Most people need some stock in their portfolio

The S&P 500 fell 0.3% last week to close at 4079.09. Support at 4,100 didn’t hold. The S&P bounced off 4,095 on Tuesday before closing at 4,136.13. Wednesday’s low was 4,103.98. Thursday’s low was 4,089.49. The S&P closed above 4,100 Tuesday and Wednesday but couldn’t hold that level Thursday, closing at 4,090.41. The close-below support at 4,100 opened the trap door and the market fell to 4,047.95 on Friday.

The S&P tried to go lower still but sellers couldn’t pull it off. The index hit 4,047 in the first 30 minutes of trading Friday. It bounced to 4,080 before 11 a.m. and then headed back to the 4,050 level. It hung out there for an hour before bouncing to 4,065. From 4065 it was back down to 4,047 by 1 p.m. where the index loitered for another hour. Deciding they couldn’t push the index any lower, traders ran the S&P back to 4,080. It stayed there for the last 90 minutes of trading. It’s a toss-up whether the S&P will move higher on Tuesday (Monday is a holiday) or try the downside again.

The odds favor more downside testing in the coming month, regardless of what happens this week. Earnings estimates continue to fall. The Fed continues to talk tough. The Fed funds futures market continues to move higher. Economic leading indicators continue to point toward recession. And liquidity is drying up.

Earnings estimates are falling rapidly. The consensus earnings per share estimate have fallen 1.7% since the end of the fourth quarter, according to Credit Suisse. Earnings estimates have been cut 16 out of 98 quarters following quarter end since 1998. Only nine times have earnings estimates fallen more than 1.7%, all during recessions. Earnings per share are expected to now fall 2.2% for Q4 2022. It has been the worst earnings season in 24 years, according to Credit Suisse chief equity strategist Jonathan Golub. Earnings for the first quarter of 2023 are expected to fall 4.8%. Analysts are continuing to lower estimates.

Meanwhile, economists are raising their forecasts for the peak funds rate to 5.25% to 5.50%. Goldman Sachs, Bank of America, and Citigroup have joined others in raising their forecasts to 5.25% to 5.50%. Their forecast now matches the federal-funds futures rate. The futures market is pricing in three more quarter-point hikes. That is up from one more hike a few weeks ago. The FOMC is expected to raise by 0.25% in March, May, and June. The June rate hike probability has risen to 57.5% as of Friday, according to Barron’s. That’s up from a 4% chance a month ago.

The January stock market rally is due partly to a surge in global liquidity, according to Citi global markets strategist Matt King. The ECB, BOJ, and People’s Bank of China has added $1 trillion to global liquidity since the start of 2023. The Treasury account at the Fed has also offset some of the impacts on Bank Reserves of the Fed’s quantitative tightening, according to King. The boost from foreign central banks and Treasury activity is past, he wrote in a research report. The absence of fresh liquidity injections will likely hurt risk assets such as stocks in the coming months.

Norwood Economics is expecting a 15% to 20% decline in the S&P 500 sometime this year. The next most likely scenario is a sideways market. Stock picking should prove rewarding in 2023, as it was in 2022.

Economic Indicators

Inflation numbers last week did not fall as much as expected. The CPI rose 0.5% in January after declining 0.1% in December. The median forecast was for a 0.4% rise. Core CPI rose 0.4% versus expectations of a 0.3% rise. Both CPI and core CPI year-over-year were higher than anticipated. As well wage growth in January was higher than expected at 4.4%. December’s data was revised higher to 4.8%. The Fed needs wage growth to fall to 3% or so to achieve 2% overall inflation.

Retail sales were stronger than expected. They rose 3.0% after declining 1.1% the prior month. Retail sales were expected to rise only 1.9%. Initial jobless claims were under 200,000 again. Producer prices rose 0.7%, well above forecasts of a 0.4% increase. Core PPI rose 0.6% after rising 0.2% the prior month.

The Conference Board’s index of leading economic indicators fell 0.3% in January after falling 1.0% the prior month. It was the tenth straight monthly decline. The Conference Board is forecasting a recession in 2023.

In summary, the economy is showing strength. Inflation progress is slowing. The Fed will continue to hike. Yet, leading economic indicators are pointing toward recession. Meanwhile, earnings estimates continue to fall. The stock market is at risk, with limited upside but plenty of potential downsides.

  Asset Liability Matching

Risk is misunderstood. Risk isn’t volatility, although institutional money managers would have you believe it is. Risk is the probability of a permanent loss of capital. Risk is also not having sufficient liquid assets to satisfy liabilities when those liabilities come due. Asset/Liability matching is about making sure bills can be paid on time and in full without being forced to sell assets for less than they are worth.

But aren’t assets worth exactly what you can get for them? Not at all. Stock represents ownership in a business. Individual stocks are often undervalued, sometimes significantly so. You don’t want to sell your share of a business for less than it is worth. Selling your share of a business for less than it is worth results in a permanent loss of capital. Asset/liability matching allows you to avoid selling at a discount.

I had a meeting today with a prospect who is risk-averse. She doesn’t want to lose money. She doesn't want to own stocks either. Yet she needs to grow her real wealth if she and her husband are going to achieve a successful retirement. Earning a 4% real rate of return will give her a shot at meeting all her spending goals in retirement. Assuming inflation runs at 3% on average over the next 20 years means she needs to earn around 7% in nominal returns. The 10-year Treasury is around 3.8%. Intermediate investment-grade corporate bonds have a yield to maturity of around 5.4%. The prospect needs stocks in her portfolio if she is going to earn a 7% return. It is unavoidable since bonds aren’t yielding 7%.

Asset/liability matching means having cash available when the bills come due. You don’t want to be forced to sell assets for less than they are worth to pay your bills. Stocks can be safely held if your time horizon is five-plus years. Use a ten-year horizon if you want to be more conservative. Spend from your cash and near cash (money market funds and short-term bonds) as needed. Use your longer-term assets to replenish your cash. Long-term assets include intermediate and long-term bonds, real estate, and stocks. Most financial planners will tell you to keep one to two years of cash and near cash available to pay your bills in retirement. The rest can be invested in bonds, stocks, and real estate to generate a higher real rate of return.

It is not risky holding stocks if your time horizon is ten-plus years. Most retirees need some exposure to stocks if they hope to meet all their spending goals in retirement.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist