Thursday, June 9, 2022

You cannot be hurt falling out of the basement.

From the Desk of Joe Rollins

By now we are all tired of seeing the massive swings in the stock market, both up and down. It seems like for every good day, a bad day follows. It is very discouraging to watch the value of your portfolio go up and down without any logical reason. I thought I would give you some insight to why the market moves, defying even the most basic economic logic. Quite frankly though, this is the way bottoms are established in markets and it looks like we are progressing in reaching that defining moment in this volatile market.

I also would like to give you a basic history lesson on interest rates and why the current Federal Reserve is doing exactly the right thing to slow the economy. There is no question that the economy is slower than it was before, but there is virtually no chance of a recession in the year 2022. I will give you my reasoning for all these projections and an explanation to the logic behind my feeling.

The month of May was a relatively flat month on the equity markets as compared to the first four months preceding. For the month of May 2022, the Standard & Poor’s 500 Index was actually up 0.2%. However, this index continues to be down 12.8% for the year 2022 and down 0.3% for the one-year period. The NASDAQ Composite was down 2% in May and is down 22.6% for the year 2022. The one-year loss on the NASDAQ Composite is 11.6%. The Dow Jones Industrial Average was up 0.3% in the month of May and down 8.4% for the year 2022 and for the one-year period is down 2.7%.

Just to illustrate that there has been very little advantage in investing in bonds for this year, the Bloomberg Barclays Aggregate Bond Index was actually up 0.6% for the month of May but is down 8.8% for the year 2022. The one-year loss on this index is 8.2% and as you can see, the loss in the bond index was greater than the one-year loss in the S&P 500 or the Dow Jones Industrial Average. This illustration indicates that in this unusual time, bond investing has not been a haven and losses continue to accrue in that index.

One thing that has always amazed me about investors is that they do not recognize or move when stocks are at their cheapest level. If Walmart were to run an unusual sale and have historically low prices on their products, people would stand in line to buy them. However, the exact opposite happens on Wall Street, when stocks are at their most desirable level most investors run for the hills rather than further invest. As illustrated in the title of this posting, it looks like we are at bargain basement prices, and it is unlikely that you could get hurt making an additional investment at this level.

Another thing that fascinates me is that so many workers do not even bother to maximize their 401(k) plans. I am not exactly sure who these workers think will support them during retirement. When times are rough in the stock market, rather than increasing their 401(k) contributions they decrease them. I ask almost every person who comes to my office why they do not maximize their 401(k) contributions. In many cases, I am told by the client that they do in fact maximize their contributions, but a quick review of their records clearly indicates that not to be the case. It is very rare indeed that I find someone who actually contributes the maximum.

One of the most common reasons those 50 and over are mistaken about this is they do not elect “catch-up.” Due to being over the age of 50, you can contribute an extra $6,500 to your 401(k) plan. So, for 2022 they can contribute $27,000 to their 401(k) plan. A Senate bill, which almost assuredly will pass, will allow an individual over the age of 60 in 2024 to contribute a $10,000 catch-up to their 401(k) plan. There could not be a better time to invest in your 401(k) account while the stock market is low and investments at this point will benefit you for the remainder of your lifetime. In 30 years, who will care about the next six months?

Reflecting on the beginning of this year, you can see the stunning turnaround that the markets have had. On January 4, 2022, the S&P 500 set a record high. Here we are now five months later, and this same index has moved into bear market territory over such a relatively short period of time. It is surprising to see the market move down with such vengeance given the strong economic data we see all around us. Yet, the S&P 500 has moved from a record high in January to a low of -20% and now -12.8% through the end of May.

My last posting ruffled some feathers when I criticized the well-meaning forecasters that projected that we would definitely be in a recession in 2022. Many of those so-called experts theorized that we are already in a recession, and we just do not know it yet. And while I call out many of those forecasters for being ill-informed for believing this, maybe I was too harsh on them.

Just to set the record straight, there will always be a recession coming. There will also always be a hurricane, earthquake or drought on the West Coast coming – and who knows, maybe even a Little League World Series win for the Pirates. The technicality in the explanation is the timeframe. Who would argue that at some point in the future there will be a recession? But it is certainly not supported by the facts today. I think far too often these forecasters exclaim these absolute truths just to get their name in the paper. Rarely do they support it with any type of economic analysis.

The technical definition of recession is that you must have two consecutive quarters of negative growth. While it is true the stated GDP rate in the first quarter of 2022 was -1.5%, to be in a recession that would require the second quarter of 2022 also be negative. As of this morning the Federal Reserve of Atlanta is forecasting the GDP for the second quarter of 2022 to be a positive 0.9% (not much, but still positive). Therefore, under its most technical terms, the only way we can have a recession in 2022 would be that the last two quarters of 2022 both be negative. Given the historically high GDP recognized by this country in the fourth quarter of any year, two consecutive negative GDP quarters coming up is most unlikely.

I want to share a little unknown fact that backs up my theory that recession is not even that close. It is a fact that over the last 50 years, there has never been a recession when the Federal Funds Rate was under 4%. You would have to exclude the two-month period in 2020, due to Covid-19, but any other year that would not be the case. So, if the Federal Funds Rate must be over 4% to create recession, where are we today? As we sit here today, the Federal Funds Rate is 0.75% with two anticipated increases of one-half point each in June and July. Therefore, if you take the numbers as projected by the Federal Reserve, they are forecasting rates at the end of 2022 at 1.9% and for 2023 at 2.8%. They are also not projecting any additional rate hikes in 2024. Assuming their projections are accurate, that would indicate that the Federal Funds Rate would not exceed 4% prior to the year 2024. Yes, a recession may be coming, but for all practical purposes it is many years away.

I just happen to catch an hour of uninterrupted viewing of the financial news this last week. As would be the case, they were interviewing so called experts in the field. You must realize that these experts in the field are not paid to be on these shows. In most cases they are pushing their own book of business and are making recommendations that would benefit their own portfolios. During this one-hour period, I noted that 13 times these so-called experts referred to the upcoming recession. Given much of the hour is cut up into commercials, it seems like they were mentioning an upcoming recession every three minutes or so. Not one person on this panel gave an explanation as to why they thought the recession was coming, but all of them were 100% backing the theory that it was inevitable that we would fall into recession and the markets would fall lower. I respectfully disagree.

It is interesting to note that the economic evidence clearly shows that the economy is slowing and that is a good thing. We had GDP growth of 5.7% in the fourth quarter of 2021, which would fall in the second quarter of 2022, if the Federal Reserve is correct, to 0.9%. We should all want this reduction in GDP growth. As we have seen throughout 2021, the substantial growth in the economy has far outstripped our ability to produce goods and services. We created inordinate supply chain problems which led to higher prices in many markets. We are already seeing that the increase in interest rates is slowing housing sales and correspondingly reducing the price of lumber to pre-Covid-19 levels. It is reported that in Atlanta house prices have gone up 20% for the one-year period that just ended. Many of my clients that own resort properties and beachfront houses report that the value of their units have doubled over the last year. Everyone reasonably attuned to any economic data should know that these increases in prices are not natural and cannot be duplicated in the future.

What the so-called experts are missing is the incredibly strong labor market which has yet to show any type of decline. As of the end of May there were 11,400,000 job openings in America and there are only 5,950,000 unemployed Americans. As you can tell, there continues to be two jobs for every unemployed person in America today. What is even more interesting is that based on the most recent labor report, the average hourly earnings by employees are up 5.5% over one-year earlier. This is a substantial move to increase employees pay which allows them to somewhat keep up with the rate of inflation. Just to remind you of how bad things were in March and April of 2020, the unemployment rate pre-Covid-19 shutdown was 3.9% in February of 2020. By the end of April 2020, the unemployment rate was 14.7% (two months later). Today, the unemployment rate is 3.6% even after reporting a strong job growth in May of 2022.

The biggest mistake made by Washington was the outrageous funding that they put into the economy fearing a long-term shutdown due to Covid-19. As it worked out, by the end of 2020, virtually all the those who filed for unemployment or where temporarily laid off were back to work. With the period from March 2020 through the end of 2020, most Americans could not travel, expend money, or enjoy the enormous benefits that they received from the government. As we rolled into 2021 and more and more of the employees were out spending their rebate money, sales and virtually all retail items exploded. Suddenly, we could not control the flow of inventory and the supply side issues were overwhelming. It was not a matter of too little supply; it was more a matter of too much demand. It is believed now that throughout the U.S. economy, U.S. citizens are holding $4.7 trillion worth of cash and savings. It is not likely that consumer spending will go down at all in 2022 with an inordinate amount of savings and one of the largest increases in employee wages in the history of American finance.

But the economy is definitely slowing and that is a very good thing. Most recent auto sales indicate that they were down 19% in the month of May. Do you remember only a few months ago where we could not supply the cars that people demanded because we could not produce them fast enough? A slowdown in sales will allow the supply chains to catch up. Would you believe that retail sales during the month of April were up 6.7% higher than they were in the previous year? But even more importantly, food services such as restaurants and bars shot up 19.8% during the month of April. These numbers do not indicate that the consumer has any intent to reduce their standard of living due to any projected slowdown in the economy. There is no sign of the consumers cutting back.

Many of us remember that during the height of Covid-19, Hawaii and Nevada suffered extraordinarily high unemployment rates. Hawaii had a rate of 22.4% and Nevada had a rate of 28.5% unemployed. While these two states have not fully recovered, they are clearly moving higher. The unemployment rate in Hawaii was reported to be 4.2% and Nevada reported 5% in April of 2022. Just think of the amount of people that continued to work from the beginning of the Covid-19 shutdowns to the restarting of the economy. Each of those working people continued to bring money and additional taxes into the economy. It is hard to fathom that under any stretch of the imagination you could turn that progress around in only the remaining six months of 2022 to recession.

There have been many people on Wall Street who criticize the Federal Reserve for moving too slowly on inflation. I never really considered Jim Cramer to be a stock picker, but more of an entertainer. His most recent exclamation is that the Federal Reserve should increase interest rates 1% at the next two meetings and strip the band-aid off the economy and get it over with.In my opinion, Jim Cramer could not be further from reality. To give you some perspective on this matter you must go back many years to see the effect the Federal Reserve can have with an uncontrolled chairman.

In 1987, then President Ronald Reagan appointed Dr. Alan Greenspan to be Chairman of the Federal Reserve. You may recall even prior to that he was Chairman of the Federal Reserve under President Jimmy Carter briefly during the high inflation rates created by oil prices in the 1970’s. Very few people remember that inflation was 15% or 16% in the late 1970’s mainly due to the price of oil. Many people forget that the price of oil was high because the Asian countries of Saudi Arabia would not sell oil to the United States due to the political backing the U.S. gave to Israel in the recent war. So, Jimmy Carter suffered through very high inflation rates not of his own making. And of course, as the government always does, they handled it incorrectly and made things worse.

In 1987, the first thing Dr. Greenspan did after his appointment was dramatically increase interest rates virtually his first week in office. Those of you who do not remember need to review the history of the stock market crash of 1987 when the Dow went from 2,200 to 1,700 in one day. The market suffered a 22% decline due to the interest rate shocks mandated by Dr. Greenspan. Not surprisingly, the day after the market crash, the Federal Reserve reversed those increases to more moderate levels, while not admitting their mistake.

If you look at a chart beginning in 1980 when Federal Reserve Chairman Volcker increased the Federal Funds Rate to 20%, the bond market has gone down from this 20% level and finally bottomed at 0% during 2020 for Covid-19. We have enjoyed a bond market rally for essentially 40 years as the long-term interest rate fell. As you well know when you get to 0% interest rates, there is nowhere else to go but up. Clearly, we are going up at the current time in gradual increments to see how we can slow the economy without it being destroyed. So far, it has been orderly.

I was often a critic of Dr. Alan Greenspan during his term being chairman of the Federal Reserve. There was a period during the Clinton administration that Dr. Greenspan thought that the interest rates needed to go up and slow the economy. During the period from 1994 through 1995, Dr. Greenspan increased interest rates 17 straight times in an attempt to slow the economy. What was interesting about this mass move in high interest rates is that Dr. Greenspan also believed the U.S. economy would not survive the Y2K problem in 1999. He flooded the economy with money and lower interest rates which created the “dotcom” boom in 1999. Once again recognizing that he was wrong in March of 2000, he restricted money supply overnight, increased interest rates, and threw the economy into severe recession. Many of you do not remember that in the year 2000, the NASDAQ Composite lost 80% of its value after these moves by Dr. Greenspan.

I recited all that history for you to just explain one fact. During all those years of Greenspan’s reign at the Federal Reserve, booms and busts were the normal way of life for him. Dr. Powell who is now in charge of the Federal Reserve is using a more conservative and, in my opinion, better method. Basically, he has said he is going to increase interest rates and see what happens as those rates are increased, which makes perfect sense to me. We can see that the moves by the Federal Reserve are clearly working. It was very interesting to read the financial results of Target and of Walmart in their most recent quarter. Both companies have admitted that they were carrying too much inventory during this sales cycle. But due to supply chain issues they were better to load up on inventory to have something to sell rather than to have empty shelves. Of course, both companies took the brunt of stock market selloffs as the so-called traders totally misunderstood this move. It always amazes me that regardless of what earnings are reported by major companies the stocks go down. But once again this is the reason why you are seeing such high volatility. Momentum traders and the big machines that trade most of the volume on Wall Street do not really care the direction of the market, whether up or down.

What they do is called seeking the correct price discovery. Can they force the market down until they get resistance, or can they force the market up until they get resistance? It doesn’t really make any difference to them whether it is up or down because they are only short-term traders seeking small profits in these huge moves. While all of us are concerned about building our portfolios higher, they are only considering trading for a few dollars notwithstanding direction. So therefore, when they go through price discovery, they push the market to extremes to find out where resistance lies. Almost always when companies report earnings, you will see immediate selling of that stock by the momentum traders even after hours when the markets have already closed.

This is best illustrated by what occurred on Friday of this past week. After an incredibly strong day on Thursday, the markets reported on Friday substantial gains in employment in the United States, which was positive news for the economy. The more people at work, the more taxes and the stronger the economy. However, closer to the opening of the market, the Chief Executive Officer of Tesla, Elon Musk, posted a Tweet saying that they would need to cut 10% of employment at Tesla. Notwithstanding the very strong employment numbers on Friday, the market tanked and went down well over 300 points. This gives you the exact reason why you should not be concerned about the short-term and volatility of the market.

First off, if you would have read the entire article, which clearly someone who trades immediately would not have done, you will find out what Elon Musk was actually saying. What he said was that by the end of the year, total employment would go up, but he needed to trim his salaried employees and increase his production employees, basically a net zero for his company. But also, the reason why the traders punished the market on this day was that if the economy was so good, the presumption would be that the Federal Reserve would have to increase interest rates substantially more than forecasted in order to slow the economy.

We are also seeing the rate of inflation actually declining. When you consider President Biden’s Administration’s war on fossil fuels and the effect it has had on the economy, you would expect at some point inflation would start to decline. As you remember when President Biden took office, the price of gasoline was $2.42 a gallon. One year later, the gas has moved up to $4.54 per gallon, basically doubling. In many states like California, gas is already selling for $6 a gallon. This increase in price will not be sustained because as with all commodities when the price gets high enough more suppliers will come out of the woodwork to furnish products. In fact, the Federal Reserve’s favorite inflation gauge has actually fallen in April to 4.9% as compared to 5.2% the year earlier. While the proclaimed rate of 8% inflation has scared everyone, it is unlikely that the rate of increase can continue. If Washington would allow drilling in the U.S., the price would drop tomorrow.

In summary, the economy is still quite good contrary to what you read in the paper. Also, we are seeing stock prices at levels only seen at the height of the Covid-19 shutdown. We are seeing major tech companies selling at less than 15 times earnings even though they grow at a higher level. Basically, this is a fabulous entry point for people to maybe get stocks at a price that would be a lifetime low. As the title of this posting relates, if you get in on the ground floor there is hardly any likelihood you could hurt yourself by falling out of the basement.

As always, the foregoing includes my opinions, assumptions, and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins

All investments carry a risk of loss, including the possible loss of principal. There is no assurance that any investment will be profitable.

This commentary contains forward-looking statements, which are provided to allow clients and potential clients the opportunity to understand our beliefs and opinions in respect of the future. These statements are not guarantees and undue reliance should not be placed on them. Forward-looking statements necessarily involve known and unknown risks and uncertainties, which may cause actual results in future periods to differ materially from our expectations. There can be no assurance that forward-looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements.

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