Major equity indexes rallied throughout October after etching lows for the year at the close of September. The divergence in index performance was significant, with the Dow (1) leading the charge throughout October, posting a 14% gain, and the NASDAQ (2), in comparison, posted a relatively paltry 3.9% gain. The S&P 500 (3) fell into the middle ground at an eight percent gain for October. The NASDAQ’s lagging performance has been the case all of 2022, which reflects the continued pressure upon big technology companies. Having enjoyed high valuations for years, big tech stocks have had their out-year earnings devalued by higher interest rates and their growth prospects brought into question by slower economic growth. Conversely, stocks with high current cash flow, growing dividends, and low valuations have done better. With sticky inflation and an outlook for interest rates holding higher levels, this rotation will likely continue.
The market is looking for two things to sustain the October rally, A less hawkish Federal Reverse and improved inflation readings.
As widely expected on November 2, the Fed followed through on a 75 basis point increase. In the press meeting that followed, Chair Powell characterized the Fed’s standpoint of continuing to raise rates with the potential of slowing future rate increases. However, the Fed’s statement incorporated new language that acknowledged “the cumulative tightening of monetary policy, the lag effects on economic activity, inflation and financial development is what we’re looking for.” This language indicates that some Fed committee members have begun to break ranks from the “fight inflation regardless of the consequences” unified front Chairman Powell has led. If the Fed committee’s dissension grows in number or is amplified in Fed committee members’ public speeches, a pause and ultimate pivot in Fed policy will appear on the market’s forward-looking radar.
October inflation data came in near expectations, which the markets liked. In addition, there’s growing evidence that future readings will reveal the worst of inflation is likely behind us. Easy prior period comparisons or “easy comps” will be a major contributing factor for better forthcoming inflation readings. Easy comps occur when a decline in a value, such as inflation, immediately follows a substantially higher period. The initial six-week comparison is significant because it is being compared to the peak. However, as the value continues to decline, the next comparison isn’t as considerable. The remaining inflation in excess of the Fed’s target rate proves more stubborn. It is no longer an “easy comp”. So, we can expect the initial decline in inflation to be significant with subsequent six-week comparisons to be more incremental.
Below is a chart from Ironsides Macroeconomics that breaks down and graphs the significant components of inflation’s actual reading and Ironside’s projections into 2023. The projections are just that, estimates by an experienced economist the makes a living making projections. Note the significant decline in core goods inflation up to the present, the expected peaking of housing and services inflation followed by declines beyond the dotted line. Combining “All Items”, the overall trend for projected inflation is to come down from 8% to 4% by June of 2023. If this becomes the trend, it should take pressure off the Federal Reserve and support a sustained investment markets rally.
These projections seem reasonable to me, given what I observe and experience. Supply chains have recovered, and consumers have refocused their spending from home improvements and Amazon goods to the experiences and services they went without during the pandemic. Housing had a huge inflationary run fueled by low-interest rates driving consumers and investors to bid up the cost of housing at a torrid pace, but that has reversed. September home sales were down 30% year-over-year and down 10% for the month, which is evidence of how hard higher mortgage rates have hit the housing sector. This week the Wall Street Journal published a short article about how higher mortgage rates have impacted home affordability. Deutsche Bank analysts defined affordable as a $2,500 monthly payment after a 20% down payment and financing the remainder with a fixed-rate 30-year mortgage. A year ago, that combination of a down payment and monthly payments would buy a $700,000 home. At today’s 7% plus 30-year mortgage rates, it will buy about a $450,000 home. It’s a problem for home buyers and the housing market. It is easy to understand that housing inflation readings will come down once the lagging data comes through.
However, there have been some recent mixed messages about the economy’s strength which belie the effectiveness of Federal Reserve policy in slowing the economy. U.S. gross domestic product (GDP) grew for the first time this year in the third quarter, expanding at a higher-than-expected 2.6% annually. Job openings came in at 10.7, hotter than the 9.8 expected. In addition, consumer inflation expectations for one year out, as measured by the University of Michigan consumer sentiment survey, show that consumer expectations for inflation declined. An economy that continues to grow with a solid labor market combined with cooling inflation could be a conducive environment for stock price recovery.
Is the bottom in? Maybe, but for the long-term investor, it is a moot point, as reacting to drawdowns by going to the sidelines is almost always a detrimental mistake. If you have investable cash, now is the time to invest while valuations are lower. Continue contributions to your retirement plan and consider increasing your contribution rate.
Don’t assume a short-term drawdown of your financial accounts will knock your retirement plan off track. Instead, let’s review your financial plan and portfolio. It is the best way to assess the impact of market changes upon achieving your goals and provides a framework to consider corrective actions if warranted.