Stocks are still well above long-term averages … how might it resolve? … new challenges on the inflation front … get your portfolio rock-solid today

Our offices will be closed tomorrow given the market holiday of Good Friday.

If you need help from our Customer Service team, they’ll be happy to assist you on Monday when we reopen.

Have a wonderful Easter weekend.

***The stock market likes balance

Things can be out-of-balance for a long time – that’s the basis for the old investing saying: “The market can remain irrational longer than you can remain solvent.”

But eventually, the market migrates back toward a position of equilibrium. In this case, we’re talking about long-term averages.

Today, it appears the markets are beginning to edge back toward greater balance. And while there are pockets of the market that will continue to treat investors quite well (we’ve been tracking them here in the Digest), the “average” stock is likely to face some headwinds as this balancing act continues.

What this means is that we’d all be wise to scour our portfolios today and prune any stocks that we’re not explicitly bullish about in today’s environment.

***Let’s look big-picture at a few charts

Below, we look at a chart of the S&P 500 over the past 12 years.

I’ve added two trend lines: The solid-blue line attempts to fit the S&P’s curve from 2010 through 2020 (while extending through today as well).

The dotted-blue line attempts to fit the period from 2020 through today.

Notice that the angle of the dotted blue “past two-year” line is vastly steeper than the angle of the solid blue “past 12-year” line.

Now, from a basic logic perspective, are stocks more likely to return to the balance of their long-term 12-year trendline? Or are they more likely to zoom higher and maintain the much steeper growth curve that formed from 2020 through 2022?

If you answer, “stay with the steeper curve,” okay. But based on what?

Remember, long term, stock prices reflect earnings strength. As we stand today, we’re dealing with the worst inflation in 40 years. It’s impacting consumers’ wallets and by extension, and it’s only a matter of time before that translates to corporate bottom lines.

In fact, yesterday marked evidence of such earnings erosion when JPMorgan reported on its 1st quarter performance.

The company noted that profit had fallen sharply from last year, and CEO Jamie Dimon said he saw “significant geopolitical and economic challenges ahead due to high inflation, supply chain issues and the war in Ukraine.”

Meanwhile, in an effort to maintain profit margins, Amazon just announced it’s tacking on a 5% surcharge for added fuel and inflation costs. This will be applied to 3rd party vendors who sell on Amazon. You think those sellers will just eat this cost or pass it along to buyers?

Is that the kind of earnings atmosphere that’s going to support an irregularly steep stock growth curve as a new normal?

By the way, some of you might be asking yourself: “If the S&P were to fall from its current value down to where it would be had it continued its 12-year growth curve, where would that put us?”

Ballpark, that would put the S&P around 3,850, which would be 13% lower from here.

And again, that drop would reflect nothing more than a return to long-term balance. No recessions or even mild economic weakness would be needed as the basis for such a decline.

***Now, let’s do the same thing with the S&P’s price-to-sales ratio

Same as above, we’ll look at the long-term trend line beginning 12 years ago, as well as the more recent two-year trendline.

Once again, a stark contrast.

So, what seems more likely? Prices fall back to long-term averages relative to sales? Or we’ve begun a new era marked by a far higher price-to-sales multiple that supports this steep angle for years to come?

If we look at the S&P’s price-to-book-value, we see the same thing:

Okay, so we know that what’s been happening is irregular, but what’s behind it? And can it be excused?

***Analyzing the pig in the python

There’s an argument that the steep angles in the charts above since 2020 reflect the trillions of dollars that flooded the U.S. economy in the wake of the pandemic through relief programs and stimulus money.

Basically, though many Americans used their stimulus dollars for basic living expenses, many others didn’t need it. So, they funneled it into the stock market and/or economy.

Additionally, as lockdowns drastically lowered monthly expenses for millions of Americans, those added savings made their way into the market or the bottom lines of corporate America.

All of this artificially steepened the growth curve of the stock market.

It’s a reasonable theory. Let’s go with it and assume it explains things.

First, as we stand today, the Fed appears dead-set on stomping out inflation, which means removing excess liquidity from the market.

If they’re not all talk, this will begin to tighten the previously loose monetary conditions that have enabled this sea of capital to flood stocks.

Second, the government has largely turned off the “free money” spigot at this point – at least to the eye-popping degree we saw in the immediate wake of the pandemic.

Put these two things together and it appears we shouldn’t expect the replenishment of the sea of capital required to support a sustained “extra steep” stock market curve.

Now, the optimistic investor might say: “Okay, well, that just means that the S&P’s growth curve levels off in its steepness and returns to its long-term average slope. Prices don’t have to crash.”

Below is how that might look. Please excuse my crude artistry.

This “return to normalcy” takes the form of the new green dotted line. It parallels the slope of the S&P’s long-term solid-blue growth curve line.

The difference is it starts at today’s S&P level. It assumes stocks won’t have to fall back to their long-term average levels.

This hypothetical basically assumes that the huge gains in the S&P since 2020 were a “freebie” and we just pick up with average growth from here.

Now, could this happen?

Sure – let’s hope it does.

But it didn’t happen during the inflationary period in the 70s. And the stock market rarely hands out freebies.

So, what’s going to happen?

There’s one big clue to watch.

***The biggest influence on what’s going to happen here is the health of the American consumer

Consumer spending makes up about 70% of the U.S. economy. So, as the U.S. shopper goes, so too does the economy.

And since, long-term, the stock market reflects earnings, which reflect the shape of the economy, it underscores the importance of the consumer.

Today, we need to be careful of a souring consumer mood.

According to the latest CNBC All-America Economic Survey, 47% of the public say the economy is “poor.” That’s the highest number since 2012.

Meanwhile, only one in five Americans say they are “getting ahead.”

Most troubling is that 56% of respondents believe we’ll see a recession in the next year.

Now, on one hand, this sour mood might be a great contrarian indicator for the stock market in the near term.

We’ve highlighted research from Luke Lango on this very point suggesting that the market tends to rally after such negative sentiment readings. This is one reason we’re not giving up on stocks today.

However, longer-term, this gloom threatens to present a self-perpetuating cycle of negativity…

Consumers who believe the economy and their personal financial situations are in bad shape stop opening their wallets because they believe worse conditions are coming… closed wallets slow down the economy… a slow economy hampers wage gains and hirings… reduced wage gains and hirings leads to increased consumer negativity… which further tightens wallets and so on…

It’s a downward spiral.

Now, the hope is that somewhere in that cycle we reach a sweet spot. Growth slows just enough to tamp down inflation without hurting the economy, at which point the Fed takes its foot off the gas.

It’s the “just right” Goldilocks sweet spot.

But inflation and the effects of interest-rate changes don’t instantly appear in the economy. There’s lag time. This increases the risk of a foot on the accelerator for too long.

Plus, the fight against inflation is suddenly running into two new issues that could give the Fed a reason to keep its foot on the gas.

***The Russia/China inflation problem

Here in the Digest, we’ve spilled lots of ink detailing the global food inflation problem that’s growing worse due to the war in Ukraine.

The world is – and will continue – to see elevated food prices due to the war that’s showing zero signs of ending.

Well, we can add to this a new problem that’s fanning inflation…perhaps a bigger problem.

It involves China, its zero-COVID policy, and the ensuing implications for global supply chains.

From CNBC:

Many goods are stuck in China right now as a result of the Covid lockdowns and it could become a “big problem” for the global economy, according to business consultant Richard Martin.

“Many of the things that we use around the world that’re manufactured, have components from China and we’re about to see a logistics snarl that’ll dwarf anything in 2020 or 2021,” Martin, managing director at IMA Asia, told CNBC’s “Street Signs Asia” on Tuesday.

“China is 20% of global demand but its role in supply chains is much bigger than that.”

The article explains that the Chinese provinces where there’s a partial or full lockdown cover roughly 40% of China’s GDP.

Keep in mind, this just represents the goods that are manufactured by China (and by extension, the impact on finished goods finding their way into stores around the globe). It doesn’t reflect the bottleneck in Chinese ports due to lockdowns. That’s a whole separate nightmare.

Here’s Bloomberg on that:

Queues of vessels carrying raw materials have jumped after Shanghai initiated a city-wide lockdown at the end of last month to combat Covid-19.

More than two weeks on, the congestion has expanded to nearby Ningbo-Zhoushan as ship-owners desperately divert ships to other ports in the country to avoid the trucker shortage and warehouse closures in Shanghai.

There were 222 bulkers waiting off Shanghai as of April 11, 15% higher than a month earlier, according to Bloomberg shipping data.

At Ningbo-Zhoushan there were 134 carriers, 0.8% higher than last month, while further north, the combined ports of Rizhao, Dongjiakou and Qingdao saw a 33% increase to 121 vessels.

The longer China shuts down, the greater the new disruption to already-wobbly global supply chains. And that puts even more pressure on inflation…

…which sours the mood of the American shopper… which closes up wallets… which impacts corporate bottom lines… and so on and so on.

On this note, headlines today are that Chinese President Xi says that China must stick to its COVID-zero policy even as the costs mount, saying “prevention and control work cannot be relaxed.”

***By the way, one quick macroeconomic note on the health of the American shopper

Here’s CNBC to explain:

Consumers ended 2021 with record levels of debt, leading into a year in which interest rates are expected to rise substantially.

Total U.S. consumer debt at the end of the year came to $15.6 trillion, a year-over-year jump of $333 billion during the fourth quarter and just over $1 trillion for the full year, according to data released Tuesday from the Federal Reserve’s New York district.

So, every time the Fed jacks up the fed funds rate to fight inflation, it’s also hurting the consumer’s financial health.

But the Fed appears adamant about killing inflation.

And so, we’ll repeat the quote from market researcher Jim Bianco, which we highlighted earlier this week in the Digest:

It will be 50 [basis points] all the way through until the Fed basically raises rates too much and breaks something.

And, then they’ll be done.

***We’re running long, so let’s wrap up

The insane stock-market growth we enjoyed coming out of 2020 reflected a moment in time in which many Americans were flush and turning to the stock market.

But the tailwinds which pushed those gains are fading.

Now, this doesn’t mean stocks have to fall. But what it means for sure is that you must be far more deliberate about what’s in your portfolio today.

If the market does leg lower, you can expect fundamentally strong stocks to bounce back, but weaker imposter stocks to flounder.

Why not scour your portfolio for those imposters today and get them out before we see a major drop?

In the meantime, keep your eyes on U.S. consumer sentiment and the Chinese lockdown situation.

We need sentiment to rebound and China to reopen. If not, the headwinds will only be getting stiffer.

We’ll keep you updated.

Have a good evening,

Jeff Remsburg