A Return of the Bull: Blog II

Updated: Apr 20

Outlook 2022

Stock traders’ market


By: Jonathan V. Bever





At the beginning of each year, investors ask what we expect the market to look like in the coming 12 months. We believe this year will be positive for equity investors, and for those who can withstand the volatility. A bull or bear market might present itself in 2023 depending on how flat the yield curve gets this year. This blog is our thinking behind this thesis.

(This blog was mostly written before the Russian/Ukraine unrest. The people of Ukraine are the most important issue right now, and our mind is on them as we are sure they are on yours as well.)


Summary: We Expect 2022 To Be Positive for Equity Investors


We are not saying the bull market is over. We believe this year will be positive for equity investors, and for those who can withstand the volatility. A bull or bear market might present itself in 2023 depending on how flat the yield curve gets this year. While the Federal Reserve will be less aggressive at fighting inflation (raising rates) due to the Ukraine conflict, they will still have to address inflation eventually. Nonetheless, the market is still expecting a rate hike this month. When and if the Fed gets aggressive at raising rates, then the markets will have to adjust according to their aggressiveness. We expect a total return in line with its historic average of high single digits for 2022. We want to reiterate the return will come with more volatility, so risk management, sector selection, and stock selection will be important for smooth sailing through the market. The obvious additional caveat to our outlook is: if the conflict remains in Ukraine.


Explanation: The Big Ideas Driving Today’s Reality


There are many currents happening at one time in relation to inflation, economies, and geopolitically- it's hard to ignore the obvious. We will try to break down the most important variables as they relate to investing. We will reintroduce the Return of Volatility series we began in 2018, as some of the variables we experienced then have returned at least as rhetoric: Quantitative Tapering (a reduction of the Fed balance sheet), and a rising Fed target rate.


2022 Equity Markets at The End of The First Quarter


So far the market is having a volatile year. Growth stocks have been declining with the enthusiasm of 2018 in anticipation of the same investment environment to come. However, a big difference between 2018 and the market today is that the Fed had already done a series of rate hikes and Quantitative Tapering (a reduction of the Fed balance sheet). Now stocks are acting much like Pavlov's Dogs. Salivating to decline just at the sound of the Fed “bell” signaling rate hikes and QT like in 2018. In 2017 the Fed began its rate hikes and QT it took several months and well into 2018 before the effects were felt; the result was an earnings recession in the market. The S&P decline about 20 % while individual stocks declined 20-60 percent. This year the S&P has declined only about 13%, and growth stocks have declined 20 to 60%. Some sectors have been particularly strong such as the energy and financial sector.


Perplexing Signals in The Market


Today there are contradictions in the market from the market of 2018, for example, the energy sector has only begun to recover from the 2018 decline and is the best performing sector year to date. If we are to believe the decline in technology stocks, for example, is in anticipation of a hawkish Fed fighting inflationary pressures then why haven't energy stocks declined in anticipation as well? Are the fundamentals changed for the energy market? Is the Russia/Ukraine situation delaying the inevitable decline? Are they just untrained dogs? Is this a return to 2018, or a different period?


Revisiting China


To answer these questions let’s look at our last blog China 1. We referred to 2003-2006 inflation regarding the Baltic Dry index. In China blog 2(a work in progress) we are going to look at crude oil prices in that period as well as it related to the aggressiveness of the Fed razing rates. Crude oil peaked in 2008 at around $147 a barrel. In short, inflation can become crippling, and the Fed has no choice but to raise rates and put the brakes on the economy. The cycle of boom-bust continues. After enough rate hikes, the economy slows and commodities ultimately plunge. It is one big cycle that repeats, but never exactly the same.


Two Indicators That Lean-to The Positive


We expect a total return of high single digits, but an increase in volatility. So, given all this noise, why are we expecting a good year all in all? Why optimism:

  1. First, the earning per share (EPS) on the S&P is expected to increase by 15% giving the S&P a price-to-earnings ratio of 19.28, and with a 10-year Treasury yield, 2% or less is a reasonable ratio. We do not expect the 10-year yield to go much over 2% and would not be surprised to see it well below 2% this time next year.

  2. We think the market is missing one glaring difference between 2018 and 2022. The difference is about 4.6 trillion on the Fed balance sheet. Just how much is that? It is mind-boggling and hard to fathom the amount of stimulus. We will keep our argument as simple as possible. If the Fed does a maximum of 6 rate hikes totaling 1.5 percent and tapers their balance sheet is less than 2 trillion, then they will still have more stimulus than in 2018. In short, the Fed is still accommodating the growth of the economy. Any rate hike or QT, in our opinion, is the only thing we call “transitory.” Freud is credited with the concept of “projection” or what we see in others and what we see in ourselves. So, The Fed's use of the term ‘transitory’ is just maybe Freudian in that it applies to their policy.


Understanding Inflation Technically


Look at inflation as indicated by the Consumer Price Index (CPI) and Personal Consumption Expenditures Index (PCE).


“The Consumer Price Index (CPI) is an index that is often used to measure inflation by tracking the changes over time in the prices paid by consumers for a basket of goods and services.” Investopedia.


The term personal consumption expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time. Personal income, PCEs ...Investopedia

You can see from the chart below that they both have been increasing rapidly. If the Fed is trying to fight deflation, they have done a great job.


Why is Controlling Deflation A Priority?


Deflation is when the general price levels in a country are falling—as opposed to inflation when prices rise. Deflation can be caused by an increase in productivity, a decrease in overall demand, or a decrease in the volume of credit in the economy. -Investopedia.


Now, let us look at the Fed balance: it is just shy of 9 trillion. We call this “Magic Money.”



Does this look like a Hawkish Fed trying to fight inflation? No! Rather, it looks like a rocket of stimulus fighting deflation, which is exactly what it is. For argument's sake, what will happen to inflation if we take away 4 trillion from the Fed balance sheet or 8 trillion from their balance sheet? It is not hard to imagine that inflation would collapse, and we would probably be in a deep recession.


Why is it so important to keep deflation low? There are many reasons such as keeping the US Dollar as an attractive world reserve currency. In our view inflation is “contingent.” We think “contingent inflation” is a better term than “transitory inflation”. Transitory sounds like something that will take care of itself, while contingent is dependent on policies of other entities, such as the policy of the Fed. Therefore, inflation is contingent.


Fed Rate Hike Expectations


The following chart shows the futures market for the number of Fed rate hikes. You can see it was about two rate hikes, then after the Ukraine crisis has dropped to under one hike.




Bond Yields


Further, there is a lot of rhetoric suggesting the 10-year US treasury yield has made a historic bottom and we can expect years of increasing yields as it should be somewhere north of inflation. This chart shows years of a declining 10-year yield, and while it has not gone straight down the trend is down. We think we have not seen the bottom to the 10-year yield any more than we see an end in sight for the expansion of the Fed balance sheet. We will say more about the Fed balance sheet in China blog 2. We are boldly going to state that just like Japan’s central bank balance sheet ratio to their GDP being over 100%, we too will one day have a Fed balance sheet ratio over 100% of GDP. In Japan, their 10-year government bond yields +-0.25 percent; likewise, this is our long-term prediction for our 10-year yield. Gold enthusiasts will argue we should return to a gold standard and quit all the money printing. A gold standard seems to follow periods of massive global unrest. So, one should be careful what they wish for.

The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. Investopedia



To Summarize:

  • 2022 will be volatile given the uncertainty of the Fed policy to fight inflation and if they really can raise rates without severe economic consequences.

  • Yet, while inflation is high it is dubious how permanent it really is.

  • Regarding the S&P return, the return ultimately will be tied to the Price to Earnings ratio the market deems fair; this will be determined in part by the 10-year treasury yield. The higher the 10- year yield the lower the P/E, and conversely the lower the 10-yield the higher the P/E.

  • The only thing transitory is the Fed putting on brakes on the economy by QT and rate hikes.

  • When the day comes that the economy can stand on its own two feet, it won't need low rates and QE. (Artificial stimulus.)

  • In our view, the 10-year will be below 2 percent, and the S&P will have a total return in the high single digits.

This will conclude the “Return of the Bull” series and will mark the beginning of another “Return of Volatility” series. The purpose of the blog is to uncover what is hidden so that we can understand the things that affect the stock market.



 

DISCLOSURES:


SPX INDEX: S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices, and many consider it to be one of the best representations of the U.S. stock market.


Quantitative easing (QE) is a monetary policy whereby a central bank buys government bonds or other financial assets in order to inject money into the economy to expand economic activity. Wikipedia

The Fed Balance Sheet


In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Wikipedia


The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. Investopedia


“The Consumer Price Index (CPI) is an index that is often used to measure inflation by tracking the changes over time in the prices paid by consumers for a basket of goods and services.” Investopedia.


The term personal consumption expenditures (PCEs) refer to a measure of imputed household expenditures defined for a period of time. Personal income, PCEs ...Investopedia


The Fed balance sheet is a weekly report that lists the Federal Reserve's assets and liabilities. The report outlines what the Fed is doing to expand or contract its balance sheet as it implements its monetary policy.


The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.


The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. This material is being provided by Registered Representative James Falcone and written by Jon Bever, a non-affiliate of Cetera Advisor Networks LLC


James Falcone is a Financial Advisor offering securities and advisory services through Cetera Advisor Networks LLC, a member FINRA/SIPC, a broker/dealer, and a Registered Investment Adviser. Some advisory services are also offered through Fulcrum Wealth Advisor, LLC. Cetera is under separate ownership from any other named entity. 10940 NE 33RD PLACE, SUITE 210, BELLEVUE, WA 98004