When even The Wall Street Journal gets in on the act, it’s time to run. In Saturday’s (July 1) edition came the headline, “Markets’ Monster 2023 Rally Defied All Expectations,” claiming that…
“Stocks burst out of a bear market, with the Nasdaq Composite up 32% and posting its best first half of a year since the 1980s.”
The problem? The reasoning is simplistic and flawed.
The simplicity: The stock market rose, so it’s a bull market
Reread that explanation: “Nasdaq Composite up 32%,” and “best first half since the 1980s.”
So, why the Nasdaq? This graph provides the easy answer…
Why just look at first halves? This graph also provides the answer. The real record breaker was 1999’s 2nd half, with a 52% return. Of course, it was followed by big downers.
In fact, many of those higher halves were followed by weak or negative halves. In other words, 2023’s 1st half rise doesn’t forecast a bull market.
The flaw: The relevant period is not only the past six months
Cherry picking performance periods may be fun, but it is improper. We live in a world of fundamentals that drive investment thinking, analysis, evaluation, action – and, of course, investor attitudes.
The period we are in started after the Covid volatility, at the beginning of 2021. That’s when inflation began its rise above the Fed’s preferred 2% level. At first, the Fed kept interest rates near zero, labeling the price rises as “temporary,” then “transitory.” With attractive borrowing (leveraging) rates and the huge increase in money supply hunting for a home, 2021’s investment activity was active and profitable.
Finally, though, the Fed saw inflation was taking root. It felt the pressure to raise interest rates, igniting the stock market’s 2022 selloff.
When the 12-month inflation and short-term interest rates neared 5% this year, the Fed reduced the increases, followed by the recent pause. Those actions reduced worries, leading to 2023’s stock market improvements.
So, is that the end of the relevant period?
No. Inflation remains a problem. Because the higher rates have been running for 1-1/2 years, organizations, businesses and consumers have adopted actions. Importantly, such specific beneficial steps will not cease simply because general inflation moderates.
Also, do not expect the 5% interest rate level to bring the inflation rate back down. History shows that inflation, once ignited, needs a recession to be reversed. It’s the only way to slow demand from organizations, businesses and consumers.
Therefore, expect the Federal Reserve to make good on Jerome Powell’s original promise: To fight inflation, even though it means pain. Two actions are at his disposal.
First, raise interest rates further. A 5% rate when inflation is running at 5% is not a condition of tight money. Therefore, expect higher rates are coming (possibly 6% to 8%). The economic indicators are simply too favorable.
Second, reduce faster the Fed’s $trillions in bond holdings acquired in 2020. All the money the Fed created continues to slosh about. Their strategy of not reinvesting some of the interest and principal payments they receive is barely making a dent. “Tight” money means just that – not having a huge slush fund that makes higher interest rates beneficial – not painful
The bottom line: The real risk is that the Fed chickens out
If the Federal Reserve tries to ease the inflation rate down by taking mini steps, they will fail. All the parties simply will adjust to the new conditions. Without a whack on their heads, the economy and financial system will continue to accept and support the higher inflation level.
Already 5% inflation and 5% interest is beginning to be okay – costs and expenses go up, but so do revenues and income. Therefore, even a step up to 6% and 6% now could be too little, too late. It’s human nature to adapt, and, with inflation, it has happened before
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