Somewhat ironically given recent events, unmanned hot air balloons are thought to have been first used in China nearly 1,800 years ago for military signaling. Soon after the first manned hot air balloon flight took place in 1783, balloons were used for reconnaissance during the War of the First Coalition in France. Observation balloons were also used during the American Civil War in the 1860s and both World Wars. As we have become aware in recent days, high altitude balloons continue to be in use today for surveillance. Much smaller and more colorful balloons are commonly used for decoration or signaling, such as for birthday parties or graduation celebrations. As we’ve mentioned over the past several weeks, we are seeing conflicting signals in the markets now. What do they mean? Have we gained clarity on what might lie ahead?
The three major stock indices suffered losses last week for the first time this year and experienced their worst week since mid-December. It seems the January Effect is now fading, and the market will again start to trade on fundamentals. Interest rates moved higher, turning into a headwind for the stock market, amid a slight repricing of the interest rate path of the Federal Reserve with a higher peak in the fed funds rate now being anticipated. The yield curve continues to cause fears of a recession with the spread between 2-year and 10-year U.S. Treasury bond yields hitting their lowest point since the early 1980s. Historically when the yield curve is inverted, i.e. shorter term rates are higher than longer term rates, a recession has followed on average one year after the beginning of the inversion. The current inversion began in March, 2022 so if the bond market is an accurate indication, a recession may not be far off.
The biggest event of the past week largely flew under the radar – revisions from recalculated seasonal adjustments to past Consumer Price Index inflation numbers. The revisions were all to the upside for the prior three months, including a rise in consumer prices in December, instead of falling as previously reported. These revisions show that inflation may not be falling as quickly as previously thought and may raise the risk of higher inflation readings in months ahead.
Another type of airship used for observation is the blimp, which in modern times are most likely associated with observations for sporting events. Blimps were used for patrols in World War I and are still in limited military use today for surveillance and airborne early- warning detection. Similar to hot air balloons, blimps provide a high-level view of events on the ground. When it comes to investing, people often get caught up in the short-term and forget to maintain a high-level view of what is going on in the economy and markets over the longer term.
According to the stock market, the most widely expected outcome this year is for a slowing economy or a “soft landing,” but not a recession. Conversely, the bond market is signaling there will be a recession. Given past precedence, we tend to think the bond market is going to end up being the more accurate indicator. Inflation, while falling, remains persistently high and well above the Fed’s comfort zone so the Fed may be forced to raise rates more than currently expected, pushing the economy into a recession.
Stock market valuations remain high, or above historical averages. There is not a rule stating valuations must remain in a certain range but based on past market action, reversions to the mean generally occur. For valuation we are referring to the price-to-earnings ratio, which can either be backward or forward looking. Measures of both are showing the market is overvalued. In order to be more in-line with historical averages, either stock prices would have to fall, or earnings need to increase. Unfortunately, recent earnings reports have primarily shown negative growth compared to a year ago, a trend we think will continue for at least the next two quarters in the midst of slowing economic growth. A common theme this quarter is that higher input costs are leading to smaller profit margins. Unless there is an upside surprise to economic growth or inflationary pressures ease considerably, earnings are not likely to improve significantly and stock prices could adjust accordingly. In the recent past, when interest rates were near zero, there were not alternatives to the stock market so investors would continue to pile in regardless of valuations. That is not true today as investors have other options for earning returns and therefore are much more sensitive to prices and valuations.
The coming week is a big one for economic data, most notably around inflation. The Consumer Price Index (CPI) is expected to show a slight drop to 6.2% on a year-over-year basis but what is likely to be watched more closely is the month-over-month number which is expected to be an increase of 0.5%, an acceleration from previous months. This report will be particularly meaningful given the growing doubts around a smooth disinflationary path and the recent revisions to previous months’ data. Housing prices, and as a result, rents as measured for the CPI, remain stubbornly high compared to a year ago and there is evidence of higher food prices, not to mention a surprising rebound in auto prices, so we would not rule out a surprise to the upside. This could potentially shock the markets, especially the stock market which has been pricing in a healthy dose of disinflation. Also of significance this week will be the Producer Price Index (PPI) and retail sales reports.
Looking out further, we anticipate a strong recovery after a potential recession or re-adjustment of stock prices. If you have cash on the sidelines, this is a good time to be cautious and you may want to consider alternatives to the stock market. But if you are fully invested, we suggest remaining patient and warn against trying to time the market since that often ends up being a fool’s game.
When it comes to the markets there are often mixed, and even conflicting, signals. This has been especially true this year, as much as any time in recent memory. Be sure no matter what the signals are, you are maintaining a high-level, or long-term, view and being keenly aware of how it applies to your own retirement planning. You cannot control what the markets do, but you can control how your retirement plan and individualized strategy incorporate income and tax planning. Please contact us if you would like to discuss your situation.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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