Q1 2023

April 6th, 2023

You will notice the stock market recovered this past quarter. Large cap stocks did particularly well, led by a rebound in technology stocks, but the rally was broad as mid/small cap stocks also registered solid performance.

Is the market signaling the end of recent troubles? Probably not, at least not yet.

Last quarter I stated we have been encouraged by the Fed’s newfound diligence in fighting inflation. Inflation remains, in our opinion, the single most important problem we face. Taming inflation is essential to the long-term health of the markets.

I do not believe the 1st quarter’s strength signals an end to that issue. What needs to be done will take time to have the needed effect. Reading too much into this quarter’s “strength” masks what is really going on.

Let’s put that statement in context.

The actual fall in the stock market occurred a year ago, between January and June of 2022. Stocks fell as prices for energy and food spiked. That price inflation moved through the rest of the economy. Since June of last year, the market has been in a trading range, a wide trading range, but a range, nonetheless.

For each of the three quarters prior to this recent quarter, the market always sold off as each quarter ended. This was because the quarter-ends coincided with news from the Fed. The Fed announced interest rate increases right around the end of each quarter sending markets lower.

Then, when the new quarter started, investor optimism would grow, and the markets would start moving to the high-end of the trading range. Investors were speculating the interest rates hikes had ended, in spite of the fact the Fed kept saying they had not.

That’s where the Fed’s behavior over the past 20 years has eroded their credibility. The Fed’s job is to ensure inflation is under control. Since 2002, they have routinely taken policy actions to support investment markets, which is not their job. Lower interest rates always stimulate markets, and whenever investment markets would get in trouble, the Fed stepped in with lower rates.

Up until last year, these actions have not resulted in inflation, so the lower rates seemed to coexist with low inflation. There appeared to be no consequences. I’ve argued for years that eventually there would be consequences and we seem to be facing them now.

Last year after each interest rate increase, investors would start to believe the Fed would be done (the “optimism” I spoke of), and the markets would move higher. What the Fed was saying had no effect, they’d been talking a good game for years, but would always support the markets in the end.

In an admittedly counterintuitive way, I’ve supported the Fed continuing to raise interest rates. Despite the fact doing so would hurt the markets, I don’t believe inflation can be tamed by a couple interest rate increases. It’ll take persistent action.

I was a bit surprised when this whole Silicon Valley Bank default was revealed this quarter. I’ve been through many market downturns and had come to expect the banks to run into some sort of trouble. They always do.

During this downturn, I was not concerned with the banking system. Higher interest rates would eventually favor the banks; low rates made it tough for them to make money. But more importantly, the banks tend to run into trouble because of bad loans. This past cycle there did not seem to be any areas of excessive lending; at least not on the scale we’ve seen in past downturns.

I did not anticipate that a bank’s management would take demand deposits and invest the proceeds in long-term bonds. In essence, taking money that could be withdrawn at any time and investing it for the long-term. The scope of the irresponsibility is simply unbelievable. Although there appear to be a few more institutions with similar issues, this does not appear to be a banking system crisis.

The “banking crisis” mid-quarter, caused the market to sell-off sharply. Then, as the scope of the problem was better understood, markets recovered. As important, the Fed’s interest rate increase at the end of the quarter was not as large as those seen last year. All this allowed the market to end the quarter on a high note.

I still believe we need to be patient. So long as the Fed remains diligent in fighting inflation, I am comfortable with the long-term outlook for stocks. I believe we’ll remain in this trading range until there is more evidence this inflation cycle is over. This is going to take longer because of some of the dislocations we are still dealing with post-COVID shutdowns. I’ll address some of that in my next letter.

Have a wonderful Spring and, as always, do not hesitate to call if you have any questions.

Sincerely,

Mark Hoonsbeen, CFA
Principal
Nicollet Investment Management
800 North Washington Ave, Suite 150 Minneapolis, MN 55401
Phone: 612-915-3033
Email: markh@nicolletinvest.com