The economy is slowing. Inflation is climbing. Investors are worried that these trends appear to be a recipe for the "S" word.

 

The economic concept of stagflation where the witches' brew of a faltering economy, aided and abetted by skyrocketing inflation, harkens back to the malaise of the late 1970s. At that time, interest rates rose to nearly 20 percent. Inflation, as measured by the Consumer Price Index (CPI), reached an annual average of 13.5 percent by 1980. Oil prices (like today) surpassed $100 a barrel.

 

Blame for this period of stagflation fell squarely on OPEC, a newly formed energy cartel of oil producers, that decided to raise oil prices sharply after decades of artificially controlled suppressed prices by mostly Western nations and their energy producers.

 

Since energy is used in so many of the industrialized economies to produce just about everything, this oil shock reverberated throughout the economy. As costs rose, prices pushed higher causing more and more inflation (sound familiar). It didn't help that for the most part, monetary expansion was the name of the game throughout most of that decade.

 

Looking back, economic growth and unemployment in the 1970s was uneven at best with two recessions, one at the beginning of the decade, and another from 1973 through 1975.

 

It's not hard to point to the similarities between then and now.

 

Today, we are confronting similar supply shocks, which began during the pandemic and have since been amplified by the onset of the Ukrainian War. We have also been functioning under a highly expansionary monetary policy that has been in place since the financial crisis of 2008-2009. Where we differ today is in the areas of economic growth and employment. Neither qualify as coming even close to stagnation.

 

Proponents of stagflation would say that it is only a question of time before the economy slows and is in fact doing so as I write this. They would be right, at least in the short-term. Most economists expect this present quarter to register anemic growth. Yet, for the year 2022, the expected growth rate is still 3 percent and 2.3 percent for 2023.

 

However, the Russian invasion of Ukraine and the resulting sanctions may trigger recessions in both warring countries. Theses actions will also spill over to the European Community (EU) and directly impact its economies. It will also create even further supply chain obstacles and higher inflation.

 

One would expect that the U.S. economy will feel these impacts as well. The Conference Board estimates that these headwinds could cut as much as half a point or more from our growth rate.  On the unemployment front, we are nowhere near where we were in the 1970s. Right now, unemployment is at a low of 3.8 percent. And readers must remember that global economies are less energy intensive than they were back then. In a research report, UBS Wealth Management USA argued that "oil intensity of global GDP has dropped by 25 percent since 1990 (and by more than 50 percent since the early 1970s when oil price shocks caused recessions)."

 

However, what we don't know is what economic impact the Fed's intention to tighten monetary policy will have on the economy. Investors point to what happened when Federal Reserve Chair Paul Volcker addressed inflation back then. He raised interest rates to double-digit levels, drove inflation down, but also sent the economy into a deep recession. Could the Fed do that again?

 

I doubt that today's Fed will ignore the past and simply "do another Volcker." But make no mistake, the Fed is going to raise interest rates next Wednesday, March 16 by 25 basis points and likely raise rates again at the next two meetings. How will the markets handle that?

 

We are the lower end of the box on the S&P 500 Index (the lower end of that box is 4,310, give or take 20 points). I believe markets will continue to move on every headline between now and the FOMC meeting next Wednesday.  If I were a betting man, I would say markets like what Chair Jerome Powell has to say. In the meantime, stocks are managing to hold up and will continue to do so, barring a game changer in the Ukraine conflict.

 

Commodities are soaring. Interest rates are falling. Stocks can't get out of their own way. All of this is occurring, while the first war in decades continues to rage in Ukraine. Seems to me that any gains in the market averages next week will remain dead cat bounces in this bear market.

 

Yes, I hate to be a squeaky wheel, but I've got to call it like I see it. We have a much greater chance of sliding lower from here than higher. Here's why.

 

Investors received a new lease on life this week when Fed Chairman Jerome Powell, testifying before the Senate banking Committee, triggered a market rise in the averages.  All he did was relieve a little market angst by stating that a 25 rather than a 50-basis point move should be expected later this month at the FOMC meeting. In that context, I would label the resulting short market bounce as simply a relief rally.

 

Initially, the markets rallied because the Fed is not raising rates as high as expected. That usually means higher stock prices, so the bounce was understandable. But the reason the Fed plans to raise rates in the first place is due to soaring inflation. What did investors do?

 

Prices of basic and precious metals, like aluminum, nickel, copper, gold, silver, and food commodities like wheat, corn, fertilizer, and of course, oil and gas were bid up leading the market gains.  The combination of these Russian fear trades, plus inflation plays, continued to lead gains throughout the week. Technology and speculative areas were largely left in the dust.

 

This action has only pushed up commodity prices even higher. Now what will that do to the inflation rate?  Push it even higher, and possibly make the Fed reconsider its plans. Those bond traders who were betting on a "one and done" interest rate hike have changed their forecast. The betting is that there will be at least two more hikes coming before June.

 

On Thursday night, March 4, the Russians attacked Ukraine's largest nuclear facility, which provides 20 percent of European electricity. Fortunately, there did not appear to be any leakage of radioactivity but that could have occurred. The U.S. dollar jumped more than 1 percent, an extraordinary event, indicating a "run for the hills" mentality overwhelming investors.

 

 Unfortunately, this is the kind of market where most market participants are headline driven. Given the circumstances, that is understandable. Algo traders are careening from buys to sells as news pops up on the terminals. Whether it is testimony from Powell, Russian cease fire rumors, oil embargo news, or new atrocities in Ukraine, stock prices either crater or explode hour to hour.

 

Few of these traders know or care about things like price/earnings ratios, balance sheets, corporate earnings or even macro data like the positive gains in employment we saw last month. Remember, most market participants have little to no experience in a higher interest rate environment nor how to invest in equities when inflation is rising. As for maneuvering world markets on a war footing, few have any experience at all.

 

It is obvious that just about everyone is focused on the oil price. The higher oil climbs, the greater the probability that inflation will continue higher, and the greater the chance that global economic growth slows.  Analysts at Bank of America, for example, have raised their forecast for oil to $120 per barrel by the middle of 2022.

 

At the present price of oil, the U. K's National Institute for Economic and Social Research estimates that the Russian-Ukraine conflict could hack $1 trillion off the value of the world economy. It could also add another 3% to the world's overall inflation rate. Predictably, Eastern Europe would get hurt the most. Those numbers worsen as the oil price rises.

 

There are all sorts of worst-case estimates as to where oil prices could go depending on whether there is an embargo on Russian oil, a reduction in exports due to war damage, or if Russia curtails energy supplies to Europe in response to sanctions.

 

It appears to me that the markets have settled on a worst-case price of between $120-$130-barrel oil at this time. If that were to happen, and remain at that level over several months, the impact on the U.S. economy would be to slow growth and bring on the specter of stagflation. I believe it is way too early to predict that outcome.  I did forecast back in December 2021, however, that this scenario would begin to make the rounds on Wall Street about now. In my opinion, the onset of stagflation would be a stretch, given the present robust growth rate of U.S. GDP and the Fed's intention of tightening monetary policy beginning in mid-March.

 

As for the future of the markets, I am sticking to my guns. Stocks will remain in a box until after the March 2022 meeting of the FOMC. That means we could easily test the lows of January 2022 again, either before or after the Fed hikes interest rates. 

 

It turns out that the president was correct in his warnings. Russia did invade Ukraine. Financial markets predictably crashed, but then rebounded. That's old news. What happens next?

 

In my last column, I wrote that the fate of the markets was in the hands of two big "ifs." One was an invasion of Ukraine by Russia. That has now occurred. That event broke the range the market was struggling to maintain on Thursday, Feb. 24. But by the end of the day Thursday the markets bounced back up big time. It was a classic investor behavior pattern of "sell the rumor, buy the news." Stocks fought to continue that bounce on Friday.

 

There is an old saying, attributed to Baron Rothschild, an 18th-century British nobleman, that "the time to buy is when there is blood in the streets." That famed member of the Rothschild banking family made a fortune buying into the panic that followed the Battle of Waterloo against Napoleon. But buying becomes a bit more difficult if the blood spilled happens to be yours.

 

I have tried to steer investors to safety over the last two months. Whether you listened or not, my target level has been 4,060 on the S&P 500 Index. This week we hit a low of 4,114. I guess you can say that was close enough for government work. As such, I would begin to add back equities into my portfolio, if you haven't already. But that does not mean that this pullback is over.

 

I do not expect a V-shaped recovery in these markets. We have yet to see a "capitulation" day where 90 percent of all stocks are sold. Rarely, if ever, is a market decline over without at least one capitulation day. In addition, geopolitical events like this Ukraine debacle usually lasts several months, not several days. If the fear index, called the VIX, remains above 20 (and it is right now above 29), we could still see 100-point swings or more in the index averages daily.

 

And as usual, Wall Street strategists, who were so bullish a month ago, are now predicting confidently that we could see the S&P 500 fall to 3,750. It is therefore not the atmosphere where stocks can soar into a new bull market. There is still a boat load of headline risk, so purchases should be done slowly and not all at once. Average in as the professionals usually do. And any adds you may decide to make should be in the more defensive sectors of the market at first.

 

Of course, the markets can go lower, or bottom a little higher than my predictions. In markets like these where geopolitical uncertainty can move markets wildly, don't expect precise measurements. Suffice it to say that most of the decline is over in my books. 

 

The face-ripping rally we experienced this week is normal in bear markets. From the lows to the highs, the S&P 500 Index swung 180 points in a single day. We could easily see the reverse happen next week.

 

In this type of a downtrend, I believe we will need to test the lows and possibly go lower one, two, or even three times before this correction is over. That should take us close to the mid-March FOMC meeting. Even then, I am not expecting the overall market to come out of the doldrums before mid-year. Why?

 

My second big "if" of last week was the Fed. I am sure that the bond market will be wondering if their present expectations for seven interest rate hikes by the Fed this year remains a possibility. Could the Fed change its monetary tightening policy because of the invasion of Ukraine and resulting U.S. sanctions? My short answer is no.

 

Soaring oil and gas prices, and dislocations in the supply chain due to this geopolitical conflict, will only add upward pressure on the inflation rate. The Fed will continue to tighten, because they must, if we don't want to see hyperinflation. But I am not in the camp that seven rate hikes are being contemplated by the Fed membership. That premise is simply noise from a crowd of neophytes who have never worked in a rising interest rate environment. If the Fed raises interest rates even three times this year, I would be surprised.

 

That said, the Fed's monetary policy change will continue to pressure stocks through the first half of the year. That should cap any real upside we see going forward over the next three to four months. Still, flatlining by the stock market is better than going down I guess.

 

 

Over the next three weeks, equities will likely trade in a wide range. The caveat to that forecast: if the Fed suddenly changes policy, or if a shooting war erupts in Ukraine. Those are two big ifs. Unfortunately, I can neither forecast when or what the next Fed head will say, nor predict Vladimir Putin's next move.

 

The next Federal Open Market Committee meeting occurs in mid-March. The latest CPI and PPI inflation data shows inflation accelerating at a rate much higher than economists and the Fed expected. It is all but certain, according to the bond market vigilantes, that the Federal Reserve Bank will raise interest rates at that time. As such, it is only a question of whether the rate increase will be a 25 or 50 basis point hike.

 

That will be only part of the equation. Investors will be expecting Chairman Jerome Powell to give them more insight as to how many rate hikes they can expect going forward, and what other monetary tightening the Fed will be planning as well. The risk will be that the equity market could swoon and test the lows if the Fed is perceived as more hawkish on tightening than expected.

 

That in the meantime, we have plenty to occupy our attention. This week the market's interest rate worries have been superseded by Russia's intentions toward Ukraine. Thus far, the conflict has been played out in the media in a "he said, she said" war of charges and counter charges.

 

War is never a good thing, suffice it to say. But besides the human costs of such a conflict, there would also be an economic price to pay. The sanctions that the U.S. and its allies are prepared to inflict on Russia in response to perceived aggression would inflict damage on the global economy and on the U.S. as well.

 

Russia supplies a great deal of the commodities that the rest of the world consumes. Sanctions could immediately cause substantial price spikes in commodities such as oil, gas, and coal. Russia is also a major exporter of rare earth minerals and heavy metals. One third of the world's supply of palladium (used in catalytic converters), for example, and titanium (think aircraft) is also mined and exported by Russia.

 

Ukraine is also a major source of neon, an essential input in the manufacturing of semiconductors. The Ukraine is one of the world's largest producers of wheat, as well as fertilizers (as is Russia). Hostilities could damage their ability to export or even harvest the nation's wheat supply.

 

I would expect price spikes in several food commodities as a result. That would add fuel to the inflation fire and could force the Fed to become even more aggressive in raising interest rates. It would not be a pretty picture for stock market investors.  

 

To be honest, no one knows whether Russia is bluffing or serious about invasion as a next step.  For me, a telltale sign of their intent would be any movement of medical facilities and supplies forward to the troop staging areas and border with Ukraine. This week, I have seen just that.

 

The risk is obvious. A shooting war would probably see the S&P 500 Index re-test the lows (4,222) of Jan. 24. Geopolitical events usually have a limited impact on the stock market, unless the hostilities are protracted and far-reaching.  If, on the other hand, a negotiated settlement was to occur, markets would likely fly higher. That "if" word is going to keep investors jumpy and prices in a box with every headline capable of moving markets 1-2 percent up or down.

 

On Groundhog Day, Wednesday, Feb. 2, Punxsutawney Phil saw his shadow, predicting that there will be at least six weeks of winter weather ahead of us. Given the market action of the last few days, can we expect inclement weather ahead for market bulls as well?

 

Last week, I warned readers to expect the stock market to bounce. It did, retracing 50 percent of the market's decline in just about four days. I also warned that investors should not get comfortable with this bounce because after the bounce markets should go south once again. That prediction seems to be playing out.

 

It would be an understatement to say that markets remain volatile in both the stock and bond markets. Commodities, the currency and crypto markets are also gyrating like a championship bronco.

 

Part of the problem lies with the FANG stocks. These large-cap mega companies account for so much of the major averages and indexes, that when one or another of these stocks catch a cold, the markets catch pneumonia. Most recently Meta (formerly known as Facebook) missed earnings and gave poor guidance on Wednesday night. The stock dropped more than 22 percent overnight. It was the single largest loss of dollar value for a public company in U.S. history. All the major averages declined with it, with the NASDAQ falling 2.25 percent, while the S&P 599 Index fell almost 1.5 percent.

 

Just the day before, Alphabet (Google) did the opposite, gaining 20 percent on stellar earnings and took the indexes for a major rise upwards. On Thursday, Amazon surprised investors with what looked like a massive beat on earnings and gained 11 percent in overnight trading. At first the U.S. indexes traded more than a percentage point higher but gave that all back by the opening on Friday morning, and so did the markets.

 

Overall, corporate earnings have held up with roughly 75 percent beating numbers, but down from 82 percent last quarter. The size of the beats, compared to the last few quarters, have been anemic, while the number of revisions upward in future earnings have been few and far between. Obviously, none of this has been enough to hold up the stock market, let alone propel it higher. I warned investors that would turn out to be the case more than a month ago.

 

The omicron variant is evidently not taking its toll on the job market yet, according to the latest payroll numbers. Friday's employment numbers saw 467,000 job gains versus the forecasts of only 110,000 gains.

 

Investors, rather than celebrate the job gains, saw them as proof that inflation is still climbing. Wages, a key element of the inflation equation, continued to move higher. The Ten-year U.S. Treasury bond spiked higher on the news to more than 1.90 percent. My target, as I have advised investors in the past, is a 2 percent yield on the "Tens" in the short-term.

 

But let's get to the meat of this column — the markets, where now, given that my forecast that the markets would see a 10-20 percent correction between mid-January and February. That prediction has been accomplished at this point. I also signaled that we would bounce this week and we have. At its height the bounce retraced 61 percent of the losses on the S&P 500 Index. But I also warned that we should not get too comfortable with this bounce. The last two days brought this point home to those who doubted that warning. Now what?

 

The stock market took less than half the time to recoup 61 percent of its losses. Since then, the volatility has exploded both up and down. This volatility will continue. Next week, for example, we could see a similar pattern as last week — up for a few days, and then down.

 

 In situations like this, over the longer term, we can expect to see a large "W" pattern in the market's behavior. We are about halfway through this pattern. At a bare minimum, we should see the markets (S&P 500 Index) retest its recent lows of 4,222 (on January 24, 2022). But it doesn't have to stop there. As I wrote two weeks ago, we could see a decline to 4,070 if investors begin to panic. But we could also see a higher low as well. Right now, the markets are in a state of indecision.

 

Given this potential scenario, I don't believe it is time to be a hero. If we retest the recent lows, sure, put a little money to work, but don't bet the house. From there, if it goes lower, start averaging in. The same maneuver could be applied on the upside as well, if 4,222 is truly the bottom. How will you know? Keep reading my columns.