The Re-test

This is the most challenging market environment I’ve experienced, possibly with the exception of ’01-’03 (the post Y2K period) and ’08-’09 (the great financial crisis).  Values of investment accounts are down, the economic unknowns far outnumber the knowns and there are no clear signals coming from the markets as to when things may begin to normalize.  With this backdrop, we watch as stocks have fallen over 9% in September, and are now down 22.7% year to date, as measured by the S&P 500.  Bonds, measured by the AGG (iShares Core U.S. Aggregate Bond ETF) fell over 4% in September and are now down over 14% year to date.  The pressure is mounting and it has recently become much harder for investors to stay the course.

                  Stocks in particular are facing a number of hurdles.  One is the macro-economic backdrop which, of course, shapes investor’s expectations around the future.  Another is monetary policy and the FOMC (Federal Open Market Committee) currently in a “tightening” cycle, raising short term interest rates.  Higher interest rates typically lead to lower prices for financial assets and lower PE ratios.  We’re also facing mounting political risks at home and around the world.  All of these will impact future earnings which are critical to future stock prices.  Finally, we have investor psychology to consider; the susceptibility we all have to our emotions and biases. 

                  On the economic front we are wrestling with a mishmash of data and reports that paint an unclear picture.  Wage growth in an out-of-balance labor market has spurred inflation.  Many workers are returning to the office, but it’s unclear yet as to what extent the culture of work has changed. Though it seems inflation has crested, August PCE (personal consumption expenditure index) was higher than expected at 6.2%, well above the Fed’s targeted 2%. The housing market has cooled with the average 30-year mortgage rate now 6.7%, double the rate at the start of the year, but it does not look as though affordability has been improved in the least. Thankfully commodity prices, especially the price of gasoline, have recovered from their spike at the onset of the war in Ukraine.

                  The Fed has now taken the hawkish position that it will raise short-term interest rates in order to slow the economy – no matter what it takes.  There have been five rate hikes this year and the Fed Funds rate has risen from near 0% to the current 3.25%. At the moment, rates are expected to be near 4.5% by year end. This has clearly jarred the stock and bond markets and the big question is, have they executed a policy error?  In late 2018, the Fed was actively raising interest rates.  It caused stocks to lose 20% of their value between September and Christmas.  Once the Fed stopped tightening, the S&P 500 rose over 12% in Q1 2019.  

Political risk is far more a relevant factor now than is typically the case.  Domestically, we have elections coming up in November that will give a clearer picture of the ongoing stability of our democratic process.  Globally, heightened geopolitical risks are substantial; the war in Ukraine, the sabotage of the Nordstream pipelines, and extended fallout from COVID control in China are just the tip of the iceberg.  It’s a big mess out there.  Interestingly, Marco Papic, chief strategist at Clocktower Group, argues in a recent Odd Lots podcast that the war is reaching stasis and the markets in the US have more or less moved on from their initial panic relating to commodities and energy markets.

                  Earnings are important for stock prices, and we are just entering the 3Q reporting season.  Some analysts are speculating that earnings are at risk with the negative GDP growth in 1Q and 2Q, signs of slowing growth in the economy.  According to FactSet Research, analysts typically reduce earnings forecasts throughout a quarter, and estimates for 3Q have been reduced by 6%. Bottom-up estimates for CY ’22 are now 2.3% lower at $224 and CY ’23 are now $242.  We are watching these figures, especially the earnings and forward guidance of the companies we own.  Investors’ tendency is to over-extrapolate, and here I am skeptical that we will see the earnings recession some are forecasting.

                  The wealth destruction from the current bear market is all too evident and is causing a spectrum of responses by investors.  Our view is that the damage is in, and it is important to hang in there. While conditions can persist, and of course stock and bond prices can go lower, there is pressure building for a rebound.  Prices are extremely oversold.  When the markets do find their footing, we want to own stocks, as prices will likely rise quickly.   In my opinion, the critical key to navigating the future recovery is cash. We want a cash reserve, based on your earnings potential; spending; and overall sense of an appropriate safety cushion, that will allow us to continue to hold quality assets while waiting for the chaotic market we are in to normalize.

                  We are celebrating our 10^th anniversary as Hotaling Investment Management in our Wayne, PA offices on December 1^st and you are invited! We are especially excited to display the remarkable artwork of our friend Kirby Fredendall and will have ample refreshments and good cheer.  If you are within driving distance, we would love to see you. Please mark your calendars and look for more information in the coming weeks. In the meantime, please feel free to call if we have not spoken recently.

Take good care,

Bruce Hotaling, CFA

Managing Partner