Stock market corrections and crashes are social spectacles where technical indicators combine with external economic events, crowd behavior and computer algorithms in a negative loop magnified by the media where humans are motivated to follow the herd off a cliff.
After the US stock and bond markets put up one of the worst first-half performances this year followed by one of the best months in history for July at 9.11% for the S&P 500 index bringing its YTD return near -10%, market experts and psychics are out in full force mulling over whether the current bear market is a bit more than half way to recovery with inflation tapering off, or just turning the corner into a major crash like the Great Recession after a temporary reprieve.
Think Like a Contrarian
Baron Rothschild, an 18th century British nobleman is credited with saying that: “The time to buy is when there’s blood in the streets.” This is an extreme example of contrarian investing and a bit more graphic than the saying to just “buy the dip.” This powerful maxim implies that the worse things appear, the better the opportunities are for profit. This is another way to think “buy low and sell high.”
Warren Buffett once warned, “you pay a very high price in the stock market for a cheery consensus.” In other words, if everyone agrees with an investment decision, it’s probably not a good one. While the crowd can be right at times during trends, no one has a working crystal ball nor can correctly call a stock, sector or market top or bottom.
Brace your portfolio and brain by seeking buying opportunities during a market correction or crash and not bailing out due to panic and fear. Basic investor habits like periodic rebalancing and dollar-cost-averaging are forms of buying low. Disciplined investors look forward to a healthy pullback as a buying opportunity, like shopping for winter clothes in the summer.
Timing is Terrible
Unfortunately, logic does not always prevail with investors as many studies indicate they have the urge to sell during market pullbacks, and crashes. Unfortunately, that impulse will likely cost them and their retirement savings.
An investor who put $10K in the S&P 500 at the top of 2001 and stayed invested would have turned it into $42,231 two decades later, for a +7.47% annual return. However, an investor who pulled out and missed the 10 best market days over that period would have just $19,347, only a +3.35% annual return.
Most interesting, seven of the market’s best days happened within just two weeks of the 10 worst, meaning even a short-lived exit may have proven costly.
Slowing Inflation May Speed Up Recovery
Investors and economists have breathed a sigh of relief as new inflation data suggest that price pressures are easing. While the prices of everyday goods and groceries are still significantly higher than a year ago, some of the underlying trends are beginning to reverse. And although inflation is sensitive to many hard-to-predict factors such as geopolitical risk, and cost increases have been worse than many originally expected, there are early signs that the stress on consumer pocketbooks could improve over the coming year.
Inflation is beginning to ease
Over the past week, a few key reports on inflation were released by the Bureau of Labor Statistics. Perhaps the most important showed that the Consumer Price Index (CPI) was flat month-over-month in July, an improvement from June’s increase of 1.3%. The new reading resulted in a year-over-year headline inflation rate of 8.5%, which while high, is an improvement from its peak of 9.1%. This was largely driven by declines in the cost of energy which have played an outsized role. This is consistent with the drops in oil, wholesale gasoline, and prices at the pump throughout the month of July.
The CPI release was followed by Producer Price Index data which measure the prices that producers receive for the goods and services they sell. These prices declined 0.5% in July thanks to many of the same factors that drove CPI. Finally, the Import Price Index, which is based on the prices of imported goods, reported a decline of 1.4% as well.
Energy prices have been a major driver of inflation over the past year and especially since March when the war in Ukraine escalated. Oil prices have declined since then and have hovered in the $90/barrel range for Brent crude, similar to their levels back in February. This has driven prices down across the energy supply chain, especially for gasoline prices which are now around $4 per gallon at the pump. Due to the timing of these energy price movements, the inflation reports in July were the first to capture these trends. Oil prices are notoriously difficult to predict and $4 per gallon is still a challenge for many households, but these improvements are welcome nonetheless.
Food prices are driven largely by labor costs
Despite the positive news around energy prices, food prices have continued to rise. The CPI food index showed that prices grew at a 1.1% month-over month rate in July, resulting in an increase of 10.9% over the past year. Unlike energy prices, swings in food prices are driven largely by labor costs and not on agricultural commodity prices alone.
The chart above highlights data from the U.S. Department of Agriculture from 2020 showing the breakdown of sectors that contribute to food production. Although agricultural commodity prices, including corn, wheat and barley, have declined since May, only 8% of food costs can be attributed to farm production. Later steps in the supply chain including food processing, trade, and services make up the majority of food costs. Moreover, 51.6% of food costs can be attributed to employee salary and benefits costs which remain high as labor markets continue to tighten. Thus, it may be longer before food prices begin to drive improvements in the inflation data.
Still, the improvements due to energy are a positive sign that have led to improved consumer sentiment and inflation expectations. The University of Michigan’s Surveys of Consumers shows that inflation expectations over the next year ticked down from 5.1% to 5.0% and sentiment for the future improved significantly, from 47.3 to 54.9. Consumer sentiment is an important leading indicator for consumer spending and the overall state of the economy, and the latest levels represent a recovery from their recent lows.
Consumer sentiment is slowly improving as expected inflation declines
Despite these improvements, the inflation story is far from over and the level of prices will likely continue to drive markets, interest rates, and Fed decisions. Three simple scenarios can help to clarify the situation and where we may be headed.
First, if month-over-month inflation rates fell to 0% across the board, the year-over-year inflation rate would rapidly decline to pre-pandemic levels. The arithmetic suggests that the year-over-year headline inflation rate would reach the Federal Reserve’s 2% percent target by April of 2023. While this scenario is unlikely, it does provide guidance on how trends could reverse.
Second, a more conservative path might be one in which inflation rates are assumed to continue at the same pace as July, except for energy which remains flat. This would result in the year-over-year inflation rate gradually declining to near 5% on a year-over-year basis by June 2023.
Third, a bit over- optimistic scenario is one in which core and food inflation categories return to their 2019 averages while energy inflation is flat. This would result in the year-over-year inflation rate falling to 2.2% by June of 2023.
The bottom line? Market volatility provides a good wake up call to check your mental mindset and portfolio results in extreme conditions to see how your strategy is holding up, and to see if your investments are positioned appropriately to your risk tolerance.
Through quite a roller coaster year for stocks and bonds, there are positive signs that inflation outcomes could improve going into 2023. Markets have recovered significantly in just a short period as energy prices and other pressures have declined. Investors ought to stay patient in order to take advantage of market recoveries.
For more information on our firm or to get in touch with Jon Ulin, CFP®, please call us at (561) 210-7887 or email [email protected].
You cannot invest directly in an index. Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss. All examples and charts shown are hypothetical used for illustrative purposes only and do not represent any actual investment. The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), and it advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.