(3D/L) June was another tough month for the markets, with the S&P 500 giving up -8.25% on a total return basis. For the second quarter it was down -16.10% and for the year to date down -19.96%. It was the worst first half performance for the index since 1970.
The word for bear in Germanic languages (English included) is a cognate of “brown” rather than the root used by most Indo-European languages that resulted in, for example, the Latin ursus. This is thought to be a relic of the world’s oldest euphemism. If you say the word for bear, one might appear, so call it the brown animal instead.
A similar superstition seemed to grip market observers over the early part of this year. Those who felt we were in a bear market greatly outnumbered those who would say so out loud. Even this inveterately glass-half-empty commentary did not use the brown word until our March letter, published at the start of April, and then only in passing. We only admitted to believing a bear market was under way last month. (Although our flagship Lee Adaptive portfolios began going to cash at the start of May.)
Reluctance to say bear out loud seems to have dissipated. A longer-term chart of the S&P 500 is pretty convincing. After years of steady and tidy gains the line makes a distinct right turn at the start of this year and proceeds almost as tidily downwards. Indeed, that the all-time market high was on the first trading day of this year, so that the bear market began and continues with 2022, seems much more than coincidental. New year, new market regime.
We have used a lot of ink in these commentaries reminding readers that bear markets (and bull markets) do not require a logical driver. Sometimes, perhaps even most times, the market falls or rises purely because of unmeasurable and irrational feelings. But sometimes bear markets do have powerful and explainable drivers. This one does. Ultimately, it is COVID, via the aggressively expansionist monetary policy that most Western countries implemented as a reaction to the pandemic.
For some time now, we have been writing about what we consider to be the natural result of the US money supply (M2) increasing by 40% over 2020 and 2021, namely inflation, and a lot of it. We have never considered this prediction to be particularly insightful. Rather, we thought the relationship between a swelling M2 and subsequent inflation to be an elementary tenet of orthodox late 20th Century macroeconomics.
We still feel like a voice in the wilderness on inflation. It could be we are the only ones who remember economics classes in the 1980s, or it could be the brown bear taboo again. If you say the word inflation out loud you might cause it. Better to stay quiet. Indeed, our biggest current challenge in anticipating the market’s near future is that we do not have clear idea what the market expects.
Several times over the past two years we have discussed the “breakeven” inflation rate as forecasted by the price of inflation protected bonds (TIPS) and their ordinary Treasury bond counterparts. For the benefit of readers who might find this number a bit esoteric, it should be emphasized how simple and brutally direct the calculation is. The US Treasury issues nearly identical bonds that differ only in that one type has a principal that is indexed to inflation and the other does not. The indexed variety (TIPS) have yields that are essentially Y% + I%, where I% is whatever inflation turns out to be, while the regular bonds simply have a yield of X%. The breakeven rate is X% – Y%, that is, the value of I% such that the bonds wind up paying the same return.
If you expect inflation higher than the breakeven rate, you can buy the TIPS and short the matching regular Treasury bond. If you think inflation will be lower, you can buy the Treasury and short the TIPS. And when we say “you” we really mean it. This is a trade any individual can do in their retail brokerage account, generally with leverage much higher than what is available for equities.
Below is the breakeven rate on five-year bonds as tracked by the Federal Reserve Bank of St. Louis.
Three things on this chart strike us as nearly inexplicable. The first is that the current five year breakeven rate from June 29, 2022 is just 2.59%. Given that the CPI (which is the index used by TIPS) showed annual inflation over 7% in each of the three monthly reports during the first quarter, and then over 8% for each of the three second quarter reports, this five year projection seems aggressively optimistic. If inflation ran at 8% for the next year it would have to run at just 1.28% annually for the next four years to hit the breakeven rate.
The second remarkable thing is that 2.59% is not especially out of line in the context of the past ten years. Prior to the pandemic, the breakeven rate ranged from about 1% to about 2.5%, roughly in line with actual experienced inflation. Surely we all believe that the post-pandemic world is meaningfully different?
But the most remarkable thing on this chart, and the one hardest to fathom, is that the breakeven rate fell, and by a meaningful amount, during the second quarter. It hit its all time high on March 25th, at 3.59%. Then over three months of bad inflation news and increasingly dire warnings from the Fed, the market’s inflation expectations, somehow, fell by more than a percent.
We freely admit to being puzzled by the inflation outlook implied by the breakeven rate. We can think of three possible interpretations.
One, that we are misunderstanding or misinterpreting the breakeven calculation in some fundamental way. Intellectual honesty forces us to suggest this, but we are fairly confident it is not the case. The breakeven calculation is straightforward. Indeed, one of the stated objectives for launching TIPS a few decades ago was providing an easy to calculate market inflation expectation.
Two, that the fixed income markets are in such a poor state that the pricing used here is either distorted or inaccurate. For example, it might be supposed that since the vanilla Treasury bonds are more liquid than their TIPS counterparts, they might carry a liquidity premium which would depress their yields and that premium might have increased over the past few months as the bear market progressed. We think this is likely directionally correct, but too small an effect to explain what we see.
Three, that the chart should be taken at face value and that the market expectations for inflation over the next few years are low and getting lower. This despite actual inflation numbers far in excess of what was expected six or twelve months ago, despite a should-be-obvious reason to expect inflation, and despite a Fed that has made it clear that inflation is now serious enough a problem that it is willing to risk inducing a recession to fight it.
We think the third interpretation is the least implausible of the three. Its implications are troubling, particularly if the market’s overly optimistic view on inflation is not realized, which seems likely. Indeed, if inflation is strong enough, we could easily see a recession as collateral damage in the Fed’s efforts to stop it. And that suggests that the bear market will continue for a while, whether or not we say it out loud.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant and uncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
Optimism declined sharply in June, while Efficiency held steady, staying within the range it has inhabited for six months.
Optimism began the month at -0.90 and ended at -1.49. It has decreased steadily since mid-2021 and is now approaching levels last seen during the worst of the pandemic.
Efficiency was largely unchanged, starting the month at -0.25 and ending at -0.24. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is under stress. It has, however, not fallen to the levels typical of a market dislocation.
As compared to two years ago, Optimism has returned to 2020 levels of pessimism, while Efficiency is higher. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with increasingly fearful investors. This would imply a challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
