Market insights and analysis

By William Hubbard, CFA

The major U.S. stock indexes declined last week. The S&P 500 fell 3.37%, the Dow Jones Industrial Average lost 2.77%, the NASDAQ Composite dropped 3.99%, and the Russell 2000 small-capitalization index took the largest hit with a 5.08% loss. The 10-year Treasury bond yield rose 9 basis points to 3.58%, taking bond prices lower for the week. Spot gold closed the week at $1,797.63, down 0.02%.

Stocks

In economic news last week, the big surprise was the miss on the producer price index (PPI). On Friday (December 9), the numbers for the PPI and core PPI, which excludes food and energy, came in much hotter than expected. The PPI was up 0.3% month over month in November and 7.4% year over year. Most of the increase (0.4%) came from demand for services, while goods were up only 0.1%.

The increase in services is a potentially longer-term problem for the Federal Reserve, since the majority of the cost for services is labor. Once wage increases are widespread, they become very sticky and much more difficult to reduce—no one likes a pay cut.

Before the release, the market was up slightly, around 0.5%. After the news broke, the market immediately fell. The market tried to recover before selling off to close back at the lows of the day.

The total miss was viewed as a negative for the future of inflation. PPI represents the prices paid to producers of goods and services. The theory is that if the costs of goods and services increase, then businesses will need to pay more for supplies. These price increases will ultimately be passed on to consumers. When the consumer price index (CPI) is already running higher than the Federal Reserve’s 2% long-run target, it challenges the idea that the Fed can pull off a “soft landing,” avoiding a deep recession.

Over the weekend, The Wall Street Journal reported that investors are growing more confident that the Fed will accomplish a soft landing. In a speech on November 30, Fed Chair Jerome Powell hinted that the Fed may moderate interest-rate hikes in December. The new expectation is a 0.50% rate increase, instead of the 0.75% hikes we’ve experienced so far this year.

With the CPI still elevated and PPI running hotter than expected, it’s hard to see how now is the time to slow rates. The Fed must have data to suggest that the lagging impact of rate increases is enough to offset runaway inflation. People are starting to believe Powell when he suggests a soft landing is possible. The question is, can it be done?

The answer is: Rate increases pretty much always lead to a recession. The following graph goes back to July 1954 and shows the effective federal funds rate (blue). The gray vertical bars are official recessions. It doesn’t take any complex math or statistics to analyze this chart: When the blue line goes up, a shaded gray area forms. Once the gray area grows, the blue line decreases. Then the cycle repeats. Something that might be particularly worrisome is the sharpness of the current rate increases compared to the past.

It will be interesting to see where rates need to go to achieve the Fed’s goals of price stability and full employment. The soft landing, or muddling through, is the best-case scenario. But with every new negative surprise, like the hotter-than-expected PPI, the likelihood of that scenario shrinks.

Bonds

The indicators pointing to a recession in stocks seem to be abundant, and fixed income is no different—so maybe that’s the contrarian indicator. The 10-year Treasury declined in value last week, with a rate increase from 3.49% to 3.58%.

The historical data for what may precede a recession is somewhat limited, but it also carries weight since human action is certainly disruptive to the natural ebb and flow of buyers and sellers. Even though Fed Chair Powell sees the path to a soft landing, the data from equities and fixed income both suggest that the runway is very narrow and getting smaller. The likelihood of a miss is so high that it’s hard to see them landing the plane.

During his speech on November 30, Powell acknowledged all the difficulties facing the economy without sounding downtrodden. In his closing remarks, he said, “The time for moderating the pace of rate increases may come as soon as the December meeting.” At the same time, he also tried to temper market-risk-seeking behavior by saying, “It makes sense to moderate the pace of rate increases as we approach the level of restraint that will be sufficient to bring inflation down,” before going on to say, “It is likely that restoring price stability will require holding policy at a restrictive level for some time.”

The bond market is extremely inverted (shorter-term maturities are yielding more than their longer-term brethren). There are many factors contributing to the inversion, including issues related to wage growth—though we won’t go into those now (Powell says “wage growth remains well above levels that would be consistent with 2 percent inflation over time”).

Bespoke Investment Group tracks a combination of yield-curve levels. Based on their data, which goes back to the 1970s, when approximately 75% of their yield-curve matrix shows an inversion, then a recession follows 100% of the time. Currently, the percentage showing an inversion is nearing that 75% figure. In the following chart, every time the blue lines (percentage of inversions) exceed the red line, there is a recession (gray shaded area).

Bespoke highlights some of the more common yield-curve spread measures: “Specifically the 10y2y [10 year/2 year spread] and the 10y3m [10 year/3 month spread] curves, both moved down to extreme inverted levels this last week. The 10y2y curve reached its most inverted level since 1981.”

Gold

Gold began a bounce off its October low and ended last week down 0.02% at $1,797.63 per ounce. All year long, it has been negatively correlated to the U.S. dollar, which, until recently, had been in a strong, multiyear rally. Gold closed the last two weeks above its 200-day moving average, while the U.S. dollar fell below its 200-day moving average early this month.

If the dollar begins to retrace, patient gold investors might be rewarded. Year to date, the dollar is still up 9.5%, while gold is down approximately 2.5%.

For U.S. investors with strategic, long-term allocations to gold, this year has been irritating—not because gold hasn’t done well relative to equities but because of expectations. Investors expect gold to be an inflation and risk-off hedge and to appreciate in value during volatile and uncertain times. That just hasn’t been the case this year; however, if the inverse correlation between the dollar and gold continues, then gold investors may have a much more pleasant 2023.

Flexible Plan Investments is the subadviser to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction nine years ago to track the daily price changes in the precious metal.

The indicators

The very short-term-oriented QFC S&P Pattern Recognition strategy started last week 40% long, increasing to 70% long on Tuesday. On Wednesday, it went to 150% long. At Friday’s close, the algorithm took some risk off to end the week 120% long. Our QFC Political Seasonality Index started last week in equities before moving to a defensive position on Wednesday’s close. (Our QFC Political Seasonality Index—with all of the 2022 daily signals—is available post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.)

Our intermediate-term tactical strategies have been varied in their degree of defensive positioning. The key advantages these strategies offer to investors are their ability to adapt to changing market environments, participate during uptrends, and adjust exposure to more defensive posturing during downtrends.

The Volatility Adjusted NASDAQ (VAN) strategy started last week 20% short before moving to 40% long on Tuesday’s close. The Systematic Advantage (SA) strategy started last week 60% exposed to the S&P 500 before moving to 30% exposed on Monday’s close. On Thursday’s close, Systematic Advantage moved back to 60% long. Our QFC Self-adjusting Trend Following (QSTF) strategy was long 100% all week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic model was long risk-on positioning all last week. Most of our Classic accounts follow a signal that will allow the strategy to change exposure in as little as a week. A few accounts are on more restrictive platforms and can take up to one month to generate a new signal.

Flexible Plan’s Growth and Inflation measure, one of our Market Regime Indicators, shows markets are in a Normal economic environment stage (meaning inflation is rising and GDP is growing). This environment is the most common and accounts for 60% of the investable days since 2003 and favors stocks and gold. On average, gold has performed best during Normal market environments, but it comes with additional drawdown risk. During Normal environments, the worst drawdown experienced by the S&P 500 and bonds is 17.18% and 4.91%, respectively. Gold, on the other hand, had a 31.92% maximum drawdown.

The S&P volatility regime is registering a High and Rising reading. From an annualized return standpoint, high and rising volatility favors stocks over gold, and gold over bonds. The combination has occurred 23% of the time since 2003. Typically, this stage is associated with lower returns and higher fluctuations for the three major asset classes.