Stocks took another sharp leg down yesterday, and the selling spread aggressively to the top- tier tech names. Microsoft#, Alphabet#, Amazon# and Tesla all fell by 5% or more. After the close, both Alphabet and Microsoft reported earnings. From the market’s standpoint, it was a split decision. Alphabet missed forecasts but Microsoft beat. While both stocks fell sharply in aftermarket trading soon after they reported, Alphabet came off its lows and Microsoft moved sharply higher after management offered solid guidance for the coming quarter. A split decision doesn’t sound very exciting, but the air was so negative yesterday afternoon that a split decision seems like a victory this morning. Futures point to a positive open.
Over the past four sessions there have been both sharp losses and sharp recoveries.
The S&P 500 is back near its late Winter lows. If they hold, the worst may be over for now. The NASDAQ is in worse shape now, having entered bear market territory. What’s going on there is similar to what happened in the 2000-2002 timeframe, when the good fell by 40% and the bad simply got obliterated. One can argue that this time is different. The leadership companies are stronger and they never sold at the insane P/Es seen during the Internet bubble. I agree. Names like Alphabet and Meta Platforms# no longer sell at any premium at all to the overall market. There is little fundamental reason for them to fall another 20% or more.
This thesis doesn’t exonerate the more speculative fringes of the NASDAQ. While many hot names that soared during the pandemic are now 50-80% below their recent 52-week highs, a lot of these names will never live up to their prior promise. Some will fall further. Some will ultimately disappear entirely. In speculative times, investors make a lot of bad bets on poorly managed companies. In the early 1980s, hundreds of companies attempted to get aboard the PC boom. Few made it to the end of the line. Most were gone completely within a few years. The same can be applied today to the EV industry, to biotech startups, and to cloud infrastructure companies. Just because you enter a horse in the Kentucky Derby doesn’t mean you have a real chance to win.
This market decline is not simply about excess speculation and technical market factors. There have been four dominant worries aside from the speculative purge:
1. Inflation and Interest Rates – The main economic focus today is on the Fed’s fight against inflation. In anticipation of aggressive Fed action, rates along the curve from 18 months out have risen sharply to a level close to 3%, before backing off a bit over the last few days. The market has most likely discounted the Fed’s probable move of the Fed Funds rate to 3% by early 2023. It is doubtful the Fed will consider a more aggressive move before the end of the Summer. If inflationary pressures, particularly related to wages and rents, show no sign of letting up, then the neutral rate may have to be reset higher. At the moment, that’s still a maybe.
2. The War in Ukraine – War itself doesn’t generally move markets. What does move markets is the economic impact, in this case largely related to sanctions. Russia is pushing back. Last night it cut off gas supplies to Moldova and Poland. Clearly it wants to stimulate unrest in Moldova, hoping the country will want to realign with Russia someday. At the moment, that seems like a bad bet, but cutting gas supplies does have economic impact. Commodity prices for oil, wheat, and several other products spiked at the war’s onset, but have since retreated as the reality didn’t quite match the fears. Many companies have cut off business with Russia. The impact is showing in Q1 earnings reports. Any further reset will depend on further economic sanctions or the spreading of war beyond Ukraine. That’s a legitimate fear, but nothing further needs to be discounted for now.
3. China – Covid-19 started in China and it seems the last major wave will end in China. Shanghai is in lockdown. Beijing may follow. China’s zero tolerance policies are not working. The condition is aggravated by the government’s insistence to attack the outbreaks using only Chinese-made vaccines and therapeutics. It hasn’t developed second stage vaccines targeted specifically at Omicron. As a result, what we may see are rolling lockdowns of major cities. Obviously, this will disrupt supply chains and could aggravate inflation in the short term, but investors with memories of the winter of 2020 will remember that the economic impact of the pandemic can dissipate quickly with government support once the infection cycle runs its course. These cycles tend to run 1-3 months, and therefore have only modest impact long term.
4. Fears of Recession – We know all of the above will impact economic growth. The China and Russia impacts will be company specific. A U.S.-only retailer will hardly be impacted by sanctions on Russia, and your local restaurant won’t feel much impact from the Covid wave in China. But inflation affects everyone. So far, as seen through first quarter earnings reports, the impacts haven’t been severe. While some volume growth rates have come down, they have been offset by higher prices, resulting in record earnings once again. We also know, however, that raising interest rates and reducing the Fed’s balance sheet will inevitably slow the pace of economic growth. What we don’t know is by how much. We don’t know how far the Fed is willing to go, we don’t know what the ultimate neutral interest rate will be, and we don’t know if inflation can be licked without the creation of some kind of employment gap, necessary to dissipate upward wage pressures. Everyone has a guess; no one has the facts.
In 2007-2009, the actual recession began in the Fall of 2007. Stocks began to fall coincident with the onset of lower earnings. The abyss was in mid-September 2008, when over the course of a weekend Lehman Brothers failed, Merrill Lynch was folded into Bank of America, and the government was forced to bail out Fannie Mae, Freddie Mac and AIG. Stocks fell sharply into late October, rallied after government action, and then retested the lows in November. From there stocks moved up again, only to retest and reset lows in March of 2009, bringing an end to the most severe bear market since the Great Depression.
2022 isn’t a repeat. The reason I bring it up is to make several points. Normally, bear markets begin as earnings start to decline. Not this time. Earnings are at record levels and should continue to rise at least for the next several quarters. So why are stocks down while earnings are rising? Because the Fed has gone out of its way to lay out a road map for the next 2 years. Of course, that road map is subject to change. Right now, the guess is that the Fed Funds rate will peak in early-mid 2023. Assuming inflation is receding back toward a 2% target, rates could start to come down again by mid-late 2023. In essence, the Fed has told markets what it will do and markets have discounted the impact of the current roadmap. If the map changes, so will markets. The actual implementation won’t matter unless it deviates from the roadmap.
Bringing this all together, markets have already discounted a lot of concerns. Interest rates have risen close to the predicted neutral rate. Commodity prices are off their recent peaks. The market still may have to deal with renewed shortages related to rolling lockdowns in China. That situation remains unclear. What is clear is that China’s government learns as it goes. It’s handling of the situation in Shanghai was far from brilliant. Lockdowns in Beijing, for instance, may be more localized versus citywide. Earnings continue to meet or exceed expectations overall. All this suggests that some reprieve is in sight. Stocks are now back to 16.8x 2023 expected earnings, in line with normal. Of course, nothing precludes a further 10% correction. Or a 5-10% bounce. In emotional times, as I point out often, emotion trumps facts, but facts always win in the long run.
Back to my replay of the 2007-2009 markets. I noted that after all heck broke loose in September 2008 markets cratered, bounced and then retested the lows in November. But it wasn’t until March, five months later, that the ultimate bottom was reached. Right now, it feels to me that along a timeline we are closer to the October-November period than to the ultimate bottom. I think markets have discounted a lot; lots of Fed Funds rate hikes, sanctions against Russia, and at least some impact from China’s Covid wave. But the real unknown is how accurate are 2023 earnings estimates? If there is a recession that begins in 2023, they will be too high and stocks ultimately will face another leg lower. If recession can be avoided, inflation falls and the Fed can ease off the brakes, markets will celebrate and move higher. But now, we don’t have the facts. Both the recession and no-recession believers have enough facts to make a cogent case to support their arguments.
So far, the Dow is down 10% from its peak, the S&P500 is down 13%, and the NASDAQ is down 23%. The Dow Transportation Average, which correlates closely for future economic activity, is down 19%. Right now, markets are biased in the direction of mild recession, but an actual recession, should it happen, is not fully discounted.
It is hard to believe that wage inflation can be tamed with some slack in the jobs market. It is hard to believe that rents will stop rising without new supply. Housing activity is the strongest in almost 20 years. More supply is coming. Excess commercial space could be transformed to apartments. The answer to the labor shortage is more problematic. If wage pressures don’t abate by year end, more steps may be required, but we are a long way off from making that decision.
Markets are oversold, the VIX volatility index is back over 34, and pessimism is everywhere. That suggests a bounce soon. Key earnings reports from Apple#, Amazon, and Meta Platforms could move markets in either direction. Whether the bounce begins today or a few trading sessions from now is unclear, but some relief should be coming soon. With that said, the focus over the coming months will be on trends in inflation. The good news is that 8% year-over-year changes in price are probably not going to recur. That may be cause for near term celebration, but the real key is to watch trends in wages and rents. How they track the rest of the year should be a marker for the stock market’s performance over the coming months.
Today, Lizzo is 34. It is also the 200th anniversary of the birth of Ulysses S. Grant.
James M. Meyer, CFA 610-260-2220