The S&P 500 is up 17% since June 16th, yet market fundamentals seem to be deteriorating. Profit margins are falling, consumer price inflation is still high at 8.5% year-over-year, higher interest rates are slowing down many sectors of the economy (especially housing), and we may have a recession.
Bulls are looking many months ahead and betting on a soft landing, peak inflation, and good corporate earnings. They are focusing on ‘green shoots’ – lower inflation, rising leading economic indicators, and better stock market breadth. They know that stocks do well in high, but falling inflation environments. There is a lot that has to go right to justify this rally. We agree this scenario is possible but maybe not the most probable. It wouldn’t take much to slow this rally, in our opinion. At 18x 2023 earnings, the stock market is not cheap.
We are not bearish, but rather think visibility here is as clear as mud. There are a number of possible outcomes over the next 12 months for the economy, inflation, interest rates, and, of course, stocks.
Corporate earnings announcements have been generally strong but guidance has been weak. EPS beats have been rising despite high inflation and lower margins; revenue beats are slowing but remain impressive at more than 70% of reported companies. Overall, the numbers have been surprisingly good given how strong results have been since Covid hit.
The problem is future guidance, which has been uncertain at best compared to ‘normal’ times. Corporate sentiment/guidance during earnings calls sank last week with a similar year-over-year decline in 2008.
There are multiple high-profile areas of concern: AT&T flagged delayed bill payments. Netflix lost subscribers. Homebuilders discussed how the surge in mortgage rates has started to slow the housing market. Snap highlighted headwinds on digital advertising spending that could have implications for the big tech names.
We don’t expect corporate CEOs to have a crystal ball. Nobody can predict the future with certainty. As we mentioned earlier, the future is very murky now which makes the investment landscape much more difficult.
Our fixed income strategy is simple: we stay with short and intermediate-term maturities. We have stayed on the short end of the yield curve the last few years because we expected interest rates would eventually rise. And we stay with high quality. Not only Treasuries but high quality corporate notes and bonds (rated ‘A’ or better) in taxable accounts as well.
Here is why we stay short-term: over the last year long-term. Treasuries are down over 17.5%, and the two-year annualized performance is a decline of 14.2%. That is a cumulative decline of 26.4% – in Treasuries! Longer-term, the performance of long-term Treasuries is abysmal with annualized gains less than 2% over the last five and ten years, and just 5.2% over the last 20 years.
Shorter-term bonds have less interest rate risk; that is, they don’t fluctuate in price as much as long bonds when interest rates rise (or fall). There is more price stability. And the yield spread between corporate bonds and Treasuries is enough to take the very small default risk, in our opinion. We will continue with the same fixed income strategy, especially with the Fed tightening and short-term rates likely to rise further.