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September 18, 2023

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The outlook for the stock market appears to be deteriorating.

Stock prices turned down last week. Stronger-than-expected data on CPI and PPI Price Inflation, Retail Sales, Empire State Manufacturing, and Industrial Production is the exact opposite what the Federal Reserve was looking for to help with its main objective of lowering the inflation rate. Wall Street had been expecting the Fed to hold interest rates unchanged after its meeting next Wednesday 9/20/2023, but given this strong data and the Fed’s clearly stated data dependence, the Fed could raise interest rates again, or at least promise to hold interest rates "higher for longer" as the Fed waits to see the lag effects of its restrictive monetary policy on the economic data.

Increasing interest rates have lessened the relative appeal of stocks because investors can now earn a higher return from fixed-income instruments, according to Bill Gross, founder of PIMCO. High interest rates encourage saving over spending and raise borrowing costs, which can curb consumer spending, erode corporate profits, pull down asset prices, and drag down the economy into recession. US economic data has been surprisingly resilient in recent months, thanks to excess pandemic savings supporting consumption as well as rising stock prices and their wealth effect on consumers’ propensity to spend, but consumer demand would be vulnerable when their excess savings run out and the stock market turns down.

Markets move in reaction to how actual conditions develop relative to general expectations. The dominant narrative on Wall Street has been promoting a just-right, Goldilocks scenario where Federal Reserve Board refrains from further interest rate hikes this year, together with a soft landing or no landing for the economy avoiding a significant recession. Such optimism contradicts most of the actual statements by Fed officials, who have consistently maintained that progress toward 2% inflation is the key to the Fed's decision on whether to make monetary policy more restrictive or less restrictive. The Fed’s monetary policy is extremely important to the markets because financial conditions are leading indicators of economic growth and contraction.

Seasonal tendencies for the stock market for September are unfavorable. Inflation and interest rates are rising. The stock market ran far ahead of fundamental economic conditions from October to July and got extremely overbought, making stock prices vulnerable to disappointment.

All of our asset management clients are making positive returns. Our technical, quantitative, and fundamental analysis indicates rising risks and overvalued market prices, so we have made sure that all of our clients are in the safest investments and are fully protected from losses. When the outlook improves, we will seek higher returns, consistent with reasonable risks, of course. Meanwhile, we plan to continue to manage your money prudently, so that you can feel secure and won’t have to worry about the risks.

No Significant Change in Our Summary of Current Issues Impacting the Financial Markets

  • Financial markets are under increasing pressure.
  • The stock market uptrend is weakening. The price trend fought the Federal Reserve Board’s restrictive monetary policy from October to July, but stocks are likely to lose that fight in the end.
  • Inflation has been exacerbated by insufficient supply in the global economy, which requires longer-term investment in production capacity, which increases the demand for money, which means interest rates may stay higher for longer, which then could lead to greater fragility for non-bank financial institutions in the shadow banking system, according to economist Mohamed El-Erian.
  • The longer inflation remains above the Fed’s 2% target, the longer the Fed may pursue a restrictive monetary policy, and the more likely a protracted recession and another banking crisis.
  • High and rising interest rates increase borrowing costs dampen business profits, business investment, consumers’ disposable income, and consumers’ willingness to spend.
  • Rising interest rates raise the rate at which future corporate earnings and dividends are discounted, making stocks less valuable
  • The Fed’s restrictive monetary policy has not been reflected in US stock market trends since 10/7/2022. Rather, it is being reflected the willingness and ability of banks to make consumer loans, and that should dampen consumer spending.
  • Rising interest rates impair financial institutions’ balance sheets and liquidity.
  • There's a $1 trillion mountain of below-investment grade, high-yield debt (private debt, syndicated loans, and bonds) that could be at risk of default in a recession, according to Bank of America. Around $550 billion of that of low-quality debt already is in various stages of stress: $400 billion is "pre-distress" and another $150 billion is "deeply distressed." Already in the 8 months 2023 defaults have surpassed the 12 months of 2022 totals, according to Moody's Investors Service. Financial distress is in a rising trend. Excessive debt is like a mine field, hidden danger just below the surface, just waiting.
  • On 8/15/2023, Fitch rating agency warned that it is mulling over sweeping rating downgrades for dozens of US banks, including the largest investment-grade banks. Fitch explained that loan defaults tend to rise in a rising interest-rate environment.
  • Moody’s cut its ratings for 10 small to mid-sized US banks on 8/7/2023. Moody’s also warned that it had placed six large US banks on review for potential downgrades. Moody’s cited a slowdown in deposits, higher funding costs, and asset quality risks, particularly in the commercial real estate sector, which suffers from weakening demand for office space. Banks with substantial unrealized losses that are not captured by their regulatory capital ratios may still be susceptible to sudden losses of confidence in a high and rising interest rate environment. Moody's warned of rising risks ahead: “Asset risk is rising, in particular for small and midsize banks with large CRE [Commercial Real Estate] exposures…. We continue to expect a mild recession in early 2024, and given the funding strains on the US banking sector, there will likely be a tightening of credit conditions and rising loan losses for US banks.”
  • On 8/22/2023, ratings agency S&P Global followed Moody’s in cutting its credit ratings on regional banks with high commercial real estate exposure.
  • Bank depositors have been moving money out of banks and into money market funds paying higher interest rates since 4/13/2022. More recently, deposit outflows accelerated after 2/15/2023, suggesting that depositors were growing fearful of getting access to their money on demand at their banks.
  • Deposit outflows weaken the financial conditions of the banks that are losing deposits.
  • Since March 2023, a few banks were found to be insolvent and were forced accept takeovers that wiped out bank shareholders.
  • Other banks may be close to similar insolvent positions that are not yet evident, so there may be a rising risk of more bank-stockholder wipeouts ahead, especially if interest rates keep rising.
  • The authorities have shown that stockholders will be sacrificed to save the financial system.
  • The U.S. Federal Reserve’s Bank Term Funding Program (BTFP) introduced in March 2023 limited the banking crisis at that time, but BTFP does not make funding for banks available based on mortgage collateral or commercial and industrial loans.
  • Banks are loaded with these illiquid, vulnerable assets and could suffer catastrophic losses caused by rising interest rates or default or both.
  • Non-bank financial institutions (NBFI) hold financial assets of $239.3 trillion, nearly half of all financial assets globally. These NBFI are subject to many of the same risks as banks--but they are less regulated, which adds risk to the global financial system because regulators are not as well equipped to quickly rescue NBFI encountering liquidity shortfalls. NBFI are not eligible for The Federal Reserve’s Bank Term Funding Program. 
  • If interest rates continue to rise, or if mortgage and other loan defaults rise significantly, many more banks and NBFI may be found to be insolvent.
  • Liquidity problems have gone global. News out of China this August revealed that Zhongrong International Trust failed to make payments and halted redemptions, Evergrande filed for bankruptcy, and Country Garden Holdings failed to make coupon payments on some bonds. This has global significance because China accounts for about 30% of global growth.
  • Large institutional investors are growing increasingly worried about the outlook for European stock markets, following a disappointing round of second-quarter profits, according to the Financial Times.
  • US government continues to spend much more than it earns, which increases national debt and inflation.
  • Wages are not keeping pace with rising prices, so consumers are losing purchasing power and becoming poorer in real terms. The number of people who have little or no savings, live paycheck to paycheck, and use credit cards to pay expenses continues to increase.
  • The Conference Board Leading Economic Index® (LEI) for the U.S. has fallen for 16 consecutive months, the longest losing streak since the recession of 2008. The Conference Board forecasts a short and shallow recession in the Q4 2023 to Q1 2024 timespan.
  • An analysis published by San Francisco Fed on 8/17/2023 estimated that households’ excess savings generated during the Covid shutdown of 2020 are likely to be depleted during the third quarter of 2023. Expect a slowdown in consumer spending in coming months as that pandemic-era money savings continues to dwindle.
  • The New York Fed reported in early August that consumer debt topped $1 trillion for the first time ever. Consumers are using credit cards to cover everyday expenses.
  • The New York Federal Reserve’s model calculates a 71% probability that the US will enter a recession in the next 12 months, highest probability since 1982.
  • Oxford Economics expects GDP to drop 1.3% and the unemployment rate to rise from 3.7% to 5.3%. 
  • The Fannie Mae Economic & Strategic Research Group expects tightening credit conditions, slowing bank lending, and shrinking money supply will lead to a downward turn in business investment and hiring, forcing consumers to pull back on spending and causing a recession to begin in the first half of 2024.
  • Top-ranked economist David Rosenberg said consumers are running out of savings and there is no chance of avoiding a recession.
  • JPMorgan Chase strategists said a recession may be inevitable and the risk-reward for equities remains poor.
  • A recession would lead to a downward spiral of diminished economic activity, lower levels of investments, and lower consumption, which would lead to higher loan delinquencies and defaults, which would cause bank asset losses and cause banks to tighten lending, which would further dampen economic activity and create a downward spiral.
  • History shows that the government is not always able to prevent a market crash or a recession, and government policy changes impact markets and the economy only after long and variable lag times.
  • The headline 3.2% CPI inflation rate has fallen more steeply than the core inflation rate, now at 4.7%. Both remain well above the Fed’s 2% target.
  • The CPI inflation rate has declined over the past year mainly because President Biden has sold off 46% of the crude oil in the U.S. Strategic Petroleum Reserve. Nevertheless, the price of Crude Oil has risen 42% since its low on 5/4/202. Petroleum geologists warn that the world’s oil supply is set to decline in the decade ahead, creating upside pressure on the price of oil long term.  
  • A re-acceleration of inflation could mean more and larger Fed interest rate hikes, which would upset optimistic stock market sentiment.
  • Corporate earnings have held up better than Wall Street analysts predicted so far, but earnings could face headwinds if the Fed’s monetary policy becomes more restrictive.
  • China plans to expand a ban on the use of iPhones to government-backed agencies and state companies. This follows US bans on selling select high-tech products to China. These could be early signs of a destructive trade war that might drag down the global economy.
  • Destructive political divisiveness continues to worsen, with a potential US government shutdown at the end of this month on 9/30/2023.
  • The military-industrial complex (which also includes financial and media interests) appears intent on exacerbating geopolitical risks. War may further some special interests, but war is not good for humanity, the environment, or for the financial markets. “Why would any politician or general ever want peace? Their funding would stop.”--Jim Quinn
  • Stocks are overvalued relative to Peak Earnings, with a high P/E of 22.92, in the top 6%.
  • Stocks are overvalued relative to Dividends, with a D/P ratio of 1.50%, in the bottom 4%.
  • Sentiment for the stock market has moderated to Neutral from irrational exuberance and Extreme Greed in July.
  • Too much stock market optimism may have been riding on the uncertain potential of artificial intelligence applications.
  • Greed and Fear of Missing Out can suddenly turn into Fear of Losing Money when the trend turns down.
  • A conservative investment strategy is most prudent when market risk is high and rising.

Every day, we use technical, fundamental, and quantitative analysis to judge the Reward/Risk probabilities of trend continuation or reversal. We work to control risks and to make sure that all of our clients are safe and protected from large losses. If you want to earn reasonable returns while avoiding large losses, move your wealth to our professional fiduciary asset management. We always put our clients’ best interests first, and we are always here to help you in times of stress.

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Robert W. Colby, CMT,
is a consultant to institutional and private investors and traders, providing regular analytical reports, custom research services, and trading systems tailored to clients' objectives. Clients include the most successful traders and investors in the world. Robert is the author of The Encyclopedia of Technical Market Indicators, Second Edition, McGraw-Hill, 2003, which has become the standard reference for indicator and trading systems design. Previously, at several large Wall Street firms, Robert worked as a proprietary trader, technical analyst, and fundamental analyst. He also was adjunct professor at New York University and New York Institute of Finance, where he developed new courses on technical analysis and market timing.

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