June was a boring month for stock market volatility—or lack thereof.
The Chicago Board of Options Exchange (CBOE) created and tracks the Volatility Index, more commonly known as the VIX. It is also referred to as the “Fear Index.”
In April 2023, I wrote about how the VIX broke below 17. At the time, I noted three things:
- A VIX around 17 foretells a five to 10 percent pullback but not a crash.
- “I’m not overly worried about a VIX” at 17 because it isn’t far from its 20-year average of 19.3.
- If a correction occurred, I’d buy that dip by shifting “from my hedged positions to something more closely correlated to an economic and market recovery.
There has never been a month when the VIX had as many lows. The VIX closed at a 52-week low on eight of the 22 trading days in June 2023. December 2004 was the only month when there were as many closing lows. On the morning of July 12, 2023, it touched 14.01.
Given the lack of volatility, as expressed by a low VIX, it is unsurprising that the S&P 500 is trading at what many people would consider an overbought level (one standard deviation above its 50-day moving average). The index was overbought for five straight weeks through July 7, 2023. The Nasdaq had been trading similarly for eight weeks.
The market is screaming, “Here comes a 5 to 10 percent correction.” But who knows when it will start? And are we ready to care yet?
According to Bespoke, this current period is the longest streak of overbought readings for the Nasdaq 100 since March 2017 and the seventh longest since the Financial Crisis of 2009. While it is logical to mentally prepare yourself for a correction after such a run, the table below shows that an average 9.79 percent correction wouldn’t necessarily disrupt the average 28.91 percent 12-month gain.
Being overbought doesn’t provide a reason to expect outsized returns; nor is it necessarily a predictor of a big crash. Will it be different this time? Others might argue that a correction could be the spark that ignites a crash. After all, the world hasn’t stopped talking about the upcoming recession for nearly a year and a half. When will it arrive?
I might bail on all my equity positions if a recession were imminent. But I can’t help but ask, “What recession?” There is something like a 50/50 chance of one starting in 2024, but I don’t see one starting in 2023. New home buying is up 20 percent from a year ago despite higher mortgage rates. Sales of new automobiles were up 13 percent in the first half of 2023, defying predictions of a decline.
Oh, we’ll eventually get a recession. But if the Fed stops raising rates after its July 2023 meeting, a U.S. recession will likely be put off until sometime in 2024. It will be tough to get out of 2024 avoiding a recession. Some Chief Financial Officers of U.S. corporations agree with that concern, according to the CFO Survey.
Often, management surveys reveal that when corporate insiders feel gloomy about the macroeconomy, they’re more optimistic about their own company. The CFO Survey, run in partnership with Duke University and the Federal Reserve, shows an interesting twist this time around. In the most recent survey, broader economic optimism is off its recent lows, but appraisals of their own companies slid to new cycle lows and are now at their worst level since the first quarter of 2020.
Nearly 40 percent of small firms expect higher financing costs and tighter lending standards to curtail business spending. Financial decision-makers lowered their expectations for U.S. economic growth in the next year. The average CFO expectation for Gross Domestic Product (GDP) for the next four quarters is 1.0 percent, down from 1.4 percent in last quarter’s survey. A 1 percent growth rate isn’t a recession, but that leaves little wiggle room should something go wrong.
“What could possibly go wrong?” he said, sarcastically.
Interest rates have been skyrocketing. The money supply has been dropping since July 2022. Consumer excess savings could run out by the fourth quarter of 2023. And earnings in the second quarter of 2023 for S&P 500 companies are expected to decline by 7.2 percent.
Sure. What could possibly tilt a 1 percent growth rate into negative territory?
The CFO Survey occurred before the Federal Reserve released a new index: The Financial Conditions Impulse on Growth (FCI-G). According to the new model, unveiled in a paper released on June 30, 2023, financial conditions are near the tightest they’ve been since the financial crisis of 2008.
The paper is relevant in that it aims to reconcile what the Fed considers financial conditions and what the Fed thinks the rest of us feel are financial conditions. The FCI-G will approximate the variables’ impact on current and one-year forward conditions. Those variables include the federal funds rate, the 10-year Treasury yield, the 30-year mortgage rate, the BBB corporate bond yield, the Dow Jones Industrial Average, Zillow home prices, and the U.S. dollar index. All those things, taken together, are currently significant headwinds to GDP growth.
So why am I not more worried currently? Jobs are plentiful. Houses and cars are selling well. Travel demand is robust. The Atlanta Fed’s GDPNow model has consistently printed estimates of around 2 percent for the second quarter of 2023; the U.S. economy has momentum going into Q3.
I am not a fan of predicting the stock market or the economy when data is so mixed, but that is the situation we’re in. It’s easy to conclude that there will be a recession in 2024. It’s challenging to determine when (or if) I should increase the cash allocations of my investment portfolio to get more defensive.
A very conservative investor could liquidate all their equity positions now and convince themselves that they would reinvest when stocks hit their lows. But would they? History shows that most investors wait for some sort of “all clear” signal that never arrives before they put cash to work in the market.
I’m not ready to pull the trigger and abandon my stock positions just yet. I see a path for higher stock prices before the next big crash.
Nowadays, the most bearish stock market chatter pertains to the 10-year Treasury Note yield breaking above 4 percent. Pundits are saying that’s the death knell for the stock market. As stated earlier, I expect a correction, but when that happens, I am more likely to use that as a buying opportunity and shrug off those 10-year Note concerns. After all, from 1990 to 2007, the 10-year Note averaged 5.3 percent. Over that time, the price-to-earnings ratio of the S&P 500 was about 18. Currently, it’s about 19. (The 19 multiple has much to do with the technology sector, where P/E multiples are 27.2 versus a five-year average of 22.4.) Valuations are not so out of whack that I feel the need to hold lots of cash when I can rely on my defined-outcome ETF hedges—especially when inflation has been cooling.
Last week, the Bureau of Labor Statistics reported the Consumer Price Index (CPI) to have increased by 3 percent year-over-year through June 2023. That is down from the 4.0 percent year-over-year rate through May 2023.
I write more about the CPI than the PCE (Personal Consumption Expenditures Price Index) because American investors tend to be more drawn to it. But it’s worth noting that the Federal Reserve pays more attention to the PCE than the CPI. In particular, the Fed looks at the Core PCE. Year-over-year Core PCE currently stands at 4.6 percent.
Core PCI year-over-year came in at 4.8 percent, down from 5.3 percent through May 2023. “Core” CPI and PCE exclude food and energy prices. Core prices have remained stubbornly high even as the headline figures have dropped. The Fed will likely keep interest rates higher than investors and corporate managers prefer because of that inflation stickiness.
Although I’ve predicted the last interest rate hike for this cycle will be at the Fed’s July 26, 2023 meeting, I’m out of consensus. The Fed’s very own minutes of its June 14, 2023 meeting suggests they expect to raise rates two more times.
Even if the U.S. economy escapes a recession in 2024, I don’t expect to keep up the pace of investment returns we have enjoyed over the last nine months. I’m not raising cash, but I’m in no hurry to reduce those hedges I own. I also don’t feel rushed to add to those hedges to protect myself from a garden-variety correction.
I am reminded of an excerpt from Morgan Housels’ book, “The Psychology of Money.”
“Disneyland tickets cost $100. But you get an awesome day with your kids you’ll never forget. Last year 18 million people thought that fee was worth paying. Few felt $100 paid was a punishment or fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one.
“Same with investing, where volatility is almost always a fee, not a fine.
“Returns are never free. They demand you pay a price, like any other product. And since market returns can be not just great but sensational over time, the fee is high. Declines, crashes, panics, manias, recessions, depressions.
“The trick is convincing yourself that the fee is worth it. That, I think, is the only way to deal with volatility; not just putting up with it, but realizing that it’s an admission fee worth paying.”
If you look at the last two years of stock market performance, there’s been a fee of sorts. The average return was only about 3.4 percent over the previous two years, compared to a long-term historical average of 10.7 percent (see the below chart from Bespoke).
The crash of 2020 was definitely a fee. But in the context of average annualized returns of 12.3 percent over the last five years, that fee was at least worth as much as a trip to Disneyland. If you haven’t read Morgan’s book, you should. Gawd, you should. I’ve already pre-ordered his next book.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
