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The Bear Pinned the Bull: Analyzing 2022, Rising Rates and Possible Recession

| June 17, 2022
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As of June 13th, the US stock markets have entered bear market territory and the FED lifted rates by 75 basis points. It’s not easy to watch account balances and markets going down, especially over such a prolonged period. It’s like a slow torture. On average, the markets have gone back to around the levels we saw during November of 2020, and all gains since the end of 2020 have been wiped out. Market volatility became heightened, and the downward trend moved along in 2022, after the previous year’s numbers performed very well. However, during the performance of the markets in 2021, several factors changed that would affect the markets, altogether.

The first was rapid and out-of-control inflation, which I’m sure most of us can’t ignore, since the costs of basic goods, such as gas and groceries, are skyrocketing. According to the US Energy Administration, the last time gas prices were at all-time highs were throughout 2008 to 2016. Groceries have also gone up, such as milk. The last time milk saw an all-time high average of $3.80 was in 2008. Today’s average price of whole milk is hovering around $5.00 per gallon…nearly the same as gasoline. 

It seems that U.S. Economic policy is not being adjudicated around the needs of middle-income and lower-income families, nor around supporting a growth and earnings economy. We are being forced into a recession that could possibly be avoided, or at least made less traumatic if it were a natural economic cycle, and forces outside of natural cyclical movements weren’t a factor; unfortunately, the economic cycle of expansion, peak, contraction, trough is now being made more volatile, prominently on the contraction, by actions that are not necessary, and can be remedied. The only question is, “Will they be fixed?”

WHAT CAN WE EXPECT?

First, nothing is certain because the economy and markets continue to adjust and change in regard to the factors that affect them. We can expect that this is temporary, but we can’t predict the amount of time of this temporary volatility. “This, too, shall pass,” we just don’t know when. But we have an idea. Looking forward, we must analyze what we know, and adjust to set up a more beneficial outlook for the long term. We can do this by understanding the fundamentals driving the markets and economy in the short term.

Probably the most significant factor next to inflation, that is driving the hurt is energy costs. Current energy policy is to reduce fossil fuels and make them scarce to drive consumers to other forms of energy. We do not see a change in policy coming, since it seems to be the current policy agenda. Unfortunately, this has consequences of reducing supply of energy. Basic macroeconomics teaches that the reduction of supply increases demand, and when demand increases, so does price. We don’t foresee reduction in prices for consumers. Energy is required for everything we consume, from food to clothing, from metals to plastics. We do not see prices going down. They will most likely hit a plateau, but no one can predict when that will occur.

When it comes to energy costs and costs of goods, we can expect that they will continue to rise, if the production costs continue to increase with the price of energy. The markets are being jolted with fear of recession and decreased earnings, which results from these higher prices and less consumption.

The other significant factor is record-high inflation. The FED waited far too long to bring interest rates back to normal, and the extreme government spending, requiring a debt ceiling increase of $2.5 trillion in December, poured gas onto the fire. The amount of money spent is paid for by FED purchases of U.S. debt (A.K.A. the government’s credit card). In order to purchase the debt, the FED prints money. The artificially low interest rates created by the FED during COVID, in an attempt to save the economy which was getting killed with shutdowns by state governments, thrust billions and billions of printed dollars into the economy. That with the trillions of other spending in 2021, forced the FED into a printing frenzy. The more dollars, the less they are valued. That is inflation, and it’s record setting.

This also creates higher prices, which leads to less consumption, and less earnings and growth. Same endgame, but another factor, still resulting in fear in the markets, and lower valuations for stocks. So, here we are.

As most investors see, everything is down, from equities to bonds. Even if you sit in cash, real inflation is eating away at the value of your cash at 8% in May.  We wish we could see the future, but all we can do is study the past. Don’t forget, we’ve been through this before. The dot-com crash in the 90’s, the financial crisis of 2007 to 2009, when the indexes lost 50%, 2011, 2015, and briefly in 2020. All those who stayed invested recovered within months, or in the cases of the dot-com and financial crisis, recovered over a longer period, but still recovered if they stayed invested. Those who stayed invested in dividend paying funds potentially ended up better off when markets returned.

Think about this, if the price of gas, milk, cars, and goods is increasing because the value of the dollar is less, it really makes no sense that stocks would be worth less, particularly those stocks providing those items. It doesn’t make any sense. Which is why it’s important to remain calm during these periods. The valuations of the markets are unknown right now. Emotional buying and selling is occurring.

There is good news, and there is a plan of action.

The good news is that we are seeing action taken on this by the Federal Reserve, even though it can be argued that they waited far too long. For this, we are seeing and may see drastic interest rate increases throughout the end of the year. This can help quelch inflation, but also could continue market volatility and economic issues, such as recession. Consumer costs will level out, as long as there are no more restrictive energy policies or regulations created, furthering the energy crisis, but if they remain high and wages remain the same, consumer spending will fall pushing us into recession sooner than later. 

Employment rates are still stable. Americans continue to stay employed with higher prices and energy costs. It seems unemployment also continues to fall as more Americans return to work after the Covid pandemic. (See Footnote 5 addressed later for more details)

According to Rob Lovelace of Capital Group/ American Funds, we will see growth for 2022 although it will be shrinking.  This seems to be agreed upon across many investment firms’ outlooks. JP Morgan’s outlook says about the same. They believe we will see 3% or less growth for the current year and possibly less in 2023. They do not see negative growth, but we can’t rule out anything as we see a soft stance taken on corporations remaining in the U.S. and consumer spending dropping. If you would like to see more details, see the footnotes linked, and I think you will see why we are seeing that this is not an End-of-World scenario.

Since most believe we will see small growth (not negative) by the end of the year at 3%, this contradicts the markets’ downturns since the beginning of the year. According to the Wall Street Journal, year-to-date as of 06/13/2022, we’ve seen the Dow Industrials average down 15-16%. The S&P 500 down approximately 21%, and the Nasdaq down 31%. If this is the case, and if we see positive returns and growth by the end of the year, it possibly means that many sectors and valuations have priced in inflation and recession into the valuation on the markets. *This does not mean that the market will go up or down. It simply means that the valuation of the companies could be nearer to the actual valuation during a recession even though they are not predicting one until 2023. It also means that the valuations of the markets could have already priced in the effects of inflation. We believe certain sectors more than others are already primed to take on a recession and inflation, and we are managing portfolios to that.

Another thing to ponder: If we could see positive growth by the end of the year, even if it’s under 3%, the markets have priced in doom and gloom, since they are around 20% decline, Nasdaq around 30%. It’s unlikely to ever see deflation at that level, so the market dive does not seem to be anything but a reaction to the possible coming of a recession. Don’t forget, even in recessions, markets can make money.

There are opportunities, and across the board, the asset managers seem to be looking toward value stocks as purchasing opportunities. Value stocks are companies trading at a value lower than the actual value of the company. (Does this mean that many of the stocks out there are being undervalued in the price of the stock?) We’ve been managing portfolios this year since the end of 2021, of course always in regard to each individuals’ risk assessment, towards value, as well as income producing equity funds. As growth slows, we are looking for dividends, dividends, dividends. As the dividends pay out, and are reinvested, investors will be buying more shares at discounted prices, setting up for better gains in those investments once the markets return to their former levels.

We are also looking at sectors that have already priced-in a recession and the inflation rate, and are probably near their resistance levels, or lowest pricing, or sectors that are undervalued.

It’s also important to keep in mind that the markets are temporarily affected by policy, but Wall Street always looks for opportunities to make money, and there will always be opportunities out there.

At the end of the year, we will also potentially see more stable opportunities for bond income, and income from certain sectors that prosper off higher interest rates.

As time goes on, we will continue managing the portfolios for the future for everyone. We continue to be in contact with our fund companies and their economic and investment specialists. 

Have positive expectations. Remember, this is a blip in time for your portfolio. Remember that the markets go up and down over time. Dividend payers will pay dividends even in times of recession. The markets are historically the best way to keep up future purchasing power in retirement because over time they keep up with inflation. Strategy wins, emotion loses. We are utilizing the time old strategy of remaining calm, and always remember that the future is about reinvestment of dividends. Dividends buy more shares; more shares pay dividends. When the tides rise again, you’ll be better off.

We have and continue to adjust your portfolios to keep up with the tides and turns of the economy and all the changes that affect your investments, and we are always looking ahead to make sure you are ready for the upswings as well as the downswings.

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