Total Eclipse of Fears

April 1, 2024

By Mark Oelschlager, CFA

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In 1983 Bonnie Tyler's "Total Eclipse of the Heart" rocked the FM airwaves, reaching number 1 on the Billboard chart.  My father, who couldn't get enough of the tune and played it over and over in the car, called it "Turn Around, Bright Eyes."  Forty-one years later we will have a total solar eclipse, with Akron lying in the path of totality.  April 8 has been eagerly anticipated, with schools in the area closing for the big day.  The Cleveland baseball team even moved back the start of their home opener to avoid any conflict.  The 72-year-old Tyler, believe it or not, is releasing a new album in April, though it is her classic track that should get plenty of play around those few minutes of darkness this month.

 

Every now and then we got a minor pullback in stocks in the first quarter, but prices kept shining, with the major indexes reaching all-time highs.  The climb in the quarter was notable for its smoothness, as any drawdowns were quickly reversed.  In mid-February, the S&P 500 had risen in 14 of the last 15 weeks, a streak not seen since 1972.  Gains continue to be driven in large part by the mega-cap tech companies, and the concentrated weighting of the index’s top constituents remains at an extremely high level, which, depending on your perspective, is reflective either of excessiveness that will eventually correct or the natural outcome of capitalism in a highly scalable, digital world.

 

Excitement about Artificial Intelligence is providing a boost, as markets price in a massive new spending cycle in technology.  It is somewhat reminiscent of the late 1990s and the enthusiasm over the Internet.  As it was then, it is difficult to project business growth several years out for the companies riding the wave, but that doesn’t stop the market from attempting to do so.  Valuations of those exposed to the new technology haven’t become as unhinged as they did back then, but they do appear to be stretched.

 

The relentless rise in stocks has surprised many, and looking at it after the fact, it’s perhaps even more surprising.  While the US has so far avoided recession in the aftermath of the Fed’s aggressive interest rate hikes, which is certainly positive, one would have thought the persistence of inflation, and the greater than expected rise in the Fed Funds rate, would have provided rougher seas for stocks.  While inflation showed progress (declined) in 2023, it did not reach the Fed’s 2% goal and in fact has reaccelerated in recent months.  Despite all this, the Fed has continued to guide the markets to expect three interest rate cuts in 2024.  This is perplexing; in dismissing the uptick in inflation, it’s almost as if the Fed is attempting to will it back to its downward trend.

 

The Fed’s talk of lowering rates has been like catnip for the stock market and has surely contributed to the massive gains since October.  Speculating about people’s motives we think is generally wise to avoid, and we are the last ones to engage in conspiracy theories, but one has to wonder how much political pressure Chairman Powell and the Fed are feeling to keep the good times rolling in an election year.  They may be concluding that 3%-4% inflation with a healthy stock market and economy and happy legislators isn’t so bad compared to 2% inflation, lower stock prices, a slowing economy, and angry legislators.  It isn’t a stretch to conclude the Fed thinks about these things, as they have waded into more areas in the last couple decades than they had before.  It is our opinion that the Fed should focus on price stability (equivalent to a sound currency), as this is the bedrock of any economy.  But the temptations to lose that focus are many.

 

Interestingly, the Fed’s goal of bringing inflation down is being made more difficult by the tremendous fiscal stimulus of recent years.  Spending by the federal government has exploded, creating excess demand, so the Fed’s attempts to control prices with monetary policy are akin to blow-drying a wet towel while it’s raining.  And in openly projecting rate cuts this year, Powell has turned the setting on the blow dryer down a notch.

 

The problem is that the longer it takes to reign in inflation, the more entrenched it becomes.  The longer price growth remains the norm, the more companies adopt the mindset of raising them on a regular basis, which of course feeds the loop.  Expectations are key (see the 1970s), and after a long period of this, it is difficult to break the cycle without driving the economy into recession.  Politicians condemn the “greedy” corporations - who provide a convenient scapegoat especially when their profit margins are high – but they share much of the blame.

 

While the US and much of the world are talking about cutting interest rates, Bank of Japan in March raised its policy rate – for the first time in 17 years.  The move also ends an eight-year period of negative interest rates there.  Think about that: for eight years people were paying to have the government borrow their money.  Japan has waged a long battle with deflation and may have finally won, with their inflation rate remaining above 2% for about two years now.  Japan has been reticent to raise rates, which has driven the Yen to a 34-year low versus the dollar.  Similarly, on the other side of the Pacific Ocean, our Fed was slow to acknowledge inflation was real three years ago and now is reluctant to declare that the natural rate of interest has risen.

 

Valuations for US stocks are currently at the high end of their historic range, remarkable in a period of elevated inflation.  With risk-free short-term bond yields north of 5%, it is a lot harder than usual to make the case for stocks over bonds.  In addition, many measures of market sentiment are elevated, historically a negative sign for the market.  All that said, there are still many publicly traded businesses trading at what we believe are reasonable valuations, and we are focused on those.

 

It will be interesting to see how this plays out over the coming months.  Will inflation come back down, vindicating the Fed?  Will the Fed indeed cut interest rates three times this year, and if so, will it be a “sell the news” event since it’s already expected?  If inflation remains sticky, will stocks decline?  Will the slow-moving commercial real estate crisis start to matter?  Will the economy slow?

 

Happy Easter and Happy Passover.

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Mark Oelschlager, CFA  

Oelschlager Investments 

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