The Bond Market Sent a Message

This was another eventful week as the enhanced volatility keeps shaking investor confidence. Bear Markets do that. They’re designed to do that.

Inflation remains enemy #1 for the Market. The Federal Reserve used to be the greatest ally. It’s become the Market’s thorn. Late to the party and behind the curve in the fight against inflation, the Fed is trying to play catch-up. They know there’s only so much they can do. The Fed’s best tools to fight inflation are levers that slow the Economy but pulled too quickly and abruptly runs the risk of sending America into recession. We got some more inflation data this week. It was Market moving.

The Consumer Price Index (CPI) came in at 8.3% in April. It continues to run hot. This persistent inflation is a big problem. But the inflation rate is finally on the decline. Remember, CPI ran at an 8.5% rate in March, which marked the highest inflation level seen since the early 1980s. A case can be made that inflation is peaking, that it’s stopped going up. Call it less bad. It’s still bad. The Market sold off sharply on Wednesday on the back of the CPI report. Aggressive rate hikes from the Fed resulting in recession is the greatest fear. The Market has been pricing that outcome in.

CPI provides a snapshot of overall prices. It is a measure of the average change over time in the prices paid by consumers for a basket of goods and services. The costs of goods escalated in the wake of the pandemic with strains in supply chains. They got worse with the war in Ukraine. The Fed pays attention to Core CPI, which excludes food and energy. It also excludes cars and rent. The irony is those are the things that impact Americans the most. Food prices are one of the biggest drivers of inflation, having increased 11% from a year ago. Core CPI is still over 6%. Demand for services remains strong while demand for stuff has slowed. Airline fares and energy prices surged 30% since last year while used car prices posted their third straight monthly decline. Airfares were up 18.6% in April alone, the largest monthly gain on record. You might have noticed. Flights are packed and airports and hotels are buzzing. Travel is up while buying things are down. Apparel prices declined 0.8% after six monthly gains.

A high-level Fed representative keeps talking tough on inflation. The central bank wants their words to do a lot of the work for them. That’s often the case. St. Louis Fed President James Bullard reiterated a preference for the Fed to get the funds rate to 3.5% by year-end, which would imply tightening into restrictive territory. That’s more than the Fed has guided, and the Market had priced in before this week. In addition, Bullard said he is sensitive to being disruptive to the Market, but also reiterated that recession risk is not high right now. The Market disagrees, worried that the central bank is forcing America into recession. Remember the old adage: Bull Markets don’t die of old age. They get murdered by the Fed.

The Fed has made it clear that it plans to raise interest rates by 50 basis points (1/2%) at each of the next two meetings. That seems to be a lock. The meetings are in June and July. “If things come in better than we expect, then we’re prepared to do less. If they come in worse than we expect, then we’re prepared to do more,” Fed Chair Powell said in an interview Thursday. The Senate finally confirmed Powell for a second four-year term by a vote of 80 to 19 this week. He’s had an eventful and historic tenure already. He has his work cut out for him still.

The Bond Market sent a message. It’s finally working. What stood out since the CPI report is the contraction in 10-Year Treasury yields. It hasn’t necessarily been a reversal, but a failure to follow through from the breakout levels of 3%. The economic slowdown should put pressure on prices, providing some relief to inflation. Yields stopped going up. Money moved back into Treasuries as a safe haven for the first time this year. This is a positive for investors. There haven’t been many safe havens in 2022. Not only is the Bond Market coming back to life, lower yields have lubricated the Stock Market, at least for a couple of days. We think there’s more to go for the Bond Market heading into Summer, particularly if the Economy keeps slowing. The Stock Market is likely to remain volatile and be subject to inflation and the direction of the Fed.

The re-opening of America continues to gain momentum. Nowhere is this more evident than looking at the earnings report from the Walt Disney Corporation. As goes Disney, so goes the country. A strong rebound was seen at Disney’s theme parks, with revenue more than doubling to $6.7 Billion during the quarter. The strength came from Disneyland and Disney World, which reported record attendances and record food and merchandise sales. People are visiting in record numbers, and they are spending more than they ever have before. Tickets start at $100. Disney’s American theme parks are exceeding the pre-Covid strength. Overseas is a different situation as lockdowns in China have shrunk crowds at Disney Shanghai and Hong Kong. People have returned to the movies with increasing frequency. Disney has some potential box-office blockbusters in the coming months, like Black Panther and Avatar sequels, Toy Story prequel Lightyear, and a new Star Wars franchise series called Obi-Wan Kenobi. They will hit theaters and/or Disney+ soon. Disney is not immune to global crises, and indicated a slowdown in Eastern European markets, including Poland and Ukraine. Disney provides a snapshot of consumer activity.

The situation with Russia keeps intensifying with western response. Both Finland and Sweden announced plans to apply to join NATO. This would reverse their decades-long policies of military neutrality in response to Russia’s attack of Ukraine. That position is sure to be seen as an escalation by Russia, which shares an 830-mile border with Finland and would double the land borders it shares with NATO territories. The Finnish government is set to debate the NATO application over the weekend, while parliament is expected to give its final approval as early as Monday.

Back to the Market: Investors Intelligence said the number of Bulls in their weekly survey fell to just 27.6%. It was 30.9% the prior week. Investor sentiment is below both the 2022 low at 29.9%, and the March 2020 low of 30.1%. Importantly, that was the panic period of the Covid Crash. These are near all-time lows for investor psychology. The number of Bears pushed up to 40.8% from 39.3%, marking a new high since the Covid Crash. As a reminder, these are contrarian indicators. Individual investors have a pretty strong track record of panicking at lows and becoming euphoric at highs. These survey numbers are a sign that investors have given up and have thrown in the towel with selling. When the selling stops, what’s left is a large population of potential buyers to get back in. It’s a pretty proven process.

Goldman Sachs reported that its US Equity Sentiment Indicator fell to -2.7, the lowest reading since the 19% S&P decline in 2011. In addition, Bernstein recently noted that its short-term Composite Sentiment Indicator fell to an extremely pessimistic level of -1.30 standard deviations heading into May. That triggered their contrarian buy signal for global equities. According to Bernstein, there have been 65 instances since the end of 2000 when such a buy signal has been triggered. The average four-week forward return has been 4% higher. So, there’s that.

The Market has finally hit the stage where everything is for sale. The Dow is down 7 straight weeks. That hasn’t happened since the Dot-com bubble burst. Even the highest quality, most defensive stocks have been hurt. It was inevitable. That needed to happen to finally bottom. It’s usually forced selling for margin calls and exhaustive declines that trigger capitulation. Sell what you can, not what you want. Seeing the Market hit lower lows is never comforting. But bottom formation is a process, which requires even the most bullish investors to finally throw in the towel. What’s been perhaps most frustrating for investors this time has been the slow bleed. Corrections are generally quick and violent. This one has been relentless. Thursday and Friday definitely brought some reprieve.

Things got oversold. It’s important to remember that not all oversold conditions are treated equally. When the Market is in a downtrend, which is the case currently, oversold conditions require a deeper dive than they would in an uptrend to produce a meaningful low. History has proven that out. Over half of the S&P 500 stocks are down over 20% this year. The percentage of stocks making 65-day lows in the S&P this week was 23%. That is not even at the highest levels on the year. It generally takes a reading of 50% to suggest a low in this type of environment. There’s been some serious damage, no question. We anticipate more choppiness ahead. Oversold bounce attempts have failed of late. Friday’s rally held. That’s something. The green on the screen Friday provided some needed comfort.

It’s gut-check time. We’re still in the thick of it. I reminded myself of a quote from John Pierpont (J.P.) Morgan: “In Bear Markets, stocks return to their rightful owners…”

You never know where the bottom is, until it’s in the rear-view mirror. To us, it feels close. A temporary low and subsequent rally would be normal about now. This is a pivotal time. There are so many serious issues that we investors are dealing with. Optimism for better outcomes is fleeting. Pessimism is everywhere. Perhaps that in and of itself is reason to stay positive. The Market reflects the negativity. It pays to stay patient and know that we are investing in dynamic, quality companies with visibility beyond the now. It’s a very challenging environment. We have been defending your portfolios. Our defense has been working. We are sticking with our disciplined approach. As always, when the facts change, so do we.

We’ve got this.

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


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