Transcript: Do Bearish Stock Market Moves Forecast a US Economic Recession?
Since Heron’s last webinar, it seems that things are going from bad to worse. For starters, do you see any clear indications that we’re heading into a bear market?
The official definition of a bear market is a 20% pullback in the S&P 500. We last saw a bear market between March and May 2020, not even two years ago, when COVID-19 first reared its ugly head. It was also the fastest recovery from a bear market; we broke even by July. Then the market took off, gaining another 40% in the next two years. The NASDAQ hit an all-time high in December 2021. The S&P 500 did the same in January.
Since then, the NASDAQ is down 22.7%, signifying a bear market for the NASDAQ. The S&P 500 is down 13.1% (as of Friday, April 29). 9% of that took place in April alone.
Why? What’s going on? There’s this disconnect between what the stock market is doing and what the U.S. economy is doing. We’re reminded in these circumstances of a famous quote from Paul Samuelson, an economist who said, “The stock market has predicted nine of the last five recessions.” We can actually update it — it’s more like eight of the last eleven recessions. The point being, the stock market’s actions are not always correlated with the real economy.
Here’s what we’re looking at in the real economy.
Jobs. Since January 2021, the U.S. economy has added 7.9 million jobs. That’s more jobs in Biden’s first year-plus than during the entire Trump administration. The unemployment rate is currently 3.5% — 1% above the postwar low.
Real Wages. Even more interesting is what’s happening with real wages, which had been stagnant ever since 2009. Real wages actually bumped up sharply this past year. All my clients that own businesses have the same complaint: “I can’t get good people without sharply increasing salaries.” In fact, one client told me that his wages were up 90% in the last two years. That’s quite a jump. He can raise prices somewhat, but he’s got to absorb a lot of it.
Consumer demand rates remain high, especially around housing. Housing prices hit record highs in January and have come down a bit since then, and will likely continue to fall with rising interest rates. Corporate revenues and earnings are solid, for the most part.
War. The Ukraine war is the main reason why investors are frightened. We talked about the Ukraine war a month ago. I said there were about four scenarios:
Russia overruns Ukraine in a couple days. That didn’t happen.
A horrible slog of missiles and shells going back and forth for years. That’s pretty much where we are now. Tens, if not hundreds of thousands of Russians and Ukrainians will die unnecessarily. Putin’s kind of like the angry boyfriend: “If I can’t have you, nobody will!” The U.S. and NATO seem to be getting progressively more assertive, sending heavier weapons, more firepower, trying to keep the balance intact.
The Ukrainians will push the Russians out of Ukraine. It’s possible. They already successfully pushed them back from Kyiv.
Putin gets really annoyed and starts launching tactical nukes. That was a risk a month ago, and it’s still a risk now.
I’ve been trying to think, what could Biden say that would get Putin to back off those nukes? Maybe he says, “Well, listen, if you go nuclear, we invoke Article 5 of NATO, which is that it’s a common threat to all nations.” Then, it would no longer be Russia vs. Ukraine, it would be Russia vs. all of Western Europe, Canada, and the U.S.
That’s something to be concerned about, but we were in Afghanistan for 20 years and Iraq for 10 years. The Russians were in Afghanistan for 10 years. These wars can go on, and economies can go on despite them.
Pandemic. The pandemic is still not over. There’s actually a little uptick in infections. It seems to me like everybody I’ve known who’s successfully avoided COVID-19 for the last two and a half years is getting it now. I haven’t gotten it yet, but I’m pretty sure it’s going to happen. The good news is that it’s not lethal. All my friends who’ve had it in the last month have said, “It was a rotten couple of days, but I didn’t have to go to the hospital or anything.” The pandemic is still out there, but New Yorkers are going back to whooping it up like they always do.
Inflation. Energy prices quadrupled since January 2020, when they were artificially way down. Now, they’re artificially way up. They backed off about 25% from the immediate reaction to the war, but they’re going to be high for a while because energy markets are disrupted.
Real food prices are at the highest level since the 1970s because Ukraine and Russia together make up for about 30% of the world’s wheat products. The Ukrainian farmers can’t plant right now because there are tanks and shells in their fields. Even if the Russian farmers do successfully plant, they’ll have a new problem in the fall: Bulk carriers won’t be able to get to Russia to load up because of insurance issues and fears of the war. That doesn’t affect the U.S. too much, but places like Africa and Asia that are dependent on Ukrainian and Russian bread are really suffering right now.
Interest rates. Rates are definitely rising. The Fed raised rates .25% so far — not much. That’s still a long way from the 2.5% we had in January 2020, right before COVID. It’s a whole lot lower than the 5.2% that prevailed in 2006, 2007, right before the financial crisis. In my mind, it’s not that interest rates are finally going up. It’s that they’ve been way too low for way too long.
Mortgage market. Mortgage bankers haven’t waited at all: Mortgage rates were at 2.65% eighteen months ago, and now they’re at 5.1%. A big, big jump. I’ve had a lot of conversations with clients asking whether they should sell their houses. I say, “Yes. Yes. Sell now.” Every time interest rates go up one percent, the affordability of your house goes down a full percent.
The national discourse. The national discourse has sunk to a level of total idiocy. There’s a great line I saw in The Atlantic recently: “The last decade has made us stupid.” If Twitter disappeared from the face of the earth, I’d be the happiest person around.
Adding it all together: Are we plunging into recession? What does this bear market mean? Are we good with our stock positions?
I think we’re going to be fine on the recession. As I said before, the Fed is raising rates, but they’re still way lower than historic norms. Inflation is going to be with us for a while. Raising rates won’t do anything about energy prices, food prices, supply chain challenges. China’s having a big surge of COVID right now, and they’re shutting down whole cities. That disrupts factories.
Raising rates will cool off the housing market. We still have a significant undersupply of affordable housing. Rents are soaring right now, and anyone who’s trying to get an apartment in New York City is just completely out of luck. There’s 35 people applying for every one apartment that becomes available.
What do you think about the possibility that prices can level off? Forget going down.
Yeah, they can level off. We’ve seen this level of energy prices before in 2006, 2007, 2008. Food prices, we saw this back in the 1970s.
I don’t think labor prices are coming down. If you look at wage growth by quintile over the last 20 years, you’ve got high earners, then you’ve got people who are well of and college educated, then people who are high school educated, then people who are not high school educated. A lot of the blue-collar jobs that required a basic high school education don’t exist anymore. Even if you go work in a factory now you’re no longer bashing metal, you’re operating a computer terminal, and a robot is actually doing all the work.
For 20 years, real wages came down for the bottom three quintiles of the U.S. population, while for the white-collar class, the professional class, they went up dramatically. Now you see a little bit of inversion, where the professional class folks are seeing their wages level off. But people who work at places like Starbucks, auto repair shops, restaurants, those wages are up sharply.
I’m fine with that. I’ve always said that it’s not realistic — forget raising a family, even trying to take care of one person on $10/hr. Even $15/hr seems too low these days. But $20/hr, then you might be able to get by. And by the way, if your business can’t survive without $10/hr labor, you don’t have a real business.
The Fed seems to have undershot and now they’re trying to overshoot. If the market continues spiraling downward, do you think that Powell might have to pull back a little bit? Or is it just pedal to the metal?
The Fed always faces the same problem: Is this inflation temporary or permanent? I always think back to the 1970s when inflation was out of control. By the time I was trying to get a job in the early 1980s, we had the Volcker recession, where they jacked up the federal funds rate to 14% to kill off the economy.
There’s a difference between inflation then and inflation now. The Fed actually looks at two kinds of inflation: sticky inflation and volatile inflation. Sticky inflation is things like, how much does ca insurance go up every year? It goes up at a pretty steady rate. Volatile inflation is around food, energy, clothing, manufactured goods.
Back in the 1970s, sticky and volatile inflation were marching together. Now sticky inflation is going sideways and volatile inflation is going up.
But we’ve already seen energy pull back by 25%. Food prices will work their way out. Maybe the report we had a couple weeks ago was peak inflation, 6.9%. Maybe it’ll drop to 5.5%, then get back down to 2%. We just don’t know.
I’ve often remarked that inflation and wars go hand-in-hand. During WWII, huge inflation. During the pandemic, huge inflation — the war on the virus. Now we’ve got a war in Ukraine, that’s very inflationary. Ukraine is kind of the Detroit of Eastern Europe. They make a lot of the parts that are shipped west to be assembled in Germany and Poland. That’s all disrupted right now. You can raise rates all you want, but if you can’t get stuff, inflation is going to be high.
Based on all of that, what’s the best course of action for investors?
Let’s look at three broad asset classes: U.S. stocks, international stocks, and bonds.
U.S. stocks had a pretty good run through January 2022. They’ve since pulled back 13%. That seems like a big deal, except that we have a pullback like that on average twice every five years. We have a bear market once every five years. We had a bear market two years ago that doesn’t really count. Maybe we have a bear market coming up later this year, maybe we don’t.
My overall forecast for the end of the year is going to stay the same. At the start of the year, I said, “I see company earnings going up. Company revenues going up. That’s good for stocks. I see interest rates going up. That’s bad for stocks. Net, we should finish the year up by 6-8%.”
So far, earnings are still strong, revenues are still strong, and interest rates are proceeding as expected. Why? Because the Fed told us what they were going to do. That leaves me still thinking that stocks will be up 6-8% by the end of the year.
We’ve seen it before. We saw it just two years ago, where the market sold off 13% and then rallied back 50% in the same year. U.S. stocks will do their thing.
International stocks are struggling right now. It always seems like when the U.S. gets a cold, the rest of the world gets the flu. Because U.S. interest rates are rising, it raises the value of the dollar; as foreign investments flow from other currencies into the dollar, a stronger dollar reduces the value of those investments. But we keep seeing the same level of exposure there, typically 10% in developed markets like Australia and Japan and Western Europe, then another 5% in emerging markets.
Then, the bond market. Bonds are getting killed this year. We anticipated this, we deliberately brought the maturity of our bond investments short. In the bond world, it’s all about interest rates and maturity. So if you have a bond that matures in the next year, it is affected very little by changes in interest rates. If you have a bond that matures in 30 years, it’s heavily affected by changes in interest rates.
We deliberately came back to the 3–5-year bond, and even so, we’re getting pounded by people selling all kinds of bonds. We’re just going to ride that out. The flip side of the bond prices falling is that yields are rising. Two years ago, we were getting 2.5% on our bonds. Then we were getting 3% in January. Now we’re getting 3.95%. We’re just going to wait patiently, take this year as a write-off in bond investments, and expect a higher return in 2023 and 2024.
And in real estate, you said, “Sell.”
Real estate is interesting to look at. Real estate hit an all-time high in 2006 amid the bubble. It was the NINJA era: No Income, No Job, No Assets. The market fell about 35% from the peak to the trough, in 2009. From 2009, it doubled, and the rate of acceleration increased the last two years. When rates went low, mortgages went low, and prices went high.
Well, now rates are coming up. Prices will level off a little bit. That’s good news for anybody who owns a house and is thinking about selling it. You won’t get the top tick, but you will get the best level ever. It’s not good for people getting into the housing market for the first time. There’s still a pretty brutal down payment involved, and those higher rates are going to make it harder to get qualified for a loan.
If we see the impact of the Fed policy anywhere, we’ll see it in the housing market. That’s a good thing I think; it’s effectively killing off a bubble that was in process.
Do you see any change in the supply chain issue?
We had a terrible impact as COVID first appeared and ripped through. Not so much in China — China very aggressively clamped down on COVID in the beginning, but we import goods from places like Vietnam, Bangladesh, Malaysia, and COVID completely ripped through those countries. Then we had average Americans stuck at home. We couldn’t go out to dinner or movies, so we bought more stuff.
Then, all the ports got clogged up. They went up to 24-hour scheduling in the Port of Los Angeles. Then there was a trucking shortage, so wait times went up. Then a boat lodged in the Suez Canal.
It seemed like we were about to get a break from that, but the Ukraine war came along, and a new COVID wave in China came along, and we’re seeing more lockdowns.
My opinion is, just be patient. If you want to buy a car this year, it’s going to cost you a couple thousand dollars over list price. But if you can wait till next year, the supply chain should work its way through. Do you absolutely need to get sneakers in 24 hours from Amazon? Maybe not.
Are you investing or holding cash in the near future?
On Friday afternoon, I fired up one of our computer systems and ranked all of our portfolios by available cash. 26 out of 200 portfolios had more cash tan usual. All of those went over to Lucas, our investment manager, to invest this week. If anybody wants to give me cash, I will invest it right now.
For people of retirement age, will you be selling into the rallies to reserve cash before recessionary pressures on the financial markets?
No. We always take the position that money in stocks is five-year money. For our clients who are retired, we have a waterfall system, where we want roughly 65% of their portfolio to be in stocks, 30% in bonds, and 5% in cash. When the market rally in general, we’ll sell some stocks, trickle that money into bonds, trickle the bonds money into cash, and pass that cash out. But we don’t get crazy and start changing the asset allocation.
It’s like we’re sailing across the ocean, and we hit a storm. We don’t change course, but we might batten down the hatches. In general, we have a well-built boat, we understand ocean currents and storm patterns, and we’re prepared to keep going forward. In the 26 years I’ve been running this firm, I’ve never once had to cut someone’s retirement draw because of stock market volatility. As long as the Russians keep their nukes in silos, I will continue to do that.
I was reading about declined demographics in Russia, which will limit their ability to wage war for longer than we think. If that’s true, what does that mean for the markets?
A number of countries are experiencing demographic decline. Japan is one, Russia is one. And people cannot remotely understand how large Russia is. It’s eleven time zones. One of them is Hawaii and Alaska. You could take the whole U.S., lay it into Russia, add another one, and still have room left over. But it only has a population of about 140 million people. The U.S. has 350 million, Western Europe has 450 million. Ukraine has 44 million. For the last 20, 30, 40 years or so, Russians have been either drinking themselves to death or immigrating.
The standing army in Russia is about 400,000 troops, and they have conscripts as well. They threw 250,000 into Ukraine. The mortality was somewhere between 15,000-25,000 so far, nobody really knows for sure. We won’t find out for a while. But some of the units in Kyiv lost 30% of their manpower, and they had to crawl back to Russia to regroup.
Now, they’re doing an annual conscription hitting young man ages, 20-24. Those will be thrown into the war with little to no training. Oftentimes, those conscriptions are used for driving trucks, doing maintenance — well, you need some training to do that, right? Driving an SUV is one thing, driving a missile carrier is something else.
Then, they’ve got a propaganda issue. Right now, Russia controls the state media in Russia, and most Russians get their news from television. They believe this is a special military operation against Nazis in Ukraine that kill babies and eat Russians. Well, now every village in Ukraine is going to have one, two, three young men killed, and that’s really going to create a problem with the dialogue of the propaganda.
Another thing that happened is that the technical class of Russians just got the hell out of Russia by any means possible. Brain drain. They took a train to Poland. They flew to Dubai. How do you run a modern economy when all your smart people are leaving? At the end of WWII, Russia was the second-largest economy in the world, half the size of the U.S. Now, it’s number 15 or so, behind Italy and Spain and Germany. That’s not impressive. They’re going to keep sliding down the ranks.
David Edwards is president and wealth advisor with Heron Wealth, a $500 million registered investment advisor based in New York City working with 225 client families across the U.S. and around the world. Dustin Lowman contributed additional research for this column.