Investors have done well to heed Marty Zweig’s advice “Don’t fight the Fed” since he published his 1970 book, Winning on Wall Street. The idea has generally stood the test of time. The most recent two major recessions and market declines, those in 2000-2002 and again in 2007-2008, were preceded by Federal Reserve (Fed) policy tightening. So too were the recessions and bear markets of 1973-1974, 1980-1982, and 1991-1992. The 1987 market crash was, likewise, preceded by rising rates.

In each case, efforts by the Fed to rein in inflation via tighter monetary policy proved effective in fighting inflation, but at the cost of a weakened economy. We could well be seeing the same process underway today.

Last week, Fed Chair Jerome Powell pressed his case for more interest rate hikes to calm inflation. The committee raised the policy rate 0.75% to 3.25%, and Powell affirmed his intention to “keep at it” until inflation is tamed. Markets expect another 0.75% increase at the November 2 meeting to 4%. If this plays out as expected, policy rates will have increased more over a 9-month period (3.75%) than at any time since 1980.

Starting this month, the pace of runoff from maturing bonds will double to $95 billion from $47.5 billion per month. Beyond this, the Federal Reserve intends to shrink its $8.8 trillion balance sheet. The process by which $4.5 trillion of assets were added to the Fed’s balance sheet to add credit and bolster liquidity is set to reverse. The combination of higher rates and potentially less liquidity poses risks to markets and the economy.

The year-to-date 25% drop in long-term U.S. Treasury bond prices and 30% drop in the NASDAQ index are examples of how this process plays out. While painful, we note that resetting valuations is helpful when looking forward.

Even though valuations are better now, we should remain cautious because trends are poor. History also proves it can be painful to “fight the Fed.”

Valuations Better

As we discussed last December in a piece titled “Five Reasons for Caution,” high valuations ranked at the top of our list of worries. However, those valuations are much better today, as the S&P 500 now trades at a more reasonable 16x earnings versus 22x at the end of last year.

Another metric to look at is the total value of U.S. stocks relative to the economy. On December 31, 2021, the aggregate value of U.S. stocks was $54 trillion versus a $22 trillion size of the economy (GDP). Thus, the ratio of stocks to GDP was 2.5 to 1. That ratio has fallen to 1.6 to 1 because stock values are now $42 trillion, and the economy is estimated to be $24.9 trillion.

As for bonds, U.S. Treasury prices are down as much as 30% for longer maturity issues. The jolt of higher rates through the spring and summer now means that investors can earn higher returns all along the curve. Consequently, the decline in bond prices means that forward-looking returns for bonds are far better today than last year.

Data Still Weak

Even though starting valuations for both stocks and bonds are now better, we should still maintain a cautious and quality focus because data trends are poor.

Indicators flashing warning signs include:

1) Market earnings forecasts are no longer growing. According to Bloomberg, 12-month forward expected S&P 500 earnings have been flat since summer’s start. Previously, expectations had been on a steady rise.

S&P 500 Earnings Forecasts Flatten Out

2) The yield curve, or difference between short and long-term Treasury bonds, is now inverted. The 10-year U.S. Treasury bond yield stands at 3.7%, while the 2-year U.S. Treasury note is 4.1%, making for a 0.5% inversion. Such inversions often precede recessions.

Yield Curve Rises and Inverts

3) The Conference Board’s Index of Leading Indicators has fallen every month since March. This index has also provided timely indications before past recessions.

Leading Economic Indicators Fade

4) Sales of big-ticket items like cars and homes are also down. According to the National Association of Realtors, existing home sales are off about 20% from a year ago. Meanwhile, automobile sales are stuck near 13 million annual units sold, well below the 17 million pace pre-pandemic.

Big Ticket Items (Homes and Autos)

5) Outside the United States, a strong dollar is pressuring currencies, with major currencies down 10-20%. The strong dollar is helping to mask inflation pressures here (we estimate inflation would be up over 10% if the dollar was flat this year) but creates risk elsewhere. Currency volatility, elevated debt levels in emerging markets, and higher inflation are all troublesome to the global outlook.

Foreign Currencies Drop vs. Dollar

6) Our WCA Barometer continues to exhibit weakness. The composite picture from this is that the near-term outlook shows weakening growth. While this may eventually lead to a reversal in Fed policy, it has not done so yet.

Conclusion

While valuations for stocks and bonds are better now, we may not yet be out of the woods and should maintain a quality focus for two main reasons. First, data trends are still poor. But most importantly, history shows that it seldom pays to “Fight the Fed.” So, as Chair Powell looks to take away the “punchbowl” to fight inflation, we should be patient and stick to our knitting.

And suppose the Fed should suddenly decide to do an about-face on tightening? In that case, we see no reason why higher quality stocks would not also participate in a recovering environment. So why would we not seek out the most predictable, profitable, and resilient companies we can as we ride out the storm?

We intend to do just this as policymakers look to handle today’s inflation problem.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Senior Risk Manager
973-549-4028

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
415-364-2635

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income
415-364-2917

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
Director, External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
External Sales and Marketing
973-549-4031

Disclosures

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.