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State of the Markets

Wells Fargo Investment Institute - September 20, 2022
Darrell Cronk

A time for every season


by Darrell L. Cronk, President, Wells Fargo Investment Institute Chief Investment Officer, Wealth & Investment Management

“The stock market is a device for transferring money from the impatient to the patient.” — Warren Buffett

Here in New York City, the transition from summer to autumn sneaks up on you, often arriving suddenly. This week brings the first official day of fall. The days gradually shorten, the leaves in Central Park show hints of red and yellow, kids toting backpacks return to school, and the U.S. Open conclusion in September yields to October World Series dreams in the Bronx and Queens.

Around the country and throughout the world, fall is also a time of harvest. You learn that there is a time to sow, and a time to reap, and you learn all about patience. For investors, there is a time for risk taking, and a time for patience. This year has taxed the patience of many investors, as almost every asset, with the exception of commodities, the U.S. dollar, and cash, has experienced negative returns year to date.

Here in New York, it feels like Wall Street is out of patience and just wants to be done with it — done with the interest rate hikes, done with the bear market, done with the recession talk, and satisfied that inflation has peaked and the Federal Reserve (Fed) will finally back off.

In fact, since Fed Chair Jerome Powell announced the first rate hike in March, the stock market has misinterpreted each of the Fed meetings in March, May, June, and July as containing dovish antidotes, rallying off of each only to be disappointed later when the scenario it wanted to will into existence failed to materialize. Each rally subsequently failed, and the S&P 500 Index dropped to new lower lows. Just as you cannot rush the leaves blowing off the trees in Central Park, you cannot rush the end of an economic cycle or a bear market.

So, where are we in the economic cycle? The U.S. economy has experienced back-to-back quarters of declining global domestic product growth — a technical recession. However, we believe a true recession is more likely by the fourth quarter of 2022, extending into the first half of 2023.

Bottoms in the stock market do not typically occur until you can see a bottom in the economy or economic data. Leading indicators have already sent clarion recessionary signals.

  • The global manufacturing Purchasing Managers’ Index recently dropped to a 26-month low, and the Institute for Supply Management’s global manufacturing data is about to move into contractionary territory, both of which typically lead earnings outlooks by an average of about six months. This suggests to us that further downward pressures remain.
  • Housing has been another reliable indicator. Since 1950, every single equity market bottom within an existing bear market has been confirmed by a bottom in housing leading indicators before eventually entering a new equity bull market. We see limited evidence today that housing has bottomed, as rising mortgage rates and slower monthly new and existing home sales persist.
  • Because consumer spending makes up about 70% of U.S. economic activity, consumer confidence and sentiment are key indicators we watch for economic signals. While the consumer comes into this slowdown in better shape financially than in previous downturns, consumer sentiment has dropped recently to multi-decade lows — even below levels seen during the 2008-2009 global financial crisis. The consumer is no doubt feeling the acute effects of higher prices, leaner real incomes, and an elevated level of uncertainty about the future.

Often the labor market is cited as an oasis of strength that will stave off recessionary pressures. While a strong labor market is both welcomed and encouraging, historically a strong labor market and a bottoming in the unemployment rate has been a precursor, not an outlier, to the next economic slowdown.

Falling sentiment has been apparent all year in financial markets. Simply put, markets drive sentiment, not the other way around, and sentiment bottoms often coincide with economic bottoms. Unfortunately, what have not bottomed yet are forward earnings revisions, housing leading indicators, and the purchasing managers’ indexes. All have been reliable precursors to finding a bottom in financial markets.

These signals have been consistent across 70-plus years of market data and economic cycle after cycle. Could it be different this time? Perhaps, but discounting a pattern that has occurred reliably across history requires more than hope. It needs clear evidence, which is difficult to plainly see in today’s data. Voltaire may have said it best, “History never repeats itself. Man always does.” Unless we suspend the laws of economics and human behavior that have governed through many cycles, we have little evidence to suggest this time will be different.

So what is an investor to do? If economic cycles are normal, with predictable patterns that have recurred over time, then we need to manage portfolios accordingly. We have stated all year that given the circumstances afoot, we believe investors should be playing defense in both their stock and bond portfolios. That message remains resolute today.

To be clear, this message is not one grounded in long-standing pessimism, but rather grounded in our belief that the best guidance is truthful and transparent guidance — even if it can be difficult to deliver sometimes. We take no joy from predicting challenging times, but we also should never shy away from sharing what we see either.

The past two recessions — the financial crisis in 2008-2009 and the pandemic recession in 2020 — were triggered by shocks to the system. There are no garden-variety recessions, but this one is more like a year in the making: a slow deterioration in the economy, a long Fed fight against inflation, and a longer pullback in markets. Neither kind of recession — the deep, sharp declines or the long gradually developing ones — is much fun. At least this variety of recession has given us time to have the planning conversations and take risk off the table with conviction.

There will come a time for sounding the trumpets loudly to play offense, a time for adding risk and positioning portfolios for early cycle dynamics and recovery. Believe me, we look forward to that day. This will likely come in one of two ways — when we see a clear turn in the indicators that we remain vigilant and watchful around, or when we simply reach a price level in markets where the risk/reward balance once again turns compelling. Until then, patience rules the day.

Those who play defense now, who exhibit patience, stick to their plan, and are not drawn into the bear market bounces, may see opportunities as soon as the latter part of the fourth quarter or the beginning of next year. The financial markets will not fully wait for the economy to trough. They will begin pricing an outlook a full 9 to 12 months in advance. If they believe they can see a bottom, or a turn, they will begin to position accordingly, so we need to be vigilant and ready.

Patience is a tough virtue — perhaps, in the end, one of the most difficult to master. However, it can also be one of the most rewarding, both within our personal lives and in the lives of an investor. Autumn shows us how beautiful it is to let things go in their own time. The colorful leaves do not fall straight to the ground; they fly and even soar, taking their time to wander gracefully to earth. Autumn, perhaps more than any other season, carries more sun-kissed gold than all of the others. History has taught investors that patience, and resilience, can generate golden opportunities on the other side.

With a head nod to the sage Warren Buffett, who said it best, the stock market can indeed be an efficient mechanism for transferring money from the impatient to the patient. Every cycle has its season. Understanding how to navigate those seasons perhaps is the most important wisdom of all.

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