Investors Searching for Clarity

I have hiked or jogged passed the trees on this Mt. Thom trail near my home
every three days for more than 20 years now. These trees and the trees on my
13-acre property have grown a lot over the years. They experienced extreme
heat and drought last summer and another long period with no rain this
summer. This is strange for being in a rainforest. But they keep growing over
time none the less. The same is true for businesses and shares in businesses. 

Shares in businesses have appreciated greatly over time but stock prices are

correcting this year. While North American economies and most businesses are
still purring along, higher inflation is creating a fire that needs to be extinguished.

I happened to drive by Hope B.C. last Friday just after this forest fire started
the night before. Within a day, smoke had covered the entire Fraser Valley just
like inflation has swept across the world. By Sunday, Vancouver had the worst air
quality of any city in the world, being rated a 10 out of 10.

This fire had to be dealt with just like the surge in inflation has to be dealt
with.

 

Due to the very steep terrain, four helicopters were called in to fight the fire by
picking up water from the Fraser River at the base of the mountain. If you look
just to the right and below the middle of the photo, you will see water falling
from the bucket and the helicopter above it.

The Bank of Canada, the Federal Reserve in the US (the Fed) and other
Central bankers are all raising interest rates to combat inflation that seems to be
raging out of control just like this fire. Raising interest rates by several percent is
not like a helicopter dropping buckets of water on a forest fire. Jacking up interest
rates like this is like blanketing the world with rain to fight a fire. Rain is good
when conditions are dry, but too much rain can cause problems too. In the same
way, moving interest rates back to a more normal level is healthy. However,
threatening to keep raising rates when inflation will likely decline in the months
ahead can cause problems in the economy. Raising interest rates too much is like
over steering in a car when it looses control. Over steering can cause a vehicle to
have an accident just like overtightening monetary conditions can cause a
recession.

Changes in interest rates quickly affect the valuation of every other asset like
stocks and real estate. However, it can take 6 or 12 months to see the full impact
of interest rate changes filter through to the economy. Central banks waited too
long to increase interest rates after the global economic shutdown due to Covid
19. Now they have to play catch up. The rate of inflation will likely be low in
March of next year. In fact, there could even be deflation by then. This leaves
investors wondering if raising interest rates much more is going to be too much.
Will higher higher rates be overkill which causes a recession by accident?
Investors are expecting the Fed to raise interest rates by 0.75% on Wednesday,
September 21st so that will not be a surprise. However, additional rate increases
after this could be too much.

The uncertainty caused by this dilemma is reflected in the volatility we are
seeing in stock prices. Please see a 3-year chart of the S&P 500 from WSJ below.

 

Warren Buffett said, “You don’t know who is swimming naked until the tide
goes out.” Rising interest rates are like the tide going out for the economy. It
exposes those who leveraged themselves too much in stocks, real estate,
businesses, etc. Some businesses could suffer or go bankrupt. The year to date
chart below shows the volatility a little more.

 

Stock prices reached a low in the middle of June and then recovered close to
half of the losses by mid-August. After a two-month recovery like that, the
uptrend was due for a pause anyway. Strong comments from Fed Chairperson
Jerome Powell about the need to raise interest rates into 2023 was the reason for
this selloff. Prices rebounded last week until inflation data came in at 8.26% last
month compared to 8.52% the month before. Inflation is coming down but not by
as much as investors expected it to. This compares to inflation of 5.25% a year
ago.

It is difficult to know what might happen in the short-term. The June lows may
have to be retested. However, the rise from the June lows showed strength that is
typically seen at the start of a new bull market. For example, the percentage of
stocks trading above the 50 day moving average was below 15% and then moved
over 90% within 50 days. Since 1957, the S&P 500 has risen an average of 22.6%
a year later after this has happened. In the previous 17 signals, there was never a
decline one year later.

As mentioned earlier, the S&P 500 recovered half of its losses after a 20%
decline. Ever since 1956, the S&P 500 has never dropped to a new low after that.
One year later, the S&P 500 was up an average of 19.3% without a loss in the
previous 15 signals.

As of July 28th, the number of advancing stocks compared to declining stocks
for all different sizes of U.S. companies over a 10-day period was 1.9 to 1. A 2 to
1 ratio or better has a perfect track record of gains 6 and 12 months later but a 1.9
to 1 ratio has been an accurate buy signal 52 out of 53 times with the average gain
being 17%.

The situation is always a little different. However, there is one factor that has
not changed in thousands of years and that is human nature. These statistics show
us how human behaviour since the June lows compares with other market bottoms
in the past half century. We may not know what will happen in the next month or
so. However, if history repeats, there is an extremely high probability that prices
should be much higher 12 months from now.

Please see a chart of the 2-Year US Bond Yield for the last 50 years below 

to put current interest rates into perspective. (From Trading Economics)

Over the last 200 years, the average yield on the U.S. 30-year bond has been
in the low 5% range. This means that a yield of close to 3% on the 2-year bond is
close to normal. The current rate of 3.8% may be a little high, as it is the highest
yield in 14 years.

Bond investors have likely factored in a rise of 0.75% in US interest rates on
Wednesday. The US 2-Year Bond is a good idea of where investors expect
interest rates to be in the future. (Chart is from Trading Economics)

It has been very quiet on the search and rescue front this month. My RBC office

in Abbotsford hosted our annual golf tournament at the scenic
Sandpiper Golf Course on September 9th and raised another $90,000 for the
Fraser Valley Health Care Foundation. I took this photo of the fine gentlemen I
was golfing with.

 

These funds will be used to buy equipment for hospitals in Abbotsford,
Chilliwack, Mission and Hope. This is something that will indirectly benefit
almost everyone in our local communities. Stay safe out there and have a good
weekend my friend!