December 2022
Market Update

By Jake Eggett

Have a look at this photo and see if you can tell whether it is a sunrise or sunset?

Sunrises and sunsets can appear identical, the sun is low on the horizon, and the rays of sunlight pass through the same distance of atmosphere.   Since we never see both side by side in nature it’s hard to detect any difference.  Researchers and scientists claim there are some differences.  For example, some argue that there are more particles in the air at sunset which can lead to brighter reds.   Others might also argue that our perception is different at the start of the day compared to the end of the day because our eyes become adapted to the dark, making the colors we see in the morning more vibrant.  The obvious difference is the sun sets in the west and rises in the east, but that is no help in gauging this photo unless you know where the photo was taken.  Without more information, determining the answer is tricky indeed.

Just as the sun has a pattern for rising and setting, the economic business cycle goes through similar patterns of rising and falling. The major difference is that it is not as precise and predictable as the sun; however, if you can tell where the sun is in the sky you might have a pretty good idea of the time of day. So it is, if you know what stage of the business cycle the economy is in, you may be able to gauge how best to invest during these times.  Let’s explore this idea a little further… oh and before I forget, it’s a sunrise!

Market Performance

Although the markets didn’t start off very well in the month of November, they finished strong, and most of the major asset classes posted positive results.  We also saw some long-term trends start to shift direction, for example, international markets were the major standouts for the month rising more than 13% and outperforming the US markets.  The main reason for that outperformance, the dollar declined by nearly 5%.  We also saw interest rates decline, which gave a much-needed boost to the bond market.  It appears the change of trend is due to the market starting to price in peak inflation and therefore a slowdown in the pace of rate hikes and Fed tightening. 

Will this rally continue through the end of the year? 

We would point to December 13th – 14th as the days that might answer that question.  The November Inflation report (CPI) will be released on the 13th and the Fed announces its decision on interest rates the following day.  How the market reacts on those critical days will likely determine if this year ends on a positive or negative note. 

The two-day Fed meeting will produce the Fed’s dot plots which should provide insight into future rate expectations.  Fed Chair Powell recently spoke and essentially told the markets that the Fed will hike 50 bps in this December meeting but what is still unclear is what they project the terminal fed funds rate to be.  Will it rise above 5%?  If the inflation report can continue its downward trajectory this may continue to pressure the Fed to slow their rate hikes and that is what this market is anticipating. 

Stages of the Typical Business Cycle

This chart shows the typical stages of a business cycle and the financial conditions that are common in each.

The economy is currently exhibiting late cycle behavior, where economic activity often reaches its peak, implying that growth remains positive but slowing.  Rising inflation and a tight labor market may crimp profits and lead to higher interest rates.  Sound familiar?

Activity Moderates 

One of the signs that the economy is slowing down is evident in the ISM Purchasing Managers Index (PMI).  The PMI is a measure of the manufacturing and service activity in the US.  Historically when the index is above 50 it represents expansion and below 50 represents a shrinking of the manufacturing and the service activity in the economy.  The November manufacturing number fell into contraction territory at 49 and the service side is decreasing but remains resilient in expansionary territory at 56.5.

Profits Under Pressure

Figuring out markets is not as simple as knowing the “correct” Price to Earnings (P/E) ratio or the “correct” forward earnings estimate.  The markets are just as non-linear as everything else in life; however, there is a clear pattern of price bottoming before earnings at inflection points.

If earnings growth recovers in 2023, the October price low could be the bottom.  But the inverted yield curve, the length of the business cycle and continued Fed tightening suggest that may be unlikely.

Summary

Although the economy is exhibiting late cycle behavior and seems to appear more like a sunset rather than a sunrise, we know that stock market generally will rise and recover well in advance of the economy.  The markets have some positive short-term momentum and seem to be pricing in the expectation that the Fed will quickly return to a neutral policy of 3-3.5% after reaching a terminal rate of 5%.  A continuation of that positive momentum may hinge on next week’s upcoming inflation data and future Fed expectations.

At Copperwynd, we have allocated 40% of our bond portfolio into high yield and bank loans and maintaining 60% in short-term treasuries.  Your bond portfolio is benefiting from higher rates, and we will continue to be diligent in following the changes in market trends.  As for stocks, we have allocated a little bit more into equities but remain somewhat defensive with some cash on hand. We continue to believe some very good opportunities will be available over the next year, and we will remain disciplined in following the trends so that we can take advantage as the markets recover.

We wish everyone Happy Holidays and are thankful to know and work with wonderful people like you!

If you have questions, please contact us.

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