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Observations on the Market:

The Madness of Predicting the Stock Market

Written by Greg Denewiler, CFA®

If you follow college basketball, you are aware that no one has ever successfully predicted the outcome of all the March tournament games. However, college sports enthusiasts keep trying. Maybe that is why they call it “madness.” Likewise, there is plenty of madness in the market, and investors keep trying to predict it. Here is what has happened in the last 30 days, and with this information, you get to guess the stock market’s reaction. The period is from February 18th, a few days before Russia invades Ukraine, to this morning, March 21st.

 

You know the price of oil goes from $91 per barrel to $109, wheat increases from $8.04 per bushel to $11.44, and interest rates (10-year Treasuries) jump from a yield of 1.93% to 2.24%. Current inflation is above 7% and appears to be trending in the wrong direction. We have a war, and we have uncertainty in the commodities markets. The world’s political stage is on edge as to what extent NATO is going to react. Will Putin, in his frustration, use chemical weapons or even a small nuclear option to achieve victory at any cost? Now back to February 18th, what are your predictions for gold and the stock market knowing these outcomes?

 

Gold is supposed to be the go-to asset in times of political chaos. We have had political instability; however, gold has only increased 1.9%. If that is all it can do considering what has happened, it doesn’t instill confidence going forward as an inflation or political hedge. On the other hand, the stock market has had lots of volatility and some news headlines that have been admittedly scary. Clearly, the world’s economy is going to be impacted, but to what degree is yet to be determined. Investors, who are supposed to hate uncertainty, apparently, are not concerned about the longer term. Even with all these factors, the S&P 500 is currently up 2.7% since February 18th. You probably know where this is going.

 

Predicting the market is extremely difficult, even if you were to be given some of the outcomes. This is not a suggestion that everything will work out great. Inflation is going to be a problem and we have an entire generation of investors that have no idea of what it takes to fight it. Even before the invasion of Ukraine, the Fed admitted it had miscalculated the persistence of inflation, and it has only intensified with the war. Wheat, which is a mainstay in our food chain, is up substantially because 25% of global wheat production comes from Russia and Ukraine. Even if the war ended tomorrow, there will be lingering issues. Not to mention the well-publicized problems with oil. There is yet to be any significant change in our domestic energy policy because it seems we ultimately want oil to be produced somewhere else. Another dilemma is whether Europe is going to go into a recession due to their lack of natural gas from Russia. If you still think you can predict the future, good luck. The future is unknowable, but there is some value in looking at what the market’s future expectations are.

 

Regarding interest rates, one measure that we have used in previous newsletters is the forward rate. If you are given a choice of buying a two-year Treasury bond today, or buying a one-year Treasury bond today, and then reinvesting it one year from now in another one-year bond, what does that future bond have to yield to equal the rate of just buying the two-year bond? Today, the two-year bond will pay you 2.02% for two years while a one-year Treasury today earns 1.22%, so you then would have to earn 2.83% one year from now to equal the two-year maturity today. If that was hard to follow, the simple translation is that based on where interest rates are today, the market doesn’t expect interest rates to be any higher than about 2.8% in the short-term future, then trending lower after two years. This most likely explains why the stock market is flat after all that has happened. Remember that expectations change daily, and this is only a snapshot of the market’s current vision. We all know that investors are prone to wake up with nightmares.

 

Interest rates are going to move higher; we just don’t know how much yet. Anything with a fixed rate isn’t going to perform well in a rising rate environment. Those investors that bought 10-year Treasuries at .5% in 2020, thinking bonds were a safe alternative to stocks, aren’t doing so well. Their statement shows a greater than 10% loss currently. Even if the market declines, looking out a few years, those investors who continue to hold bonds purchased at .5% in 2020 are going to feel even worse. Even with a ten-year Treasury at 2.25%, it is still not a good bet. In a world with inflation, companies that increase their payments to shareholders help maintain your purchasing power.

 

Observations on the Market No. 369 − Published Mar 22, 2022