Bear Market Bounce or Stock Market Bottom?

Markets will remain volatile, but the short-term strength in the equity markets may continue through the mid-term elections. A pause or even a signal of a slowdown in rate increases by the Federal Reserve can extend this current market rally. A decline in the U.S. dollar could also be a much-needed market tailwind going forward.

• Section 1: Bear Market Bounce or Stock Market Bottom?

• Section 2: Risks

  • Inflation & Overtightening

  • Russia

  • China

• Section 3: Opportunities

  • Fixed Income

  • Energy

  • Healthcare

  • Durable Growth

  • Election

Bear Market Bounce or Stock Market Bottom?

Over the next twelve months, the deteriorating outlook for the U.S. economy is a major cause of the pessimism hanging over stock market sentiment. It is ensured by the Federal Reserve Board's colossal miscalculation on inflation that the economy will slip into a recession over the next twelve to eighteen months. Historically, waiting for the economy to bottom before entering the market has been a mistake. However, stocks have typically been 28% above their lows by the time the real economy bottoms. In eleven out of the last twelve global recessions, the S&P 500 bottomed before the recession was over. The only exception was the 2001 technology bubble recession.

Buying stocks after a 20% market decline has typically led to exceptional returns over the next one and three-year time frames. There are no guarantees that stocks will rebound quickly, but the median bear market lasts about a year. While it is nearly impossible to market time the stock market bottom, waiting for an improvement in economic activity as a signal will lead to significant underperformance.

Within equity markets, investors should focus on companies that can survive a likely recession and thrive once the storm passes. Given the inflationary threat, a company's power to pass along price increases without collapsing demand for its products is critical.

Stocks have usually bottomed about six months before the economy but have bottomed as much as ten months before the economic decline is over.

Bear market troughs have common characteristics. Low valuations are necessary, though more is needed to signal a bottom. However, equity markets do recover while economic conditions are still weak and profits are depressed, and it is usually not until the rate of earnings deterioration has slowed that investors start to price in a recovery. Reaching a peak in interest rates, inflation, bearish sentiment, and negative positioning are also important.

Are we there yet? Not all of these negative conditions have been met yet, and markets are in for a continued downward trajectory. There was a brief period of market optimism in the summer focused on the Federal Reserve pivot and the belief that we were nearing a peak in inflation and interest rates. However, we have learned from Jackson Hole, and since then, that it was premature. Global Central banks have become more hawkish, yet again, both in the U.S. and Europe, as they struggle to regain any sense of credibility that is so apparently lacking. So, we think there is still some way to go as the Fed is most likely to keep hiking until they break something as they make their second major policy mistake.

Inflation and the Risk of Overtightening

Money Supply

The U.S. money supply has rapidly increased by an astronomical $6 trillion since the beginning of the pandemic. U.S. policy is trying to mitigate that growth to help slow down inflation.

Money Supply Growth

The money supply depicted above consists of currency in circulation and money in savings, checking, and money markets funds for consumer and business accounts. The money supply growth rate is decelerating due to the Federal Reserve's interest rate hikes and its balance sheet reduction.

Given that economic expansion equals the money supply multiplied by the frequency, a deceleration in money growth should lead to weaker economic growth. As a result, the money supply is already contracting significantly, and further acceleration in the money supply is projected. While money growth declines may bring down inflation, its side effect will dramatically slow the real economy.

Slower economic growth does not impact all equities equally. Companies with higher margins and less debt should do better, as should those whose fundamentals are driven more by market share gains than economic growth.

Will the Federal Reserve make a second mistake and break the market? The Federal Reserve has obviously made its first mistake by keeping rates artificially low for too long and continued its massive bond-buying program as home prices and markets soared. However, the question is, does the Fed dramatically overcorrect and slow down the economy to the point it breaks? There is a six to 9 month lag on the effects of interest rate hikes, and it is our opinion that the Fed overcorrects, which will cause them to reverse course and pause rate hikes.

Some global public pension plans are exposed to margin calls. These plans used leveraged derivatives to substitute for bonds in their portfolio and increase the total amount they could invest in boosting returns. The pensions adopted the strategy because low-interest rates were not generating enough returns to pay promised benefits. Global Central banks are rapidly raising interest rates at the sharpest pace in more than 40 years, showing signs of market stress.

Recent trouble in the British bond market and currency markets is one example. That disturbance has exposed potential risks looming in pensions and government bond markets, which were relative oases of calm in past financial flare-ups. As a result, some pain is anticipated in the global fight against inflation. Raising interest rates usually leads to lower equity prices, higher bond yields, and a stronger dollar.

However, abrupt adjustments can lead to a slowdown more severe than what the Fed and other central banks want. As a result, threats to financial stability sometimes spread from unexpected sources.

Meanwhile, the U.S. dollar has risen sharply against foreign currencies, threatening higher interest costs to emerging-market economies that borrowed heavily in recent years from foreign investors seeking higher returns.

The United Nations recently urged the Fed and other central banks to halt rate increases, warning that alarm bells are sounding in developing countries, many of which are edging closer to debt default.

Russia

A Ukrainian offensive continues to gain significant ground in the country's east. The U.S.says they have received no new intelligence that indicates that Putin was preparing to move on his threat to use nuclear weapons, following unusually sharp comments from President Biden that warned of the "prospect of Armageddon." An official said that the President also wanted to stress that nuclear weapons, even tactical nuclear weapons, would be disastrous. Even a tactical nuclear strike or a false flag dirty bomb would be catastrophic.

China

• Real Estate

• Zero-Covid

• Risky External Loans

• Russia's invasion of Ukraine

Companies with significant China exposure can no longer ignore the increasing economic risks linked to a Chinese invasion of Taiwan and should accelerate their contingency planning. Moreover, establishing supply chains elsewhere in Asia is a sensible strategy that companies should pursue more aggressively.

Companies with significant revenue from China should anticipate substantial revenue loss if an invasion occurs and ongoing reputational risks and should diversify their sales base accordingly.

If China chooses to invade Taiwan, I do not doubt that the U.S. and its allies will come to Taiwan's aid and ultimately defeat the Chinese military. However, the ramifications for the global economy would be profound and severe. Hopefully, peace will prevail, so I will focus on other risks to the Chinese economy and how those risks will affect the world markets.

The western world is focused on the atrocities being committed by Russia in Ukraine, and China's choice to stand with Russia is straining their globalization links.

China's economic challenges go beyond the war in Ukraine. Threats to China's economic outlook are rising in four distinct but overlapping areas: at home, in health, in debt, and in a fracturing globe.

Real estate

Chinese real estate defaults continue. For example, China saw a record number of default payments from Evergrande and many others among Chinese developers last year. As a result, S&P estimates that 20% and 40% of Chinese property developers may face a major default.

Once home prices stall and start significantly falling, we know the effect of debt on declines in home prices from our own housing crisis. Underwater homeowners stop discretionary spending as their home values fall.

We would be naive to think that standard economic boom and bust rules do not apply in China or to assume that the Chinese government can always effectively manipulate prices across the entire country indefinitely.

Zero-Covid

As China's housing markets stumble, the effects of the pandemic policy are making economic matters worse.

China's zero-Covid policy, which has the strictest medical and public health response to the pandemic anywhere in the world, is in trouble.

As the virus mutates and becomes even harder to control, those measures may be more costly. Lockdowns are being imposed in major cities across China. The adverse economic effects of its ridiculous Covid policy are already apparent. Economists continue to cut economic growth forecasts for the country.

As demand in China weakens, everyone outside the country may feel it too. However, it is still being determined whether the Chinese government is willing to pivot from its zero-tolerance policy to a new approach, even though such a shift appears increasingly necessary to the rest of the world.

Risky External Loans

Interest rates are rising as the modern developed world tries to contain inflation. Many loans made by Chinese companies as part of Beijing's Belt and Road Initiative are straining central bank balance sheets in low-income countries across the globe. However, they will also burden China's largest banks with nonperforming loans, which will affect the economic performance of those banks, which are vital sources of Chinese domestic investment, businesses, and the economy. In addition, Belt and Road have saddled developing states with at least $385 billion in debt.

Russia's invasion of Ukraine

Globalization, the engine that powers China's economy relied on for so many years, is beginning to stall under the pressure of the pandemic and Russia's war with Ukraine.

China is choosing Russia over globalization is shortsighted and could result in secondary sanctions on Chinese firms. China will also pay a heavy price if it continues to back Russia.

Opportunities

• Fixed Income

• Energy

• Healthcare

• Durable Growth

• Elections

Fixed Income

It is almost time to pull the trigger on long-duration bonds.

Bond prices have an inverse relationship with interest rates. When interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. If prevailing interest rates on government bonds are falling, older bonds that offer higher interest rates become more valuable. The investor who holds these bonds can charge a premium to sell them in the secondary market.

Alternatively, if prevailing interest rates increase, older bonds become less valuable because their coupon payments are now lower than new bonds offered in the market. As a result, the price of these more senior bonds drops, and they are described as trading at a discount.

The Federal Reserve Board is scheduled to reveal its next rate decision on November 2nd. In updated projections, the Fed signaled plans to lift rates by another 1.25 percentage points before the year is over, bringing the federal funds rate to 4.25-4.5 percent before 2022 comes to a close. Considering the Fed only has two meetings left, that could mean another 75 basis-point hike in November, followed by a half-point increase in December.

Looking even farther into the future, the Federal Reserve is bracing to lift rates to 4.5-4.75 percent by next year. Six officials, however, see rates soaring to 4.75-5.0 percent next year, which would be the highest since 2007 if it comes to fruition.

After the next rate decision on November 2nd, the time is right to start increasing exposure to fixed income by buying long-duration bonds in companies with a strong balance and a low default risk. Tax-exempt municipal bonds and treasuries also present an excellent opportunity for more risk-averse clients. We cannot predict the top in rates or if some exogenous event will cause the fed to pause the rate height cycle prematurely. However, we are closer to the top than most are predicting, so we advise our clients to start building a small position and increase that position after every rate hike.

Energy

Oil prices skyrocketed due to the Russia-Ukraine war. The S&P energy sector is the only positive sector this year and is up more than 50% so far this year.

The mismatch between demand and supply growth going forward means oil prices have to go sufficiently higher over the next two to three years to destroy discretionary demand. Destroying oil demand will be extremely tough with a recovering global economy now adjusting to a pre-pandemic normal.

A sharp slowdown in economic activity will hurt demand, but the lack of supply will outweigh any downturn in oil demand caused by a global recession. Another outlier that would cause a dramatic increase in demand is when China abandons its zero covid policy.

OPEC and its allies announced they would cut production by 2 million barrels per day. Oil prices sharply jumped on the news, and West Texas Intermediate crude topped $90 per barrel.

When analyzing energy companies, we are searching for companies with a strong financial profile with an investment-grade bond rating, large amounts of cash on hand or access to affordable credit, and manageable, well-structured debt maturities. Additionally, we screen for low costs of operations or relatively stable cash flow streams. E&P companies need to sustain operations profitably at oil prices of less than $40 a barrel. Our buy list recommends oil companies that are partially vertically integrated by engaging in several different activities.

Natural Gas

Liquified natural gas prices have skyrocketed in various parts of the world this year, most notably in Europe.

The issue with much of the world's trade in LNG is that it is landlocked and therefore localized region by region, unlike oil which is freely tradeable worldwide. Some areas of the world are in short supply of natural gas, like Europe, and pay significant premiums to those with a sizeable local supply, such as the United States. As a result, we have seen a surge in U.S. LNG exports.

The lack of significant local natural gas production or terminals to receive LNG is one of the reasons Germany and other European economies suffer from high natural gas prices. From aiding fertilizer production to powering and heating our homes, people will pay considerably higher prices in the short term for this essential commodity.

We believe that companies helping to alleviate the major LNG imbalance by building terminals and transportation infrastructure may have substantial growth opportunities. Freight rates shipping LNG to Europe have increased six-fold, which is worrisome for the industry, but in our view, U.S. companies that produce natural gas may have bright prospects for exports as LNG capacity dramatically increases in years to come.

Healthcare

Healthcare Stocks Have Consistently Outperformed in Down Markets. Today's Healthcare Sector Combines Defensive with Opportunity.

We are focusing our healthcare positioning with an emphasis on high-quality, sensibly priced healthcare and healthcare-related companies with already high or improving returns on capital and strong reinvestment capabilities. Even some traditional, value-oriented healthcare names can offer compelling opportunities today, like health insurers Elevance Health and United Health Group, as both continue to improve patient outcomes, manage expenses and grow revenues.

Another factor driving strong performance in healthcare stocks was rebounding medical spending in 2021 as families who deferred medical treatments during the pandemic's peak started to return. One way of looking for healthcare companies to invest in could be searching for leading industry names, focusing on the top healthcare companies.

Markets remain volatile, downside protection is always helpful, and we think that includes healthcare stocks, which have historically been reliable defenders. We believe the dynamic products and services that now dominate the healthcare space are the main reason select stocks have the wherewithal to withstand challenging economic environments and deliver long-term returns.

Durable Growth

Some growth is cyclical, subject to the economy's ups and downs. Other growth is secular, which means it is independent of economic volatility. So, where should investors look to allocate assets if the U.S. enters a recession?

With the threat of a recession on the horizon, investors may consider shifting from economically sensitive exposure, such as retail or machinery, to secularly growing market share gainers that are best of breed in each respective market. Durable growth names have a proven track record, strong management teams, competitive advantage, strong balance sheets, great brands, and sound business models. As the market continues to decline, having a shopping list of best-of-breed secular growth names will be essential to drive growth in your portfolio for the next bull market. Select best-of-breed market leaders are already beginning to form a base of support at key levels. Look for companies that have price support on the big market down days or that have firm price support even with negative news.

Elections

The outcome of most midterm elections is determined partly by the President's current approval rating. Historically, the approval rating has caused about half the variation in the number of seats gained or lost in the House of Representatives.

During a president's first term, the President's party usually loses seats in the House. In our view, this historical evidence, plus Biden's current approval ratings, positions the Republicans to have a significant chance of taking majority control of the U.S. House, especially since they only need to win five seats to gain control.

A divided U.S. government usually means less meaningful legislation, which reduces uncertainty and is typically good for equity investors. Since 1982, the market has gained based on the clarity that follows elections, with an average return of 14% for the S&P 500 in the 12 months following mid-term elections. If history repeats itself, the market may again be comforted by completing this year's election.

Conclusion

Markets will remain volatile, but the short-term strength in the equity markets may continue through the mid-term elections. A pause or even a signal of a slowdown in rate increases by the Federal Reserve can extend this current market rally. A decline in the U.S. dollar could also be a much-needed market tailwind going forward. We would be a seller towards the end of the year because we see further downside in the equity markets. However, we are seeing plenty of current opportunities in healthcare, oil, and liquified natural gas names and soon in select fixed income. We suggest buying slowly and incrementally as the market declines, increasing your buying at predetermined levels. Nevertheless, as markets continue to fall, it is critical to have a shopping list of secular growth names to take advantage of a once-in-a-decade buying opportunity, but will you be prepared to take advantage?

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Investment Disclosures

​This material is not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities.

The views expressed are the views of Infinitus Wealth Management, LLC. These views are subject to change at any time and may not represent the views of all portfolio management teams, Wealth Advisors, or other Investment Professionals. These views should not be interpreted as a guarantee of the future performance of the markets, any security, or any funds managed by Infinitus Wealth Management, LLC. These views are not meant to provide investment advice and should not be considered a recommendation to purchase or sell securities. Investment Advice will be given to individual clients based on risk tolerance, time horizon, investment objectives, and other considerations.

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