WARNING SIGNALS You Must Not Miss: Asset prices are headed lower

The market narrative has changed again in recent weeks, potentially ushering in a new phase to the bear market that started over a year ago. Hey everyone, I'm Phil Clark. Welcome to another edition of We're Talking Money. If you're like many investors, you're probably wondering what's next for the stock market. Are we headed into recession? Are stocks going lower? Well, I have the answers, so stay tuned.

Where he started with a bang. Stocks were soaring, and investors, they were opining how the downturn is behind us now and we've entered a new bull market. In my view, it's easy to see why markets suddenly seem to be flashing the all clear. This is a classic case of crowd following. Let's talk about it.

Allow me to go back in time to set the stage. Now, let's start with January 2022. The markets were doing well until credit began to tighten, and the tightening became embedded by October of 22. Major indexes had fallen some 28 percent despite earnings reports that were mostly positive. This was the first phase of what we will call a repricing of assets, and it was based on the rising cost of capital. Interest rates were going up, cost of capital was going up, price to earnings ratios, they came down, even though we had positive earnings at that time. Suffice it to say, there was plenty of fear in the air.

Now, keep in mind that markets have come to expect the Federal Reserve's intervention when things get tough. Naturally, with the sell-off happening across much of 2022, investors wrongly assumed that Federal Reserve chairman Jerome Powell, our federal chair, would pivot, that he would intervene, he would stop raising rates and maybe even lower them prematurely. Now, this kicked off a so-called new bull. Everyone's talking about it. I'm going to say there's definitely some kind of bull going on here, if you know what I mean.

Now, just as this reversal began, earnings finally started to decline, so the rising interest rate environment is beginning to take hold. You might recall in another show just a few weeks ago, actually, I stated that investors might be ignoring the fundamentals. Well, what I just described is precisely what I meant. Look, when earnings are coming down, stocks should not be rising if you have rational investors.

The optimism of a Fed pivot and evidence that inflation was coming down, it turned everybody somewhat bullish, and that became a nice recovery, which started back in October 2022, and it's lasted through January and really through most of February. Now, we did see a pullback in February, but for the most part that rally began in October and led through, well into February. That bounce led to major indexes recapturing nearly half of their decline during 2022.

From our point of view, economic headwinds have not abated, and anyone that thinks they have, maybe they're just ignoring the data. It is plausible at this point that the headwinds have increased. Let me share with you what I mean.

So topping the list of headwinds is inflation, and it's likely the most concerning. This wasn't a concern prior to, say, mid-2020, when we saw early signs of inflation, but early 2021 it was clear that inflation was moving up, and it was moving up rapidly. Now, by June of 2022, inflation was above nine percent. That was a 40 plus year high. Our inflation has been very persistent, and it remains pretty hot, around six and a half percent. Now, in the next chart, however, inflation is even worse in the services sector, and this is very problematic.

Let's talk about the yield curve. This is another headwind. So the yield curve, or the yield curve inversion, has been a near perfect, and I hate to use the word perfect, but it has been a near perfect predictor of the economy sliding into recession. Basically what it means is that longer term treasury yields are less than shorter-term treasury yields. Now, we saw this condition develop in mid-2022, and it has worsened ever since. Now, the weakness in this perfect predictor is timing. Recession may not occur for as many as 18 months following the inversion. Suffice it to say, the inversion is widening, and global yield curves seem to be following the same path.

Now, our next headwind is nominal wage growth and real wage growth. What's the difference? Well, I'm glad you asked. Nominal is the amount that someone's paid. For example, say the hourly rate of pay is twenty dollars. That's nominal. Real wage, on the other hand, is the amount the employee earns minus inflation. In other words, what money will purchase is more important than the wage itself.

As of this show, wages have grown since the COVID recession. Growth peaked around six percent in early 2022, and since then, however, wage growth has been declining, and it currently sits around four percent. Now let's apply inflation. So real wage growth is suddenly negative, negative two percent in fact. So this trend is not sustainable. What I mean by that is that consumers will be forced, if they have not already been forced, to reduce their cost of living, or they have to turn to savings and credit.

So that brings us to another headwind: consumer savings and revolving credit. This headwind cannot be ignored, since consumer spending, remember, we've said this many times throughout our shows, consumer spending is responsible for nearly 70 percent of America's GDP. Consumer spending is a must for our economy, seventy percent of it. And so far, consumer resilience, it's been nothing short of impressive. But while consumers are spending the same amount, inflation is affecting the amount of goods and services that you get for every dollar spent.

Looking at revolving credit and personal savings rates, we can see that consumers may be spending more than they have to simply maintain a certain lifestyle. Look at the following chart. I want you to notice something here. Look at the gold line, how it has dipped below the orange line. What this means is consumers are saving less. Savings rates are lower now than they have been in many, many years, and they're spending more. How do I know they're spending more? Because credit card debt is rising, and it's rising rapidly. In fact, it's reaching highs that we haven't seen in decades. Making matters worse, the spending is happening on revolving type credit, credit cards, which comes with very high interest rates.

Finally, let's talk about another headwind: employment. So this headwind has not cooperated as it relates to inflation. The Federal Reserve was expecting payrolls to start slowing. Instead, January payrolls increased much more than expected, and unemployment fell to multi-decade lows. We haven't seen those numbers in a long time. That was followed by the latest retail sales report, which showed consumers have been spending more, more than expected in the face of inflationary pressures.

How is it that our consumers are so resilient? Well, most people don't want to reduce their lifestyle, so they find a way, whether that's savings, credit cards. Sound familiar? We just talked about that.

On the surface, economic activity is painting a very bright picture: low unemployment, robust consumer spending, and stocks seem to be ignoring the fundamentals, or I should say investors are ignoring the fundamentals. What could be wrong? This ostensibly good news is anything but good, and I don't want to pour water on the fire, but let's be honest here. I'm just going to simply tell you the truth. I'm going to give you my perspective; you do with it what you will.

First, the Fed is determined. They have made it clear, to get inflation wrestled to the ground. Their goal is two percent. Remember, I said it's at around six and a half or maybe seven. Standing in the way is Consumer Price Index, a measure of inflation, the producer price index or PPI, and personal consumption expenditure price index, another measure of inflation. All of these will force the Fed to continue raising rates. Some people thought they would stop. In fact, they thought after the last hike we were done, but another is coming in March and probably another in May, and now the Fed is talking about as many as eight hikes during the year 2023.

What will higher rates mean for the economy at this juncture? What am I expecting? Well, I believe that the terminal rate will reach well above the Fed's estimate. If Jerome Powell intends to defeat inflation, or slay the dragon as he calls it, he has a lot of work to do, and I am confident in saying his soft landing theory is no longer plausible. In fact, I don't believe it's been plausible for some time.

Higher rates will further invert the yield curve. They're going to raise the cost of capital, we've talked about that, and ultimately these things will drive down asset prices as they slow spending. All of that will make things more affordable, but to get there, we'll have to go through a recession.

Now, another hallmark of raising rates is deteriorating profits. In our opinion, the stock market adjusted down for much of 2022. I mentioned a little while ago, about 28 percent, but was it enough? That's the ultimate question. Now, was the correction in 2022 enough? So looking at earnings and forecasts across 2023, based on how earnings estimates have been progressing, earnings on the S&P 500 is likely to finish in the negative for 2023.

So let's talk about the outlook for stocks. Inflation, it has come down some, but it's getting sticky at this level. It was at 9, 9.1; we're down to six and a half to seven, but it's not moving very quickly, not the way it did in the early stages of this fight against inflation. But we are a long way from the Fed's target rate of two percent. The jobs numbers were surprisingly high in January, which moved the unemployment number down, clearly not what the Fed wanted to see. And then real wages are negative. Consumers appear to be saving less by the data, and they're spending more on their credit cards. All this is wrapped with a yield curve that has been inverted and a debt ceiling dilemma that will most certainly end with theatrics and ultimately the 79th raising of the ceiling.

It's hard to imagine stocks doing well against that backdrop. Hardly the conditions, in my opinion, for a soft landing. Nevertheless, the more important question for investors is whether last year's decline in valuations, meaning those P/Es coming down by about 50 percent, was it enough to offset this year's earnings contraction? Earnings are coming down this year, and so fundamentals become extremely important. This will be a stock picker's market, without question, and I'm so glad that our firm is an active manager. This will be a year that stock picking becomes very important.

So did earnings, or rather, did the price to earnings ratios come down enough last year? If so, we're likely to see what I believe will be a sideways market for the remainder of 2023. If not, I imagine we have not seen the bottom. Now, everyone may not agree with that, but I believe if we didn't get a large enough correction last year, we could see a continuation of the sell-off.

On a positive note, I believe that a lot of the pain for stocks was front loaded in 2022. That's a good thing, but I don't believe it was enough. However, my confidence is high when I say we don't yet have conditions for the next bull market. I don't think this up, up and away is something that is going to stay in place. Until we do, our portfolios here at OmniStar, they will remain defensive. They have been for some time, and they have become more defensive, and we will remain that way until we see appreciably better undercurrents in the global economy.

In next week's episode, we'll be talking about how to save for retirement, what it means, how much you need to save, what it's going to take to have a successful retirement. That's all for this edition. We'll see you next time on We're Talking Money.

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