Seeing Around the Corner
The financial world has become a guessing game around the actions of Chairman Powell. Most recent financial prognostication has taken up the wager for how high Chairman Powell will take interest rates and when. Unfortunately, Chairman Powell does not have a comfortable level of confidence in his own plan. Along the way, complications come into being, the results of accidental occurrences. This propensity for accidents comes from the sheer size and complexity of our financial structure. The Silicon Valley Bank accident was very expensive for our smaller regional banks, and the end results are not yet clear. A quick look around the corner reveals that real estate, in general, is showing some price deterioration, and one would be wise to try to get a fix on bank vulnerability to real estate loans. There seems to be a credit problem brewing and a constant look “around the corner” may be helpful in giving the right perspective.
In fact, there’s not enough looking around the corner in any respect for a high-risk time like this. There seems to be a prevailing attitude that the economy in general is good and solid. The same goes for the stock market. Really? Well, a look around the corner shows almost every sector of the Standard & Poor’s profit margins to be in a state of decline. If profit margins are in decline, how can the economy and profits for the stock market be good, and solid?
Additionally, a look around this corner is telling us that corporate profits in the future are featuring a higher price/earnings (P/E) ratio for the Standard & Poor’s, which is currently requesting an 18x price/earnings ratio. On that score, market history tells us that bear markets like our current one should bottom-out with a P/E of 14x. The current drop in profit margins coupled with a high P/E is giving us a deadly warning. This, coupled with real estate prices waning in both the commercial and home markets is giving us a severe macro-warning about our economy, our stock market, and our banking credit system. There are 78 S&P 500 companies that have issued negative EPS guidance for the first quarter, the highest number since March 2019.
There are other factors that give us cause for concern. Our Nation’s budget will require borrowing to meet obligations set by Congress, however, we are running into a debt ceiling that will make borrowing impossible. The predictability of government financing to help our economy has become a problem because the power structure in the House of Representatives is split along party lines. The market areas most closely tied to the economy are still extremely weak and are flashing the same recession signal that has been provided by the Fed-led yield curve for months now. For all the talk of a ripping equity market, consider that we still have bank stocks down 39% from the highs, consumer discretionary off 31%, real estate slipping a hard 27%, and transports factoring 18% from their peaks. Together these four sectors are down 32% from the cycle highs. Then tack on the fact that small-cap stocks remain in a world of pain—down 27% from their highs.
One market indicator we are closely watching for a signal of a market bottom is investor sentiment. Current investor sentiment remains euphoric. What we really need to see is investor sentiment measures moving from this euphoric state to disgust and despair, because it is only then that bear market lows are truly formed.
We have to call them like we see them—because we seem to be on the edge of a bad occurrence when you really start looking. Bank balance sheets have diminished since the Silicon Valley Bank fiasco. The fundamentals are pointing to more deflation in our lives ahead and this is why we’ve picked up more long-term bonds. Deflation could give us a big bond rally, hence our willingness to own some bonds. We really need to see the end result of our debt ceiling issue. There may be compromise in the end, but so far neither side is offering a solution.
The political process leading up to the presidential election in two years is also a wait and see. The Donald Trump Grand Jury issue is still out there and is not going away.
Lastly, the geo-political risk of war is not going away. Ukraine, China, Russia, and Taiwan are plenty to create a crisis in markets, so we see little proof of positive probability in markets. The basis for more solid decisions should be forthcoming before too long. Until then, we hedge our bets and must remain patient.
