For more than a decade, Wall Street and the Federal Reserve had seemed like they would be best friends forever, but no longer. Like a romantic relationship gone bad, the Fed, once Wall Street’s main squeeze, is now viewed with fear and loathing by investors.
It’s no surprise why this relationship has turned toxic. Central banks (CBs) globally are hitting the panic button on interest rates, with rate hikes coming fast and furious. The U.S. Fed has raised short-term rates from near zero percent to 3.25% currently, and have been joined by Australia, Europe, Britain and most other free enterprise countries in the rate raising frenzy. Japan, the outlier among major developed economies, has mysteriously remained committed to a near-zero interest rate policy, which has pushed the yen to a record low against the dollar and prompting the first intervention to support the currency since 1998.
Inflation is of course the cause of this panic, as prices are rising due to supply constraints, a leap in energy prices, and, not least, the CBs decade-long hyper-stimulus program of money printing known as “quantitative easing” (QE). Central banks had been lulled into complacent apathy over the last decade-plus as their stimulus efforts did little to lift consumer good inflation, though it did wonders for asset price inflation, such as real estate. Regrettably, not a single CB has admitted its QE policies have been a key contributor to the inflation dilemma we now face.
Wall Street, too, had been lulled into a state of hypnosis by the never-ending stream of liquidity provided by global CBs. These sleepwalking bulls are now reckoning with the abrupt realization that the QE era was the abnormality, and that the current interest rate environment more accurately reflects financial reality.
Over the last 13 years, investors had gotten accustomed to V-shaped bottoms defining stock market lows, as they could reliably count on the Fed to open the spigot of liquidity to stem market declines. But now, with the focus solely on controlling inflation and correcting their hapless QE policies, Wall Street can no longer count on the Fed to bail them out. We are moving back to an era where financial fundamentals again dominate investing decisions as monetary policy normalizes at higher interest rate levels.
For most of the summer, Wall Street had been peddling the narrative that the Fed would recognize the risk of triggering a recession and “pivot” to much more gradual interest rate hikes, or even (in Wall Street’s dreams), begin to cut interest rates. Alas, this proved a false narrative as the economy has held up well in many respects. Job creation has remained stable, and industrial production and retail sales have maintained positive (albeit slow) momentum, all pointing to the Fed sticking to its guns on rate hikes.
With that last hope of a “pivot” now gone, investors are also hitting the panic button. Stocks and bonds have endured a brutal month in September, which has lived up to its seasonal reputation as the weakest month of the year. Spurred on by the relentless drumbeat of negative headlines, investors have headed for the exits.
Just how profound the selling has been is evident in the charts of our old friends, the NYSE advance/decline (a/d) line and the NYSE Bullish %.
We highlighted the upturn in the NYSE a/d line in recent Market Outlooks as a source of hope for battered bulls. It turns out that hope was premature, as the summer rally reversed course and broad selling generated a sell signal in both the daily and weekly (shown) versions of the a/d lines.
The NYSE Bullish %, compiled by Investors Intelligence (www.InvestorsIntelligence.com), measures the percentage of stocks on the NYSE that are on buy signals, as measured by their point-and-figure (p&f) charts. The NYSE Bullish % has succumbed to the weight of selling and as of this writing has moved to a bearish sell signal.
It takes a lot to turn these measures around, and once reversed, they tend to persist in the prevailing direction of their p&f signals, which is now “down.” With these key indicators in negative modes, investors should take a cautious approach with any new stock buying.
With these reversals of fortune, are there any silver linings investors can look to? We believe there are, though they may not provide immediate balm for the short term.
First, margin debt is falling. Rising interest rates are making it more costly to finance leveraged positions in the stock market. Leverage (borrowing) increases the risk of an abrupt sell-off as falling prices generate “margin calls,” which in turn can reinforce panic selling in a declining market. Indeed, this is part of the problem today, as aggressive investors and hedge funds employ leverage to squeeze profits out of an increasingly stingy market. The decline in margin debt is lowering the risk profile of the market, reducing the odds of a financial “accident.”
Second, genuine value is starting to appear in various sectors of the market. The continuing bear market is lowering prices faster than earnings fall, thereby lowering the price-to-earnings (p/e) ratio of most stocks. The grossly overvalued state of stocks is moderating, creating some attractive buying opportunities. While aggregate index valuations have not gotten to “cheap” levels, under the surface many individual stocks have reached historic low valuations. However, investors should be very picky about their buying given the message from the NYSE Bullish % and a/d line discussed above.
Value is grudgingly returning to the real estate market also. The latest Case-Shiller real estate index showed a marked cooling in single-family home prices, as higher mortgage rates took their toll on buyer willingness to pay ever higher prices for homes. Hopefully, this will bring prices back to some level of affordability for young families.
Third, TINA has died. TINA is the acronym for “There Is No Alternative” which was the widely touted mantra during the QE era that investors used to justify abandoning bonds and money market funds in favor of stocks. TINA led to a massive over-allocation to stocks, even among conservative investors.
With bond yields now breaching the 4% level, TINA no longer holds—there finally is an alternative to stocks! Traditional CD and money market investors made the greatest sacrifice under QE, as yields were often under 1% for over ten years, not even keeping up with the low rate of inflation over that span. While 4% yields don’t fully compensate for an 8% inflation rate, they are closing the massive gap that existing at the start of 2022. Bonds now provide some genuine competition for stocks, and we should expect to see a gradual reallocation toward fixed income as investors acclimate to higher bond yields.
Finally, the Fed’s resolve to keep raising rates is putting to rest Wall Street’s needy codependence that it always needs to be rescued by the Fed’s liquidity injections. This “save me from myself” attitude has cultivated a whole generation of advisors whose sole strategy is to buy the dip, predicated on the assumption that the Fed (until now) would truncate any bearish trend. They have lost the ability to actually perform financial analysis for the benefit of their clients, substituting passive index investing for analytical skills.
The panic of central banks is understandable, as they seek to atone for their hubris of the last 13 years, and financial media headlines make the rise in interest rates sound like the end of the world. For highly leveraged investors it may be, but for the rest of us this is a new chapter in financial history. We should welcome a return to normality in the financial markets, though the adjustment from the QE era has clearly not been easy. Interest rates at “normal” levels will help bring all risk assets into better balance and give Main Street investors more sustainable, if perhaps less exciting, returns in the future.