Perfect Storm

Investing Environment Review and Outlook – Volume 57

Perfect Storm

Markets entered a perfect storm this year. After we had finally learned to cope with COVID, we are now confronting 7.9% inflation, war in Europe, renewed supply chain bottlenecks, commodity price spikes like oil to $130, and a regime change at the Federal Reserve. Add to that the humanitarian disaster unfolding in Ukraine. Despite these challenges and talk about recessions and bear markets, the S&P 500 has so far only declined 13% on the 3/14/22 low, in line with prior declines since 2010. For perspective, during the 2009 – 2020 bull market, 5 larger declines occurred. In this issue we discuss the implications of the initial Fed interest rate hike, the crude oil price spike, extreme investor positioning, and inflation.
This month we raised the U.S. equity rating to a neutral 3 rating. Foreign-developed, emerging markets and gold remain a bullish 5 rating. Long-term bonds remain a cautious 1 and commodities are a neutral 3.

Equity Investor Positioning Extreme: Bullish

Due to the persistent negative headlines and price declines in both the S&P 500 and the Nasdaq, investor positioning has reached a further extreme this, with all investor groups bearish and likely underinvested after institutions, the last hold-out, capitulated this month. The current reading is even better than the March 2020 low. This means investors have excess liquidity available to drive the next rally. It also means the worst probable outcome is likely discounted in prices, lowering the bar for a positive surprise. In the 6 prior cases since 2010, sharp equity rallies followed. Next, we discuss two possible catalysts which may cause a reversion to the upside.

Equity Catalyst #1: Crude Oil Extreme

On 3/7/22 crude oil reached $130 a barrel and 50% above the 200-day average, an extreme not seen since 1990 after Iraq’s surprise invasion of neighboring Kuwait, quite similar in some ways to Russia’s Ukraine invasion. These types of extreme rallies are typically unsustainable, since they can indicate emotional or forced buying rather than a rational market assessment of supply and demand. In the 1990 case, the Kuwait invasion was followed by a decline in the S&P 500 as the oil price doubled to $40. Then on 10/11/90, without any particular news, the S&P 500 hit bottom the same day crude oil peaked. Despite the October reversal, there was no formal resolution of the invasion for three months until U.S. forces took control in January 1991. In other words, markets often turn well ahead of any significant news. This year, the recent 20% crude oil reversal from the 3/7/22 peak may be a similar signal for equities to reverse higher, with supporting news to follow in the coming weeks. The July 2008 crude oil extreme was also followed by an equity rally as well, although it only lasted 6 weeks with much larger systemic banking issues to deal with. Both of those cases marked the beginning of recessions. It is something we are watching closely, but odds are against it for now. When the Fed is hiking, an economic slowdown is a positive since it pulls inflation down and takes pressure off the Fed.

Equity Catalyst #2: Initial Fed Hike

The Fed is expected to hike the Fed Funds target rate on 3/16/22. In the 5 prior initial hikes back to 1994, the S&P 500 was down every time, a month later, by an average of 3.6%. The worst decline within 3 months averaged 7.5%. Cases prior to 1994 are less comparable since moves were not telegraphed ahead of time to investors like they are today. This year there has been endless media discussion about the Fed, likely contributing to the first S&P 500 decline prior to an initial hike. The extreme investor positioning means the worst possible outcome is likely discounted, making it more likely the market will rally on the news rather than decline as it did historically. 6 months after initial hikes the average S&P 500 move was positive at +7% and +14% a year later. Future returns this year will largely depend on the direction of inflation. No prior cases had inflation over 4.0% vs. 7.9% this year as of February.

Inflation Direction Key for Equities: Watch Crude Oil

Inflation is a critical factor in determining the expected return for equities, since the worst combination is high and rising inflation while the Fed hikes rates. With this combination historically, the market generally declines because it discounts the fact the Fed has no real option to pause or reverse course. That is the bear case for equities and the reason we took the U.S. equity rating down to a 2 last month. However, the S&P 500 returned 14% annualized, better than the norm when the Fed was hiking while inflation was falling, even if it was high similar to today. Although our inflation outlook indicators remain elevated at 77, this month we have two offsets. First is the 20% decline in crude from the recent peak, which may continue lower if it follows the 1990 case. Energy is less important for inflation today than it was 30 years ago, but it remains a significant coincident indicator of CPI. The second point is high comps started a year ago in March, making it more likely the CPI Y/Y rate decreases as we go forward. For instance, even if monthly changes average 0.6% the rest of the year, CPI will end the year lower at 7.5%. If monthly changes average 0.3%, CPI will end the year at just 4.0% which would be a boost for equities.

Summary

This month we discussed the perfect storm that hit markets this year and specifically the implications of the war in Europe, crude oil spikes, and initial Fed hikes. Although there are significant negatives to contend with, markets are forward looking, so the extreme investor positioning may indicate the worst is already priced in, making an upside surprise more likely going
forward. The sharp crude oil reversal combined with the much anticipated initial Fed hike are likely catalysts for a reversion to the upside in equity prices. At times like this, we are testing the fast changing conditions for implications on an hourly basis. Thank you for your support and please contact us with any questions.

 

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