The Mother Of All Bear Markets

Q1 growth slowed to a 1.3% annual rate despite 12% inflation. This is the very definition of STAGFLATION. Much of the growth in the last two quarters came from inventory build-up that will reverse in coming quarters. Q2 growth may rebound a little as imports fall due to a combination of the China lockdowns and excessive inventories. Inflation will also slow, but this is just the calm before the next storm.

History provides some perspective. Bank of America recently released a long-term study showing the average bear market loses 37% from peak to trough (S&P 3000 vs the January 4796 peak). We’re about half way there. When a recession is avoided the bear markets tend to be mild (20-30%). Bear markets that precede recessions decline 47% on average (that’s not a worst case scenario). Stagflation will morph into recession in the next 12-18 months bringing with it a severe bear market.

All this may sound pessimistic but is great news for those of us who sat out the post pandemic bubbles. Defensive strategies are paying off. Sometime in the next six to twelve months most investors will capitulate. Investment bargains like we saw in 2002 and 2009 will reappear for those of us with our cash intact.

US GROWTH HAS PEAKED – INFLATION WILL PERSIST

I headlined the Winter newsletter with that statement then explained.

“Reported CPI will jump in the next few months as annual change gets measured from the Spring 2020 shutdown. … that statistical anomaly will pass … but prices will continue to rise… Businesses attempting to satisfy rising demand will face ever higher costs in 2022, beginning with payrolls.”

The 70% Solution Jan 7, 2022

Inflation soared but real GDP retreated back to 1.3% growth in Q1. The Q4 growth surge came from an unsustainable rise in goods inventories just a consumer spending was shifting to services.

Sub 2% growth (far short of consensus 4-6% forecasts for 2022) will continue throughout the year. Higher interest rates, a huge reduction in the federal deficit, and consumers squeezed by inflation make growth unlikely to reaccelerate. However, the strong job market, rising wages, as well as solid household and corporate balance sheets will combine with spending by state and local governments awash in cash (led by California’s near 100 billion dollar surplus) also make a 2022 recession unlikely.

“…while real growth retreats to below the 2% seen in Q3 after an upward blip in Q4…Despite slower growth, recession is unlikely in 2022.”

The 70% Solution Jan 7, 2022

Putin’s war and the Chinese shutdown frontloaded 2022 inflation. The increase in consumer prices that most forecasters expected to retreat back towards 2% this year instead rose at six times that pace in Q1. That will slow, but consumer price will rise closer to 6% than 2% in 2022. Improvement from the worst levels will embolden the bull market geniuses that brought you this stock market bubble to again claim the inflation crisis has passed. Don’t hold your breath. Inflation will only slow until the profit squeeze forces business to hike prices further. Inflation is transitioning from spikes in food, gasoline, and commodity prices into a more persistent rise in services. Wage pressures, rent hikes, restaurant meals, airline fares, hotel rooms, etc. etc. are all moving up. The retreat from globalization (security benefits notwithstanding) and tariffs continue to put upward pressure on consumer prices. Ultimately the economy is headed for recession in 2023. This year ongoing stagflation is more likely.

“The more likely scenario is that inflation remains over 4% (and potentially much higher)”

The 70% Solution Jan 7, 2022

Paychecks are not keeping pace with inflation. Rising prices are destroying demand discretionary spending by low income households. Used car prices that have soared for over a year declined slightly in April. Gasoline consumption actually fell by more than prices rose last month, The increase in all other retail sales categories was primarily driven by higher prices. The effect was clear in the Q1 financial results from Walmart and Target. Year over year sales rose about 3%, but profits declined as cost increases exceeded sales. The economy may avoid recession in 2022, but the profits recession has started.

THE FED

Everyone is aware that individual prices are determined by demand and supply. The Fed attempts to manage overall demand by tightening or easing credit. It has no tools to address supply. Sufficiently tight credit can cause demand to collapse. It takes longer for easy credit to stimulate demand as it works its way through the banking system. Inflation doesn’t respond directly to Fed actions. It can take up to a year or more for Fed actions to work its way through the economy and another year or two before the full impact on consumer prices is felt. The process is accelerated when the Fed is directly funding government spending rather than encouraging banks to lend. In the interim supply conditions can change dramatically, mitigating or amplifying the actions of the central bank.

The last few decades saw huge increases in global productivity as world trade expanded and supply soared. Fed policy turned out to be a lot less inflationary than almost anyone (including me, who should have known better) expected. In the last four years the world has retreated from globalization. At exactly the same time, central banks (especially the Fed) aggressively expanded credit (25% money expansion in 2020) to offset the pandemic shutdowns. I have repeatedly warned readers that the monetary expansion of the last few years made rising inflation inevitable. The inflation struck in a big way when demand from easy money already compounded by reduced world trade was aggravated by events in Russia, Ukraine, and China.

Money growth slowed to a somewhat less inflationary 12% pace in 2021. That trend accelerated this year when the Fed announced rate hikes. Annualized money growth through April money was only 3% (money supply actually contracted in the last two months). If this continues the 2023 recession is virtually assured. Following the recession, inflation should slow further as growth resumes in 2024. It will however remain well above the Feds current 2% target as the retreat from globalization weighs on global productivity. Re-shoring supply chains has merit from a national security perspective, but the price is reduced growth and higher consumer prices.

The Fed is well aware that it has a short window between election years to get inflation under control. It will be hard pressed to stay the course when growth slows and unemployment rises. If they elect to postpone the recession by easing credit, the transition from stagflation to recession may occur later. The (inflation) cow got out of the barn a couple of years ago. Closing the door now won’t bring the cow back. The US labor shortage should keep the 2023 recession relatively mild, but the economy may oscillate between mild recessions and stagflation for years. Only huge productivity gains from massive domestic business investment and re- globalization can end the cycle. Shrinking profit margins and political pressures make either outcome unlikely.

Unlike the 1970s, bond yields were near zero when inflation accelerated late last year. In the last four months rates have increased to the level that they started from in the 1970s. I lived and breathed those years. as an institutional fixed income portfolio manager. In 1979 Jimmy Carter finally appointed Paul Volker as Fed Chair with instructions to do whatever it took to end inflation. Things got really ugly fast, eliminating any chance of Carters’ reelection (no good deed goes unpunished!). It’s the job of the New York Fed to implement monetary policy. On a more personal note, part of my job in those days was to speak regularly with Gerry Corrigan (President of the New York Fed). Last week Gerry passed away. The current N.Y. Fed President John Williams has some big shoes to fill.

Bonds

Wall Street has perennially assured investors that a mix of 60% stocks and 40% bonds was a bullet proof strategy. The bonds were supposed to appreciate when stock prices plunged. Few investors understand the “bond protection” was entirely dependent on the regular interest payments that bonds provide. Interest payments reduce the “duration” (the time it takes to get your money back without selling the asset) of bonds. When bond yields drop to zero, the protection evaporates. Short “duration” assets are stable, while long “duration” assets are volatile. Even after yields rose last year, bonds suffered their biggest four-month loss in history in 2022.

At the lows, long term (“risk free”?) treasury bonds (as measured by the TLT ETF) had fallen about 20% (and about 30% since 2020 highs). At that point, long term T-Bond yields approached 3.25%. The half percent Fed rate hikes expected in the next few months (as well as some additional quarter percent hikes later in the year are already reflected in bond prices). Bonds have rallied since then, reducing those yields about one-half percent below their recent peak. At current prices, treasuries and other high-quality bonds should be relatively stable through the summer. High yield bonds are also benefiting, but will suffer when the market begins pricing in the reduction in Q2 profit margins.

US STOCKS

Rising yields pose no immediate threat to stocks from current levels. However, rising rates now pushed all of our three short term stock market liquidity indicators into bear territory. Since then, the drop in stock prices has made one of three long-term value indicators significantly less bearish. Overall, our indicators remain bearish but bear market rallies like we had in late March and May will continue to recur. Those rallies are selling opportunities before the market heads lower. In the meantime, relatively stable interest rates combined with a reduction of extreme valuations will support stock prices until earnings shortfalls increase bearish sentiment.

Long duration assets benefitted in the late May rally, but we continue to prefer short duration assets from an investment (as opposed to trading) perspective. Overall value (short duration) stocks have dramatically outperformed growth (long duration) stocks this year. Prices swing because investor confidence increases when prices rally and fears rise when prices fall. Therefore, we don’t encourage most investors to follow our example of frequent repositioning. The wild swings in bank stocks this year are a great example. This kind of market requires the stomach to only buy stocks when others are fearful and quickly take profits when other investors become more confident.

The recent lows (S&P 3900) are not the bottom, but should provide support for a couple of months. Shrinking profit margins will eventually take the S&P down to the 3400-3600 area. Although inflation is already declining from the 12% pace in Q1, high inflation will persist resulting in further stock losses. S&P 3400-3600 is merely interim support. We will be surprised it this bear market bottoms above S&P 2300-2400 (2020 pandemic lows).

Companies able to sustain earnings as growth slows (along with those that benefit from higher inflation or interest rates) will fare relatively better in this environment. These will likely include consumer staples (earnings), commodities (inflation) and banks (interest rates) that still trade at reasonable prices. Banks stocks will initially benefit from the rise in long term rates. That will change when inflation forces the Fed to hike short term rates more than expected.

The 70% Solution Jan 7, 2022

Our Diversified Portfolio Strategy is enjoying high single digit gains this year (vs a 10-15% loss in the Dow, 15-20% loss in the S&P 500 and 25-30% losses in the Nasdaq). We periodically take long positions in deep value sectors following market drops. This is in addition to core positions in John Hussmans’ fund (HSGFX), precious metals (GLD), short term inflation protected Treasury Bonds (STIP) and energy pipelines (AMLP). We like defensive equities like the Russell Pure Value ETF (RPV) and the Consumer Staple ETF (XLP) but are quick to take profits in rallies. Other than gold (GLD) we are currently avoiding alternative asset classes as well. Holding short term treasury bills and money market funds that will lose ground to inflation will still outperform long duration assets.

CRYPTO CURRENCIES

Crypto (currencies?) are about the longest duration assets you can buy. They don’t produce any reliable income and unlike bonds or commodities have no maturity or liquidation value. Crypto was supposed to protect investors from losses in fiat currencies during inflation and losses from stock market declines. El Salvador adopted Bitcoin as legal tender. After an initial surge, usage has steadily declined because it costs more to conduct transactions in Bitcoin than dollars dispensing ATMs.

Crypto has neither income streams or residual values. Prices are totally dependent on what future speculators will pay. Even more than other assets, falling interest rates encouraged speculation in Crypto. Now rates are rising, stocks are down, Crypto is sinking at twice that pace. The most widely quoted Crypto, Bitcoin has dramatically underperformed stocks, bonds and cash this year.

Blockchain distributed ledger technology will almost certainly find valuable applications but that value is unrelated to speculative Crypto-currencies. Most countries are studying government issued digital currency in order to lower costs and reduce counterfeiting. This will greatly reduce financial privacy. The government will be able to directly access personal financial records, without court subpoenas required to access bank records.

GOLD AND GOLD MINERS

Gold is a long duration asset. Like other long duration assets gold responds inversely to interest rate changes. Gold also responds to changes in “expected” inflation. Unlike “Crypto” gold has significant liquidation value and will never become worthless. Central bank gold reserves continue to assure a currency function for gold. Liquidation valuation beyond speculation is assured by jewelry and industrial demand. For example gold is a superior electrical conductor. At lower prices industrial demand would soar.

Rates and expected inflation have risen in tandem this year, neutralizing the impact on gold prices which are close to year end levels. Like stocks and bonds, gold prices are likely to remain in a trading range for a few months. Unlike other assets that are likely to break out of the trading range to the downside, gold prices are poised to the upside. when recession risks pressure the Fed to raise the inflation target to 4% from 2%. Alternatively, if the Fed stays the inflation fighting course into recession, gold (and bonds) will benefit as “safe haven” assets.

“We continue to add metals positions whenever gold falls below $1800/oz. but will happily take profits on rallies.” The 70% Solution Jan 7, 2022

Today we are now confident that gold purchased below $1850/oz. will pay off soon. Our Diversified Portfolio Strategy began the year with approximately 15% invested in gold (GLD) and 10% in gold miners (GDX). We took some profits after gold soared above $2000/oz. Although the inflationary impact of soaring fuel prices benefit gold, they reduce mining profits. The invasion of Ukraine caused us to shift focus from GDX to GLD. Mining stocks are really cheap in terms of long-term earnings prospects in a rising inflation environment. They do not however provide safe haven protection like gold during a stock market meltdown. We will keep our GDX positions small.

REAL ESTATE

The final rise in home prices the we predicted in January ended in April. Higher prices and mortgage rates (that rose from 3% to 5%) have made purchases unaffordable for most Americans.

“Unlike a decade ago, rising rents have reduced the “duration” of housing as a real estate investment, making them less vulnerable. The immediate issue is affordability… mortgage rates are now rising rather than falling. This will put downward pressure on home sales and prices later in 2022. Don’t be surprised if home prices rise further first. Buyers racing to beat the next rate hike could easily push prices higher given the general lack of inventory. After that, prices are likely to stalemate as unrealistic sellers hold firm and buyers are unable to qualify for mortgages. Home prices will eventually fall as the economy enters recession sometime in 2023, but the carnage of a decade ago will not be repeated”. The 70% Solution Jan 7, 2022

“REPORTED” home prices may rise for another month or two. Those prices are based on sales agreed to a month or two earlier. For the first time in years home sellers started cutting their asking prices in the last month. Those cuts are far from sufficient to actually sell the rising number of properties that will come to market in the next few months. Contracts for both new and existing home sales have been declining for months. Sales will keep declining as sellers hold out for prices thar are now unrealistic. Prices will decline meaningfully as we enter 2023. In the meantime, few homes will sell. Prices have peaked, but cuts will not be as severe as the bloodbath preceding the financial crisis. Homeowners have a lot more equity today. Most of today’s homes were purchased or refinanced at very low interest rates. Payments are low. The strong job market will enable most owners to make those payments, at least until the recession begins. Even then owners will be able to rent the house for more than their payments. Although this price decline may be less severe, it may persist longer. The most chronologically challenged baby boomers are entering their late 70s. In a few years baby boomer selling pressure will exceed buying pressure from millennials. Millions of boomer homes will come to market as boomer relocation goes subterranean.

SUMMARY

INFLATION HAS ENDED THE SPECULATIVE LUNACY

RECESSION IS COMING IN 2023 even as it remains unlikely in 2022. Growth is simply a matter of how many people are working and how productive they are. Our workforce is shrinking 10,000 baby boomers per day are turning 65 while most millennials have already entered the workforce. The recent immigration surge barely dents the low skill labor shortage in hospitality and construction (the housing bust will soon eliminate some of those jobs). Productivity is declining as untrained new hires replace retiring boomers. The federal budget deficit is down another 25% this year (after falling in 2021) reducing the stimulus of the last couple of years. However, a robust job market, savings accumulated during the pandemic, available credit card credit lines, low interest mortgage payments and massive state budget surpluses will all keep the economy moving this year.

INTEREST RATES HAVE TEMPORARILY PEAKED. The 20% plus decline in long term T-Bond prices has fully discounted likely Fed rates hikes over the next few months. Rates will rise a lot more later in the year. Rates could easily double again in 2023 if recession is postponed.

“THE MOTHER OF All BEAR MARKETS” in stocks has started... Investor sentiment has deteriorated sufficiently to fuel another bear market rally, but is nowhere close to the despair that defines market bottoms (stock prices measure profit margins and the multiple investors will pay for those profits). In the very short-term, investor sentiment drives those multiples. Over time interest rates, profits, and savings fuel multiples and bull markets. Interest rates are rising, profits are falling while savings rates just hit a fourteen year low. A recession is on the way in 2023. In the last two recessions profits were cut in half, despite massive boosts from globalization and labor surpluses that no longer exist. Don’t panic in downdrafts, but use rallies to reduce any remaining big stock market exposure.

Hopefully you’ve booked your stock profits, and refinanced your mortgage at a ridiculously low rate. If you used those savings along with government handouts and PPP payments to increase your cash position and put some money to work in Series I savings bonds you are in fat city. Eventually stocks will bottom and slowly recover, but no one can predict exactly when. Once you have minimized your stock exposure, you can begin a plan to reinvest 1/24th of your cash hoard back into stocks monthly over the next two years.

Sincerely,

Clyde Kendzierski

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