Market Update: September 13, 2022

The other day I was sitting at an evening bar mitzvah party enjoying the good food and drink talking to friends about the state of the world. Here we were gathered at this joyous event, a bar mitzvah gala, celebrating a youngster thirteen years of age who had just passed a major milestone in his life and wowed us with his wit and humor and his angelic voice as he chanted the chapters of the Torah in fluent Hebrew. It was a site to see … yet somehow after a few drinks the challenges of today’s world weighed heavily upon our adult shoulders. As we analyzed the situation the basic truths became ever more evident. It seemed nearly all that the schmoozers were concerned about was the cost of stuff; whether it be cars, or houses, or food, or college tuition, or even electricity needed to charge their newly purchased electric vehicles. This was not a run of the mill group of participants, rather it was an eclectic group of entrepreneurs, doctors, lawyers, and engineers. These were highly trained professionals in their outright fields. They were mostly a financially comfortable group – yet somehow, they found it difficult to ignore the cost of stuff. The overarching complaint amongst this group of comfortable corporate types was that the world has become a lot more expensive, and they were unanimously concerned about the recent performance of their retirement savings. Another common theme amongst this intelligentsia is that they seemed utterly lost as to how our leaders will lead us out of this economic mess. It appeared there was a general opinion that the world was beyond hope.

As I interacted with my fellow investors, I pontificated how the Oracle of Omaha would react to such despair. This is the type of investment kvetching that the great Warren Buffet loves to see. All is lost and all is beyond hope. People scurrying for the hills and mass exiting stocks and bonds all at once. Mr. Buffett likes to say, “be fearful when others are greedy, be greedy when others are fearful.” Whether this is the time to gradually increase equity exposure is a very personal decision, based on your long term expected returns and your stomach for risk. It is a decision that requires staying power and a protracted outlook. You will have to look beyond the 2023 recession and see the end of the proverbial tunnel of despair.

To determine the proper course of action as we are in the middle of this tunnel, one must look at previous periods to gain important perspective. We must first ask of ourselves, how relevant is this move in interest rates? Is this historically significant and what can we expect economically speaking? By now you know that I probably have considered this exact interrogatory. I have looked at historical performance of assets during a bond bear market and measured equity performance one year after the bloodletting. What I have found is that once most investors have exited risk, opportunities to prosper appear in abundance. Since 1990, there have been six major bond bear markets with an average interest rate move of 2.774%. Our current bond bear market now spans 25 months, and the move has totaled 3.397%. It is now officially the deepest and fastest bond bear market since Paul Volker’s 1982-83 inflation destruction campaign.

To be quite honest, given my age, the only thing I can remember from the Paul Volker days is my own bar mitzvah in late 1982. I recall standing at the bema (sanctuary) and becoming nearly vapor locked as I was entrusted with chanting the Torah to the crowd at hand. I had prepared tirelessly for nearly a year for this moment, yet when the time came to perform, I was overcome with trepidation. Somehow, I managed to get through this rite of passage, and obtain my passport to adulthood. A grand moment indeed … The lesson to be learned is that if you are properly prepared with a gameplan, like all those who have passed the test before you, success will most likely be your fate. This is exactly the times that the great Mr. Buffett and other sages of Wall Street have prepared for. We know deep in our hearts that the Federal Reserve (and other central banks) will put an end to this inflationary cycle. They have and will continue to raise interest rates and remove accommodation expeditiously until they are convinced that what they have done is sufficient to guide us to an acceptable rate of inflation (roughly 2%). We will most likely see a recession where unemployment must rise to balance the job market and arrest the wage spike cycle. This will undoubtedly pressure corporate profits, and if history is to be repeated, we should expect earnings to contract approximately 10%. But at the end of this process, after inflation has subsided, companies will be ready to expand responsibly. Earnings will once again rise, and multiples will once again expand.

In the most relevant three bond bear markets in the 1980s and 1990s, the average one-year return for the SP500 from the end of the bond rout has been 35.8%. Those days were relatively high inflation periods with a hawkish Federal Reserve that was keenly aware of the inflationary period of the 1970s. The predominant theme for investors was a period of rapidly evolving technological advancements. The mid-1980s brought about a period of deregulation and financial disintermediation that would provide capital to many new entrants. The mid-1990s was the era of computer advancement and fostered the beginning of the Great Moderation (bringing in decades of low and stable inflation). Today we live in an era of historic technological and societal change, as we are shifting mobility to electrification, and we are rapidly moving forward with fossil fuel reduction initiatives. In addition, the globe is quickly adopting a remote work model that will propel advancements in efficiency standards of corporate office utilization. Furthermore, genetic sequencing technologies will provide untold health advancements that could potentially treat diseases in unimaginable ways.

I cannot tell my avid readers when the perfect time is to re-engage the market. But what I can share with you is that after the dust settles and the bond bear market is complete, I would expect inflation to fall to more normal levels. I would further expect that given the strong balance sheet positions of corporate America we should prepare for companies to eventually see earnings growth, and invariably we should begin to see multiples expand. All that finance talk is a fancy way of saying stocks will rally again once the Federal Reserve stops tightening. I suspect some will question my thesis, claiming that this time its different. Well in truth it is always different; no two markets are exactly alike. That is precisely why I look at historical analogs to compare how markets performed in similar macroeconomic periods. It is my sense that we are in the early days of a generational technological shift. Just look forward ten years from now: nearly all new cars will be electric and self-driving. Imagine a world where box trucks are running completely driverless – 24 hours a day. The cost savings for the overall economy will be in the trillions of dollars. My economic crystal ball is telling me that by the end of 2022, the Federal Reserve will be ready to pause the rate hike cycle. They are keenly aware that monetary policy works with a lag of 6-18 months. The fruits of their rate hikes will be felt sometime in the spring of 2023. Chairman Powell will most likely signal the tightening pause by December 2022. By then I suspect short term rates will be approximately 4.00-4.50%, the yield curve will be properly inverted, and nearly $1 trillion would have rolled off the central bank’s balance sheet. This should be ample ammunition to attack inflation. And once inflation begins to move lower … well … we are going to wish we had more stocks in our portfolios.

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