Why the Markets have not Bottomed

 

All experienced investors can recite a number of valid market "rules":

1. The market will rally when there is "blood in the streets" and all optimism is wrung out.  (courtesy Warren Buffett). 

2. The market discounts the future; when the market has discounted the recession (priced the impact into stock prices), the market will rally.

3. The market will rally when investors least expect it.  (Bearish sentiment is a contrary indicator)

[Feel free to add your own to my list]

As i write this on May 26, 2022, for YTD, the NASDAQ  Composite is down 28.9% and SPX is down -16.3% (Bloomberg), many analysts are tempted to say that the markets are close to the bottom.  

The problem facing investors is that there is too much uncertainty to make any useful prediction of future market dynamics.  

Inflation is the major financial/economic issue facing both the financial markets and the Federal Reserve.  At this point, we know one thing for certain.  The Fed is focused on crushing inflation and bringing it back to within range of its 2% target.  To do that, the Fed MUST slow US economic growth.  At the neutral rate, somewhere around 2.5%, by definition, rates will NOT slow economic growth.  The Fed will have to raise interest rates above the neutral point, to some higher rate AND convince the market that rates will move even higher until inflationary expectations are wrung out of the consumer's psyche.  The "market" consensus, that 3% would be an appropriate end point is much too optimistic.  It is easily possible that the Fed will have to raise rates well past 3%, possibly to 5% to both reduce demand and really change inflationary perceptions. 

As Chairman Powell has repeatedly pointed out, the Fed can only deal with the demand side of the inflation equation.  Demand will not slow until there is a slowdown in the general US economy, including job growth (and the resulting wage growth).  Of course, the Fed has a dual mandate, but job growth is much too hot, and as a result wage growth is too hot.  The Fed aspires to bring down the job vacancy ratio from 2:1 to a more normal 1:1 and asserts that by doing so, it will temper inflationary pressures.  This would be the "soft landing" that would temper inflationary pressures without increasing unemployment.  Regrettably, that is not consistent with human behavior.  Wage pressures will not abate until there is some fear of losing a job and possible unemployment (i.e., some equilibrium is restored between labor and capital).  In today's environment, employees can demand higher wages, without any penalty for pushing too hard.  Another job is around the corner, AND savings accounts are high so some time off does not seem so bad.  The hallmark of the US labor market is that employees are able to transition between jobs relatively easily (very different from he Euro markets), but this feature has gotten out of balance in the current environment. 

Interest rates are not the only story; external inflationary pressures also have to be considered, although these are more supply side driven.  The war in Ukraine will  have its own inflationary pressures due to the impact on Ukraine (food prices) and the sanctions on Russia (gas and Nat Gas prices).  These are long term impacts.  Over the course of time, the markets and the global economy will adjust to these factors, but the point of equilibrium is likely to be well beyond 2022. We must also add the impact of other inflationary forces to this tasty stew.  Supply chain disruptions are clearly resulting in inflationary pressures due to the fitful and incomplete restart of the global economy after the pandemic.  As of today, China is clearly not in restart mode, and clearing the bottleneck will take some even after it reaches full restart.  It seems fanciful to think that this aspect of "return to normal" will occur in 2022. 

Some other factors for investors to consider independent of the above analysis.  (1) the impact of the War in the Ukraine, (2) the impact of the shift to QT from QE, and (3) the impact of the end of TINA. I could write a separate column on each of these factors.  For the moment, I will only point out that all of these will tend to lead to higher interest rates across the yield curve, and lower stock prices. 

If my analysis is correct, what are the implications? 

The market has exhibited an inability to discount the impact of inflation (rising input costs; rising inventory costs) combined with the initial indications of a slowdown in spending, at least is some sectors.  Good example (of many) is the reaction to Target's earnings release.  This a premier company with excellent management and a long track record of success.  Nevertheless, Target was unable to simply pass through higher labor and inventory costs.  It also implies that consumer demand was not sufficient to allow the firm to raise prices.  The result was that its stock price declined nearly 25% in one day. 

My conclusion from this analysis, despite being a true believer in market's efficiency, is that there is simply too much uncertainty for the moment to reach any conclusions about the future course of market movements.  We will not be able to rationally forecast a market bottom until the market has a much better idea of (1) the end point in the interest rate cycle; (2) the long term impact of QT; (3) the depth of the economic slowdown necessary to tame inflation, and finally and most importantly, the impact of this end state on individual companies and the demand for their products and services.