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Insane Gain After Fed & Ukraine Pain

Insane Gain After Fed & Ukraine Pain

April 01, 2022
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After a painful start to 2022, the stock market surged last month, with the S&P 500 index gaining a respectable +3.6%, while the technology-heavy NASDAQ index rose by +3.4%. With volatility on the rise, getting caught up in the emotions of the headlines can be challenging for some investors. At Sidoxia, we are determined to objectively stick to the facts and migrate investments to the areas of the market that provide the best risk-reward opportunities to our clients, based on their unique objectives and constraints. There certainly are some headwinds for investors to contend with, but for long-term investors, it’s also important to recognize the positive tailwinds and not miss the forest for the trees.

As I pointed out last month, we are coming off a heroic advance over the last three years (2019/2020/2021) with the S&P 500 soaring +90%. The hangover from COVID has created significant supply chain disruptions and widespread economic shortages. Adding the Russian invasion of Ukraine to the mix has been like pouring gasoline on the flames of inflation, especially when it comes to the energy and food sectors. As you can see from the CRB index below (a basket of 19 commodities ranging from aluminum to orange juice and live cattle to wheat), in recent years the index has been highly volatile in both directions, but is up +27% this year. Since the COVID-driven trough, prices have about tripled over the last two years, but that does not mean prices will fly to the moon forever.

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Source: Trading Economics

Many traders have short-term memories. People forget that commodity prices approximately doubled after the 2008 Financial Crisis, only to experience a subsequent slow bleed over the next decade until prices were essentially chopped in half. As the saying goes, “price cures price.” In other words, as prices skyrocket, greedy capitalists and businesses then decide to take advantage of the high pricing environment by investing to produce more supply, which eventually leads to deflation. This supply expansion process takes time and will not happen overnight.

With gasoline prices exceeding $4/gallon nationally, and breaching $6/gallon in my Southern California backyard (see chart below), it should come as no surprise that oil companies are taking advantage of the lucrative environment by drilling for more oil.

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Source: GasBuddy.com

The rising Baker Hughes drilling rig count below reflects the miracle of supply-demand economics operating in full force. As prices rise and accelerate during geopolitical shocks like we have experienced in Ukraine, naturally supply rises, which eventually depresses prices until an equilibrium is reached. Even our government is now attempting to increase supply by releasing up to 180 million barrels of oil from our country’s Strategic Petroleum Reserve (the largest release in the almost 50-year history of the reserve), while also pushing for penalties on those energy companies sitting on unused permits (i.e., not producing oil on leased oil land). High energy prices will most certainly become a hot-button political issue in the upcoming midterm elections.

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Source: Trading Economics

Adding to investor anxiety, our Federal Reserve is embarking on an interest rate hiking cycle that is expected to take the targeted Federal Funds interest rate from effectively 0% to a range around 2.5% over the next couple of years. The Fed’s goal is to increase the cost of borrowing, thereby slowing down the economy and reducing inflation. On the surface this sounds scary, but do you remember what happened the last time the Fed tapped the interest rate brakes during 2015 – 2018? Despite the Fed raising interest rates from 0% to 2.5%, the stock market increased dramatically over that timeframe. The current Fed interest rate cycle may more closely resemble 1994 when the Fed aggressively hiked rates from 3% to 6%. Similar to now, back then stock prices swung wildly throughout the year to eventually finish the year flattish.

If Things Are So Bad, Why Are Prices Going Up?

In the face of such horrible and scary headlines, how can prices still go up? The short answer is that companies are making money hand over fist and the economy remains strong (3.6% unemployment rate; record 11.3m job openings3% forecasted growth in 2022 GDP) in a post-COVID recovery world, where consumers remain financially healthy and are now looking to spend their shelter-in-place savings on vacations, houses, and cars (all healthy industries).

Not only are corporate profits at record levels, they are also expected to grow at a healthy rate (+10% in 2022, +10% in 2023) after mind-boggling growth of +50% in 2021 (see chart below).

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Source: Yardeni.com

Could the headwinds previously described cause prices to go lower? They certainly could, but valuations remain attractive given where interest rates currently stand. If interest rates rise dramatically, all else equal, then that will be challenging for all asset pricing. Moreover, discounting or forecasting future Russian military actions is a difficult chore as well, which could also potentially throw a curve ball at investors.

In the meantime, what are companies doing with this flood of growing cash? Well, besides combing the job boards in search of hiring a scarce number of qualified workers, investing in technology to improve productivity, and expanding geographically to grow revenues, companies are also returning gobs of cash to investors in the form of record, swelling dividends and share buybacks (see charts below).

Darling Dividends

The gift that keeps on giving. Dividends now amount to more than half a trillion dollars and they are still growing.

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Source: Yardeni.com

Beautiful Buybacks

As you can see, the trajectory of buybacks are more volatile and discretionary than dividends, but record profits are driving more than $1 trillion in share buybacks on an annualized basis – not too shabby.

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Source: Yardeni.com

Although there are plenty of reasons for investors to rationalize a run for the hills, there remains some extraordinarily strong fundamental tailwinds intact. In spite of the economic pain caused by Ukraine, the Fed, and inflation, there are plenty of reasons to remain optimistic. The strong economy, impressive profit growth, historically low interest rates (even though slowly rising), cash-rich corporations, and attractive valuations mean there is still ample room for future market gains.

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www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (April 1, 2022). Subscribe at InvestingCaffeine.com for the complete text.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.