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Bear Market Update

The S&P 500 has recently slid into a bear market due to inflation and fears of a recession. As expected, the Fed announced a 0.75% interest rate hike.1  That may not sound like much, but it’s the largest single rate increase since 1994. 1  To keep you up to date on what’s going on, let’s do a quick Q&A. 

Q: What, exactly, did the Federal Reserve do?

A: Raise the “Federal Funds Rate”.  This is the interest rate that banks pay each other for overnight loans.  When the rate goes up, it costs more for banks to loan each other money. In response, banks raise their own interest rates. That’s why, when the Federal Reserve raises the federal funds rate, it eventually affects consumers and small businesses whenever they apply for a loan.  Specifically, the Fed raised the rate up 0.75% to approximately 1.6%.1 

Q: How did the markets react?

A: Initially, the markets rose soon after the announcement, as it was expected, and because many experts believe it’s necessary to tamp down on inflation.

The day after, though, the markets continued their slide.  The S&P 500 and NASDAQ are firmly in bear market territory, and the Dow is getting close. 

The reason for this is because the Fed also announced that a second 0.75% rate increase is possible in July.  While higher interest rates are a proven tool for fighting inflation, each rate hike increases the odds of a recession, even if it’s a small one.  The markets dropping further is essentially investors pricing in the likelihood of more action from the Fed…and a greater chance of an economic downturn. 

Q: What is the Fed hoping to achieve here?

A: When the Fed announced the rate hike on Wednesday, they also revealed something else: Their economic outlook for the rest of 2022.  The Fed’s hope is to achieve what’s called a “soft landing.”    This is where economic growth slows, but a full-blown recession is avoided.  There’s some justification for this hope.  After all, if you remove inflation from the equation, the economy is actually in pretty good shape.  The unemployment rate is at 3.6%, which is almost back to where we were in January 2020 before COVID hit.2  And consumer spending – the bedrock of our economy – remains strong.  It was to shore up the economy that the Fed dropped interest rates in the first place.  Now, the thinking goes, that mission is complete, which means it’s time for the Fed to pivot to the second prong of their “dual mandate”: stabilizing prices.  (The first prong is stable employment.)

Unfortunately, soft landings are historically difficult to achieve, and the most recent data suggests an economic slowdown may already be happening.  Consumer sentiment is dropping, retail sales numbers have dropped slightly over the last month, and while the economy continues to add jobs, it did so at a slower pace in May.1  Even the Fed admits that the unemployment rate will likely go up over the next few years.  (Moving from 3.6% to 4.1%, according to their projections.1

Q: So, what should we do moving forward?

A: The main thing right now is to remember that the markets move based on what investors expect to happen, not what is happening right now.  At any point, those expectations could change.  Every new bit of economic data between now and the Fed’s next meeting in July will be carefully scrutinized.  That’s why it’s never a good idea to overreact to the day-to-day swings in the market, even if they seem significant.  The sentiment that drives the market today may be completely different tomorrow. 

Remember: We endured both a bear market and a recession not very long ago.  Keeping the long-term in view helped us not only get through rough times but take advantage of a tremendous recovery. 

Of course, if you have any immediate financial goals, or need access to some of your money in the short-term, let us know and our team will help you promptly.  And of course, if you have any questions or concerns about your portfolio, don’t hesitate to reach out.  That’s what we’re here for!     

As the summer progresses, we’ll keep you apprised about what’s going on in the markets.  In the meantime, enjoy the warmer weather knowing that we are here to do everything we can to keep you working toward your financial goals.      

1 “Fed hikes its benchmark interest rate by 0.75 percentage point, the biggest increase since 1994,” CNBC, https://clicktime.cloud.postoffice.net/clicktime.php?U=https%3A%2F%2Fwww.cnbc.com%2F2022%2F06%2F15%2Ffed-hikes-its-benchmark-interest-rate-by-three-quarters-of-a-point-the-biggest-increase-since-1994.html&E=maryellen%40mmwealth.com&X=XID793AFuR7T7793Xd2&T=MMWL&HV=U,E,X,T&H=46cf2e46f2cc5f68e79a2d364fd4ec5052f5340f

2 “The Employment Situation – May 2022,” Bureau of Labor Statistics, https://clicktime.cloud.postoffice.net/clicktime.php?U=https%3A%2F%2Fwww.bls.gov%2Fnews.release%2Fpdf%2Fempsit.pdf&E=maryellen%40mmwealth.com&X=XID793AFuR7T7793Xd2&T=MMWL&HV=U,E,X,T&H=0c145dfe397266fae066dd051f8fdcdbef3da5e2

Turbulent Times 2022

Recently, we overheard two people talking about the NBA playoffs, which are currently underway.  While praising their favorite team’s defensive performance, one of them said something that stuck with us:

“Defense wins championships.”   

What a great line!  Defense wins championships.  The reason this stuck with us is because we’ve been thinking about defense while studying the markets recently. As you probably know, market volatility has been persistent since the middle of January. The S&P 500 has moved in and out of correction territory for the past two months, and the NASDAQ is technically in a bear market. (Quick reminder: A “correction” is defined as a drop of 10% or more from a recent peak, while a “bear market” is a drop of 20% or more.)

As you can imagine, this sustained volatility has a lot of investors concerned for the future.  And make no mistake: it’s clear that we are living in turbulent times right now. Some analysts are warning of a potential bear market across the entire stock market; some economists, meanwhile, are even forecasting the possibility of a new recession.1 (Though it’s worth noting this prediction does not seem to be the prevailing one among most economists.)

No one enjoys investing during times like these.  But as your financial advisors, we decided to write this letter to assure you that we have a major advantage: We don’t have to suffer from turbulent times.  Because we have the ability to play defense with your portfolio.

And defense wins championships. 

Let us explain what we mean by quickly recapping why the markets are so volatile. The various reasons are all interconnected, so we can untangle the knot of events fairly easily.

On Monday, April 25, health authorities in Beijing, China, rushed around the city to conduct as many COVID-19 tests as they possibly could. By the end of the day, they had tested almost 3.7 million people.2 Their goal?  Identify and quarantine every infected person in the vicinity – so they could avoid the city-wide lockdown that nearby Shanghai has been dealing with for the past four weeks. 

The reason this matters is because the world depends on China for a lot of things: Foodstuffs, rare earth metals, computer chips, cars, steel, plastics, etc.  The worry is that if China goes on lockdown again, production on all these items will plummet.  That would throw a major wrench into global supply chains, which are still – still – struggling to recover from the pandemic. 

This is something the world can ill-afford at the moment, especially given the ongoing war in Ukraine.  Much of the world depends on both these countries for the goods they need.  Wheat and neon gas from Ukraine, for example.  Oil and natural gas from Russia.  Thanks to this conflict, and due to the sanctions imposed on Russia as a result of it, it’s now not only more expensive to buy certain items.  It’s more important to ship them, too. 

All these supply chain issues, of course, have contributed to the rampant inflation we’ve seen this year.  For example, take something as simple as chicken eggs.  Russia exports a huge percentage of the components that go into agricultural fertilizer.  When it becomes more expensive for farmers to buy fertilizer, the price of corn goes up.  When the price of corn goes up, the price of chicken feed goes up.  When the price of chicken feed goes up, the price of raising chickens goes up.  That leads to higher-priced eggs, which is further compounded by higher oil prices making it more expensive to ship those eggs to the market and…well, you get the point.

Understanding how the world’s issues, like COVID and war, contributes to supply chain problems makes it easier to see how they also contribute to inflation.  And what does inflation have to do with the stock market?  Simple: Inflation doesn’t just affect consumers.  It affects companies, too.  During periods of high inflation, it becomes more and more costly for companies to produce the products they sell.  They can – and usually do – raise their own prices to compensate, but this can backfire if it leads consumers to go elsewhere.  Either way, the company’s profit margin suffers – which means they return less value to shareholders.  Shareholders, in response, then start selling their stock, driving the price down.  These are the reasons we’ve seen such sustained volatility in the markets – and why that volatility will likely continue for some time. 

These are indeed turbulent times we live in.  But here’s the good news.  If you look closely, nothing we’ve just explained to you is new, is it?  We’ve been dealing with COVID since 2020; with inflation since 2021.  In the last two years, we’ve lived through both a bear market and a recession and come out on the other side.  We’ve been reading about supply chain issues for months; trade issues with China for years.  The sources of today’s volatility are largely the same as yesterday’s. 

Which means we know exactly how to deal with it.

As you know, when COVID first hit, we immediately moved to “play defense” with your portfolio.  We accepted that growing wasn’t the objective anymore – it was preserving capital.  Over the years, we’ve honed our tactics to be able to move to defense whenever the situation demands it.  Our team will continue to monitor the situation, but we’re prepared for the possibility of a bear market.  Would we rather always stay on offense, seeking to find new opportunities to grow?  Of course.  But sometimes, the best way to move forward is to keep yourself from moving backwards.  Sometimes, avoiding market pain is the best possible gain.  Due to our use of technical analysis, and the systematic rules we have in place that let us know when it’s time to buy and when it’s time to sell, defense will be our objective whenever conditions warrant it. 

1 “A major recession is coming, Deutsche Bank warns,” CNN Business, https://clicktime.cloud.postoffice.net/clicktime.php?U=https%3A%2F%2Fwww.cnn.com%2F2022%2F04%2F26%2Feconomy%2Finflation-recession-economy-deutsche-bank%2Findex.html&E=maryellen%40mmwealth.com&X=XID257ADbqfQ0600Xd3&T=MMWL&HV=U,E,X,T&H=8081c2db199c4424978bc13342bb584b0eaec739

2 “Beijing Orders Citywide Covid-19 Testing,” The Wall Street Journal, https://clicktime.cloud.postoffice.net/clicktime.php?U=https%3A%2F%2Fwww.wsj.com%2Farticles%2Fbeijing-braces-for-omicron-wave-with-hoarding-and-testing-11650866581&E=maryellen%40mmwealth.com&X=XID257ADbqfQ0600Xd3&T=MMWL&HV=U,E,X,T&H=a81b7794ae33406bc76baf938642e9b857fd38b4

Trending Now: Interest Rates & Inflation

One year.  It seems incredible, but it’s been one year since COVID-19 struck our shores.  One year since the World Health Organization declared a pandemic.  One year since the markets crashed and the schools closed and we realized just how much we take toilet paper for granted. 

Since then, the markets have recovered and risen to new heights.  The economy, meanwhile, has recovered more slowly.  Now, a quarter of the way through 2021, we have a new president, several new vaccines, and a completely different world than the one we knew before all this started.  We’ve also seen some renewed volatility in recent weeks.  This has many of our clients asking, “Where are the markets going next?  What should we expect for the rest of 2021?” 

We’ll address those questions in this email.

As you know, there are two types of long-term market situations: Bull markets and bear markets.  But the whole “bull vs bear” concept can also be used to describe two types of investor sentiment.  Bulls are investors who have a positive, or “bullish”, view of where the markets are headed.  Bears, meanwhile, generally have negative, or “bearish” expectations.  So, we’re going to let both animals debate each other, each presenting their case for why the markets will have a positive year or a negative one.  We’ll start with the Bull, move onto the Bear, and then give the Bull a chance for a short rebuttal.  Finally, as financial advisors, we’ll give you our view. 

The Bullish View

Last year’s market crash was sudden, swift, and deep.  But in the grand scheme of things, it didn’t last very long.  In fact, it took only six months for the markets to recover.  (By contrast, it took the markets almost six years to recover after the Great Recession.)  Since then, the markets have risen to new highs. 

Three things propelled the markets to this remarkable turnaround: Low interest rates, federal stimulus, and the expectation of a major economic recovery.  Let’s start with the first one.  To help juice up the economy, the Federal Reserve lowered interest rates to a historic degree.  Low interest rates promote more borrowing and spending, two pillars our economy is based on.  They also help people buy homes and encourage businesses to invest more in themselves.  (Including hiring more workers.) 

Congress, meanwhile, has passed three major stimulus packages in the last year.  The most recent bill was signed by President Biden on March 11.  The America Rescue Plan Act of 2021, as it’s called, provides $1.9 trillion in aid for both businesses and consumers.1  Among other things, the Act extends COVID unemployment benefits through Labor Day, provides $1,400 direct payments to individuals, expands certain tax credits, and grants billions to small businesses to help meet payroll and retain workers.1  The first two stimulus packages had a positive impact on things like retail sales and consumer spending, and it’s widely expected that this one will, too. 

This combination of low interest rates and government stimulus have helped the economy tread water while we deal with the virus.  But much of the market’s rise is due to something else: Expectation.  Specifically, expectation that the pandemic will end, and the economy will hit the accelerator. As more people are vaccinated and case numbers fall, the thinking goes, more and more of society will re-open, releasing a flood of pent-up demand.  Demand to travel, to eat out, to catch a movie in theaters, you name it.  Add the latest round of stimulus to the mix, and suddenly Americans have both extra money in their pocket and the means to spend it.  In other words, all the ingredients are there for a major economic comeback, the likes of which we haven’t seen in decades. 

Now, we seem closer than ever to that expectation becoming reality.  As of this writing, there are three approved vaccines in the U.S., with more than 115 million doses administered.2  (40 million people are currently considered fully vaccinated, approximately 12.3% of the total population. 2)  Currently, our nation is averaging over 2 million shots each day.2  It’s no surprise, then, that cases in the U.S. have been falling for weeks.  In fact, as of March 19, cases are down over 14% over the last two weeks.3 

We’re not out of the woods yet, not by a long shot.  Masks and social distancing will continue to be a part of our lives for some time yet, and of course there are relatively new variants of the coronavirus to deal with.  But if we can maintain this trajectory, increasing the number of people vaccinated and reducing the number of people sick, that could do wonders for our economy.  It could lead to more of society re-opening, leading in turn to more jobs, more consumer spending, and greater company earnings.  Greater earnings, of course, usually lead to higher stock prices. 

The Bearish View

So, in light of all this, how can anyone have a negative view of where the markets are headed?  It all comes down to a single word:  Inflation.

Inflation.  It’s a scary-sounding word that conjures up images of German children stacking useless money in the 1920s, or gas rationing in the 1970s.  For decades, economists have monitored it relentlessly.  The Federal Reserve considers managing inflation to be a core aspect of its mission.  That’s partly why our nation’s inflation rate has been relatively stable over the last twenty years. 

But recently, some analysts and investors have begun stressing over inflation again.  They don’t deny that the economy is poised to grow.  They just worry that it will grow too much, too fast.  There’s a word for this, too.  Economists call it overheating.

When an economy overheats, it essentially no longer has the capacity to meet all the demand it faces from consumers.  Some producers will simply not be able to supply all the goods their customers want.  Other producers, to keep up with that demand, will be forced to raise prices.  It’s a classic example of the Law of Supply and Demand.  (When the demand for something outpaces its supply, the price goes up.)  For example, if everyone suddenly decides to fly to that vacation spot they’ve been putting off for a year, the cost of air travel would skyrocket.

If the economy were to grow too quickly, prices would rise across the board – and the value of our currency would drop.  This, essentially, is inflation: When the general price level rises, a dollar simply pays for less than it used to.  That makes it much harder for people to buy the goods and services they need.  Or to pay off their debts.  It makes it harder for businesses to hire new workers or pay the workers they already have.  The upshot?  When inflation gets too high, consumer spending plummets, unemployment jumps, and economic booms turn into economic busts. 

Some experts worry this is what’s in store in 2021.  They see the economy as a garden hose that’s been tied up into a knot.  Untie the knot – or re-open the economy too quickly – and the water will burst out with sudden, savage force. 

So, here’s what this has to do with the stock market.  Normally, the Federal Reserve combats inflation by raising interest rates.  Higher interest rates tend to cool off the economy, because they prompt people to save their money instead of spending or borrowing it.  A cooler economy decreases inflation, and gradually things go back to normal.  The problem is the stock market has become accustomed to the Fed’s low interest, “easy money” policies.  Low interest rates mean that many types of investments, most notably bonds, simply don’t provide the same return on investment as they would in a high-interest rate environment.  That drives more and more investors into the stock market to get the returns they need.  But what happens when interest rates go up?  Consumers and businesses could cut back on spending, which in turn could cause earnings to fall and stock prices to drop. 

Fear of inflation, and fear of higher interest rates.  That’s the bearish view in a nutshell. 

Rebuttal

We promised the Bull would have the opportunity for a short rebuttal, so here it is.  There are two main reasons for thinking this fear of high interest rates are overblown.  The first is that, even if inflation does go up – which it likely will – we have a lot of room to work with before it becomes a problem.  In 2020, the inflation rate was only 1.2%.4  That’s well below the 2% mark the Fed generally aims for, and nowhere close to the mind-boggling numbers we saw in the late 70s and early 80s.  (In 1979, for example, the inflation rate was 13.3%.4

The other reason is that there’s no reason to assume the Federal Reserve will automatically raise interest rates just because inflation goes up.  Why?  Because the Fed itself has said that it won’t!5  Currently, the Fed sees stimulating the economy and boosting employment to be far bigger priorities than tamping down on inflation, and recently, the Fed Chairman suggested interest rates would remain low at least until 2022. 

Our View

We’ve told you what the Bulls and Bears think.  So, here’s what we think. 

Here at Minich MacGregor Wealth Management, we don’t focus on guessing what the Fed will do, or anyone else.  We don’t have a crystal ball.  No one does!  That is why we base our strategy on both technical and fundamental analysis.  We analyze – and take advantage – of market trends, relying on the Law of Supply and Demand rather than fighting it. 

Historically, an improving economy leads to a stronger stock market.  If that happens in 2021, wonderful!  But if interest rate fears worsen and volatility goes up, we are ready to play defense and move to cash.  Remember, we don’t need to “buy and hold” even when there’s a Bear roaring in our face.  If there’s a general rise in prices and inflation skyrockets above what the Fed can handle, we don’t have to ride out another market crash like so many investors do.  We’ll obey the rules of our strategy and do what the trend dictates.  If our technical signals indicate major volatility on the horizon, we’ll be prepared. 

It’s been a year since the pandemic began.  A year since some of the worst market turmoil in a long time.  We got through that by being flexible, disciplined, and diligent, and we’ve been rewarded.  So, that’s what we’ll continue to do. 

If you have any questions or concerns about the market, please feel free to contact us.  In the meantime, enjoy the upcoming spring season!       

SOURCES:

1 “The American Rescue Plan Act Greatly Expands Benefits through the Tax Code in 2021,” Tax Foundation, March 12, 2021.  https://taxfoundation.org/american-rescue-plan-covid-relief/

2 “How is the COVID-19 Vaccination Campaign Going In Your State?” NPR, March 19, 2021.  https://www.npr.org/sections/health-shots/2021/01/28/960901166/how-is-the-covid-19-vaccination-campaign-going-in-your-state