Not A Surprise.

It has been wild in the markets these last weeks.

The largest interest rate hike we have experienced since 2000. Rising inflation. Fear based stock sell offs. The drop in meme stocks.

And what about a recession?

Royal Harbor Partner's Natalie Picha, Glenn Royal and Jason Strzyzewski discuss the  market reaction after the May 9th Fed meeting and why they are not the least bit surprised.

Get to know us at: www.royalharborpartners.com

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https://podcasts.apple.com/us/podcast/rhp-market-talk/id1538051530

Transcript

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Introduction

Natalie Picha 0:08

Welcome to the RHP Market Talk Podcast, Episode Number 19, brought to you by Royal Harbor Partners Wealth Management, located along the beautiful Gulf Coast of Houston, Texas serving families across the country. I'm Natalie Picha...

Glenn Royal 0:20

...and I'm Glenn Royal...

Jason Strzyzewski 0:22

...and I'm Jason Strzyzewski.

Fear Based Selling

Natalie Picha 0:24

And we're here today to talk about the wild start that we've had to this year already. We are recording this Monday, May 9th and we wanted to wait to put this podcast out after seeing what the market's reactions were going to be to the Fed hike that happened last week. So Glenn and Jason? Oh my gosh. What are you thinking? I know we've been doing some podcasts this year and we've been talking about the roller coaster ride. I think we've been trying to prepare our listeners for what we knew was coming. When the feds started raising these interest rates and pulling the money back out of the system. We knew that it was going to be painful. Here it is. We're right in the middle of the pain.

Glenn Royal 1:02

Yeah, the roller coaster continues as we've been discussing this whole year. One of the things that last week brought was just wicked whipsaw. That roller coaster. We were all over the place. We finished the week, the S&P would had a slight gain for the week but it didn't feel like it, right . It felt like the world was coming to an end. If you were an investor in assets, one of the things that we look for to kind of end these bear market selloffs is something called capitulation and that's based on fear. And we didn't really get that full fear last week. But I think it's evident that we're getting it today on Monday. It's really starting to bleed in the markets. But what I'm finding interesting today is where the pain is at is in those growth stocks. You know , those old FANG stocks. Little bit in commodity space. Well , which kind of gives me an indication. This is fear based selling. Just taking the baby out with the bath water today. But as I look at things, one of the things we like to focus on is factors in the market what's working. What's not working. And we've got a broad based rally today in value stocks. Companies that are profitable companies that pay dividends. Companies that are buying back shares. These are not the stocks that worked the last few years. Jason, what are you seeing that that kind of catches your eye?

Jason Strzyzewski 2:26

Yeah I'm right there with you Glenn. Recently, with all this tumultuous activity forced by the fed and where we've known, things were going to go all along. I'm with you. We're looking for those stable dividend payers. Continuing that move to real assets away from the markets. Volatility throughout this time to try and get some sort of stability in a portfolio when you've got risk off days. Half the days of the week and you're ending flat. So it's been a very interesting time to say the least. Because like you mentioned last week, felt like the world was ending. But we were roughly flat these wild swings in a very fickle market. It's to the outsider. If you're paying attention to a lot of news, it can be very concerning, but just know that we're on top of this at all times and we're searching the market for really anything. Any kind of fundamental deals, any so another portion that we're looking in, real assets and these dividend payers, we still really like the energy sector. We like healthcare . And part of that reason is we're seeing in the commodities , in this fundamental supply shortage in energy, the crack spreads are absolutely through the roof and the outflows are still remaining the same. So it's just encouraging more profitability for us. And on top of that, a transition to EV's...ESG, that whole movement. It's going to be very painful because the infrastructure simply isn't there just yet.

Glenn Royal 3:57

Yeah. And that move is perhaps a little ahead of itself. It's ideal. I think to go towards environmental, societal government type things. Trying to reduce greenhouse gas emissions. But what that's caused the last few years is under investment in the energy patch. And so we have structural under investment in it. That's now catching us. Biting us in the rear and you're starting to see those type of stocks go, particularly with the admin what's happening in Ukraine. Big time right now. I, you know , the other thing is I want point out is with the fed meeting last week, they raised a half a point. Back in March they raised a quarter of a point. When this first started back in March of 2020. COVID at the scene. There was a G7 group seven nation meeting. They described what was happening in COVID was becoming a pandemic. The fed responded with a quarter point hike. Excuse me, this cut to interest rates. They took that down from two and a quarter to one and three quarters. A half a percent cut. And then wasn't a week later, they cut a full percentage 0.1 and quarter down to a quarter. All in all, that was a two percentage point cut. So here we are today, the fed is basically raised rates three quarters of a point. They've only taken back half of that initial cut that they did. So we expect that half a point increase, at the coming meetings in June. Follow about another half, a point in July that takes that fed funds rate back up to 2%. Then we start to see where the fed can kind of slow down and start to go to those quarter point , hikes if they need to.

The May Fed Meeting

Natalie Picha 5:36

So that's a great point. And something I'm reading about hearing about. And you know, we talk about markets being forward looking . And that really, this market's on a lot of the heavy lifting for the fed. They're front, running it considerably,.you know what we're expecting and what Powell said at the last meeting about we're not gonna go 75 basis points. We're only going 50. How do you think the market's reacted to that information? Knowing that the market has already got priced in at this point, more hikes than we're expecting from the fed.

Glenn Royal 6:06

So, a couple of the fed speakers that are calling the policy wants. Fed governors. They pointed out that there's a lot of criticism on the feds. And they're behind the curve on inflation. Right? We're hearing that everywhere. But there's something that we looked at called Goldman Sachs Financial Conditions Index, FCI. That has been increasing. Many conditions have been tightening without the Fed's action. Just by them simply talking about it. Addressing inflation to back to levels prior to the COVID pandemic. So the fed isn't necessarily behind the curve . When you look at those tightening of financial conditions. That's, what's taken out the valuations and these growth stocks. That has been going on really since November, where we end that , I don't know. I mean, how much further do conditions have to tighten? In this case, it is always a little different we're dealing with inflation, right? If we didn't have inflation in the picture, I think that fed would be coming to the rescue here. Because of the wealth effect is the damage to the wealth effect of equities, is part of what tightens financial conditions in addition to rising rates. So that's generally where the fed would come in and pause and want to start to protect wealth destruction. But because we're fighting inflation, they may have a little bit of a...they may keep this trade going longer than we normally would expect.

Jason Strzyzewski 7:25

Exactly Glenn. And that's why we're so data dependent. With this week's CPI Data releasing on Wednesday. We're expecting the Street's expecting 8.1% currently at 8.5% and that's a big beat to have for the fed. And that really depends... that determines their action and how swift and how much more aggressive they need to go. Because if they can't capture that genie and put it back in the bottle, then you know, last week's talk was 75 basis points is off the table. But if they can't do that, then maybe that discussion gets a little louder again.

Glenn Royal 7:59

Yeah. All options will be open for the fed at that point.

Jason Strzyzewski 8:02

Exactly.

Glenn Royal 8:02

We'll be watching...actually in that number. One of the key things we look at is the three month trend. Don't see this reported as much. But we want to see that short term trend and CPI. Is that actually rolling over a bit. To give us confidence that really plays into my thinking in the second half of the year. Of more, the blue sky scenario. Is that the inflation does come down. And corporate profits stay strong. I mean , we haven't talked about that. But Jason corporate profits have been through the few quarters. They haven't skipped a beat.

Jason Strzyzewski 8:34

And that's still very encouraging for our outlook. We're just facing the music that we knew was going to be played at this time of the year. We're here!

A Strong Underlying Economy

Natalie Picha 8:42

Let's talk a little bit about that. Because, if you guys don't mind just addressing, and I know it's a topic of conversation around here. But it's a weird time in the markets. When we have kind of a break in the fact that we do still have a pretty strong underlying economy. Even though this market is causing a lot of pain for people right now. The overall economy is pretty strong. How does that play into this?

Glenn Royal 9:05

So it's evidence. I'm seeing it today in the market. While you're having tech stocks and crypto, and the number of things get blasted now 9% or so on the day. Value stocks are up 6%. Stocks that are profitable are up 6%. Stocks that do share buybacks and dividend payouts are both up almost 5%. So under the surface, you're seeing a rotation from growth to value. And value, this is their markets. And when this rotation occurs, it's sticky. It stays for a while . So I think that Tech's probably going to continue to have resistance until the fed stops raising rates. The economy kind of bites in. At the same time to me, this is, I got deja vu with the Dot Com. You pumped up a lot of risky assets that were all in the future expectations of payout. And those are the ones that are getting clocked. Down 67% . Exactly what were you seeing on a stat Jason?

Jason Strzyzewski 10:01

Yeah, we're looking at the NASDAQ. And 47% of the components of the NASDAQ. They're down over 50%. 39% down 60%. Plus just under the surface of that index, there's just a lot of pain. And it's a result, the free money area's over and we're moving into more of a normalized rate. So the big question is, how much can the economy handle? How much, how quickly can we control inflation? And where is that fed funds neutral rate? What does that mean?

Glenn Royal 10:31

That's...you know , that terminal rate. Where does it end? Markets right now are pricing in around two and three quarters. Which is deemed the neutral rate. It's a level of when it's not too hot. Not too cold in economies. It allows for growth. Corporate profitability doesn't roll over. But we do know that the fed has something like 12 of the last 14 hiking cycles. The Fed's gone into a recession. You know, they don't have a great track record of these so called soft landings. But we'll have to see. I mean, that's what everybody's working with . So, we're really closely watching their earnings...corporations to see if they hold in here. So far, knock on wood, everything's doing pretty good.

Natalie Picha 11:09

Well, and you know, a lot of this inflation was also exacerbated by the whole Ukraine-Russia war. So it's a supply chain issue, not just other normal inflationary pressures that we would get in this type of a very compressed market cycle.

Glenn Royal 11:24

Makes it difficult for the fed. China is in lockdown in there too.

A Recession or Not?

Natalie Picha 11:28

Right. China's in lockdown right now. And we just saw our first month of some negative GDP growth. So are we going into a recession or not?

Glenn Royal 11:36

You know...that's the question that nobody knows. Right now, the probabilities of us entering a recession, are 35% within the next two years. Now, let's put that in context. All economists, on an ongoing basis, generally have a 15% probability of a recession. Right? So we do see the increasing probabilities, but they're still manageable at this time. We just don't know.

Natalie Picha 12:03

...and the markets have already priced a slow down in. You know, they've already priced in that slow down.

Glenn Royal 12:07

Yeah. So the other thing is exciting to me today is, I've got a bid in the bond market., Across all maturities. Everything is bid up strong. So, the bond market, maybe got ahead of itself and its sell off. Which really bled over into equity valuations and brought those down. But with the fact that I've got value stocks running. Profitable companies running higher today. And I've got a bond market bid. Gives me some reason to be optimistic that we're trying to find a low point in this market selloff. Now that being said, I wouldn't want to own high growth stocks in here with no earnings. I think those are still in danger. And that's a lot of the FANG stocks. It's there's Cathy Wood and Ark Fund. If people know that. It's in the press right now. She...you know...feel a lot of pressure in her names . Those are innovative technology companies.

Energy Price Expectations

Natalie Picha 12:58

So, you touched on this earlier, but I know a lot of people like to hear, especially in our area, in the Houston Gulf Coast areas. Energy price expectations, right? That was a big part of the inflationary story. Just a couple or few weeks ago, some of those numbers have started to roll over a bit. Where do you think we go from here? Energy wise?

Glenn Royal 13:20

So, again, I go back to that push towards environmental green. What that did, was it removed capital from the energy space? So if I'm a CEO of an energy company today, I don't have a lot of reasons to trust the government. That they're going to back me. If I go out and increase my capital expense to pump more oil out. So what we're seeing these companies do is return cash to shareholders. They're buying back shares. Their earnings are through the roof. They're phenomenal right now. They're increasing their dividends and paying down debt. So as an equity investor, I like that space from the return on capital to me as an investor. I feel pretty good about it. I think it's got legs. I, you know...you are seeing in Europe right now...there's a little bit of some backing of the original hard move towards sanctions. Certain countries can't totally back off of Russia. So, that's living a little bit over into negative , prices on energy on the day. Also, I think you're getting a little capitulation. That's moving in some of those stocks. But I like that space a great deal. It's in that value camp. These stocks are trading pretty cheap. We picked up a name the other day. A non-energy related name. But it's value. It's a company that is trading. Call it 60% cheaper than its historical price earnings multiple. It's trading at very, very low levels. Those are , those are the stocks that are being bid up and it pays a dividend. So what we're trying to bring in the portfolios are those stable companies that don't have a lot of earnings volatility. That are returning cash to us. Either through increasing dividends. Or share buybacks. Or even paying down debt. Making their profitability that much more attractive. I'm pretty excited about it. One thing too, I want to point out...I think this is key too...I've been on this like a broken record for a long time. But we are finally...because of inflation, it took that to occur...but the world has exited zero interest rate policy. If I go back to the end of the year. Start of the year, I still had a number of companies with negative interest rates. And if I was buying their 10 year treasury, I was paying that government for the privilege of owning that debt. That's gone. We're not the only central banker that's raising rates. It's happening all over. Because it's a global phenomenon. The inflation. Supply logistics, things of that nature. COVID related . And then a lot of stimulus money put in the system. But that exit from zero interest rate policies, what that's doing is that's bleeding back into where I can get paid on a CD. I can get paid on money markets. I haven't seen that in a long time. I know a lot of our clients have earned one basis, point on their checking account or savings account at the bank. You're going to start to see those rates come up. We have moved to take advantage of that. Because of the shorter maturities in the bond market. They were the first ones to reprice the potential for the fed to go in two and three quarters from a quarter. Perhaps it got a little overdone on the upside. And that's an area where we've seen a lot of opportunity and we've been adding to the portfolios.

Strange Times For The Younger Generation

Natalie Picha 16:32

So that's a good , good little segue way. And Jason, you may want to comment on this. Being of a younger generation. We have an entire generation of people that have never seen this change.

Glenn Royal 16:42

Five handle mortgage?

Natalie Picha 16:43

This sea change, right? They've never seen a mortgage rate of 5% or more. They have never seen, well, this sort of market damage , in growth. What are your thoughts on what this looks like? Because the meme stocks. And cryptos and all of those things. The retail investor just jumped right in. We're hearing about it. When everybody had to shut down and stay home. Everybody...

Jason Strzyzewski 17:08

Yes. Sports is over and everbody needs something to do.

Natalie Picha 17:11

... and everybody used their phone to trade stocks.

Jason Strzyzewski 17:13

Exactly. So it , I mean, it's been a real eye opening experience for me personally. I've had experience, here and there within the market, but to be fully entrenched in the day to day and really understand what's going on under , underneath the surface. Seeing these day to day whipsaws. And these rotations at the sector level and factor level. Factor, being certain investment styles of companies. Growth. Value, like Glenn mentioned earlier. To see those quick changes and then the cost of capital, the fed changing this entire investing environment. To a new area that I haven't experienced before.

Glenn Royal 17:57

What does buy the dip mean to you now?

Jason Strzyzewski 18:01

It means sell the rip. Don't buy the dip.

Natalie Picha 18:05

Sell the rip . Don't buy the dip . Good . And I have to tell something on Jason here. The joke was is that Jason was in the back of the room. He was the kid in the back of the room that was trading stocks in the middle of class, instead of paying attention.

Jason Strzyzewski 18:19

Instead of it was a lot more fun than sitting through history I'll tell that much .

Glenn Royal 18:22

Well, it was a lot more fun when you had to fed at your back.

Jason Strzyzewski 18:25

Yes. Yeah. Having that, helping hand, it makes everyone an investing pro.

Retail Investing

Natalie Picha 18:29

It's been very interesting that , we've seen that retail investor kind of get washed out of this market.

Jason Strzyzewski 18:35

Yeah. When you look at...

Natalie Picha 18:36

We're seeing the volume. Yeah. And institutional good old fundamental stock picking is back.

Glenn Royal 18:42

I've been whispering pets.com up and down this hallway is a carryover from the Dot Com blow up. You know , pets.com was the poster child. The sock puppet was selling everything. And, but I think the parallels are eerie to me. You had a lot of...you had a fed induced rally. They were , you know , whenever the fed giveth and the fed taketh way. But it pumps so much money liquidity into the system. And when they do that, it bleeds out into risk assets. They're the ones that rip higher, right? Cheap money. Lots of money. Up it goes . Right . But whenever they stop filling , we always use the punch bowl analogy. Right? Well, the fed is draining the punch bowl right now. So they're in, in the party and you're seeing that equity valuations and a lot of these riskier assets. I think it's fantastic to go through these experiences. Jason's getting a lesson he could never get at university. This is a real live fire experience and it's just going make him a better investor in the future.

Natalie Picha 19:37

For sure. Well, and I think what's key and I think key for the listeners. Key for our clients. Markets go up and markets go down. We're in a very compressed business cycle. There's always a bottom. There's always a top. Now we never know exactly where the bottom is. We never know exactly where the top is. But we're in that period of like you mentioned fear...we got a lot of inexperienced investors that are first time seeing this loss at this level, without the ability to know where to go. So there's been this...I love this term...it's been out there. Tina.

Glenn Royal 20:13

There Is No Alternative.

Natalie Picha 20:14

There is no alternative. Both bond market and the equity markets both were under fire.

Glenn Royal 20:19

That really came about. And it was true, when you had rates and fed funds at a quarter of a point and your treasuries, you....

Jason Strzyzewski 20:27

Didn't get paid in the bond market. So your only alternative was equity. So it's been a very interesting experience to say the least.

This Is The Transition

Glenn Royal 20:35

I think that what our , what investors need to understand in here is that, this is the transition. The way the markets move. We have moved to position the portfolios to be in front of some of this. So, we did that in the fourth quarter. We went towards that value bin. Which is hard to do. When you switch to value while the growth is still going. It's hard to justify the underperformance that you're going to get during that time period. That's really, really challenging for a portfolio manager. That was...is the right thing to do because of all the metrics that you see are pointing to overvalued markets. We went from 30 times earnings on the S&P 500 price earnings multiple ratio last fall. That's down to 20. If I had to draw a line in a sand, I'd go out on a limb here and say, where could this thing bottom out...historically with inflation being where it is and interest rates, you'll probably see this thing about 18 times earnings. If I apply that to what our expectations are for the S&P 500 earnings. That puts you around 3,800. We're 39 91 on the S&P 500 right now. So, you see it within sight. Now where I could be wrong is if that earnings does fall going forward. If we do get a contraction, that recession becomes evident and it starts drawing down earnings. Then I think you have more downside in this market.

Natalie Picha 22:02

Right? Well, and I've seen some consumer spending expectations, that it's going to hold . As far as consumer spending goes in this market, that's going to continue for about 12 months. There's a lot of people still on the sidelines. They're still waiting to get their stuff. They've been trying, yeah. They've been waiting right? To get their stuff? So I think that some of that consumer spending is what may well...

Glenn Royal 22:23

And a lot of that money, you know, work from home...all those things that we had last year. The government stimulus programs. Those are dried up. People are going back to the office and that's going to change their consumption pattern . We're already seeing it. One of the big drivers of inflation was goods. Purchase of goods. We talked about that before. We are seeing that roll over . You're seeing services. The cruise ships. The airlines. Travel.

Natalie Picha 22:47

Vacations are back on.

Glenn Royal 22:48

Air BnB. Everybody's back at it. Back to those services side economy. And that's why you're with the expectations for CPI is starting to roll over. We start to see some of that going forward. Markets are still pricing in...inflation will roll over. So that's what we'll be watching really closely here. As we finish out this year. Earnings and inflation.

Natalie Picha 23:09

Well, thank you both. I know these are always just a fun conversation. And I like trying to bring it all together. Because we have these walking by each other's office and have a quick conversation about this or that. And clients call and we're addressing their questions. And we always hope that these podcasts, not just for our clients, but for those that they might be sharing with. It gives them food for thought. And if you ever have any questions and you want to give us a call. We are happy, happy to have these conversations on a one-on-one basis if necessary. At RHP we're passionate about planning for your financial future. We're devoted to our relationships with multi-generational families, for the creation of successful legacies. Through our one-on-one conversations, we can help you navigate your personal wealth management and investment journey. How different will your life look with the right advice? Please feel free to contact us through our website at www.royalharborpartners .com

Disclosure

Disclosure 24:05

Royal Harbor Partners is a registered investment advisor and the opinions expressed by Royal Harbor Partners on this show are their own. All statements and opinions expressed are based upon information considered reliable. Although it should not be relied upon as such. Any statements or opinions are subject to change without notice. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investment, or investment strategies. Investments involve risk, and unless otherwise stated are not guaranteed. Information expressed does not take into account your specific situation or objectives and is not intended as recommendations appropriate for any individual. Listeners are encouraged to seek advice from a qualified tax, legal or investment advisor to determine whether any information presented may be suitable for their specific situation. Past performance is not indicative of future performance.