Gaugers, it was another choppy week in the stock and bond markets with negative returns for all of the major indices.

Small caps, which can be most negatively affected by rising interest rates, had the worst performance of the major equity indexes, with a decline of 5% for the week.

Most of the other indices were down from 2.7% (Dow) to -3.7% (QQQ) for the week.  Bonds were also down on the week fueled by Thursday’s PPI (Producer Price Index) report that came in hotter than expected and led interest rates to rise in expectation of a more hawkish Fed.

Looking back at 2022

It certainly has been a difficult and choppy year in BOTH the stock and bond markets.  As we have shown repeatedly, this has been the worst year for a balanced portfolio approach with most balanced funds (60% equites and 40% fixed income) down in the mid-teens.  I noticed yesterday that Vanguard’s $43 billion dollar Balanced Mutual Fund is down over 19% year-to-date.  I feel bad for all the 401k investors that have just closed their eyes and kept their investments in this and other Balanced funds.

If you were a passive investor during 2022, the Dow was the best place to be invested and is down in single digits (as opposed to the S&P 500, the NASDAQ and Small Caps which are all down mid-teens to almost 30% for QQQ).  WOW.

The Dow (mostly large cap value plays) has vastly outperformed the other indices because of its high concentration of industrial stocks, health care, energy, and less weighting on technology.  See charts below:

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This has been the largest outperformance of the Dow over the S&P since its modern version origination in 1957.

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There have been 4 sectors that have been the bright spots during 2022.  XLE – Energy, XLV-Health Care, XLP-Consumer Staples, and XLU-Utilities.  As expected, these are commodity related sectors (Energy) or Defensive areas of investments (Staples, Health Care & Utilities).  See chart below (adjusted for dividends):

XLE-Energy (light blue): +51%
XLU-Utilities (purple): +1.97%
XLP-Staples (orange): +0.50%
XLV-Health Care (yellow): +0.47%
S&P 500 (dark blue): -16.75%

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What Bias Do You Have?

Below is a chart showing two different historical perspectives overlaid on the S&P 500.  Which one do you relate to more?  The negative or positive scenario?  Let us know.

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Will there be a long-awaited Fed Pivot?

The Fed will meet again this Tuesday & Wednesday December 12/13.  They are expected to raise rates yet again to curb elevated and ongoing persistent inflation.  However, Chairman Powell and other Fed Governors have recently been implying that it may be time to slow down the rate of the raises.  Given this more dovish rhetoric coming out of them, here is how the stock and bond market has acted since the last raise in early November:

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However, to keep this in perspective, the Fed has raised rates faster and higher, breaking historical precedents.

Additionally, with last week’s hotter than expected PPI, the Fed is likely to continue increasing rates and 0.75% which everyone thought was OFF the table, may be back on.  While the Fed may slow down their raise from the previous 0.75% to 0.50%, most analysts are expecting several additional increases as we head into 2023.  Expectations remain that we will get to 5% (or possibly even higher) on the Fed overnight lending rates before they are finished.

Economics 101

I was fortunate to attend a University (Ohio University) which was one of the first in the US to offer courses on economics.  John Galbraith, a successful American businessman and economist, graduated from there in 1922.  As an economist, Galbraith urged economists to look at the real world and not made-up financial calculations.

In 1977 I attended a course whose guest speaker was Milton Friedman. Friedman, a professor at University of Chicago (today considered the best economics university in the US) received the Nobel Prize for Economics in 1976.  He authored many books about monetarism.  He was an economic advisor to Presidents Nixon and Reagan.  It was Friedman who convinced Reagan to reduce income tax rates to spur economic growth.

Don’t Fight the Fed

Part of Friedman’s teachings were that if economic policy had been different and more accommodative, we might have avoided the Great Depression.

I bring this up because all one really needs to do is watch current monetary policy to see the most probable trajectory for interest rates and the stock and bond markets.

An interesting chart came out this week showing exactly what Milton Friedman wrote and spoke about in the 50s, 60s and 70’s.  Monetary policy rules everything.  Check out the following chart showing the effect of the Fed’s quantitative tapering (selling their bond holdings and draining liquidity from the system) and then having to infuse liquidity to prop up a falling market.   See below:

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People keep sending me all kinds of articles and commentary on why we may be in a new “bull market.”  I hope they are all spot on, but I don’t buy it.  Inflation and economic policy do not add up.  We may instead be on the precipice of another leg down.

Maintaining a Positive Bias

As most frequent readers will attest to, we try and provide a fair and balanced view of any future perspective.  Recently, we have pointed out positive seasonality trends, positive behavior from the decline in longer-term interest rates and the US Dollar.  All these factors and the above Fed supported liquidity chart above shows a recent positive stock AND bond performance bias.

Recession Clouds Persist

The original thoughts on this week’s article was to refrain from a negative bias. Then a series of articles dropped overnight indicating Blackrock (the world’s largest asset manager) has recently joined Morgan Stanley, Banc of America, and Deutsche Bank (to name a few) in warning of what they believe is likely to come.

All their collective beliefs (and our own Guru Mish) is that we will see elevated inflation far into the future and this will lead to more of an economic downturn.  This would be no surprise given the heavily inverted yield curve that has existed for the past few months.  Historically this inversion has accurately predicted a recession with over 90% certainty.

These large investment firms believe that the Fed is willing to allow the economy to slide into a deep recession if that is necessary to bring down inflation to its target of even 3%-4%, which some say is the new (secret) target.

These analysts are also pointing to a possible decline of another 20% or more in the stock market before a bottom is reached.

Blackrock produced the following charts to drive home their negative market thesis:

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Unlike other recessions that were affected by rising unemployment and a large number of corporate layoffs, this one could be different.  We have a shortage of workers and that will compound STAGLFATION and keep corporate America from downsizing enough to offset persistently high labor costs. See chart below:

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