The release of the Fed minutes on January 5th removed all the wind from December’s Santa Rally and created a selling vacuum that dragged down most of the major indices. The minutes were interpreted as a shift in Fed policy to a much more aggressive hawkish stance -much more than the market expected. As a result, stocks sold off fiercely, and the weakness continued throughout most of the month. It was only after the following January Fed meeting, held on the 26th, that prices began to stabilize.
In January, the major indices suffered their most significant losses since the Covid market crash in March of 2020. While expectations for future Fed tightening remain elevated for the rest of the year, the market took the latest comments to conclude that the Fed will not be as overly aggressive as the street first speculated earlier in the month. This relief propelled stocks to stabilize and begin recovering going into month-end.
One of Wall Street’s oldest adages is that “as goes January, so goes the rest of the year.” Since 1950, the S&P has posted negative returns for the first month of the year 29 times (40%). Within those 29 Januarys, the S&P has posted an average return of -1.16% over the next eleven months. While this January’s return has historically signaled trouble for the remainder of the year, this adage seems to have lost some luster since the turn of the century. Since the year 2000, the S&P experienced a negative January twelve times and the average calendar year return for these twelve years was +4.62%. Either way, the data points to an underwhelming year for investors, and expectations should be lowered and patience should be increased.
February Historical Data Points
February has become the weak link of the “best six-month period” in the market. February has traditionally been the second-worst month of the year for the S&P 500, only trailing September.
February is one of the few months that historically has experienced better returns during mid-term election years (as we are currently in).
The market is closed on Feb 21st for President’s Day. Over the last 25 years, the market has seen elevated volatility in the trading days before and after the holiday.
Could the Fed be Wrong?
As previously mentioned, the release of the Fed minutes on January 5th created a lot of concern on Wall Street. Investors are worried that the Fed will be too aggressive in their switch from “accommodative” to “tightening.” The Fed is changing its stance to address the current level of inflation which is sitting at a 40-year high. After calling inflation “transitory” for over a year, it appears they now believe the issue to be more "sticky" and will begin to act in an attempt to slow the inflation rate down.
The US economy has only had to deal with inflation at or above the current levels a handful of times, dating back to the start of the 20th century. It’s interesting to note that periods of higher inflation all occurred during or immediately after a major war. These include World War I, World War II, and the Vietnam War. The last major bout of inflation the US economy faced in the late 70’s & early 80’s was also heavily influenced by the massive price increase of oil due to the 1973 & 1979 oil shortages. The inflation we are seeing today has no characteristic similarities to past periods. Today’s issues resulted from the Covid related shutdowns and the amount of money “pumped” into the economy (for better or worse) to help keep it moving.
Interestingly, just as the Fed suddenly moved away from their transitionary inflation outlook, certain data points suggest otherwise. Below are a couple of major data points that speak to a deflationary environment period ahead in the economy vs the current inflation we are seeing:
1. While last week’s GDP number was a significant surprise to the upside, it was driven by a massive gain in inventories which could raise deflationary risks caused by too much supply.
2. Across almost all the US regional PMI (Purchasing Managers Index), data continues to show encouraging signs that supply chains are normalizing. Delivery times have fallen to six-month lows, prices paid (although still elevated) have fallen from their highs, and unfilled orders have fallen significantly. If these trends continue, supply-side induced inflation should soon correct itself.
3. The Baltic Dry Index, which provides real-time data on global shipping rates, offers a great reading on supply chain tightness and is an excellent leading indicator for inflation. This index has fallen 76% since its peak in October 2021 and historically this index leads the consumer price index by a few months. The chart below from Invictus Research shows the relationship between the two indices since late 2017:
We believe that inflation will remain elevated, but supply-induced inflation will begin to work its way back down to its historical trends. Based on the underlying economic data, we feel that the Fed will not have to act aggressively when it comes to monetary policy at this time. It would be a mistake for the Fed to move as quickly as some expect, especially if the overall economy begins to soften. We would anticipate that the Fed had learned from past mistakes when aggressive tightening became a considerable influence on major economic disruptions.
February Market Expectations
Another important risk for the equity markets includes the United States' potential involvement in the conflict between Russia and Ukraine. We view this as a low risk since it would likely be detrimental for the Democratic party to get pulled into a major geopolitical conflict during a midterm election year. After "celebrating" the exit from Afghanistan and facing stiff competition at the polls in November, we find it tough to believe that Congress would approve of a massive conflict. For now, we would expect the chances of a major conflict erupting in Ukraine to be around 15%.
While most of our indicators have weakened slightly in January, we are still impressed by the overall relative strength of the market internals. Our money flow indicators have bounced off a multiyear low, while our relative performance data has continued to get stronger. The current setup of the market looks very familiar to many of the market lows we have seen over the last decade. At this time, we continue to believe that the intraday low seen on January 24 will remain the "internal market low" for this correction. This level is where most of our data is the weakest. While it will take time to work out of this correction (and there is a chance of a retest), any mover lower in the market should be viewed as a buying opportunity.
The Fed will continue to be the wild card for the remainder of the year and it does not have its next meeting until the middle of March. While economic data should continue to show that inflation pressures are easing, any hawkish comments from the Fed minutes could rattle stocks again. The market does not like uncertainty, so volatility will likely remain heightened until we can move past certain issues regarding rate hike expectations and potential balance sheet runoffs. If our belief that the Fed will move slowly is accurate, it will be a major positive for stocks. However, investors must prepare that it will likely take a few months and not weeks to confirm our view.
We are expecting February to be a choppy month with little overall direction for stocks. Although we have bounced the last few days, it would be healthy for the market to take its time getting back to previous highs. It is essential to see the market form a solid bottom to provide future support. While we continue to believe that intraday lows of January 24th will be the internal low for this correction, we do not expect much upside excitement until the March Fed meeting. The following six weeks will likely produce a range-bound market that may allow for an excellent bottom to trade out of.