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Quality is the Volatility Remedy

| March 13, 2023

Not long ago we said we would be closely watching the M2 measure of money supply, specifically awaiting data related to January. Well, the report is in. As expected, the total amount of M2 money in the U.S. financial system is falling like springtime snow.

This measure of money shrank by 1.3% in December. The most recent data showed the money supply dwindled another 1.7% in January:

We’re in unprecedented territory, but common sense and economic theory lead us at Cornerstone to believe this situation will inevitably become deflationary by the end of this year (or early into 2024).

What do we mean by “common sense?” Well, less money chasing a similar amount of goods and services means less price pressure overall.

The M2 spike that started in 2020 caused most of the inflation and subsequent Federal Reserve tightening. We wouldn’t be surprised if the eventual result will be the Fed worrying about the economy a lot more than inflation.

The Fed likes to say there is no strong correlation between money supply growth and inflation. But the year-over-year surge in M2 (due to Washington D.C. giving away money) is about double what occurred during the three inflation spikes in the 1970s and 1980s. In our opinion, the only reason inflation hasn’t ascended more is because our economy is more digital – it’s harder to raise prices.

The Fed’s recent reaction has been extreme hawkishness. Chairman Jerome Powell squashed stock market excitement last week when he said interest rates will likely be higher than anticipated. That tone led to a sharp increase in Treasury yields. So the bond market’s tail is wagging the equities market’s dog again.

Interestingly, while Treasury yields increased significantly over the last month, two weeks ago we saw the 10-year yield drop from 4.09% to 3.97% in short order. That led to a S&P 500 surge of more than 125 points.

Why point this out?

Readers know about our capitalized profits model of fair market valuation. Right now, the 4.00%-4.25% level of the 10-year Treasury is important from a discount rate perspective. Now that we have more than a year of data, we can start to see trends. What’s notable is the stock market tends to ignore a rise in Treasury yields for about a week or two before beginning to worry.

For example, Treasury yields rose to start February, but the stock market didn't begin to feel it until mid-February. During the quick drop a couple weeks ago, the market celebrated. But when the 10-year yield rises, we’re seeing a stock market lag:

The key is to see if the 10-year yield is headed for a retest of its October 2022 high of 4.33%. If you'd asked a month ago, we’d say it was unlikely. But now it could be in the cards, especially given Chairman Powell’s language.

The next catalyst we were eyeing was the February jobs report. It showed decelerating employment growth and a slight uptick in the unemployment rate.

It's clear the strength of the January report that led to much of the Fed’s hawkish language and bond yields rising was due to unnatural seasonal factors. The February dip could bring a release of some of the “tail wagging the dog” pressure which would be a welcome reprieve.

Now the risk from bond markets is, while the 10-year note hasn't retested its October highs, the two-year note is past its November highs, creating an even greater inversion:

If the economy doesn’t begin to weaken, an assault on that 4.33% high for the 10-year Treasury is near certain (historically, a yield curve this inverted is a negative sign for economic growth about six to nine months from now).

There is a pot of gold at the end of the rainbow though: the M2 measure of money supply has continued to slow. We’ve always considered the money supply to be critical to taming inflation.

If, as economists believe, M2 affects “real” inflation adjusted output with a lag of about nine to 12 months, then the support for activity likely peaked early this year. That means it should dwindle sharply by the end of the year. And that would be more data supporting the original base thesis of an equity markets rebound in the second half of 2023.

Our narrative may sound like a broken record. But that’s because so many datapoints continue to line up to support a recovery timeline for stocks later this year. Market upturns in January were a surprise gift. It made some (even us) question if the timeline had been pulled forward. But as more data emerges, more support aligns for a late 2023 equities resurgence.

So, what do we do in the meantime? We stick with the successful strategy of the last year. January was a pleasant surprise, but we don’t want to take our eyes off the ball and look a gift horse in the mouth. We appreciate the early 2023 jumps. But stocks are continuing to lose steam and there’s likely more choppiness ahead.

The macro uncertainty discussed above should play out more. But remember that macro uncertainty favors high quality stocks.

While mixed signals abound, it pays to keep things simple. The “higher for longer” interest rate outlook hurts stocks in two ways:

  1. Reduced economic and earnings visibility
  2. Short-term Treasury yields siphon scared money from the market (the one-year Treasury bill yields 5.1% right now)

Until wage inflation drops more, the S&P 500 is likely to stay range-bound and rather choppy:

And while everybody loves a rally (like in January), we must trade the market we have, not the market we want. One outlier month shouldn’t alter the course. Sometimes stocks need a breather as investors await better fundamentals, which is where we are today.

Thus, the 2022 playbook is still in play. You might think defensive, countercyclical sectors like health care, staples, or utilities should outperform – but not in this environment. The focus should be on quality stocks with high returns on equity, stable year-over-year earnings growth, and low financial leverage (i.e., debt).

These fundamental attributes protect from the macro headwinds worrying investors right now. Unlike defensive, countercyclical strategies, a multi-sector diversified portfolio of quality stocks offers plenty of upside exposure once the bull market returns when wage inflation eventually cools.

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