Dougherty Dispatch—Blood on the Street

Dear Besieged Client,

Today the financial markets dropped the most since June 2020, the dark days of Covid.  Please refrain, however, from kicking your dog or jumping out of planes without a parachute.

The impetus for the drop was retailer Target Corporation reporting surprisingly dismal quarterly profits.  The CEO explained that they underestimated the negative effects of inflation on their profit margins, and secondarily, the effect that high fuel prices impact the ability of the consumer to spend.

As a result, investors in the market now believe that inflation factors could indeed trigger a higher likelihood of a recession, which is defined as two consecutive quarters of the year with negative economic growth.  Inflation itself causing a recession is historically unusual. Usually, inflation means people are out there earning and spending and keeping the economy charged with good growth.

As it turns out, a recession typically occurs when the Federal Reserve slows the economy by raising interest rates to fight inflation.

It was very unusual in the 1970s when we had both high inflation and no growth, which came to be called stagflation.  Perhaps not coincidentally, we also had oil supply problems during that period as well.

The financial market links situational items:  High fuel prices reduce spending ability for other goods and services.  At the same time, higher oil prices create higher prices for other things that depend on fuel, such as transportation goods, vacation travel, and plastic petroleum products.  Higher prices result in higher costs for companies which reduce their profits, and lower profits drag down the price of their stocks.  Another complication: higher prices caused by companies chasing products they had trouble getting from companies that were shutdown during Covid.

How long will this down-trend continue?  Historically, the stock market turns around before the economy does.  It turns around when the Federal Reserve stops or indicates it will stop raising interest rates.  Ironically, this usually happens when we have higher unemployment, the economy is lousy, and many people say we should never invest ever again.  Bottom line:  we can not wait on the sidelines until the economy has returned to growth, because by then, much of the stock market has rebounded—it has anticipated the rebound.

Ben Bernanke, former chairman of the Federal Reserve recently said that if inflation is primarily caused by Covid re-opening supply chain issues, inflation will ease soon and the Fed will not have to keep raising interest rates, resulting in a small or no recession.  If inflation persists, however, the Fed will raise rates higher and for a longer time, creating a worse recession.

What are some early indicators that the Fed will be able to ease interest rate hikes and therefore trigger a turnaround in the markets?  First, an indication that inflation is slowing.  Second, new data that the economy is slowing (Yes, I know this is counterintuitive:  we start buying stocks when the economy is slowing!?).  Our firm will monitor these indicators closely.

Those investors who are now selling are those who are uneducated about markets and their short-term fluctuations.  For example, Google’s stock dropped almost 4% today.  It’s the most profitable corporation in the world.  Is this company’s value really worth 4% less--in one day???

Meanwhile, what does the most successful investor do now?  Read the headline in this Tuesday’s Wall Street Journal:  “Buffett Buys Stocks as Markets Fall.”

John D