The rally off the mid-June lows has been impressive, not so much for the extent of the rebound but rather in light of the litany of concerns equities have had to overcome. Unfortunately, I see the markets succumbing to these forces on the near horizon because of the extent of the headwinds. Here are my three main concerns around the market currently.
Risk of Policy Error
The Federal Reserve is aggressively tightening monetary policy even as the economy has experienced two straight quarters of GDP decline, or what used to be known as a recession. When was the last time that combination has occurred? The central bank has little choice considering it waited too long to act to counteract surging prices, but the risk of a monetary error seems beyond high.
In addition, thanks to the just-passed and almost comically named Inflation Reduction Act, we are raising taxes even as the country is technically in a recession. I also don't see an additional 87,000 IRS agents doing much for small business confidence, which is already in the dumps.
As bad as the economic situation is herein the US, it is going to be much worse in Europe. Inflation levels generally are higher there thanks to economic sanctions on Russia and because the European Central Bank has been more reluctant to increase interest rates due to the disparate economic and political situations among the European Union's member states.
Electricity prices are soaring throughout the continent and some rationing measures are being implemented. The situation will only get worse as winter arrives, barring a settlement in Ukraine, which no party seems serious in pursuing. Therefore, I see the recession coming to the continent being longer and deeper than the economic contraction here, which should support the dollar but ding US multinationals that receive a decent portion of their sales from Europe.
I keep hammering on this worry as I don't think it is getting the media attention it deserves.
The consumer accounts for about 70% of economic activity in the United States. The average consumer has lost buying power for five straight quarters now. The personal savings rate is at lows not seen since the financial crisis 15 years ago. More and more people are taking a second part-time or full-time job to make ends meet, which was one key reason the July Jobs Report was so strong. Credit card debt is rising at a crisp clip as well as many individuals are going deeper into debt to maintain their standards of living. This situation is not sustainable, which is why consumer sentiment is near historical lows.
Given these headwinds, I am using the recent rally to take some profits and build the cash balance in my portfolio. As my covered calls expire in the money in the coming months, I plan to boost my cash allocation from 20% to about 35%. I just see equities eventually taking the next leg down as the forces described above take greater hold on investor sentiment.