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Plan Now For When The U.S. Fed Beats Inflation

Published 03-10-2022, 02:30 pm

Let's be frank: The third quarter was a mess for stocks. It doesn't much matter where the stocks were traded, except this: U.S. stocks in September were not a place you wanted to be.

The Dow Jones Industrial Average and the S&P 500 had their worst September performances since 2002, with the Dow off 8.8% and the S&P 500 falling 9.3%. The Nasdaq Composite dropped 10.5%, its worst September since 2008.

It also meant that the major averages ended September in bear-market territory, defined as a decline of 20% or more from a recent top.

At the end of September, the Dow had fallen 21% for the year with the S&P 500 off 24.8% and the Nasdaq sagging 32%.

But markets do bottom. Sometimes quickly. And understanding what's happening now may help in getting ready for the inevitable recovery.

Most of the market pain is due to the Federal Reserve's stated goal of pushing interest rates higher to beat down inflation to 2% a year at some date in the future. It's now running at 6% to 8%, depending on the measure.

There are three related factors at play, too:

  • Global inflation pressures, fueled by soaring food costs and fuel costs, continued problems with global supply chains, and a sudden eruption of a financial crisis in Britain that some worry will spread elsewhere.
  • The soaring U.S. Dollar. The U.S. Dollar Index is up more than 17% this year alone. The dollar is up 17% against the British pound and 25% against the Japanese yen.
  • Global tensions, especially the intractable war between Ukraine and Russia and the latter's threat to use nuclear weapons against Ukraine. Add to that the tensions between the West and China over Taiwan.

Success, at least as Chairman Jerome Powell describes it, means softening up a very tight labor market and demand generally so prices overall will start to come down. Food and energy prices have been the big economic stresses, with prices for food at home up 13.5% for the 12 months ended in August, according to the most recent Consumer Price Index Report.

Energy costs are up about 25% on the year. The American Automobile Association estimated the U.S. retail price of gasoline at $3.796 a gallon as of Sunday. But in a break for consumers, gas prices are down some 24% from their $5.016 peak in mid-June

Short-term rates look to push above 4% in 2023. At their last meeting, Fed officials projected 4.6% as the median 2023 level on its key Federal Funds rate, the rate banks charge each other for overnight loans.

In other words, pain for everyone as the Fed tries to get U.S. inflation down from 6% to 8%. And it means a recession is coming. How nasty a recession is not clear.

The Fed's efforts may work. But it is possible the central bank is going too far and will be forced to dial back its campaign.

The Fed's moves—pushing the Federal Funds rate from 0%-to-0.25% at the end of 2022 to 3%-to-3.25%—have affected the economy already. Retailer Gap (NYSE:GPS) has said it will be cutting 500 jobs. Fitness-equipment maker Peloton (NASDAQ:PTON) has announced more than 4,150 job cuts. Electric vehicle maker Rivian Automotive (NASDAQ:RIVN) will chop 6% of its 14,000-person workforce.

The National Association of Realtors said sales in August were off 19.9% from a year earlier and reflected higher mortgage rates. Freddie Mac, the big supplier of mortgage capital, said the average rate on a 30-year mortgage was 6.7% last week. The rate had bottomed at 2.98% in early November.

The damage from a miserable market

All 11 sectors of the S&P 500 were lower in September with real estate, the worst performer, down 13.4% according to S&P Dow Jones. The best performing sector was healthcare, down just 2.7%.

Energy was the top sector for the third quarter, up 1.16%. But the sector looks toppy. It's up 39% for the year, reflecting high oil prices. And for the first time this year, no energy stock was among the top 10 S&P 500 performers for the month.

Three healthcare stocks were among the top four: Biogen (NASDAQ:BIIB), up 36.66% (on news that an Alzheimer's treatment may slow the disease's progression); Regeneron Pharmaceuticals (NASDAQ:REGN), up 18.6%; and Eli Lilly (NYSE:LLY), up 7.34%.

The biggest loser for the index was shipping giant FedEx (NYSE:FDX), down 29.6% for the month and 42.6% on the year. after warning of weakening global demand for its services. It was the biggest drag on the Dow Jones Transportation Average (down 13% for the month and 26.8% for the first nine months).

It's worth noting that the market for initial public offering offerings remains crushed by the higher rates and the reluctance of investors to buy into companies with no profits and minimal prospects for near-term profitability.

That said, let us praise Porsche (F:P911_p), the German high-end car company spun out of Volkswagen (ETR:VOWG_p). Porsche sold an €8.2 billion ($8.4 billion) IPO last week, which gave the company a valuation of about €76 billion. It was the biggest European IPO in 10 years and raised 20% more money than all U.S. IPOs did this year combined, according to Renaissance Capital.

What do you do with your investments now?

All the uncertainty has left investors around the world wondering how to cope, not lose money, and in the long run, make some money. The likelihood, many on Wall Street say, is more of the same ahead with stocks starting to rise and interest rates not rising or starting to fall sometime next year.

That assumes the Fed has judged it has won the fight over inflation.

Which means anyone looking to invest should consider their options carefully.

Let's start with the obvious. Unless you have a strong stomach, now is not a great time to buy stocks manically. Stocks were overvalued by the end of 2021 and into 2022 because the Fed and central banks around the world kept interest rates at record lows, more concerned about keeping the global economy afloat in the wake of the COVID-19 pandemic.

If the cost of capital is at or near zero, you can do anything. So, stocks soared, often in completely crazy ways. The forward price-earnings ratio on the S&P 500 peaked at 33.6 in the first quarter. It has since dropped to 18.36.

Home prices also took off, with demand jumping from workers seeking to get out of the way of COVID-19. The 10-year Treasury yield started 2022 at about 1.5%. It touched 4% this past week. Mortgage rates have jumped from about 3% to 6.7%. The effect on a borrower of $300,000 for a 30-year loan: a $674 bump in monthly principal and interest payment. The increases are already crashing some sales.

If you believe that stock prices are coming your way, then you should be readying a plan to conserve your capital and take advantage of a market bottom, likely to arrive in 2023.

If you want to slowly sell stocks and put the rest into cash or short-term bonds, that's a valid strategy. For the record, the 2-year Treasury note was yielding 4.28% on Friday, risk-free.

Wait for clear evidence of a bottom before getting into stocks.

If you must buy stocks, a rule in this environment is to look for companies that have these characteristics:

  • Low debt on their balance sheets.
  • A long, long history of paying dividends.
  • A domestic focus.

The list might include healthcare companies like Eli Lilly (NYSE:LLY) and Merck (NYSE:MRK). Add in Travelers Companies (NYSE:TRV), one of just four Dow components that had a gain in September, and Costco (NASDAQ:COST) or Walmart (NYSE:WMT) or Procter & Gamble (NYSE:PG), which has paid a dividend every quarter for 65 years and boosted it as well.

Don't forget oil companies unless you can't stomach the idea. Chevron (NYSE:CVX) and ExxonMobil (NYSE:XOM) are fierce defenders of their dividends and, obviously, huge beneficiaries of sky-high oil and natural gas prices. Chevron is still up 22% on the year after falling 3.5% in September.

Lastly, experts tout the idea of dollar-cost averaging into stocks or mutual funds. That is, put money into a stock or fund you believe in on a regular basis. You build up more shares as you go along at a lower overall price, and, when the market turns, you're set up.

Index funds thrive on investors doing just that and charge low fees.

What to avoid right now are investments that require taking on a lot of debt. A house, for example. Shares in homebuilding companies, which depend on priced mortgages for customers. Some retailers, whose startups depend on regular infusions of cash.

The best phrase that describes how one should look at investing now that September has gone away is: Be careful out there.

Market sentiment is horrible. Here's an example. Stocks making new 52-week highs in September totaled 535, according to Barchart.com data. Stocks making 52-week lows totaled 11,580.

But bear markets end and open new opportunities for the smart investor. The 2008-2009 bear market started in October 2007 and bottomed after a bit more than 16 months. That set off a powerful rally that saw the Dow recover all its losses in just five months.

The task for anyone trying to decide right now what to do is to map out both the hoped-for goals and the process by which the goals are achieved.

Homework pays off.

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