The theme of our April 2021 Outlook & Trends likened the economic condition at the time to Bob Dylan’s song, “The Times They Are A-Changin”. Now, almost two years later, it has become clear that the economic “Times They Have A-Changed”. As the Fed withdraws its support, the economy and markets are likely to produce slower growth and more volatile investment returns.

The Economy

Observations of economic strength show many apparent contradictions and cross-currents. GDP grew at an annual rate of 3.2% in the 3^rd quarter of 2022. The real-time GDPNow estimate is suggesting that 4^th quarter growth will be 3.7%. These positive numbers are supported by the strong labor market, with a low unemployment rate of 3.7%, reflecting a condition where there are more available jobs than workers. In the past, this unemployment level has been seen only near business cycle peaks. As you are no doubt painfully aware, inflation has decreased purchasing power by 7.1% over the last year. High inflation is a sign of strong consumer demand. These are the marks of an economic boom.

At the same time, the manufacturing Purchasing Manager’s Index suggests the production of goods is slowing on both a domestic and global basis. Consumer confidence remains at levels usually associated with recession. The recent consumer price index for the last month showed a small increase in the inflation rate, only 1.2% on an annualized basis. These signs of a slow-down are echoed by the Conference Board’s Leading Economic Index, which has fallen for the last 9 months to a point that the Conference Board says, “continues to indicate a recession”.

The previously red-hot real estate market continues to cool rapidly. The national inventory of unsold homes has more than doubled since February. This is not surprising, because increasing mortgage rates have decreased home affordability by 55%, despite the fact that home prices have dropped by 10% from the recent peak.

These contrasting indications have the Federal Reserve Bank’s fingerprints all over them. The economic excess was caused by their “experimental” interest rate policy, which kept rates too low and money too available for much longer than necessary. The cooling-off process that we see now is due to their policy shift to increase interest rates and also reduce the available supply of money to bring inflation back under control. The seemingly inconsistent observable economic conditions are not mutually exclusive though, because there are time lags in the slow-down process. Tight money, initial inflation rate reductions, falling asset prices, and leading indicators all precede a recession. The eventual weakening of the labor market and business activity follows later.

The Markets

The stock market (S&P500 index) was able to produce a countertrend rally of 7% during the fourth quarter, leaving the index down 19.4% for the year. It was the worst year since 2008. Growth stocks, represented by the NASDAQ index, finished even worse, down 36%.  The Dow Jones Industrial Average, representing “value” stocks, dropped only 8%, but may be following the script from 2000 and 2001, when the value category rolled over almost a year after its growth cousins. At that time the delay did not help much, since this group finished that bear market down by 45%.

Last year’s results were not limited to stocks. Ten-year treasury bonds finished 19% lower than their peak in 2020. This performance nullified the usual volatility-reducing benefit of a typical 60% stock / 40% bond portfolio.  Bond prices drop when interest rates rise and vice-versa, so it is not surprising that the shift in Fed policy produced this result.

Despite the reduction in portfolio values and retirement savings, if this were a one-time, over-and-done occurrence, we could still perhaps gladly accept temporary lower market prices, because lower long-term valuations improve long-term return potential. But according to a number of long-term valuation indicators, stocks continue to be overvalued. One such indicator, Market Value/ GDP, popularized as Warren Buffet’s favorite indicator, suggests that a further drop of 23% would be required just to get back to a historically neutral trendline (and therefore historically normal return expectations). Similar measures that have a longer available data history suggest that the current valuation level is on par with or still above the 1929 market peak. While a bottom could occur at any time, the down trends currently remain in place and are likely to continue until after the Fed finishes its inflation work and a recession becomes noticeable.

The More We Learn, The More We Forget

Periods of gross overvaluation occurred in 1929, 1969, 2000, and 2021. Is it any coincidence that these periods are one or two generations apart? Human behavior, learning and forgetting occur in cycles. At the bottom of bear markets, after losing their nest eggs, the populace swears never to invest in stocks again. The lesson learned by one generation is not felt with the same intensity by succeeding generations. In an effort to gain votes, politicians loosen the restraints and controls put in place after the last bubble. The supply of money is increased to compensate for gradually lowering productivity. Easy money increases speculation and increases investors’ desire to make a “quick buck”. The progression is similar, whether it was the “nifty fifty” in the late 1960s, the “.com” stocks of 2000, or the “crypto” and “meme” stock themes of 2020.

The rally that occurred in the last quarter was likely a countertrend rally within a continuing downtrend. The probabilities favor this case if the Fed continues to reduce the money supply and raise rates as they have said they are determined to do until inflation is well under control. Why do these rallies occur? Over the last 10 years there have been several market drops in the 10 to 20% range. Therefore, for investors who expect that stock prices turn up after a decline of this magnitude, it makes sense to try to recognize a bottom and “buy the dip”. History shows that these “small” declines are far more frequent than large ones, so more frequently than not, this has been a good strategy.

But occasionally, especially after an economic bubble, less frequent large-scale declines can occur. Today, there are very few investors or advisors that were investing in the 1970’s. There are not even many who experienced the 2000 bubble and its following bear first-hand. There are, however, many who have only seen stocks go up and do not recognize what an extended bear market can do. Speaking of generational learning, I recall my father telling me from his experience, that the most investor money was not lost in the initial 1929 crash. It was lost by those re-entering on the subsequent countertrend rallies that eventually failed.

During those events, the “buy and hold” strategy did not work very well either. This strategy works when climbing a bubble, but can backfire in a grizzly bear market. It took 23 years for the S&P500 to regain its former value after the 1930’s bear market. In 1980, stocks were at the same level as 1968. It took until 2013 to leave year 2000 prices in the dust. All these periods started with significant long-term overvaluation, like today. Long-term valuation matters.

During long-term bull markets, the stock market is thought of as a great money machine. To the extent that the gains come from economic improvement and productivity growth, the gains can be durable. If the gains are due to government money creation (Fed policy and administrative deficit spending), some or all of the returns may prove to be illusory in face value, inflation-adjusted value or both. The problem is that people may not understand that they are only experiencing part of a repeating cycle. Due to this “recency bias”, there is a tendency to think that recent experiences will continue forever, unless one has longer term knowledge to counteract this expectation. It is worthwhile to develop a good strategy that considers all the possibilities, not just the most recent.

The future is unknowable, but it is clear that following a financial plan and strategy that actively considers the possible outcomes and adjusts accordingly as events become clear is important to keep your finances healthy.