Hello everyone,
We are coming up on the anniversary of the stock market low, which hit October 12, 2022. We still don’t know whether that date is the final low for the bear market that started last year.
We can categorize bear markets into two categories: those with recessions and those without. The distinction is important because the pain is much worse when recessions hit. Historically, bear markets with recessions have lasted 15 months with an average decline of 35% versus six months and -28% for those without. For context, last year’s 25% downturn for the S&P 500 took ten months to transpire.*
So the big question is, are we out of the woods? As I’ve mentioned in recent meetings, the stock market’s health improved over the summer, but the weight of the evidence never tipped the scales to give us enough confidence the coast was clear. We do not base our recommendations on predicting the future. You’ll never hear me say let’s do this because I think X (recession, inflation, etc.) will occur. We analyze what has already happened in the stock market to gauge the strength or weakness of the current environment.
My recent letters have provided insight into the stock market’s health. This time, I’m going to look into something different. Since the Fed started raising rates, the most puzzling question is why more damage has not occurred. Why is unemployment still low, and why are people still spending money at a healthy clip? There have been several articles lately that provide some insight I’d like to share.
The pandemic lockdown and the resulting response might have delayed the anticipated pain that higher interest rates bring. So far, we can identify some winners and losers. First, everyone is affected by higher prices. However, homeowners who refinanced when interest rates nosedived in 2020 have those savings to offset today’s higher costs. For homeowners without a mortgage, their savings now generate more income, which also helps offset higher expenses. For folks in both groups, the rate rise has been stimulative. In this simple example, their cost of debt has not increased since it is locked in, but their savings have benefited. Now, take someone who rents with little to no savings; their cost has only increased. They have no extra earnings from savings to offset higher grocery bills, and their rent might have actually increased.
The longer interest rates stay elevated, the chances of a recession grow. To quote a recent WSJ article, “Rates Are Up. We’re Just Starting to Feel the Heat” by Greg Ip:
The effects will come; just wait. In the first year of the pandemic, many borrowers locked in low-cost funding for many years, effectively delaying any day of reckoning. As that debt matures, higher interest costs will start to bite, unless rates unexpectedly fall back to their old lows.
Individuals meanwhile are already paying higher rates on credit cards and car loans. Interest expense, excluding mortgages, consumed 2.2% of personal income in July, up about a percentage point in two years.
To avoid paying that higher rate homeowners are staying put. That can’t go on forever: Almost everyone eventually has to move, and as they do, interest will consume more of household incomes.
The article continues with a perspective on corporate borrowings:
American corporations could be next. “In 2020, we had these very unique circumstances where companies didn’t know if the economy would be shut down for another year or how long the Fed’s intervention in the corporate-debt market would last, and they issued a huge amount of debt,” said David Mericle, chief U.S. economist at Goldman Sachs. This has insulated them from the need to refinance as rates have risen in the past year.
That is going to change. As that debt is refinanced, corporate interest expenses will rise, which can in turn limit companies’ ability to spend, research and hire.
If the Fed can begin to lower interest rates before the bite of higher costs ensnare more borrowers, we’ll probably avoid a recession. How this will shake out is anyone’s guess. My recommendation is to stick with what we do know. We can earn a decent rate of return with income-producing securities while avoiding the uncertainty of the stock market.
Eventually, the scales will tip one way or another, which will be the time to reassess. I’ll end by paraphrasing a recent commentary from our market perspective service:
“…report also reiterated that the initial stage of every new bull market generates several highly consistent patterns of aggressive buying. It stated, “…because what many investors perceive as the ‘bargains of a decade’ are everywhere at a major bottom, buying is very broad-based. And, since investors are anxious to expose more capital to equities, volume typically explodes upward during the early months of a new bull market.”
Please reach out if you’d like to discuss further. I’ll be in touch when I know more.
Best,
Brian Lock
*Source: CFRA
*Source: Sterling Capital