Just a Hint of Good News Boosts Stocks

Jerome Powell did it again two weeks ago. He repeated the mistake he made
in late 2018. Donald Trump appointed him as the Chairperson of the Federal
Reserve in 2018 and he has proven to be reactive instead of proactive.

After increasing interest rates in early December 2018, Powell stated that
they were going to keep raising interest in 2019. We must remember that a WSJ
study done in 2016 showed that the forecasts for interest rates by economists six
months into the future were only accurate 33% of the time over a 30-year period.
Last week’s Update showed that the record of forecasts by Powell and other
Federal Reserve Board officials has not been much better in recent years.

Stock prices fell sharply into Christmas Eve 2018 with the S&P 500 down
19.8% from the high. Realizing that his projection for interest rates had caused
such mayhem, he gave a talk in the first days of 2019, showing that he was at
pains to convince investors that any future interest rate decisions would be
dependent on the data, not based on a predetermined policy that ignored the most
recent economic information. Stock prices were back at record highs within a few
months after that and continued to produce attractive returns for the rest of the
year.

On August 26th, Powell said that the Fed would continue to increase interest
rates and do whatever they had to do in order to ensure that the rate of inflation
came down. In that eight-minute speech, he also mentioned Paul Volker, the Fed
Chairman, who defeated inflation in the early 1980’s. Paul Volker defeated
inflation by increasing interest rates to 20% and keeping them there a long time.
By saying this, Powell was implying that he would also keep interest rates high
for a long time even if it meant going into a severe recession. This created fear in
the minds of investors and the public.

The issue is that the inflation problem today is much different than it was 41
years ago. By 1981, high rates of inflation had been entrenched into the economy
and the minds of the public for more than a decade. In contrast, the current
inflation rate has been the result of a very rare perfect storm of supply chain
problems due to the pandemic, a shortage of commodities coming out of the
Ukraine and a shortage of oil and natural gas due to the boycott of oil, natural gas
and other products coming from Russia.

While much of the spike in the price of wages and goods due to Covid may
stick, there are unlikely to be additional increases from current levels. Rising costs
due to Russia invading the Ukraine are likely to return to normal as soon as other
sources of supply are found and able to be delivered. The one exception is the cost
of natural gas in Europe. As an example of prices coming down, please see the
chart of oil prices on the next page from WSJ.

This week, the price of crude oil dropped to $82, which is lower than the price
of $84 last November, well before Russia invaded the Ukraine. The price yesterday
was down 33% or $122 from the highs in March and June of this year.

US gasoline prices have dropped from a peak of $5.10 to $3.86 a gallon
compared to $3.50 last November. (See the chart below from MarketWatch.) I
would not be surprised to see gasoline prices fall back to the levels of last
November once oil prices remain at these lower levels for a longer time. This
means that inflation could be much lower in March and June of 2023. In fact there
could even be deflation for a short period of time. What investors are seeing on the
ground and what Powell was seeing seems to be two different things.

 

The Bank of Canada and the Fed should have slowly been raising interest rates
from historic lows a year ago as economies were recovering from the effects of
the pandemic. Due to that error in judgement, they are now trying to play catch
up. As mentioned last week, in the last month, 26 out of 27 inflation indicators are
declining. Not only are they declining, they are declining faster than they typically
have before. The only other time they have fallen this fast was during the
Financial Crisis in 2008 and 2009. As was the case in December 2018, once
again, the Fed is stating that they are going to keep raising interest rates based on
policy instead of the data. Powell may well have to backtrack again and say that
any rate changes will be based on the most recent data since the most recent data
does not seem to merit much more than a 1% or so increase in interest rates from
here. In fact, interest rates may actually have to come down a little next year if the
economy has slowed down too much.

There are twelve members that form the Federal Open Market Committee
(FOMC) that vote on U.S. interest rate changes. Since stock prices fell sharply in
the days after Powell’s August 26th speech, FOMC members have already been
conveying a change in their tune before the next meeting on September 20-21,
when it is expected that interest rates will increase by another 0.75%.

After seven days of declines, stocks rallied sharply on Wednesday when Fed
Vice Chair Lael Brainard said there are risks of going too far with raising interest
rates. She said, “At some point in the tightening cycle, the risks will become more
two-sided. The rapidity of the tightening cycle and its global nature, as well as the
uncertainty around the pace at which the effects of tighter financial conditions are
working their way through aggregate demand, create risks associated with over
tightening.”

The S&P 500 is up more than 1.5% again today, after Federal Reserve
Governor Christopher Waller said, “Looking ahead to our next meeting, I support
another significant increase in the policy rate. But, looking out, I can’t tell you
about the appropriate path of policy. The peak range and how fast we will move
there will depend on data we will receive about the economy.” Federal Reserve
Board officials seem to be qualifying Powell’s statement that interest rates will
keep rising into 2023. They are stating that any further rate increases after this
month will be based on the most recent economic data, not on a pre-set path. This
is the way it should be! Since measures of inflation are falling at the fastest pace
all across the board since the Financial Crisis, these comments are starting to
restore the confidence that existed before Powell’s speech.

The S&P 500 has staged a strong recovery off of the lows in mid-June, with a
rise of 12%. As mentioned in previous Updates, the strength observed in the
market statistics off of that rise show how human behaviour has manifested itself
in the market place. The behaviour in the stock market as it rallied off of the June
lows is consistent with the typical start of a new long-term uptrend.

As of the time of writing today, the S&P 500 is down 5.5% from the August
16th high and down 15.6% from the high on January 4, 2022. The three-month
chart below shows the recovery stocks have started this week after the sell-off
induced by Powell’s remarks two weeks ago.

We must remember that markets reflect what investors are expecting 6 to 12
months into the future. Since Mid-June, investors were seeing signs of lower
inflation and a peak in interest rates. Powell threw cold water on the idea of a
peak in interest rates and it seemed like he was on a dangerous path of over
tightening. After seeing the repercussions of this, other Fed officials have
recently been making it clear that there are risks to raising interest rates too high.
More importantly, they have stated that additional interest rate increases after this
month will be based on economic data. These clarifications are restoring investor
confidence, which is enabling stock prices to rebound after a seven-day sell-off.
This seven-day sell-off brought the stock market to levels that were extremely
oversold levels and pessimism increased sharply. These are the perfect conditions
that should enable stock prices to make more progress in the early stages of what
should be a new long-term uptrend. Please see a one-year chart of the S&P 500
below.

was a guest speaker and panellist at the Vancouver International Financial
Summit last Friday and Saturday. While some might want to hang out at the bar
or sit around in a restaurant after that, my style is to enjoy some beautiful scenery
and get a good workout. The photo on the next page shows me standing in the
misting station at the top of Grouse Mountain after completing the Grouse Grind
at a temperature of 32C. It is a world famous hike with an elevation gain of 2,800
feet in only 2.9 km or basically straight up. It is so steep that most of the trail is
stairs made out of rocks or wood. You are not permitted to hike down as it is too
dangerous. A gondola takes hikers down. I call it a stairway to heaven☺

I hope you stay safe and have a great weekend!