Volatility, deep drawdowns, bear market territory. For now, 2022’s markets are under water. Compared to recent market highs, the S&P 500 is at -23.5%, with the tech-heavy NASDAQ at -33.7%, and the Russell 2000 off by 32.4%.
A crippling combination of inflation, slowing growth, and a sharply hawkish Federal Open Market Committee (the Fed) is pushing markets lower. But have the markets reached “the bottom”?
The oversized impact of the Fed’s moves to collar inflation is at the center of the action. This month’s robust rate hike of 0.75% suggests it’s willing to sacrifice some growth to tame increasing prices, for now. But whether the Fed maintains this pace and when it will signal an acceptable compromise between economic expansion and contraction, are still unknown.
We believe the markets will touch bottom as these actions begin to converge. We see the bottom as less of an absolute price level and more of a process involving at least one of the following:
- Indicative economic data stops deteriorating
- The Fed pivots away from tightening
This is supported by historical data, in which every market low over the last 21 years has aligned with at least one of these conditions, if not both.
How Fed Tightening Moves Through the Economy
Historically, economic fallout from rate hikes has percolated through the economy more or less sequentially. The Fed’s impact is first seen in housing data, followed by factory ordering activity, corporate earnings, and finally, in the labor markets. And importantly, it can take a year or more for the full effect of tightening to weave its way through.
As the economy weakens, the markets generally bump their way down in kind. However, accurately calling when they hit bottom requires an understanding of where we are in the sequence. Alex Oxenham, Co-Chief Investment Officer, explains: “Given this cyclical framework, we rely on a disciplined, data-driven process to determine where we are relative to bottoming out.”
What the Current Data Says
Zeroing in on indicative economic data is a key part of the analysis, as it helps formulate a view on the direction and pace of things to come. And despite recent market tumbles, current data seems to indicate we may have some distance to cover before we reach the basement. Oxenham adds, “We probably have a ways to go yet.”
Here are a few examples that illustrate the point.
Current Housing Data
As expected, the impact of recent rate hikes appears to be present in current housing data. The NAHB/Wells Fargo Housing Market Index (HMI) is a composite index measuring current and future (six months hence) sale conditions in the single-family housing market.
On a scale of 0 to 100, with higher levels reflecting expectations for stronger sales, June’s figure fell to a two-year low of 67. Growth is still apparent but at slower rates.
Single-family housing starts, which measures new residential construction, is also starting to trend down.
NAHB/Wells Fargo Housing Market Index (HMI) and New Single Family Starts
January 1, 1985 to June 15, 2022
Source: NAHB/Wells Fargo Housing Market Index | U.S. Census Bureau.
ISM Manufacturing PMI
The Institute for Supply Management (ISM) Manufacturing PMI (PMI) is a monthly composite index of product demand based on U.S. economic production. The index includes survey data from more than 300 purchasing managers and is used as a proxy for broad economic activity. Levels 0-49 indicate economic contraction with 50 and above indicative of economic growth.
The index has been declining from a high near 65 in March 2021 but has remained in expansionary territory. May’s level even increased 0.7 to 56.1, suggesting demand remains relatively positive for the moment, even if the overall trend is slowing growth.
Consistent with the Fed’s rate hikes we expect to see continued declines at least through the level 50 threshold, signaling a shift to recessionary territory.
ISM Manufacturing and Services PMI
December 31, 2000 to May 31, 2022
Source: Bloomberg/Hilton Capital Management
You cannot invest directly in an index.
The Conference Board Leading Economic Index (LEI)
The Conference Board Leading Economic Index (LEI) is a broader composite index commonly used to forecast the strength of the business cycle. It includes 10 components across housing, new orders, consumer expectations, and market data.
Slowdowns in housing, economic growth, and consumer optimism have put the index on a downward trend, though nominal levels remain close to historic highs. Tightening monetary policy is expected to lead to further deceleration.
Conference Board Leading Economic Index (LEI)
December 31, 1974 to June 28, 2022
Source: Bloomberg/Hilton Capital Management
Corporate Profits
Current earnings data remains positive, though at significantly lower levels versus 2021’s double digit rates. This suggests companies will struggle to continue to pass on supply costs, a big factor in their 2021 success. According to American financial data and software company FactSet Research Systems Inc. (FactSet), Q2 2022 estimates for S&P 500 year-over-year aggregate earnings growth are expected to be 4.3%. And If it comes in as expected, it’ll be the lowest earnings growth rate reported by the index since Q4 2020 (3.8%).
Analyst EPS estimates for the S&P 500 were also revised downward for the second quarter by 0.9% (since March 31), but at lower than average rates of decline.
In short, the story at this point is mixed, though slower growth in the aggregate is here and gaining traction.
Labor Indicators
The current labor market remains tight, with nearly two open jobs for every worker looking for work. However, over time, we would expect to see signs of the Fed’s impact here, too.
By most accounts, wage increases haven’t kept up with inflation, and there’s still room in profit margins for wage raises. Both Apple and Microsoft announced pay increases in May, for example.
However, as profitability declines and cash reserves dwindle, we would expect wages to level off or declineーand layoffs to pick up. This would be reflected in the data as significant increases in jobless claims and Job Openings and Labor Turnover (JOLTs)一neither of which we currently see.
Recent data, while possibly turning upwards, is still at historic lows.
U.S. Initial Unemployment Claims & JOLTS
December 31, 2000 to June 17, 2022
Source: Bloomberg/Hilton Capital Management
Unemployment also continues to drop to historic levels, with a current reading of 3.6%. If the unemployment rate reverses course and starts to increase, that will signify that monetary tightening has run its course.
In effect, the economy will have bottomed out, which could prompt a Fed pivot, if not before.
What About Market Valuations?
Market valuations, such as price-to-earnings multiples (P/E), are often considered when determining the market’s floor. However, there can be limitations to relying on them exclusively. P/E multiples tend to lag earnings revisions, which can be misleading about “actual” equity valuations. This suggests that during periods of declining corporate profits, market valuations may be higher than they appear and are not necessarily indicative of a bottoming out.
Confirmation Comes From the Data
We believe an approach grounded in disciplined, data-driven analysis best enables us to identify when the markets are approaching their lowest levels. And our record of outperformance on the downside bears this out.
“Bear markets are notoriously unstable,” Oxenham contends. ”It may be tempting to wade in after a significant drawdown一and you might win for the week一but get crushed a week later.”
“Leaning primarily on underlying economic data and Fed activity provides more of the confirmation we need to act decisively and with conviction,” he concludes.
When that is, however, remains to be seen. As always, we will stay focused on what the data is telling us and seek to position our portfolios accordingly.
