Investors & Friends,
We are pulling forward our quarterly letter by a few weeks as we know many clients and subscribers are watching the market volatility of the past few weeks with nervous consternation. For good reason, it has been the 5th fastest correction in 75 years and we had 16 straight days with intraday Nasdaq declines of 1% or more.
We had also gone 343 trading days without a correction, nearly double the historical average of 173, and at the end of last month the price-to-earnings multiple of the S&P 500 was 25x, well above its long-term average of 16x. In other words, we were due.
Market corrections of -10% happen in 64% of years since 1928, or every 1.6 years.
Buckle up, a lot of charts for you this quarter!
Let’s start with an excerpt from a recent note by LPL Financial’s Chief Investment Officer, Marc Zabicki.
… The Trump Administration’s tariff policies have introduced some unease among market participants. Are those policies negotiation tactics or are they part of a new governance framework? The answer appears to be a little of both. Is that framework clearly and sustainably inflationary? We believe it is premature to say, as past data does not seem to draw a straight-line conclusion to that effect. Will the action cause the economy to weaken materially? Again, that is probably too early to conclude, but it does cause further unease around economic indicators that have been showing some slight signs of weakness for some time. … it is often not the current level of any indicator, but the directional change in that indicator which eventually causes markets to take note.
So, what are some of the economic indicators that Marc mentioned have been showing signs of weakness already.
For starters, household debt delinquencies have ticked up. It is also important to note that the large-scale deferment of student debt has ended, which will likely lead to further stress on the cash flows for lower and middle-income households.
And a rising percentage of those pandemic era sky-high car payments are no longer sustainable as excess savings has worn off. Highest car payment delinquencies in at least 40 years.
The mortgage refi rejection rate has jumped, indicating either deteriorating consumer credit or heightened lending standards. Either one points to slowing economic activity.
Consumers worried about losing their jobs are now at levels normally seen during recessions.
Looking at corporations, the capital expenditure plans of the manufacturing survey done by the Philadelphia Federal Reserve shows a stark decline since the beginning of the year. Companies are holding back on investing in property, plant, and equipment until they have further clarity on policies coming out of Washington.
The bond market is typically regarded as the “smart” market, and when high yield bond spreads increase significantly above Treasuries, that is generally taken as a sign of deteriorating economic expectations.
But as is often the case with economic data, a different perspective tells a different story. Zooming out on this chart above and we will see that the recent trend is up but the absolute level of spread is still well below historical averages.
One of our favorite analysts, Ed Yardeni, who has been spot on these past few years with his forecasts and came into this year expecting significant upside said the below in a recent note.
He reduced his S&P 500 2025 year-end forecast by 8.5%, but that is still a 14% increase from where we are as of writing.
And finally, it looks like the post-pandemic revenge travel season is officially over. This has been confirmed on earnings call with the airlines and travel companies. They are seeing softening demand.
So, clearly economic activity is slowing down, and we have been overdue for a market repricing, but should that be surprising? Not really. Our post 2008 Financial Crisis GDP growth trend has been 2ish% and since the pandemic we have been closer to 3ish%, so a slowdown back to pre-pandemic growth was entirely predictable, healthy, and serves as a hopeful sign that inflation will continue to cool along with growth.
And while there have been fits and starts in that inflation data, the trend is still down. Slowing growth should help. In fact, this is exactly what the Federal Reserve has been trying to do, slow the economy without putting it in to recession.
While the headline indices have corrected 10-15%, underneath the hood the average stock in the wider Russell 3000 is actually down more than 30%, indicating that most stocks have already significantly corrected, and that could signal things have run their course.
Oh, and the doom and gloom headlines? Well, you can generally ignore them. The US equity market is up 58% since these gems hit the tape in October 2022. None of these people are ever held accountable to their predictions.
What we know is that the trajectory of our economy is less certain today than it appeared three months ago and the market is reflecting that reality. The biggest cause of that change is the trade policy coming out of Washington, with significant escalations in tensions with all three of our largest trading partners. The scope of this trade battle is much wider than it was in President Trump’s first term. Many analysts (including me) didn’t expect the breadth and velocity with which these tariffs have been put in place.
How these disputes evolve and how long they take to resolve will be key drivers of market sentiment over the balance of the year. If you want the full timeline, the Peterson Institute for International Economics has a good breakdown here.
But good luck to anyone trying to parse through this and make major trading or investment decisions around it.
What we can do is look at some historical comparisons of similar market and sentiment readings to see how things have fared in the past.
The Nasdaq index closed at the low last week more than 3 standard deviations below the 50 day moving average. That is a significantly outsized move and is commonly called an “oversold” condition. Going back to 1985, the average forward one year return under those circumstances has been 26.87% and the index has been up 90% of the time.
For stocks to stay down double digits on the year, there is almost always a significant negative catalyst. In other words, years like that generally don’t happen without an outside shock. A prolonged global trade war could qualify but we aren’t there yet.
With all of this in mind, it isn’t surprising that investors aren’t feeling particularly optimistic right now. But just how negative they are caught me by surprise.
Bearish sentiment by the American Association of Individual Investors survey has been above 55% for four straight weeks, eclipsing the three-week record set during the depths of the financial crisis in 2009!!
I mean, things have been a little tumultuous but wow, the unemployment rate in March 2009 was nearly 9%! Extremely bearish sentiment has typically been a good contra-signal. By the way, March 6th 2009 was the market low.
And that is what the data tells us. Periods of highly bearish sentiment typically result in above average forward returns.
And finally, another way to look at a similar thing is the Policy Uncertainty Index.
More good news for balanced investors is that it appears that the diversification benefit of owning bonds is back, with most fixed income indices up on the year, providing that ballast to an equity market portfolio that we have historically been used to.
And diversified investors have had things in their portfolio’s that have been working while the US equity markets go through their correction. Developed international stocks, emerging markets, and gold are all up solidly on the year.
Any precious metals referenced are being presented as a proxy, not as a recommendation
Another source of the general unease stems from the rapid pace at which the administration is reshaping the federal government’s workforce and scope of activities. There is no doubt that it will have an impact on the unemployment numbers in the coming months, both through direct government positions but also the large number of contractors that do work on behalf of the government that are seeing that cash flow turned off.
I won’t claim to know what the right approach should be, but I do know that running a 7% deficit as a percentage of GDP during peacetime and absent a recession is a recipe for disaster. The first years of the pandemic understandably warranted a large fiscal and monetary response, but we absolutely must reign back in government spending and not make crisis levels of outlays the normal course of business. We are adding a trillion dollars to the debt every ninety days at present.
Coming into the year the market was priced for perfection and while policy uncertainty will likely remain a headwind for much of the year, our expectation is still for tariffs to ultimately not be a permanent feature.
And if you are still thinking that you want to step aside and wait for calmer waters, it is crucial to remember that if you miss just the best two days of the trading year, you might as well invest in Treasuries. If you miss the 5 best days you are better off with money stuffed in your mattress. No one can reliably time these peaks and valleys over full market cycles and the biggest up days tend to cluster around the biggest down days.
What times like these are good for is to revisit and reconfirm your allocation with your advisor, perhaps rebalance your portfolios, and to evaluate that allocation in the context of your unique circumstances and goals. In periods of volatility, zooming out for some higher-level perspective on your overall financial plan is often the most prudent step.
With abundance,
Zachary S. Mineur CFA, CFP®
Chief Investment Officer
Independence Square Advisors
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