there was no more stimulus to give. We’ve never seen a situation like this where the Fed did whatever it took to stem the Covid crisis in early 2020. The level of asset purchases on top of zero rates had never before been done. So, the unwinding is new too. Whatever it takes comes at a cost. We are now paying the bill, and it has proven to be quite expensive. 

Cycles move faster than ever these days. Central banks have played a huge role in that. Easing and tightening, easing and tightening. It’s led to boom/bust, crash up/crash down. The Covid crash was the fastest Bull to Bear in history. That was followed by the fastest Bear Market in history. It lasted just 5 weeks. Crash down, crash up. The Bull Market that just ended this year was the shortest since WWII. It was 21 months old. It was also the quickest Bull Market to ever double in price. It happened from the Covid lows. Many of those gains have been erased. There have been a series of fake-outs for investors. This Market volatility will continue. The era of low inflation and zero rates is over. Cheap and easily accessible money is gone.

We are getting to the point where bad news is good news for the Market. The slowing economy should cool the inflationary pressures, which would theoretically allow the Fed to pull back from its aggressive tightening. But we are months away from that. As for the prospect of a soft landing; Even the Fed conceded that the US Economy’s eventual touchdown may be a bit bumpier than previously hoped for. That seems like an understatement.

Bad news is easy to find today, it’s seemingly everywhere. Remember, bad news sells. The good needs more oxygen and brighter lights. In the midst of all the angst, here’s some reason for optimism: Innovators keep innovating. Visionaries see a better tomorrow. After 9 years of thought, design and preparation, Amazon announced it will begin Prime Air drone deliveries. The service will start in a town 40 miles south of Sacramento, in Lockeford, California. It’s a town of 3,000 people. Consider this a pilot program, without a pilot…

There will be specific items available for this trial service. The items will be identified on the Amazon site as Prime Air ready and can be purchased regular way. According to Amazon, for these deliveries, the drone will fly to the designated delivery location, descend to the customer’s backyard, and hover at a safe height. It will then safely release the package and rise back up to altitude. It’s unclear how many drones will be flying across Lockeford simultaneously. We’ll find out soon enough. When asked why Lockeford, a local responded who knows? Outside of the big water tower, there’s not a lot of stuff to run into. It’s as good a reason as any, I suppose. 

Amazon is not alone in drone delivery. The Digital Age has companies hyper-focused on speed, efficiency and innovation. Alphabet’s Wing already launched its commercial service just north of Dallas in April. Walmart’s drone delivery program is also available to more than 4 Million households across the country, making it possible for customers to get select items delivered in 30 minutes or less. Even Uber Eats is planning their entry into drone delivery with meals going by air in the near future. Leaders are going to lead. They see opportunity in every environment. It’s all very investable, if you can see past the now. 

Back to the Market: Corrections can be nasty. Bear Markets are gut-wrenching. But they are a critical part of the process. This one has been particularly painful because the Bond Market has been hit hard too. It has not been the safe-haven investors have been accustomed to. Rising rates are bad for bonds. Price discovery is complicated during a crisis. Bottoms are formed when investors can’t take it anymore and throw in the towel. History is littered with examples of people chasing gains by buying high and panicking in corrections by selling low. It’s supposed to be the opposite. It’s much easier said than done. 

Volume swelled on Friday’s session. It was an option expiration day. This one was a “Quad Witch.” This happens 4 times per year when all 4 sets of options expire simultaneously. The event always creates some additional volatility with the increase in volume. Friday was the second heaviest trading day of the year. The March Quad Witch was the other. Something else might have been at play this week which caused the abrupt selling. As previously mentioned, the Swiss National Bank surprised everyone with its first interest rate hike since 2007. It seemingly came out of nowhere overnight. This sent the Swiss Franc higher, which helps fight inflation. However, the Swiss Bank is also a big owner of US stocks. It reportedly owns nearly $200 Billion worth. The Tech Titans are the largest holdings. These stocks were hit exceedingly hard in pre-Market trading Thursday morning, immediately following the Swiss announcement. Rumors circulated that in addition to raising rates, they were selling stocks too. That would make some sense as to understanding the Thursday throttling. The Bond Market’s recovery and subsequent rally provided some reprieve and stability into the weekend.

My career has been filled with these boom/bust cycles. You learn to recognize the moment and rise to the occasion. But you never get used to them. Sentiment is as sour today as it’s ever been. Optimism has been orphaned. There was some definite panic selling in place this week. More could be in store. Bottom formation is a process. You never know a bottom is in until it’s deep in the rear-view mirror. It feels like we are close, at least for a near-term low. 

Investing is hard. In times like this, I’m reminded of a message I learned my first week in the business: Adversity is a test. It’s designed to break the weak and elevate the strong. No pain, no gain is real. The moment you’re ready to quit is right before the miracle happens. Adversity and Opportunity are neighbors. The majority quit. Bedell Frazier does not quit. Bear Markets are about survival. We know what to do. We are doing it. We’ve been active and we’re going to stay active. Hang in there. We are getting through this. We’re doing it together.

Have a nice weekend. The Market is closed on Monday in observance of the new Federal holiday, Juneteenth. Our office will be closed too.

We’ll be back, dark and early on Tuesday.

Happy Father’s Day to all you fellow dads!


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