For those of you who have read my letters over the years, you should know about my 2-day rule. It states that two consecutive days of outsized moves in the opposite direction of recent market trends marks a reversal. Certainly, the gains Monday and yesterday qualify as strong up sessions in sharp contrast to the sharp declines of late August and September. They signify a trend reversal. I use two days in my rule to eliminate sharp one-day rallies usually accelerated by short covering. The second day means real buyers are starting to step in while sellers hesitate.
The rule sounds a bit foolish but has a good track record. The real question is whether the rally that began Monday represents a market bottom or an interim bear market rally. To answer that, we need to first try to decipher what triggered it.
As I noted Monday, it is my belief that the steep interest rate increase cycle is nearly complete. As often happens when prices spike, either up or down, momentum can carry a bit too far. It is rare to see big daily moves in bond yields. Last week and so far this week, daily changes of 10-20 basis points have been the norm. 1-2 is normal. At one point, Friday, the 10-year Treasury yield reached 4.1%. The real yield, as measured by TIPS spreads exceeded 1.75%. Only in the last few months has that spread been positive, meaning there was a real cost to borrowing. By yesterday, the yield had settled back to about 3.6%, a more reasonable figure.
Again, as noted in recent letters, a material slowing of the upward slope for interest rates means the bear market P/E adjustment is coming to an end. Fed Fund futures suggest another increase of 50-75 basis points in November (just last week, 75 was a near certainty), perhaps another 50 in December, followed by a pause. Again, just last week, another 25 was predicted for early next year. I should note that the market forecast for Fed rate changes has been quite volatile for months. First the markets were more hawkish than the Fed. Then, by late August when Jerome Powell spoke forcefully at Jackson Hole, the Fed got more hawkish than the market sparking a sharp September decline in stock prices. It could always change again, depending on data. Key release dates to watch near term are Friday’s employment report for September, and an updated CPI reading before the market opens on October 13th. Either could move markets meaningfully.
If the P/E cycle is done, the next question is the earnings cycle. Right now, markets are discounting fairly flat earnings next year on top of sub-normal gains this year. That is synonymous with a slow economy but not a severe recession. At the moment, any prediction is more a guess than anything else.
Where does that leave us? If markets are in the range of fair value, it suggests any further rally from here should be fairly muted until there are clearer signs that a slowdown or recession is near an end. We should learn a lot more during earnings season. It should also remind us that the performance of any one company’s stock can deviate materially from the leading averages. Some companies and some industries are going to be hurt by a pending slowdown more than others. We saw similar divergences during and immediately after the pandemic. 70% of our GDP relates to consumer spending. In real terms, that should be flat to down a bit over the next year. In nominal terms, however, there will be growth, even if inflation slows. The ability to be able to raise prices, if necessary, is important and will vary company to company.
The bottom line is that I believe we are entering a phase where individual company performance will trump overall market trends. When markets are rising or falling at an annualized pace of 20-30%, that trend overwhelms individual company performance. When markets trade in a much narrower range, individual company performance dominates.
If this is a market bottom, expect a “dead cat bounce” for some of the names most beaten down in the bear market. Don’t be tempted. The word dead is part of that expression for a reason. What an investor is always looking for is a growing company with improving prospects. Warren Buffett famously opts for great companies at a fair price rather than decent companies at a cheap price. Market bottoms are a great time to find such great companies attractively valued.
I don’t know whether this is a market bottom or not. If there is a stronger than expected downturn next year, there will be another earnings adjustment needed and stocks could ultimately retreat to a final low, but I believe we are near a bottom. We will learn a lot more this earnings season that begins next week. If this isn’t a bottom, there is still room for a tradable rally within the context of a market groping for a bottom. If the economic bottom, the depth of the downturn, is to be reached sometime in the middle of 2023, a bottom could be near. Just as likely, a downturn could extend to the end of next year meaning the bear market isn’t over yet. I offered a current fair value range based on different earnings outcomes of 3200-3600 recently with upside to or above 4000 by the end of next year depending how bright the 2024 outlook is by the end of 2023. I still believe that post-recession or slowdown, real GDP growth will average no better than 1-2% with inflation close to 2.0-2.5%. Stocks will do well to average 5-7% per year after the initial bounce off bear market lows. The big difference versus last cycle is that I expect the days of free money to be over. A Fed Funds rate of 2-3% will be the new norm and longer duration rates closer to 4% or even a bit higher. Bonds that offer positive real returns will be more attractive than they were in the 2008-2021 era. Balanced portfolios are likely to revert to historic 60-40 mixes versus the 70-30 allocations of the past decade when real bond returns were negative.
Today, the artist Maya Lin, who designed the Vietnam Memorial in Washington, is 63. Neil deGrasse Tyson turns 64. It is also the 120th anniversary of the birth of McDonald’s founder Ray Kroc.
James M. Meyer, CFA 610-260-2220