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Rising bond yields & Fed rate hike sink stocks; S&P 500 in bear market

If you can invest your money under fair conditions, in fact under attractive specific conditions, I think one certainly should do so even if the market should go down further and even if the securities you buy may go down after you buy them. – Benjamin Graham 

When it rains, it pours. Investors must be feeling that way now as the S&P 500 Index closed in bear market territory on Monday as recession fears grew and only added to those losses to end the week. It was the worst week for the benchmark index since March 2020 as it declined nearly 6%. The S&P 500 Index and the Nasdaq Composite Index now have the dubious distinction of closing lower in 10 of the last 11 weeks. There was plenty of blame to go around for last week’s dismal performance as economic data was unfavorable, bond yields rose and the Federal Reserve raised interest rates. Following a hotter than expected consumer price index (CPI) the previous week, the producer price index (PPI) for May showed no relief from inflation as it rose nearly 11% over the past year. The increase in May was double the increase in April as energy made up most of the gain and meant that producer prices remained near their historic highs. The news sent bond prices tumbling and yields soaring as the 2-year Treasury yield topped 3.40% while the 10-year Treasury yield eclipsed 3.45%, the highest level in 11 years. The interest rate on a 30-year mortgage loan also jumped to 6.3%, up from 5.5% just a week ago. The elevated inflation data prompted the Federal Open Market Committee (FOMC) to hike the federal funds rate at its meeting by 0.75%, the biggest increase since 1994. That increase put the fed funds rate between 1.5% and 1.75% and it is anticipated that by the end of the year, the Fed’s benchmark rate will be approximately 3.4%. Federal Reserve Chairman Jerome Powell said after the meeting that decisions on future rate hikes will be made “meeting by meeting” and the Fed will communicate their intentions as much as possible to eliminate any surprises. This announcement seemed to calm the bond market as yields dropped with the 10-year Treasury yield falling to 3.23% by Friday. The Fed also lowered its GDP estimate for economic growth in 2022 and expects inflation as measured by the personal consumption expenditures (PCE) index to fall below 3% next year. While this is certainly good news, the risk is that the Fed goes too far, too fast in raising interest rates, which increases the chances of a recession.

Last Week

The elevated producer price index (PPI) was not the only unfavorable piece of economic data last week as retail sales in May fell more than expected and were much lower than in April. Leading economic indicators also fell in May for the second straight month, fueled by falling stock prices, a slowdown in housing construction and weaker consumer sentiment. Housing starts in May plunged to a 13-month low and weekly jobless claims fell 3,000 to 229,000, higher than forecasts of 215,000.

For the week, the Dow Jones Industrial Average fell 4.8% to close at 29,888 while the S&P 500 Index dropped 5.8% to close at 3,674. The Nasdaq Composite Index declined 4.8% to close at 10,798.

This Week

Existing home sales for May are expected to be less than in April as record high home prices and higher mortgage rates have reduced home sales while new home sales for May are forecast to be on a par with those in April. Weekly jobless claims could continue to be higher as there have been layoff announcements in the technology and housing sectors recently.

The most notable companies that are scheduled to release their quarterly earnings this week include Lennar, KB Home, H.B. Fuller, Rite Aid, CarMax, Darden Restaurants, Smith & Wesson Brands, FedEx and Accenture.

Portfolio Strategy

Last week’s losses put the S&P 500 Index well into a bear market as stocks have become extremely oversold based on their current valuation and earnings estimates for this year and next, provided those estimates have been revised to reflect inflation and a more aggressive Federal Reserve determined to combat high prices with higher interest rates. The Fed’s intentions will be clarified this week as Federal Reserve Chairman Jerome Powell will testify before both houses of Congress and he’s expected to remain steadfast in his plan to bring inflation down. Rising bond yields have been a significant headwind for the stock market with technology stocks being hit particularly hard along with cyclical names in industries such as airlines and cruise lines. The odds of a recession are increasing as recent economic data such as housing starts, retail sales, consumer sentiment and jobless claims have been weakening. The Biden administration’s war on fossil fuels also has hurt the economy. It has contributed to a surge in oil prices and higher inflation at a time when the U.S. should be increasing its domestic oil production rather than depending on hostile regimes in order to lower gasoline prices. Unfortunately, there has been no place to hide in this stock market sell-off. Client portfolios have been structured to favor value-oriented mutual funds and ETFs that emphasize quality stocks with above-average dividend yields and consistent dividend growth prospects as well as stocks with below average price earnings ratios that are far less than those of the overall market. These investments have held up much better than growth-oriented funds that pay little or no dividends and have sky-high valuations, although they still have suffered losses. Intermediate and longer-term bond funds have not offered any protection either as rising interest rates have led to losses of anywhere from 10% to 20%. (Bond prices and yields move in opposite directions). For the most part, the duration of client portfolios has been shortened considerably by replacing these intermediate-term bond funds with short-term bond funds, resulting in only modest losses as yields have spiked.

I will be out of the office the week of June 27th, returning to the office on Tuesday July 5th, but I will be available if you need to reach me for any reason. The next weekly newsletter will be sent on July 5th.