Why are stocks in pullback mode?

Stocks have recently been in a pullback period after what has been a great year so far.

After a year like 2022 where both stock and bond markets had terrible returns and inflation peaked at 9.1% year-over-year, we all entered 2023 extremely cautious.

If we’re being honest, most of us were a bit – or a lot a bit – bearish. But, we started to see positive stock market returns in early January and February, only to be pulled back in March to the tune of about 8%. If you remember, it felt like confirmation that we were headed for another down year.

It felt like confirmation of the looming recession everyone seemed to be predicting.

With what felt like catching lightning in a bottle, stocks lifted off again in April based on forward guidance around A.I. and the semiconductor demand to expand the use of that technology.

Now, nearing the end of August, we have seen a recent pullback of about 5%.

So, why is it happening and where might we go from here? Let’s get some context for where we are and think about where we might be headed.

This post will be relatively long, contains several charts, and will include a TL;DR at the end.

Why do stocks pullback?

First, let’s talk about stock pullbacks. Even though they can seem to come out of nowhere or for no good reason, they happen every single year. In fact, they happen every single year at an average of 14.3% drawdown.

The below chart shows the S&P 500 intra-year pullbacks and recoveries going back to 1980. Notice the red dots that show up every year. Also, notice the grey bars to reflect where the S&P 500 finished in each respective year.

In 30 of the 42 years (not including 2023), the S&P 500 rebounded to finish positive. In 2011 it finished with a flat return at roughly 0%.

If we count 2011 as not having a negative return, the S&P 500 has finished with gains 74% of the time. I like those odds.

chart source: JP Morgan Guide to the Markets, data as of 07/31/23

Sometimes when stocks go through a pullback period we think there’s something wrong. We look for a culprit or signal of something to come; another shoe to drop.

In the case of 2023, there’s not much negative to point to. Well, other than the fact the Fed has continued raising rates, which I’ll get to shortly. For now, here’s a look at effect of Fed rate hikes on the US Treasury Yield Curve since March 2022.

If you’re unsure what this chart represents, let’s just say the top line is not healthy for the bond market. It does, however, show why money market funds and CDs are so attractive this year.

As I type this, the S&P 500 is up 14.73% year to date. But that return is a little deceiving. Just 7 stocks account 27.4% of the S&P 500 index value, yet as of July 31st they collectively delivered an average return of about 64%.

The “Magnificent Seven” stocks: Microsoft (MSFT), Amazon (AMZN), Meta Platforms (META), Alphabet (GOOG), Apple (AAPL), Nvidia (NVDA), and Tesla (TSLA).

These seven stocks have lost their shine, now account for something like half of the market value loss so far in August.

On a month-to-date basis, Microsoft is down 4.13%. Amazon up 1.94%. Meta is down 10.88%. Alphabet is down 2.57%. Apple is down 8.05%. NVDA is down 1.80%. Tesla is down 10.68%.

Because of how much these stocks ran up, we may be able to chock this up to profit taking and the market not having the confidence to justify higher multiples based on the forward earnings guidance.

Let’s now look a little broader than stock performance.

The Fed keeps raising rates

Since March 2022, the FOMC has aggressively raised rates by more than 525bps, or 5.25%. By historical context, it’s a head-spinning pace. When you add the fact that they’re also unwinding their balance sheet – effectively removing money from the market – at the same time, it’s one of the tightest – if not THE tightest – periods of tightening on record.

What’s more? The FOMC appears poised to raise rates YET AGAIN in 2023. Why? Inflation remains higher than their 2% target, and the labor market is still tighter than target at a persistent 3.5% or so.

chart source: JP Morgan Guide to the Markets, data as of 07/31/23

Even if the Fed does raise rates again this year, the broad expectation is they will have to cut rates over the next year.

The chart below shows the Fed even forecasts rates to fall by up to 1% by the end of 2024. They also expect to see positive GDP growth, lower inflation, and more slack in the labor market over the same period.

chart source: JP Morgan Guide to the Markets, data as of 07/31/23

Interest rate hikes take a while to filter through the economy, and they are doing their damndest to engineer a “soft landing.” But, historically, they always overshoot their target.

Never mind 2024 is an election year and, aside from all the other social issues and candidate hoopla, the economy will of course be a primary issue.

Speaking of the economy, let’s have a further look under the hood.

How healthy is the economy?

After the pandemic the obscene (my carefully chosen word) amount of stimulus that followed, we kept right on spending and have pretty much returned to trend. As the chart below shows, 68.2% of GDP is consumption.

And for all that spending, the U.S. consumer still has a significantly healthier balance sheet than the period heading into the Great Financial Crisis. Even going back to 1980, the debt payments as a percentage of disposable personal income is historically low.

However, the chart to the lower left shows a slight increase in 30+ days delinquencies in auto and credit care payments over the past two years.

Look at the student loan line in orange… keep in mind payments for federal loans restart in October. I fully expect to see a rise in delinquencies here, as payments have been removed from cash flow for 3.5 years, and some borrowers will flat refuse to pay in protest to the Biden forgiveness being reversed by the Supreme Court.

Speaking of delinquencies, some financial pundits have pointed to a possible correlation with a significant rise in credit card balances since the pandemic, and even pre-pandemic. By the numbers, total credit card balance in this country has topped $1.031 Trillion, which is the highest balance ever.

At the same time, it’s estimated that just over 2% of Americans are delinquent by 30 days or more on their credit card payments.

In context though, there are significantly more consumers with credit cards now than back in 2008 – so OF COURSE the total balance number is higher.

And then there’s the persistently high mortgage rates.

The average rate for a 30 year fixed mortgage in 2021 was 2.96%, then 5.34% in 2022, and now roughly 8.14% in 2023.

The St. Louis Fed (FRED) estimates the current average home sales price across the country at $495,100, which is roughly $100,000 higher than just two years ago, but down approx. $50,000 from just one year ago.

Yet, with significantly higher borrowing costs than in recent memory, consider the average mortgage rate from 1971 to 2023 is 7.74%. With low down payment programs and seller-funded rate buy downs, homes are still selling. And, home building is still booming and will continue to do so for the foreseeable future.

Here’s the TL;DR.

With unemployment under 4%, housing starts rising another 3.9% month-over-month in July, and real wage growth now outpacing inflation by more than 1%, the probability of a recession is significantly lower than we all expected at the start of 2023.

All things considered, the economy continues to soldier on despite Fed rate hikes of more than 5.25% since March 2022. Higher rates, in theory, are a tool to slow down economic growth and bring down inflation. The trailing effect of slowing economic growth, which means slower GDP growth, which means lower corporate production, which may mean lower stock valuations.

That said, where the market goes from here will largely hinge on whether or not the Fed continues to raise rates. If the Fed pauses, or even eventually cuts, we could possibly see borrowing rates decline based on bond yield movements.

Stock market pullbacks are a natural part of investing, and so far in 2023 we’ve seen as much as 8% drawdown, which is less than the average intra-year decline of 14.3%. Much of the current pullback of roughly 5% or so has been caused by the same 7 stocks that led the market significantly higher through July.

Clients of Life Moves Wealth Management have over and over heard me state the importance of remaining on the field and playing the game – staying invested. Market pullbacks are an opportunity, for those who have the capacity, to invest more.

More importantly, we keep buying regardless of what the market is doing today because the game is won by playing smart over time.

The performance of your investment accounts may not match the return of the S&P 500 in any given year; in fact, if your investment strategy is properly diversified and appropriately matched to your individual risk tolerance, the performance of a broad stock-only index is an irrelevant comparison.

What IS relevant, however, is what your investment strategy is designed to accomplish over time and what you have in place to help weather periods of market volatility… financially and emotionally.

What is your investment strategy built to accomplish? Unsure? We can help.

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