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  • Writer's pictureJoshua Henry

December 01, 2023: Market Note

Following a poor 2022 and strong start to the year 2023, beginning in Jul 31 the US stock market began to sell off. That was followed by a bad Sept and Oct (which are seasonably bad months) for a total pullback from the Jul 31 high of over -10.2%.


The bond market also did poorly over roughly the same period. That has since been followed by a rally beginning at the end of October following through to the present in both the bond and stock markets. I don’t want to lean too much into seasonals, but this wasn’t particularly surprising because late October (the 27th if we have to pick a date) usually marks the end of what is a seasonably negative period of Sep – Oct. As of this writing, 90% of the S&P 500 is above its 20 day moving average which is a short term bullish (positive) indicator.


Let’s consider 2 major data points and then 1 major point of context.

1. Inflation is coming down which is good for stocks, bonds and consumers. The most recent consumer Price Index (CPI) released showed a year over year increase of 3.2% (down from a high of 9.1% in June of 2022) and a month over month rise of 0.0%. The Producer Price Index (PPI), which leads the CPI contracted -0.5% for the month.


2. Growth has been strong (Q3 GDP grew at a 5.2% rate), but GDP is a historical number and growth is beginning to slow and could slow more early 2024, potentially even cross over into a recession. Retail sales slowed year over year and contracted month over month. Unemployment has also ticked up. The reason why this slow down has taken longer to happen than consensus expected is probably because a lot of households still had COVID cash on their household balance sheets and employment was stronger than expected for longer than expected (and those two items could be related).

The other issue is Leading Economic Indicators (LEIs) when they first turn negative) portend events many months out into the future and tightening monetary policy has long lags and often doesn’t translate into an economic recession until an average of 8 months after the last rate hike (in a rate hike cycle) by the Federal Reserve. The LEIs have a good record of forecasting recessions but they are not good timing tools. The index of LEIs peaked 21 months ago and it been down for 18 straight months.


3. So the larger context is that the price of investments matters to returns, and bonds and stocks are cheaper than they were in the very beginning of 2022, which was almost two years ago.

We are nearly two years further into the future than we were in the beginning of 2022 and while there are business cycles, over time corporate earnings improve and trend upwards so the future either has higher earnings or is closer to when higher earnings are realized than the past. As such, current valuations for stocks (i.e. prices that the market is willing to pay per dollar of company earnings) are more attractive now than 2 years ago. It doesn't mean we couldn't go into a downturn in 2024 if the economy slows down but it simply means that from a valuation perspective and a fundamental basis which matters to investors (as opposed to traders), stocks are better priced now than they were two years ago and as such investors are on more solid ground than they were two years ago. Bonds have also begun to rally after a difficult few years. In the intermediate term, bonds represent good values even though on a longer term basis, their value is questionable because of high federal government fiscal defi-cits. Political leaders will need to address the deficit for the health of the federal fisc, for the sustainability of entitlement programs and in order to issue bonds at reasonable rates of interest.


What do we do with that information? A reason to continue to hold some combination of stocks and bonds is (as we said before) they both represent better values now than they did in the last 2 years. If we had a 2024 recession, bonds could go a long ways towards buoying a portfolio making this time tested combination of asset classes still appropriate. We never know which asset class is going to perform better than the other in a short to intermediate term and if one goes down, the other is likely to go up partially offsetting poor performance in the other asset class.


That is because most times throughout history, stocks and bonds have negative correlations (i.e. they move in different directions), which results in a higher level of risk adjusted returns and less portfolio volatility, which is key to investors when they get close to the point at which they begin taking distributions. Furthermore, a reduction in portfolio volatility is often something from a psychological standpoint people closer to or in retirement want to reduce. The objectives in the distribution phase are different than in the accumulation phase and swinging for the fences is often not appropriate during the distribution phase.


One thing that is really important to note and to understand why bonds are important to hold is that generally in recessions, when growth goes negative, inflation decelerates, interest rates go down, and fear increases, there is a desire to move toward “risk free” investments or “risk off” investments. High quality bonds are usually top on that list, particularly US Treasuries or agency securities. One often quoted market strategist and Senior Managing Director at Virtus Investment Partners, Joe Terranova has noted recently that if we experience an economic contraction in 2024, bonds will return 10% which means in a sense bonds are a recession hedge that offset losses on the equity side of the portfolio during a possible recession.

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