Finance

Is this stock market volatility rational, and will it ever end?

By David R. Guttery, RFC, RFS, CAM. President, Keystone Financial GroupTrussville Al. May 26, 2022

The ongoing volatility of the stock market does make sense based on the general rules of economics. When thinking of economics as financial physics, there is a cause-and-effect relationship, or a stimulus and response. In last month’s article about inflation, we learned how it was having a huge impact on patterns of consumption behavior.

Within a recent article from Insider.com, a Bloomberg economist suggested that the average consumer would have to budget $5,200 more this year to pay for the same basket of goods and services as last year. This may be possible if you earn half a million dollars per year, but what about the millions of families who earn $50,000 per year? It would be impossible for those families to make an extra 10% materialize out of thin air.

With this being said, get ready to hear the word austerity a lot this year. Austerity is essentially the exercise of deciding what will be cut from your budget until further notice. If patterns of consumption are changing, then so should revenue and earnings assumptions for the companies who make the products. Is company X really worth $200 per share, or in light of weakening sales activity, is it now only worth $150 per share? That’s a high-level example of what is happening in the market.

The economics of wages not rising as fast as inflation, and the impact such is having on patterns of consumption, causes the market to reprice risk, and sometimes, quickly.

Personally, I believe the current market volatility will not end until enough risk has been priced out of the market to balance valuation against perceived risk. Right now, that is largely a function of the Federal Reserve. In my opinion, I believe they waited much too long to enter into quantitative tightening. They told us for too long that inflation was transient, and indeed, it has proven to be stubbornly persistent and pervasive.

Because of this, the Federal Reserve is having to play catch up in an effort to quell the inflation being caused in large part, by the precedent setting amount of money they have printed over the last two years. Rather than a gradual and modest approach to tightening, the Federal Reserve continued to print money and add to its balance sheet through February of this year.

This is akin to sprinkling gasoline on a fire and believing it will help to extinguish the blaze because it is wet. The Federal Reserve is having to be much more active, in terms of policy and unwinding its balance sheet, and the market is pricing into itself the odds that such might hasten, or worsen a recession.

I have suggested for nearly a year that we could find ourselves in a recession by 2022 and most media outlets continue to suggest that such is a greater risk next year.

Frankly, I think we are in the beginning stages of a recession now. We have already seen the first negative read on Q1 GDP, and I do not see anything on the horizon that could change that outcome. Furthermore, I do not anticipate anything changing in time for Q2 to reflect a positive GDP outcome either.

If the definition of a recession is two consecutive, negative quarters of GDP output, then we may already be in the recession. The question of for how long, and how deep, is anyone’s guess.

Confident consumers spend money. According to the most recent University of Michigan consumer sentiment survey, we have the third lowest confidence reading since the Great Recession.

Headline inflation remains stubbornly high at 8.3% year over year as of April, and those forces do not seem to be abating.

Over the same period of time as shown in this graph above, non-farm payrolls grew by 5.6% on a gross basis, so net after tax, if the average consumer kept 4.7% of that increase, while inflation rose by 8.3%, then for a fifth consecutive rolling 12-month period of time, our capacity to consume has declined.

We know that not everything we consume went up by 8.3%. Some economically inelastic things, like gasoline, have risen at a much faster pace.

This is due in large part to supply chain disruption, caused by the war in Ukraine, and other logistical impediments. The much higher cost of fertilizer has hit grain growers across the world very hard, and now, we are anticipating significantly higher cost of food over the balance of the year as a result.

Meanwhile, according to the Federal Reserve, the average household use of consumer credit is higher today than at any point over the last twenty years, including the great recession.

So, connecting these, and many other economic dots, I do not see an optimistic view of the potential for growth. I believe that we are in a recession already. What makes it worse is that the Federal Reserve is doing things that are normally seen at times when the economy is expanding too rapidly, and the intent is to disincentivize borrowing. Companies are much more focused on being lean and efficient now, not larger. The economy is contracting, not expanding.

The worry is that while the Federal Reserve tries to reign in what they spent two years creating, they could be doing it at a very bad time, when the economy is contracting anyway. A mild recession could become a bad one, exacerbated by the Federal Reserve. That is why this market volatility makes sense to me, because of looking at it from the perspective of economic, financial physics.

In order for the average person, investing into their 401(k), to navigate a period of time like this, the key is to stay the course. The worst thing you can to is quit. 1. People must be mindful of goals that are 10 years or longer into the future. 2. The 401(k), or the IRA, or the investment account, should be driven by an over-arching plan. If it is not, then you are just throwing money into an investment platform with no idea what to expect from it in the future. In that case, the minute-by-minute market volatility will keep you up at night. 3. As mentioned in last month’s article, successful, long-term investment management is planning first, execution second, and without exception. Execution is important, but not more important than the plan that governs the account. 4. Pay attention to what you own. Do not take an auto pilot approach to your investments. There are times to own stocks of growth and discretionary companies, and there are times when its best to own stocks of companies that make economically durable products that you are going to consume regardless of the state of the economy.

Look for companies trading with attractive rations of forward price to earnings ratios, at discounts to fair value, and that pay attractive dividends. That is the defensive way to survive in this environment. Pay attention to the fixed income portion of the portfolio, because with the Federal Reserve in quantitative tightening mode, and with two inverted yield curves, you might want to curtail long term exposure to debt instruments that are suffering from significant price distortion. Remember, this is a marathon, and not a sprint. (*) David R. Guttery, RFC, RFS, CAM, is a financial advisor, and has been in practice for 31 years, and is the President of Keystone Financial Group in Trussville. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results.

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