Stress Tests

There was a rally on Wall Street this week, as the Stock Market clawed back some of the losses from the largest weekly decline since the Covid crash in the Spring of 2020. It’s nice to see green back on the screen heading in the weekend. The month of June has been beyond tough for investors. June brought back-to-back 5+% weekly declines on the S&P, something that has happened only 7 times since WWII. That streak ended this week. This has been a rare stretch for any Bear Market. But we are navigating the turbulence.

The rally was triggered by some interest rate reprieve and signs that the aggressive Fed tightening campaign could be slowing ahead. The 10-Year Treasury yield fell a 1/2 point from its multi-year high, in just 10 days. Falling Oil prices were another major positive, which sent gas prices lower. The national average price for unleaded has declined 9 straight days, taking it back below $5 a gallon. In fact, many commodity prices have fallen of late. Natural Gas prices fell 10% this week. Copper is down 26% from its 2022 highs. The CRB index, which consists of 19 global commodities ranging from cotton and wheat to corn, cattle, and aluminum, has also started to roll over. These are all key inputs in our daily consumption. It’s where inflation lives. These declines in commodity prices are another sign that inflation may just finally be peaking.

In­vestors have blamed the Fed­eral Re­serve for Mar­ket routs for decades. There’s an old adage on Wall Street that Bull Markets don’t die of old age; They get murdered by the Fed. It’s a pretty graphic saying, but there’s plenty of evidence to support the claim. However, the Fed has of­ten had a hand in Mar­ket turn­arounds, too. Here’s a study from Goldman Sachs: Going back to 1950, the S&P 500 has declined 20+% on 17 oc­ca­sions. The declines ranged from 20.6% to 51.9%, the latter occurring in response to the Financial Crisis of 2008. The average length of a Bear Market is 11 months, although the range has been 1 month to 19. On 11 of those 17 occa­sions, the Stock Mar­ket bot­tomed out around the time the Fed shifted back to­wards loos­en­ing mon­e­tary pol­icy again.

Today, the Fed is still very much in tightening mode. It won’t last, not with the Economy slowing. It’s our sense that the Market is sniffing out a Fed pause around the corner. There won’t be any rate cuts in the near future, but an end to the aggressive tightening campaign should be well received. Importantly, the Market moves well in advance of both a recession and recovery.

Fed Chair Powell was on Capitol Hill this week. It was his biannual testimony to Congress on the state of the Economy. Representatives in both the House and Senate got their chance to show off to their constituencies with anger about inflation. It’s standard Washington games. But inflation is clearly a problem. We all know that. The Fed Chair reiterated the central bank’s unconditional commitment to fighting it. Powell admitted that the rate hikes and quantitative tightening could provoke a recession. He was quick to remind that recession is not the Fed’s intention. Powell also reiterated that a soft landing will be very challenging given the war, commodity prices, and supply chain issues.

The Market has gone a long way towards pricing in a recession already. It seems very likely that the Economy does ultimately recess, even if it’s shallow. The timing is setting up for early next year. Consumers are still spending; They’re just spending on different things. The spending should continue throughout the Summer with increased activities and travel. Food and gas prices keep sucking away Dollars from other areas in retail. Last Friday was the busiest day for the airlines all year. Nearly 2.5 Million people were scanned by TSA, which was the largest single day for flight occupancy since Thanksgiving. You know what else is up? Complaints of short staffing. There were a lot of flight cancellations last week. The skies weren’t all that friendly. Airlines are having trouble keeping up with demand. Restaurants are too. From coast to coast, Americans are paying more for less.

What’s really noticeable is the American people are buying less stuff. Factory activity in the Midwest has cooled, slowing in June for the third consecutive month. New factory orders are growing at their lowest level in 18 months. Retailers have an inventory problem. Early in the pandemic, they didn’t have enough stuff to meet the insatiable demand. So, stores double ordered. That demand has since been satisfied. Now stores have too much stuff. It’s a double whammy for retailers: Weakening consumer spending with excess inventories. Blowout sales are coming. This should put further downward pressure on prices paid.

Stress tests have become the norm for the Banks since the Financial Crisis. They just got tested again. They all passed. The stress tests are a hypothetical scenario of a severe global recession with substantial stress in commercial real estate and corporate debt. These annual health checks dictate the required size of each bank’s “capital buffer.” That’s the extra cushion of money that’s set aside on top of the regulatory minimum needed to support its daily business. This is no small deal. Passing this test indicates our financial institutions can withstand another crisis should one occur. The tests also determine how much lenders can return to shareholders in the form of share buybacks and dividends. We’ll learn about that next week. The Banks are still on a tight leash.

Inflation remains the #1 Market issue today. But it seems like we’ve hit a new stage, transitioning from hyper inflation fears towards slowing growth and recession fears. These are generally deflationary. Earnings Season is just around the corner. We will soon learn how much this economic slowdown is impacting Corporate America. The Street hasn’t cut earnings expectations much at all. Multiple compression has been entirely responsible for this Bear Market sell-off. In other words, the price investors are willing to pay for earnings has shrunk. Heading into the year, the S&P 500 was trading at well over 20X future earnings. Today it is closer to 15X. That’s the P/E ratio. The most important issue is the E. E = Earnings. Are Street estimates too high? We will find out in July. It will be important to see if CEOs are more cautious and conservative with their outlook for the rest of the year. Remember, above all else, earnings are the biggest driver of stock prices.

I often mention sentiment and contrarian indicators. Sentiment has seldom been this sour. Buy low and sell high is supposed to be the way for investors. History keeps proving the opposite occurs. Investors tend to chase rallies and panic sell at lows. Both the Stock Market and the Bond Market rallied this week. Therefore the ‘Balance’ in Balanced portfolios started working again. The decline in interest rates means higher bond prices. Credit spreads also tightened, a sign of confidence. These are positive developments. But individual investors were selling. In fact, equities had the largest outflows in 9 weeks. Global Bond funds saw the biggest weekly outflows since April of 2020. That was during the Covid crash. This is another indication of bottom formation. Finding a bottom is a process. It takes a lot of patience. It really tests our collective patience. The test is always stressful.

We are approaching the midpoint of the year. 2022 has been like one massive stress test. There are so many issues going on simultaneously, which has put serious pressure on the Financial System and the psychology of the American people. Everywhere you look, there is some sort of stress and agitation. It has permeated economics, politics, geopolitics, our legal system; Pretty much everything in our society. Inflation continues to be the greatest nemesis to America’s Economy. Another 3/4 point hike seems certain for July. Stocks and Bonds seem to be sniffing out a less aggressive Fed for the second half of the year. A soft-landing looks unlikely. But a crash-landing does too. That said, the turbulence will likely stick around. It’s felt everywhere.

Quoting one of my favorite people, Marlene, this week: “I don’t get this Wacko World…” The more I think about it, she’s so right. This is a Wacko World indeed. But we keep navigating through it. Nothing will stop us from that.

Have a nice weekend. We’ll be back, dark and early on Monday.


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