The Signs Are Everywhere, But What Do They Say?
BY: JIM McELROY
The folly of predicting economic cycles and market reactions can sometimes appear uncomfortably close to the practice of past generations, who believed in the predictive power of heavenly phenomena, weather disruptions, plagues and other “signs.” Modern sensibility requires that we see cause and effect between signs—which we now prefer to call statistics and data—and future events: for example, the sign of high interest rates, all other things being equal, usually results in slower economic growth.
But, in order to provide a forecast that has a prayer of being profitable, modern day seers must rely on signs that are two or more removes from an actual cause: instead of predicting the direction of interest rates, pundits employ data on the demand and supply of consumer goods to predict the direction of prices, which has an impact on overall inflation, which in turn can predict the direction of interest rates. The greater the remove of the predictive sign from the proximate cause, the greater the tenuousness of the prediction.
Some of the more popular, though more tenuous, signs among the oracles of Wall Street are those that attempt to measure investor sentiment or psychology, usually along the fear/greed spectrum, and to make predictions about how close investors may be to changing directions. Extreme fear or extreme greed indicates an over-sold or over-bought condition, respectively, and given the right catalyst, a setting for a violent race to either the starting gate or the exit ramp.
The current bull market, which has been setting records almost daily, could be approaching an overbought condition. There are some clear signs of fearlessness among investors: the wild, Reddit fueled runs in otherwise desperately unappealing stocks (GameStop, AMC, etc.); the enormous popularity of SPACs (Special Purpose Acquisition Companies, or blank-check companies), which solicit funds from trusting investors to purchase an undisclosed private company in order to take it public; and the cult of crypto currencies, which sell themselves as more efficient, private and stable versions of central bank managed funds, but whose investors have been buying primarily because of their many orders of magnitude growth vis-à-vis the dollar. These manias normally end badly for the maniacs, but their collapse doesn’t always infect the broader market. For now, we see these signs as mere indicators of the degree to which greed has overwhelmed fear in investor psychology, not immediate signs of a collapsing market.
Less tenuous signs come from recent comments by the Federal Reserve. Having spent the last year fighting the pandemic with near zero interest rates and extensive bond purchases, all with no hint of a timetable for reducing these accommodations, the Fed now suggests that they might consider moderately raising short term rates, maybe to .6% by the end of 2023, and slowing bond purchases by “baby steps.”
The proximate cause for this modest suggestion of possible contraction of liquidity was the sign from the Bureau of Labor Statistics that in May, the trailing twelve months (TTM) reading on Consumer Price Inflation was 4.9%. Since the Fed has maintained for some time that it prefers an annual inflation rate near 2%, the near 5% reading for May was somewhat of a shock. It’s true that the May 2021 TTM number had as a base the CPI index from May 2020, when prices had been declining for three months — the April 2021 reading was also elevated (4.2%) for the same reason — and that the annual average over the trailing twenty-four months was a more acceptable 2.5%, but a 5% CPI certainly got everyone’s attention. And anecdotally, there have been signs that prices have been increasing dramatically across a broad spectrum of consumer goods and services.
The Fed bravely asserts that these increases are temporary. The Fed may be right: consumers, flush with stimulus checks and weary of pandemic privations, have been tugging strongly on the demand-pull component of inflation, while corporations, faced with pandemic related disruptions in their supply chains, have been pushing higher costs on to buyers. Once all the stimulus checks have been spent and corporations are able to refill their employee ranks with trained and productive workers, the argument goes, inflation pressures will abate.
For now, the Fed is signaling that the recent inflation numbers are transitory. We’ll see. Continued high inflation—well above the Fed’s 2% comfort zone—would not be a good sign.
Now that the U.S. is winding down its lockdowns and social distancing, we find ourselves searching for signs (data) that will tell us how quickly we are returning to pre-pandemic levels and whether we will continue improving from there. Most of the signs (e.g., employment numbers, airline traffic, restaurant reservations, etc.) indicate that while activity has not completely recovered to 2019 levels, it is in sight. Interest rates (ten-year U.S. Treasuries) have recovered almost a full percentage point from their pandemic lows but are still slightly lower than their pre-pandemic levels.
Judging by these signs, we would say that the direct economic effects of the pandemic, though not completely behind us, appear to be fading. But an indirect effect of the pandemic will remain in the post-pandemic era: the record expansion of federal debt over the last year, in the cause of economic stimulus and support, is a worrying sign.
The fiscal deficits during the pandemic were the highest as a percentage of GDP since the post WWII era. Currently, as of the end of this year’s first quarter, the national debt stands at about 128% of GDP, down from the record of 136% set in the second quarter of 2020, but still a staggering number. No one really knows what effects this enormous imbalance of debt will have upon the economy and the markets—the size alone puts it into unchartered territory—but most of the effects are not benign. At the very least, it will exert upward pressure on interest rates, which already lag inflation. These are not good signs for owners of fixed income investments.
The signs for equity investors, however, have been quite positive. One of the most closely watched signs for stock investors occurs in corporate earnings announcements, normally released in the second month following the end of the quarter (February, May, August and November are generally regarded as earnings seasons). Wall Street analysts pore over these numbers to compare corporate earnings results with predictions.
Companies that produce results better than expectations are usually rewarded by augmented future earnings expectations and, of course, higher stock prices. Those that fall short of expectations receive the opposite treatment. In May of this year, companies in the S&P 500 reported quarterly earnings per share far enough above expectations to warrant an upward revision in expected 2022 earnings, from a previous $175 per share to $214 per share, an almost 38% improvement.
The next earnings season will be in August: it should reflect continued earnings gains from the continuing relaxation of pandemic restrictions. In addition to earnings, analysts will be paying close attention to profit margins to see how well companies are offsetting higher production costs with increased efficiencies and/or price increases. This sign will bear watching, not only because of what it may say about the durability of earnings growth, but also what it may reveal about the transience of inflation.
Given this analysis of the tea leaves, equities appear to have an edge over bonds in asset allocation strategies. With the pandemic waning in the U.S., the signs of an improving economy are becoming more pronounced. Corporate earnings should continue to improve and stock prices should respond accordingly. Fixed income investments provide a relatively stable return, but the likelihood of declining interest rates from current levels — many government bonds are yielding less than the rate of inflation — seems remote. In fact, it seems more likely to us that rates will rise gradually in the coming months, in response to quickening economic activity, rather than fall.
There’s always the risk that recent inflation is not transient and that the Fed will respond with dramatic hikes in interest rates and a sponging up of liquidity but, for now, we think this is unlikely. In balanced portfolios (mixed stocks and bonds), we recommend a moderate over weighting in stocks. That’s what the signs tell us.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
