On Money & More – August 2022

A recession is not “officially” determined by two straight quarters of negative Gross Domestic Product (GDP) readings, but that definition has been used for so long that is has become accepted as fact. And after one of the worst starts to the year in history for stocks, the debate about whether or not the United States was already experiencing two quarters of negative growth was moot—investors clearly thought a recession had already arrived.

If so, this is an odd recession. Employment is booming. Hotels and flights are full. Finding parking at Costco is as difficult as ever! Consumers are flush with cash and looking to spend the money they couldn’t spend for the last several years. Why would an economy with very low unemployment, solid household balance sheets, and reasonable bank debt levels be on the possible brink of recession? We all know the answer (unless you haven’t filled up your gas tank this year): inflation.

Bear markets are the “cost of admission” for equity investors. The risk that investors assume by owning stocks validates the returns that are achieved over long periods of time. But, what has been especially troublesome for investors has been the simultaneous decline of bonds. Many conservative investors look to bonds for their stability and income, and that hasn’t been the case. In the face of such nearly unprecedented bad news, we wanted to present some silver linings for investors to consider:

Silver lining #1: Is inflation peaking? Have you noticed lingering real estate listings in your neighborhood? Gas prices surged into June but sold off into July. We have witnessed significant drops across most commodities, notably lumber and copper. Even gold, the longstanding “inflation hedge” is down this year. Many retailers are overstocked and sitting on high inventories (as Target noted in their recent earnings call). We could see sizable markdowns as retailers look to offload overstocked items. Rents are the fly in the ointment for inflation, as they continue to climb. But what happens if inflation moderates? Our view is that stocks will move up as the Fed takes their foot off of the economy’s brakes.

Silver lining #2: Yields matter once again. When markets are speculative, cash flows don’t matter. Bitcoin goes to the moon, and SPACs/NFTs (pick your acronym) become the rage. As Warren Buffett said, “Only when the tide goes out do you discover who’s been swimming naked.” Well, the tide is out, and cash flows are working. Dividend stocks are holding up relatively well. Bond yields, especially after the drop we saw in the first half, are more attractive. As we discussed last month, the yield curve has “inverted.” This means investors see rates (and inflation) peaking as we enter a recession. What to do now? We believe investors should find cash flows they are comfortable with to swim through the recession. In our view, that means dividends and high-quality shorter-term bonds.

Silver lining #3: Stock valuations are back within historical norms. Equities have fallen back into historically average valuation levels at roughly 16x earnings (source: JP Morgan). This means that they also should hold less risk today than at elevated valuations, a fact that should reassure market participants. The question now is, “Can companies weather a recession without too much of an impact on their earnings streams?” We are already seeing companies (such as Facebook, aka Meta) announce hiring slowdowns to control their costs. Without revenue growth, cost control will become the corporate tactic du jour.

Looking forward, we expect volatility to remain elevated, especially as the word “recession” becomes more prevalent—whether we are officially in such a period or not. However, we believe that this is not a time to abandon stocks. The broad indexes are already sold down to a point where the market seems to expect a deeper, longer recession than what Cutler would expect. Why the optimism? In our view, we have never experienced a recession with such a well-capitalized economy.

All opinions and data included in this commentary are as of July 15, 2022 and are subject to change. The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. All investing involves risk, including loss of principle.