Stocks and bonds both took a breather yesterday in a relatively quiet session. During earnings season, we are likely to see up and down days depending on the daily reaction to individual earnings reports. Friday and Monday, trading was impacted by negative reactions to generally good bank earnings. Yesterday, United Healthcare# dispelled the worst fears associated with a recent hacking incident and the impact of Medicare Advantage reimbursement cuts. Meanwhile, there was little movement in the bond and oil markets. The net was a sideways market.
But that doesn’t alleviate the damage done to investor psyches so far in April. Most economic reports, punctuated by a strong March retail sales report, suggest no letup in economic strength. High interest rates are pinching certain industries and low-income consumers, but for both businesses and families flush with cash, the good times roll on. On the other hand, stronger demand has kept inflation stickier than the Fed and equity investors had hoped for. Can’t have your cake and eat it too. It is notable that inflation remains stickier in the U.S. than in the rest of the world. Thus, while Christine Lagarde, head of the European Central Bank, suggests interest rate cuts beginning shortly, Fed Chair Jerome Powell strongly suggested yesterday that a June rate cut would be too soon.
Why the differences? Look at some of the key components of our inflation. A lot of attention has been paid to shelter costs. Inflation helped to create a spike in home prices. While the pace of price rises has slowed, it hasn’t stopped. This is true throughout the developed world. Thus, it remains a key factor but doesn’t differentiate our inflation from that of other countries. What is different, however, are our health care and legal systems. As government regulation pushes back on some prices, a free enterprise system shifts the burden elsewhere. Thus, as government focuses on prices of specific drugs, or reimbursement rates for healthcare costs it funds directly, providers raise prices and rates elsewhere to compensate. Unless a government wants to enforce price controls massively, targeted efforts simply don’t work without unintended consequences.
Insurance cost increases reflect two broad realities. First, climate change has created more natural disasters. Again, that is true all over the world. But only in the U.S. does our legal system allow the broad range of claims made by plaintiff lawyers. The situation got so extreme in Florida, that laws had to be passed to contain the expense, as many insurers simply left the market leaving homeowners the choice between skyrocketing insurance rates, no insurance, or reduced levels of coverage. Along the same lines, cost to comply with greater regulation has amplified the differences between our inflation and that of other developed nations.
Next, there is the immigration factor. Overall, immigration is a good thing. Our nation is a country of immigrants. Last year over 3 million people entered the U.S. to stay. Some did it according to the rules; some did not. But economically, that’s a 1% increase in population, mouths that must be Fed. They are additive to GDP and probably additive to inflation if demand rises faster than supply.
The solution is clear. Rates in the U.S. will have to stay higher for longer, at least until the deflationary forces of tight money, better productivity, and lower import prices succeed to win the war against inflation. It’s an election year. If the White House controlled rates rather than the Fed, the odds of multiple cuts this year would be higher. President Biden already said publicly that rate cuts are coming soon. But he doesn’t set policy. While the Fed risks a recession staying with high rates too long, adding stimulus to an economy where inflation is persistent risks a redo of the hyper inflation of the 1970s. No central banker wants that.
Higher short-term rates are one thing. What really matters to equity markets are longer duration rates. Stocks are long duration assets and they compete directly against long duration debt choices. The high short-term rates are a short-term alternative. Now that money market funds yield more than inflation, even tax adjusted, suggests it is a good viable alternative, something that hasn’t been a choice for decades when the Fed Funds rate was kept close to zero. But that is the equivalent to punting on fourth down. It isn’t an offensive choice; it’s a defensive one. When stock prices are in retreat, it becomes a more attractive choice. Do you go for it on fourth-and-one? Maybe. But if it’s fourth-and-twenty, going for it is only a Hail Mary option.
Thus, let’s look at the 10-year yield. At the beginning of 2024 it was about 3.9%. Today, it is closer to 4.6%. Inflation data has erased the Pollyanna hope for seven rate cuts this year. The 10-year yield reflects the public’s view not only that short rates will be higher for longer, but that the 2% target may not be within reach under the current mix of fiscal and monetary policies. A rule of thumb for the proper 10-year yield is to add the long-term inflation forecast to the long-term growth expectation. If the inflation forecast is a bit higher, say closer to 2.5%, and long-term economic growth in the U.S. returns to the multi-decade trendline of 2%, then the proper 10-year yield would be about where it is today. That doesn’t mean current momentum can’t bring it up to 5% or that fears of inflation can reduce it to 4%. But it does suggest any meaningful deviation from 4.5% is unsustainable for long unless either the growth or inflation forecasts I just outlined are out of whack.
If the 10-year yield were to stabilize shortly, and earnings season progresses as targeted, might the current correction be near its end? That could be true, except for valuation concerns. The S&P earnings estimate for this year is in the $230-235 range. A normal multiple for forward earnings, based on history, is close to 17. I will concede and add a point or two for two reasons. First, the pace of stock buybacks has increased in recent years reducing supply and putting persistent upward pressure on stock prices. Second, the top of the S&P is dominated by tech companies growing significantly faster than the overall economy. If that persists (and it can’t forever due to the laws of large numbers), that puts upward pressure as well. But adjusting for both doesn’t support a valuation today of over 21.5x 2024 earnings. Every multiple point of downward adjustment is 230-235 points in S&P 500 terms, or 4.5% based on the current S&P 500 value. A 3 multiple point revision would be a 12-13% correction, close to traditional averages for a correction in a non-recessionary environment. If, and I repeat, if that were to take place, it doesn’t have to be now, nor does it have to be in a straight line. But given a 10-year Treasury yield range of 4-5%, modest growth in earnings, and a realistic expectation that market valuations return toward historic norms, a correction of 10-15% is reasonable.
For long-term investors, that isn’t fearsome. It’s a correction. It restores reasonable fair value. It creates new bargains. It’s part of a long-term process that links corporate values to proper expectations of future earnings and the cost of money. What it isn’t is a reason to panic. An old adage is that markets ride the escalator up and the elevator down. But even elevators go up and down. They don’t sit on the ground floor for very long.
Today, Jennifer Garner is 52.
James M. Meyer, CFA 610-260-2220