CWS Market Review – September 13, 2022

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The Stock Market Suffers Its Worst Day Since 2020

This morning, the government released its report on inflation for August. Wall Street had been eagerly anticipating this report. Last month inflation was unchanged, and it was hoped that we would see more good news on the inflation front.

The equation is simple: If inflation backs off, then the Federal Reserve may back off with its rate hikes as well. After all, gasoline prices have fallen for over 90 days in a row. Up and down Wall Street, all eyes were hoping for good news.

Well, we didn’t get it.

Instead, inflation is alive and well. According to the Bureau of Labor Statistics, the U.S. economy had inflation of 0.1% last month. That beat expectations of -0.1%.

Over the last year, inflation is running at 8.3%. Wall Street had been expecting 8%. At that rate, that means if you’re paid a salary at a constant rate for one full year, then you work one month for free.

We know that falling energy costs have had a major impact on the overall inflation rate, so let’s also look at core inflation which excludes food and energy prices.

Eh, not much good news. For August, core inflation was up 0.6% (see chart below). That doubled Wall Street’s forecast of 0.3%. I think this is the stat that really stung people. Over the last year, core inflation is now running at 6.3%.

Here are some details:

Energy prices fell 5% for the month, led by a 10.6% slide in the gasoline index. However, those declines were offset by increases elsewhere.

The food index increased 0.8% in August and shelter costs, which make up about one-third of the weighting in the CPI, jumped 0.7% and are up 6.2% from a year ago.

Medical care services also showed a big gain, rising 0.8% on the month and up 5.6% from August 2021. New vehicle prices also climbed, increasing 0.8% though used vehicles fell 0.1%.

This bout of inflation is unusual in that it appears to be hitting regular consumers harder than the overall numbers suggest. It’s one thing to say that inflation has increased by 8.3% over the last year, but that’s just the average. For example, the index for food is up by 11.4% over the last 12 months. That’s the highest rate since 1979. The price for electricity is up nearly 16% in the past year.

Larry Summers, the former Treasury Secretary, tweeted:

Traders hated the report. I mean, they hated this report. Prior to the report coming, the futures indicated that the stock market was ready to open higher. Today could have been the market’s fifth up day in a row.

But as soon as the report came out, so did the bears. They loved the lousy inflation news. This was the stock market’s worst day since 2020. The S&P 500 lost 4.32% and the Dow gave up more than 1,200 points. The Nasdaq Composite lost more than 5% on the day. Today was just ugly.

The strong inflation news gives political cover to Jerome Powell and his friends at the Fed to continue hiking interest rates. When the Fed hikes rates, risky stocks suffer the most and conservative stocks provide much greater protection. I feel like a broken record on this point, but we saw it so clearly today.

Here are some numbers from today that make the story clear. The S&P 500 High Beta Index lost 5.16% today while the S&P 500 Low Volatility Index fell “only” 2.89%. It’s a similar story with growth and value. The S&P 500 Growth Index lost 5.19% while the S&P 500 Value lost 3.49%.

Amazon and Netflix were both off by more than 7%. Facebook was down more than 9%.

On our Buy List, Hershey (HSY) is probably one of the best examples of a conservative, defensive stock. It’s our top-performing stock this year. Not surprisingly, it was among our top-performing stock today. In fact, today really was a microcosm for the whole year so far. Our Buy List outperformed the S&P 500 today by more than 1% today.

Where do we go from here? The Federal Reserve meets again next week. We can almost certainly expect another 0.75% rate increase. This would be its third 0.75% rate hike in a row. There’s even a decent chance (around 33%) that we’ll see a full 1% increase, but I doubt that will happen. Six months ago, the Fed’s range for short-term interest rates was 0% to 0.25%. After next week, it will be 3% to 3.25%.

The meeting after next week will be on November 2, just before Election Day. Yesterday, the futures market was indicating only a 14% chance of a 0.75% rate hike. Thanks to today’s inflation report, that’s up to 53.5%. That would bring the upper range to 4%.

One of the reasons why I like to track the two-year Treasury yield is that it serves as an unofficial estimate for what the Fed will eventually do. It’s not perfect, but it’s a decent proxy for what Wall Street is thinking. Today the two-year yield got as high as 3.75%. That’s a 14-year high (see chart below). More importantly, it’s much higher than you see in most stocks. The yield on the 30-year Treasury topped 3.5% today. Eighteen months ago, during Covid, it was at 1%.

Today’s message is clear. The Fed still does not have a handle on inflation. Despite assurance that inflation is merely transitory, inflation is becoming annoyingly persistent. The Fed now realizes that it will have to take bold action to defeat inflation. Christopher Waller, a Fed governor, said, “This is a fight we cannot, and will not, walk away from.”

As long as the Fed is determined to raise interest rates, then the stock market will be soggy. I’m not predicting a crash, or even a downward market, but bulls will find it difficult to get a sustained rally going. As fun as this summer’s rally was, it’s come to an end.

The other important takeaway is that holding risky assets right now is dangerous. I’m mostly speaking of high-volatility stocks, but this spills into NFT and crypto as well. With higher rates on the way, conservative stocks will fare much better. That’s been consistent for the last 10 months. These stocks aren’t nearly as impacted by the Fed’s inflation battle as is the rest of Wall Street.

BofA’s Investor Survey

Bank of America recently conducted a survey of major investors. I’m brining this to your attention because I was struck by the level of fear it revealed. Personally, I like to keep an attitude of reasonable optimism. In most cases, it’s too easy to let fear overtake what should be a sober process.

According to the survey, 52% of investors are underweighted in stocks, and another 62% are overweight in cash. I would not have guessed it’s that high.

As concerns over the economy escalate, the number of investors expecting a recession has reached the highest since May 2020, strategists led by Michael Hartnett wrote in a note on Tuesday. Sentiment is “super bearish,” with the energy crisis further weighing on risk appetite, they said. A net 42% of global investors are underweight European equities, the largest such position on record.

What also stood out to me is that a new 92% of the respondents expect profits to fall next year. Investors are clearly shying away from risk.

Persistently high inflation is seen as the biggest tail risk, followed by hawkish central banks, geopolitics and a global recession. Only 1% of participants see a resurgence in the Covid-19 pandemic as a tail risk.

Unfortunately, investors see more problems in Europe. According to the survey, 70% of respondents think Europe’s energy crisis will push the continent into a recession.

One positive note is that 79% of investors expect to see inflation calm down in the U.S. over the next year, and 36% see the Fed ending rate hikes by Q3 of next year.

Stock Focus: McGrath RentCorp

One of my hobbies is finding interesting (and hopefully profitable) businesses that few on Wall Street know about. I’ve featured many of them in these pages. This week, I want to introduce you to McGrath RentCorp (MGRC). This is a fascinating and little-known stock. The company is involved with business-to-business renting.

McGrath rents relocatable modular buildings, portable storage containers, electronic test equipment and liquid containment tanks. This means things like modular classrooms. Or imagine a construction site in the middle of nowhere. McGrath can rent the foremen an instant office. These things are more common than you might expect.

But McGrath does more than that. They also rent test equipment and storage tanks. The company currently operates through four segments: Mobile Modular, TRS-RenTelco, Adler Tanks and Enviroplex.

Only two Wall Street analysts currently follow the stock, but despite being almost completely ignored by Wall Street, this is a very sound company. McGrath has raised its dividend for 31 years in a row. Earlier this year, they bumped up the quarterly dividend from 43.5 to 45.5 cents per share.

The company was founded by Bob McGrath in March 1979 in a small two-acre inventory center in San Leandro, California. McGrath was quickly successful and by 1984, the stock IPO’d on the Nasdaq at $6 per share.

Since then, McGrath has split 2-for-1 three times which comes to 8-to-1. That means that McGrath’s split-adjusted IPO price was 75 cents per share. Today it’s at $85.37 per share.

Check out this chart:

And it’s only gotten the attention of two analysts!

McGrath was hurt during Covid but it still managed itself well. The company’s EPS dropped from $4.16 in 2020 to $3.66 in 2021. I think the company has a good shot this year of topping its all-time EPS high from 2020.

During Q1 of this year, the company made 77 cents per share which beat by five cents. For Q2, McGrath made $1.07 per share which beat consensus by 17 cents per share. (Please bear in mind that with so few analysts following it, that’s a stretch to call it a “consensus.”)

The current market cap is a little over $2 billion. McGrath runs a very strong business and the shares are going for a very good price. That may not last long.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

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