Crude oil hit $110 a barrel this week. The price of natural gas rose in sympathy. In addition to the already announced economic sanctions, demands to add an embargo on Russian energy exports are increasing. Be careful what you wish for.

 

Most of the world governments have already instituted several hard-hitting sanctions against Russia. Financially, the harshest step so far has been barring Russia's central bank and several large Russian banks from using the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system. SWIFT is a messaging network used by almost all financial institutions to quickly and accurately receive information such as money transfer instructions. As such, the entire Russian financial system has been cut off from the international financial system. It was considered a "financial nuclear weapon" by most credit analysts.

 

Most bystanders neither understand, nor care about this action. That indifference may be a mistake. No one really knows the ramifications of such a move on the global financial system. While the financial isolation cripples Russia, it may also have unpredictable consequences for other financial institutions.

 

How many of our U.S. or European banks are exposed to Russian debt, for example? How will they receive payments from Russian debtors? Are there assets, holdings, or obligations that are now in jeopardy because of these sanctions? Could the blowback take down parts of our global financial system along with Russia? Global investors are not waiting around to find out. Prices of banks and other financial institutions in world markets have been a free fall.

 

As for the energy market, only Canada has said it was banning Russian oil imports. So far, no other nation has targeted Russia's energy complex directly. Several global oil companies have announced they will be pulling out of activities in Russia. In the private energy markets, there is a clear preference to avoid buying Russian crude, which constitutes a semi-embargo situation right now. But most of the nations opposed to Russia's aggression have kept silent on energy embargos.

 

The problem with an energy embargo is that, even before Russia's evasion of the Ukraine, oil supplies have been tight with supply constraints swamped by increasing global demand. Any additional reduction in supply could not only send the inflation rate much higher but might also plunge the world and the U.S. into a recession.  That said, could the worsening situation in Ukraine precipitate a Russian embargo despite the economic risks?

 

It could, which is why the International Energy Agency decided to hold an "emergency" meeting on Tuesday, March 1. They discussed what IEA members can do to stabilize energy markets and announced a 60-million barrel release from strategic reserves. The U.S. is providing half of that amount. Naturally, several other nations are planning to release energy supplies from their strategic stockpiles. That would amount to a drop in the bucket, however, since those emergency supplies would only cover energy demand for a week at most. A reduction in government taxes on gasoline might help, but not by much.

 

There are two other avenues that the world could use to limit the rise in energy prices. One would be a breakthrough in the Iran/U.S. nuclear negotiations. The 10-month talks have been difficult, since under the last administration, former president Donald Trump arbitrarily quit the negotiation process. The Biden administration revived the talks, but the wall of Iranian distrust has been difficult to climb.

 

The talks are dragging on over resolving questions over uranium traces found at several old but undeclared sites in Iran. "Significant differences" keep both sides from signing a pact. But as energy prices climb higher, the one million barrels of oil that Iran could sell on the open markets become increasingly attractive for a country suffering the impact of economic sanctions. From the U.S. side, those extra barrels could go a long way to corral rising oil prices, at least in the short term.

 

OPEC is also another wild card that could help increase supply somewhat. The oil producer's cartel met on Wednesday, March 2, but made no move to increase supply beyond their already announced program. Both Saudi Arabia and the UAE could increase production, but that would put them at odds with Russia, a member in good standing in OPEC-plus.

 

All of the above, I am afraid, might knock the price of oil down by $5 or so in the very short-term, but I suspect that given the ongoing risks of a war in Ukraine, oil will make higher highs in the weeks ahead.

 

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.

 

 

The war drums are beating. Oil and gas prices are soaring. Inflation is at a decades-long high. Bearish sentiment is exploding. And the stock market is giving investors angina. What to do?

 

Take a deep breath and remember that whatever the circumstances, this too shall pass. I know that is easy to say, but a longer-term perspective might prevent you from doing something foolish like selling into this downturn.

 

Let's address the present fear that today's geopolitical tension will somehow escalate into possibly WWIII. Sure, anything can happen, but is war the most probable outcome? The present reaction by the U.S. and its allies regarding Vladimir Putin's aggression toward Ukraine has been confined to economic sanctions. No one in the administration is contemplating a military response.

 

Make no mistake, the economic sanctions that we implement against Russia could have a certain amount of blowback for the U.S. and European nations. We already see higher prices for energy (oil is above $100 a barrel as I write this. Other commodities have also shot up in price. This could mean that further increases are ahead and for a longer period of time than we expected, which would make fighting the present rate of inflation more difficult, but not impossible.

 

From a historical perspective, the specter of a new cold war shouldn't have a debilitating impact on the world economy. Economies, including our own, have thrived despite decades-long cold wars in the past. Could we see further hacking attacks directed against our companies or financial system? We could, but I suspect they would be more of an inconvenience than a real body blow. If anything, it may change the investment prospects for certain sectors (such as defense or IT security) in the future.

 

As for how the markets are handling this event, one must understand that for many this kind of correction is brand new. There are 25 million investors new to the stock market that have only seen markets go higher in the last year or so that have been investing. And there is an entire generation of investors who have never seen an environment of rising interest rates and higher inflation.  

 

In addition, there are now armies of short-term traders with software programs set to react instantly to news based on certain key words. You can guess that words like "war," "invasion," and "sanctions," in connection with "Ukraine" or "Russia" are triggering buy or sell programs with millions (if not billions) of dollars at risk. The fact that the world media is broadcasting every accusation, every rumor, every quote concerning this crisis simply heightens this type of trading.

 

Don't mistake these computer-generated day trades as indicative of what the market thinks will or will not happen. The professional institutional investors are not panicking. Dark pool buying, which is a better indication of what the pros are doing, has seen consistent buying for the last few weeks. Of course, what they are buying (and selling) could be significant.

 

In this age of higher inflation, materials, financials, commodities, and defensive sectors like REITS, telecommunications, and utilities are in demand. Technology and speculative areas, such as cryptos and the "Kathy Wood" stocks, are being liquidated and will continue to be a source of funds, in my opinion.

 

Will the overall market continue to decline? If the Federal Reserve Bank continues its monetary tightening program, the odds are that we have more downside ahead of us. If things get out of hand (and it appears today that they are),  this decline fall another 6-7 percent in the S&P 500 Index. That would bring the total decline to almost 20 percent overall between now and the end of March.  Given the market's outstanding performance over the last few years, it seems to me a small price to pay for those gains.

 

Yes, a loss like that in less than six months would be painful, but not the end of the world. And losses you might incur now could easily be recouped by the end of the year. If you hold through this downturn, they would only be paper losses. If you sell in a panic however, they will become real losses. Selling the "news" is a bad strategy, but selling when the news cannot even be verified is a real sucker's game. We are in that kind of investment atmosphere today.

 

Take it from me, it is too late to sell. Hang in there, ignore the news, and take a deep breath.

 

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.

 

You would think that the Americans would be feeling pretty good right now. Wages are increasing almost monthly. Workers have their pick of jobs in this tight labor market and the coronavirus seems to be peaking. So why are so many consumers unhappy?

 

Consumer sentiment numbers, as measured by the University of Michigan Consumer Sentiment Survey, fell in preliminary February 2022 numbers to its lowest level in more than a decade. Back then in October 2011, the unemployment rate was more than double the present 4 percent rate.

 

In a January 2022 Gallup Poll, 72 percent of those surveyed thought it was a great time to find a quality job. That was the highest reading since 2001. Historically, there is a strong correlation between consumer sentiment and rising employment but this time it is different. So, what has changed?

 

In one word: Inflation. To understand why, we need to recognize that economic society has two roles: the average worker is both a producer and a consumer. Essentially, most Americans receive a certain income in exchange for some level of production. In a perfect world, the more one produces, the higher the pay, or so the economists tell us.

 

The consumer side of us believes that in exchange for our production we receive money and access to buying products at reasonable prices. Today, that side of the equation is becoming increasingly problematic as the inflation rate climbs and supply chain problems continue to make some products scarce at any price. As such, we may feel that we are not getting a fair shake in this economy.

 

I also suspect that the Michigan survey's target audience had something to do with this decline in consumer sentiment. The survey was confined to those families that are making more than $100,000 annually. That demographic, more likely than not, earmarks some of their income annually toward retirement savings. In the stock market. As such, their attitude may be partially influenced by what is happening in the financial markets.

 

That brings me to the latest data from the American Association of Individual Investors (AAII), which surveys investors' sentiment toward the stock market. Over the last few weeks, the number of individuals that believe the stock markets are going to continue to fall is much higher than historical averages. In short, individuals are bearish on America. This negative sentiment, coupled with the shock of a higher rate of inflation, may explain the sour state of the consumer right now.

 

I count myself as one of these disgruntled consumers/producers. As my loyal readers know, the equity markets are going through one of the most volatile periods in recent memory. I warned readers almost two months ago to reduce risk and prepare for this outcome. But don't think the wild daily swings in the markets are a cake walk no matter how well prepared you may be.

 

The stress for those trading these markets frequently (like me) is extremely high. To relieve stress, I often resort to cooking (and exercise). Imagine my dismay, therefore, over the past few months when grocery shopping.

 

Aside from the risk of contracting the Omicron variant while standing in line, I increasingly discover that some of the most important ingredients for my dinner menu are nowhere to be found. Worse, even if they are available, the prices climb on a weekly basis. That package of London broil or lamb chops has doubled in price in just a few short months. "One package per customer" signs assault me at every turn.

 

This weekend, I noticed everything from a loaf of fresh-baked bread to a container of almond milk have shrunk seemingly overnight. Even the rotisserie chickens seem to have gone on a diet, despite hefty price increases.

 

My own reaction is to spend less, work harder, and try to quell the helpless anger I feel at this sudden turn of events. I am old enough to remember when inflation was a fact of life for Americans, but it is still a shock to me. I can just imagine how younger workers, who have never seen the devastating impact of inflation, could be somewhat grumpy with their lot in life at the moment.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.