Monthly Outlook: October 2022
We’ve avoided a lot of the market decline this year by avoiding stocks. That sounds simple or obvious, perhaps, but it’s a big decision that most money managers won’t make. Our iFolios strategy is a trend-following strategy with rules-based signals that tell us when to buy for growth and when to sell for protection. Following our signals, we have been massively underweighted stocks for the past six months. As a result, we’re beating market benchmarks by 10% or more, YTD. As we sit in protection mode, our managed portfolios are moving sideways as the markets, and buy-and-hold portfolios, gyrate lower.
Federal Reserve Chairman, Jay Powell, looked right into the camera after their most recent Board meeting on September 21st and told us that the Fed will use its tools to act as a brake on the economy and quell inflation. At least, that’s what we thought he said. Did he mean break the economy? We’re starting to wonder. As stubborn as inflation is proving to be, it just might take a more serious economic break to re-set prices.
Markets loved loose monetary policy for the past ten years or so. And as we’d expect, markets do not like tighter monetary policy, at all. Nearly every market, or asset class, remains downtrending this year. The S&P500 lost another 9.2% in September and is now down 23.9%, YTD. The tech-heavy NASDAQ is down 10.5% and 32.4%, for the MTD and YTD. Tighter money is a global issue now, and international stocks are down, too: -9.7% and -26.2%, for the MTD and YTD. Bonds are not immune, either, due to the Fed’s rate hike program. Bonds are down -4.2% and -14.5%, MTD and YTD. Where is an investor expected to go? The only safe haven is Cash.
Will the Fed’s Tightening Policy Work?
With Fed Funds now at 3.00% (up from 0.00% just six months ago), we would expect to see some weaker economic data from such tightening. The Fed has promised even more tightening, projecting the Fed Funds rate will rise to 4.00% by early next year, plus their plan to shrink their $9 trillion balance sheet by $1 trillion/year. The takeaway is that the Fed (and other global central banks) have reversed course in 2022 and are now executing very significant monetary tightening programs. It reminds me of the expression, “the floggings will continue until morale improves.” The Fed is effectively saying, “rate hikes and tighter money will continue until inflation is tamed, even if it means breaking the economy to do it.”
So far, we have only seen mild signs of an economic slowdown. Retail sales, industrial production, homebuilding, and energy prices are only starting to decline. But labor continues to be strong, with only minimal layoffs and a slight uptick in the unemployment rate, from a 40-year low of 3.5% to 3.7%. Remember that monetary policy is primarily a tool to affect demand (for money and credit). It’s not very effective at altering the supply, either of stuff or labor. To break the inflation cycle, we need to see an increase in the supply of “stuff” and willing workers and/or a decrease in the demand for goods and services and the need for employees. A recession would do the trick, and the Fed knows this, though they can’t quite say it.
With Stocks Down 25%, Isn’t it Too Late?
With stocks down 25%, YTD, outside investors ask us, “Well, it’s great that you’re out and not losing, but now it’s too late to sell. We just have to hold on and hope, right?” Nonsense, it’s never too late. The Fed still has a lot of work to do, the price trends remain down, and no one knows how low this bear market will go. We would use any rally to reduce exposure to stocks, as long as the price trends remain down. It’s entirely possible that stocks will slide 30%, 40%, and even 50% before this bear market gives up. By raising cash, you’ll protect from further losses, and you’ll be ready to invest for growth when the next uptrend comes, and it will come. In uptrends, it’s wise to buy the dip. But in downtrends, like now, it’s best to sell the rally.
On a positive note, we are seeing a glimmer of hope for bonds, especially U.S. Treasuries. Even though the Federal Reserve is raising short-term interest rates, longer term rates may have peaked for this cycle and could move lower as the economy rolls into recession. If so, high-quality bonds could provide some stability and modest returns to portfolios. For now, it’s best to stay protective with Cash, some Bonds, and minimal Stocks.