2 Big Problems That Could Further Impact the Stock Market

In last week’s commentary, we noted that the S&P 500 (SPY) had been range-bound, but that “it may be prudent to pare back on risk and exposure” due to signs of weakness like rising credit spreads and a weakening growth outlook. However, I didn’t anticipate the speed and intensity of the decline. Since last Thursday, we are down 8.7%. The reason is obvious. Rising credit spreads indicate more financial stress, while a weakening growth outlook means more economic stress. Then, you have the Fed hiking by more than expected and taking an even more hawkish stance despite the rapid slowing in many parts of the economy which is just beginning to course through the system. Today’s commentary will explore this issue in more detail. Read on below….

(Please enjoy this updated version of my weekly commentary published June 16^th, 2022 from the POWR Stocks Under $10 newsletter).

First, let’s review the past week…

Over the past week, the S&P 500 is down by 8.7%. There was more damage in the Nasdaq which was down 9.4% and the Russell 2000 which was down 10.7%.Another notable development was the action in Treasury yields. The 2-year yield hit a new high of 3.45% and the 10-Y hit a high of 3.48%.

There are 2 problems here. One is that rates are at their highest levels since 2011. And, it’s not necessarily the level but how we got there – in a quick ascent with rates more than doubling in the first six months of the year.

That will blowup any businesses/industries/trades that are dependent on rates staying low. Just look at crypto and all the leveraged players going bust.

In most economies, this can be absorbed with minimal collateral damage as growth in other parts will compensate for weakness. Not the case in a fragile economy like we have today.

The other problem is that the yield curve is flat as evidenced by the tight spread between the 10Y and 2Y. This is evidence that the market is pessimistic about the economic outlook.

Earnings and Rates

If you somehow lose your mind and decide to watch CNBC from 9:30 to 4pm every day from Monday to Friday then amid all the noise and time-fillers, 2 items will stand out in importance in terms of impacting market prices.

-> Earnings and Interest Rates.

Earnings are straightforward, and it’s self-evident to any investor why it and its trend matter.

Rates are tougher because a multitude of factors is involved. On the short-end, it’s under the Fed’s discretion and influence. The longer the duration, the more the market’s assessment of other factors like inflation, economic growth, political stability, etc., matter.

But, rates and their trend play a big role in determining the market’s multiple. Right now, we are in the position of having the earnings outlook deteriorate while multiples contract due to higher rates.

This is an inverse of what we experienced in 2020 when stocks relentlessly climbed with the earnings outlook improving and Fed keeping its foot on the accelerator and fiscal policy bazooka firing.

2 Bad Catalysts

Over the past week, we got 2 catalysts to push rates higher (and multiples lower). In turn, this is the main contributor to the selloff.

CPI came in above expectations. Inflation continues to broaden out, and the increases in food and energy prices are unnerving. Then, the Fed came out and was more hawkish than expected with a 75 basis point hike, and Chair Powell focused a lot on gasoline and energy prices needing to come down before it could say it had succeeded.

There are 2 solutions to high prices. One is to reduce demand by inducing a recession. The other is to invest in new supply.

In terms of energy, reducing demand could be a short-term solution but the long-term one has to involve more supply or capacity in the case of gasoline. Assuming the Fed is successful in inducing a recession, would we be short-circuiting a very necessary CAPEX cycle in energy production?

Portfolio Strategy

The combination of falling earnings and rising rates is poison for equity prices especially when they are falling and rising at a sharp rate.

Our nascent bullish case (RIP) from late May rested on this notion of China coming back -> earning growth and inflation turning the corner -> falling rates.

Both were wrong. We cut our losses and reduced exposure but should have acted even more aggressively given the brunt of the damage.

At this point, I don’t see a catalyst to turn things around beyond just a major capitulation in the markets, a Fed pivot, or a turn lower in oil and gas prices. And, as you will see in our portfolio discussion, I actually don’t think the latter is crazy.

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All the Best!

Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Stocks Under $10 Newsletter

SPY shares were trading at $367.56 per share on Friday afternoon, up $0.91 (+0.25%). Year-to-date, SPY has declined -22.37%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.

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