Last week, I gave a presentation to members of the Spokane Valley Chamber of Commerce in the Greater Valley Networking Group. The hypothesis was straight forward – there are signs suggesting that the bull run we have experienced in equity markets so far this year may not be sustainable, but opportunities for reliable income abound. I recently read an article from CNN’s Nicole Goodkind suggesting that Warren Buffett and Michael Burry (the famed investor who predicted the ’08 housing market crash) share this idea of an impending downturn in markets, and it inspired me to share this message with a larger audience!
The stock market has had a great start to 2023 with the S&P 500 up over 15% and the NASDAQ up over 30%. However, companies’ earnings, and expected earnings, are not keeping pace with this growth. Much of the upward moves have been made by a select few companies, in large part due to optimism surrounding AI technologies. Massive companies like Apple (+37% ytd), Alphabet (+47% ytd), and Nvidia (+215% ytd) have bolstered returns in the broader market.
These companies have shown outsized growth in their share prices, but quarterly earnings reports might not substantiate these upward moves. So, what is propelling these stocks upward? It isn’t their earnings! It is investor optimism, spurred on in large part by the promise of AI linked returns to come in the future. This reminds me of a quote from a legendary value investor, John Templeton. “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” According to Bank of America’s data as of August 2023, investors are feeling the least pessimistic since February of 2022.
Since March of 2022, the Federal Reserve has been battling stubborn inflation by raising interest rates, which now sit at the highest level since 2002 – higher even than in the wake of the 2008 crash. These elevated interest rates cut into companies’ earnings, and with signs of current inflationary pressures continuing, there isn’t a clear path downward for rates. Details from the latest meeting showed Fed officials open to even further rate increases as inflation proves to be sticky. This was further substantiated last Friday when Federal Reserve Chair Jerome Powell said “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.” While this doesn’t bode well for the stock market, it does provide opportunities for dependable income not seen in over fifteen years! Twelve-month treasuries issued by the United States government are yielding over 5%, and so are CDs and corporate debt investments. There are even high-yield savings accounts returning well over 4%!
Further evidence of an impending economic downturn can be seen when looking at the yield curve. Often used as an indicator for the direction of the stock market, the yield curve compares the return on long-term bonds to those on short-term bonds. Between 1975 and 2021, the yield curve was ‘inverted’ (short-term bonds yielding higher returns than long-term bonds) 6 different times. All 6 of these inversions have been quickly followed by a recession. No outcome is ever guaranteed in the stock market, but history suggests that inverted yield curves are often followed by a recession.
With inflation proving to be sticky, interest rates poised to remain elevated, and the yield curve inverted, we believe Wall Street will soon abandon their hopes for a soft landing. Once that optimism has gone, there will be nothing left supporting high stock valuations, and the market could make a serious correction downwards. Therefore, it is our belief at Karel Capital that the best reward relative to risk is currently in income-based investments that actually benefit from high interest rates. This isn’t to say there aren’t companies who will thrive in the coming months and years, but for the stock market as a whole, the near-term outlook is murky. This makes it even more important to know what you own, and to capitalize on high-yielding income investments.