Q1 2023 Market Update: Rough Seas Ahead

The federal government seems to have stemmed the recent banking crisis for now. Its aggressive intervention to back customer deposits has had the intended calming effect. The Federal Reserve, however, was partly responsible for the collapse of Silicon Valley Bank, the catalyst of the crisis. But the Fed’s apparent negligence in overseeing the bank is only part of the problem.

Blunders by the Fed

The Fed has long had a policy of “easy money.” By keeping its key interest rate near 0% for years, the Fed drove income-seeking investors into the stock market and high-yield (“junk”) bonds in search of higher returns.

Then came COVID. The resulting shutdown caused collapsing consumer spending, temporary product shortages, economic stagnation, and deflation. The Fed and Congress responded by flooding the system with money, with the Fed’s added view that inflation was too low! The record size of the stimulus resulted in huge overspending by consumers, widespread investor overconfidence, and rampant speculation in stocks and cryptocurrencies—one of the biggest market bubbles of the last 50 years.

Inflation surged due to the consumer spending binge and the shortage of goods. Then the Fed overreacted again, this time with the most aggressive tightening of monetary policy in 40 years (by hiking the key overnight interest rate repeatedly and shrinking the amount of money in the banking system). Though each cycle is different, aggressive monetary policy tightening has always led to a disruptive financial event.

Is it 2008 Again?

With the recent banking troubles, we must consider whether there will be other surprises. At this point, the banking system seems to be healthier than it was in 2008, the height of the Global Financial Crisis—for the largest banks, at least. Smaller and regional banks hold a large share of commercial real estate loans, which we think are an area of potentially large losses. (Clean Yield has had minimal holdings of bank stocks since last autumn because of deteriorating industry prospects.)

The Economic Outlook

Overall economic conditions are weak, despite the dubious positive headlines about large monthly job additions and the low unemployment rate. On a net basis, there have been no full-time jobs added since last May; all have been part-time and have been centered on low-wage sectors. As for corporate profits, they have been falling for months, and we expect larger declines.

The U.S. economy runs on credit. In addition to raising interest rates to curb spending demand, the Fed has sharply curtailed the amount of money in the banking system by shrinking its balance sheet (allowing the U.S. Treasury bonds it holds to mature). Banks have been more cautious to lend since last autumn, leading to a credit crunch, especially for small businesses. In a recent survey of small-business owners, only 25% said their credit needs were being met. Even worse, bankruptcy filings for small and mid-size businesses have surpassed the COVID-era peak set in June 2020.

Where Is the Economy Headed?

We think that the focus of the Fed and of pundits on concurrent or lagging indicators, such as trailing inflation, are misplaced. We think that inflation, for example, is yesterday’s news. Inflation peaked last June at 9%. It lately has been about 6%, and we think it is headed toward 3% by autumn. We expect it to be much lower next year, perhaps close to 1%. At prior cycle peaks (2000 and 2008 most recently) high inflation that was followed by tight monetary policy resulted in recessions and much lower inflation.

Instead of using the rearview economic mirror, it’s more important to look at leading economic indicators. The Conference Board’s Leading Economic Indicators, for example, have fallen for 11 straight months. It’s not just the U.S. that has poor prospects. The International Monetary Fund expects five-year global economic growth (GDP) to be the weakest in at least three decades.

Investment Strategy

A sharp decline in profits, combined with a reassessment of the appropriate valuation of those profits, will probably result in a large drop in the major stock market indexes.

Despite being 16 months into a bear market, on one reliable indicator (the Shiller price/earnings multiple), the S&P 500 is more expensive than it has been over 90% of the time over the past 140 years. And relative to bonds, stocks are more expensive than at any time since October 2007, which was the cycle peak for the stock market.

Not surprisingly, we expect more trouble ahead for stocks, continued declines in interest rates, and increases in bond prices.

When adjusted for risk, bonds are MUCH more appealing than stocks. Unlike stocks, shorter-term government bonds offer relative price stability and a near-guaranteed return of principal on maturity. In every recession, inflation recedes, interest rates fall, and bond prices rise.

And yet we do find pockets of opportunity in the stock market. Many stocks have already fallen sharply and have reached historically inexpensive levels. Some of those have high dividend yields (4-8%), which we favor, especially when bond yields are falling.

We have set disciplined buy price points for the stocks we follow, and when the price is right, we buy. In the meantime, selectivity, discipline, and patience are crucial now more than ever.