Coming Out of Hibernation
One adaptation that has evolved in some mammals is hibernation, which is a state of dormancy that allows animals to avoid periods of famine, such as over the winter when food is scarce. As the weather warms up here in the Upper Midwest and we are able to be outdoors more, we ourselves might feel as if we are coming out of our own hibernation. Bears are especially known to be animals that hibernate. We experienced bear markets in 2022, but 2023 is off to a much better start. Are the bears going to return to hibernation and are the bulls finally taking charge?
The gains in the stock market year-to-date (YTD) have been driven primarily by the Technology and Communications Services sectors. It is the companies in these sectors that are also driving the strong YTD performance of the Nasdaq, but still not enough to bring it out of its bear market as it remains some 25% off its all-time high. The forward price-to-earnings ratio of the tech sector remains elevated above long-term averages, but not yet reaching levels seen in 2020-2021, implying that either earnings need to improve or stock prices need to fall for prices to be more in-line with the historical norm. There is no rule stating stocks must trade at a particular P/E ratio, but the sector again looks expensive, and we would remain cautious in this area until we see confirmation earnings are improving.
Last week the S&P 500 and Nasdaq finishing slightly lower after three weeks of gains. Concerns about growth moved back to the forefront during the holiday-shortened week amid a steady stream of weaker-than-expected economic reports. While these seemingly firmed expectations for the Federal Reserve to pause its interest rate hikes at their next meeting in early May, at the same time they provided additional fuel for hard-landing and recessionary concerns. Following recent stress in the banking sector, there have also been signs of weaker loan demand and tighter credit terms, which also are adding to the shift in sentiment.
Despite those events, there are also advocates for a more bullish view. Bank-crisis headlines appear to have stabilized and there are presently no indications of further contagion, but that does not mean we are out of the woods yet. The coming earnings season remains a big focus given expectations for a notable year-over-year drop in S&P earnings amid a softer economic backdrop and pressure from wage growth. There is also a sense the bar for this earnings season has already been lowered.
Goldilocks and the 3 Bears
Most everyone is familiar with the fairy tale “Goldilocks and the Three Bears” where a young girl, Goldilocks, enters the home of three bears, sits in their chairs, eats their porridge and sleeps in their beds. She tries the porridge of each, with the first being too hot, the second being too cold and the third being just right.
Last week’s jobs report could be considered a “Goldilocks” scenario that is “just right.” Employers are adding jobs at a healthy, but more moderate pace. New workers are reentering the labor force, helping meet the demand for staff, resulting in wage gains normalizing. If this is sustained in coming months this could lead to a not-too-hot or not-too-cold healthy labor market with steady job growth and low inflation. The Fed has been looking for the labor force to come back into balance, helping subdue wage growth and inflationary pressure.
After the employment reports were released, Treasury yields rose sharply, reflecting a sense that the continued robust job market implies tighter money supply. Stated another way, the jobs report provided further room for the Fed to continue raising interest rates and a rate hike in May now has a higher probability of occurring. But we will caution many data points will be released prior to the next Fed meeting, including key inflation reports this coming week. The central bank will be reluctant to back off its campaign to raise interest rates until there is clear evidence inflation is cooling significantly.
First quarter earnings season will get underway this week with big banks reporting results on Friday. Investors are likely to turn their attention slightly away from Fed policy and towards the state of profitability in corporate America. However, the most anticipated event of the week will be the latest inflation reading from the Consumer Price Index (CPI) on Wednesday, followed by the Producer Price Index (PPI) on Thursday. CPI is expected to show prices being 5.2% higher than a year ago, a slowing in inflation from the 6% reported last month, but still much higher than the Fed’s 2% target. The week wraps up with the monthly retail sales report on Friday, which will show the health of consumer spending.
Current market expectations indicate about a 50/50 split in chances for a quarter point rate hike by the Fed in May, with odds of a hike increasing after last week’s jobs reports but very much subject to change as mentioned earlier. Looking out further, markets are pricing in a pause at the June meeting with a quarter point drop in July. Our thoughts are the market is not pricing probabilities correctly and absent a major unanticipated event, we highly doubt the Fed would raise rates and then begin to lower a few short months later. Not since the early 1980’s has the Fed not held rates at their peak for less than 6 months, often holding them for up to a year, before cutting. And looking back to the early 1980’s when there were large swings in interest rate moves by the Fed, they made policy errors by not holding rates high enough for long enough, allowing inflation to quickly grow. The current Fed is aware of this past precedent and it is unlikely they will want to repeat the same type of errors.
When bears hibernate, they store up enough food and liquid in their bodies to survive the long winter. Their physiology and metabolism shift in rathe incredible ways to help them survive. Investors should prepare themselves in much the same way when it comes to bear markets – by having an income stream available so they do not need to rely on their investments when markets are lower. If you are concerned about what a bear market could impact your retirement, contact us to discuss strategies to help you remain feeling secure.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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