Bad today, better tomorrow

Equities closed in the green yesterday after Chairman Powell’s testimony gave us nothing new from his earlier testimony – no news was good news. Major banks passed the Fed’s stress test paving a path for dividend hikes and buybacks by the group.

Jumping the shark. Two outa’ three ain’t bad… especially these days. Well, we now have two up days over the past three, despite the entrance of a new market threat: recession. It is not that we haven’t all been thinking about the threat of recession, but once the Federal Reserve’s Chairman starts talking recession, we must really start to consider the possibility…for real. The stock market is an interesting character. It offers us the ability to measure our worth every millisecond from 9:30 AM to 4:00 PM every day except weekends and certain holidays. At each millisecond, many of us ponder opportunities to “make it big” while others of us watch our dreams of a comfy retirement go from good to bad to, hopefully good again. It is not a comfortable place for those with a delicate constitution. But, as I suggest often in this note, if one maintains a longer-term view while being prudent, one can reap solid rewards…without losing one’s, er… cookies. If you are able to step back and take a broader forward-looking view, you will notice that the markets are actually, quite rational. Let’s ponder this for a moment.

The most powerful banker in the world, just Wednesday, told us that there is a possibility of recession at some point in the future. As one might suspect, the stock and bond markets flew and flopped, to and fro, in response to the very mention of the word. Traders made and lost lots of money between the Chair’s testimony and the market close, as bonds rallied while stocks rallied and faded into the close. That intraday price action was in no way reflective of the value of any given stock in the future. Let’s go back to basics. A stock’s theoretical value is the sum of all its future cash flows discounted into today’s dollars. The key word in that valuation is: future…as in next year, the year after that, the year after that, and, in fact, in perpetuity. So, let’s assume that we actually end up in a recession in 2023 (next year). If we are considering a stock that has income exposure to a recession, we can assume that its income for next year may be slightly lower. But if you think back to that theoretical value from a few sentences ago, that recession is not likely to affect the company’s income in the “year[s] after that”…assuming that the recession lasts less than a year and that the company is solid. To be clear, I am not suggesting that if a stock moves down sharply on economic news that you shouldn’t take notice, but I am suggesting that if you are diligent in your research, you will improve your chances of long-term success. Further, as you will see, at some point, if not already, markets will factor in that potential recession and start to price in the future beyond. I hate to do this, but I must, to illustrate the point.

You may recall that during the worst part of the COVID crisis as companies were shuttering and people were dying, all seemed lost…the future looked bleak. But not for stocks, which were rallying. Many believed that the stock market was disconnected from reality, but it wasn’t…markets were already factoring in the recovery after the crisis. As more and more information bubbled in about the progress of vaccines, investors were able to ponder a timeline in which the world would return to some semblance of normal. This was not unique to the pandemic swoon. The same thing happened in every prior market shock. That is why, on average, the S&P500 has positive annual return, around +10.5% to be more exact.

These past several months have been trying, to put it politely. Markets had to digest high inflation, slowing growth, an aggressively hawkish Fed, and a war in Ukraine. Market volatility has been higher than what we have witnessed in a long time, and drawdowns have been eye-watering for most stocks, good and bad. Following the futures markets during the past several months you can see that the markets began to factor in more and more rate hikes and even the possibility of a recession. Just this week, the Fed Chair mentioned the possibility of a recession for the first time. He also mentioned that if the economy weakened, that the Fed would slow down the pace of its rate hiking…also for the first time. You know what also happened for the first time in a long time? Futures markets began to factor in lower rates…NOT HIGHER. That’s right, futures have lowered their year-end rate predictions by -25 basis points in the past 2 days. Will this shift persist and continue? Will stocks now begin to factor in the world beyond an economic downturn, high inflation, and higher interest rates? It is clearly far too early to tell, but it is worth noting. We are far from out of the woods at this point. The edge of the woods is not yet even visible, but if you are long-term focused, you will take some comfort in knowing that all woods have an edge.

YESTERDAY’S MARKETS

Stocks ended the session higher as the Fed added no new bad news, which was good news for stock investors, who took delight in lower bond yields. The S&P500 climbed by +0.95%, the Dow Jones Industrial Average rose by +0.64%, the Nasdaq Composite Index traded higher by +1.62%, and the Russell 2000 Index added +1.27%. Bonds rallied and 10-year Treasury Note yields declined by -6 basis points to 3.08%. Cryptos rallied by +4.88% and Bitcoin climbed by +4.73%.

NXT UP

• University of Michigan Sentiment (June) is expected to come in at 50.2, in line with prior estimates.
• New Home Sales (May) may have fallen by -0.2% after declining by -16.6% in April.
• Next week: we have more housing numbers, Consumer Confidence, GDP, Personal Consumption, PCE Deflator, and ISM Manufacturing. Check back in on Monday for calendars and details.