Stocks gave up ground yesterday in a quiet session in front of today’s scheduled CPI report. Some of the more speculative NASDAQ stocks that had experienced sharp rebounds since the June lows led to declines. Semiconductor stocks, in particular, were hit hard after earnings warnings from Nvidia and Micron. This morning’s calming CPI report will likely give investors a nice bounce.
When investment sentiment shifts sharply as it does at market bottoms, investors, trying to leverage the recovery, often seek out the stocks they perceive as most volatile. That not only leads them to the NASDAQ and small cap names, but it leads them to the junkiest ones. Companies given up for dead often achieve the biggest bounces, percentagewise. A stock that goes from $200 per share to $20 in a bear market might recover to $30 in an initial recovery bounce. If one catches it perfectly, that’s a 50% gain although it still leaves the stock 85% below its highs.
We saw that once again in July. As markets surged, the animal spirits of speculators were reignited. The meme stocks that helped start the euphoric phase of speculation took off once again last week for no apparent fundamental reason. These include names like GameStop, AMC, and Bed, Bath & Beyond. The aforementioned semiconductor group was another example, but in the end, fundamentals matter. We have seen plenty of earnings warnings not only from Nvidia and Micron but also giant Intel to tell us that the near-term outlook for semi stocks is drastically different than it was a year ago. The semiconductor industry isn’t one big monolith. Supply and demand characteristics for memory chips are far different than for analog sensors. Chips aimed at PCs, smartphones, gaming and crypto mining applications are taking the biggest hit as demand wanes and double ordering disappears. My point is that facts trump speculative forces in the early stages of a recovery. A dead cat bounce can only take markets so far.
Reality also hit some of 2021s hottest names away from semiconductors. Roblox, a maker of video games, and Sweet Green, the salad restaurant chain, both reported significant slowdowns in growth last evening leading both stocks sharply lower in aftermarket trading. A hot concept doesn’t often become an enduring success.
With all that said, there is a very strong case to be made that the June market lows will prove to be the lows for this cycle, particularly if one can make the case that any economic slowdown either doesn’t lead to recession or causes only a modest one. Stock prices are a function of interest rates and earnings. P/Es are nothing more than an inversion of interest rates. 10-year Treasury yields briefly touched 3.5% this past spring. They now hover around 2.75%. Earnings estimates for the S&P 500 have remained relatively steady all year close to $225 for 2022 and $245-250 next year. I think markets are pricing in somewhat lower earnings for 2023 than the posted estimates. It isn’t logical for earnings to grow 10% in a flat or down economy. If I use 17.5x as an appropriate P/E given current market interest rates, and $235 for earnings next year, the market today is right at fair value. What doesn’t that imply? To me, it says that for shares to move meaningfully lower, either long- term interest rates have to push back toward 3.5% or earnings estimates must fall well below $235. For rates to move higher, inflation has to be sharper and more persistent than consensus now believes. That would require an economy that is persistently stronger. Last Friday’s surprising employment report, for instance, pushed rates a bit higher.
The Fed has made it clear that its primary mandate is to defeat inflation. That means, if necessary, it will raise rates at a more rapid pace. Before the employment report, the consensus put the Fed Funds rate at the end of 2022 at just over 3%. The strong numbers probably added 25 basis points to that forecast. If the Fed errs, it will do so to the upside. To predict beyond meeting to meeting is a mistake. With that said, whereas the consensus for September’s FOMC meeting had been an increase of 25-50 basis points, it is now 50-75, even given this morning’s encouraging CPI report.
Back to valuation, forces that move interest rates up and P/Es lower, also elevate earnings. Higher earnings and lower P/Es are counterforces. The same can be said the other direction. If the economy softens faster than expected, earnings estimates will fall but P/Es should rise. A real serious recession would likely cause earnings estimates to fall faster than long term inflation expectations leading to a return to new lows. That’s today’s big economic risk. Right now, I don’t see that. Both consumers and corporations are in great shape with economic cushions to fall back on should economic times prove a bit harsher than the current outlook suggests. There are no apparent systemic cracks that led to enormous foreclosures this time around.
On the other hand, it’s difficult to see a lot of upside at the moment either. Population growth is anemic. There are still about 2.5 million fewer Americans at work today than before the pandemic. Productivity has declined sharply for the past two quarters. All the remote working isn’t helping. Nor are persistent supply chain snarls. Just look at airlines. They can’t rebuild schedules to prior levels because there aren’t enough pilots, baggage handlers, and air traffic controllers. One strong line of thunderstorms at any major hub is a precursor to chaos. Car lots are still empty. Despite declining demand, home builders still require 1-2 months longer to get a house built because of supply shortages.
The reality is that with a limited trained labor force, full employment and no slack, there are clear limits as to how fast our economy can grow. After the Great Recession, growth averaged just under 2% per year for over a decade. During that time, even at that slow growth rate, excess capacity got absorbed. Now the unemployment rate is 3.5%. Capacity utilization is back close to 80%. There is no slack. Therefore, our economic leadership has to accept the fact that sustainable growth is barely over 1%. If demand growth is higher, supply chain snarls will reappear quickly as will inflation. A mild recession could create a bit of slack, but only a bit. Again, look at the airlines. Summer holiday weekends have been a mess, yet the number of boardings this summer is still 5-10% less than in 2019. Finding new pilots or air traffic controllers can’t be done overnight.
I made a point using airlines because the picture is so visible and simple to understand, but it’s everywhere. If you want a new car, you need to preorder it (and prepay it, at least in part) and wait weeks or longer. Retailers must order inventory further in advance increasing risks that it orders the wrong things or too little of the right thing. Right now, demand is strong and supply has to catch up. Eventually, partly due to used up savings, partly due to higher interest costs, demand will slow and balance gets restored. That’s an ongoing process. At the start of this year, the common expectation was that supply chains would normalize by now. In some cases, they have. In others, we are now entering a world of oversupply. Look no further than the PC industry. Working from home required new PCs. As we reenter a normalized post-Covid world, that has normalized.
The bottom line is that while I believed the despair of June was overdone and a good case can be made that the lows have been set, it’s hard to make a case for robust growth from here forward. Some weeks ago, I thought a trading range of 3600-4200 for the S&P 500 was a reasonable outlook. We are near the top of that range today. For now, I will stick to that range although this morning’s better than expected CPI report will give a nice lift today.
To move above it, three things are needed. First, there has to be meaningful and persistent progress against inflation. Commodity prices have begun to fall and that will lead to a sharp drop in nominal GDP over the next several months, but winning the war requires some downward movement in rent and wage growth. Both have held persistently in the 5-6% range. They will come down, but not as quickly as commodity prices. Second, the Fed has to signal in some way that it won’t increase the Fed Funds rate beyond a certain level or time. Today, most expect the peak either late this year or early next year. Cuts should begin according to consensus sometime around spring 2023. That may be a bit optimistic. It’s hard to see inflation defeated with an unemployment rate below 4.0%. Finally, the political saber rattling between the U.S. and China must stay within bounds. Any sort of economic war between China and the U.S. would be harmful.
For now, that suggests a trading range until the fall. Said differently, the overall market isn’t going to be your friend or enemy over the next several months. That will accentuate good stock picking.
Today, actress Angie Harmon is 50.
James M. Meyer, CFA 610-260-2220