What is the Stock Market Telling Us?

If there’s one thing all investors and advisors can agree on, it’s that we’re experiencing some serious stock market volatility. In mid-May, the S&P 500 briefly dipped into a 20% bear market before recovering later in the week. But, the questions remain: What’s next? And when does the market recover?

In this post, I hope to answer most of your questions about what’s going on with the stock market and how this situation may play out. You’ll also learn what a “Greenspan pump fake” is.

It all started with inflation. We can place the blame for inflation on a lot of factors, but it comes down to two key reasons: low interest rates and supply/demand.

• Dating back to the Global Financial Crisis and again during the pandemic, the Federal Reserve (Fed) lowered interest rates to near zero for short-term borrowing, then purchased trillions of bonds to lower interest rates for longer term borrowing. Low interest rates allowed more people to borrow to buy homes and more companies to borrow and invest for future growth. Accordingly, prices jumped on both real estate and stocks.
• Post pandemic, supply/demand got way out of whack. We have never before exited a time where the entire world (except Florida and Texas) shut down for months on end. Simply put, demand began soaring when supply was not ready for it. As an example, take used car demand. At the beginning of the pandemic, many people weren’t leaving their houses, let alone commuting to work or taking long roadtrips. Once people got used to the pandemic and consumers were flush with cash, they were ready to drive (but not necessarily fly). What happens when demand for cars outstrips supply? Prices jump. Parts of Asia still on COVID lockdown and the war in Ukraine (a key supplier of global wheat) only add to the imbalance.

Follow the dominos from here: the Fed has only one method of battling inflation, and that’s to slow down the economy. Their main tool to slow down the economy? Higher interest rates.

Job well done, Federal Reserve. We now have higher interest rates and the economy is slowing.

But, Barry, the Fed has just begun raising rates. Isn’t there so much more pain to come as they raise rates much further?

Not necessarily. Fed Chair Jerome Powell just pulled what I call an “Alan Greenspan Pump Fake.” You see, a pump fake in basketball is when a player makes most of the motion to jump up to shoot, pumps his arms up, but never shoots the ball. What the player hopes for is a reaction by the defender jumping high in the air to block a shot that hasn’t yet occurred.

I saw Greenspan do this multiple times in the 90’s. “Higher Fed rates are coming!!!” (paraphrasing). Then, even before he raised that ultra-short-term Fed Funds rate, all other rates jumped, pricing in the anticipated rate hikes. With other interest rates jumping, Greenspan accomplished what he hoped and the economy slowed, without lifting a finger.

That’s what’s happened so far this year, and we can measure it. Through mid-May, while the Fed has raised their rate by 0.75% from its 2021 low, the two-year Treasury rate has increased by more than 2.5%, and the ten-year by almost 2%.

Want to see this in the real world? The average rate for a 30-year mortgage jumped from about 3% to 5.5% in less than a year. Want to slow down surging home prices? Start with raising monthly payments on new mortgages by 35% or so.

My point is that if you’re worried about the Fed taking away the “steroids” that boosted the economy, it’s already happening.

That means a few important items as we look forward:

1. Most of the pain in the bond markets is likely behind us. Those negative returns on bonds year-to-date likely have priced in the expectations of the Fed, but also the worries of individuals who may later find themselves panicking and cashing out near the bottom. Even high quality municipal bonds have been more volatile than most, as the majority of owners are individuals – who may react more on emotions – than pensions, institutions or other bond holders.
2. Tech stocks have been…hammered. It started with low-profit growth names, moved on to the beloved pandemic stocks like Zoom and Teladoc, and now is finally hitting the mega-cap names of Apple and Google (Alphabet).
3. Retail stocks are the current reason for recent volatility, and not just the designer names. Walmart, Target, Ross Stores, Dollar General and even Amazon were all down more than 25% in the first 20 days of May!

What may come next? Likely recession, in both official terms and earnings, then layoffs, then recovery.

Is a recession coming? Of course it is at some point. In fact, we may already be in recession. While a number of leading indicators are positive and reflect a healthy economy, it is clear that economic growth has at least slowed down from its incredible 2021 pace.

The traditional definition of recession is two quarters in a row of negative GDP (the economy shrinking). The first quarter of 2022 was negative, and if these retail numbers being reported by the companies above are any indication, then we may already be in a recession.

While the retail numbers are ugly from a revenue standpoint (people spending less amidst higher prices), profits have fallen because costs are jumping at the same time. We are likely going to see an earnings recession where companies simply make less than they did the previous quarter or year. This doesn’t imply that companies will lose billions, just make less than they did. They may combat this by raising their own prices, passing increased cost to consumers, or cutting costs where possible. The reaction of the stock market to these earnings adjustments may not be reflective of the true state of profitability for that company.

We have begun to see layoffs where profits are impacted. Tech companies like Netflix, Robinhood, and Carvana have laid off employees already, and mortgage companies won’t need as many processors with fewer refinances happening. I don’t want to gloss over the horrible impact of people losing their jobs, but keep in mind that we are starting from historically low unemployment. It may jump to levels that, in the past, were considered “full employment.”

This is all a normal – but painful – part of the cycle when the economy overheats, inflation picks up, the Fed does their thing, the bond market reacts, then stocks react in anticipation of a slowdown.

But before you panic, remember that the market is a forecasting machine. Stocks tend to fall well before a recession begins and bottom well before a recession ends. And in fact, stocks on average are well higher two years after a recession starts. We can see this illustrated historically in this chart from Dimensional Funds.

In short, the stock market is likely an indicator of what’s to come, but will also be an early indicator of the recovery that every recession eventually experiences. The best course of action is to think long-term.